Baumol cash model
The model assumes cash is used at a known steady rate and replenished in equal transfers from interest-earning assets or another specified source. The optimal transfer amount is C = sqrt(2FT/i), where F is fixed cost per transfer, T is cash required over the period and i is the opportunity-cost rate for that period. Average cash is C/2 in the basic model. The assumptions resemble those of EOQ and are restrictive where receipts and payments fluctuate unpredictably. Ensure the rate and cash requirement cover the same time period.
Worked example
Annual cash use is $1,200,000, each transfer costs $30 and the annual opportunity-cost rate is 6%. Optimal transfer C = sqrt(2 × 30 × 1,200,000/0.06) = approximately $34,641. Average cash is about $17,321 under the basic assumptions.
Common mistake
Using a monthly cash requirement with an annual interest rate, or treating the optimal transfer amount as the average balance.
Where it appears in your exams
| Qualification | Exam | Relationship | Period |
|---|---|---|---|
| ACCA | FM | Direct | September 2026–June 2027 |