Brealey−Meyers: Principles of Corporate Finance, 7th Edition - Chapter 31 ppsx

It deposits the check, and both the companyand the bank increase the ledger balance by $100,000: Company's ledger balance ac-show that United Carbon has an available balance of $1 millio

CASH MANAGEMENT

CHAPTER 30 PROVIDEDan overall idea of what is involved in short-term financial management Now it

is time to get down to detail We begin in this chapter by looking at how companies manage theirholdings of cash and marketable securities Then in the next chapter we look at the terms on whichfirms sell their goods and how they ensure that their customers pay promptly

Out first task is to explain how cash is collected and paid out In the United States small routinepayments are commonly made by check You want to ensure that when customers pay by check, youcan convert these payments into usable cash in the bank quickly and cheaply The use of checks is onthe decline and large payments are almost always made electronically You therefore need to under-stand how electronic payment systems work

Our second task is to consider how much cash the firm should hold Companies have a choice tween holding cash in the bank and investing it in short-term securities There is a trade-off here Cashgives you a store of liquidity, which can be used to pay employees and suppliers However, cash hasthe disadvantage that it does not pay interest As we explain in the second section of this chapter,the trick is to strike a sensible balance

be-In the last chapter we explained how companies raise short-term loans to tide them over a porary cash shortage If you are in the opposite position and have surplus cash, you need to knowwhere you can park it to earn interest So in the final section of this chapter we look at the menu ofshort-term investments that are available to the financial manager

tem-881

31.1 CASH COLLECTION AND DISBURSEMENT

The majority of small face-to-face purchases are made with coins or dollar bills

The most popular alternative in the United States for retail purchases is to pay by

check Each year individuals and firms write about 70 billion checks

Notice that the United States is unusual in this heavy use of checks For

exam-ple, Figure 31.1 compares retail payment methods in the United States and

Hol-land You can see that checks are almost unknown in Holland: Most payments

there are made by debit cards, direct debit, or credit transfer.1

How Checks Create Float

How does the firm’s cash balance change when it writes or deposits a check? Suppose

that the United Carbon Company has $1 million on demand deposit with its bank It

now pays one of its suppliers by writing and mailing a check for $200,000 The

com-pany’s ledgers are immediately adjusted to show a cash balance of $800,000 But the

company’s bank won’t learn anything about this check until it has been received by

the supplier, deposited at the supplier’s bank, and finally presented to United

Car-bon’s bank for payment.2During this time United Carbon’s bank continues to show

1 Debit cards allow the cardholder to transfer money directly to the receiver’s bank account With a

credit transfer the payer initiates the transaction, for example by giving her bank a standing order to

make a regular payment With a direct debit the transaction is initiated by the payee and is usually

processed electronically.

2 Checks deposited with a bank are cleared through the Federal Reserve clearing system, through a

cor-respondent bank, or through a clearinghouse of local banks.

in its ledger that the company has a balance of $1 million The company obtains thebenefit of an extra $200,000 in the bank while the check is clearing This sum is often

called payment, or disbursement float.

Check Direct debit Debit card Credit card Credit transfer

F I G U R E 3 1 1

Shares of noncash retail payments in the USA and Holland in 1997 Notice the heavy use of checks in the USA.

Source: “Retail Payments in Selected Countries: A Comparative Study,” Bank for International Settlements, Basel, 1999.

Company's ledger balance

Float sounds like a marvelous invention, but unfortunately it can also work in

reverse Suppose that in addition to paying its supplier, United Carbon receives a

check for $100,000 from a customer It deposits the check, and both the companyand the bank increase the ledger balance by $100,000:

Company's ledger balance

ac-show that United Carbon has an available balance of $1 million and an availability

float of $100,000:

Notice that the company gains as a result of the payment float and loses as a

re-sult of the availability float The difference is often termed the net float In our

ex-ample, the net float is $100,000 The company’s available balance is therefore

$100,000 greater than the balance shown in its ledger

As financial manager you are concerned with the available balance, not with the

company’s ledger balance If you know that it is going to be a week or two before

some of your checks are presented for payment, you may be able to get by on a

smaller cash balance This game is often called playing the float.

