2. Baumol’s Model
Assumptions
Firm is able to forecast cash needs
The firm cash payments occur uniformly over a
period of time.
The opportunity cost of holding cash is known
The firm will incur same transaction cost
whenever it converts securities
3. Types of cost- while converting marketable
securities
Conversion cost per period
Cost incurred when converting marketable
securities each time.
Opportunity cost
Rate of return which is lost
4. Equations
1. Conversion cost per period = b (t/C)
b- cost per conversion
t- transaction cash needed for the period
C- cash balance
{total no of transactions = t/C
2. Opportunity cost = i (C/2)
5. Equations
Total cost = conversion cost + opportunity
cost
= b (t/C) + i (C/2)
Optimal conversion amount
=
2𝑏𝑡
𝑖
6. Limitations
• Certainty is not possible
• Nothing about precautionary cash reserves
• Does nit consider fluctuations in cash
requirement
• Transaction cost cannot be measured in
advance
• Interest rate also fluctuates frequently