ACCA FM Syllabus C. Working Capital Management - Baumol Model - Notes ^{3 / 4}

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 $100,000 during the year, how much should we transfer into their account (from their deposit account)?

All of it would mean some of the cash 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.

Step forward the….Baumol model!

This works just like EOQ for stock. It tells you how much cash to order (sell investments / take from deposit account) at a time, in order to minimise holding (losing out on deposit interest) and order costs (cost of transferring cash / selling investments)..

Holding Cost 
= Average cash balance x Interest rate;
= Cash transferred in / 2 x interest rate
= HC/2 x i

Order Cost 
=  Total cash used during period / Cash transferred in X Transaction cost

(Annual Demand/Amount cash ordered (transferred) x Cost per Order

Total Cost = Opportunity cost + Trading cost

To calculate the optimum amount of cash to transfer use this equation:
√(2 x Order Cost x Annual demand for cash) / Holding cost (Interest)

Illustration

Subsonic Speaker Systems (SSS) has annual transactions of $9 million. The fixed cost of converting securities into cash is $264.50 per conversion. The annual opportunity cost of funds is 9%.

What is the optimal deposit size?

Square root (2 x 264.5 x 9,000,000 / 0.09)
= 230,000

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