The Baumol cash management model

The Baumol cash management model

Baumol noted that cash balances are very similar to inventory levels, and developed a model based on the economic order quantity(EOQ).Assumptions:
  • cash use is steady and predictable
  • cash inflows are known and regular
  • day-to-day cash needs are funded from current account
  • buffer cash is held in short-term investments.
The formula calculates the amount of funds to inject into the current account or to transfer into short-term investments at one time:
Q=square root 2 into C0 into D divide by Ch 
where:
CO = transaction costs (brokerage,commission, etc.)
D = demand for cash over the period
CH = cost of holding cash.
The model suggests that when interest rates are high, the cash balance held in non-interest-bearing current accounts should be low. However its weakness is the unrealistic nature of the assumptions on which it is based.

Example using the Baumol model

A company generates $10,000 per month excess cash, which it intends to invest in short-term securities. The interest rate it can expect to earn on its investment is 5% pa. The transaction costs associated with each separate investment of funds is constant at $50.

Required:

(a)What is the optimum amount of cash to be invested in each transaction?
(b)How many transactions will arise each year?
(c)What is the cost of making those transactions pa?
(d)What is the opportunity cost of holding cash pa?

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