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CHAPTER 5

CASH OR LIQUID ASSET MANAGEMENT

CHAPTER CONTEXT: THE BIG PICTURE

This chapter introduces the process of liquid asset management and is the first chapter in the four-chapter section entitled “Part 2: Managing Your Money.” This section of the text introduces different strategies for controlling the financial plan through cash management, credit management, and management of large expenses. Cash management lays the foundation for maintaining adequate liquidity to meet everyday expenses and avoiding the sale of other assets to meet emergency expenses. Specifically, this chapter introduces the principles of liquid asset management and describes the alternatives available for cash management and liquid investments. Students are encouraged to critically evaluate the products and to tailor choices to best match their needs.

CHAPTER SUMMARY

This chapter establishes the importance of implementing an effective cash management plan. A basic premise of the chapter is the importance of maintaining some liquid assets to be used in the event of an emergency. Cash management institutions, their features, and the characteristics of the accounts offered are summarized. Rates of return on different cash management and liquid investment alternatives are discussed. Strategies for selecting and using cash management vehicles, such as the checking account, are discussed. An explanation of the benefits of automating cash management with electronic funds transfers and online banking concludes this chapter.

LEARNING OBJECTIVES AND KEY TERMS

After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms:

1. Manage your cash and understand why you need liquid assets.a. cash managementb. liquid assets

2. Automate your savings.3. Choose from among the different types of financial institutions that provide cash

management services.a. deposit-type financial institutionsb. non-deposit-type financial institutions

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

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c. online banking

4. Compare the various cash management alternatives.a. demand depositb. NOW (negotiable order of withdrawal) accountc. savings accountd. money market deposit account (MMDA)e. certificate of deposit (CDs)f. money market mutual funds (MMMFs)g. asset management accountsh. U.S. Treasury Bills, or T-Bills i. denominationj. U.S. Savings bond

5. Compare rates on the different liquid investment alternatives.a. annual percentage yield (APY)b. after-tax returnc. Federal Deposit Insurance Corporation (FDIC)d. National Credit Union Association

6. Establish and use a checking account.a. direct depositb. safety deposit boxc. overdraft protectiond. stop paymente. cashier’s checkf. certified checkg. money orderh. traveler’s checks

7. Transfer funds electronically and understand how electronic funds transfers (EFTs) work.a. electronic funds transfer (EFT)b. automated teller machine (ATM), or cash machinec. personal identification number (PIN)d. debit carde. smart cards

CHAPTER OUTLINE

I. Managing Liquid AssetsA. The reservoir effectB. Risks associated with liquid assets

1. Risk-return trade-off2. Spending risk


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II. Automating Savings: Pay Yourself FirstA. Automatic depositB. Payroll deduction

III. Financial InstitutionsA. “Banks” or deposit-type financial institutions

1. Commercial banks2. Savings and loan associations3. Savings banks4. Credit unions

B. Non-deposit-type financial institutions1. Mutual funds2. Stock brokerage firms

C. Online Banking1. Instant access2. Transfers3. Pay bills

D. What to look for in a financial institution1. Service2. Safety3. Cost

IV. Cash Management AlternativesA. Checking accounts

1. Demand deposits2. Negotiable order of withdrawal accounts

B. Savings accounts1. Passbook accounts2. Statement accounts

C. Money market deposit accountsD. Certificates of depositE. Money market mutual fundsF. Asset management accountG. U.S. Treasury bills, or T-billsH. U.S. Series EE bonds

1. Denominations2. Tax advantages

V. Comparing Cash Management AlternativesA. Comparable interest rates


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B. Tax considerationsC. Safety

1. Federal Deposit Insurance Corporation (FDIC)2. Money market mutual funds and safety

VI. Establishing and Using a Checking AccountA. Choosing a financial institutionB. The cost factor

1. Monthly fees2. Minimum balances3. Charge per check4. Balance-dependent scaled fees

C. The convenience factor1. Safety deposit boxes2. Overdraft protection3. Stop payments

D. The consideration factorE. Balancing your checking account

1. “Check 21”F. Other types of checks

1. Cashier’s check2. Certified check3. Money order4. Traveler’s check

VII. Electronic Funds Transfers (EFTs)A. Automated teller machines (ATMs)B. Debit cardsC. Smart cardsD. Stored value cardsE. Fixing mistakes—theirs, not yours

APPLICABLE PRINCIPLES

Principle 5: Stuff Happens or The Importance of LiquidityUnforeseen events require you to have liquid assets to protect your other investments. Rather than being forced to sell the investment at a loss to cover the emergency expense, you can simply pay in cash.