You can increase your available cash balance by increasing your net float This

means that you want to ensure that checks paid in by customers are cleared

rap-idly and those paid to suppliers are cleared slowly Perhaps this may sound like

rather small beer, but think what it can mean to a company like Ford Ford’s daily

sales average about $450 million Therefore if it can speed up the collection process

by one day, it frees $450 million, which is available for investment or payment to

Ford’s stockholders

Some financial managers have become overenthusiastic in managing the float

In 1985, the brokerage firm E F Hutton pleaded guilty to 2,000 separate counts of

mail and wire fraud Hutton admitted that it had created nearly $1 billion of float

by shuffling funds between its branches, and through various accounts at different

banks These activities cost the company a $2 million fine and its agreement to

re-pay the banks any losses they may have incurred

Managing Float

Float is the child of delay Actually there are several kinds of delay, and so people in

the cash management business refer to several kinds of float Figure 31.2 summarizes

Of course the delays that help the payer hurt the recipient Recipients try to

speed up collections Payers try to slow down disbursements

Speeding Up Collections

Many companies use concentration banking to speed up collections In this case

customers in a particular area make payment to a local branch office rather than

to company headquarters The local branch office then deposits the checks into a

CHAPTER 31 Cash Management 883

Company's ledger balance

local bank account Surplus funds are transferred to a concentration account at one

of the company’s principal banks

Concentration banking reduces float in two ways First, because the branch office

is nearer to the customer, mailing time is reduced Second, since the customer’s check

is likely to be drawn on a local bank, the time taken to clear the check is also reduced.Concentration banking brings many small balances together in one large, central bal-ance, which can then be invested in interest-paying assets through a single transaction.For example, when Amoco streamlined its U.S bank accounts in 1995, it was able toreduce its daily bank balances in non-interest-bearing accounts by almost 80 percent.3

Often concentration banking is combined with a lock-box system In a lock-box

system, you pay the local bank to take on the administrative chores The systemworks as follows The company rents a locked post office box in each principal re-gion All customers within a region are instructed to send their payments to thepost office box The local bank, as agent for the company, empties the box at regu-lar intervals and deposits the checks in the company’s local account Surplus fundsare transferred periodically to one of the company’s principal banks

Payer sees same delays

as payment float

Recipient sees delays

as collection float

Check received

Check deposited

Check charged to payer's account

Cash available

to recipient

Check mailed

Processing float

Presentation float

Availability float

Mail float

F I G U R E 3 1 2

Delays create float Each heavy

arrow represents a source of

delay Recipients try to reduce

delay to get available cash

sooner Payers prefer delay

because they can use their

cash longer

Note: The delays causing

avail-ability float and presentation float

are equal on average but can differ

from case to case.

3“Amoco Streamlines Treasury Operations,” The Citibank Globe, November/December 1998.

How many collection points do you need if you use a lock-box system or

con-centration banking? The answer depends on where your customers are and on the

speed of the U.S mail For example, suppose that you are thinking of opening a

lock box The local bank shows you a map of mail delivery times From that and

knowledge of your customers’ locations, you come up with the following data:

• Average number of daily payments to lock box: 150

On this basis, the lock box would increase your collected balance by

150 items per day ⫻ $1,200 per item ⫻ (1.2 ⫹ 8) days saved ⫽ $360,000

Invested at 02 percent per day, $360,000 gives a daily return of

.0002 ⫻ $360,000 ⫽ $72The bank’s charge for operating the lock-box system depends on the number of

checks processed Suppose that the bank charges $.26 per check That works out to

150 ⫻ 26 ⫽ $39 per day You are ahead by $72 ⫺ 39 ⫽ $33 per day, plus whatever

your firm saves from not having to process the checks itself

Our example assumes that the company has only two choices It can do nothing,

or it can operate the lock box But maybe there is some other lock-box location, or

some mixture of locations, that would be still more effective Of course, you can

al-ways find this out by working through all possible combinations, but it may be

simpler to solve the problem by linear programming Many banks offer linear

pro-gramming models to solve the problem of locating lock boxes.4

Controlling Disbursements

Speeding up collections is not the only way to increase the net float You can also

