Solution manual financial management 10e by keown chapter 19

How should the investment in liquid assets be split between actual cash holdings and marketable securities.. Several techniques are available to improve the management of the firm's cash

I Why a company holds cash

A Sound cash management techniques are based on a thorough understanding

of the cash flow process

1 Cash holdings are increased from several external sources on an

irregular basis

2 Irregular cash outflows reduce the firm's cash balance

3 Other major sources of cash arising from internal operations occur

on a rather regular basis, i.e., accounts receivable collections

B Three motives for holding cash balances have been identified by Keynes

1 The transactions motive

2 The precautionary motive

3 The speculative motive

II Cash management objectives and decisions

A The risk return trade-off

1 Strike an acceptable balance between holding too much cash and

holding too little cash

2 A large cash investment minimizes insolvency, but penalizes

profitability

1 On-hand cash must be sufficient to meet disbursal needs.

2 Idle cash balances must be reduced to a minimum

C The decisions

1 How to speed up cash collections and slow down cash outflows?

2 What should be the composition of the marketable securities

portfolio?

3 How should the investment in liquid assets be split between actual

cash holdings and marketable securities?

D Perspective on collection and disbursement procedures

III Collection and disbursement procedures

A Cash acceleration and deceleration techniques revolve around the concept of

B Float reduction can result in (l) usable funds that are released for company

use and (2) increased returns produced on these freed-up balances

C Several techniques are available to improve the management of the firm's

cash inflows and may also provide for a reduction in float

1 The lock-box arrangement expedites cash gathering

a The objective is to reduce both mail and processing float

b The procedure includes rental of a local post office box and

authorization of a local bank, in which a demand depositaccount (DDA) is maintained, to pick up remittances fromthe box

c The arrangement provides for (l) increased working cash, (2)

elimination of clerical functions, and (3) early knowledge ofdishonored checks

d Added costs must be evaluated

2 Pre-authorized checks (PACs) also speed up the conversion of

receipts into working cash

a The objective is to reduce mail and processing float

b A PAC (l) is created with the individual's legal authorization,

(2) resembles an ordinary check, and (3) does not contain thesignature of the person on whose account it is being drawn

c PAC systems are most useful to firms that regularly receive a

large volume of payments of a fixed amount from the samecustomers

3 Depository transfer checks (DTCs) are used in conjunction with

concentration banking

Major objectives of using DTCs are (1) elimination of excess cashbalances held in several regional banks and (2) reduction of float

4 Wire transfers offer the fastest method for moving funds between

commercial banks Two major communication facilitiesaccommodate wire transfers: (1) Bank Wire, and (2) FederalReserve Wire System

D Techniques used by firms that hope to improve the management of their cash

flow

1 Zero balance accounts (ZBAs) permit centralized control, but also

allow the firm to maintain disbursing authority at the local level Themajor objective is to achieve better control over cash payments Itmight also increase disbursement float

2 Payable-through drafts (PTDs) have the physical appearance of

ordinary checks but they are drawn on and paid by the issuing firminstead of the bank

a The objective of a PTD system is to provide for effective

control of field-authorized payments

b Stop payment orders can be initiated on any drafts

considered inappropriate

c Legal payment of individual drafts takes place after review

and approval of the drafts by the company Disbursing float isusually not increased by the use of drafts

IV Electronic funds transfer systems (EFT) reduce transit, mail, and processing float

A Transactions are immediately reflected on the books and bank accounts of

firms doing business

B This ideal has not yet been fully reached

C The purpose of the EFT is the elimination of the check as a method of

transferring funds

D Perspective on evaluating costs

V Evaluating the costs of cash management services

A Whether a cash management system will provide an economic benefit can

be evaluated by:

added costs = added benefits

B If the benefits exceed the costs, the system is economically feasible

C On a per unit basis, this relationship can be expressed as follows:

