(^218) Financial Management
- Administration, information and control costs
Required Cash Balance
The question may be designed as whether it is possible to define the amount of cash
which out to be held at any time? Cash is needed for three reasons:- To finance transactions (which was the main theme of the previous paragraphs):
- As a precaution - a safeguard against the inaccuracies in cash forecasts - bearing
in mind that every forecast, by its very nature, will be inaccurate. - For speculative purposes - to take advantage of any profitable opportunities that
arise.
What average cash balance then should be held to finance normal transaction, including
any necessary margin of safety? The word ënormalí is important because it may be
assumed that small deviation from the norm will be covered by overdraft facilities.
This is a question closely akin to one we shall be asking about stockholdings in the next
unit. Attempts are sometimes made to establish a equation based on:
l The ëholding costí of cash (i.e., the opportunity cost of keeping the cash un-
invested;
l The ëprocurement costí of cash (.i.e., the transaction cost of converting securities
into cash, or otherwise obtaining new funds).
The estimates used in such calculations are likely to be suspected, and the model to
which they give rise is only applicable when the demand for cash is reasonably consistent
from period to period.
There are two models used. The first one is Baumol Model which works exactly on the
lines of inventory model and that is its biggest shortcoming. The second one is Miller-
Orr model which specifies a minimum and a maximum level of cash in the system and
expects the cash levels to move between the two.
Let us look at Miller-Orr model in slightly more detail. Figure below gives you the basic
functioning of Miller-Orr model. We can see that The company has established upper
and lower limits within which it allows the cash levels to operate. If the cash level
touches the upper level, the company converts extra cash into securities so as to bring
it to the target cash balance. It follows the same procedure for the lower limit where it
sells securities instead of buying it. This makes it easy for the company to manage cash
as the levels of cash is difficult to predict very accurately.
Note that the target cash balance point is at one-third of the distance between the
lower and upper level, from the lower level instead of half-way between the two because