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Introduction to Business Finance Introduction It is very important to understand the algorithm of the preparation and drawing up a budget of the company in order to effectively manage its cash balances. There are a number of theories and models for the management of cash balances, such as the Baumol and Miller- Orr models. However, Party and Dodds assert that these models for the management of cash balances are "of little practical value." Lets examine them more thoroughly to evaluate Puts and Dodds assumption. First of all, effective management of cash balances is crucial to the companys successful development. For example, the maximum flight of capital is usually accounted for by the purchases of components and necessary materials.
Tax assessment is rated on a certain percentage basis, different for different companies. When the company reveals the planned cash balance, it may make decision on whether to invest it in something (for example, funds or securities, deposits, etc) in order to gain an additional profit. The Baumol Model The Baumol model defines the optimal amount of the funds to be held in a predictable business environment. The model is aimed to minimize the fixed cost of buy and sell investment transactions and minimize the opportunity cost of holding cash (Cash Flow Planning and Modeling 2007). According to this model, the company should be able to predict its cash requirements and should receive a certain amount at regular time intervals. The company should also have a steady rate of cash payments.
The opportunity cost of holding cash should be obligatory known and should not change in the course of time. Finally, according to this model, the company should incur the same transaction cost whenever it converts securities to cash (Baumol's Model 2007). Besides, the transaction should also incur a variable and fixed cost. According to the Baumol Model, opportunity cost = C/ 2 (Average cash balance) x K (Interest rate) Trading cost = (T/C) x F, where T = total disbursements during the time interval, C = initial cash balance, and F = given fixed cost. Total cost = opportunity cost + trading cost.
The Baumol model has limitations. Basically, it doesnt allow cash flows to fluctuate and doesnt take into account overdraft. The Baumol model also has some uncertainties concerning the future cash flows. The Miller- Orr Model The Miller- Orr Model defines the optimal amount of the funds to be held in an unpredictable business environment. It is necessary to take into account setting the lower control limits, estimating the standard deviation of the daily cash flows, determining interest rates and, finally, estimating the trading costs for buying and selling for the marketable securities. The Miller- Orr Model also has some limitations.
Although in contrast to the Baumol Model, the Miller- Orr Model allows cash flows to fluctuate, and funds may be transferred at any time and are instantaneous with a fixed transfer cost (Financial Management, Systems and Technologies 2007), the model may be difficult to calculate and the monitoring should obligatory be continuous. The Baumol and Miller- Orr Models: Evaluation In order to effectively manage cash balances, the company should determine minimum requirements in cash balances. Therefore, it is very important to consider this issue in all its aspects. The Baumol model implies exact planning of the demand in cash balances.
However, as far as business environment may rarely be steady and predictable, it is very difficult (and even almost impossible) to make accurate prognoses concerning the revenues and outflow of capital. In these conditions, the most accurate forecasts can be made in case the company uses statistic data concerning the dynamics of cash balances during the preceding spans of time. Therefore, it is necessary to use the model that will take into account stochastic (probabilistic or statistically distributed) characteristics of monetary circulation such as depletions. The methods used in the Miller- Orr model meet these requirements. However, this model is designed for the management of cash balances at the companys account current in the context of developed market (both economic and stock market). At the same time, these markets are quite weak as they are not predictable.
In addition to that, high (or even moderate) rate of inflation (even creeping inflation or suppressed rate of inflation) may cause additional difficulties during the application of the Miller- Orr model. Conclusion In closing it may be said that according to the analysis of the Baumol and Miller-Orr models, these models insufficiently take into account the influence of the taxation, inflation rate, underdeveloped stock market, peculiarities of the barter deals and transactions, some limits imposed by the government on currency speculation, and exchange restrictions, to mention a few. The Baumol Model also allows no cash flows to fluctuate and doesnt take into account overdraft. Besides, this model has some uncertainties concerning the future cash flows. The Miller- Orr model is more effective, because it eliminates the Baumol models limitations. Yet, the Miller- Orr model may be difficult to calculate and the monitoring should obligatory be continuous for the companys successful development.
Therefore, although these models are quite reasonable and effective, for the management of cash balances the Baumol and Miller-Orr models are of little practical value. Works Cited Baumol's Model. 22 June 2007
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