Every business needs to hold some cash — but how much is "just right"? Hold too little and you scramble to pay suppliers or miss early-payment discounts. Hold too much and money sits idle instead of earning returns on short-term investments. Cash Management Models give a mathematical answer to this question.
CA Inter tests two models. Baumol's Model treats cash like inventory (borrowing EOQ logic): a firm periodically converts short-term investments into cash in fixed chunks. Two costs trade off — the transaction cost (F), the fixed cost each time you convert, and the opportunity cost (i), the interest forgone on idle cash. The optimal conversion amount is **C\* = √(2TF/i)**, where T is total cash needed in the period. Average cash holding = C\/2. Total cost = (T/C\) × F + (C\*/2) × i. Baumol assumes cash outflows are steady and predictable — it works best for firms with regular, uniform payment schedules.
Miller-Orr Model handles the real world, where cash flows are uncertain and lumpy. Management first sets a lower limit (L) — a minimum safety buffer. The model calculates a Spread (Z) = 3 × ∛(3Fσ²/4i), where σ² is the variance of daily net cash flows and i is the daily opportunity cost rate. From this: Upper limit (H) = L + Z and Return point (R) = L + Z/3. The rule is simple: when the cash balance hits H (too much cash), invest the excess and pull the balance back to R. When it hits L (too little), liquidate investments and restore to R. Between L and H — do nothing. This "do nothing" zone is what makes Miller-Orr efficient; you only transact at the boundaries, minimising unnecessary transaction costs.
This topic is asked frequently as a 6–8 mark working problem in Paper 6. Baumol tends to appear in MCQs and short theory questions; Miller-Orr dominates full-length numericals. Know both formulas cold, and — critically — understand when to apply which model. If the question mentions steady, predictable cash outflows, reach for Baumol. If it mentions variance (σ²) or random cash flows, that is Miller-Orr territory. That single judgment call is often worth a mark on its own.