Question

What are the limitations of the Baumol model?

Answer 1

The Baumol model is a cash management model. The Baumola model is used to determine the appropriate level of cash, which will minimize the total transaction costs and alternative costs as a result of maintaining a given level of cash.

The limitations of the Baumol model are as below:

1. the company has to use up the stock evenly in order for the model to work. In practice, this is almost impossible.
2. It is difficult to determine the precise demand for financial resources, also the expenses incurred by the company do not spread equally over the entire period.
3. A time-varying transaction commission, which can often be negotiated and depends on the size of the transaction and the maturity date.
4. The interest rate on the current account is variable over time, as is the yield on treasury bills, which additionally depends on the maturity of separate series.
5. The model works satisfactorily for a firm which uses cash at steady rate but not if there are larger inflows and outflows of cash over time
6. Future interest rates can not be predicted precisely.