I have a question – The cost of interest lost (0.095) and interest earned (0.05) is actually on different average amounts of cash (850,000) and (75,000) respectively in the year. But, still they are cancelled out and a net cost of 4.5 percent is considered in the denominator of the formulae (which means that the company is actually only losing 4.5 percent of 1.5 million investments, but they are actually losing out on more)

So, is this also one of the reasons why this model is not really practical, and perhaps a bit flawed?

I think this is not a reason why this model is not really practical: the formula is ok, but it seems there is an error.
This is a function of total cost: TC(q) = T * D / q + ((q + D) / 2) * r1 – q/2 * r2,
where T – transaction cost, D – total demand per year, q – quantity of investment to be solved, r1 – rate on investment, r2 – rate on current account bank balance.
So, to find EOQ (or economic quantity of cash) we should differentiate this function:
TC'(q) = (T * D * (-1 / q^2) + (q / 2) * (r1 – r2) + (D * r1) / 2)’ = (-T * D) / (q^2) + (r1 – r2) / 2 and then solve an equation: TC'(q) = 0.
(T * D) / (q^2) = (r1 – r2) / 2 q = sqrt((2 * T * D) / (r1 – r2)).

Mr. Moffat, you are fantastic! I couldn’t afford to sit classes for the ACCA and you have saved mine and many a career. If we have not said it enough you and Open tuition is amazing and we are so appreciative!

Good day sir
Thanks for the good lectures. Please why cant we calculate the total cost in the last example by simply multiplying the 800000 by the net percentage used it the formular that is 9.5%-5%=4.5% so we simply have 800000*4.5% since that is the percentage used in the formular. Thanks.

Dear Sir Moffat,
thanks for your lecture. It was great.
The formula states net interest cost of holding. I understand the example, but it is quite different from the practice question 5.
Here we use the gross costs for the lost investment and don’t add the first withdrawal to the 1.5m investment when calculating the lost interest. What are the reasons for the different approach?

It is a very very old exam question (which I am going to remove) and is actually not a very good question.
However, the question gave the formula and says what figures to actually use in the formula.

(The practice questions are going to be removed anyway. We have online MCQ tests for every chapter, and for long-form (section B) questions it is more important to attempt all the past exam questions listed in our free Study Guide (and preferably all the questions from a Revision Kit also 🙂 )

Good day sir Moffat
sir i am slightly confused about the explanation u have provided earlier.
why is it that we’ll be getting interest on the whole 1.5 million at the start of the year? Arent we going to sell off $150,000’s worth of investment at the beginning of the year itself to finance our cash requirements at the beg. months? And in that case,wont we just be getting interest on $1.35m?
also 5.2 weeks before the year end, wont we have sold the last $150,000 and hence receive no more interest?

Sir in that case, since the amount of investment on which we are earning interest is decreasing from $1.35m to 0 over the year,shouldnt we be calculating the average by (1.35m / 2)?
I am having difficulty grasping the logic behind d average computation shown

Just wanted to ask are all interest charges (per day) on overdrafts charged by taking the amount overdrawn by the end of day multiplied by the interest rate? (or for F9 purposes at least?

Good day Mr. Moffat, I still don’t get the reason why when it was time to do the average we kept doing 150000+1500000÷2 and 100000+1500000÷2. Instead of simply 1500000÷2.. I would appreciate if you can kindly shed more light on that. Thank you.

At the start of the year they have investment of 1,500,000 earning interest.
This amount is falling gradually over the year.
If it fell to zero by the end of the year, then the average amount on which interest is earned would be 1,500,000 / 2 = 750,000

If it falls to 150,000 by the end of the year, then the average amount on which interest is earned would be slightly higher: (1,500,000 + 150,000) / 2

Hi john sir.. your lectures are brilliant and very entertaining thanks alot… i wanna ask you about interest earn on current balance. I understood when we withdraw or sell investment we loose interest but how does it affect on current asset. In above example we r given 2 interest rate 5 and 9%. Does it mean we put this investment money in a bank once we took it off from investment.. thank you in advance..

Because you sell investments in ‘lumps’ you do not spend it all at once. For example. you might sell 100,000 of investments each time. You will spend that 100,000 but spread over a few weeks, not all at once.
As soon as you sell the investments you lose interest on the whole amount. Since you are not spending the amount all at once you will put it in an account to earn some interest (but at a much lower rate). So instead of losing all of the 9% you are only actually going to lose the difference of 4%.