P = (D) (S) (i)where P = increase in per-check processing cost, if new system is

adopted

D = days saved in the collection process

S = average check size in dollars

i = the daily, before-tax opportunity cost of carrying cash

D The product of (D) x (S) x (i) must exceed P for the system to be beneficial

to the firm

E Perspective on the marketable securities portfolio

VI Composition of marketable securities portfolio

A Five factors to consider when selecting a proper marketable securities mix

B Marketable security alternatives

1 A Treasury bill is a direct obligation of the U.S government

a May be purchased in denominations of $1,000 and higher

($10,000, $15,000, $50,000, $100,000, $500,000, and

$1,000,000)

b Currently offered with maturities of 91, 182, and 365 days

c Since Treasury bills are sold on a discount basis, the investor

does not receive an actual interest payment

d The bills are considered risk-free and sell at lower yields than

other marketable securities of like maturity

e Income from Treasury bills is subject to the federal income

tax and is taxed as ordinary income

2 Federal agency securities represent debt obligations of corporations

and agencies that have been created to manage the various lendingprograms of the U.S government

3 Bankers' acceptances are drafts drawn on a specific bank by an

exporter in order to obtain payment for goods shipped to a customerwho maintains an account with that bank

a Maturities run mostly from 30 to 180 days

b Acceptances are sold on a discount basis

c Income generated is fully taxable at all levels

d Provide investors with a higher yield than do Treasury bills

4 A negotiable certificate of deposit (CD) is a marketable receipt for

funds that have been deposited in a bank for a fixed time period at afixed interest rate

a CDs are offered in denominations ranging from $25,000 to

$10,000,000

b Maturities range from 1 to 18 months

c Yields are higher than those of Treasury bills

d Income received is taxed at all governmental levels

5 Commercial paper refers to short-term, unsecured promissory notes

a Paper ranges from $5,000 up to $5,000,000

b The notes are generally sold on a discount basis with

maturities ranging from 3 to 270 days

c Paper has no active trading in a secondary market

d Return received is taxable at all governmental levels

6 Repurchase agreements involve the actual sale of securities by a

borrower to the lender, with a commitment on the part of theborrower to repurchase the securities at the contract price plus astated interest charge

a These agreements are usually executed in sizes of $500,000

or more

b There is a specified maturity date or time period

c Yields are higher than for Treasury bills and are taxable at all

governmental levels

7 Money market mutual funds usually invest in a diversified portfolio

of short-term, high-grade debt instruments

a Shares are sold to a large number of small investors

b Funds offer a high degree of liquidity

c Returns are usually taxable at all governmental levels

ANSWERS TO END-OF-CHAPTER QUESTIONS

19-1 The procedure by which funds generated from company activity are accommodated

(directed) through the firm from the time of their initial receipt until their ultimatedisposition Over the long run, accounts receivable collections account for thelargest regular source of cash in the typical manufacturing company Payment ofaccounts payable, payroll expenses, and the distribution of income to the owners(cash dividends) are the major forms of cash disbursal Other sources of cash for acompany may include receipts from the sale of assets, assumption of additionaldebt, issuance of new stock, or gains realized from investments While these areimportant sources of cash to a company, the proceeds are not available on a regularbasis Major capital expenditure programs, new company acquisitions, andinventory stockpiling are examples of irregular disbursals of cash outside thenormal course of everyday business

19-2 The three classical motives for holding cash and near-cash balances are: (1) the

transactions motive; (2) the precautionary motive; (3) the speculative motive.Transactions balances allow the firm to make payments that arise in the ordinarycourse of doing business Precautionary balances provide a buffer stock of liquidassets that can be drawn down if unexpected demands for cash arise Speculativebalances permit the economic unit to take advantage of future profit-makingsituations

19-3 Concentration banking involves the use of multiple cash collection centers and the

deposit of funds in regional banks located near the collection centers Funds arethen transferred from the regional commercial banks to a concentration bank Aconcentration bank is one where the firm maintains a major cash disbursingaccount Concentration banking may permit the firm to: (1) operate with lowerlevels of excess cash; (2) maintain more effective control over the firm's cashresources; (3) make prudent decisions concerning marketable securitiestransactions Moreover, concentration banking will reduce both mail float andtransit float

