- May 22, 2022 at 9:30 am #656172AFNAAANMember
- Topics: 16
- Replies: 12
King Co is a decentralised organisation whose different divisions have approached the
matter of cash control in different ways, partly because of their different circumstances.
Assume 365 days in a year.
The Western division is facing a two?year major capital investment programme for which
significant funds need to be raised to meet the steady demand for cash. The division
intends to use the ‘Baumol model’ to decide when to raise funds, which will be done by
selling off investments currently earning 5% per annum. The transaction cost of these sales
will be $500 per transaction and the total amount needed over the two years is $2,000,000.
The Alpine division has no significant investment plans but finds itself regularly having to
either sell investments to make funds available or invest surplus cash. This is because of
the considerable variation in daily cash inflows, which has been quantified as having a
standard deviation of $7,000. As a result, the division uses the ‘Miller?Orr model’ to
determine when to invest and when to make sales, using the same transaction cost and
investment rate as the Western division.
What does the Miller?Orr model suggest is the spread between the upper and
lower limits of cash levels that the Alpine division should maintain?
answer:Miller?Orr spread = 3 × (¾ × $7,000² × $500 ÷ (0.05/365))1/3 = $153,569
my quetion is why did they divide interst rate by 365????May 22, 2022 at 4:32 pm #656194John MoffatKeymaster
- Topics: 57
- Replies: 51555
Because it is the daily interest rate that we use in the formula.
I do explain this in my free lectures on cash management! The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
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