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How BAT & Miller-Orr Models Influence Target Cash Balance

How BAT & Miller-Orr Models Influence Target Cash Balance
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  • 0:03 Cash Balances in Business
  • 0:53 The Bath Model
  • 2:10 The Miller-Orr Model
  • 3:01 Lesson Summary
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Lesson Transcript
Instructor: Natalie Boyd

Natalie is a teacher and holds an MA in English Education and is in progress on her PhD in psychology.

How can a company figure out how much cash to keep on hand? In this lesson, we'll look at two major models for figuring out the optimal cash balance for a business: the BAT model and the Miller-Orr model.

Cash Balances in Business

Anais is chief financial officer, or CFO, of a large corporation. It's her responsibility to make sure that the company makes as much money as possible. But she's noticed a problem: the company has a lot of cash sitting around in a checking account, waiting for checks to clear but not making any money in the process.

As Anais has noticed, cash does not make money for a company. The opportunity cost, or the value of the best alternative choice, of having too much cash is that it can't be invested elsewhere and earn the company money. As a result, a lower level of cash is best.

But how can Anais figure out how much cash the company should keep in its checking account? To help her figure it out, let's look at two ways to think about the optimal cash balance: the BAT model and the Miller-Orr model.

The BAT Model

As we've seen, Anais wants to know how much money to invest for her company and how much to leave in a cash account to pay the bills. One way to figure out the optimal level of cash for a corporation is the Baumol-Allais-Tobin model, also known as the BAT model. With this method, a certain amount of money is deposited into the cash account at regular intervals. For example, perhaps Anais figures out that, on average, the company spends $1,000,000 every two weeks. She might then deposit $1,000,000 into the company's cash account every two weeks.

There are two major costs to consider when using the BAT model: opportunity cost and trading cost. The opportunity cost, as we've already mentioned, is how much the money could make if invested elsewhere, instead of kept in cash. The trading cost is how much it costs to trade in securities or other investments for cash.

When the opportunity cost is equal to the trading cost in the BAT model, that is the optimal cash balance. So, for example, Anais may find that the opportunity and trading costs are equal if she deposits $500,000 every week instead of $1,000,000 every two weeks. That would mean that the optimal situation is for her to deposit weekly instead of biweekly.

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