Thoroughbred Industries has been practicing cash management for some time by using the Baumol model for determining cash balances. Some time ago, the model called for an average balance (C*/2) of $500; at that time, the rate on marketable securities was 4 percent. A rapid increase in interest rates has driven the interest rate up to 9 percent. What is the appropriate average cash balance now?
A) $200
B) $333
C) $414
D) $500
E) $666

Question

Quizplus · Accepted Answer

The Baumol model formula for cash balance is C* = sqrt((2bT)/i). When the interest rate increases, the average cash balance decreases. With the interest rate increasing from 4% to 9%, the new average balance is $333.

Thoroughbred Industries Has Been Practicing Cash Management for Some Time