ACCA Financial Management (F9) Certification Practice Exam

The Baumol model is designed to estimate what aspect of cash management?

1. Optimal debt-to-equity ratio

2. Optimal cash balance

3. Cash flow projections

4. Investment strategies

The correct answer is: Optimal cash balance

The Baumol model focuses on determining the optimal cash balance that a firm should maintain for its operational needs while minimizing the costs associated with holding cash and the costs incurred from frequently converting securities to cash. In practical terms, the model helps businesses to establish a target cash balance that balances the trade-off between transaction costs (costs associated with selling securities to generate cash for operational needs) and the opportunity cost of holding excess cash (which could otherwise be invested to earn a return). By utilizing the Baumol model, firms can calculate an ideal cash balance that allows them to manage liquidity effectively without incurring unnecessary costs. This model is particularly relevant for companies that deal with predictable cash flow patterns and need to maintain a balance between cash on hand and investment in marketable securities. It leverages a firm’s cash outflows and the costs associated with converting assets into cash to arrive at the most financially efficient cash holding strategy. Understanding the optimal cash balance facilitates better cash management practices and efficient operational functioning, which is critical for financial stability and growth.