The Norris Company is trying to determine its optimal average cash balance. The firm has determined that it will need $5,000,000 net new cash during the coming year. The fixed transaction cost of converting securities to cash is
$50, and the firm earns 10 percent on its marketable securities investments.
-What will be the total cost to Norris of maintaining the optimal average cash balance, as determined by the Baumol model?
A) $35,356
B) $ 7,071
C) $18,493
D) $70,711
E) $53,190

Question

Quizplus · Accepted Answer

The Baumol model calculates the optimal cash balance using the formula: C* = sqrt((2 * F * T) / r), where F is the fixed transaction cost, T is the total cash needed, and r is the interest rate. Plugging in the values: C* = sqrt((2 * 50 * 5,000,000) / 0.10) = $70,711. The total cost is the sum of the transaction cost and the opportunity cost, which is (T/C*) * F + (C*/2) * r = (5,000,000/70,711) * 50 + (70,711/2) * 0.10 = $7,071.

The Norris Company Is Trying to Determine Its Optimal Average