• 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.

  1. avatar says

    Dear John,
    Its( $1.5M ) is our requirement and we have this money tied-up in the investment. Now we are taking it off, then why we have used to call it as selling investment. To whom we are selling, its not that we are picking it off from the current investment and re-filling our requirement throughout the year. So what does it mean by selling investment?

    Many Thanks

    • Profile photo of John Moffat says

      There are various places that you might have invested the money – it might be invested in shares or government securities. If you want to get the money out then you need to sell some of the investments. (It doesn’t matter who you sell them to – you sell them on the stock exchange).

  2. Profile photo of massivecodedake says

    Dear John, I have two questions about your workings.The first one is that as we will lose the whole year’s interest from the investment once we withdraw the amount from investment.Why we need to calculate the average amount we withdraw from the investment when we calculate the lost interest?(Why just can”t be 1500000/EOQ*9.5%?) The second question is I remember F2 says that when the company order their goods in EOQ,the total order cost will equal to the
    total holding cost. Why your workings doesn’t show this conclusion? THX John!

    • Profile photo of John Moffat says

      In answer your first question, we are not losing a whole years interest. In part (a), we withdraw 150,000 at the start of the year and so lose a whole years interest on that. The next 150,000 will be withdrawn a few weeks later and so we will only lose part of a years interest on it, the next one a few weeks after that and so so. Instead of working out the interest lost on each withdrawal separately, we have calculated the interest lost on the average balance for the year.
      (Also, taking 1500000/EOQ x 9.5% would make no sense at all – interest is only on a cash amount and 1500000/EOQ is not a cash amount).

      With regard to your second question, in inventory control, at the EOQ the total order cost will indeed equal the total holding cost – but only if we ignore any fixed costs. The same happens here. If you look at the costings, then there is a term 1500000/2 x 9.5% which will be the same whatever the quantity of cash withdrawn each time. If this is removed from the costings then total order cost does equal total holding cost at the EOQ. (This is however irrelevant to both inventory control and to the Baumol cash model.)

  3. avatar says

    Hi Everyone,
    I have 2 questions which I really appreciate your help for. In the Practice Questions sheets, question number 5- Pearl plc, part b- Advise Emerald as to the most beneficial cash management policy:

    Question1: Average cash balances has been calculated as follows: $25,000/2= $12,500. Why did we divide it by 2?
    Question2: Should not the total income for the secured loan be: ($1.5m * 9%)=$135,000 instead of (%12 * $1.5m)=$180,000? if not, why not? Thanks a lot

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