Unit - II : Management of Cash and Marketable Securities (8 Hrs)

Meaning of Cash, Motives for holding cash, objectives of cash management, factors
determining cash needs, Cash Management Models, Cash Budget, Cash
Management: basic strategies, techniques and processes, Lock Box system and
concentration banking, compensating balances ; Marketable Securities: Concept,
types, reasons for holding marketable securities, alternative strategies, choice of
securities; Cash Management Practices in India.

Meaning of Cash and cash Equivalent

The term cash and cash equivalents includes: currency, coins, cheque received but
not yet deposited, petty cash, savings accounts, money market accounts,
marketable securities and short-term, highly liquid investments with a maturity of
three months or less at the time of purchase such as treasury bills and commercial
paper. The items included as cash and cash equivalents must also be unrestricted.

A cash equivalent is a highly liquid investment having a maturity of three

months or less. It should be at minimal risk of a change in value.
Examples of cash equivalents are:

 Certificates of deposit
 Commercial paper
 Marketable securities
 Money market funds
 Short-term government bonds
 Treasury bills
CASH MANAGEMENT

Cash management is one of the key areas of working capital

management. Cash is the most liquid current assets. Cash is the common
denominator to which all current assets can be reduced because the other
major liquid assets, i.e. receivable and inventory get eventually converted
into cash. This underlines the importance of cash management.
The term “Cash” with reference to management of cash is used in
two ways. In a narrow sense cash refers to coins, currency, cheques, drafts
and deposits in banks. The broader view of cash includes near cash assets
such as marketable securities and time deposits in banks. The reason why
these near cash assets are included in cash is that they can readily be
converted into cash. Usually, excess cash is invested in marketable
securities as it contributes to profitability.
Cash is one of the most important components of current assets.
Every firm should have adequate cash, neither more nor less. Inadequate
cash will lead to production interruptions, while excessive cash remains
idle and will impair profitability. Hence, the need for cash management.
The cash management assumes significance for the following reasons.
SIGNIFICANCE
1. Cash planning - Cash is the most important as well as the least
unproductive of all current assets.
Though, it is necessary to meet the firm’s obligations, yet idle cash earns
nothing. Therefore, it is essential to have a sound cash planning neither
excess nor inadequate.
2. Management of cash flows - This is another important aspect of cash
management. Synchronization between cash inflows and cash outflows
rarely happens. Sometimes, the cash inflows will be more than outflows
because of receipts from debtors, and cash sales in huge amounts. At other
times, cash outflows exceed inflows due to payment of taxes, interest and
dividends etc. Hence, the cash flows should be managed for better cash
management.
3. Maintaining optimum cash balance - Every firm should maintain
optimum cash balance. The management should also consider the factors
determining and influencing the cash balances at various point of time.
The cost of excess cash and danger of inadequate cash should be matched
to determine the optimum level of cash balances.
4. Investment of excess cash - The firm has to invest the excess or idle
funds in short term securities or investments to earn profits as idle funds
earn nothing. This is one of the important aspects of management of cash.
 Thus, the aim of
cash management is to
maintain adequate cash
balances at one hand and
to use excess cash in
some profitable way on
the other hand.
MOTIVES
Motives or desires
for holding cash refer to
various purposes. The
purpose may be different
from person to person
and situation to situation.
There are four important
motives to hold cash.
a. Transactions motive -
This motive refers to the
holding of cash, to meet
routine cash requirements
in the ordinary course of
business. A firm enters
into a number of
transactions which
requires cash payment.
For example, purchase of
