Page 187 - DMGT409Basic Financial Management

Basic Financial Management

Notes Optimum cash balance can be determined by a number of mathematical models. But here the
most important two models are discussed. They are:
1. Baumol Model (Inventory Model)
2. Miller—Orr Model (Statistical Model)

11.6.1 Baumol Model

This model was developed by Baumol. This model is suitable only when the cost fl ows are
predictable (under certainty). It considers optimum cash balance similar to the economic order
quantity, since it is based on EOQ Concept and also in both the cases there is trade off between
cost of borrowing (sale of securities cost) and opportunity the cost. The point where the total cost
is minimum. Figure shows Baumol model.

!
Caution Baumol model is based on the following assumptions:

The firm knows its cash needs with certainty.
1. The cash payment (disbursement) of the firm occurs uniformly over a period of time

and is known with certainty.
2. The opportunity cost of holding cash is known and it remains stable over time.
3. The transaction cost is known and remains stable.

Elements of Total Cost

The total cost associated with management of cash under this model involves two elements (a)
Conversion cost (transaction cost) and (b) Opportunity cost (interest cost).
1. Conversion Cost (Transaction cost): Conversion costs are those costs that are associated

with sale of marketable security and raise whenever firm converts marketable security into
cash. Conversion Cost (C) = C [F/M]
Where, C = Cost per conversion;
F = Expected cash need for future period
M = Amount of marketable securities sold in each sale.

2. Opportunity Cost: Is the (cost benefit) foregone by holding idle cash. In other words,

opportunity cost is the interest forgone on an average cash balance. Symbolically,
Opportunity cost (O) = I (M ÷ 2)
Where, I = Interest rate that could have been earned

M ÷ 2 = Average can balance [(Opening cash + Closing cash)/2]
Total cost = Conversion cost + Opportunity cost

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