A firm has to maintain sufficient liquidity by managing minimum cash balance. Firm needed cash to pay suppliers of raw materials, pay salaries and other expenses as well as paying interest, tax and dividends. Sufficient liquidity means the availability of cash to pay the firm obligations in time. Generally, the minimum cash balance is equal to the cash needed for transaction plus safety cash that can be maintained based on firm’s past experience. Maintenance of cash balance provides sufficient liquidity but involve opportunity cost (loss of interest), whereas less cash balance maintenance weakens liquidity and involves profitability. A firm has to maintain optimum cash balance. Optimal cash balance is that cash balance where the firm’s opportunity cost equals to transaction cost and the total cost are minimum. Then how to determine optimum cash balance?
Optimum cash balance can be determined by a number of mathematical models. But here the most important two models are discussed. They are:
1. Baumol Model (Inventory Model)
2. Miller and Orr Model (Statistical Model)
This model was developed by Baumol. This model is suitable only when the cost flows are predictable (under certainty). It considers optimum cash balance similar to the economic order quantity, since it is based on EOQ Concept and also in both the cases there is trade off between cost of borrowing (sale of securities cost) and opportunity the cost. The point where the total cost is minimum. Figure 13.1 shows Baumol model.
Assumptions: Baumol model is based on the following:
1. The firm knows its cash needs with certainty.
2. The cash payments (disbursement) of the firm occur uniformly over a period of time and is known with certainty.
3. The opportunity cost of holding cash is known and it remains stable over time.
4. The transaction cost is known and remains stable.