Answer to Appendix Review and Self Test Problem

20A.1 From the BAT model, we know that the target cash balance is:

The average cash balance will be C*/2 = $20,000/2 = $10,000. The opportunity cost of holding $10,000 when the going rate is 12 percent is $10,000 X .12 = $1,200. There will be $240,000/20,000 = 12 orders during the year, so the order cost, or trading cost, is also 12 X $100 = $1,200. The total cost is thus $2,400.

If $15,000 is held, then the average balance is $7,500. Verify that the opportunity, trading, and total costs in this case are $900, $1,600, and $2,500, respectively. If $25,000 is held, these numbers are $1,500, $960, and $2,460, respectively.

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