Question

1. The average yield on marketable securities is 9 percent/year; the fixed cost of transaction is $50 per transaction. The past cash balance study indicates that the firm's standard deviation of daily cash balance changes is equal to $800. The firm sees no reason why this variability should change in the future. The firm does maintain $1,000 in its demand deposits account at all times.

1. What is the optimal cash return point?
2. What is the upper cash balance?
3. Explain how the model will work?

Answer 1

a]	Optimal cash return point is given by:
	Return Point = Lower Limit + 1/3 × Spread
	Spread = 3*(3/4 x Transaction cost x Cashflow variance / interest rate)^(1/3)
	Substituting values:
	Spread = 3*(0.75 *50*800^2/(0.09/365))^(1/3) =	$               13,800
	Optimal return point = 1000+13800/3 =	$                 5,600
b]	Upper cash balance = lower limit+Spread = 1000+13800 =	$               14,800
c]	When the cash balance, which fluctuates randomly, touches
	the upper limit, the firm sells enough marketable securities
	to take the cash balance down to the optimal return point.
	Instead, if the cash balance touches the lower limit, enough
	marketable securities would be sold to raise the cash
	balance to the optimal return point.
	Till the cash balance raaches the upper limit or lower limit,
	it fluctuates randomly, with no action taken.
	The lower limit is set by the firm and would be based on its
	requirement for safety stock of cash in hand.