PDF | On Jan 1, , Jiří Valecký and others published Baumol's model for cash management with random value of transactions. The Baumol Model William Baumol was the first to provide a formal model of cash management incorporating opportunity costs and trading costs.1 His model . Cash Management models by William J Baumol Miller and Orr; 3. William J. Baumol's Model William J. Baumol developed a model (The.

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BAUMOL'S MODEL - Free download as Powerpoint Presentation .ppt), PDF File .pdf), Text File .txt) or view presentation Stone Model for Cash Management. Cash management is concerned with the managing of (i) Cash flows into and out of .. Baumol Model: The Baumol cash management model provides a formal. The Baumol-Allais-Tobin (BAT) model is a classic means of analyzing the cash model and very useful for illustrating the factors in cash management and.

Delaying Disbursements Accelerating collections is one method of cash management; paying more slowly is another. The cash disbursement process is illustrated in Fig. Techniques to slow down disburse- ment will attempt to increase mail time and cheque clearing time.

Corporate customers Local bank Post office deposits lockbox receipts Corporate Funds are transferred to customers concentration bank by depository checks and wire transfers. Concentration bank Cash manager analyses bank balance and deposit internation and revises cash allocation.

Firm cash manager Maintenance of Short-term Maintenance of Disbursements cash reserves investments of cash compensating balance at creditor bank Figure Float in terms of slowing down payment cheques comes from mail delivery, cheque processing time, and collection of funds. This is illustrated in Fig. Disbursement float can be increased by writing a cheque on a geographically distant bank. For example, a British supplier might be paid with cheques drawn on an Italian bank.

This will increase the time required for the cheques to clear through the banking system. The account has a zero balance as cheques are written. As cheques are presented to the zero-balance account for payment causing a negative balance , funds are automatically transferred in from a central control account.

The master account and the ZBA are located in the same bank.

Thus the transfer is automatic and involves only an accounting entry in the bank. Drafts Firms sometimes use drafts instead of cheques. Drafts differ from cheques because they are drawn not on a bank but on the issuer the firm and are payable by the issuer.

The bank acts only as an agent, presenting the draft to the issuer for payment. Devices to delay cheque clearing Delivery of cheque to supplier. Write cheque on distant bank. Hold payment for several days after postmarked in office.

Call supplier firm to verify statement accuracy for large amounts. Bank collects funds. After the draft has been accepted, the firm must deposit the necessary cash to cover the payment.

The use of drafts rather than cheques allows a firm to keep lower cash balances in its disbursement accounts, because cash does not need to be deposited until the drafts are presented for payment. If not, a cash manager could be drawing on uncollected cash as a source for making short-term investments.

Most banks charge a penalty for use of uncollected funds. However, banks may not have good enough accounting and control procedures to be fully aware of the use of uncollected funds. This raises some ethical and legal questions for the firm. Electronic data interchange EDI is a general term that refers to the growing practice of direct electronic information exchange between all types of business.

One important use of EDI, often called financial EDI, or FEDI, is to transfer financial information and funds electronically between parties, thereby eliminating paper invoices, paper cheques, mailing and handling. For example, it is possible to arrange to have your cheque account directly debited each month to pay many types of bill, and corporations now routinely directly deposit pay cheques into employee accounts.

More generally, EDI allows a seller to send a bill electronically to a downloader, thereby avoiding the mail. The downloader can then authorize payment, which also occurs electronic- ally. The net effect is that the length of time required to initiate and complete a business transaction is shortened considerably, and much of what we normally think of as float is sharply reduced or eliminated. As the use of FEDI increases which it will , float management will evolve to focus much more on issues surrounding computerized information exchange and fund transfers.

The initiative aims to harmonize payments across Europe by treating the different countries within the region as a single area.

Introduction and links with the related literature

As a result, the payment system in Europe will be akin to a domestic market, and clearing times will be improved accordingly. The forms of payment affected by SEPA are credit transfers, direct debits, and credit and debit card payments. Full adoption of SEPA is expected by the end of The market for short-term financial assets is called the money market. The maturity of short-term financial assets that trade in the money market is one year or less.

Most large firms manage their own short-term financial assets, transacting through banks and dealers.

Some large firms and many small firms use money market funds. These are funds that invest in short-term financial assets for a management fee. The management fee is compensation for the professional expertise and diversification provided by the fund manager. Among the many money market mutual funds, some specialize in corporate customers. Banks also offer sweep accounts, where the bank takes all excess available funds at the close of each business day and invests them for the firm.

Firms have temporary cash surpluses for these reasons: to help finance seasonal or cyclical activities of the firm, to help finance planned expenditures of the firm, and to provide for unanticipated contingencies. Seasonal or Cyclical Activities Some firms have a predictable cash flow pattern.

