Cash management

Question 1

Intro (BM) - who and when?

Answer 1

Developed by William Baumol 1952

Question 2

Intro (BM) - inspired by what?

Answer 2

Inspired by inventory management models

Question 3

Intro (BM) - what does it do?

Answer 3

Balances trading costs and opportunity costs to find the optimal cash balance

Question 4

Intro (BM) - model assumes what?

Answer 4

Assumes steady predictable cash usage over time

Question 5

what kind of model is the Baumol model

Answer 5

A cash management model

Question 6

what are the two cash management models?

Answer 6

Baumol model and Miller-Orr model

Question 7

what is a key intro difference between the two cash management models?

Answer 7

The Miller-Orr model deals with more uncertain cash flows

Question 8

Cash management - what are the three reasons for holding cash?

Answer 8

Transactional purposes, compensating balances and investment opportunities

Question 9

Transactional purposes e.g

Answer 9

Such as paying dividends on stock

Question 10

Compensating balances explained

Answer 10

Some banks require firms to hold a minimum amount of cash in their account as part of a lending agreement

Question 11

Investment opportunities

Answer 11

Having excess cash at hand may allow firms to take advantage of investment opportunities

Question 12

what are the 2 costs of holding cash?

Answer 12

Trading costs and opportunity costs

Question 13

Opportunity cost meaning

Answer 13

The foregone returns that could’ve been earned from alternative investments

Question 14

Trading cost meaning

Answer 14

Relates to the costs incurred when converting assets to cash

Question 15

when is trading cost (TC) increased?

Answer 15

TC is increased when a firm must sell securities to establish a cash balance

Question 16

when is opportunity cost (OC) increased?

Answer 16

OC is increased when a firm has a cash balance when there is no return to cash

Question 17

BM how much cash should they keep? Here’s the trade off:

Answer 17

If they keep more cash they replenish less often saving on trading costs such as brokerage fees. However the larger the cash balance the greater the opportunity cost (which is the returns that could have been earned from marketable securities)

Question 18

BM what is the opportunity cost formula?

Answer 18

OC = (C/2) x R, where C is the cash replenishment level and R is the OC rate

Question 19

BM what is the trading cost formula?

Answer 19

TC = (T/C) x F, where T is the new cash needed over planning period, C is the cash replenishment level, F is the fixed cost of replenishing the cash and T/C is the amount of times a firm would need to convert securities into cash

Question 20

BM what is the equation for total cost?

Answer 20

OC + TC

Question 21

BM what is the equation for optimal cash balance? (given)

Answer 21

OCB = root (TF/R), where T is the new cash needed over planning period, F is the fixed cost of replenishing the cash and R is the OC rate

Question 22

what is the Baumol model limitation?

Answer 22

Assumptions don’t often hold in real life

Question 23

what assumptions don’t hold in real life?

Answer 23

Constant OC rate, FC of converting securities to cash, no safety stock of extra cash, constant disbursement rate for cash and no cash receipts during planning period

Question 24

Intro (MO) - who and when?

Answer 24

Miller and Orr 1966

Question 25

Intro (MO) - why?

Answer 25

Developed to better reflect how cash balances behave in reality

Question 26

Intro (MO) - what does it assume?

Answer 26

The model assumes that cash flows are random and allows for cash inflows and outflows

Question 27

Intro (MO) - how does it help?

Answer 27

Helps companies set upper and lower limits for cash balances like a "warning system"

Question 28

Intro (MO) - what happens between limits?

Answer 28

In between limits companies do nothing - they let cash balances "wander" naturally without taking action

Question 29

MO what is the equation for optimal cash balance? (given)

Answer 29

Z* is the optimal cash balance, F is the fixed cost of replenishing cash, 0^2 is the variance of cash flows, R is the OC rate typically expressed as a daily rate and L is the lower limit of cash balances

Question 30

MO what is the equation for optimal value of upper control limit?

Answer 30

U* = 3Z* - 2L

Question 31

What are the 3 application points of the MO model?

Answer 31

COVID-19 pandemic, trade tariffs and wars and geopolitical tension

Question 32

MO application COVID-19

Answer 32

Sudden and unpredictable changes in consumer demand and supply chain disruptions

Question 33

MO application trade tariffs

Answer 33

Such as US-China trade tariffs, unexpected cost increases for imported goods impact daily cash flows

Question 34

MO application wars and geopolitical tension

Answer 34

Volatile commodity prices (like oil and wheat) create unpredictable cash needs