materials, payment of
wages, salaries, taxes,
interest etc. Similarly, a
firm receives cash from
cash sales, collections
from debtors, return on
investments etc. But the
cash inflows and cash
outflows do not perfectly
synchronise. Sometimes,
cash receipts are more
than payments while at
other times payments
exceed receipts. The firm
must have to maintain
sufficient (funds) cash
balance if the payments
are more than receipts.
Thus, the transactions
motive refers to the
holding of cash to meet
expected obligations
whose timing is not
perfectly matched with
cash receipts. Though, a
large portion of cash held
for transactions motive is
in the form of cash, a part
of it may be invested in
marketable securities
whose maturity conform
to the timing of expected
payments such as
dividends, taxes etc.
b. Precautionary motive
- Apart from the non-
synchronisation of
expected cash receipts
and payments in the
ordinary course of
business, a firm may be
failed to pay cash for
unexpected
contingencies. For
example, strikes, sudden
increase in cost of raw
materials etc. Cash held
to meet these unforeseen
situations is known as
precautionary cash
balance and it provides a
caution against them. The
amount of cash balance
under precautionary
motive is influenced by
two factors i.e.
predictability of cash
flows and the availability
of short term credit. The
more unpredictable the
cash flows, the greater the
need for such cash
balances and vice versa.
If the firm can borrow at
short-notice, it will need a
relatively small balance
to meet contingencies and
vice versa. Usually
precautionary cash
balances are invested in
marketable securities so
that they contribute
something to profitability.
c.Speculative motive -
Sometimes firms would
like to hold cash in order
to exploit, the profitable
opportunities as and when
they arise. This motive is
called as speculative
motive. For example, if
the firm expects that the
material prices will fall, it
can delay the purchases
and make purchases in
future when price actually
declines. Similarly, with
the hope of buying
securities when the
interest rate is expected to
decline, the firm will hold
cash. By and large, firms
rarely hold cash for
speculative purposes.
d. Compensation motive
- This motive to hold cash
balances is to compensate
banks and other financial
institutes for providing
certain services and loans.
Banks provide a variety
of services to business
firms like clearance of
cheques, drafts, transfer
of funds etc. Banks
charge a commission or
fee for their services to
the customers as indirect
compensation. Customers
are required to maintain a
minimum cash balance at
the bank. This balance
cannot be used for
transaction purposes.
Banks can utilize the
balances to earn a return
to compensate their cost
of services to the
customers. Such balances
are compensating
balances. These balances
are also required by some
loan agreements between
a bank and its customers.
Banks require a chest to
maintain a minimum cash
balance in his account to
compensate the bank
when the supply of credit
is restricted and interest
rates are rising.
Thus cash is
required to fulfill the
above motives. Out of the
four motives of holding
cash balances, transaction
motive and compensation
motives are very
important. Business firms
usually
do not speculate and need
not have speculative
balances. The
requirement of
precautionary balances
can be met out of short-
term borrowings.
Objectives
The basic objectives
of cash management
are
(i) to make the
payments
when they
become due
and
(ii)to minimize
the cash
balances. The
task before
the cash
management
is to reconcile
the two
conflicting
nature of
objectives.
1. Meeting the payments
schedule - The basic
objective of cash
management is to meet
the payment schedule. In
the normal course of
business, firms have to
make payments of cash to
suppliers of raw
materials, employees and
so on regularly. At the
same time firm will be
receiving cash on a
regular basis from cash
sales and debtors. Thus,
every firm should have
adequate cash to meet the
payments schedule. In
other words, the firm
should be able to meet the
obligations when they
become due.
The firm can
enjoy certain
advantages
associated with
maintaining
adequate cash.
They are:
a. Insolvency - The
question of
insolvency does not