They have surplus cash flows during part of the year and deficit cash flows the rest of the year. Such a firm may download marketable securities when surplus cash flows occur and sell marketable securities when deficits occur. Of course, bank loans are another short-term financing device. Planned expenditures Firms frequently accumulate temporary investments in marketable securities to provide the cash for a plant construction programme, dividend payment, and other large expenditures.

Thus firms may issue bonds and shares before the cash is needed, investing the proceeds in short-term marketable securities, and then selling the securities to finance the expenditures. The important characteristics of short-term marketable securities are their maturity, default risk, marketability and taxability.

Maturity Maturity refers to the time period over which interest and principal payments are made. Seasonal demand for investing is low. The surplus cash flow is invested in short-term marketable securities. Time 2: A deficit cash flow exists.

Seasonal demand for investing is high. The financial deficit is financed by selling marketable securities, and by bank borrowing. As a consequence, firms that invest in long-maturity securities are accepting greater risk than firms that invest in securities with short-term maturities. This type of risk is usually called interest rate risk.

Most firms limit their investments in marketable securities to those maturing in less than 90 days. Of course, the expected return on securities with short-term maturities is usually less than the expected return on securities with longer maturities.

Default Risk Default risk refers to the probability that interest or principal will not be paid on the due date or in the promised amount.

Baumol-Tobin Model of Cash Management (With Diagram)

These ratings are connected to default risk. Of course, some securities have negligible default risk, such as Treasury bills. Given the pur- poses of investing idle corporate cash, firms typically avoid investing in marketable securities with significant default risk.

Marketability Marketability refers to how easy it is to convert an asset to cash. Sometimes marketability is referred to as liquidity. It has two characteristics: 1 No price pressure effect: If an asset can be sold in large amounts without changing the market price, it is marketable.

Price pressure effects are those that come about when the price of an asset must be lowered to facilitate the sale. In general, marketability is the ability to sell an asset for its face market value quickly and in large amounts. The most marketable of all securities are Treasury bills of developed countries. Taxability Several kinds of security have varying degrees of tax exemption: The interest on the bonds of governments tends to be exempt from taxes.

Pre-tax expected returns on government bonds must be lower than on similar taxable investments, and therefore are more attractive to corporations in high marginal tax brackets.

The market price of securities will reflect the total demand and supply of tax influences. The position of the firm may be different from that of the market. Different Types of Money Market Security Money market securities are generally highly marketable and short-term. They usually have low risk of default. They are issued by governments Treasury bills, for example , domestic and foreign banks certificates of deposit, for example , and business corporations commercial paper, for example.

Treasury bills are obligations of the government that mature in 90, , or days. They are pure discount securities. The day and day bills will be sold by auction every week, and day and day bills will be sold at longer intervals, such as every month. Treasury notes and bonds have original maturities of more than one year. They are interest- bearing securities. The interest may be exempt from state and local taxes.

Commercial paper refers to short-term securities issued by finance companies, banks and corporations. Commercial paper typically is unsecured. Maturities range from a few weeks to days. There is no active secondary market in commercial paper. As a consequence, their marketability is low.

However, firms that issue commercial paper will directly redownload before maturity. The default risk of commercial paper depends on the financial strength of the issuer. Certificates of deposit CDs are short-term loans to commercial banks.

There are active markets in CDs of 3-month, 6-month, 9-month and month maturities. Redownload agreements are sales of government securities for example, Treasury bills by a bank or securities dealer with an agreement to redownload. Redownload agreements are usually very short-term — overnight to a few days.

Eurodollar CDs are deposits of cash with foreign banks. Summary and Conclusions The chapter discussed how firms manage cash. The Baumol model and the Miller—Orr model are two transaction models that provide rough guidelines for determining the optimal cash position. Some methods to speed collection are lockboxes, concentration banking and wire transfers.

The money market offers a variety of possible vehicles for parking this idle cash. How about too little? What is the situation here? If this is an ongoing situation, what ethical dilemma arises? How would you frame the issue here?

What are the advantages and disadvantages of this use of excess cash? Suppose you are out of money in your bank current account; however, your local grocery store will, as a convenience to you as a customer, cash a cheque for you. Of course, this cheque will bounce unless you do something.

You repeat this process every day, and in doing so you make sure that no cheques bounce. Eventually, manna from heaven arrives perhaps in the form of money from home , and you are able to cover your outstanding cheques. To make it interesting, suppose you are absolutely certain that no cheques will bounce along the way.

Assuming this is true, and ignoring any question of legality what we have described is probably illegal cheque-kiting , is there anything unethical about this? If you say yes, then why?

Cash efficiency for bank branches

In particular, who is harmed? Give an intuitive explanation for why this happens. What happens if the variance drops to zero? Use the letter I to denote an increase and D to denote a decrease. Briefly explain your reasoning in each case. What are the opportunity cost of holding cash, the trading cost, and the total cost? The trading cost? The usual clearing time for the cheques is four days. The cash from the payments is available to the firm after two days.

