Sessions 18

Module # 4 : Working Capital

Management

Cash Management
Materials are majorly used from the
textbook “Corporate finance 10e” by
RWJJK

27A-0
 Solution to Handout # 8: Short
Term Financing & Planning
• Question 3
Ans: Cash collection from sales (in millions):
Q2: Rs.83
Q3:Rs.96.7
Q4: Rs.125.84

27A-1
The Short-Term Financial Plan

• The most common way to finance a temporary cash

deficit is to arrange a short-term loan.
• Unsecured Loans
– Line of credit (at the bank)
• Secured Loans
– Accounts receivable can be either assigned or factored.
– Inventory loans use inventory as collateral.
• Other Sources
– Banker’s acceptance
– Commercial paper

27A-2
 Reasons for Holding Cash
• Speculative motive – hold cash to take advantage of unexpected
opportunities
• Precautionary motive – hold cash in case of emergencies
• Transaction motive – hold cash to pay the day-to-day bills
• What is needed to satisfy the speculative and precautionary motives is an ability to
pay quickly – a need that is met with liquidity. Although cash is the most liquid
asset, assets such as marketable securities are near substitutes for cash. The ability
to borrow quickly is also a close substitute for cash (having a line of credit, for
example).

27A-3
 Cash management

• Cash management deals with the optimization

of the collection and disbursement of cash (i.e
try to make a trade off between the uses and
sources of cash).
• Cash management originated as a means of
dealing with float.
• Float occurs when there is a difference between
the mailing time and processing times of cheques.

27A-4
 Float
• Float, for the PAYER (say co is the payer is cheque is issued to supplier)
refers to the time that elapses between the point that a company issues a
cheque and the point at which the funds covering that cheque are actually
withdrawn from its accounts.
• For the PAYEE firms (say supplier who got the cheque), float represents the
time between the check’s issuance and the availability of good(usable) funds in
its accounts
There are various types of float”
• Mail time-the period between the issuing and mailing of a check and the time
that it is received by the payee
• Processing time-once the check is received by the payee, a certain amount of
time will be generally elapse before it is deposited in the bank.
• Collection time-the amount of time that it takes for the funds to be transferred
through the banking system from the account of the payer to that of the
payee.
• BILLING float which refers to the time lapse where the seller who have
sold/delivered the goods to the buyer but wasted time to prepare and mail its
sales invoice to the buyer18
27A-5
 Understanding Float
• Float – difference between cash balance recorded in the cash account in
your books and the cash balance recorded at the bank.
Book balance – the amount of cash recorded in the accounting records of the
firm
Available balance – the amount of cash the bank says is available to be
withdrawn from the account
Float = Available balance at bank– book balance
• Disbursement float
– generated by checks the firm has written that have not yet cleared the
bank; arrangements can be made so that this money is invested in
marketable securities until needed to cover the checks
– Available balance at bank – book balance > 0
– Positive float implies that checks that have been written have not yet
cleared. The company needs to make sure that it adjusts the available
balance so that it does not think that there is more money to spend
than there actually is.
• The available balance is more important than the book balance.

27A-6
• Collection float
o Generated by checks that have been received by the firm but are not yet
included in the available balance at the ban.
o Available balance at bank – book balance < 0.
o Negative float implies that checks that have been deposited are not yet
available. The firm needs to be careful that it does not write checks over
the available balance, or the checks may bounce.

• Net float = disbursement float + collection float

Managers need to be more concerned with net float and available balances
than with the book balance.

27A-7
 Example: Types of Float

• You have $3,000 in your checking (bank) account.

You just deposited $2,000 and wrote a check for
$2,500.
– What is the disbursement float?
– What is the collection float?
– What is the net float?
– What is your book balance?
– What is your available balance?

