DETERMINING THE TARGET CASH

BALANCE

Target Cash Balance

The target cash balance involves a trade-off between the
opportunity costs of holding too much cash and the
trading cost of holding too little cash.
If a firm keeps its cash holdings too low, it will have to sell
marketable securities more frequently than if the cash
balance was higher.
The opportunity costs of holding cash rise and trading
costs fall as the cash holdings rise.

Determining the Target

Cash Balance
Cash Conversion Models balance the relevant
costs and benefits of holding cash versus
investing in marketable securities to determine
the economically optimum quantity of each.
The Baumol Model
The Miller-Orr Model

THE BAUMOL MODEL

Baumol Model
Assumptions of the model:
1. Net cash flow is the same everyday
2. Net cash flow is known with certainty

Baumol Model
Golden Peak Corp. began week 0 with a cash balance (C) of P1.2
million. Each week, outflows exceed inflows by P600,000. The
cash balance drops to zero at the end of week 2.
Average cash balance = (Beginning balance + Ending balance)
over the 2-week period
2
= (P1,200,000 + P0)
2
= P600,000

At the end of Week 2, the company replenishes its cash by selling

marketable securities.

Baumol Model

Baumol Model
If C were set higher, say P2.4 million, cash would last
4 weeks before the firm would have to sell
marketable securities, but the firms average cash
balance would increase to P1.2 million (from
P600,000).
If C were set at P600,000, cash would run out in 1
week, and the firm would have to replenish cash
more frequently, but the average cash balance would
fall from P600,000 to P300,000.

Baumol Model
To determine the optimal strategy, the firm needs to
know the following:
F = the fixed cost of selling securities to
raise cash (trading or transaction cost)
T = the total amount of cash needed over the
relevant planning period (for ex., one year)
K = the opportunity cost of holding cash (interest
rate)

Baumol Model
Opportunity costs (interest forgone):
= Average Cash Balance x Interest Rate
= (C/2) x K

Trading costs:
= No. of times the firm sells marketable securities x Fixed
Cost of trading
= (T/C) x F

Baumol Model
Assuming Golden Peak Corporations opportunity cost is 10%
and incurs $1,000 each time it sells its marketable securities.
Weekly cash requirement is $600,000; therefore total cash
needed in a year is $600,000 x 52 weeks or $31,200,000.

Baumol Model
Total Costs = Opportunity costs + Trading costs
= [(C/2) x K] + [(T/C) x F]
Using the numbers generated earlier, we have:

Notice that total costs start out at P246,500 and declines to about P82,000 before starting to
rise again.
So what is the optimal cash balance (ECONOMIC CONVERSION QUANTITY or ECQ)?

The Baumol Model

The optimal cash balance is found where the opportunity
costs equals the trading costs
Opportunity Costs = Trading Costs

C
T
K = F
2
C
Multiply both sides by C

T F
C =2
K

C
K =T F
2

2TF
C =
K
*

The Baumol Model

C
T
Total cost = K F
2
C

C
K
Opportunity Costs
2

Trading costs T F

C*
Size of cash balance
The optimal cash balance is found where the opportunity
costs equals the trading costs
C* =

2T
F
K

The Baumol Model

For Golden Peak Corp, we have T = P31.2,
F = P1,000, and K = 10%.
Therefore the optimum cash balance (ECQ) is:
_______________________
ECQ = (2 x P31,200,000 x P1,000)/.10
= P789,937

The Baumol Model

We can verify the answer by calculating the various costs at
this balance, as well as a little above and a little below:

The total cost at the ECQ level is P78,994, and it does appear to
increase as we move in either direction.

The Baumol Model

The Bulusan Corp. has cash outflows of P100
per day, seven days a week. The interest rate
is 5%, and the fixed cost of replenishing cash
balances is P10 per transaction. What is the
ECQ? What is the total cost? Assume a 365day year.

