The annual cash requirement for a firm is $1,000,000.The cost for each security transaction is $20 and current short-term return is 5 percent.Using Baumol's model estimate the initial cash balance.

Question

Quizplus · Accepted Answer

Baumol's model formula for calculating the optimal cash balance is:

Square root of ((2 x Annual cash requirement x Cost per transaction)/Holding cost per unit of cash)

Plugging in the given values:

Square root of ((2 x 1,000,000 x 20)/0.05)

= Square root of 8,000,000

= $2,828.42 (Optimal transfer amount)

To find the initial cash balance, we subtract the optimal transfer amount from the annual cash requirement:

$1,000,000 - $2,828.42 = $997,171.58

Therefore, the initial cash balance is $28,284.27 (option B).

The Annual Cash Requirement for a Firm Is $1,000,000