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?

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.

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.

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?

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).

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!

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.)

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

Dear John,
May I say how much I love your lectures on F5 as well as F9. I gain a lot from your lectures. I just love the way you present them in such an understandable manner. In addition, your lectures are laced with some wry humour and your personal comment. You epitomise a British lecturer with that uncanny British accent. I just love it.
Cheers!

Suppose a company has an estimate of 1000 employees and raw material costing $50,000 to be used in next year. New machinery is being considered for purchase. 15 employees will work on this new equipment and $3000 worth of raw material will be used by this equipment. Electricity expense is $3000 of which $500 is consumed by the machine. Assume there is little or no depreciation.
Net Operating cash flows take out cash expenses, do these expenses include wages of 15 employees, $3000 spent on raw material and $500 of electricity.
If YES then why can’t we say NPV is expected net profit/loss for this project.
Secondly, other than depreciation can you name three other types of expenses that are not CASH expenses?

Dear Jhon,
Thanks a lot for such a quick reply to my previous post.
Can you please tell us
1) Which book are you using for lecture and notes?
2) Which exam kit, such as BPP or Kaplan or any other do you recommend for practice questions for F-9 Exam?

For my fellow students there is another approach to solve the Baumol model Question part a).
Step 1
Interest received (1,500,000-150,000)/2*.095=64125 (Since 150,000 is withdrawn on the first day of the year therefore we subtract it from 1,500,000 so the amount available for interest is 1350000 and therefore we divide it by 2 to calculate average)
See my previous post where I have proved 64125 of interest gained through month by month basis.
Step 2
Calculate interest received on current account 150,000/2=3750
Total interest received is 64125+3750=67875
Step 3
Total interest available if there were no withdraws from the bank 1,500,000*.095=142500
so interest forgone is 142500-67875=74625
Step 4
Transection cost 10*150=1500
So total cost interest forgone + transection cost
1500+74625=76125 Both methods give the same answer.

Dear Jhon
In burmol model you have taken average by adding the year beginning and and year end balance and dividing it by two (1,500,000+150,000)/2*.095, My question is that the ending balance is Zero so why are we not dividing (1,500,000+0)/2*.095 instead of adding 150,000.
Secondly if we do not take average instead calculate interest forgone month by month the correct answer is only achieved by (1,500,000-150,000)/2*.095.
Here is month by month working
Since on 1st of January we withdraw 150,000 so we are left with 1,350,000 also 9.5% is per annum and since we are making 10 transections this means after every 10/12=1.2months money is withdrawn. So .095*1.2/12 will give us interest per month. I have assumed every month consist of 30 days.
1st January 1,500,000 2nd January to 6th February interest lost 1,350,000*.095*1.2/12 =12825
7th February 1,350,000 8th February to 12th March interest lost 1,200,000*.095*1.2/12=11400
13th March 1,200,000 14th March to 18th April interest lost 1,050,000*.095*1.2/12=9975
19th April 1,050,000 20th April to 24th May interest lost 900,000*.095*1.2/12=8550
25th May 900,000 26th May to 30th June interest lost 750,000*.095*1.2/12=7125
1st July 750,000 2nd July to 6th August interest lost 600,000*.095*1.2/12=5700
7th August 600,000 8th August to 12th September interest lost 450,000*.095*1.2/12=4275
13th September 450,000 14th September to 18th October interest lost 300,000*.095*1.2/12=2850
19th October 300,000 20th October to 24th November interest lost 150,000*.095*1.2/12=1425
Once net payment is withdrawn on 25th November there is no balance left so for last month there will be no interest payment. Adding all these figures up gives us 64125 total interest lost in step 1 of part a).
(1,500,000-150,000)/2*.095=64125
The answer in lecture can be achieved if we add 14250 (1,500,000*.095*1.2/12) in 64125 to give 64125+14250=78375 but here we can see that we have to assume interest on 1,500,000 for 1.2 months which is irrational since 1,500,000 was never kept for 1.2 month to gain interest as this amount is withdrawn on the very first day of the year.
Please explain why there is difference between answers calculated through average approach and month by month approach.
Anyone who can answer this ambiguity please feel free to answer.

To answer the first part, we are not saying that the ending balance is 150,000.

What is happening is that we sell 150,000 of investments at the start of the year, and so initially we are losing interest on 150,000. We lose interest on this for 1.2 months (until the second sale takes place – there is a sale every 1.2 months since we need to make 10 sales to get the 1.5M).