19-4 The "regular" depository transfer check is a pre-printed form that is filled out and

mailed by a company employee in order to move demand deposit balances from onebank to another The automated depository transfer check (ADTC) eliminates themail delay associated with the "regular" depository transfer check The depositinformation in this latter case is telephoned by a company employee to a regionaldata collection center The data collection center transmits the information to thefirm's concentration bank Ordinarily, both of these systems are used in conjunctionwith a concentration banking arrangement

19-5 The firm which regularly receives a large volume of payments from the same

customers will find the pre-authorized check system a useful device Commonexamples are insurance companies, savings and loan associations, consumer creditfirms, leasing enterprises and charitable and religious organizations

19-6 The firm must: (1) maintain adequate cash balances that will permit it to meet the

disbursal needs that occur in the course of doing business; (2) reduce idle cashbalances to a minimum

19-7 (1) Choosing among various methods available for speeding up cash receipts,

slowing down cash payments, and providing for more effective control overcash outflows

(2) Splitting the firm's liquid asset holdings among cash and marketable

securities

(3) Choosing the appropriate marketable securities mix

19-8 (1) Mail float: this represents funds which are not usable to the firm because of

the time necessary for a customer's remittance check to travel through themails to a company collection center

(2) Processing float: this represents funds tied up due to the time needed for the

company to process the remittance checks and get them ready for deposit in

a demand deposit account

(3) Transit float: this represents funds tied up because of the time necessary for

a deposited check to clear through the commercial banking system andbecome "good" funds to the firm

(4) Disbursing float: this refers to funds available in the firm's demand deposit

account due to the time needed for a payment check to clear through thebanking system

19-9 In the context of cash management, financial risk is the uncertainty of future

returns from a security caused by possible changes in the financial capability of thesecurity-issuer to make future payments to the security-owner This is sometimescalled default risk On the other hand the uncertainty related to the expectedreturns from a financial asset caused by changes in interest rates is called interestrate risk

19-10 Liquidity is the ability to change a security into cash A money market instrument

that is highly liquid can be converted into cash quickly and at a price near itsprevailing market price

19-11 Commercial paper

19-12 Bills 5.90%

Agencies 6.10%

Paper 6.25%

19-13 (1) Maturity periods on repurchase agreements can be individually tailored to

the needs of the investor

(2) The price at which the repo will be liquidated is set at the time the contract

is finalized

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

Solutions to Problem Set A

19-1A

Average daily float =

Year

in Days

RevenuesAnnual

=

365

000,000,40

Thus, the cost of the Healthy Herbal's current billing system is:

And, the net annual gain from adoption of the proposed concentration banking system is:

Less: cost of concentration banking system 40,000Net annual gain from proposed system $33,35619-2A

Analysis of the two alternatives requires that the net earnings be computed for each alternative for each of the specified time periods as follows:

Invest in Money Market Fund:

Available Rate Period Earnings Cost Earnings

Cash Interest Holding Annual Annual NetAvailable Rate Period Earnings Cost Earnings

Money Market Fund Direct Investment Recommendation

19-3A

Annual collection = ($6,232,375) (12 regions) = $74,788,500

Daily collections = $74,788,500 / 365 = $204,900

Use of the lock-box system will reduce Marino Rug Company's float by 3 days according

to the study done by National Bank of Miami The value of the float reduction is found bypresuming the freed funds will be added to the marketable securities portfolio and will earnthe 9.75% yield noted in the text of the problem The gross annual savings from the systemare:

($204,900) (3) (.0975) = $59,933The annual cost of operating the lock-box system is:

($325 per month) (12 regions) (12 months) = $46,800The net annual savings are:

($59,933) - ($46,800) = $13,133Marino's management should approve the use of the proposed lock-box system and,

thereby, save $13,133 per year

(a) The average accrued wages under the monthly payment system are:

2

)000,675($

4

= $1,350,000

This means the firm has, on average, $1,012,500 (i.e., $1,350,000

-$337,500) more to invest This provides an annual return of ($1,012,500)(.085) = $86,063 Therefore, Mac's Tennis Racket should move to themonthly payment system since it will generate $86,063 - $50,775 = $35,288

in net annual savings

(b) Let r = the break-even rate of return on the near cash portfolio:

