ACCA F9 Management of Working Capital The Baumol Model (example 2)

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1. 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

• 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. says

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

• 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.

3. 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!

• 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 The next 150,000 will be withdrawn a few weeks later and so we will only lose part of a years interest on it, the next one a few weeks after that and so so.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.)

4. 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

5. says

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

6. 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!

7. 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?

8. 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.

9. 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.

• 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!

• 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.

10. 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.

• says

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

11. 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

• 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.

• 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.

• 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.

12. 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!!!

• 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.

• 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!!

13. says

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

14. 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

15. 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?

• 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