After 1.2 months, we then sell another 150,000, so we are now losing interest on a total of 300,000 for the next 1.2 months.

After another 1.2 months we sell another 150,000, so now we are losing interest on a total of 450,000, and so on.

After the 10th sale, we have sold 1.5M in total, and so we then are losing interest on the full 1.5M.

You can work it out on each bit individually, but easier (and expected in the exam) is just to say that since we are losing interest on just 150,000 at the beginning, and on a total of 1.5M at the end, and therefore to calculate the interest as though for the whole year on the average amount. (Doing it on each bit individually may well be slightly different, but not significantly.)

Having said all that (and I hope that answers your problem), the examiner has never asked for calculations using Baumol (he has mentioned it briefly twice in written answers, but that is all). He has also removed the formula from the formula sheet (it used to be given several years ago) and so I will be astonished if he asks for any calculations on it in the future. (If he does then he will certainly give the formula in the question, but it is incredibly unlikely that he will ask calculations.) His reasoning is probably because it is all rather impractical! 🙂

Many thanks for explaining Baumol model in proper English, makes much more sense now.

But I do have a question about the example 2 you just did on the lecture. Where comes from and how we work out transaction costs and costs on lost interest it’s all clear an understanding. But I do loose a track of logic on how we work out earned interest of current account. To work out earned interest we have to AVERAGE AMOUNT x INTEREST% = interest earned p.a. in current bank account.

My question is why we do not multiply AVERAGE AMOUNT x INTEREST% x TIME OF TRANSFERS because we will get money in and out our current account several times during the year so that is why I would multiply everything by the time of transfers???

Please advise me on where do i loose a track of understanding on this topic. Many thanks for the answers.

Dear John,
in baumol model wrt interest lost calculation, as per your working its average of (150,000+1,500,000)/2*9.5%.
My doubt is in many of the financial management texts that i read it says that interest lost is 150,000/2*9.5%.
the explanation is opportunity cost on interest lost = avg cash balance * int rate
please help….

There are two elements to the interest.
One is the interest lost on the amount taken from investments, and the other is the interest earned on the amount in the current account.

With regard to the interest lost on the investments, they start the year having taken 150,000, but then as that 150,000 is spent they keep taking more 150,000 so that by the end of the year they have taken a full 1,500,000. So…they are losing interest on 150,000 at the beginning but on a full $1,500,000 by the end.
So the total interest lost is the average amount taken ((150,000 + 1,500,000)/2) times the interest rate.

With regard to the interest earned on the current account. They start the year with 150,000, they spend it and then get another 150,000 and so on. So the average balance on the current account is 150,000/2 = 75,000.

This is in line with all financial management texts.

Dear john,
I understand your point. But the problem is if i proceed as per your working my ordering cost wont be equal to interst lost at Economic order qty , which is the base of this formula as developed by Mr Baumol.
and sir please SUGGEST ME A GOOD FINANCIAL MANAGEMENT TEXT FOR REFERENCE. i would like to study this subject better.

The ‘ordering cost’ is the transaction cost every time we make a sale. It is nothing to do with the interest.
I really would not waste time reading up any more on Baumol – see my answer to the more recent question. Quite frankly I have stopped teaching it in detail on courses because it is so very very unlikely that he would ask it.

Thank you for the lecture….It seriously helped me a lot!!!
Can anyone tell me where is the lecture for payables-Ex 4 and 5???
In the lecture note they have shown just receivables 1,2 and 3 and have directly jumped to working capital cash budgets!!!

@s1234, during the lectures the lecturer noted that payable (ie eg 4 and 5) are similiar to eg 1,2 and 3,so we should work them out ourselves.He also said they are rarely asked in exams.

why do you subtract the interest earned on bank balance from the total cost to the company because im thinking that if the interest was earned then it shouldnt be considered when calculating cost to the company. are we working under the assumption that the 5% earned on the current account is included in the total but if so then we wouldnt be truly withdrawing the full $1500000 from investments

thanks for the really helpful video
got a question:
Why the average interest loss using(150,000+1,500,00)/2
But interest earned on current account only use 150,000/2
Don’t they share the same logic? total deposit added up at the end of the year should be the same as total investment sold which is $1,500,000, isn’t it?

@gtr32, The current account only includes the investment sold which is $150,000 at no time is there ever 1.5m in the current account because investments are transferred when needed. So we only find the interest earned on the 150,000 investment transferred.

