Skip to main content

How to use Miller Orr Model?

Cash is essential to meet day to day requirement for smoothly running a business. And managing the cash is also necessary because if cash is less than requirement level then company have to borrow the fund which increases the company’s interest paying burden and if more cash is available in comparison to required level in that case the unnecessary cash is acted as wastage for a company. To manage day to day cash and fulfil the requirement of the business Miller Orr Model is used.  

In this model the idle cash and the cash level is maintained properly. The below diagram explain the model briefly:

In above diagram the vertical line shows cash in rupees and horizontal line shows time period. The L line shows the minimum level or limited level of cash beyond which cash doesn’t go. Or you can say the safety level of company.  The Z line or point shows the target level or return point of cash should be available in a company. The H line shows the excess level of cash available in a company. The cash between H and Z is idle and to manage this cash efficiently it is used by purchasing the marketable securities. If the cash is below from Z point or level then those marketable securities which are purchased earlier are sold to meet the cash requirement of the company. So, that company does not need any borrowed funds to meet the cash requirement.

Formula:

Return point = Limited amount + 1/3 spread

Spread = 3[(3*transaction cost*variance of cash flows)/4*Daily Interest rate] ^1/3

OR

Spread = 3[(3*transaction cost*variance of cash flows)/4*annual Interest rate/365] ^1/3

Upper limit = 3z – 2l

Variance of cash = σ2 or (standard deviation) 2

Example: Company PQR has decided to maintain limited amount of cash which is Rs.25, 000. The cash variance is 5,7,60,000 (standard deviation 2400). The selling and purchasing cost of marketable securities is Rs. 5,000. The annual interest rate is 6.2% Find out the targeted return point.

Solution:  Optimal return point = Limited amount + 1/3 (3[(3/4*transaction cost*variance of cash flows)/Interest rate] ^1/3)

= 25,000 + 1/3 (3[(3*5000*5760000)/4*(0.062/365)] ^1/3)

= 25,000 + 1/3 *(3[86, 40, 00, 00,000/0.00068]^1/3)

= 25,000 + 1/3 *(3[12, 70, 58, 82, 35, 29, 411.76] ^1/3)

= 25,000 + 1/3 * 1, 50,819.047

= 25,000 + 50,273.016

= Rs.75, 273.016

Example: Mehta & Sons wants to maintain minimum Rs.10, 000 cash balance. The daily variance of cash is Rs. 50, 00,000 and transaction cost for purchasing and selling securities is Rs. 150. The daily interest rate is 0.007%. Find out the return point and upper limit of cash balance with the help of Miller Orr model.

Solution: Optimal return point = Limited amount + 1/3 (3[(3/4*transaction cost*variance of cash flows)/Interest rate] ^1/3)

= 10,000 + 1/3 (3[(3*150*50, 00,000)/4*0.00007] ^1/3)

= 10,000 + 1/3 (3[2, 25, 00, 00, 000/0.00028] ^1/3)

= 10,000 + 1/3 (3*[80, 35, 71, 42, 85,714.29] ^1/3)

= 10,000 + 1/3* 60,089.15

= 10,000 + 20,029.72

= 30,029.72

Upper limit = 3z-2l

= 3*30, 029.72 – 2*10,000

= 90, 089.16 – 20, 000

= 70, 089.16

 

 

 

 

 

Comments

Post a Comment

Popular posts from this blog

How to calculate Cost of Preference Share Capital?

Cost of Preference Share Capital:  An amount paid by company as dividend to preference shareholder is known as Cost of Preference Share Capital. Preference share is a small unit of a company’s capital which bears fixed rate of dividend and holder of it gets dividend when company earn profit. Dividend payable is not a tax deductible amount. So, there is no tax adjustments required for comparing with cost of debt. Formula for Cost of Preference Share: Irredeemable Preference Share Redeemable Preference Share K p  = Dp/NP K p  = D p +((RV-NP)/n )/ (RV+NP)/2 Where, K p  = Cost of Preference Share D p  = Dividend on preference share NP = Net proceeds from issue of preference share (Issue price – Flotation cost) RV = Redemption Value N = Period of preference share Example:  A company issues 20,000 irredeemable preference share at 8% whose face value is Rs.50 each at 4% discount. Find out the Cost of ...
88 comments
Read more

What is the difference between Cheque book and Pass book?

 Cheque book is issued by bank in customers / account holder request. With the help of this book account holder can withdraw cash from his/her account. Bank does not charge any fee to issued cheque book to its customer. But afterward bank charges some amount for using bank facility like cheque book, Debit card etc.So, Automatic some definite amount deducted from customer bank account. Pass book is  also issued by bank to its customer. It helps to record all the bank related activity according to date that is withdrawal and deposit. It is recorded by bank but the book is kept by customer to know the current balance of  his /her account.  Point of difference Pass book Cheque book What is the meaning of pass book and cheque book? Passbook is a book in which all withdrawal and deposit against customer account is recorded.   Cheque book is a book of cheques which are used to withdrawal the money to b...
Post a Comment
Read more

Numericals with solutions of Net income Approach

Net income approach questions and answers:   Questions:  Find out the value of the firm with the help of given information: Particulars Amount Earnings before interest and tax 3, 50, 000 Cost of equity 10% Cost of debt 7.2% Debenture 1,00,000 Find out the overall cost of capital with the help of net income approach. (Assume tax rate-10%) Solution: Particulars Amount Earnings before interest and tax 3, 50, 000 Less: Interest @7.2% 7, 200 Earnings before tax 3, 42, 800 Less: Tax@10% 34, 280 Net income 3, 08, 520 Cost of equity 10% Market value of equity (S =net income/ cost of equity) 30, 85, 200 Market value of debt (B) 1, 00, 000 Value of the firm (S+B) 31, 85, 200 Questions:  Find out the overall cost of capital if the equity capitalisation rate is 12...
Post a Comment
Read more