Effect of holding cash on firm’s liquidity and profitability. After that it explains the cash management, its objectives and significance in the present scenario. It also states different models of cash management along with its major problems. 3.2 Cash: Cash is the most liquid form of asset for incurring day to day expenditures.
The following points highlight the two models of cash management, i.e., 1. William J. Baumol’s Model 2. Miller and Orr Model.
Cash Management Model # 1. William J. Baumol’s Model:
William J. Baumol developed a model (The Transactions Demand for Cash: An Inventory Theoretic Approach) which is usually used in inventory management but has its application in determining the optimal cash balance also. Baumol found similarities between inventory management and cash management.
As Economic Order Quantity (EOQ) in inventory management involves tradeoff between carrying costs and ordering cost, the optimal cash balance is the tradeoff between opportunity cost or cost of borrowing or holding cash and the transaction cost (i.e. the cost of converting marketable securities into cash etc.) The optimal cash balance is reached at a point where the total cost is the minimum. The figure below shows the optimum cash balance.
Illustration 1:
The annual cash requirement of A Ltd. is Rs 10 lakhs. The company has marketable securities in lot sizes of Rs 50,000, Rs 1, 00,000, Rs 2, 00,000, Rs 2, 50,000 and Rs 5, 00,000. Cost of conversion of marketable securities per lot is Rs 1,000. The company can earn 5% annual yield on its securities. You are required to prepare a table indicating which lot size will have to be sold by the company. Also show that the economic lot size can be obtained by the Baumol Model.
Cash Management Model # 2. Miller and Orr Model:
Baumol’s model is based on the basic assumption that the size and timing of cash flows are known with certainty. This usually does not happen in practice. The cash flows of a firm are neither uniform nor certain. The Miller and Orr model overcomes the shortcomings of Baumol model.
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M.H. Miller and Daniel Orr (A Model of the Demand for Money) expanded on the Baumol model and developed Stochastic Model for firms with uncertain cash inflows and cash outflows.
The Miller and Orr (MO) model provides two control limits-the upper control limit and the lower control limit along-with a return point as shown in the figure below:
When the cash balance touches the upper control limit (h), markable securities are purchased to the extent of hz to return back to the normal cash balance of z. In the same manner when the cash balance touches lower control limit (o), the firm will sell the marketable securities to the extent of oz to again return to the normal cash balance.
The spread between the upper and lower cash balance limits (called z) can be computed using Miller-Orr model as below:
Variance of Cash Flows = (Standard deviation)2 or (s)2:
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Illustration 2:
A company has a policy of maintaining a minimum cash balance of Rs 1, 00,000. The standard deviation in daily cash balances is Rs 10,000. The interest rate on a daily basis is 0.01%. The transaction cost for each sale or purchase of securities is Rs 50. Compute the upper control limit and the return point as per the Miller-Orr model.
Illustration 3:
A firm having an annual opportunity cost of 15 per cent is contemplating installation of a lock box system at an annual cost of Rs 3, 00,000. The system is expected to reduce mailing time by 4 days and reduce cheque clearing time by 3 days. If the firm collects Rs 4, 00,000 per day, would you recommend the system?
Thus, it is recommended that the proposed lock box system should be installed.
Illustration 4:
Beta Ltd. has an annual turnover of Rs 84 crores and the same is spread evenly over each of the 50 weeks of the working year. However, the pattern within each week is that the daily rate of receipts on Mondays and Tuesdays is twice that experienced on the other three days of the week.
The cost of banking per day is estimated at Rs 2,500. It is suggested that banking should be done daily or twice a week Tuesdays and Fridays as compared to the current practice of banking only on Fridays. Beta Ltd. always operates on bank overdraft and the current rate of interest is 15% per annum.
This interest charge is applied by the bank on a simple daily basis. Ignoring taxation, advise Beta Ltd. the best course of banking. For your exercise, use 360 days a year for computational purposes.
