William J. Baumol developed a model (The transactions Demand for Cash: An Inventory Theoretic Approach) which is usually used in Inventory management & cash management.Baumol model of cash management trades off between opportunity cost or carrying cost or holding cost & the transaction cost. As such firm attempts to minimize the sum of the holding cash & the cost of converting marketable securities to cash.Relevance
At present many companies make an effort to reduce the costs incurred by owning cash. They also strive to spend less money on changing marketable securities to cash. The Baumol model of cash management is useful in this regard.
Use of Baumol Model
The Baumol model enables companies to find out their desirable level of cash balance under certainty. The Baumol model of cash management theory relies on the trade off between the liquidity provided by holding money (the ability to carry out transactions) and the interest foregone by holding one’s assets in the form of non-interest bearing money. The key variables of the demand for money are then the nominal interest rate, the level of real income which corresponds to the amount of desired transactions and to a fixed cost of transferring one’s wealth between liquid money and interest bearing assets.
There are certain assumptions or ideas that are critical with respect to the Baumol model of cash management:
The particular company should be able to change the securities that they own into cash, keeping the cost of transaction the same. Under normal circumstances, all such deals have variable costs and fixed costs.
The company is capable of predicting its cash necessities. They should be able to do this with a level of certainty. The company should also get a fixed amount of money. They should be getting this money at regular intervals.
The company is aware of the opportunity cost required for holding cash. It should stay the same for a considerable length of time.
The company should be making its cash payments at a consistent rate over a certain period of time. In other words, the rate of cash outflow should be regular.
Equational Representations in Baumol Model of Cash Management:
Holding Cost = k(C/2)
Transaction Cost = c(T/C)
Total Cost = k(C/2) + c(T/C)
Where T is the total fund requirement, C is the cash balance, k is the opportunity cost & c is the cost per transaction.
Limitations of the Baumol model:
1.It does not allow cash flows to fluctuate.
2. Overdraft is not considered.
3. There are uncertainties in the pattern of future cash flows.