(2.0 days) ($750,000) = 1,500,000

= Total Float Reduction $2,625,000(b) The opportunity cost of maintaining the current banking arrangement is:

(.092) ($2,625,000) = $241,500(c) The average number of checks to be processed each day through the lock-

box arrangement is:

sizecheck Average

sremittanceDaily

=

750,3

000,750

$

= 200 checks per day

Now we can calculate the cost of the lock-box system on an annual basis asfollows:

(200 checks) ($0.35) (270 days) = $18,900Next, we compute the cost of the automated depository transfer check(ADTC) system Second National Bank will not contribute to the cost of theADTC arrangement because it is the lead concentration bank and, thereby,receives the transferred data Thus, James Waller will be charged for sixADTCs (or, three locations @ 2 checks each) each business day The cost

of the ADTC system is:

(6 daily transfers) ($27 each) (270 days) = $43,740

The total cost of the proposed system will be:

Lock-box cost $18,900

Total cost $62,640 (d) Waller Nail Corp should adopt the proposed system The projected net

annual gain will be $178,860

Projected return on freed balances $241,500Less: Cost of new system 62,640

19-6A Initially, compute the firm's average remittance check size and daily opportunity

cost of carrying cash The average check size is:

000,15

000,000,40

$

= $2,666.67The daily opportunity cost of carrying cash is:

365

09 = .0002466 per day

Next, the days saved in the collection process can be evaluated according to thisformat:

Added costs = Added benefits or

P = (D) (S) (i)

$0.35 = (D) (2,666.67) (.0002466)0.5322 days = D

We know Mountain Furniture will experience a financial gain if it adopts the box system and, thereby, speeds up its collections by more than 0.5322 days

lock-19-7A

year

in Days

revenuesAnnual

=

365

000,000,890

$

= $2,438,356per daysales

(0.096)

yield)(assumed6)

($2,438,35

day)per (sales

= $234,082

19-8A (a) First, it is necessary to compute Mustang's average remittance check size

and the daily opportunity cost of carrying cash The average check size is:

000,6

000,000,12

Second, the days saved in the collection process can be evaluated according

to the general format of Added Costs = Added Benefits

or

P = (D) (S) (i)0.20 = (D) ($2,000) (0.0001918)0.5214 days = D

Therefore, Mustang Ski-Wear will experience a financial gain if it adopts thelock-box system and speeds up its collections by more than 0.5214 days.(b) In this situation the daily opportunity cost of carrying cash is:

365

045.0 = 0.0001233 per day

For Mustang to break even should it choose to install the lock-box system,the cash collections must be accelerated by 0.8110 days as follows:

$0.20 = (D) ($2,000) (0.0001233)0.8110 days = D

(c) The break-even cash acceleration period of 0.8110 days is greater than the

0.5214 days found in part (a) This is due to the lower yield available onnear-cash assets (or 4.5 percent annually versus 7.0 percent) Since thealternative rate of return on the freed-up balances is lower in the secondsituation, more funds must be invested to cover the costs of operating thelock-box system The greater cash acceleration period generates thisincreased level of required funds

19-9A The value of one day of processing float is:

270

000,000,18

$

= $66,667The annual savings at 8% are:

(2 days) ($66,667) (0.08) = $10,66719-10A

Annual collections = ($5,200,000) (12) = $62,400,000

Daily collections = $62,400,000/365 = $170,959

The opportunity cost of the mail and processing float is:

($170,959) (4.0) (0.09) = $61,54519-11A

This exercise attempts to illustrate that a change in the firm's accounts payable policy can properly be viewed as a part of the overall problem of cash management Before evaluating the 45 day and 60 day payment alternatives it is necessary to calculate the amount of purchases that are actually discounted and the value of the annual purchase discount earned by Bradford Construction These amounts are calculated below:

Purchases discounted

($37,500,000 annual purchases) (0.25) = $9,375,000

Purchase discounts earned

($9,375,000) (0.03) = $281,250

with $281,250 in purchase discounts earned Bradford actually pays:

($9,375,000) - ($281,250) = $9,093,750, 10 days after purchase

The annual amount not discounted is ($37,500,000) - ($9,375,000) = $28,125,000