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  1. avatar says

    I read the comments left by ayeodele but I still can’t understand why the average amount of investment is 1,500,000 + 150,000 / 2… is there another way to explain this?

    Thank you very much

    • Profile photo of John Moffat says

      Suppose you start the day with $100 dollars in your pocket, and at the end of the day you have nothing left. Then on average you would have had 100/2 = $50.

      Suppose however the you start with $100 but at the end of the day you have still of $10 left. Surely on average you had a little more than before? On average it would be (100 + 10)/2 = $55.

      I hope that helps.
      (However, I really would not spend time on Baumol – I think the chances of it being asked are almost impossible. For that reason I am considering removing it from the notes (and removing the lecture) completely :-) )

    • Profile photo of John Moffat says

      They are selling investments of 150,000 each time. Since in total they need 1,500,000 during the year (spread evenly) it means they will be making 10 sales – i.e. selling every 5.2 weeks.

      At the start of the year they will be receiving interest on the full 1.5M, but as they sell off investments the amount they will be receiving interest on keeps falling by 150,000 every 5.2 weeks. For the final 5.2 weeks they will only be receiving interest on the last 150,000.

      It is all very approximate to be honest (and to my mind rather stupid – I cannot see it being particularly useful in real life!).
      I think that is the reason why the examiner simply never asks Baumol calculations (years ago he used to give the formula on the formula sheet, but removed it – presumably because he is not going to ask you to use it).

      I really would not spend time on it. Just be aware of the idea, because it would be good to briefly mention it in a written part of a question if you are asked to write about ways of managing cash. I think I am correct in saying that the only times ever it has been mentioned in the exam are that twice (over a period of at least 15 years) the examiner has made a passing mention of it in his answer to a written part of a question. He didn’t explain the technique – just mentioned it as being available :-)
      Miller Orr is far more practical and more important for the exam.

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