Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-1

Chapter Thirteen

Cash and Liquidity Management

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-2

13.1 Reasons for Holding Cash

13.2 Determining the Target Cash Balance

13.3 Managing the Collection and Disbursement of Cash

13.4 Investing Idle Cash

13.5 Regulation of Financial Intermediaries

13.6 Summary and Conclusions

Chapter Organisation

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-3

Chapter Objectives

• Understand the various reasons for holding cash.• Explain and apply both the BAT model and the Miller–Orr

model.• Explain what float is and the different types of float.• Discuss various ways of managing float.• Outline ways that firms overcome temporary surpluses/deficits

of cash.• Discuss the role of the various regulators of financial markets.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-4

Reasons for Holding Cash

• Speculative motive—the need to hold cash to take advantage of additional investment opportunities, such as bargain purchases.

• Precautionary motive—the need to hold cash as a safety margin to act as a financial reserve.

• Transaction motive—the need to hold cash to satisfy normal disbursement and collection activities associated with a firm’s ongoing operations.

• Compensating balance requirements—cash balances kept at commercial banks to compensate for banking services the firm receives.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-5

Target Cash Balance

Key issues:

• What is the trade-off between carrying a large cash balance versus a small cash balance? That is, carrying costs versus shortage costs.

• What is the proper management of the cash balance? BAT model versus Miller–Orr model.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-6

The BAT Model

4 8 Weeks

Average cash

0

Starting cash

C=$2 000 000

$500 000=C/4

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-7

The BAT Model

/RF T 2C

F = fixed cost of making a securities trade to replenish cash

T = total amount of new cash needed for transactions purposes over the relevant planning period

R = the opportunity cost of holding cash (the interest rate on marketable securities)

Assumptions-Cash is spent at the same rate every day-Cash expenditures are known with certainty

Optimal cash balance is where opportunity cost of holding cash ([C/2]*R) = trading cost ([T/C]*F):

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-8

Miller–Orr Model

• Assumes that, if left unmanaged, a company’s cash balance would follow a random walk with zero drift.

• Cash balance is allowed to wander freely between an upper limit (U*) and a lower limit (L).

• If cash holdings reach U*, management intervenes by withdrawing U* – C* dollars to return the cash balance to the target level C*.

• If cash balance reaches L, management intervenes by injecting C* – L dollars to return the cash balance to the target level C*.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-9

Miller–Orr Model

U* is the upper control limit. L is the lower control limit. The target cash balance is C*. As long as cash is between L and U*, no transaction is made.

Cash

TimeX Y

L

C*

U*

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-10

Miller–Orr Model

34balancecash Avg.

23

σ

firm by theset

31

2

/L C

L C U

R F 4

3 L C

L

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-11

Example—Miller–Orr Model

$2423

/3$0 817 $1 4 balancecash Avg.

$5451

$0 2 817 $1 3

817 $1

0.0052000$ $10

4

3 $0

31

2

U

C

Assume L = $0, F = $10, i = 0.5 per cent per month and the standard deviation of monthly cash flows is $2000.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-12

Miller–Orr Model Implications

• Considers the effect of uncertainty (through 2 in net cash flows).

– The higher the 2, the greater the difference between C* and L.

– The higher the 2, the higher is the upper limit and the average cash balance.

• All things being equal:– the greater the interest rate, the lower is the C*– the greater the order costs, the higher is the C*.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-13

Miller–Orr Model With Overdraft

• Yield on short-term investments < cost of bank overdraft < yield on long-term investments.

• A dollar invested in short-term assets earns less than the costs saved by applying that dollar to reduce overdraft usage.

• The company invests nothing in short-term assets and as much as possible in long-term assets, while meeting its liquidity needs through using the overdraft facility.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-14

Miller–Orr Model With Overdraft

C

CL

dRFC

U

2 level overdrawn Target

3

/ 4

3

0

31

2

Where:

d = cost of bank overdraft

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-15

Understanding Float

• What is float?– The difference between book cash and bank cash,

representing the net effect of cheques in the process of being cleared.

• Types of float:– Disbursement float—the result of cheques written;

decreases book balance but does not immediately change available balance.

– Collection float—the result of cheques received; increases book balance but does not immediately change available balance.

– Net float—the overall difference between the firm’s available balance and its book balance.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-16

Float Management

• Objectives:– In cash collection—speed up cheque collections (reduce float

components).– In cash disbursement—control payments and minimise costs

(increase float components).

• Components of float:– Mail float—cheques trapped in postal system.– Processing float—until receiver of cheque deposits cheque.– Availability float—until cheque clears in the banking system.

• Mail float + processing float + availability float = total time delay.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-17

Measuring and Costing the Float

delay avg. weighted receiptsdaily Avg. float daily Average

or

days Total

float Total float daily Average

The cost of collection float to the firm is the opportunity cost from not being able to use that cash.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-18

Managing the Float

• Factoring—the selling of receivables to a financial institution (the factor), usually ‘without recourse’.

• Credit insurance—protection against the risk of bad debt losses.

• Delaying disbursements—increases the disbursement float.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-19

Investing Idle Cash

• Temporary cash surpluses can be invested in marketable securities.

• Temporary cash deficits—sell marketable securities or use short-term bank financing.

• The temporary surpluses/deficits are a result of:– seasonal or cyclical activities– planned or possible expenditures.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-20

The Securities Markets

Temporary cash surplus

Long-term

debt market

Futures

market

Options

market

Sharemarket

Short-term

money market

Foreign exchange

market

Financial

intermediaries

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13-21

Short-term Securities

Characteristics of short-term securities include:

• Maturity maturities usually less than 90 days. Investments then avoid interest rate risk but have low returns.

• Default risk idle cash generally invested in less risky securities (e.g. government issues).

• Marketability idle funds usually invested in highly liquid securities.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-22

Investing Cash

• Temporary Cash Surpluses

-Seasonal or cyclical activities—buy marketable securities with seasonal surpluses, convert securities back to cash when deficits occur.

-Planned or possible expenditures—accumulate marketable securities in anticipation of upcoming expenses.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-23

Financing Seasonal or Cyclical Activities

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-24

Regulation of Financial Intermediaries

Council of

Financial

Regulators

Australian Prudential Regulation Authority (APRA)

Prudential supervision of all deposit-taking entities, insurance and superannuation funds.

Australian Securities and Investments Commission (ASIC)

Corporate regulation, consumer protection, market integrity.

Reserve Bank of Australia (RBA)

Payments system, monetary policy, stability of the financial system.

Source: Australian Financial Review, 18 March 1998, p.4.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

13-25

Regulation of Financial Intermediaries

Terminology to know:• CGS Commonwealth Government Securities• ESAs exchange settlement accounts• RTGS real-time gross settlement• ADIs authorised deposit-taking institutions• CAR capital adequacy ratio• PAR prime assets ratio