arise as the firm
will be able to meet
its obligations.
b. Good relations -
Adequate cash
balance in the
business firm helps
in developing good
relations with
creditors and
suppliers of raw
 materials.
c. Credit worthiness -
The maintenance of
adequate cash
balances increase
the credit
worthiness of the
firm. Consequently
it will be able to
purchase raw
materials and
procure credit with
favorable terms and
conditions.
d. Availing discount
facilities - The firm
can avail the
discounts offered by
the creditors for
payments before the
due date.
e. To meet unexpected
facilities - The firm
can easily meet the
unexpected cash
expenditure in
situations like
strikes, competition
from customers etc.
with little strain.
So, every firm should
have adequate cash
balances for effective
cash management.
2. Minimising funds
committed to cash
balances - The second
important objective of
cash management is to
minimise cash balance. In
minimizing the cash
balances two conflicting
aspects have to be
reconciled. A high level
of cash balances will
ensure prompt payment
together with all
advantages, but at the
same time, cash is a non-
earning asset and the
larger balances of cash
impair profitability. On
the other hand, a low
level of cash balance may
lead to the inability of the
firm to meet the payment
schedule. Thus the
objective of cash
management would be to
have an optimum cash
balance.
Factors determining cash
needs - Maintenance of
optimum level of cash is
the main problem of cash
management. The level of
cash holding differs from
industry to industry,
organisation to
organisation. The
factors determining
the cash needs of the
industry is explained
as follows:
i. Matching of cash
flows - The first and
 very important
factor determining
the level of cash
requirement is
matching cash
inflows with cash
outflows. If the
receipts and
payments are
perfectly coincide
or balance each
other, there would
be no need for cash
balances. The need
for cash
management
therefore, due to the
non-synchronisation
of cash receipts and
disbursements. For
this purpose, the
cash inflows and
outflows have to be
forecast over a
WORKING CAPITAL
MANAGEMENT
 period of time say
12 months with the
help of cash budget.
The cash budget
will pin point the
months when the
firm will have an
excess or shortage
of cash.
ii. Short costs - Short
costs are defined as
the expenses
incurred as a result
of shortfall of cash
such as unexpected
or expected
shortage of cash
balances to meet the
requirements. The
short costs includes,
transaction costs
associated with
raising cash to
overcome the
shortage, borrowing
costs associated
with borrowing to
cover the shortage
i.e. interest on loan,
loss of trade-
discount, penalty
rates by banks to
meet a shortfall in
compensating, cash
balances and costs
associated with
deterioration of the
 firm’s credit rating
etc. which is
reflected in higher
bank charges on
loans, decline in
sales and profits.
iii. Cost of cash on
excess balances -
One of the
important factors
determining the
cash needs is the
cost of maintaining
cash balances i.e.
excess or idle cash
balances. The cost
of maintaining
excess cash balance
is called excess cash
balance cost. If
large funds are idle,
the implication is
that the firm has
missed
opportunities to
invest and thereby
lost interest. This is
known as excess
cost. Hence the cash
management is
necessary to
maintain an
optimum balance of
cash.
iv. Uncertainty in
business -
Uncertainty plays a
key role in cash
management,
 because cash flows
cannot be predicted
with complete
accuracy. The first
requirement of cash
management is a
precautionary
cushion to cope
with irregularities in
cash flows,
unexpected delays
in collections and
disbursements,
defaults and
expected cash needs
the uncertainty can
be overcome
through accurate
forecasting of tax
payments,
dividends, capital
expenditure etc. and
ability of the firm to
borrow funds
through over draft
facility.
iv. Cost of
procurement and
management of
cash - The costs
associated with
establishing and
operating cash
management staff
and activities
determining the
cash needs of a
business firm. These
costs are generally
 fixed and are
accounted for by
salary, storage and
handling of
securities etc. The
above factors are
considered to
determine the cash
needs of a business
firm.

