Executive Summary

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Executive Summary

• Cash management is not as complex and
  conceptually challenging as other topics, such as
  capital budgeting and asset pricing.
• Financial managers in many companies, especially
  in the retail and services industries, spend a
  significant portion of their time on cash
  management.
• Most large Canadian corporations hold some of
  their assets in cash and marketable securities.

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Chapter Outline

• 28.1 Reasons for Holding Cash
• 28.2 Determining the Target Cash Balance
• 28.3 Managing the Collection and Disbursement of
  Cash
• 28.4 Investing Idle Cash
• 28.5 Summary Conclusions

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28.1 Reasons for Holding Cash

• Transactions motive
• Transactions related needs come from normal
  disbursement and collection activities of the
  firm.
• The disbursement of cash includes the payment of
  wages and salaries, trade debts, taxes, and
  dividends.
• The cash inflows (collections) and outflows
  (disbursements) are not perfectly synchronized,
  and some level of cash holdings is necessary to
  serve as a buffer.
• Perfect liquidity is the characteristic of cash
  that allows it to satisfy the transactions motive.

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28.2 Determining the Target Cash Balance

• The target cash balance involves a trade-off
  between the opportunity costs of holding too much
  cash (lost interest) and the trading costs of
  holding too little.
• If a firm tries to keep its cash holdings too
  low, it will find itself selling marketable
  securities more frequently than if the cash
  balance were higher.
• The trading costs will tend to fall as the cash
  balance becomes larger.
• The opportunity costs of holding cash rise as the
  cash holdings rise.

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28.2 Determining the Target Cash Balance

• The Baumol Model
• The Miller-Orr Model
• Other Factors Influencing the Target Cash Balance

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Costs of Holding Cash
Costs in dollars of holding cash
Trading costs increase when the firm must sell
securities to meet cash needs.
The investment income foregone when holding cash.
C
Size of cash balance
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The Baumol Model

• F The fixed cost of selling securities to raise
  cash
• T The total amount of new cash needed
• K The opportunity cost of holding cash this is
  the interest rate.

Time
1 2 3
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The Baumol Model

• F The fixed cost of selling securities to raise
  cash
• T The total amount of new cash needed
• K The opportunity cost of holding cash this is
  the interest rate.

As we transfer C each period we incur a trading
cost of F each period. If we need T in total over
the planning period we will pay F, T C times.
Time
1 2 3
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The Baumol Model
C
Size of cash balance
The optimal cash balance is found where the
opportunity costs equal the trading costs
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The Baumol Model
The optimal cash balance is found where the
opportunity costs equal the trading costs
Opportunity Costs Trading Costs
Multiply both sides by C
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The Miller-Orr Model

• The firm allows its cash balance to wander
  randomly between upper and lower control limits.

When the cash balance reaches the upper control
limit H cash is invested elsewhere to get us to
the target cash balance Z.
When the cash balance reaches the lower control
limit, L, investments are sold to raise cash to
get us up to the target cash balance.
Time
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The Miller-Orr Model Math

• Given L, which is set by the firm, the Miller-Orr
  model solves for Z and H

• where s2 is the variance of net daily cash flows.
• The average cash balance in the Miller-Orr model
  is

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Implications of the Miller-Orr Model

• To use the Miller-Orr model, the manager must do
  four things
• Set the lower control limit for the cash balance.
• Estimate the standard deviation of daily cash
  flows.
• Determine the interest rate.
• Estimate the trading costs of buying and selling
  securities.
• The model clarifies the issues of cash
  management
• The best return point, Z, is positively related
  to trading costs, F, and negatively related to
  the interest rate K.
• Z and the average cash balance are positively
  related to the variability of cash flows.

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Other Factors Influencing the Target Cash Balance

• Borrowing
• Borrowing is likely to be more expensive than
  selling marketable securities.
• The need to borrow will depend on managements
  desire to hold low cash balances.
• Relative costs
• For large firms, the trading costs of buying and
  selling securities are very small when compared
  to the opportunity costs of holding cash.