do so by slowing down disbursements One tempting strategy is to increase mail

time For example, United Carbon could pay its New York suppliers with checks

mailed from Nome, Alaska, and its Los Angeles suppliers with checks mailed from

Vienna, Maine

But on second thought you will realize that such post office tricks are unlikely

to give more than a short-run payoff Suppose you have promised to pay a New

York supplier on February 29 Does it matter whether you mail the check from

Alaska on the 26th or from New York on the 28th? Of course, you could use a

re-mote mailing address as an excuse for paying late, but that’s a trick easily seen

through If you have to pay late, you may as well mail late.5

There are effective ways of increasing presentation float, however For example,

suppose that United Carbon pays its suppliers with checks written on a New York

City bank From the time that the check has been deposited by the supplier, there

CHAPTER 31 Cash Management 885

4See, for example, A Kraus, C Janssen, and A McAdams, “The Lock-Box Location Problem,” Journal of

Bank Research 1 (Autumn 1970), pp 50–58.

5 Since the tax authorities look at the date of the postmark rather than the date of receipt, companies have

been tempted to use a remote mailing address to pay their tax bills But the tax authorities have reacted

by demanding that large tax bills be paid by electronic transfer.

will be an average lapse of little more than a day before it is presented to UnitedCarbon’s bank for payment The alternative is that United Carbon pays its suppli-

ers with checks mailed to arrive on time but written on a bank in Helena, Montana;

Midland, Texas; or Wilmington, Delaware In these cases, it may take three or fourdays before each check is presented for payment United Carbon, therefore, gainsseveral days of additional float.6

Some firms even maintain disbursement accounts in different parts of the try The computer looks up each supplier’s zip code and automatically produces acheck on the most distant bank

coun-The suppliers won’t object to these machinations because the Federal Reserveguarantees a maximum clearing time of two days on all checks cleared through itssystem The Federal Reserve, however, does object and has been trying to preventremote disbursement

A New York City bank receives several check deliveries each day from the eral Reserve system as well as checks that come directly from other banks orthrough the local clearinghouse Thus, if United Carbon uses a New York City bankfor paying its suppliers, it will not know at the beginning of the day how manychecks will be presented for payment It must either keep a large cash balance

Fed-to cover contingencies or be prepared Fed-to borrow However, instead of having a

disbursement account with a bank in New York, United Carbon could open a

zero-balance account with a regional bank that receives almost all check deliveries in the

form of a single, early-morning delivery from the Federal Reserve Therefore, it canlet the cash manager at United Carbon know early in the day exactly how muchmoney will be paid out that day The cash manager then arranges for this sum to

be transferred from the company’s concentration account to the disbursement count Thus by the end of the day (and at the start of the next day), United Carbonhas a zero balance in the disbursement account

ac-United Carbon’s regional bank account has two advantages First, by choosing

a remote location, the company has gained several days of float Second, becausethe bank can forecast early in the day how much money will be paid out, UnitedCarbon does not need to keep extra cash in the account to cover contingencies.The Finance in the News box describes how one Canadian company was able

to reduce its cash needs by concentrating its cash holdings and using balance accounts

zero-Electronic Funds Transfer

Throughout the world the use of checks is on the decline For consumers they arebeing replaced by credit or debit cards In the case of companies, payments are in-creasingly made electronically.7Electronic payments are relatively few in numberbut they account for the majority of transactions by value Electronic payment sys-

tems may be of two kinds—a gross settlement system or a net settlement system.

With gross settlement each payment is settled individually; with net settlement allpayment instructions are accumulated and then at the end of the day any imbal-ances are settled

6Remote disbursement accounts are described in I Ross, “The Race Is to the Slow Payer,” Fortune, April

18, 1983, pp 75–80.

7 Consumers also may receive and pay bills electronically via their personal computer Currently tronic Bill Presentment and Payment (EBPP) accounts for only a small proportion of payments but it is forecasted to grow rapidly.

