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Corporate FinanceRoss Westerfield Jaffe

Sixth Edition

28

Chapter Twenty Eight

Cash Management

Prepared by

Gady Jacoby

University of Manitoba

and

Sebouh Aintablian

American University of

Beirut

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Executive Summary

Cash management is not as complex andconceptually challenging as other topics, such as

capital budgeting and asset pricing.

Financial managers in many companies, especially

in the retail and services industries, spend a

significant portion of their time on cash

management.

Most large Canadian corporations hold some oftheir assets in cash and marketable securities.

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Chapter Outline

28.1 Reasons for Holding Cash28.2 Determining the Target Cash Balance

28.3 Managing the Collection and Disbursement ofCash

28.4 Investing Idle Cash28.5 Summary & Conclusions

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28.1 Reasons for Holding Cash

Transactions motive: Transactions related needs come from normal

disbursement and collection activities of the firm.

The disbursement of cash includes the payment of wages

and salaries, trade debts, taxes, and dividends.

The cash inflows (collections) and outflows

(disbursements) are not perfectly synchronized, and some

level of cash holdings is necessary to serve as a buffer.

Perfect liquidity is the characteristic of cash that allows itto satisfy the transactions motive.

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28.2 Determining the Target Cash Balance

The target cash balance involves a trade-offbetween the opportunity costs of holding too much

cash (lost interest) and the trading costs of holding

too little.

If a firm tries to keep its cash holdings too low, it

will find itself selling marketable securities more

frequently than if the cash balance were higher.

The trading costs will tend to fall as the cashbalance becomes larger.

The opportunity costs of holding cash rise as the

cash holdings rise.

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28.2 Determining the Target Cash Balance

The Baumol Model The Miller-Orr Model

Other Factors Influencing the Target Cash Balance

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Costs of Holding Cash

Opportunity

Costs

Trading costs

Total cost of holding cash

C*

Costs in dollars of

holding cash

Size of cash balance

The investment income

foregone when holding cash.

Trading costs increase when the firm

must sell securities to meet cash needs.

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The Baumol Model

F= The fixed cost of selling securities to raise cashT= The total amount of new cash needed

K= The opportunity cost of holding cash: this is the interestrate.

Time

C

If we start with $C,

spend at a constant rateeach period and replace

our cash with $Cwhen

we run out of cash, our

average cash balance

will be .2

C

2

C

1 2 3

The opportunity cost

of holding is

2

CK

C

2

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The Baumol Model

F= The fixed cost of selling securities to raise cashT= The total amount of new cash needed

K= The opportunity cost of holding cash: this is the interestrate.

Time

C

As we transfer $Ceach

period we incur a trading

cost ofFeach period. If

we need Tin total over the

planning period we will

pay $F,T Ctimes.2

C

1 2 3

The trading cost is F

C

T

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The Baumol Model

C* Size of cash balance

FTKC C2

costTotal

Opportunity Costs KC

2

FT

C

Trading costs

The optimal cash balance is found where the opportunity

costs equal the trading costs

FK

T

C 2

*

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The Baumol Model

Opportunity Costs = Trading Costs

FCTKC

2

The optimal cash balance is found where the opportunity

costs equal the trading costs

K

TFC

2*

Multiply both sides by C

FTKC 2

2

K

FTC

22

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The Miller-Orr Model

The firm allows its cash balance to wanderrandomly between upper and lower control limits.

$

Time

H

Z

L

When the cash balance reaches the upper control limitHcash

is invested elsewhere to get us to the target cash balanceZ.

When the cash balance

reaches the lower

control limit,L,

investments are soldto raise cash to get

us up to the target

cash balance.

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The Miller-Orr Model Math

GivenL, which is set by the firm, the Miller-Orrmodel solves forZandH

LK

F

Z 3

2*

4

3 LZH 23**

where s2 is the variance of net daily cash flows.

The average cash balance in the Miller-Orr model

is

3

4balancecashAverage

*LZ

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Implications of the Miller-Orr Model

To use the Miller-Orr model, the manager mustdo 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.

