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Lecture

#8
Cash Management
CF-II (Term III) 2012
#8
Prof. Kulbir Singh (IMT-Nagpur)
Slide 2
Key Concepts and Skills
Understand the reasons for holding cash
balances, as well as potential methods for
determining the target cash balance
Understand the concept of float, as well as
Prof. Kulbir Singh (IMT Nagpur)
Understand the concept of float, as well as
tools for managing disbursement and
collections float
Slide 3
Lecture Outline
1 Reasons for Holding Cash
2 Determining the Target Cash Balance
3 Managing the Collection and Disbursement
of Cash
4 Investing Idle Cash
Prof. Kulbir Singh (IMT Nagpur)
4 Investing Idle Cash
Slide 4
1 Reasons for Holding Cash
Transactions motive
Ability to cover normal activities of the firm
Compensating balances
Hold required balances with financial
Prof. Kulbir Singh (IMT Nagpur)
Hold required balances with financial
institutions
Slide 5
Costs of Holding Cash
Opportunity
Total cost of holding cash
Costs in dollars of
holding cash
Trading costs increase when the firm
must sell securities to meet cash needs.
Prof. Kulbir Singh (IMT Nagpur)
Opportunity
Costs
C
*
Size of cash balance
The investment income
foregone when holding cash.
Slide 6
2 Determining the Target Cash
Balance
The Baumol Model
The Miller-Orr Model
Other Factors Influencing the Target Cash
Balance
Prof. Kulbir Singh (IMT Nagpur)
Balance
Slide 7
The Baumol Model
F = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed
R = The opportunity cost of holding
cash, a.k.a. the interest rate.
spend at a constant rate
each period and replace
our cash with \$C when
Prof. Kulbir Singh (IMT Nagpur)
Time
C
1 2 3
C
2

our cash with \$C when

we run out of cash, our
average cash balance
will be .
C
2

The opportunity cost

of holding is
C
2

C
2

R
Slide 8
The Baumol Model
C
As we transfer \$C each
period we incur a
period.
Prof. Kulbir Singh (IMT Nagpur)
Time
period.
1 2 3
C
2

T
C

T
C
If we need \$T in total
over the planning
period we will pay \$F
times.
Slide 9
The Baumol Model
F
T
R
C
+ =
C 2
cost Total
Opportunity
Costs
R
C

2
Prof. Kulbir Singh (IMT Nagpur)
C
* Size of cash balance
F
T

C
The optimal cash balance is found
where the opportunity costs equals
F
R
T
C =
2
*
Slide 10
The Baumol Model
F
T
R
C
=
The optimal cash balance is found where the opportunity
Prof. Kulbir Singh (IMT Nagpur)
F
C
T
R
C
=
2
R
TF
C
2
*
=
Multiply both sides by C
F T R
C
=
2
2
R
F T
C

= 2
2
Slide 11
The Miller-Orr Model
The firm allows its cash balance to wander
randomly between upper and lower control
limits.
\$
U
When the cash balance reaches the upper control limit U, cash
is invested elsewhere to get us to the target cash balance Z.
Prof. Kulbir Singh (IMT Nagpur)
Time
U
Z
L
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.
Slide 12
The Miller-Orr Model Math
Given L, which is set by the firm, the
Miller-Orr model solves for Z and U
L
F
Z + =
3
2
*
3 L Z U 2 3
* *
=
Prof. Kulbir Singh (IMT Nagpur)
L
K
F
Z + =
3
*
4
3 L Z U 2 3 =
where
2
is the variance of net daily cash flows.
The average cash balance in the Miller-Orr model
is:
3
4
balance cash Average
*
L Z
=
Slide 13
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
Prof. Kulbir Singh (IMT Nagpur)
2. Estimate the standard deviation of daily
cash flows.
3. Determine the interest rate.
selling securities.
Slide 14
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 R.
Prof. Kulbir Singh (IMT Nagpur)
related to the interest rate R.
Z and the average cash balance are
positively related to the variability of cash
flows.
Slide 15
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
Prof. Kulbir Singh (IMT Nagpur)
The need to borrow will depend on
managements desire to hold low cash
balances.
Slide 16
3 Managing the Collection and
Disbursement of Cash
Accelerating Collections
Delaying Disbursements
Disbursement Float
Zero-Balance Accounts
Prof. Kulbir Singh (IMT Nagpur)
Zero-Balance Accounts
Drafts
Ethical and Legal Questions
Electronic Data Interchange
Slide 17
Float
The difference between bank cash and
book cash is called float.
Float management involves controlling the
collection and disbursement of cash.
Prof. Kulbir Singh (IMT Nagpur)
collection and disbursement of cash.
Slide 18
Accelerating Collections
Customer
mails
payment
Company
payment
Company
deposits
payment
Cash
Mail Processing Clearing
time
Prof. Kulbir Singh (IMT Nagpur)
Mail
delay
Mail
float
Processing
delay
Processing
float
Clearing
delay
Clearing
float
Collection float
Slide 19
Overview of Lockbox Processing
Corporate
Customers
Corporate
Customers
Corporate
Customers
Corporate
Customers
Local Bank
Collects funds
from PO Boxes
Post Office
Box 1
Post Office
Box 2
Prof. Kulbir Singh (IMT Nagpur)
from PO Boxes
Envelopes opened;
separation of
checks and receipts
Deposit of checks
into bank accounts
Details of receivables
go to firm
Firm processes
receivables
Bank clears checks
Slide 20
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
Firm prepares
check to supplier
Post Office
processing
Delivery of check
Prof. Kulbir Singh (IMT Nagpur)
statement accuracy for large
amounts.
4. Mail from distant post office.
5. Mail from post office that
requires a great deal of
handling.
Delivery of check
to supplier
Deposit goes to
suppliers bank
Bank collects funds
Slide 21
Drafts
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.
Prof. Kulbir Singh (IMT Nagpur)
to the issuer for payment.
When the draft is transmitted to a firms 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.
Slide 22
Ethical and Legal Questions
The financial managers must always work
with collected company cash balances and
not with the companys book balance,
which reflects checks that have been
Prof. Kulbir Singh (IMT Nagpur)
which reflects checks 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.
Slide 23
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.
Prof. Kulbir Singh (IMT Nagpur)
money market mutual funds.
Firms have surplus cash for three reasons:
Seasonal or Cyclical Activities
Planned Expenditures
Different Types of Money Market Securities
Slide 24
Seasonal Cash Demands
Short-term
Total Financing needs
Marketable
securities
Bank loans
Prof. Kulbir Singh (IMT Nagpur)
Long-term
financing
Short-term
financing
Time
J F M A M
securities
Slide 25
Quick Quiz
Identify reasons for holding cash.
Explain the tradeoffs involved in holding
cash.
Define float (disbursement, collections,
Prof. Kulbir Singh (IMT Nagpur)
Define float (disbursement, collections,
net).
Identify ways to improve float from the
firms perspective.