27A-8
• Disbursement float = $2500
• Collection float = -$2000
• Net float = 2500 – 2000 = $500
• Book balance = $3000 + 2000 – 2500 = $2500
• Available balance = $3000

27A-9
 Costs of Holding Cash
• The opportunity cost of holding cash is the return
that could be earned by investing the cash in other
assets.
• However, there is also a cost to converting
marketable securities into cash when needs
comes(shortage)
• The optimal cash balance will consider the trade-off
between these costs to minimize the overall cost of
holding cash.
• The firm doesn’t want to bounce checks, but they
also don’t want to carry excess cash.
•
27A-10
 Costs of Holding Cash

Costs in dollars of
holding cash Trading costs increase when the firm
must sell securities to meet cash needs.
Total cost of holding cash

Opportunity
Costs
The investment income
foregone when holding cash.
Trading
costs/shortage costs
C* Size of cash balance
The desired cash balance is determined by the trade-off between
carrying costs and storage costs.
27A-11
 Models in Cash Management
• Cash management models are aimed at minimising the total
costs associated with movements between a company's current
account (very liquid but not earning interest) and their short-
term investments or marketable securities (less liquid but
earning interest).
The models are devised to answer the questions:
 at what point should funds be moved?
 how much should be moved in one go?

There are two famous models for obtaining the optimal cash
balance:
• Baumol-Allais-Tobin (BAT) Model
• The Miller-Orr Model

27A-12
 BAT model
• Baumol noted that cash balances are very similar to inventory levels and
hence we need to maintain an optimal cash balance at all times .
Assumptions:
• cash use/disbursements is steady and predictable
• cash inflows are known and regular
• day-to-day cash needs are funded from current account
• Opportunity costs of holding cash is known and constant
• buffer cash is held in short-term investments and transaction costs is
constant & known.
2TF
C *

R
• Where, C*=amount of funds to inject into the current account or hold as cash or
to transfer into short-term investments at one time (invest) (optimal cash balance)
• F=fixed costs per transaction (brokerage, commission, etc. for converting
security to cash
• T=Demand for cash over the period/annual cash distribution
• R=Opportunity cost of holding cash (interest foregone)
27A-13
 Baumol-Allais-Tobin (BAT) Model

If we start with $C, spend at a

constant rate each period and
C replace our cash with $C
when we run out of cash, our
average cash balance will be – C
–C2 as (C+0/2)=C/2 2
The opportunity cost of
C ×R
holding –2
Cis
–2
1 2 3 Time

27A-14
 The BAT Model

As we transfer $C each
period we incur a
trading cost of F.
C

If we need $T in total
–2
C over the planning
period we will pay $F –T
times. C

1 2 3 Time
The trading cost is –
T ×F
C

27A-15
 The BAT Model

C T
Total cost   R   F
2 C
C
Opportunity R
Costs
2

T
Trading costs  F
C
C* Size of cash balance

You need T amount over a year

2T
C*  F and each time you use C. So
R total time you need to replenish
cash is T/c. Cost is FT/C
27A-16
 The BAT Model

The optimal cash balance is found where the opportunity

costs equals the trading costs.

Opportunity Costs = Trading Costs

C T
R  F
2 C

Multiply both sides by C

C2 TF
R TF C  2
2

2 R
2TF
C 
*

R
27A-17
 Example

Hermes Co. has cash outflows of $500 per day, the

interest rate is 10% p.a and the fixed transfer cost is
$25.What is the optimal cash balance to be
maintained?

Ans: As per BAT model,

– T = 365*500 = 182,500 p.a ( you need this much
over a year)
– F = 25
– R = .1
C* = $9,552.49
27A-18
 Example
• A company generates $10,000 per month excess
cash, which it intends to invest in short-term
securities. The interest rate it can expect to earn on
its investment is 5% pa. The transaction costs
associated with each separate investment of funds is
constant at $50.
Required:
(a)What is the optimum amount of cash to be invested
in each transaction?
(b)How many transactions will arise each year?
(c)What is the cost of making those transactions pa?
(d)What is the opportunity cost of holding cash pa?
27A-19
 Solution
1) F=$50, R=5%,T=$10000*12=$120000
Optimum amount of cash to be invested in each
transaction=$15492
2) No of transactions p.a=$120000/15492=7.75
3) Cost of making those transactions pa=50*7.75=$387.3
(FT/C)
4)opportunity cost of holding cash p.a=CR/2=15492
*0.05.2=Rs.387
2TF
C 
*

