ExpertMedium2 marksMultiple Choice
ACCA · Question 10 · Working Capital Management
Section A
AlgoTrade LLC, a high-frequency trading firm, requires $2,000,000 in cash over the next year to cover operational expenses. The cost of converting marketable securities into cash is $50 per transaction. The firm can earn 5% per annum on its marketable securities.
Using the Baumol model, what is the optimal cash conversion amount (the economic order quantity for cash)?
Section A
AlgoTrade LLC, a high-frequency trading firm, requires $2,000,000 in cash over the next year to cover operational expenses. The cost of converting marketable securities into cash is $50 per transaction. The firm can earn 5% per annum on its marketable securities.
Using the Baumol model, what is the optimal cash conversion amount (the economic order quantity for cash)?
Answer options:
A.
$31,623
B.
$44,721
C.
$63,246
D.
$200,000
How to approach this question
Apply the Baumol model formula: Q = square root of [(2 * Cost per transaction * Annual cash demand) / Interest rate].
Full Answer
C.$63,246✓ Correct
The Baumol model calculates the optimal cash balance to minimize the sum of transaction costs and opportunity costs (lost interest).
Formula: Q = √[(2 * C * D) / i]
Where C = $50, D = $2,000,000, i = 0.05.
Q = √[(2 * 50 * 2,000,000) / 0.05]
Q = √[200,000,000 / 0.05]
Q = √4,000,000,000 = $63,245.55 (rounded to $63,246).
Common mistakes
Using the interest rate as a whole number (5) instead of a decimal (0.05), or forgetting to take the square root.
Practice the full ACCA FM — Financial Management Practice Exam 6
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