In my little summation, the monies being transferred are as needed and therefore at any one time the balance in the account is $150,000 – 0 before another transfer takes place

Chetan says

Hi Sir, Great lecture as always!

I have a question – The cost of interest lost (0.095) and interest earned (0.05) is actually on different average amounts of cash (850,000) and (75,000) respectively in the year. But, still they are cancelled out and a net cost of 4.5 percent is considered in the denominator of the formulae (which means that the company is actually only losing 4.5 percent of 1.5 million investments, but they are actually losing out on more)

So, is this also one of the reasons why this model is not really practical, and perhaps a bit flawed?

Roman says

Hello!

I think this is not a reason why this model is not really practical: the formula is ok, but it seems there is an error.

This is a function of total cost: TC(q) = T * D / q + ((q + D) / 2) * r1 – q/2 * r2,

where T – transaction cost, D – total demand per year, q – quantity of investment to be solved, r1 – rate on investment, r2 – rate on current account bank balance.

So, to find EOQ (or economic quantity of cash) we should differentiate this function:

TC'(q) = (T * D * (-1 / q^2) + (q / 2) * (r1 – r2) + (D * r1) / 2)’ = (-T * D) / (q^2) + (r1 – r2) / 2 and then solve an equation: TC'(q) = 0.

(T * D) / (q^2) = (r1 – r2) / 2 q = sqrt((2 * T * D) / (r1 – r2)).

Aleena says

Mr. Moffat, you are fantastic! I couldn’t afford to sit classes for the ACCA and you have saved mine and many a career. If we have not said it enough you and Open tuition is amazing and we are so appreciative!

Thank you

John Moffat says

Thank you very much indeed for your comment 🙂

Ernest says

Good day sir

Thanks for the good lectures. Please why cant we calculate the total cost in the last example by simply multiplying the 800000 by the net percentage used it the formular that is 9.5%-5%=4.5% so we simply have 800000*4.5% since that is the percentage used in the formular. Thanks.

John Moffat says

9.5% is lost on all the money taken from investments, 5% is earned on the average short-term balance.

Ernest says

Its clear to me now. Thank you very much.

John Moffat says

You are welcome 🙂

Raphael says

Dear Sir Moffat,

thanks for your lecture. It was great.

The formula states net interest cost of holding. I understand the example, but it is quite different from the practice question 5.

Here we use the gross costs for the lost investment and don’t add the first withdrawal to the 1.5m investment when calculating the lost interest. What are the reasons for the different approach?

Best regards, Raphael

John Moffat says

It is a very very old exam question (which I am going to remove) and is actually not a very good question.

However, the question gave the formula and says what figures to actually use in the formula.

(The practice questions are going to be removed anyway. We have online MCQ tests for every chapter, and for long-form (section B) questions it is more important to attempt all the past exam questions listed in our free Study Guide (and preferably all the questions from a Revision Kit also 🙂 )

Raphael says

Thanks a lot for the answer and also for the exam advice 😉

Wish you a pleasant weekend.

John Moffat says

Thank you, and you too 🙂

sayma says

Good day sir Moffat

sir i am slightly confused about the explanation u have provided earlier.

why is it that we’ll be getting interest on the whole 1.5 million at the start of the year? Arent we going to sell off $150,000’s worth of investment at the beginning of the year itself to finance our cash requirements at the beg. months? And in that case,wont we just be getting interest on $1.35m?

also 5.2 weeks before the year end, wont we have sold the last $150,000 and hence receive no more interest?

John Moffat says

That is true and the way Baumol takes the average is only a rough approximation.

sayma says

Sir in that case, since the amount of investment on which we are earning interest is decreasing from $1.35m to 0 over the year,shouldnt we be calculating the average by (1.35m / 2)?

I am having difficulty grasping the logic behind d average computation shown

sayma says

sorry i meant our investment is decreasing from $1.5 m to 0.

therefore, shouldnt average be(1.5m/2) instead of

(1.5 m + 150000)/2?

John Moffat says

I can only repeat my previous reply. That is the way that we use the Baumol formula.

Ali Karmali says

Hi John.

Just wanted to ask are all interest charges (per day) on overdrafts charged by taking the amount overdrawn by the end of day multiplied by the interest rate? (or for F9 purposes at least?

John Moffat says

Yes (and usually in real life also 🙂 )

Ali Karmali says

Hi John.

