Question

Using the data from problem 15, PRI’s financial managers are adjusting their optimal cash amount C* from the Baumol Model to respond to changing market conditions. Interest rates have declined so that their marketable securities now yield 3.25% and their bank raised its deposit charge from $12.95 to $13.95. By what amount will PRI’s optimal cash amount C* increase from what you calculated in problem 15? Enter your answer rounded to two decimal places. Do not enter $ or comma in the answer box. For example, if your answer is $12,300.456 then enter as 12300.46 in the answer box.

DATA FROM PROBLEM 15

Paradise Retailers, Inc. (PRI) determined that $1,500,000 is needed for cash transactions made during the next year. Each time PRI deposits money in its checking account, a charge of $12.95 is assessed to cover clerical costs. If PRI can hold marketable securities that yield 4.5%, and then convert these securities to cash at a cost of only the $12.95 deposit charge, what is the optimal cash amount C* to transfer from marketable securities to the checking account according to the Baumol Model?

Answer 1

The current situation mentioned below is as per problem 15 and new situation is the solution for the required question.

		Current	New
F	Fixed cost of transaction	12.95	13.95
T	Total cash requirement for the period	1,500,000	1,500,000
I	Interest rate on marketable securities	4.50%	3.25%
Formula	(2*F*T/I)^(0.5)	29,382.53	35,884.43

The optimal cash balance will increase by 35,884.43 - 29,382.53 = 6,501.90