Implications of the BAT and Miller Orr Models

Our two cash management models differ in complexity, but they have some similar implications. In both cases, all other things being equal, we see that:

1. The greater the interest rate, the lower is the target cash balance.

2. The greater the order cost, the higher is the target balance.

2M. H. Miller and D. Orr, "A Model of the Demand for Money by Firms,' August 1966.

Quarterly Journal of Economics, w

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VII. Short-Term Financial Planning and Management

20. Cash and Liquidity Management

© The McGraw-Hill Companies, 2002

PART SEVEN Short-Term Financial Planning and Management

These implications are both fairly obvious. The advantage of the Miller-Orr model is that it improves our understanding of the problem of cash management by considering the effect of uncertainty as measured by the variation in net cash inflows.

The Miller-Orr model shows that the greater the uncertainty is (the higher u1 is), the greater is the difference between the target balance and the minimum balance. Similarly, the greater the uncertainty is, the higher is the upper limit and the higher is the average cash balance. These statements all make intuitive sense. For example, the greater the variability is, the greater is the chance that the balance will drop below the minimum. We thus keep a higher balance to guard against this happening.

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