THE STRATEGIES
FOR CASH
MANAGEMENT
I) Projection of cash
flows and cash
planning - The cash
planning and the
projection of cash flows
is determined with the
help of cash budget. The
cash budget is the most
important tool in cash
management. It is a
device to help a firm to
plan and control the use
of cash. It is a statement
showing the estimated
cash inflows and cash
outflows over the firm’s
planning horizon. In other
words the net cash
position i.e., surplus or
deficiency of a firm is
highlighted by the cash
budget from one
budgeting period to
another period.

Cash budget
Cash budget is a financial
budget prepared to
calculate the budgeted
cash inflows and outflows
during a period and the
budgeted cash balance at
the end of the period.
Cash budget helps the
managers to determine
any excessive idle cash or
cash shortage that is
expected during the
period. Such information
helps the managers to
plan accordingly. For
example if any cash
shortage in expected in
future, the managers plan
to change the credit
policy or to borrow
money and if excessive
idle cash is expected, they
plan to invest it or to use
it for the repayment of
loan.

All businesses need to

maintain a safe level of
cash to enable them to
carry on business
activities. The managers
of a business need to
determine that safe level.
The cash budget is then
prepared by taking into
consideration, that safe
level of cash. Thus, if a
cash shortage is expected
during a period, a plan is
made to borrow cash.
Format of cash budget
Cash Budget

For the period ending………

II) Determining optimal
level of cash holding in
the company - One of
the important
responsibilities of a
finance manager is to
maintain sufficient cash
balances to meet the
current obligations of a
company. Determining to
optimum level of cash
balance influenced by a
tradeoff between risk and
profitability. Every
business enterprise
holding cash balances for
transaction purposes and
to meet precautionary,
speculative and
compensative motives.
With the help of cash
budget the finance
manager predicts the
inflows and outflows of
cash during a particular
period of time and there
by determines the cash
requirements of the
company. While
determining the optimum
level of cash balance
(neither excess nor
inadequate cash balances)
the finance manager has
to bring a trade off
between the liquidity and
profitability of the firm.
The optimum level of
cash balances of a
company can be
determined in various
ways : They are
WORKING CAPITAL
MANAGEMENT
a) BAUMOL’s
Model Inventory
model (Economic
Order Quantity) to
cash management
b) Stochastic model
c)
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A)BAUMOL’s Model
Inventory Inventory
model (EOQ) to cash
management - Economic
Order Quantity (EOQ)
model is used in
determination of optimal
level of cash of a
company. According to
this model optimal level
of cash balance is one at
which cost of carrying the
inventory of cash and
cost of going to the
market for satisfying cash
requirements is
minimum. The carrying
cost of holding cash
refers to the interest
foregone on marketable
securities where as cost of
giving to the market
means cost of liquidating
marketable securities in
cash.
Optimum level of cash
balance can be
determined as follows:

C=
√2FT/r
Where C= Optimum
level of cash
Balance
F = Total
amount of
cash required
during the
year
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r = Cost of
carrying cash
inventory,
i
.e., interest
rate on
marketable
securities for
the period
involved.
Assumptions:
The model is
based on the
following
assumptions:
1) The demand for
cash, transactions
costs of obtaining
cash and the
 holding costs for a
particular period are
given and do not
change during that
period.
2) There is a constant
demand for cash
during the period
under consideration.
3) Cash payments are
predictable
4) Banks do not
impose any
restrictions on firms
with respect of
maintenance of
minimum cash
balances in the bank
accounts.
For example : Teja &
Company estimated cash
payments of Rs. 36,000
for a period of 30 days.
The average fixed cost
for securing capital from
the market (ordering cost)
is Rs. 100 and the
carrying cost or interest
rate on marketable
securities is 12% per
annum. Determine the
optimum quantity of cash
balance?

Optimum transaction of
cash: Rs. 8,485.28
Limitations - The EOQ
model to determine the
optimum size of cash
balances is suffered with
several practical
problems. The first and
important problem
(limitation) is related with
determination of fixed
cost associated with
replenishing cash. The
fixed cost includes both
explicit cost (interest rate
at which required capital
can be secured from the
market and implicit cost
(time spent in placing an
order for getting financial
assistance etc.) The
computation of implicit
cost is very difficult. The
model is not useful and
applicable where the cash
flows are irregular in
nature.
B) Stochastic (irregular)
Model - This model is
developed to avoid the
problems associated with
the EOQ model. This
model was developed by
Miller and Orr. The
basic assumption of this
model is that cash
balances are irregular,
i.e., changes randomly
over a period of time both
in size and direction and
form a normal
distribution as the number
of periods observed
increases. The model
prescribes two control
limits Upper control
Limit (UCL) and Lower
Control Limit (LCL).
When the cash balances
reaches the upper limit a
transfer of cash to
investment account
should be made and when
cash balances reach the
lower point a portion of
securities constituting
investment account of the
company should be
liquidated to return the
cash balances to its return
point. The control limits
are converting securities
into cash and the vice –
versa, and the cost
carrying stock of cash.
The Miller and
Orr model is the
simplest model to
determine the optimal
behavior in irregular cash
flows situation. The
model is a control limit
model designed to
determine the time and
size of transfers between
an investment account
and cash account. There
are two control limits.
Upper Limit (U) and
lower limit (L).According
to this model when cash
balance of the company
reach the upper limit,
cash equal to “U – O”
should be invested in
marketable securities so
that new cash balance
touches “O” point. If the
cash balance touch the
“L’ point, finance
manager should
immediately liquidate
that much portion of the
investment portfolio
which could return the
cash balance to ‘O’ point.
(O is optimal point of
cash balance or target
cash balance)
The “O” optimal
point of cash
balance is
determined by using
the formula

