Baumol Model Of Cash Management Case Study

The operation of the model is as follows:

(i) A company should have its desired cash level, an upper limit and lower limit on cash balances.

(ii) When the cash balance reaches the upper limit, the company has too much cash. It then should use its cash to buy marketable securities in order to bring the cash balance back to its desired cash level.

(iii) When the cash balance hits the lower limit, the company lacks cash. It then sells its securities in order to bring the cash balance back to its desired cash level.

(iv) If the cash balance lies between the upper and lower limits, there will be no transaction in securities.

The Miller-Orr model increases its practicability by incorporating an assumption that cash balances randomly fluctuate

Baumol developed a model (The transactions Demand for Cash: An Inventory Theoretic Approach) which is usually used in Inventory management & cash management. Baumol model of cash management trades off between opportunity cost or carrying cost or holding cost & the transaction cost. As such firm attempts to minimize the sum of the holding cash & the cost of converting marketable securities to cash .Relevance at present many companies make an effort to reduce the costs incurred by owning cash. They also strive to spend less money on changing marketable securities to cash. The Baumol model of cash management is useful in this regard.

Use of Baumol Model

The Baumol model enables companies to find out their desirable level of cash balance under certainty. The Baumol model of cash management theory relies on the trade off between the liquidity provided by holding money (the ability to carry out transactions) and the interest foregone by holding one’s assets in the form of non-interest bearing money. The key variables of the demand for money are then the nominal interest rate, the level of real income which corresponds to the amount of desired transactions and to a fixed cost of transferring one’s wealth between liquid money and interest bearing assets.

Assumptions

There are certain assumptions or ideas that are critical with respect to the Baumol model of cash

Limitations

The Baumol model represents an important contribution to cash management. The limitations of the model include the following:

1 The model assumes the firm has a constant disbursement rate. In practice, disbursements can be only partially managed, because due dates differ, and costs cannot be predicted with certainty.

2 The model assumes there are no cash receipts during the projected period. In fact, most firms experience both cash inflows and outflows daily. 3 No safety stock is allowed. Firms will probably want to hold a safety stock of cash designed to reduce the possibility of a cash shortage or cash-out. However, to the extent that firms can sell marketable securities or borrow in a few hours, the need for a safety stock is minimal. The Baumol model is possibly the simplest and most stripped-down, sensible model for determining the optimal cash position. Its chief weakness is that it assumes discrete, certain cash flows. We next discuss a model designed to deal with