27A-20
 Uses of the BAT model
• It enables companies to find out their desirable level of cash
balance under certainty.
• The Baumol’s model of cash management theory relies on
the tradeoff between the liquidity provided by holding
money (the ability to carry out transactions)and the
interest foregone by holding ones assets in the form of non-
interest bearing money.
• The key variables of the demand for money are then the
nominal interest rate, the level of real income which
corresponds to the amount of desired transactions and to a
fixed cost of transferring ones wealth between liquid
money and interest bearing assets.
27A-21
 Miller Orr Model

• It helps companies to manage their cash

while taking into consideration the
fluctuations in daily cash flow.
• As per the Miller and Orr model of cash
management the companies let their cash
balance move within two limits
• a) Upper Control limit
• b) Lower Control Limit

27A-22
 The Miller-Orr Model
• The firm allows its cash balance to wander randomly between
upper and lower control limits and allows it should come back to
C*
When the cash balance reaches the upper control limit U,
cash is invested elsewhere to get us to the target cash
$ balance C*. That is to say, the firm transfers cash (buys
securities) in the amount of U - C*.
Upper limit: Buy security
U
When the cash balance
reaches the lower
control limit, L,
Return Point
C* investments are sold to
raise cash to get us up
to the target cash
L balance (C*). That is to
lower limit: Sell security
say, the firm sells C* -
Time L worth of securities to
add to cash.
27A-23
 The Miller-Orr Model Math
• The lower limit, L is set by management depending upon how much risk
of a cash shortfall the firm is willing to accept, and this, in turn, depends
both on access to borrowings and on the consequences of a cash shortfall.

• Given L, which is set by the firm, the Miller-Orr model solves for C*
(Return point) and U
U  3C  2 L
* *

3F  2
C*  3 L Spread = 3* (3/4 × 50×
4R 9,000,000/0.0003)1/3
Or C*=(Spread/3)+L


where 2 is the variance of net daily cash flows(cash flow” refers to both
the amounts that go into and come out of the cash balance)

4C  L *
Average cash balance 
3
27A-24
 Example
– Suppose F = $25, R = 1% per month, and the
variance of monthly cash flows is $25,000,000 per
month. Assume a minimum cash balance of
$10,000.What is the optimal cash balance? &
upper limit?

Ans:
– C* = 10,000 + ( ¾ (25)(25,000,000)/.01)1/3 =
$13,605.62
– U* = 3(13,605.62) – 2(10,000) = $20,816.86

27A-25
 Example
• The minimum cash balance of $20,000 is required at
Miller-Orr Co, and transferring money to or from the bank
costs $50 per transaction. Inspection of daily cash flows
over the past year suggests that the standard deviation is
$3,000 per day, and hence the variance (standard deviation
squared) is $9 million. The interest rate is 0.03% per day.
Calculate:
(i)the spread between the upper and lower limits
(ii)the return point.
(iii) the upper limit

27A-26
 Solution

Solution:
(i)Spread = 3 (3/4 × 50× 9,000,000/0.0003)1/3
= $31,200
(ii) Upper limit = 20,000 + 31,200 = $51,200
(iii)Return point = 20,000 + 31,200/3 =
$30,400

27A-27
 Implications of both the
models
– The higher the interest rate (opportunity cost),
the lower the target balance you maintain.
-The higher the transaction cost, the higher the
target balance you maintain

27A-28
Implications of the Miller-Orr Model

• The model clarifies the issues of cash

management:
– The optimal cash position, C*, is positively related to
trading costs, F, and negatively related to the
interest rate R.
– C* and the average cash balance are positively
related to the variability of cash flows. That is to say,
the greater the variability of cash flows, the higher
the target balance

27A-29
 Handout # 8: Cash
Management
• Question # 1
• Question # 2
• Question # 3

27A-30
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 management’s desire
to hold low cash balances.
• -Compensating balance requirements
• -The number and complexity of checking
accounts
•

27A-31