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Business valuations and market efficiency

Question 5

Miller Orr model

The cash balance at ABC plc fluctuates over time with some months seeing a
large positive cash balance and others showing an overdraft. The company
wishes to control its cash more efficiently and take advantage of available short-
term investments when it has surplus cash. It wishes to maintain a minimum
cash balance of $10,000. The short-term investments earn interest at 0.04%
per day.

If the transaction cost of switching cash between the current account and the
company’s short-term investments is $15 and the variance of the company’s
cash flows is $6 million per day, use the Miller Orr model to calculate the
spread, the return point and the upper limit.

1/3
Spread = 3 × [0.75 × $15 × $6,000,000/0.0004] = $16,578

Return point = $10,000 + (1/3 × $16,578) = $15,526

Upper limit = $10,000 + $16,578 = $26,578

NB: remember that 0.04% expressed as a decimal is 0.0004

479