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Q. Calculate the optimum amount of funds to transfer?
The Baumol model is derived from the EOQ model and is able to be applied in situations where there is a constant demand for cash or cash disbursements. Regular transfers are made as of interest-bearing short-term investments or cash deposits into a current account. The Baumol model believes the annual demand for cash (D) the cost of each cash transfer (C) and the interest difference between the rate paid on short-term investments (r1) and the rate paid on a current account (r2) in order to calculate the optimum amount of funds to transfer (F). The model is like follows.
F = ((2 × D × C)/(r1 - r2))0.5
By optimising the amount of money to transfer the Baumol model minimises the opportunity cost of holding cash in the current account thereby reducing the costs of cash management. Nevertheless the Baumol model is unlikely to be of assistance to Thorne Co because of the assumptions underlying its formulation. Steady annual demand for cash is assumed whereas its cash budget suggests that Thorne Co has a varying need for cash. The model presumes that each interest rate and the cost of each cash transfer are constant and known with certainty. In reality interest rates as well as transactions costs aren't constant and interest rates, in particular can change frequently. A cash management model which is able to accommodate a variable demand for cash such as the Miller-Orr model may be more suited to the needs of the company.
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