Lecture on Cash Management

This lecture pertains to Chapter 6 of the free lecture notes available on OpenTuition.com, focusing on cash management. It discusses the reasons for holding short-term cash and techniques related to managing it effectively.

Overview of Cash Management

• Importance of holding short-term cash.
• Techniques for managing cash:
  1. Cash Budgets (discussed in a previous lecture).
  2. Baumol Model (current focus).
  3. Miller-Orr Model (to be discussed in the next lecture).

Baumol Model

• Developed by Baumol; considered less practical but is part of the syllabus.
• Rarely mentioned in exams historically but should be understood for safety.
• Similar logic to inventory control models.

Example Scenario

• Cash Requirement: A company needs $1.5 million throughout the year.
• Interest Rates: Investments earn 9.5% and current account earns 5%.
• Transaction Costs: Selling investments incurs a $150 cost per transaction.

Strategies for Selling Investments

• Sell All at Once: Sell $1.5 million at the start, incur one transaction cost of $150, but lose interest on the full amount for the year.
• Sell in Parts: E.g., sell $750,000 every six months, incurring two transaction costs but less interest loss each period.

Calculating Costs

1. Selling Costs

   • Number of sales = Total cash needed / Amount sold per transaction.
   • Example: $1.5 million / $150,000 = 10 sales; Cost = 10 * $150 = $1,500.

2. Lost Interest

   • Compute average interest lost over the year.
   • Example: Start losing interest on $150,000, increasing to full amount lost by year-end.
   • Average interest lost is on $825,000 at 9.5%, resulting in $78,375.

3. Interest Earned on Current Account

   • Interest earned on average balance kept in the current account.
   • Example: Average balance $75,000 at 5% = $3,750 earned.*

Total Cost Calculation

• Total Cost = Selling costs + Lost interest - Interest earned.
• Example: $1,500 + $78,375 - $3,750 = $76,125 per year.

Economic Order Quantity (EOQ) for Cash

• Optimal selling quantity minimizes total costs.
• Formula similar to inventory control:
  • [ \sqrt{2 * (Annual Cash Requirement) * (Cost per Transaction) / Net Interest Rate} ]
• In the example, EOQ = $100,000.

Recalculating Costs with EOQ

• Selling Costs: $2,250 for 15 sales.
• Lost Interest: $76,000 on average cash holdings.
• Interest Earned: $2,500 on average current account balance.
• Net Total Cost: $75,750, lower than previous strategy.

Conclusion

• While the Baumol Model might seem impractical for many companies, understanding it is crucial for exams.
• The example demonstrates how different strategies and optimization can impact total costs.
• Upcoming lecture will cover the Miller-Orr Model, which is deemed more practical than the Baumol Model.