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

Using the Baumol model, Kaveri Textiles expects a cash requirement of Rs 4,00,000 for the year. The fixed cost per transaction of converting securities into cash is Rs 50 and the annual interest rate on marketable securities is 10%. What is the optimum cash conversion size?

The optimum conversion size is Rs 20,000. Under the Baumol model it equals the square root of twice the annual cash need times the transaction cost divided by the interest rate, which is the square root of 40,00,00,000. At this size, transaction and holding costs are both Rs 1,000.

  1. ARs 20,000Correct
  2. BRs 40,000
  3. CRs 2,000
  4. DRs 4,000

Explanation

Baumol: C = sqrt(2 x U x P / S) = sqrt(2 x 4,00,000 x 50 / 0.10) = sqrt(40,00,00,000/1)... compute: 2 x 4,00,000 x 50 = 4,00,00,000; divided by 0.10 = 40,00,00,000; square root = 20,000. Check: transactions = 4,00,000/20,000 = 20; cost = 20 x 50 = 1,000 and holding cost = 10,000 x 10% = 1,000, which are equal, confirming the optimum. Rs 2,000 results from forgetting to divide by the interest rate properly.

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