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The Miller- Orr Model.pptx

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The Miller- Orr Model  Limitation Baumol Model- it does not allow cash flow to fluctuate.  The MO Miller- Orr) model Overcomes this shortcoming and allows for daily cash flow variation.  Assumption-Net cash flows are Normally Distributed with a zero value of mean and a standard deviation.  The MO Model provides for Two Control Limits – Upper Control limit and Lower control limit as well as Return Points.
The Miller- Orr Model • If the firm's cash flow fluctuate randomly and hit the upper limit, then it buys sufficient marketable securities to come back to a normal level of cash balance (the return point). • Similarly, When the firm’s cash flow wander and hit the lower limit, it sells sufficients securities to bring the cash balance back to normal level.( The return point).
The Miller-Orr Model • The difference between the upper limit and the lower limit depends on the following factors 1) Transaction cost. 2) Interest rate. 3) The standard deviation of net cash flow. The formula for determining the distance between upper and lower control limits( called Z= Spread) (Upper Limit - Lower Limit) = (3/4 x Transaction Cost x Cash Flow Variance/Interest Rate) Z= 3 4 × 𝑐𝜎 2 ⅈ 1 3  The financial manager can set the lower limit according to the firm's liquidity requirement Upper limit= lower limit + 3Z Return point= lower limit+ Z Average Cash Balance = lower limit + 4/3Z
Numerical PKG Company has a policy of maintaining a minimum cash balance of Rs 5,00,000. The standard deviation of the company's daily cash flows is Rs 2.00.000. The annual interest rate is 14 percentage .The transaction cost of buying or selling securities is Rs 150 per transaction. Determine PKG's upper control limit and the return point as per the Miller - Orr model. solution given lower limit = Rs 500000 S.D = Rs 200000 Annual Interest = 14% ( per day interest rate 0.14/365) transcation cost (c ) = Rs 150 • Z= 3 4 × 𝑐𝜎 2 ⅈ 1 3 Z= Rs227226 UL= LL+3Z =500000 +(3*227226) =RS 1181678 Return Point=LL +Z = 500000+ 227226 =Rs 727226

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The Miller- Orr Model.pptx

  • 1. The Miller- Orr Model  Limitation Baumol Model- it does not allow cash flow to fluctuate.  The MO Miller- Orr) model Overcomes this shortcoming and allows for daily cash flow variation.  Assumption-Net cash flows are Normally Distributed with a zero value of mean and a standard deviation.  The MO Model provides for Two Control Limits – Upper Control limit and Lower control limit as well as Return Points.
  • 2. The Miller- Orr Model • If the firm's cash flow fluctuate randomly and hit the upper limit, then it buys sufficient marketable securities to come back to a normal level of cash balance (the return point). • Similarly, When the firm’s cash flow wander and hit the lower limit, it sells sufficients securities to bring the cash balance back to normal level.( The return point).
  • 3. The Miller-Orr Model • The difference between the upper limit and the lower limit depends on the following factors 1) Transaction cost. 2) Interest rate. 3) The standard deviation of net cash flow. The formula for determining the distance between upper and lower control limits( called Z= Spread) (Upper Limit - Lower Limit) = (3/4 x Transaction Cost x Cash Flow Variance/Interest Rate) Z= 3 4 × 𝑐𝜎 2 ⅈ 1 3  The financial manager can set the lower limit according to the firm's liquidity requirement Upper limit= lower limit + 3Z Return point= lower limit+ Z Average Cash Balance = lower limit + 4/3Z
  • 4. Numerical PKG Company has a policy of maintaining a minimum cash balance of Rs 5,00,000. The standard deviation of the company's daily cash flows is Rs 2.00.000. The annual interest rate is 14 percentage .The transaction cost of buying or selling securities is Rs 150 per transaction. Determine PKG's upper control limit and the return point as per the Miller - Orr model. solution given lower limit = Rs 500000 S.D = Rs 200000 Annual Interest = 14% ( per day interest rate 0.14/365) transcation cost (c ) = Rs 150 • Z= 3 4 × 𝑐𝜎 2 ⅈ 1 3 Z= Rs227226 UL= LL+3Z =500000 +(3*227226) =RS 1181678 Return Point=LL +Z = 500000+ 227226 =Rs 727226
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