Conversely, Is the interest earned on a term deposited earned the same way, per day?

John Moffat says

Yes, but deposits are usually for fixed periods and usually at fixed interest.

Susan says

Good day Mr. Moffat, I still don’t get the reason why when it was time to do the average we kept doing 150000+1500000÷2 and 100000+1500000÷2. Instead of simply 1500000÷2.. I would appreciate if you can kindly shed more light on that. Thank you.

John Moffat says

At the start of the year they have investment of 1,500,000 earning interest.

This amount is falling gradually over the year.

If it fell to zero by the end of the year, then the average amount on which interest is earned would be 1,500,000 / 2 = 750,000

If it falls to 150,000 by the end of the year, then the average amount on which interest is earned would be slightly higher: (1,500,000 + 150,000) / 2

Ali Karmali says

But it does fall to zero at the end, doesnt it? I mean once u sell off the final 150

I dont get it.

John Moffat says

For the first month they would be earning interest on the full 1,500,000. In the last month they earn interest on 150,000.

Ali Karmali says

In other words, the remaining 150,000 will earn some interest by the time it is sold off and hence ghats makes the average higher?? Right?

John Moffat says

Right 🙂

javid says

Hi john sir.. your lectures are brilliant and very entertaining thanks alot… i wanna ask you about interest earn on current balance. I understood when we withdraw or sell investment we loose interest but how does it affect on current asset. In above example we r given 2 interest rate 5 and 9%. Does it mean we put this investment money in a bank once we took it off from investment.. thank you in advance..

John Moffat says

Because you sell investments in ‘lumps’ you do not spend it all at once. For example. you might sell 100,000 of investments each time. You will spend that 100,000 but spread over a few weeks, not all at once.

As soon as you sell the investments you lose interest on the whole amount. Since you are not spending the amount all at once you will put it in an account to earn some interest (but at a much lower rate). So instead of losing all of the 9% you are only actually going to lose the difference of 4%.

javid says

Thank you for your reply.. god bless you. Very good explanation. Thank you.

siddharth says

sir , please can u explain y in transaction cost , even after we calculate 1.5M / 150000 .. we multiply 10 ??

John Moffat says

1.5M/150,000 = 10, so there are 10 transactions a year. Each transaction costs 150, so the total cost over the year is 10 x 150 = $1500.

Killqa 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

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.

sab says

Wow I liked that example.

Thank you so much for clarifying it…..

GOD you are so kind and so helpful!!

May God Bless You.

umer says

This explanation on how the average is calculated was really helpful. Thank you sir

ayeodele says

why is the average 150,000+1500,000/2 instead of 1500,000/2 not quite clear

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.

acca2050 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

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).

sdmaalex says

Great Lecture! I attended F9 classes in my country, but I cannot remember attempting any questions regarding this area. Anyhow, thanks alot!

John Moffat says

Thank you. It is almost impossible that he will ask calculations on this, but it is nice to mention if there is a written part on cash management.

sdmaalex says

Thanks alot 🙂

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!

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.)

MIB 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

nari says

FYI

On page 143, there’s a typo regarding the calculation for $76,000- $150,000 was used instead of $100,000.

M Fauzi says

Dear John,

May I say how much I love your lectures on F5 as well as F9. I gain a lot from your lectures. I just love the way you present them in such an understandable manner. In addition, your lectures are laced with some wry humour and your personal comment. You epitomise a British lecturer with that uncanny British accent. I just love it.

Cheers!

sam420 says

Suppose a company has an estimate of 1000 employees and raw material costing $50,000 to be used in next year. New machinery is being considered for purchase. 15 employees will work on this new equipment and $3000 worth of raw material will be used by this equipment. Electricity expense is $3000 of which $500 is consumed by the machine. Assume there is little or no depreciation.

Net Operating cash flows take out cash expenses, do these expenses include wages of 15 employees, $3000 spent on raw material and $500 of electricity.

If YES then why can’t we say NPV is expected net profit/loss for this project.

Secondly, other than depreciation can you name three other types of expenses that are not CASH expenses?

sarmad738 says

Dear Jhon,

Thanks a lot for such a quick reply to my previous post.

Can you please tell us

1) Which book are you using for lecture and notes?

2) Which exam kit, such as BPP or Kaplan or any other do you recommend for practice questions for F-9 Exam?

For my fellow students there is another approach to solve the Baumol model Question part a).

