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The Baumol Model

The Baumol model is a cash management model that treats cash like inventory and aims to optimize cash balances. It is based on the economic order quantity model and assumes predictable cash flows, fixed costs of transferring cash, and a constant interest rate. The Baumol formula calculates the optimal cash level based on demand, transfer costs, and alternative costs. While a classic model, it is difficult to apply in practice due to its assumptions of even cash usage and precisely predictable demand.

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73 views3 pages

The Baumol Model

The Baumol model is a cash management model that treats cash like inventory and aims to optimize cash balances. It is based on the economic order quantity model and assumes predictable cash flows, fixed costs of transferring cash, and a constant interest rate. The Baumol formula calculates the optimal cash level based on demand, transfer costs, and alternative costs. While a classic model, it is difficult to apply in practice due to its assumptions of even cash usage and precisely predictable demand.

Uploaded by

Noreen Delizo
Copyright
© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
Download as pdf or txt
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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

𝟐𝒙𝑻𝒙𝑭
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:
𝐶𝑥𝑅
𝐾𝐴 =
2
𝑇𝑥𝐹
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.

𝟐𝒙𝑻𝒙𝑭
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 𝒕𝒊𝒎𝒆𝒔
(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 = 𝟐 𝑪
𝟏𝟑, 𝟏𝟔𝟔
=
𝟐
= Php. 6,583

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