During any month, Cashmachine Co. has a 50% chance of receiving a $1,000 cash inflow and 50% chance that there will be a $1,000 cash outflow. For every $1,000 in cash on hand at the end of a month, Cashmachine incurs a $15 cost (due to lost interest). At the beginning of each month, Cashmachine can adjust its on-hand cash balance upward or downward with the cost per transaction being $20.
Cashmachine can never let the on-hand balance become negative. The sequence of events during each month is as follows:
a. Observe beginning cash balance;
b. Adjust (if desired) case balance;
c. Cash balance changes due to inflow or outflow of cash;
d. Opportunity cost is assessed.
The company is considering the following two cash management policies:
Policy 1: at the beginning of a month in which the on-hand cash balance is $3,000, immediately reduce the cash balance to $1,000. At the beginning of a month in which the on-hand balance is $0, immediately bring the on-hand cash balance up to $1,000.
Policy 2: at the beginning of a month in which the on-hand cash balance is $4,000, immediately reduce the cash balance to $2,000. At the beginning of a month in which the on-hand balance is $0, immediately bring the on-hand cash balance up to $2,000.
What policy will incur lower expected monthly costs (opportunity plus transaction)?
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