CASH MANAGEMENT MODELS

Cash management models are aimed at minimizing the total costs associated with movements
between a company's current account (very liquid but not earning interest) and their short-term
investments (less liquid but earning interest).

The target cash balance involves a trade-off between the opportunity costs of holding too much cash
and the trading costs of holding too little. For example if we know a division needs P100,000 during
the year, how much should we transfer into their account (from their deposit account)?

All of it would mean some of the cash are lying in the current account doing nothing (not getting
interest unlike in a deposit account) at the early stages; whereas, transferring bits at a time (when the
cash is needed) would mean lots of transaction costs.

The models are devised to answer the questions:

 At what point should funds be moved?
 How much should be moved in one go?

Two common models of cash management are: BAUMOL Model and MILLER-ORR Model.

BAUMOL Cash Management Model

The Baumol Model of Cash Management helps in determining a firm's optimum cash balance under
certainty. It is extensively used and highly useful for the purpose of cash management. As per the
model, cash and inventory management problems are one and the same.

William J. Baumol developed the model (The Transactions Demand for Cash: An Inventory Theoretic
Approach) which is usually used in inventory management and cash management. The model trades
off between holding cost (or opportunity cost or carrying cost) and transaction cost. As such, a firm
attempts to minimize the sum of the holding cash and the cost of converting marketable securities to
cash.

Use of the Baumol Model

The model enables companies to find out their desirable level of cash balance under certainty. The
model’s 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.

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 model is useful in this
regard.

Assumptions
There are certain assumptions or ideas that are critical with respect to the Baumol Model:
1. The particular company should be able to change the securities that they own into cash,
keeping the cost of transaction the same. Under normal circumstances, all such deals have
variable costs and fixed costs.

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 2. The company is capable of predicting its cash necessities. They should be able to do this with
a level of certainty. The company should also get a fixed amount of money. They should be
getting this money at regular intervals.
3. The company is aware of the opportunity cost required for holding cash. It should stay the
same for a considerable length of time.
4. The company should be making its cash payments at a consistent rate over a certain period of
time. In other words, the rate of cash outflow should be regular.

Basic Equation or Formula

The formula calculates Q, the amount of funds to inject into the current account or to transfer into
short-term investments at one time:

2𝐶𝑂 𝐷
𝑄= √
𝐶𝐻

where:
CO = costs per transaction (brokerage, commission, etc.)
D = demand for cash over the period
CH = cost of holding cash (interest rate); opportunity cost

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.

Equational Representations
 Annual Holding Costs = Opportunity Cost x Ave. Cash Balance = CH x (C/2
 Annual Transaction Costs = Cost per Transaction x No. of Transactions = CO x (D/C)
 Total Cost = Annual Holding Costs + Annual Transaction Costs = CH x (C/2) + CO x (D/C

Limitations of the Baumol model

 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

Example using the Baumol model

A company generates P10,000 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 P50.

Required
1. What is the optimum amount of cash to be invested in each transaction?
2. How many transactions will arise each year?
3. What is the cost of making those transactions p.a.?
4. What is the opportunity cost of holding cash p.a.?

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The MILLER-ORR Cash Management Model
The Miller-Orr model, the expanded the Baumol model developed by M.H. Miller and Daniel Orr (A
Model of the Demand for Money), is used for setting the target cash balance for a company. It deals with
cash inflows/outflows that change on a daily basis. It works in terms of upper and lower control
limits, and a target cash balance.

As long as the cash balance remains within the control limits the firm will make no transaction.

To use the Miller-Orr model, the manager must do four things

1. Set the lower control limits for the cash balance.
This lower limit can be related to a minimum safety margin decided by management
2. Estimate standard deviation of daily cash flows
3. Determine interest rate
4. Estimate the trading costs of buying and selling marketable securities.

The diagram below shows how the model works over time.
 The model sets higher and lower control limits, H and L, respectively, and a target cash
balance, Z.
 When the cash balance reaches H, then (H-Z) pesos are transferred from cash to marketable
securities, i.e. the firm buys (H-Z) pesos of securities.
 Similarly when the cash balance hits L, then (Z-L) pesos are transferred from marketable
securities to cash.

The lower limit, L is set by management depending upon how much risk of a cash shortfall the firm is
willing to accept, and this, in turn, depends both on access to borrowings and on the consequences of
a cash shortfall.

The formulae for the Miller-Orr model are:

𝟑
𝑺𝒑𝒓𝒆𝒂𝒅 (𝒁) = 𝟑( 𝒙 𝑻𝒓𝒂𝒏𝒔𝒂𝒄𝒕𝒊𝒐𝒏 𝑪𝒐𝒔𝒕 𝒙 𝑽𝒂𝒓𝒊𝒂𝒏𝒄𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘𝒔 ÷ 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑹𝒂𝒕𝒆)𝟏/𝟑
𝟒

𝑺𝒑𝒓𝒆𝒂𝒅 (𝒁)
𝑹𝒆𝒕𝒖𝒓𝒏 𝑷𝒐𝒊𝒏𝒕 = 𝑳𝒐𝒘𝒆𝒓 𝑳𝒊𝒎𝒊𝒕 +
𝟑

Notes:

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 • Variance of cash flows = standard deviation squared
• Variance and interest rates should be expressed in daily terms.

Benefits
1. Allows for net cash flows occurring in a random fashion.
2. Transfers can take place at any time and are instantaneous with a fixed transfer cost.
3. Produces control limits which can be used as basis for balance management.

Limitations
1. May prove difficult to calculate.
2. Monitoring needs to be continuous for the organization to benefit.

Comparison
Baumol Model is a deterministic model—Future cash requirements and disbursements are known with
perfect certainty.

Miller-Orr Model is a stochastic model—Daily cash flows vary according to a normal probability
distribution with known variance.

Example using the Miller-Orr model

The minimum cash balance of P20,000 is required at Miller-Orr Co, and transferring money to or from
the bank costs P50 per transaction. Inspection of daily cash flows over the past year suggests that the
standard deviation is P3,000 per day, and hence, the variance (standard deviation squared) is P9
million. The interest rate is 0.03% per day.

Required
1. The spread between the upper and lower limits
2. The upper limit
3. The return point.