Chapter 6: Management of working capital (4) – Cash

(a) Cash transfers (Baumol). Next year a company forecasts a cash requirement of $1,500,000, the use being constant throughout the year. The company has investments in excess of this amount which are earning 9.5% p.a. The company earns interest of 5% on its current account bank balance. The cost of selling investments is $150 per transaction. (i) If the company sells $150,000 of investments each time, calculate the total cost p.a. to the company. (ii) What is the optimal economic quantity of cash to transfer each time? (iii) At that quantity, what is the total cost p.a.?

Economic quantity of cash = square root of (2 x annual cash required x cost of ordering cash / net interest cost of holding cash).

(b) Cash control limits (Miller-Orr). A company has decided it needs a minimum balance of $10,000. The transaction cost (of making transfers to or from deposit) is $5 per transaction. The standard deviation of cash flows is $2,000 per day, and the interest rate is 5.11% p.a. (or 5.11 / 365 = 0.014% per day). What should be the upper and lower limits, and the return point?

Spread = 3 x (3/4 x transaction cost x variance of cash flows / interest rate) to the power 1/3. Return point = lower limit + 1/3 x spread.