O=
Where,
O = target
cash balance
(Optimal cash
balance)
T= Fixed cost
associated
with security
transactions
I = Interest per
day on
marketable
 securities
V = Variance
of daily net
cash flows.
Limitations: This
model is subjected
to some practical
problems
1) The first and
important problem
is in respect of
collection of
accurate data about
transfer costs,
holding costs,
number of transfers
and expected
average cash
balance.
2) The cost of time
devoted by financial
managers in dealing
with the transfers of
cash to securities
and vice versa.
3) The model does not
take in account the
short term
borrowings as an
alternative to selling
of marketable
securities when cash
balance reaches
lower limit.
 Besides the
practical difficulties in
the application of the
model, the model helps in
providing more, better
and quicker information
for management of cash.
It was observed that the
model produced
considerable cost savings
in the real life situations.
C) Probability Model -
This model was
developed by William
Beranek. Beranek
observed that cash flows
of a firm are neither
completely predictable
nor irregular (stochastic).
The cash flows are
predictable within a
range. This occurrence
calls for formulating the
demand for cash as a
probability distribution of
possible outcomes.
According to this
model, a finance manager
has to estimate
probabilistic out comes
for net cash flows on the
basis of his prior
knowledge and
experience. He has to
determine what is the
operating cash balance
for a given period, what is
the expected net cash
flow at the end of the
period and what is the
probability of occurrence
of this expected closing
net cash flows.
The optimum cash
balance at the beginning
of the planning period is
determined with the help
of the probability
distribution of net cash
flows. Cost of cash
shortages, opportunity
cost of holding cash
balances and the
transaction cost.
Assumptions :
1) Cash is invested in
marketable
securities at the end
of the planning
period say a week
or a month.
2) Cash inflows take
place continuously
throughout the
planning period.
3) Cash inflows are of
different sizes.
4) Cash inflows are not
fully controllable by
the management of
firm.
5) Sale of marketable
securities and other
short term
investments will be
effected at the end
 of the planning
period.
The probability model
prescribed the decision
rule for the finance
manager that the finance
manager should go on
investing in marketable
securities from the
opening cash balance
until the expectation, that
the ending cash balance
will be below the
optimum cash balance,
where the ratio of the
incremental net return per
rupee of investment is
equal to the incremental
shortage cost per rupee.
D) The BAT Model
The Baumol-Allais-
Tobin (BAT) model is a
classic means of
analyzing the cash
management problem. It
is a straightforward
model and very useful for
illustrating the factors in
cash management and,
more generally, current
asset management.
To develop the BAT
model, suppose the
Golden Socks
Corporation starts at
Time 0 with a cash
balance of C 5 $1.2
million. Each week,
outflows exceed inflows
by $600,000. As a result,
the cash balance drops to
zero at the end of Week
2. The average cash
balance is the beginning
balance ($1.2 million)
plus the ending balance
($0) divided by 2, or
($1.2 million 1 $0)/2 5
$600,000 over the two-
week period. At the end
of Week 2, Golden Socks
replaces its cash by
depositing another $1.2
million.
As we have
described, the cash
management strategy for
Golden Socks is very
simple and boils down to
depositing $1.2 million
every two weeks.

