Corporate finance 7e ross ch27

Chapter Outline27.1 Reasons for Holding Cash 27.2 Determining the Target Cash Balance 27.3 Managing the Collection and Disbursement of Cash 27.4 Investing Idle Cash 27.5 Summary & Concl

27

Cash Management

Chapter Outline

27.1 Reasons for Holding Cash

27.2 Determining the Target Cash Balance

27.3 Managing the Collection and

Disbursement of Cash

27.4 Investing Idle Cash

27.5 Summary & Conclusions

27.1 Reasons for Holding Cash

27.2 Determining the Target Cash Balance

27.3 Managing the Collection and

Disbursement of Cash

27.4 Investing Idle Cash

27.5 Summary & Conclusions

27.1 Reasons for Holding Cash

Transactions motive

Compensating balances

Transactions motive

Compensating balances

27.2 Determining the Target

Cash Balance

The Baumol Model

The Miller-Orr Model

Other Factors Influencing the Target Cash

Balance

The Baumol Model

The Miller-Orr Model

Other Factors Influencing the Target Cash

Balance

Costs of Holding Cash

Opportunity Costs

Size of cash balance

The investment income foregone when holding cash.

Trading costs increase when the firm must sell securities to meet cash needs.

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, a.k.a the interest rate.

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, a.k.a the interest rate.

If we start with $C, spend at a

constant rate each period and

replace our cash with $C when

we run out of cash, our average cash balance will be C

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, a.k.a the interest rate.

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, a.k.a the interest rate.

Time

C

As we transfer $C each period

we incur a trading cost of F

If we need $T in total over

the planning period we will

pay $F times.

The trading cost is –C T × F

The Baumol Model

C*

Size of cash balance

F

T K

cost Total

F

T

 C Trading costs

The optimal cash balance is found where the opportunity costs equals the trading costs

The Baumol Model

Opportunity Costs = Trading Costs

The optimal cash balance is found where the opportunity costs equals the trading costs

Multiply both sides by C

F C

T K

C   

2

F T

C*  2

The Miller-Orr Model

The firm allows its cash balance to wander randomly between

upper and lower control limits.

The firm allows its cash balance to wander randomly between

upper and lower control limits.

$

Time

H

Z L

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.

The Miller-Orr Model Math

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

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

L K

• The average cash balance in the Miller-Orr model

is

3

4 balance

cash Average

Z 



Implications of the Miller-Orr Model

To use the Miller-Orr model, the manager must

do four things:

1 Set the lower control limit for the cash balance.

2 Estimate the standard deviation of daily cash flows.

3 Determine the interest rate

4 Estimate the trading costs of buying and selling

securities.

To use the Miller-Orr model, the manager must

do four things:

1 Set the lower control limit for the cash balance.

2 Estimate the standard deviation of daily cash flows.

3 Determine the interest rate

4 Estimate the trading costs of buying and selling

securities.

Implications of the Miller-Orr Model

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.

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.

Other Factors Influencing the Target

Other Factors Influencing the Target

The difference between bank cash and book cash

is called float.

Float management involves controlling 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

27.3 Managing the Collection and

Accelerating Collections

Customer mails payment

Company receives payment

Company deposits payment

Cash received

Mail delay

Mail float

Processing delay

Processing float

Clearing delay

Clearing float

time

Collection float

Overview of Lockbox Processing

Corporate

Customers

Corporate Customers

Corporate Customers

Corporate Customers

Local Bank Collects funds from PO Boxes

Envelopes opened;

separation of checks and receipts

Deposit of checks into bank accounts

Post Office Box 2

Delaying Disbursements

1 Write check on a distant bank.

2 Hold payment for several days after

postmarked in office.

3 Call supplier firm to verify

statement accuracy for large amounts.

4 Mail from distant post office.

5 Mail from post office that requires a

great deal of handling.

postmarked in office.

3 Call supplier firm to verify

statement accuracy for large amounts.

4 Mail from distant post office.

5 Mail from post office that requires a

great deal of handling.

Firm prepares check to supplier

Post Office processing

Delivery of check

to supplier

Deposit goes to supplier’s bank

Bank collects funds

Firms sometimes use drafts instead of checks.

Drafts differ from checks because they are not drawn on a bank but on an issuer (the firm) and are payable by the issuer.

The bank acts only as an agent, presenting the draft to the issuer for payment.

When the draft is transmitted to a firm’s bank for collection, the bank must present the draft to the issuing firm for acceptance

before making payment

After the draft has been accepted, the firm must deposit the

necessary cash to cover the payments.

This allows the firm to keep less cash on hand.

Firms sometimes use drafts instead of checks.

Drafts differ from checks because they are not drawn on a bank but on an issuer (the firm) and are payable by the issuer.

The bank acts only as an agent, presenting the draft to the issuer for payment.

When the draft is transmitted to a firm’s bank for collection, the bank must present the draft to the issuing firm for acceptance

before making payment

After the draft has been accepted, the firm must deposit the

necessary cash to cover the payments.

This allows the firm to keep less cash on hand.

Ethical and Legal Questions

The financial managers must always work with collected company cash balances and not with

the company’s book balance, which reflects

checks that have been deposited but not

collected

If you are borrowing the bank’s money without their knowledge, you are raising serious ethical and legal questions

The financial managers must always work with collected company cash balances and not with

the company’s book balance, which reflects

checks that have been deposited but not

collected

If you are borrowing the bank’s money without their knowledge, you are raising serious ethical and legal questions

27.4 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.

Firms have surplus cash for three reasons:

Seasonal or Cyclical Activities Planned Expenditures

Different Types of Money Market Securities

A firm with surplus cash can park it in the

money market

Some large firms and many small ones use money market mutual funds.

Firms have surplus cash for three reasons:

Seasonal or Cyclical Activities Planned Expenditures

Different Types of Money Market Securities

Seasonal Cash Demands

Long-term financing

Short-term financing

Time

Total Financing needs

Marketable securities

Bank loans

27.5 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

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

27.5 Summary & Conclusions

Two transactions models that provide rough

guidelines for determining the optimal cash

postion are:

The Miller-Orr model The Baumol model

Two transactions models that provide rough

guidelines for determining the optimal cash

postion are:

The Miller-Orr model The Baumol model

27.5 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

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

27.5 Summary & Conclusions

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 company’s book balance

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 company’s book balance

27.5 Summary & Conclusions

If you are borrowing the bank’s money without their knowledge, you are raising serious ethical and legal questions

The answers to which you probably know by

now

If you are borrowing the bank’s money without their knowledge, you are raising serious ethical and legal questions

The answers to which you probably know by

now