cash management model is discuss baumols model

1. CASH MANAGEMENT
MODELS
BAUMOL’S MODEL

2. DETERMING
OPTIMUM
CASH
BALANCE
CASH FLOW
IS CERTAIN
CASH FLOW
IS UNCERTAIN
THE
BAUMOL’S
MODEL
THE MILLER –
ORR MODEL

3. Optimum cash balance under certaninty: BAUMOL’S MODEL
Baumol model was introduced by : William J. Baumol
 Baumol model is similar to EOQ of inventory mgt.
 It trade off between opportunity/holding/carrying cost & the transaction cost .
 Baumol model of cash management helps in determining a firm’s optimum cash balance under certainty . try to
minimize the sum of the cost of holding cash and the cost of converting marketable securities to cash.
 The purpose of this model is to determine the minimum cost amount of cash that
a financial manager can obtain by converting securities to cash, considering the cost
of conversion and the counter-balancing cost of keeping idle cash balances which
otherwise could have been invested in marketable securities. The total cost associated
with cash management, according to this model, has two elements: (i) cost of
converting marketable securities into cash and (ii) the lost opportunity cost

4. Optimal cash
balance
For example, let us assume that the firm sells securities and starts with a cash balance of C rupees. When the firm spends
cash, its cash balance starts decreasing and reaches zero. The firm again gets back its money by selling marketable
securities. As the cash balance decreases gradually, the average cash balance will be: C/2. This can be shown in the
following figure

5. Costs involved :
Cost of holding cash + transaction cost = total cost
Holding cost – cost of keeping cash balance
he firm incurs a cost known as holding cost for maintaining the cash balance.
It is known as opportunity cost, the return inevitable on the marketable
securities.
K – opportunity cost , C- Cash balance
Holding cost = 𝑘
𝑐
2

6. Transaction cost – cost incurred in converting marketable
securities to cash .
Whenever the firm converts its marketablesecurities to cash, it
incurs a cost known as transaction cost.
T-total fund requirement , C-cash balance ,c – per transaction cost
Transaction cost = 𝑐
𝑇
𝑐
The total annual cost of the demand for cash will be:
Total cost = 𝑘
𝑐
2
+ 𝑐
𝑇
𝑐

7. Optimum cash balance C is obtained when the total cost is minimum .
Formula : optimum cash balance
C =
2𝑐𝑇
𝑘
C is the optimum cash balance
c is the cost per transaction
T is the total cash needed during the year
K is the opportunity cost of holding cash .

8. Assumptions
 The requirement for cash for a given period is known with
certainty.
 cash disbursement over a period of time is know with certainty
Selling of securities can be done immediately (There is no delay
in placing and receiving orders).
 Opportunity cost of holding cash is know and remain constant .
 Transaction cost of converting securities into cash is known and
remain constant .

10. Limitations:
Assumes a constant disbursement rate; in reality cash outflows occur
at different times, different due dates etc.
Assumes no cash receipts during the projected period, obviously
cash is coming in and out on a frequent basis.
No safety stock of cash is allowed for, reason being it only takes a
short amount of time to sell marketable securities.

11. Numerical
(Average cash balance = Cash conversion size/2)
C =
2𝑐𝑇
𝑘

12. Thank you