Determining Optimum Level of Cash Balance
A prudent finance manger desires to maintain only that much amount of cash balance as is just only that much amount of cash balance as is just sufficient to satisfy transaction requirements as well as to meet precautionary and speculative motives. This task is so important that carrying of excess cash balance entails loss of interest earnings to the firm and thus causes low profitability and maintaining a small, cash balance renders the firm’s liquidity position weak, although a higher profitability us ensured. Thus, determination of suitable level of cash holding involves risk-return trade-off.
Determination of appropriate level of cash balance is not only necessary to optimize cash utilisation but also to decide the level of investment in marketable securities. It is worth stressing that the optimal level cash should be larger of (i) the transaction balances required when cash management is efficient and (ii)the compensatory-balance requirements of commercial banks with ‘which the firm has deposit accounts.
A number of cash management models have been developed to decide the optimal level of cash balance. We shall examine here two of the more widely used models. These models are based on such terest rate on marketable securities and cash.