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CA Intermediate · Financial Management and Strategic Management · Treasury and Cash Management

Under the Baumol model, a firm needs Rs 6,00,000 cash a year, the cost per transaction of converting securities is Rs 300 and the annual holding cost is 12% of cash held. What is the optimal cash conversion size?

Using the Baumol formula, the optimal conversion size is the square root of 2 times annual cash need times transaction cost divided by holding cost rate. That gives about Rs 54,772, so Rs 50,000 is the closest option.

  1. ARs 30,000
  2. BRs 50,000Correct
  3. CRs 1,00,000
  4. DRs 1,50,000

Explanation

C = sqrt(2 x U x P / S) = sqrt(2 x 6,00,000 x 300 / 0.12) = sqrt(3,00,00,00,000) = sqrt(3,000,000,000)... compute: 2x600000x300 = 360,000,000; divided by 0.12 = 3,000,000,000; the root is about 54,772, so the nearest option is Rs 50,000 only if rounded. Wrong values arise from using 12 instead of 0.12 or omitting the factor 2.

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