Elec-In the United States there are two systems for making large-value electronic

payments—Fedwire (a gross system) and CHIPS (a net system) Fedwire is

op-erated by the Federal Reserve system and connects over 10,000 financial

institu-tions in the United States to the Fed and thereby to each other Suppose Bank A

instructs the Fed to transfer $1 million from its account with the Fed to the

ac-count of Bank B Bank A’s acac-count is debited immediately and Bank B’s acac-count

is credited at the same time Fedwire is therefore an example of a real-time gross

settlement (RTGS) system Most developed countries now operate RTGS systems

for large-value payments

Real-time gross settlement suffers from a potential problem If Bank A needs to

pay Bank B, B needs to pay C, and C needs to pay A, there is a risk that the system

could gridlock unless each bank kept a large reserve with the Fed (A might not be

able to pay B until it has been paid by C, C can’t pay A until paid by B, and B in

turn is awaiting payment by A.) To oil the wheels, therefore, the Fed takes on the

credit risk by paying the receiving bank even if there are insufficient funds in the

account of the payer Since each payment is final and guaranteed by the Fed, each

receiving bank can be sure that it has the money and can give its customer

imme-diate access to the funds

Cross-border high-value payments in dollars are handled by CHIPS, which is a

privately owned system connecting 115 large domestic and foreign banks CHIPS

accumulates payment instructions throughout the day, and at the end of the day

each bank settles up the net payment using Fedwire This means that, if the bank

receiving payments makes the funds available to its customers during the day, it

would be at risk if the paying bank goes belly up during the day Banks control this

risk by imposing intraday credit limits on their exposure to each other

887

F I N A N C E I N T H E N E W S

HOW LAIDLAW RESTRUCTURED

ITS CASH MANAGEMENT

The Canadian company, Laidlaw Inc., has more

than 4,000 facilities throughout America, operating

school bus services, ambulance services, and

Grey-hound coaches During the 1990s the company

ex-panded rapidly through acquisition, and its number

of banking relationships multiplied until it had

1,000 separate bank accounts with more than 200

different banks The head office had no way of

knowing how much cash was stashed away in these

accounts until the end of each quarter, when it was

able to construct a consolidated balance sheet

To economize on the use of cash, Laidlaw’s

fi-nancial manager sought to cut the company’s

aver-age float from five days to two At the same timemanagement decided to consolidate cash manage-ment at five key banks This enabled cash to bezero-balanced to a single account for each divisionand swept daily to Laidlaw’s disbursement bank.Because the head office could obtain daily reports

of the company’s cash position, cash forecastingwas improved and the company could reduce itscash needs still further

Source: Cash management at Laidlaw is described in G Mann and

S Hutchison, “Driving Down Working Capital: Laidlaw’s Story,” Canadian Treasurer Magazine, August/September 1999.

Fedwire and CHIPS provide same-day settlement and are used to make value payments Bulk payments such as wages, dividends, and payments to sup-

high-pliers generally travel through the Automated Clearinghouse (ACH) system and take

two to three days In this case the company simply needs to provide a computerfile of instructions to its bank, which then debits the corporation’s account and for-wards the payments to the ACH system The ACH system is the largest paymentsystem in the United States and in 1999 handled 6.2 billion payments with a value

• The marginal cost of transactions is very low For example, it costs less than

$10 to transfer huge sums of money using Fedwire and only a few cents tomake an ACH transfer

• Float is drastically reduced Wire transfers generate no float at all This can result

in substantial savings For example, cash managers at Occidental Petroleumfound that one plant was paying out about $8 million per month three to fivedays early to avoid any risk of late fees if checks were delayed in the mail Thesolution was obvious: The plant’s managers switched to paying large billselectronically; that way they could ensure they arrived exactly on time.9

International Cash Management

Cash management in domestic firms is child’s play compared with that in largemultinational corporations operating in dozens of countries, each with its own cur-rency, banking system, and legal structure

A single, centralized cash management system is an unattainable ideal for thesecompanies, although they are edging toward it For example, suppose that you arethe treasurer of a large multinational company with operations throughout Eu-rope You could allow the separate businesses to manage their own cash but thatwould be costly and would almost certainly result in each one accumulating littlehoards of cash The solution is to set up a regional system In this case the companyestablishes a local concentration account with a bank in each country Then anysurplus cash is swept daily into central multicurrency accounts in London or an-other European banking center This cash is then invested in marketable securities

or used to finance any subsidiaries that have a cash shortage

Payments also can be made out of the regional center For example, to pay wages

in each European country, the company just needs to send its principal bank a puter file with details of the payments to be made The bank then finds the leastcostly way to transfer the cash from the company’s central accounts and arrangesfor the funds to be credited on the correct day to the employees in each country

com-8J D Moss, “Campbell Soup’s Cutting-Edge Cash Management,” Financial Executive 8 (September/

October 1992), pp 39–42.