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Book Detail:Financial Management & Cost Accounting
Language: English
Pages: 187
Author: Mahendra D. Gurjar, K. K. Datta
Price: Free
Course Outline: Financial Management & Cost Accounting
Module 1. Introduction to Financial Management
Lesson 1. Introduction to Financial Management
Lesson 2. Finance and Accounting
Lesson 3. Finance and Accounting
Lesson 4. Types of Accounting
Module 1. Introduction to Financial Management
Lesson 1. Introduction to Financial Management
Lesson 2. Finance and Accounting
Lesson 3. Finance and Accounting
Lesson 4. Types of Accounting
Module 2. Accounting procedure
Lesson 5. Types of accounts and rules for Debit and Credit
Lesson 6. Introduction to Journal
Lesson 7. Preparation of Journal
Lesson 8. Posting in Ledgers and Balancing the Ledgers
Lesson 9. Subsidiary book – Cash Book
Lesson 10. Purchase Book and Sales Book
Lesson 11. Purchase Return Book, Sales Return Book, Bills payable and Bills receivable books
Lesson 5. Types of accounts and rules for Debit and Credit
Lesson 6. Introduction to Journal
Lesson 7. Preparation of Journal
Lesson 8. Posting in Ledgers and Balancing the Ledgers
Lesson 9. Subsidiary book – Cash Book
Lesson 10. Purchase Book and Sales Book
Lesson 11. Purchase Return Book, Sales Return Book, Bills payable and Bills receivable books
Module 3. Trial balance , bank reconciliation, depreciation and final accounts
Lesson 12. Trial Balance –preparation, limitations and Method of preparing Trial Balance
Lesson 13. Bank Reconciliation
Lesson 14. Capital and Revenue Expenditure
Lesson 15. Introduction and preparation Trading Account
Lesson 16. Introduction and Preparation of Profit and Loss Account
Lesson 17. Balance Sheet
Lesson 12. Trial Balance –preparation, limitations and Method of preparing Trial Balance
Lesson 13. Bank Reconciliation
Lesson 14. Capital and Revenue Expenditure
Lesson 15. Introduction and preparation Trading Account
Lesson 16. Introduction and Preparation of Profit and Loss Account
Lesson 17. Balance Sheet
Module 4. Financial statement analysis
Lesson 18. Introduction to financial statements
Lesson 19. Types of ratios/ liquidity
Lesson 20. Capital structure ratio
Lesson 21. Activity ratios
Lesson 22. Profitability ratios
Lesson 23. Importance and limitations of financial ratios
Lesson 18. Introduction to financial statements
Lesson 19. Types of ratios/ liquidity
Lesson 20. Capital structure ratio
Lesson 21. Activity ratios
Lesson 22. Profitability ratios
Lesson 23. Importance and limitations of financial ratios
Module 5. Investment decision
Lesson 24. Introduction, Nature of Investment Decisions, Type of Capital Budgeting Decisions
Lesson 25. Methods of Capital Budgeting, NPV Method, Time Value of Money
Lesson 26. NPV Method of Capital Budgeting
Lesson 27. IRR Method of Capital Budgeting
Lesson 28. PAY Back Period, Accounting Rate of Return Method
Lesson 29. Cost of Capital
Lesson 24. Introduction, Nature of Investment Decisions, Type of Capital Budgeting Decisions
Lesson 25. Methods of Capital Budgeting, NPV Method, Time Value of Money
Lesson 26. NPV Method of Capital Budgeting
Lesson 27. IRR Method of Capital Budgeting
Lesson 28. PAY Back Period, Accounting Rate of Return Method
Lesson 29. Cost of Capital
Module 6. Working capital management
Lesson 30. Working Capital
Lesson 31. Factors Affecting Working Capital
Lesson 32. Working Capital Management, Inventory Management
Lesson 33. Receivables Management, Cash Management
Lesson 34. Financing of Working Capital
Lesson 35. Cost Volume Profit Analysis
Lesson 36. Determining Break Even Points, Break Even Charts, Margin of Safety
Lesson 37. Profit Volume Analysis
Lesson 30. Working Capital
Lesson 31. Factors Affecting Working Capital
Lesson 32. Working Capital Management, Inventory Management
Lesson 33. Receivables Management, Cash Management
Lesson 34. Financing of Working Capital
Lesson 35. Cost Volume Profit Analysis
Lesson 36. Determining Break Even Points, Break Even Charts, Margin of Safety
Lesson 37. Profit Volume Analysis
Module 7. Inventory management
Lesson 38. Introduction to Inventory Management
Lesson 39. Techniques of Inventory Management
Lesson 40. Economic Order Quantity model and ABC analysis
Lesson 41. Purchase Procedure
Lesson 42. Stores Management
Lesson 43. Codifications and Standardisation
Lesson 38. Introduction to Inventory Management
Lesson 39. Techniques of Inventory Management
Lesson 40. Economic Order Quantity model and ABC analysis
Lesson 41. Purchase Procedure
Lesson 42. Stores Management
Lesson 43. Codifications and Standardisation
Module 8. Costing
Lesson 44. Introduction to cost accounting
Lesson 45. Classification of costs
Lesson 46. Main elements of costs
Lesson 47. Valuation of inventory
Lesson 48. Labour cost and overheads
Lesson 44. Introduction to cost accounting
Lesson 45. Classification of costs
Lesson 46. Main elements of costs
Lesson 47. Valuation of inventory
Lesson 48. Labour cost and overheads
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