ACCA Financial Management (F9) Certification Practice Exam

What formula is used to calculate the spread in the Miller-Orr Model?

1. 3 x ((3/4 x Transaction cost x variance of revenues)/Interest Rate)^1/3

2. 3 x ((3/4 x Transaction cost x variance of cash flows)/Interest Rate)^1/3

3. 4 x ((3/4 x Transaction cost x variance of cash flows)/Interest Rate)^1/3

4. 3 x ((4/3 x Transaction cost x variance of cash flows)/Interest Rate)^1/3

The correct answer is: 3 x ((3/4 x Transaction cost x variance of cash flows)/Interest Rate)^1/3

In the Miller-Orr Model, the formula for calculating the spread is essential for effectively managing cash balances to minimize transaction costs while ensuring that sufficient liquidity is maintained. The correct formulation takes into account the transaction cost, variance of cash flows, and the interest rate, which are all crucial factors in determining the optimal spread. The usage of variance of cash flows in the formula reflects the uncertainty and variability in cash inflows and outflows that a company might experience, which affects how much cash should be readily available. The inclusion of transaction costs highlights the need to balance liquidity against the costs incurred when converting short-term investments into cash. The interest rate factor serves to adjust the calculations for the present value of these costs and the benefits gained from holding cash versus investing in other assets. Overall, the chosen formula effectively incorporates these elements to establish an optimal cash reserve strategy that minimizes costs associated with liquidity and transaction processes. The proportions and constants in the formula are derived from theoretical considerations of cash management, where the modeling focuses on ensuring that excess cash is efficiently utilized while still allowing for the operational flexibility that depends on having liquid resources readily available.