| Baumols Model
firms try to minimise the sum of the cost of holding cash
and the cost of converting marketable securities to cash.
Baumols cash management model helps in determining
a firms optimum cash balance under certainty. As per
the model, cash and inventory management problems are one
and the same.
are certain assumptions that are made in the model. They
are as follows:
firm is able to forecast its cash requirements with certainty
and receive a specific amount at regular intervals.
2. The firms cash payments occur uniformly over a
period of time i.e. a steady rate of cash outflows.
3. The opportunity cost of holding cash is known and does
not change over time. Cash holdings incur an opportunity
cost in the form of opportunity foregone.
4. The firm will incur the same transaction cost whenever
it converts securities to cash. Each transaction incurs
a fixed and variable cost.
example, let us assume that the firm sells securities and
starts with a cash balance of C rupees. When the firm spends
cash, its cash balance starts decreasing and reaches zero.
The firm again gets back its money by selling marketable
securities. As the cash balance decreases gradually, the
average cash balance will be: C/2. This can be shown in
The firm incurs a cost known as holding cost for maintaining
the cash balance. It is known as opportunity cost, the return
inevitable on the marketable securities. If the opportunity
cost is k, then the firms holding cost for maintaining
an average cash balance is as follows:
cost = k (C/2)
the firm converts its marketable securities to cash, it
incurs a cost known as transaction cost. Total number of
transactions in a particular year will be total funds required
(T), divided by the cash balance (C) i.e. T/C. The assumption
here is that the cost per transaction is constant. If the
cost per transaction is c, then the total transaction cost
Transaction cost = c (T/C)
total annual cost of the demand for cash will be:
Total cost = k (C/2) + c (T/C)
level of cash balance
demand for cash, C increases, the holding cost
will also increase and the transaction cost will reduce
because of a decline in the number of transactions. Hence,
it can be said that there is a relationship between the
holding cost and the transaction cost.
optimum cash balance, C* is obtained when the total cost
cash balance (C*) = Ö2cT/k
Where, C* is the optimum cash balance.
T is the total cash needed during the year.
k is the opportunity cost of holding cash balances.
the increase in the cost per transaction and total funds
required, the optimum cash balance will increase. However,
with an increase in the opportunity cost, it will decrease.
of the Baumol model:
It does not allow cash flows to fluctuate.
2. Overdraft is not considered.
3. There are uncertainties in the pattern of future cash