Mathematical approaches to cash management

In this lesson

1. 0:00 Mathematical approaches to cash management
2. 0:31 The Baumol model formula and components
3. 1:53 Baumol model worked example
4. 4:01 Introduction to the Miller model
5. 6:14 Miller model formulas explained
6. 8:41 Calculating the spread step by step
7. 10:30 Miller model worked example
8. 14:19 Managing cash surpluses with securities
9. 15:06 Working capital funding strategies

About this lesson

This video teaches you to calculate the economic order quantity for cash drawdowns and to set upper and lower limits that allow cash balances to fluctuate safely within predefined ranges. Both techniques are directly relevant to the FM and AFM papers, and mastering them will help you answer cash management questions with confidence and precision. The Baumol model works like the economic order quantity formula you may already know from inventory management. You'll learn how to calculate the optimal amount of cash to draw down each time by balancing transaction costs against interest costs. The formula incorporates the cost per drawdown, the total cash required over the period, and the net interest cost of holding cash. Once you've found the optimum transfer quantity, you can determine how many times you need to draw down funds during the year. The Miller-Orr model is more realistic because it recognises that cash demand varies across a period. Rather than assuming uniform demand, it allows your cash balance to fluctuate between an upper limit and a lower limit you set in advance. The model calculates three key values: the lower limit (minimum cash you must hold), the return point (the target balance you restore after each transaction), and the upper limit (the maximum before you invest surplus cash). When your balance hits the upper limit, you buy short-term securities to bring it back to the return point; when it hits the lower limit, you sell securities to restore it. This approach balances the cost of transactions against the interest earned and lost on cash holdings, tailored to your business's specific cash flow variability.

Duration: 16m