The delay in clearing is typically four days. The current interest rate is 0.

The larger cheque takes four days to clear after it is deposited; the smaller one takes five days. A bank has approached you concerning a new service that will decrease your total collection time by two days. You typically receive 12, cheques per day.

The daily interest rate is 0. What would the net annual savings be if the service were adopted? How do you interpret your answer? Use the result to calculate the average daily float. Per cheque?

It is expected that the new system will reduce receipt and deposit times to three days total. Average daily collections are NKr,, and the required rate of return is 9 per cent per year.

How much interest can the company earn annually if it delays transfer of funds from an interest-bearing account that pays 0. Ignore the effects of compounding interest. No More Books is contemplating cancelling the agreement and dividing its Belgian activities so that two other banks will handle its business. Should the company proceed with the new system? What will be the annual net savings?

Assume that the T-bill rate is 5 per cent annually. The annual interest rate on money market securities is 6. After the initial investment of excess cash, how many times during the next 12 months will securities be sold?

The interest rate is currently 0. Calculate the target cash balance and upper limit using the Miller—Orr model. Describe how the system will work. The opportunity cost to the firm of holding cash is 7 per cent per year. What interest rate must All Night be using? It therefore is considering using a lockbox system offered by a bank located in Inverness. The bank has estimated that use of the system will reduce collection time by two days.

Based on the following information, should the lockbox system be adopted? The estimated reduction in collection and processing time is one day. Treasury bills are currently yielding 5 per cent per year.

The annual interest rate on marketable securities is 5. The annual interest rates Gold Star and Silver Star can get are 5. Each of the three objectives raises problems. The liquidity problem At first sight this problem is simple enough. If a company knows that it will need the funds in three days or weeks or months , it simply invests them for just that period at the best rate available with safety.

The solution is to match the maturity of the investment with the period for which the funds are surplus. However there are a number of factors to consider: The exact duration of the surplus period is not always known. It will be known if the cash is needed to meet a loan instalment, a large tax payment or a dividend. It will not be known if the need is unidentified, or depends on the build-up of inventory, the progress of construction work, or the hammering out of an acquisition deal.

The safety problem Safety means there is no risk of capital loss. Superficially this again looks simple. The concept certainly includes the absence of credit risk.

For example, the firm should not deposit with a bank which might conceivably fail within the maturity period and thus not repay the amount deposited. If the purpose for which the surplus cash is held is not itself fixed in the local currency, then other criteria of safety may apply. The profitability problem The profitability objective looks deceptively simple at first: go for the highest rate of return subject to the overriding criteria of safety and liquidity. However, here there are complications.

Short-term borrowing Short-term cash requirements can also be funded by borrowing from the bank. There are two main sources of bank lending: bank overdraft bank loans. Bank overdrafts A common source of short-term financing for many businesses is a bank overdraft. These are mainly provided by the clearing banks and represent permission by the bank to write cheques even though the firm has insufficient funds deposited in the account to meet the cheques.

An overdraft limit will be placed on this facility, but provided the limit is not exceeded, the firm is free to make as much or as little use of the overdraft as it desires.

The bank charges interest on amounts outstanding at any one time, and the bank may also require repayment of an overdraft at any time. The advantages of overdrafts are the following.

Flexibility as they can be used as required. The disadvantages of overdrafts are as follows. Overdrafts are legally repayable on demand.

Normally, however, the bank will give customers assurances that they can rely on the facility for a certain time period, say six months.

Security is usually required by way of fixed or floating charges on assets or sometimes, in private companies and partnerships, by personal guarantees from owners. Interest costs vary with bank base rates. This makes it harder to forecast and exposes the business to future increases in interest rates. Bank loans Bank loans are a contractual agreement for a specific sum, loaned for a fixed period, at an agreed rate of interest. They are less flexible and more expensive than overdrafts but provide greater security.This action will decrease the cash balance to Z.

The diagram below shows how the model works over time.

Working Capital Cash Management

A lockbox system reduces mailing time, because cheques are received at a nearby post office instead of at corporate headquarters. All this process is done with the target of not generating a surplus of money. Also, this net deleveraging process goes along with a noticeable lower short-term debt ratio ratio of current liabilities to total assets , at an average pace of 1.

The financial deficit is financed by selling marketable securities, and by bank borrowing. These are mainly provided by the clearing banks and represent permission by the bank to write cheques even though the firm has insufficient funds deposited in the account to meet the cheques.

Corporate customers Local bank Post office deposits lockbox receipts Corporate Funds are transferred to customers concentration bank by depository checks and wire transfers.

Suppose the annual cost of debt capital is 10 per cent.