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Chapter 10

Question 3

Baumol model

A profitable company has a cash balance that is growing over time. Each
month it generates $25,000 excess cash. It intends to transfer this cash into a
short-term deposit account which would earn 3% per annum. Every time it
transfers money into the account, it incurs a transaction fee of $25.

Using the Baumol cash model, calculate the optimum amount of cash to be
transferred each time.

Co = $25

D = $25,000 × 12 = $300,000

Ch = $0.03

Q = √(2 × $25 × $300,000/$0.03) = $22,361

NB: in a similar way to the EOQ model for inventory, the optimum transaction
value balances the transaction costs against the opportunity costs of holding
cash:

Transaction costs = D/Q × Co = $300,000/$22,361 × $25 = $335

Opportunity costs of holding cash = Q/2 × Ch = $22,361/2 × $0.03 = $335

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