Step 1

Interest received (1,500,000-150,000)/2*.095=64125 (Since 150,000 is withdrawn on the first day of the year therefore we subtract it from 1,500,000 so the amount available for interest is 1350000 and therefore we divide it by 2 to calculate average)

See my previous post where I have proved 64125 of interest gained through month by month basis.

Step 2

Calculate interest received on current account 150,000/2=3750

Total interest received is 64125+3750=67875

Step 3

Total interest available if there were no withdraws from the bank 1,500,000*.095=142500

so interest forgone is 142500-67875=74625

Step 4

Transection cost 10*150=1500

So total cost interest forgone + transection cost

1500+74625=76125 Both methods give the same answer.

sarmad738 says

Dear Jhon

In burmol model you have taken average by adding the year beginning and and year end balance and dividing it by two (1,500,000+150,000)/2*.095, My question is that the ending balance is Zero so why are we not dividing (1,500,000+0)/2*.095 instead of adding 150,000.

Secondly if we do not take average instead calculate interest forgone month by month the correct answer is only achieved by (1,500,000-150,000)/2*.095.

Here is month by month working

Since on 1st of January we withdraw 150,000 so we are left with 1,350,000 also 9.5% is per annum and since we are making 10 transections this means after every 10/12=1.2months money is withdrawn. So .095*1.2/12 will give us interest per month. I have assumed every month consist of 30 days.

1st January 1,500,000 2nd January to 6th February interest lost 1,350,000*.095*1.2/12 =12825

7th February 1,350,000 8th February to 12th March interest lost 1,200,000*.095*1.2/12=11400

13th March 1,200,000 14th March to 18th April interest lost 1,050,000*.095*1.2/12=9975

19th April 1,050,000 20th April to 24th May interest lost 900,000*.095*1.2/12=8550

25th May 900,000 26th May to 30th June interest lost 750,000*.095*1.2/12=7125

1st July 750,000 2nd July to 6th August interest lost 600,000*.095*1.2/12=5700

7th August 600,000 8th August to 12th September interest lost 450,000*.095*1.2/12=4275

13th September 450,000 14th September to 18th October interest lost 300,000*.095*1.2/12=2850

19th October 300,000 20th October to 24th November interest lost 150,000*.095*1.2/12=1425

Once net payment is withdrawn on 25th November there is no balance left so for last month there will be no interest payment. Adding all these figures up gives us 64125 total interest lost in step 1 of part a).

(1,500,000-150,000)/2*.095=64125

The answer in lecture can be achieved if we add 14250 (1,500,000*.095*1.2/12) in 64125 to give 64125+14250=78375 but here we can see that we have to assume interest on 1,500,000 for 1.2 months which is irrational since 1,500,000 was never kept for 1.2 month to gain interest as this amount is withdrawn on the very first day of the year.

Please explain why there is difference between answers calculated through average approach and month by month approach.

Anyone who can answer this ambiguity please feel free to answer.

John Moffat says

To answer the first part, we are not saying that the ending balance is 150,000.

What is happening is that we sell 150,000 of investments at the start of the year, and so initially we are losing interest on 150,000. We lose interest on this for 1.2 months (until the second sale takes place – there is a sale every 1.2 months since we need to make 10 sales to get the 1.5M).

After 1.2 months, we then sell another 150,000, so we are now losing interest on a total of 300,000 for the next 1.2 months.

After another 1.2 months we sell another 150,000, so now we are losing interest on a total of 450,000, and so on.

After the 10th sale, we have sold 1.5M in total, and so we then are losing interest on the full 1.5M.

You can work it out on each bit individually, but easier (and expected in the exam) is just to say that since we are losing interest on just 150,000 at the beginning, and on a total of 1.5M at the end, and therefore to calculate the interest as though for the whole year on the average amount. (Doing it on each bit individually may well be slightly different, but not significantly.)

Having said all that (and I hope that answers your problem), the examiner has never asked for calculations using Baumol (he has mentioned it briefly twice in written answers, but that is all). He has also removed the formula from the formula sheet (it used to be given several years ago) and so I will be astonished if he asks for any calculations on it in the future. (If he does then he will certainly give the formula in the question, but it is incredibly unlikely that he will ask calculations.) His reasoning is probably because it is all rather impractical! 🙂

amitacharya says

This one is very good explanation Mr.John. You are a star. I had also doubt earlier but now it is all clear. Many Thanks.

skarotaegle says

Many thanks for explaining Baumol model in proper English, makes much more sense now.