9R J Pisapia, “The Cash Manager’s Expanding Role: Working Capital,” Journal of Cash Management 10

(November/December 1990), pp 11–14.

Companies that maintain separate balances in each country are liable to find

that they have a cash surplus in one country and a shortage in another In this case

the company could lend the surplus and borrow the deficit However, that is likely

to be costly, since banks need to charge a higher rate to borrowers than they pay to

lenders One alternative is to convert the surplus cash pool into the currency which

is in short supply, but the simpler solution is to arrange for the bank to pool all your

cash surpluses and shortages In this case no money is transferred between

ac-counts Instead, the bank just adds together the credit and debit balances and pays

you interest at its lending rate on the net surplus

Most large multinationals have several banks in each country, but the more

banks they use, the less control they have over their cash balances So development

of regional cash management systems favors banks that can offer a worldwide

branch network These banks also can afford to invest the several billion dollars

that are needed to set up computer systems for handling cash payments and

re-ceipts in many different countries

Paying for Bank Services

Much of the work of cash management—processing checks, transferring funds,

running lock boxes, helping keep track of the company’s accounts—is done by

banks And banks provide many other services not so directly linked to cash

man-agement, such as handling payments and receipts in foreign currency or acting as

custodian for securities.10

All these services have to be paid for Usually payment is in the form of a

monthly fee, but banks may agree to waive the fee as long as the firm maintains a

minimum average balance in an interest-free deposit Banks are prepared to do

this, because, after setting aside a portion of the money in a reserve account with

the Fed, they can relend the money to earn interest Demand deposits earmarked

to pay for bank services are termed compensating balances They used to be a very

common way to pay for bank services, but there has been a steady trend away from

using compensating balances and toward direct fees

CHAPTER 31 Cash Management 889

10

Of course, banks also lend money or give firms the option to borrow under a line of credit See Section 30.6.

31.2 HOW MUCH CASH SHOULD THE FIRM HOLD?

Cash pays no interest So why do individuals and corporations hold billions of

dol-lars in cash and demand deposits? Why, for example, don’t you take all your cash

and invest it in interest-bearing securities? The answer of course is that cash gives

you more liquidity than securities You can use it to buy things It is hard enough

getting New York cab drivers to give you change for a $20 bill, but try asking them

to split a Treasury bill

In equilibrium all assets in the same risk class are priced to give the same expected

marginal benefit The benefit from holding Treasury bills is the interest that you

re-ceive; the benefit from holding cash is that it gives you a convenient store of

liquid-ity In equilibrium the marginal value of this liquidity is equal to the marginal value

of the interest on Treasury bills This is just another way of saying that Treasury bills

are investments with zero net present value; they are fair value relative to cash

Does this mean that it does not matter how much cash you hold? Of course not.The marginal value of liquidity declines as you hold increasing amounts of cash.When you have only a small proportion of your assets in cash, a little extra can beextremely useful; when you have a substantial holding, any additional liquidity isnot worth much Therefore, as financial manager you want to hold cash balances

up to the point where the marginal value of the liquidity is equal to the value of theinterest forgone

If that seems more easily said than done, you may be comforted to know thatproduction managers must make a similar trade-off Ask yourself why firms carryinventories of raw materials They are not obliged to do so; they could simply buymaterials day by day, as needed But then they would pay higher prices for order-ing in small lots, and they would risk production delays if the materials were notdelivered on time That is why they order more than the firm’s immediate needs.11

But there is a cost to holding inventories Interest is lost on the money that is tied

up in inventories, storage must be paid for, and often there is spoilage and oration Therefore production managers try to strike a sensible balance betweenthe costs of holding too little inventory and those of holding too much

deteri-It is exactly the same with cash Cash is just another material that you require tocarry on production If you keep too small a proportion of your funds in the bank, youwill need to make repeated sales of securities every time you want to pay your bills

