Question Tag: Baumol Model

You are the assistant to the Finance Manager of Horthman Holdings Ltd. The Directors of the company are reviewing the cash management practices of the company. The main concern is that excessive cash balances are held in non-interest-bearing demand deposit accounts for relatively long periods. Your boss has been asked to advise the Directors on the appropriate cash balance levels the company should keep and matters relating to the investment of excess cash.

To assist your boss, you analysed the company’s demand for cash over the last three years and looked for some financial market figures. On the usage of cash, you found that the company’s daily cash needs vary with a standard deviation of GH¢25,000. However, the annual demand for cash averages around GH¢65 million. Considering the results of your examination, your boss proposes that the minimum cash balance is set at GH¢100,000 going forward.

From your search on the financial markets, you found that the company can earn interest from investments in money market securities at an annual rate of 21.6% on an actual/360-day count convention. Also, you found out that the average transaction cost for trading investments in such money market securities is GH¢2,500.

Your boss recommends using the Miller-Orr model for determining the critical cash control levels and investment of temporary excess cash in money market securities.

Required:
a) Using the Miller-Orr model, determine the following:
i) The cash spread between the lower and upper cash limit. (3 marks)
ii) The cash return point. (2 marks)
iii) The cash level at which the company should invest excess cash. (2 marks)

b) The Chief Executive Officer (CEO) believes that the Baumol model is a simpler model than the Miller-Orr model, and your boss should consider recommending that to the Directors. Considering the information provided in the preamble, would you say that the Baumol Model would be more appropriate? Explain. (4 marks)

c) Your boss recommends that temporary excess cash be invested in money market securities. Explain TWO (2) conditions required when deciding on investing temporary excess cash. (4 marks)

d) Future contracts and forward contracts (more commonly referred to as futures and forwards) are used by businesses and investors to hedge against risks or speculate. Futures and forwards are examples of derivative assets that derive their values from underlying assets. Both contracts rely on locking in a specific price for a certain asset, but they have differences.

Required:
Explain FOUR (4) differences between futures and forwards. (5 marks)