Financial management revision question and answer

Multi-Link Ltd., a trading company, currently has negligible cash holdings but expects to make a series of cash payments totaling Sh.150 million over the forthcoming year. These payments will become due at a steady rate. Two alternative ways have been suggested of meeting these obligations.

Alternative I
The company can make periodic sales from existing holdings of short-term securities. The average percentage rate of return on these securities is 12 over the forthcoming year. Whenever Multi-Link Ltd. sells the securities, it will incur a transaction fee of Sh.15,000. The proceeds from the sale of the securities are placed on short-term deposit at 7% per annum interest until needed.

Alternative II
The company can arrange for a secured loan amounting to Sh.150 million for one year at an interest rate of 18% per annum based on the initial balance of the loan. The lender also imposes a flat arrangement fee of Sh.50,000 which would be met out of existing balances. The sum borrowed could be placed in a notice deposit at 9% per annum and drawn down at no cost as and when required. Multi-Link Ltd.‟s treasurer believes that cash balances will be run down at an even rate throughout the year.

(a) (i)Explain the weaknesses of the Baumol model in the management of

(a) Advise Multi-Link Ltd. as to the better alternative for managing its cash.

(b) Lynx Services Ltd., a debt collection agency, has estimated that the standard deviation of its daily net cash flow is Sh.22,750. The company pays Sh.120 in transaction cost every time it transfers funds into and out of the money market. The rate of interest in the money market is 9.465%. The company uses the Miller-Orr Model to set its target cash balance. The minimum cash balance has been set at Sh.87,500.

(i) The company‟s target cash balance.
(ii) The lower and upper cash limit.
(iii) Lynx Services Ltd.‟s decision rules.
Weaknesses of Baumol Model in management of cash.

Baumol Model is the EOQ approach in cash management according to this model, the optimal cash balance owned.

Where: T = annual cash requirement

b = Transaction cost
i = Interest rate on short term marketable securities.

Two costs are identified withholding the optimal cash balance:

(i) Opportunity cost/foregone interest income = ½ci
T b
(ii) Conversion/transfer cost = /C

The weaknesses of the Baumol Model are inherent in its exemptions which are:

(i) Annual cash requirement is known and constant
(ii) Conversion cost is certain throughout the year
(iii) Interest rate on short term marketable securities
(iv) A firm has a steady cash inflows and outflows which occurs at regular intervals.

(v) A firm does not incur any cost due to shortage of cash e.g lost investment opportunities.

(ii) The phrase indicating that cash balances will be run down at an even rare throughout the year means that on average the firm will earn interest of 9% on the amount of loan borrowed. The firm pays interest at 18%, it will generate interest income at 9% interest rate, when the borrowed fund is placed in a notice deposit …

Alternative II
Interest charges payable = 18% x 150m (27.00m)

Interest income on deposit =   9% x 650m 13.50m
Net cost/interest charges           13.50m
Add Flat arrangement fees         (50,000) 0.50m
Net cost of the option                (13.55m)

Alternative I
The Sh.150m will be raised from sale of short term marketable securities. Therefore there will be conversion costs every time the securities are sold to realize cash. This can be determined using Baumol Model. Where:

Annual cash requirement = 150m T
Transaction/conversion fee = 15,000 b
Interest rate on short term securities = 12% I

Since the firm is depositing cash at hand i.e Sh.6,123,724 in a notice deposit to earn interest at 7% p.a., then there is no opportunity cost. The firm will generate interest income on the average optimal cash balance.

However, the cash inflow and outflow occurs at a steady rate. Therefore the average cash outflow = ½ x 150m = 75m
The interest rate foregone on short term marketable securities at 12%:

(b) (i)According to Miller Orr Model of cash management:

The decision criteria for Baumol Model could be illustrated graphically as follows:

The decision criteria for this model is:
(i) If the cash balance moves from Z – H, the firm has excess cash = H – Z which should be invested buying short term securities.
(ii) The firm should sell short term marketable securities to realize cash if the cash balance declines to lower limit L. The amount realized = Z – L
(iii) The firm should maintain a cash balance range (spread = H – L) i.e 255,662 –

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