WORKING CAPITAL
MANAGEMENT
 Implicitly, we
assume the net cash
outflow is the same every
day and it is known with
certainty. These two
assumptions make the
model easy to handle. We
indicate what happens
when they do not hold in
the next section.
If C were set
higher, say, at $2.4
million, cash would last
four weeks before the
firm would have to sell
marketable securities, but
the firm’s average cash
balance would increase to
$1.2
million (from $600,000).
If C were set at $600,000,
cash would run out in one
week and the firm would
have to replenish cash
more fre- quently, but its
average cash balance
would fall from $600,000
to $300,000.
Because transaction
costs must be incurred
whenever cash is
replenished (for example,
the brokerage costs of
selling marketable
securities), establishing
large initial balances
lowers the trading costs
connected with cash
management. However,
the larger the average
cash balance, the greater
is the opportunity cost
(the return that could
have been earned on
marketable securities).
III. Strategy for
economizing cash - Once
cash flow projections are
made and appropriate
cash balances are
established, the finance
manager should take
steps towards effective
utilization of available
cash resources. A number
of strategies have to be
developed for this
purpose they are: a)
Strategy towards
accelerating cash inflows,
and b) Strategy towards
decelerating cash
outflows
a) Strategy
towards accelerating
cash inflows - In order to
accelerate the cash
inflows and maximize the
available cash the firm
has to employ several
methods such as reduce
the time lag
between the movement of
a payment to the
company is mailed and
the movement of the
funds are ready for
redeployment by the
company. This includes
the quick deposit of
customer’s cheques,
establishing collection
centers and lock – box
system etc.
i) Quick deposit of
customer’s cheques -
The inflow is
accelerated through
quick deposit of
cheques in the banks,
the moment they are
received. Special
attention should be
given to deposit the
cheques without any
delay.
ii) Establishing
collection
centres/Concentr
ation Banking -
In order to accelerate
the cash inflows the
organization may
establish collection
centres in various
marketing centres of
the country. These
centres may collect
the cheques or
payments from the
customers and
deposit them in the
local bank. Thus,
these cheques are
 collected
immediately at the
collection centre and
the bank can transfer
the surplus money, if
any, to the
company’s main
bank. Thus, the
decentralized
collection system of
the company reduced
the time lag in cash
remittances and
collections.
iii) Lock-box method -
The new device
which is popular in
recent past is lock-
box method which
will help to reduce
the time interval
from the mailing of
the cheque to the use
of funds by the
company. Under this
arrangement, the
company rents lock-
box from post offices
through its service
area. The customer’s
are instructed to mail
cheques to the lock-
box. The company’s
bank collects the
mail from the lock-
box several times a
day and deposit them
directly in the
company’s account
 on the same day.
This will reduce the
time in mailing
cheques, deposit
them in bank and
thereby reduce
overhead costs to the
company. But one of
the serious
limitations of the
system is that the
banks will charge
additional service
costs to the
company. However,
this system is proved
useful and economic
to the firm.
b) Strategy for
slowing cash outflows -
In order to accelerate cash
availability in the
company, finance
manager must employ
some devices that could
slow down the speed of
payments outward in
addition to accelerating
collections. The methods
of slowing down
disbursements are as
flows:

