The Baumol model helps in determining the minimum amount of cash that a manager can obtain by converting securities into cash.
Baumol model is an approach to establish a firm’s optimum cash balance under certainty. As such, firms attempt to minimise the sum of the cost of holding cash and the cost of converting marketable securities to cash.
Baumol model of cash management trades off between opportunity cost or carrying cost or holding cost and the transaction cost.
The Baumol model is based on the following assumptions:
- The firm is able to forecast its cash requirements in an accurate way.
- The firm’s payouts are uniform over a period of time.
- The opportunity cost of holding cash is known and does not change with time.
- The firm will incur the same transaction cost for all conversions of securities into cash.
Cash balances are refilled and brought back to normal levels by the sale of securities. The average cash balance is C/2. The firm buys securities as and when it has above-normal cash balances. This pattern is explained in figure
