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SOLUTIONS

5.1. Campbell Corporation uses Baumol model to manage cash. The cost of transferring
money from a money-market fund, which pays 6% interest on balances, to a checking
account is $32 per transaction. Campbell needs $13 million annually to pay its bills. Find
the annual cost of interest forgone.
$3533 ♥
Solution:
Annual requirement of cash (A) = $ 13 million
Transaction cost (T) = $ 32 per transaction
Opportunity cost of holding cash (R) = 6%
According to Baumol model to manage cash
Total cost = Transaction cost + Opportunity cost
Let C* be the optimum cash balance that minimizes the cost of holding cash
Transaction cost = A x T
C*
Opportunity cost = C* x R
2
Total cost = A x T + C* x R
C* 2
Differentiating with respect to C* we get
0 = - A x T + 1 x R
C*
2
2
- A x T = 1 x R
C*
2
2
C* = √(2AT) / R
Therefore
C* = √(2*13,000,000* 32) / 0.06
C* = √13866666666.67
C* = $ 117756.81
The annual cost of interest foregone is the opportunity cost
Opportunity cost = C* x R
2
=($ 117756.81/2) *0.06
= $ 3533
The annual cost of interest foregone is $ 3533.

5.2. Genentech Corporation, by analyzing its weekly balances in its checking account,
has determined that the variance of cash flows is $3,000,000. Further, the cost of
transferring money from the checking account to a money market account is $65 per...