Page 121 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes of these limits is reached. The assumption made here is that the net cash flows are normally
distributed with a zero value of mean and a standard deviation. This model provides two
control limits – the upper control limit and the lower control limit as well as a return point.
When the firm’s cash limit fluctuates at random and touches the upper limit, the firm buys
sufficient marketable securities to come back to a normal level of cash balance i.e. the return
point. Similarly, when the firm’s cash flows wander and touch the lower limit, it sells sufficient
marketable securities to bring the cash balance back to the normal level i.e. the return point.

The lower limit is set by the firm based on its desired minimum “safety stock” of cash in hand
The firm should also determine the following factors:
1. An interest rate for marketable securities, (i)
2. A fixed transaction cost for buying and selling marketable securities, (c)
3. The standard deviation if its daily cash flows, (s)

The upper control limits and return path are than calculated by the Miller-Orr Model as follows:
Distance between the upper limit and lower limit is 3Z.
(Upper limit – Lower limit) = (3/4 C Transaction Cost C Cash Flow Variance/Interest Rate) 1/3

Z = (3/4 C cs2/i) 1/3
If the transaction cost is higher or cash flows shows greater fluctuations, than the upper limit and
lower limit will be far off from each other. As the interest rate increases, the limits will come
closer. There is an inverse relation between the Z and the interest rate. The upper control limit
is three times above the lower control limits and the return point lies between the upper and
lower limits. Hence,
Upper Limit = Lower Limit + 3Z
Return Point = Lower Limit + Z
So, the firm holds the average cash balance equal to:

Average Cash Balance = Lower Limit + 4/3 Z
The Miller-Orr Model is more realistic as it allows variation in cash balance within the lower
and upper limits. The lower limit can be set according to the firm’s liquidity requirement. To

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