WORKING CAPITAL
MANAGEMENT
SCHOOL OF DISTANCE
EDUCATION

i) Delaying outward
payment - The
finance manager can
increase the cash
turnover by delaying
the payment on bills
until the due date of
the no-cost period.
Thus, he can
economize cash
resources of the firm.
ii) Making pay roll
periods less frequent
- The firm can
economise its cash
resources by changing
the frequency of
disbursing pay to its
employees. For
example, if the
company is presently
paying wages weekly,
it can effect
substantial cash
savings if the pay is
disbursed only once in
a month.
iii) Solving
disbursement by use
of drafts - A
company can delay
disbursement by use
of drafts on funds
located elsewhere.
When the firm pays
the amount through
drafts, the bank will
 not make the payment
against the draft
unless the bank gets
the acceptance of the
issuer firm. Thus the
firm need not have
balance in its bank
account till the draft is
presented for
acceptance. On the
other hand, it will take
several days for the
draft to be actually
paid by the company.
Thus finance manager
can economize large
amounts of cash
resources for at least a
fort night. The funds
saved could be
invested in highly
liquid low risk assets
to earn income there
on.
iv) Playing the float -
Float is the difference
between the
company’s cheque
book balance and the
balance shown in the
bank’s books of
accounts. When the
company writes a
cheque, it will reduce
the balance in its
books of accounts by
the amount of cheque.
But the bank will
debit the amount of its
 customers only when
the cheque is
collected. On the
other hand, the
company can
maximize its cash
utilization by ignoring
its book balance and
keep its cash invested
until just before the
cheques are actually
presented for
payment. This
technique is known as
“playing the float”.
v) Centralized payment
system - A firm can
delay payments
through centralized
payment system.
Under this system,
payments will be
made from a single
central account. This
will benefit the
company.
vi) By transferring funds
from one bank to
another bank firm can
maximize its cash
turnover.
Models of Cash Management

The following points highlight the two models of cash management,

i.e., 1. William J. Baumol’s Model 2. Miller and Orr Model.
Cash Management Model # 1. William J. Baumol’s Model:

William J. Baumol developed a model (The Transactions Demand for

Cash: An Inventory Theoretic Approach) which is usually used in
inventory management but has its application in determining the optimal
cash balance also. Baumol found similarities between inventory
management and cash management.

As Economic Order Quantity (EOQ) in inventory management involves

tradeoff between carrying costs and ordering cost, the optimal cash
balance is the tradeoff between opportunity cost or cost of borrowing or
holding cash and the transaction cost (i.e. the cost of converting
marketable securities into cash etc.) The optimal cash balance is reached
at a point where the total cost is the minimum. The figure below shows
the optimum cash balance.

47
Illustration 1:

The annual cash requirement of A Ltd. is Rs 10 lakhs. The company has

marketable securities in lot sizes of Rs 50,000, Rs 1, 00,000, Rs 2,
00,000, Rs 2, 50,000 and Rs 5, 00,000. Cost of conversion of marketable
securities per lot is Rs 1,000. The company can earn 5% annual yield on
its securities. You are required to prepare a table indicating which lot
size will have to be sold by the company. Also show that the economic
lot size can be obtained by the Baumol Model.

48
Cash Management Model # 2. Miller and Orr Model:

Baumol’s model is based on the basic assumption that the size and
timing of cash flows are known with certainty. This usually does not
happen in practice. The cash flows of a firm are neither uniform nor
certain. The Miller and Orr model overcomes the shortcomings of
Baumol model.

M.H. Miller and Daniel Orr (A Model of the Demand for Money)
expanded on the Baumol model and developed Stochastic Model for
firms with uncertain cash inflows and cash outflows.

The Miller and Orr (MO) model provides two control limits-the
upper control limit and the lower control limit along-with a return
point as shown in the figure below:

49
When the cash balance touches the upper control limit (h), markable
securities are purchased to the extent of hz to return back to the normal
cash balance of z. In the same manner when the cash balance touches
lower control limit (o), the firm will sell the marketable securities to the
extent of oz to again return to the normal cash balance.

The spread between the upper and lower cash balance limits (called
z) can be computed using Miller-Orr model as below:

Variance of Cash Flows = (Standard deviation)2 or (s)2:

Illustration 2:

A company has a policy of maintaining a minimum cash balance of Rs

1, 00,000. The standard deviation in daily cash balances is Rs 10,000.
The interest rate on a daily basis is 0.01%. The transaction cost for each
sale or purchase of securities is Rs 50. Compute the upper control limit
and the return point as per the Miller-Orr model.

50
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