BUSF_A01.qxd

Cash (including overdrafts and short-term deposits)

A business plans to use £20,000 of cash during the forthcoming year. It holds most of its

cash in a deposit account from which it costs £30 to make each withdrawal and which pays

interest at 10 per cent p.a. What is the optimal size for each withdrawal?

Example 13.3

C=£

=£3,464

Therefore, about £3,464 should be withdrawn from the deposit. When all that is spent,

a further withdrawal of a similar amount should be made, and so on.

D

F

2 × 30 ×20,000

0.10

A

C

Solution

As with its close relation the economic order quantity, this model takes a very sim-

ple view of the world, though it is probably better than nothing.

Modifications to the basic model have been proposed by Miller and Orr (1966), and

Beranek (1963) suggested another approach.

Bank overdrafts

Bank overdrafts are facilities allowed by commercial banks enabling customers to

have negative balances on their current accounts. The bank overdraft is therefore a

form of borrowing for which the bank will charge interest, typically at 1 or 2 per cent

above the relevant base lending rate. Banks usually make a fixed charge for establish-

ing the facility as well.

Once the facility is established, the customer may continue to conduct the bank

account as normal, except that it can now incur a negative balance up to a specified

limit. This tends to be a cheap form of finance, as the customer is required only to pay

for the funds used for as long as they are being used. In fact, overdrafts are in essence

short-term borrowings of fluctuating amounts, with fluctuating interest rates.

As was discussed on page 357, businesses seem to use overdrafts particularly to

overcome temporary cash shortages, caused perhaps by seasonal fluctuations. For

example, a retail business whose main trading period is during the summer holiday

season will tend to stock up during the late spring. This will put a temporary strain on

its cash resources, which will gradually be relieved as the summer progresses. The

only alternative to overdraft finance may be some long-term source. If the business

borrowed through a term loan, it would then be saddled with interest payments

throughout the year on funds that it only needs for a month or two. It could, of course,

put the spare cash on deposit for the other 10 or 11 months, but the nature of the mar-

ket for finance tends to mean that interest received will not match interest paid on

those funds.

Bank overdrafts have a major disadvantage compared with long-term borrowings:

they are usually repayable at call (that is, immediately) as a condition of the facility

planned payments for the forthcoming time period and His the interest forgone on the

cash withdrawn (that is, the interest rate of the deposit).