But I do have a question about the example 2 you just did on the lecture. Where comes from and how we work out transaction costs and costs on lost interest it’s all clear an understanding. But I do loose a track of logic on how we work out earned interest of current account. To work out earned interest we have to AVERAGE AMOUNT x INTEREST% = interest earned p.a. in current bank account.

My question is why we do not multiply AVERAGE AMOUNT x INTEREST% x TIME OF TRANSFERS because we will get money in and out our current account several times during the year so that is why I would multiply everything by the time of transfers???

Please advise me on where do i loose a track of understanding on this topic. Many thanks for the answers.

John Moffat says

Sorry for not replying to this sooner – I missed it. I hope my answer to the recent question above answers your question also.

priyanair says

Dear John,

in baumol model wrt interest lost calculation, as per your working its average of (150,000+1,500,000)/2*9.5%.

My doubt is in many of the financial management texts that i read it says that interest lost is 150,000/2*9.5%.

the explanation is opportunity cost on interest lost = avg cash balance * int rate

please help….

John Moffat says

There are two elements to the interest.

One is the interest lost on the amount taken from investments, and the other is the interest earned on the amount in the current account.

With regard to the interest lost on the investments, they start the year having taken 150,000, but then as that 150,000 is spent they keep taking more 150,000 so that by the end of the year they have taken a full 1,500,000. So…they are losing interest on 150,000 at the beginning but on a full $1,500,000 by the end.

So the total interest lost is the average amount taken ((150,000 + 1,500,000)/2) times the interest rate.

With regard to the interest earned on the current account. They start the year with 150,000, they spend it and then get another 150,000 and so on. So the average balance on the current account is 150,000/2 = 75,000.

This is in line with all financial management texts.

priyanair says

Dear john,

I understand your point. But the problem is if i proceed as per your working my ordering cost wont be equal to interst lost at Economic order qty , which is the base of this formula as developed by Mr Baumol.

and sir please SUGGEST ME A GOOD FINANCIAL MANAGEMENT TEXT FOR REFERENCE. i would like to study this subject better.

John Moffat says

The ‘ordering cost’ is the transaction cost every time we make a sale. It is nothing to do with the interest.

I really would not waste time reading up any more on Baumol – see my answer to the more recent question. Quite frankly I have stopped teaching it in detail on courses because it is so very very unlikely that he would ask it.

amitacharya says

Again Nice Explanation.

parker01 says

This was great thanks sir.

lolo822 says

Thanks this was very helpful

hammadsana says

U are great Sir

faizan1185 says

no sound of lecture please check……

s1234 says

Thank you for the lecture….It seriously helped me a lot!!!

Can anyone tell me where is the lecture for payables-Ex 4 and 5???

In the lecture note they have shown just receivables 1,2 and 3 and have directly jumped to working capital cash budgets!!!

Pobeak says

@s1234, during the lectures the lecturer noted that payable (ie eg 4 and 5) are similiar to eg 1,2 and 3,so we should work them out ourselves.He also said they are rarely asked in exams.

Al-shaad says

@s1234, Please see at the end of your lecture notes, the solutions + workings!

As the Lecturer said, it’s worked out in the same way as Receivables!!

rssd says

Dear Admin

Why iam not able to view lecture on Management of working capital (The Baumol method) example 2. Please advice….

admin says

@rssd, Lecture works fine,

Please visit the support page: http://opentuition.com/support/ for help

neishai says

why do you subtract the interest earned on bank balance from the total cost to the company because im thinking that if the interest was earned then it shouldnt be considered when calculating cost to the company. are we working under the assumption that the 5% earned on the current account is included in the total but if so then we wouldnt be truly withdrawing the full $1500000 from investments

praveenkaur says

Thanks

gtr32 says

thanks for the really helpful video

got a question:

Why the average interest loss using(150,000+1,500,00)/2

But interest earned on current account only use 150,000/2

Don’t they share the same logic? total deposit added up at the end of the year should be the same as total investment sold which is $1,500,000, isn’t it?

tameablebunchy says

@gtr32, The current account only includes the investment sold which is $150,000 at no time is there ever 1.5m in the current account because investments are transferred when needed. So we only find the interest earned on the 150,000 investment transferred.

In my little summation, the monies being transferred are as needed and therefore at any one time the balance in the account is $150,000 – 0 before another transfer takes place

Comments anyone