Portmore Community College

Financial Management 2
Unit 2 Cash Management Model
The Baumol Model of cash management

Definition
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.
The Baumol-Tobin model is used in corporate finance as a cash management technique to help
determine the cash balance that grants the minimum amount of transaction cost and opportunity
cost (foregone interest on marketable securities).
Assumptions of Baumol-Tobin model
If the Baumol-Tobin model is applied, the following assumptions should be met:
1. The spending rate of cash is constant, and the total cash need is known in advance.
2. Funds can be held in either money or short-term investments (e.g., marketable
securities).
3. The minimum cash balance is zero.
4. The opportunity cost for holding cash is constant.
5. The excess cash is invested in marketable securities.
6. The transaction cost is the same each time when marketable securities are converted to
cash.
7. The line of credit or overdraft is not available.

Formula
The optimal cash balance (OCB) is derived from the Baumol-Tobin model total cost equation,

C× T×
TC
K  + F
= 
2 C

where C is the cash balance,

K or (i) is opportunity cost (e.g., interest rate on marketable securities),
T is annual total cash need, and
F is transaction cost (e.g., brokerage fee).

TC = Cost of holding cash + Transaction cost

TC= C x k + T x F
2 C

To find the cash balance with minimum total cost, we should calculate the derivative of the total
cost function with respect to variable “C” and set it equal to zero assuming that other variables
are constant.
0 K T×F
 - 
=  2 C 2

2×T×
C  = F
2

K
Solving the equation with respect to variable “C” will give the optimal cash balance.

Opportunity cost vs. transaction cost

Opportunity cost and transaction cost are inversely related. To decrease transaction cost, the
number of transactions should be reduced, which means a higher cash balance to be
maintained. Such a scenario leads to an increase in opportunity cost (the interest foregone on
marketable securities). In turn, reducing opportunity cost requires a lower cash balance to be
maintained, which leads to an increase in the number of transactions and therefore an increase
in transaction cost. Moreover, a low cash balance could negatively affect the solvency of a
company.
This relationship between opportunity cost and transaction cost is shown in the graph below.
Optimal cash balance calculation example question
XYZ Company has an annual total cash need of $3,000,000. The company has an opportunity to
buy a certificate of deposit with an annual fixed interest rate of 3.75%.(0.0375) The brokerage
cost is $750 per transaction.

Required: Determine:

i) the optimal cash balance

ii) the number of transactions per year
iii) average cash holdings
iv) the total cost of holding cash balances

C* = √ 2 × T×F
k
Where
T=3 000 000 ; F= $750 ; K=0.0375

C* = √ 2×3 000 000×750 = $346 410

0.0375

ii) No of transactions per year = T/C = 3 000 000/346 410 = 9

iii) average cash holdings = C/2 = $346 410/2=$173 205

iv)

TC = Cost of holding cash + Transaction cost

TC= C xk + T x F
2 C

TC = 173 205×0.0375 + 9×750= $13 245

To prove this is the minimum cost of holding this cash balance. We are going to use a cash
balance of $250 000 and $450 000
C = $250 0000 and $450 000
Graph
If the basic assumptions of the Baumol-Tobin model are met, the graph of cash spending and
cash balance replenishment is as follows:

The maximum cash balance equals the optimal cash balance and is being spent at a constant
rate until reaching zero. At this time, marketable securities should be sold to replenish the cash
balance to the maximum level.( optimal cash balance)

Question 2
Sada Plc requires $500 in cash for meeting its transaction needs of $500 000 over the next
five months.
• This amount is available to the firm in the form of marketable securities.
• It can earn 18 percent annual yield on its marketable securities. The conversion of
marketable securities into cash entails a fixed cost of $500 per transaction.
Required: Determine
i.) the optimum cash balance
ii.) Average cash holding
iii.) Number of transactions
iv.) Average number of days per transaction (assume 30 days per month)
v.) Total cost of holding cash balance
vi.) Per day usage of cash

i) C* = √ 2 × T×F
K
T = $500 000; K =0.18/12×5 =0.075 ; F=$500
C* = √2×500 000×500= $81650
0.075
ii)Average cash holdings = C/2 = $81 650/2= $40 825
iii) No. of transactions = T/C = 500 000/81 650 = 6
iv) Average number of days per transaction = (5×30)/6 = 25 days
v) TC = Cost of holding cash + Transaction cost
TC= C x k +T x F
2 C
TC = 40 825×0.075 + 6×500= $6 062

vi) Per day usage of cash = C*/ avg. no of days per transaction
= 81 625/25= $3 266
Question 3
Alley Ltd. requires $ 8.5 in cash for meeting its transaction needs of $800 000 over the next
four months.
• The firm has sufficient amount of marketable securities to arrange the cash when required.
• It can earn 20 percent annual yield on its marketable securities. The conversion of
marketable securities into cash entails a fixed cost of $ 600 per transaction.

Required: Determine
i.) the optimum cash balance
ii.) Average cash holding
iii.) Number of transactions
iv.) Average number of days per transaction (assume 30 days per month)
v.) Per day usage of cash.