The Baumol Model

Total cash needed for the year is 365 x P100 = P36,500.
___________________
ECQ = (2 x P36,500) x 10)/.05
= P3,821
Average cash balance = P3821/2 = P1,911
Opportunity cost = P1,911 x .05 = P96
Because Bulusan needs P100 a day, the P3,821 balance will last 38.21 days
(P3,821/P100). The firm needs to replenish the account 365/38.21 or 9.6 times per
year. So the trading cost is:
Trading cost = 9.6 x P10 = P96
Total cost = Opportunity cost + Trading cost
= P 96 + P96
= P192

The Baumol Model

Advantage of the Baumol Model:
Simple to use

Limitations of the Baumol model:

assumes steady, certain cash flows
assumes a constant disbursement rate
ignores cash receipts during the period
does not allow for safety cash reserves

The Miller-Orr Model

The Miller-Orr Model

assumes that cash inflows and outflows fluctuate randomly from day to
day
management sets the lower limit (or safety stock), L, depending on how
much risk of a cash shortfall the firm is willing to tolerate.

as with the Baumol model, the optimal cash balance (Z) depends on
trading costs and opportunity costs.
the only extra data needed is 2, the variance of the net cash flow per
period. The period can be a day, a week, a year, for example, as long as
the interest rate and the variance are based on the same length of time.

The Miller-Orr Model

The firm allows its cash balance to wander randomly between
upper and lower control limits.
$ When the cash balance reaches the upper control limit H cash
is invested elsewhere to get us to the target cash balance Z.

H
When the cash balance
reaches the lower
control limit, L,
investments are sold
Z
to raise cash to get
us up to the target
cash balance.
L

Time

The Miller-Orr Model

Given L, which is set by the firm, the Miller-Orr
model solves for Z and H

H = 3Z 2L
3
F
Z* = 3
L
4K
where s2 is the variance of net daily cash flows.
The average cash balance in the Miller-Orr model
is
4Z * L
Average cash balance =
3
2

The Miller-Orr Model

Example:
F = P10
Minimum cash balance L = P100
Interest rate = 1% per month
Standard deviation of the monthly net cash
flows = P200

The Miller-Orr Model

The variance of the monthly net cash flows is 2 = P2002 =P40,000
Z = L + (3/4 x F x 2/K)1/3
= P100 + (3/4 x P10 x P40000/.01)1/3
= P411
The upper limit, H = ( 3 x Z ) (2 x L)
= (3 x P411) (2 x P100)
= P1,033
Average cash balance = [(4 x Z) L]/3
= [( 4 x P411) P100]/3
= P515

Implications of the Miller-Orr Model

To use the Miller-Orr model, the manager must
do four things:
1. Set the lower control limit for the cash balance.
2. Estimate the standard deviation of daily cash flows.
3. Determine the interest rate.
4. Estimate the trading costs of buying and selling

securities.

Exercises

Baumol Model
Your firm utilizes P165,000 a week to pay bills. The standard deviation of these
cash flows is P20,000. The fixed cost of transferring funds is P48 a transfer. The
applicable interest rate is 6%. The firm has established a lower cash balance limit
of P100,000. Answer these five questions using the Baumol model:
What is the optimal cash balance?
What is the optimal average cash balance?
What is the opportunity cost of holding cash?
What is the trading cost of holding cash?
What is the total cost of holding cash?

Baumol Model
Your firm utilizes P165,000 a week to pay bills. The standard deviation of these
cash flows is P20,000. The fixed cost of transferring funds is P48 a transfer. The
interest rate is 6% per annum. The firm has established a lower cash balance limit
of P100,000. Answer the following using the Baumol model:
What is the optimal cash balance? (P117,167)
What is the optimal average cash balance? (P58,584)
What is the opportunity cost of holding cash? (P3,515)
What is the trading cost of holding cash? (P3,515)
What is the total cost of holding cash? (P7,030)

Baumol Model
What is the optimal initial cash balance?

C* =
=

( 2T F)
R
2 $165,000 52 $48
.06

$823,680,000
=
.06
= $117,166.55
= $117,167

Miller-Orr model
Your firm utilizes P130,000 a week to pay bills. The standard deviation of these
cash flows is P15,000. The fixed cost of transferring funds is P51 a transfer. Your
firm has established a lower cash balance limit of P80,000. The weekly interest
rate is .067%. Use the Miller-Orr model to answer these three questions.

What is the optimal initial cash balance?

What is the optimum upper limit?
What is the average cash balance?

Miller-Orr model
What is the optimal initial cash balance?

3
s
C* = L F
R
4

1/ 3

3
$15,000

= $80,000 $51
.00067
4
= $80,000 $23,417.26
= $103,417.26
= $103,417

.33333

Miller-Orr model
What is the optimum upper limit?

U* = (3 C*) (2 L)
= (3 $103,417) (2 $80,000)
= $310,251 $160,000
= $150,251

Miller-Orr model
What is the average cash balance?

(4 C*) - L
Average cash balance =
3
(4 $103,417) $80,000
=
3
= $111,222.67
= $111,223