Models for Cash Management and Temporary Investments

Objectives of the
chapter

To determine the To explore S. T. investment To see the role of

target cash balance strategies and to decide transaction costs of
whether it is worthwhile to investing and
make S. T. investments by disinvesting in these
analyzing a set of models for investment
situations where surplus is strategies.
small and is available for very
short period of time.
Factors affecting the level of target cash
balance
The optimum amount of cash held by a company usually depend on the
following factors:
• forecasts of the future cash inflows and outflows of the company;
• the efficiency with which the cash flows of the company are managed
(speeding up collection and controlling disbursement)
• the availability of liquid assets to the company;
• the borrowing capability of the company;
• the company’s tolerance of risk, or risk appetite
Determining the target cash balance
It involves a trade-off
between the opportunity
Starts with the projection of costs of holding too much
future net cash flows over a cash (lost interest) and the
near-term planning period transaction costs of holding
too little.
Target cash
balance
If a firm tries to keep its cash The transaction costs tend to
holdings too low, it will find fall as the cash balance
itself selling marketable becomes larger.
securities more frequently The opportunity cost of
than if the cash balance were holding cash rises as the cash
higher. holding rises.
Costs of Holding Cash
Costs in dollars of Transaction costs increase when the
holding cash firm must sell securities to meet cash
needs.
Total cost of holding cash
Opportunity
Costs

The investment income

foregone when holding
cash. Transaction
costs
C* Size of cash balance
 Determining the Target Cash Balance and
Investment strategy through these models

• The Baumol Model

• The Beranek Model
• The Miller-Orr Model
• The Stone Model

These models are useful to provide strategies for firms that have small surpluses available for short
period of time and where transaction costs play an important role.
Each model assumes a particular pattern of future cash flows and develops an optimum strategy for
investment and disinvestment for that assumed pattern based on the trade-off between investment
income (opportunity cost) and transaction cost
 The Baumol Model
Assumptions:

1. The firm is able to forecast its cash flow with certainty.

2. Cash inflows are periodic and instantaneous.
3. Cash outflows occur at a constant rate
4. The opportunity cost of holding cash is known and it does not change
over time
5. The firm will incur the same transaction cost for investment and
disinvestment

Cash Balance

C*
= 200,000

Time
3 6 9 12
The Baumol Model
a = cost of selling securities to raise cash
Y = The total amount of new cash needed
i = The opportunity cost of holding cash: this is the interest rate.
If we start with $C,
spend at a constant
rate each period and
C replace our cash with
$C when we run out of
cash, our average cash
C
balance will be C .
2 2
The opportunity
cost of holding C
2
Time C
1 2 3 i
2
The Baumol Model
a = The fixed cost of selling securities to raise cash
Y = The total amount of new cash needed
i = The opportunity cost of holding cash: this is the interest rate.
As we transfer $C to the
disbursement account (by
selling off the mkt sec)
C
each period, we incur a
transaction cost of a each
C period. If we need Y in
2 total over the planning
period we will pay $a, Y ÷
C times.
1 2 3 Time The transaction cost is Y
a
C
The Baumol Model
C Y
Total cost   i   a
2 C
C
Opportunity Costs i
2

Y
Transaction a
costs C
C* Size of cash balance
The optimal cash balance is found where the opportunity
costs equal the transaction costs
2Y
C 
*
a
i
The Baumol Model
The optimal cash balance is found where the opportunity cost
equals the trading costs
Opportunity Costs = Trading Costs

C Y
i  a
2 C
Multiply both sides by C

C2 Y a
i  Y a C  2
2

2 i
2Ya
C 
*

i
Baumol Model

* 2aY
C=
i

Here, C*= optimum cash balance

a = Cost per transaction
Y = Total funds required
i = return on marketable securities/ opportunity cost
Total Cost = i (C*/2) + a (Y/C*)

Holding cost Transaction cost

 Baumol’s Model

Illustration :

ABC Chemical limited estimates its total cash requirement as Tk. 2 crore next year. The
company’s opportunity cost of funds is 15% per annum. The company will have to incur
Tk. 150 per transaction when it converts its short-term securities to cash. Determine
the optimum balance. How much is the total annual cost of the optimum cash balance?

* 2(150) (20,000,000)
C= = Tk. 200,000
0.15

Total Cost = 0.15 (200,000/2) + 150 (20,000,000/200,000)

= Tk. 30,000
Baumol Model: Investment Strategy
Given the firm has periodic inflows and steady outflows, what is the
appropriate strategy for investing funds until they are needed?
1. Two-transaction strategy
2. Three-transaction strategy

Whether the three-transactions strategy is more profitable than

the two transaction strategy, that depends on the amount of
additional interest earned versus the additional transaction cost
paid.
Two-transaction strategy: One investment of funds and
one disinvestment of funds

• When cash flow is received, invest half

of the total inflow; put the remaining
half in the disbursement account

• During the first half of the period, pay

disbursements from the disbursement
account. This account will be exhausted
one half of the way through the period.
At that time sell the investments and
place the funds in the disbursement
account

• Use these funds to pay disbursements

during the remainder of the period.
Two-transaction strategy
Y = amount of cash inflow
i = interest rate per period
Interest income = (1/2)(1/2)Yi = (1/4)Yi
Profit = (1/4)Yi – 2a
Here, there are two transactions in this strategy: one investment and
one disinvestment and cost per transaction is “a”
Three-transaction strategy: One investment of funds and
two disinvestment of funds
• When cash flow is received, initially invest
two-thirds of the total inflow; put the
remaining one-third in the disbursement
account

• One-third of the way through the period,

the disbursement account will be exhausted.
At this time, disinvest one half of the funds
in the investment account and put the funds
in the disbursement account

• Two-thirds of the way through the period,

the disbursement account will again be
exhausted. Disinvest the remaining (1/3)Y in
the investment account and move the
proceeds to the disbursement account Use
these funds to pay disbursements during the
remainder of the period.
Three-transaction strategy
Interest income = (1/3)(2/3)Yi + (1/3) (1/3)Yi = (1/3)Yi
Profit = (1/3)Yi – 3a
Here, a = Cost per transaction
Y = Total funds required *
n= iY
i = return on marketable securities/ opportunity cost
n* = Optimal number of transaction 2a
n = number of transaction

Interest Income = [ (n-1)/2n]iY

Profit = [ (n* -1)/2 n*]iY – n*a
Initial Deposit = [ (n* -1)/ n*]Y
Withdrawal= [ 1/n*]Y

In Baumol Model, the firm will always make one deposit and (n* - 1)
withdrawals i.e. disinvestment from the investment account.
Example from ABC Chemical Company:

ABC Chemical limited estimates its total cash requirement as Tk. 2 crore next
year. The company’s opportunity cost of funds is 15% per annum. The company
will have to incur Tk. 150 per transaction when it converts its short-term
securities to cash. What is the optimal number of transaction and what is the
investment strategy?

* 0.15 * 20000000
n=
= 100
2* 150

Interest Income = [ (100-1)/2*100]*0.15*20000000 = 1485000

Profit = [ (100-1)/2*100]*0.15*20000000 - 0.15 (200,000/2) – 150* 100
= 1455000
Initial Deposit = [ (100 -1)/ 100]* 20000000 = 19800000

Withdrawal= [ 1/100]*20000000 = 200000

See the example from text page 129 last para