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2Xtxf: Baumol'S Model Formula

The Baumol model, also known as the Baumol-Allais-Tobin (BAT) model, provides a formula for determining the optimal cash level a company should hold by selling marketable securities or borrowing when cash payments are made regularly. The model assumes demand for cash can be forecast and is constant, cash inflows are predictable, interest rates are fixed, and cash transfers are instantaneous. The formula calculates the optimal cash level based on total demand for cash over the period, fixed transfer costs, and alternative costs of holding cash. The model has limitations in practical application due to assumptions that demand and expenses are evenly spread over time.

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Noreen Delizo
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86 views3 pages

2Xtxf: Baumol'S Model Formula

The Baumol model, also known as the Baumol-Allais-Tobin (BAT) model, provides a formula for determining the optimal cash level a company should hold by selling marketable securities or borrowing when cash payments are made regularly. The model assumes demand for cash can be forecast and is constant, cash inflows are predictable, interest rates are fixed, and cash transfers are instantaneous. The formula calculates the optimal cash level based on total demand for cash over the period, fixed transfer costs, and alternative costs of holding cash. The model has limitations in practical application due to assumptions that demand and expenses are evenly spread over time.

Uploaded by

Noreen Delizo
Copyright
© © All Rights Reserved
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Download as DOCX, PDF, TXT or read online on Scribd
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The Baumol model, also known as the 

Baumol-Allais-Tobin (BAT) model, is a
cash management model.

In 1952, William Baumol presented the idea of managing the surplus of funds through the optimal use of
stock supply quantities. He came to the conclusion that money can also be treated as a specific type of
stock, one that is necessary when doing business.

When we talk about cash optimization and their balances, there is a clear analogy between cash and
materials. When we compare cash management and inventory management, it results from the fact that
cash surpluses are kept in enterprises as securities, most often they are treasury bills. The Baumol model
is based on the economic model of supply size, i.e. Model EOQ (economic order quantity).

The main assumptions of the BAT model include:


 Possible to be forecast and fixed for the entire period, the demand for cash
 Constant and predictable inflow of cash
 Fixed interest rate throughout the period when investing in securities
 Rhythmic cash receipts
 Instant cash transfers

Baumol’s Model Formula

2 xT x F
C=
√ R

Where: 
C-optimal cash level by selling marketable securities or by borrowing
T-demand for cash over the entire period considered (year) 
F-fixed costs of cash transfer 
R-alternative cost of maintaining cash.

This formula comes from the fact that if the level of cash is to be optimal, then the following equality
must exist: KA = KT, the alternative cost must equal the transaction costs. These, in turn, are calculated
as follows:
C xR
K A=
2
T xF
KT=
C
Restrictions on the Baumol model
Although the Baumol model is a classic model of cash management, it is difficult to apply it in everyday
life. The main limitation is that the company has to use up the stock evenly in order for the model
to work. In practice, this is almost impossible. Also, the difficulty is that in the enterprise it is difficult to
determine the precise demand for financial resources, also the expenses incurred by the company do not
spread equally over the entire period.

Illustration:
ABC Ltd. Makes cash payment of Php. 10,000 per week. The interest rate marketable securities is 12%
and every time the company sells marketable securities, it incurs a cost of Php. 20.

Required:
(a) Determine the optimal amount of marketable securities to be converted into cash every time the
company makes the transfer.
2 xT x F
C=
√ R
T= 52 x 10,000 = 520,000
F= 20
R= 12%
2 x 520,000 x 20
C=
√ 0.12
C= Php. 13,166

(b) Determine the total number of transfers from marketable securities to cash per year.
T
Total no. of transfers =
C
T= Php. 520,000
C = Php. 13166
520,000
¿
13,166
= 39.5
≈ 40׿
(c) Determine the total cost of maintaining the cash balance per year
1 T
TC= CR+ F
2 C
13,166 x .12 520,000 x 20
¿ +
2 13,166
= 790 + 790 = Php. 1,580
TC= Php. 1580

(d) Determine the firm’s average cash balance.


1
Average cash balance = C
2
13,166
¿
2
= Php. 6,583

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