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28.3 Managing the Collection and Disbursement of
Cash

• The difference between bank cash and book cash is
  called float.
• Float management involves controlling the
  collection and disbursement of cash.
• The objective in cash collection is to reduce the
  lag between the time customers pay their bills
  and the time the cheques are collected.
• The objective in cash disbursement is to slow
  down payments, thereby increasing the time
  between when cheques are written and when cheques
  are presented.

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Electronic Data Interchange

• Electronic Data Interchange (EDI) is a general
  term that refers to the growing practice of
  direct, electronic information exchange between
  all types of businesses.
• One important use of EDI is to electronically
  transfer financial information and funds between
  parties, to eliminate paper invoices, paper
  cheques, mailing, and handling.
• One of the drawbacks of EDI is that it is
  expensive and complex to set up.

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Accelerating Collections
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Overview of Lockbox Processing
Local Bank Collects funds from PO Boxes
Envelopes opened separation of cheques and
receipts
Deposit of cheques into bank accounts
Details of receivables go to firm
Firm processes receivables
Bank clears cheques
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Electronic Collection Systems

• Focus on reducing float virtually to zero by
  replacing cheques with electronic funds transfer.
• Examples used in Canada
• Preauthorized payments
• Point-of-sales transfers
• Electronic trade payables
• Smart cards.

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Controlling Disbursements

• Firms use zero-balance accounts to avoid carrying
  extra balances in each disbursement account.
• With a zero-balance account, the firm, in
  cooperation with its bank, transfers in just
  enough funds to cover cheques presented that day.
• The firm maintains two disbursement accounts one
  for suppliers and one for payroll.

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Ethical and Legal Questions

• The financial managers must always work with
  collected bank cash balances and not with the
  companys book balance, which reflects cheques
  that have been deposited but not collected.
• If you are borrowing the banks money without
  their knowledge, you are raising serious ethical
  and legal questions.
• The issue is minor in Canada since there can be a
  maximum of only one days deposit float.

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28.4 Investing Idle Cash

• A firm with surplus cash can park it in the
  money market.
• Some large firms and many small ones use money
  market mutual funds.
• Canadian chartered banks compete with money
  market funds offering arrangements in which the
  bank takes all excess available funds at the
  close of each business day and invests them for
  the firm.
• Firms have surplus cash for three reasons
• Seasonal or Cyclical Activities
• Planned Expenditures
• Different Types of Money Market Securities

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Seasonal Cash Demands
Total Financing needs
Short-term financing
Long-term financing
Time
J F M A M
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Characteristics of Short-term Securities

• Maturity
• Longer maturity securities are more exposed to
  interest rate risk than shorter maturity
  securities.
• Default risk
• DBRS compiles and publishes ratings of various
  corporate and public securities.
• Marketability
• No price-pressure effect
• Time.
• Taxability

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Some Different Types of Money-Market Securities

• Money-market securities are highly marketable and
  short-term.
• They are issued by the federal government,
  domestic and foreign banks, and business
  corporations.
• Examples are
• T-bills
• Commercial paper
• Bankers acceptances
• Dollar swaps

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28.5 Summary Conclusions

• A firm holds cash to conduct transactions and to
  compensate banks for the various services they
  render.
• The optimal amount of cash for a firm to hold
  depends on the opportunity cost of holding cash
  and the uncertainty of future cash inflows and
  outflows.
• Two transactions models that provide rough
  guidelines for determining the optimal cash
  position are
• The Miller-Orr model
• The Baumol model

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28.5 Summary Conclusions

• The firm can make use of a variety of procedures
  to manage the collection and disbursement of cash
  in such as way as to speed up the collection of
  cash and slow down payments.
• Some methods to speed collections are
• Lockboxes
• Concentration banking
• Wire transfers
• The financial managers must always work with
  collected company cash balances and not with the
  companys book balance.

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28.5 Summary Conclusions

• If you are borrowing the banks money without
  their knowledge, you are raising serious ethical
  and legal questions.
• The answers to which you probably know by now.