Principle 8: Risk and Return Go Hand in Hand



Because liquid assets, such as a savings account or money market mutual fund, can be easily converted to cash, they have very little or no risk. But these accounts also don’t provide a high return. Nevertheless, low-risk, high-liquidity investments are an integral part of your cash management plan. Just don’t keep too many assets in these accounts.

Principle 10: Just Do ItEstablish a savings habit by having savings automatically deducted from your paycheck. The “if you don’t see it, you won’t spend it” adage has a lot of truth to it and can eventually pay great rewards—even when considering the low returns associated with liquid accounts.

Principle 3: The Time Value of MoneyThe earlier you start saving, the greater the effect compound interest has on the investment return. Start saving immediately; time is your greatest ally—even more important than how much you save.

CLASSROOM APPLICATIONS

1. Ask students to list several reasons why starting to save immediately after employment (or other life cycle event such as marriage, birth of a child, or divorce) can be difficult. Discuss the reasons why saving, regardless of the amount, is beneficial and should be strongly encouraged.

2. Innovations and automations in cash management accounts, online banking, and electronic fund transfer options continue to evolve. For example, future ATM machines may “read” the user’s retina instead of a PIN. Ask the students to locate recent news articles to update the class on the latest innovations and automations.

3. Ask the class to collect brochures, newspaper or magazine advertisements, or other information on various liquid asset accounts. While working in small groups, have the students create appropriate consumer scenarios from across the financial life cycle to match to each account. Remind them to consider rate of return, length of investment period, and minimum deposit in their answers. Are some accounts simply not good choices when compared to others available?

4. Have the class do online research to compare “Web-based” banks to traditional “brick and mortar” institutions. Ask students to compare the types of accounts offered, the fees imposed, the rates of return, the services available, and the privacy of client data. With the class, discuss the drawbacks associated with “Web-based” banks and why these institutions would or would not be a viable alternative for individual banking needs. For interest, divide the class into small groups, with each representing a bank of their choice.


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REVIEW QUESTION ANSWERS

1. Liquidity is the ability to easily convert certain financial products, such as checking accounts, money market funds, and CDs, into cash. It is important to have liquidity because, as Principle 5 says, “Stuff happens.” By keeping some funds in liquid assets, money is available to cover financial emergencies such as unemployment or car repairs. That way, long-term investments (e.g., stock) do not have to be sold at an inopportune time, perhaps at an unfavorable price. Liquid assets are also used to hold money used for paying normal household living expenses (e.g., rent, utilities). Unfortunately Principle 8 refers to the risk-return trade-off, because with higher liquidity comes lower return. So there will be some loss of earnings potential with highly liquid accounts.

2. Student answers may vary; however, the following are some characteristics: Can quickly be turned into cash without loss of principal. Considered low-risk assets (compared to other investments). Provide a relatively low expected rate of return. Useful for holding funds that you expect to use in the near future. A good place to put an emergency fund of three to six months’ expenses. Very sensitive to interest rate changes taking place in the economy.

Some disadvantages of having too much money too liquid are: Low overall return due to low investment risk. Risk of spending due to ease of access.

Some disadvantages of having too little money too liquid are: Higher liquidation cost in the event of an emergency. Greater amount of time to receive the money. Increased risk of not having access.

3. The two factors are (1) less government regulation (deregulation) and (2) increased competition between banks and other financial institutions.

4. The primary advantage of automating your savings is best addressed with Principle 10: Just Do It. According to this idea, it is easier to spend than save. If you automate your savings, then you are creating an expense for your savings plan, and you are not as likely to neglect it.

5. Deposit-type institutions (a.k.a. banks) provide traditional checking and savings accounts and offer the most variety in financial services, including safe deposit boxes, credit cards, and a wide array of savings and loan options.



