Assumptions of the BAT model

 The requirement of cash for the given period is known.

 The requirement of cash is evenly distributed for the given period.
 Selling of securities can be done immediately.
 There are two main costs associated with cash holding-opportunity cost and transaction
(or conversion) cost.
 The cost per transaction is constant regardless of the size of the transaction.
 The opportunity cost is a fixed percentage of the average value cash holding.

Let T = 12000 ( early cash requirement)

C = 1000
No of transactions in a year = 12000/1000 = 12
C = 6000, No of transactions in a year = 12000/6000 = 2
No of transaction in a year = T/ C
F is the cost of trading or shifting cash to your current act.
Total transaction charges = No of transactions X cost of transaction
Total transaction charges or conversion cost= T/C X F
Total Opportunity cost = C/2 X R
Total cost = Total transaction charges + Total Opportunity cost
TC = T/C X F + C/2 X R , We want to minimize TC.
[T , F, and R are constants. C is variable as you can change it.]
To get the minimum value of TC function, we differentiate it w.r.t. C.
TF C R
TC = C +
2 , we take its first derivative.
CR
TC = TF C-1 + 2 [ if f(x) = xn, then its first derivative: f/(x) = nxn-1 ]
 −2 R
TC/ = - TF C +
2 ; to get the minimum value we equate it to zero
TF R TF R 2TF
TC/ = 0 ; - + =0
C2 2
; =
C2 2
; R C2 = 2 TF ; C2 = R ;
2 TF
C* = √ R
; This is amount of cash the company should bring every time
in its current act. Doing so the total of cash management cost will be
minimum.

Ex. A company requires $500,000 in cash for meeting its transaction needs
over the next 6 months. The company can generate this amount of cash by using
marketable securities. These securities give 18% annual yield. The conversion of
marketable securities into cash entails a fixed cost of $500 per transaction. Find
the optimum cash conversion size.
Solution: Note that the transaction period is 6 moths or half year.
2 TF
C* =
√ R

T= $500,000; F= $500; R= 18% /2 = 6% for 6 months.

2 TF 2 ×500,000 ×500
C* =
√ R
=
√ 0.06
= 91,287.092917 = $91,287 (round figure)

Number of transactions = T/C = 500,000 / 91,287 = 5.477 or 5 transactions.

Average number of days per transaction = (30X6)/5 = 36 days
(30 days for a month)

Per day usage of cash = 91,287 / 36 = $2,535.75 = $2,536 (rounded figure)

Miller & Orr Model
It is an improvement over Baumol Model.
On the basis of empirical data, Miller and Orr argued that the cash balances fluctuate randomly.
It does not follow a constant consumption rate.
Baumol model tells us how much to be the optimum transaction size, but it does not talk about
treatment of surplus cash balance.

Assumptions

 The changes in cash balances are random. It is applicable for cash inflows and cash outflows
both.
 There are opportunities for transactions of marketable securities.
 Transaction of marketable securities has transaction cost.
 Holding of cash has opportunity cost.
 The firms maintain a minimum level of cash balance.
1
3 ×tr cost × var
S= ( 4R ) 3
[ R : daily interest rate]

LL : is set by the firm based on previous experience.

C* or RP = S + LL [RP : Return Point]
UL = RP + 2(RP – LL) = 3RP – 2LL or 3 C* - 2LL

Ex. A company provides the following information about its cash management system.
The annual yield on its marketable securities is 15%.
The fixed cost of per transaction of marketable securities transaction is $2000.
The standard deviation of the change in daily cash balance is $5,000. The minimum cash
balance is $50,000.
Calculate the return point (RP) and the upper limit (UL). [use 360 days for a year]
[Note: if number of days in a year is not given, take it 360 days.]
SOLUTION

R = 0.15/360 = 0.0004167
1 1
3 ×tr cost × var 3 ×2000 ×50002 3
S= ( 4R )=(
3
)
4 × 0.0004167
=¿44814.05 = 44814

RP or C* = S + LL = 44,814 + 50,000 = 94,814

UL = 3RP – 2LL = 3 X 94814 – 2 X 50,000
= 284,442 - 100,000 = $184,442