Optimum cash balance - baumols model, Managerial Accounting

The Baumol Model in 1952 considers cash management complication as same to inventory management problem. For itself the firm attempts to minimize the total cost that is the sum of cost of holding cash and the transaction cost or cost of converting marketable securities to cash. The Baumol model is depends on the subsequent assumptions as:

  • The firm is capable to forecast its cash require with certainty,
  • The opportunity cost of holding cash is identified and it does not modify over time, and
  • The transaction cost is not change.

Let us suppose that the firm sells securities and begins with a cash balance of C rupees. Over a period of time this cash balance reduces steadily and attains zero. At that point the firm replenishes its cash balance to C rupees through selling marketable securities. Such pattern continues over an era of time. Because the cash balance decreases steadily thus the average cash balance is C/2. Such type of pattern is demonstrated in figure 3.

Cash Balance

245_Optimum Cash Balance - Baumols Model.png

Figure: Pattern of Cash Balance: Baumol's Model

The firm incurs a holding cost for keeping cash balance. This is an opportunity cost that is the return foregone on market-able securities. The firm's holding cost for maintaining an average cash balance is as given below, whether the opportunity cost is I:

Holding Cost = I (C/2).

The firm incurs a transaction cost when this converts its marketable securities to cash. Total number of transactions throughout the year would be the total fund need T divided via the cash balance C that is T/C. Because per transaction cost is assumed to be constant and whether per transaction cost is B the net transaction cost would be as B (T/C).

The total cost may be appears as: TC = I (C/2) + B (T/C)

= Holding cost + Transaction cost

 Here

 C =   Amount of marketable securities converted into cash per cycle

I    = Interest rate earned on marketable securities

T   = Projected cash requirement during the period

TC = Total cost or sum of conversion and holding costs.

The value of C that minimizes TC may be determined from the subsequent equation:

C* =√(2bt/I)

 The above equation is derived as given below:

Determine the first derivative of total cost function regarding C.

dTC/dC = ((I/2) - (bT/c2))

Setting the first derivative equivalent to zero, we acquire

((T/2) - (bT/ c2)) = 0

Solving for C as

C* =√(2bt/I)

One can confirm for second derivative condition ensuring that C* to be minimized.

Posted Date: 4/9/2013 3:40:26 AM | Location : United States







Related Discussions:- Optimum cash balance - baumols model, Assignment Help, Ask Question on Optimum cash balance - baumols model, Get Answer, Expert's Help, Optimum cash balance - baumols model Discussions

Write discussion on Optimum cash balance - baumols model
Your posts are moderated
Related Questions
Importance of a budget A Budget is a plan expressed in monetary terms. It is prepared prior to the budget period and may show income, expenses and the capital to be used i.e. a

differentiate between multiple product , selling cots and margin management

ABM(Activity based management): ABM system is primary source of information for AM as a part of ABM identify value added and non-value added activity and management are also to

The subsequent short-term investment opportunities are obtainable to companies in India to invest their temporary cash excess. a) Treasury Bills: Treasury Bills are short-term

Your manager has informed you that the company is trying to determine if it should use a periodic system or a perpetual system in accounting for the inventory. He wants you to spea

VALUE ADDED STATEMENTS Are intended to show how much wealth or value has been created by the company’s operations and how the wealth has been shared out to interested groups e.

Determine the Inputted cost It is hypothetical cost required to be considered to make costs comparable. It is the owner of the factory charges rent of the factory to the cost

After going through this section, you must be capable to: Know the concept and characteristics of working capital; Identify with the difference among net working capital

Cost Advantage and Value Chain Cost advantage is one of the two types of competitive advantage a firm may possess. Cost is also of vital significance to differentiation strate

Explains how activity –based techniques can be used to improve performance