On the other hand, if you keep excessive cash in the bank, you are losing interest

The Inventory Decision

Let us look at what economists have had to say about managing inventories andthen see whether some of these ideas may also help us to manage cash balances.Here is a simple inventory problem

Everyman’s Bookstore experiences a steady demand for Principles of Corporate

Finance from customers who find that it makes a serviceable doorstop There are

two costs to holding an inventory of the book First there is the carrying cost This

includes the cost of the capital that is tied up in the inventory, the cost of the shelf

space, and so on The second type of cost is the order cost Each order involves a

fixed handling expense and delivery charge

These two costs are the kernel of the inventory problem An increase in ordersize increases the average number of books in inventory, and therefore the carry-

ing cost rises However, as the store increases its order size, the number of orders falls, so that the order costs decline The trick is to strike a sensible balance between

these two costs When carrying costs are high, you should hold a smaller inventoryand replenish it more often When order costs are high, you should hold a largerinventory and place orders less frequently

Some numbers may help to illustrate Suppose that the bookstore sells 100copies of the book a year Suppose also that the carrying cost of inventory worksout at $4 per book and that each order placed with the publisher involves a fixedorder cost of $2 The upward sloping line in Figure 31.3 shows that carrying costsincrease in proportion to order size The effect of order size on order costs is de-

picted by the downward sloping line Order costs halve when the bookstore orders

two books at a time rather than one, but thereafter the savings from increases in

or-der size steadily diminish

The upper curve in Figure 31.3 shows the sum of the carrying and order costs

You can see that total costs are minimized when the store orders 10 books at a time

Thus, 10 times a year the bookstore should place an order for 10 books and it

should work off this inventory over the following five weeks.12

The Extension to Cash Balances

William Baumol was the first to point out that this simple inventory model can tell

us something about the management of cash balances.13Suppose that you keep a

reservoir of cash that is steadily drawn down to pay bills When it runs out, you

re-plenish the cash balance by selling Treasury bills The order cost is the fixed

ad-ministrative expense of each sale of Treasury bills The main carrying cost of

hold-ing this cash is the interest that the firm is loshold-ing

Deciding on the firm’s cash holding is exactly analogous to the problem of

op-timum order size faced by Everyman’s Bookstore You just have to redefine the

variables For example, instead of referring to the number of books per order,

or-der size becomes the amount of Treasury bills sold each time the cash balance is

re-plenished Order cost becomes cost per sale of Treasury bills, while carrying cost is

just the interest lost from holding cash rather than bills

If high interest rates increase the cost of carrying cash, you should hold a smaller

inventory of cash and therefore make smaller and more frequent sales of Treasury

CHAPTER 31 Cash Management 891

Order size (number of books)

Total cost Order cost Carrying cost

See the Principles of Corporate Finance Web page (www.mhhe.com/bm7e) for an explanation of how to

calculate the optimal order size.

13

W J Baumol, “The Transactions Demand for Cash: An Inventory Theoretic Approach,” Quarterly

Jour-nal of Economics 66 (November 1952), pp 545–556.

bills On the other hand, if the firm incurs high costs in selling securities, youshould hold larger cash balances.

The Cash Management Trade-off

Baumol’s model of cash balances is unrealistic in one important respect: It assumesthat the firm is steadily using up its cash inventory But that is not what usuallyhappens In some weeks the firm may collect some large unpaid bills and therefore

receive a net inflow of cash In other weeks it may pay its suppliers and so incur a net outflow of cash Some of these cash flows can be forecasted with confidence; in

other cases the amount of the flow or its timing is uncertain

Economists and management scientists have developed a variety of more orate and realistic models that allow for the possibility of both cash inflows andoutflows.14But no model will ever succeed in capturing all the intricacies of thefirm’s cash requirements or provide a substitute for the judgment of the cash man-ager The importance of Baumol’s model and its many offspring is that they allhighlight the basic trade-off that the cash manager needs to make between thefixed costs of selling securities and the carrying costs of holding cash balances.Since there are economies of scale in buying or selling securities, the firm shouldwait and place a sufficiently large order rather than place a series of smaller orders.Baumol’s model helps us understand why small and medium-sized firms holdsignificant cash balances But for very large firms, the transaction costs of buyingand selling securities become trivial compared with the opportunity cost of hold-ing idle cash balances

elab-Suppose that the interest rate is 8 percent per year, or roughly 8/365 ⫽ 022 cent per day Then the daily interest earned by $1 million is 00022 ⫻ 1,000,000 ⫽

per-$220 Even at a cost of $50 per transaction, which is generously high, it pays to buyTreasury bills today and sell them tomorrow rather than to leave $1 million idleovernight

