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Understanding Miller-Orr Cash Management Model

Mar 27, 2025

Lecture Notes: Cash Management - Miller-Orr Model

Introduction

  • This is the final lecture on cash management, Chapter 6.
  • Focuses on the Miller-Orr cash management model.
  • The emphasis is on understanding the concept rather than just calculations.

Key Concepts of the Miller-Orr Model

  • Objective: Efficient management of cash balances.
  • Cash Fluctuations:
    • Daily changes in cash balance due to receivables and expenses.
    • Goal is to avoid excess cash or shortages.

Cash Management Strategy

  • Short-term Deposits: Surplus cash should be placed on short-term deposits to earn interest.
  • Upper and Lower Limits:
    • Upper Limit: When cash exceeds this, it should be deposited.
    • Lower Limit: Minimum cash balance required to operate smoothly.
    • Return Point: The target cash balance—midpoint to return to after adjustments.

Calculating the Limits and Points

  • Lower Limit:
    • No formula; it depends on the company's cash budget and minimum operating cash.
  • Upper Limit:
    • Calculated by adding a "spread" to the lower limit.
    • Spread Formula:
      • 3 x (3/4 x Transaction Cost x Variance of Cash Flows) / Interest Rate^(1/3)
    • Terms:
      • Transaction Cost: Cost of moving cash to/from deposit.
      • Variance of Cash Flows: Derived from the standard deviation squared.
      • Interest Rate: Given as a daily rate.
  • Return Point:
    • Lower limit plus one-third of the spread.

Example Calculation

  • Given: Minimum balance of 10,000 (Lower Limit).
  • Transaction Cost: $5 per transaction.
  • Standard Deviation of Cash Flows: 2,000 per day.
  • Daily Interest Rate: Converted from annual to daily.
  • Spread Calculation:
    • Calculated using the given formula and figures.
  • Results:
    • Upper Limit = Lower Limit + Spread.
    • Return Point = Lower Limit + (1/3) Spread.
  • Practice with a calculator is recommended to handle the calculation complexities.

Important Reminders

  • Understanding the model conceptually is as important as the calculations.
  • Practice using the given formulas for spread and return point.
  • Recognize that lower and upper limits cater to a company's specific requirements, based on cash flow stability.

Conclusion

  • The lecture concludes the working capital segment of the syllabus.

Note: These notes are structured to summarize key points from the lecture on cash management and Miller-Orr model, suitable for review and study.

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