The model clarifies the issues of cash

management: The best return point,Z, is positively related totrading costs,F, and negatively related to the interestrateK.

Zand the average cash balance are positively related

to the variability of cash flows.

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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 managements desire

to hold low cash balances.

Relative costs

For large firms, the trading costs of buying and selling

securities are very small when compared to the

opportunity costs of holding cash.

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28.3 Managing the Collection and

Disbursement of Cash

The difference between bank cash and book cash iscalledfloat.

Float management involves controlling the

collection and disbursement of cash.

The objective in cash collection is to reduce the lag

between the time customers pay their bills and the

time the cheques are collected.

The objective in cash disbursement is to slow downpayments, thereby increasing the time between

when cheques are written and when cheques are

presented.

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Electronic Data Interchange

Electronic Data Interchange (EDI) is a general termthat refers to the growing practice of direct,

electronic information exchange between all types

of businesses.

One important use of EDI is to electronically

transfer financial information and funds between

parties, to eliminate paper invoices, paper cheques,

mailing, and handling. One of the drawbacks of EDI is that it is expensive

and complex to set up.

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Accelerating Collections

Customermails

payment

Companyreceives

payment

Companydeposits

payment

Cash

received

Mail

delay

Mail

float

Processing

delay

Processing

float

Clearing

delay

Clearing

float

time

Collection float

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Overview of Lockbox Processing

Corporate

Customers

Corporate

Customers

Corporate

Customers

Corporate

Customers

Local Bank

Collects funds

from PO Boxes

Envelopes opened;

separation of

cheques and receipts

Deposit of chequesinto bank accounts

Details of receivablesgo to firm

Firm processes

receivablesBank clears cheques

Post Office

Box 1

Post Office

Box 2

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Electronic Collection Systems

Focus on reducing float virtually to zero byreplacing cheques with electronic funds transfer.

Examples used in Canada:

Preauthorized payments

Point-of-sales transfers

Electronic trade payables

Smart cards.

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Controlling Disbursements

Firms use zero-balance accounts to avoid carryingextra balances in each disbursement account.

With a zero-balance account, the firm, in

cooperation with its bank, transfers in just enough

funds to cover cheques presented that day.

The firm maintains two disbursement accounts: one

for suppliers and one for payroll.

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Ethical and Legal Questions

The financial managers must always work withcollected bank cash balances and not with the

companys book balance, which reflects cheques

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.

The issue is minor in Canada since there can be amaximum of only one days deposit float.

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28.4 Investing Idle Cash

A firm with surplus cash can park it in the moneymarket. Some large firms and many small ones use money market

mutual funds.

Canadian chartered banks compete with money marketfunds offering arrangements in which the bank takes allexcess available funds at the close of each business dayand invests them for the firm.

Firms have surplus cash for three reasons: Seasonal or Cyclical Activities

Planned Expenditures

Different Types of Money Market Securities

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Seasonal Cash Demands

Long-termfinancing

Short-termfinancing

Time

Total Financing needs

J F M A M

Marketablesecurities

Bank loans

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Characteristics of Short-term Securities

Maturity Longer maturity securities are more exposed to interest

rate risk than shorter maturity securities.

Default risk

DBRS compiles and publishes ratings of various

corporate and public securities.

Marketability

No price-pressure effect Time.

Taxability

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Some Different Types of Money-Market Securities

Money-market securities are highly marketable and short-term.

They are issued by the federal government, domestic and

foreign banks, and business corporations.

Examples are:

T-bills

Commercial paper

Bankers acceptances Dollar swaps

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28.5 Summary & Conclusions

A firm holds cash to conduct transactions and tocompensate 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.

Two transactions models that provide rough

guidelines for determining the optimal cash positionare:

The Miller-Orr model

The Baumol model

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28.5 Summary & Conclusions

The firm can make use of a variety of procedures tomanage the collection and disbursement of cash in

such as way as to speed up the collection of cash

and slow down payments.

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

companys book balance.

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28.5 Summary & Conclusions

If you are borrowing the banks money withouttheir knowledge, you are raising serious ethical and

legal questions.

The answers to which you probably know by now.