A corporation with $1 billion of annual sales has an average daily cash flow of

$1,000,000,000/365, about $2.7 million Firms of this size end up buying or sellingsecurities once a day, every day, unless by chance they have only a small positivecash balance at the end of the day

Why do such firms hold any significant amounts of cash? There are basicallytwo reasons First, cash may be left in non-interest-bearing accounts to compensatebanks for the services they provide Second, large corporations may have literallyhundreds of accounts with dozens of different banks It is often better to leave idlecash in some of these accounts than to monitor each account daily and make dailytransfers between them

One major reason for the proliferation of bank accounts is decentralized agement You cannot give a subsidiary operating autonomy without giving itsmanagers the right to spend and receive cash

man-Good cash management nevertheless implies some degree of centralization Youcannot maintain your desired inventory of cash if all the subsidiaries in the groupare responsible for their own private pools of cash And you certainly want toavoid situations in which one subsidiary is investing its spare cash at 8 percent

14

For example, the problem of cash management when inflows and outflows are unpredictable is

ana-lyzed in M H Miller and D Orr, “A Model of the Demand for Money by Firms,” Quarterly Journal of

Economics 80 (August 1966), pp 413–435 The Miller–Orr model is described in the Principles of rate Finance Web page.

Corpo-while another is borrowing at 10 percent It is not surprising, therefore, that even

in highly decentralized companies there is generally central control over cash

bal-ances and bank relations

CHAPTER 31 Cash Management 893

31.3 INVESTING IDLE CASH

The Money Market

Temporary cash surpluses are generally invested in short-term securities The

mar-ket for these short-term investments is known as the money marmar-ket The money

market has no physical marketplace It consists of a loose agglomeration of banks

and dealers linked together by telex, telephones, and computers But a huge volume

of securities is regularly traded on the money market, and competition is vigorous

Most large corporations manage their own money-market investments,

buy-ing and sellbuy-ing through banks and dealers or over the Web Small companies

sometimes find it more convenient to hire a professional investment

manage-ment firm or to put their cash into a money-market fund This is a mutual fund

that invests only in low-risk, short-term securities We discussed money-market

funds in Section 17.3

Valuing Money-Market Investments

When we value long-term debt, it is important to take default risk into account

Al-most anything may happen in 30 years, and even today’s Al-most respectable

com-pany may get into trouble eventually This is the basic reason that corporate bonds

offer higher yields than Treasury bonds

Short-term debt is not risk-free either When Penn Central failed, it had $82

mil-lion of short-term commercial paper outstanding.15After that shock, investors

be-came much more discriminating in their purchases of commercial paper

Such examples of failure are exceptions; in general, the danger of default is less

for money-market securities issued by corporations than for corporate bonds

There are two reasons for this First, the range of possible outcomes is smaller for

short-term investments Even though the distant future may be clouded, you can

usually be confident that a particular company will survive for at least the next

month Second, for the most part only well-established companies can borrow in

the money market If you are going to lend money for only one day, you can’t

af-ford to spend too much time in evaluating the loan Thus you will consider only

blue-chip borrowers

Despite the high quality of money-market investments, there are often

signifi-cant differences in yield between corporate and U.S government securities Why

is this? One answer is the risk of default Another is that the investments have

dif-ferent degrees of liquidity or “moneyness.” Investors like Treasury bills because

they are easier to turn into cash on short notice Securities that cannot be converted

quickly and cheaply into cash need to offer relatively high yields

During times of market turmoil investors often place a high value on having

ready access to cash On such occasions the yield on illiquid securities can increase

dramatically This happened in the fall of 1998 when a large hedge fund, Long

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Commercial paper is short-term debt issued by corporations We described it in Section 30.6.