Commercial banks Savings and loan associations Savings banks (a.k.a. mutual savings banks, credit unions)Non-deposit-type financial institutions have more recently (since deregulation in the early 1980s) begun to offer similar services to compete with banks, while banks have begun to offer services traditionally provided by non-deposit institutions (e.g., securities purchases). Thus, over the past two decades, traditional lines between the two types of financial institutions have blurred considerably. Mutual funds Stock brokerage firms Insurance firms

6. Student answers may vary but should be drawn from the following lists. Advantages

1. Personal financial management support from financial planning programs2. Convenience3. Efficiency4. Effectiveness

Disadvantages 1. Increased start-up time2. Adapting to online banking may have a steep learning curve for some3. Not feeling comfortable4. Little or no customer-service

7. A credit union is a non-profit, depositor-owned financial institution made up of members with some type of common bond (e.g., employment, religion, college affiliation). Credit unions offer a wide range of competitive financial services (e.g., loans, checking accounts).Characteristics of credit unions: Due to “affiliation requirement,” only about half of Americans are eligible to join. Often smaller and more efficient than commercial banks. Tend to have lower fees and minimum balances than banks. Loans tend to be made at more favorable rates. Some do not provide home mortgages. Very convenient: often located at members' place of employment.

8. NOW stands for “negotiable order of withdrawal.” NOW accounts are checking accounts in which you earn interest on your balance. Generally, you must maintain a certain minimum balance in order for interest to be paid. Advantage: Extra income provided by an interest-bearing account. Disadvantage: Owners must generally place more money in a checking account than

needed to pay bills in order to meet minimum balance requirements. There is an


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opportunity cost associated with interest that could have been earned on alternative, higher-paying investments.

9. The characteristics of CDs include: CDs pay a fixed rate of interest for a specified period of time. Generally, the longer the time period until maturity, the higher the rate of return. If money is withdrawn prior to maturity, an early-withdrawal penalty may be assessed. CD rates vary from bank to bank and between banks and other financial institutions

10. A money market deposit account (MMDA) is a bank product that provides a variable rate of interest that fluctuates with market conditions. Up to three checks per month can be written against the account without incurring additional charges. Often, a minimum balance of $1,000 or more is required to open an MMDA and they are FDIC insured. A money market mutual fund (MMMF) is an investment company product (not FDIC insured) and also provides a variable rate of interest. The issuer pools the funds of many investors and invests the fund portfolio in short-term debt instruments issued by government entities or large corporations. Limited check writing is also available (checks must exceed a certain amount, such as $250 or $500). Minimum initial deposits vary. MMMFs almost always pay a slightly higher yield than bank MMDAs.

11. Asset management accounts are a comprehensive financial services package, offered by brokerage firms, that provide a single consolidated monthly financial statement and coordinate the flow of cash between MMMFs and other investments in the account. That way, no money sits idle without earning interest. Components of an asset management account can include a checking account, a credit card, securities such as stocks or bonds, a MMMF, and automatic loan payments. Interest and dividends earned on investments are swept into the MMMF daily to immediately earn additional interest.

However, not everything about these accounts is beneficial. Their annual cost is about $50 to $125, which may or may not be worth the benefits provided. Another disadvantage is that these accounts typically have fairly high minimum balances and, of course, you must pay a commission to purchase any investments.

12. Treasury bills (T-bills) are short-term federal government debt instruments with maturities ranging from 3 months to 12 months. The minimum denomination to purchase a T-bill is $10,000. T-bills are purchased at an amount less than the face value received at maturity. The difference between the purchase price and the face value is the interest paid to an investor. T-bills are taxable on federal tax returns but are free from state or local taxes.

EE bonds are issued in denominations ranging from $50 to $10,000. They are purchased at half of their face value. Like T-bills, interest grows until maturity and they are state tax free.



Rates for both products vary with market conditions. Interest may be exempt from federal tax if EE bonds are used to pay college tuition and fees and income limits are met.

13. Generally, the higher the investors’ marginal tax bracket, the more they'll benefit from tax-exempt investments such as municipal bonds. This is because taxes affect the real rate of return on investments by taking away some of the yield earned by investors in taxable securities. To decide on the best investment alternative (taxable versus tax-exempt), investments should be compared on an equivalent after-tax basis.

14. The factors are typically referred to as the three Cs:1. Cost (e.g. Return item charges, Service charges, Minimum balance requirements)2. Convenience (e.g. Location, Hours, Available services)3. Consideration (e.g. Personal service, Safety)

15. Electronic funds transfers (EFTs) are financial transactions that take place electronically. In other words, money is quickly moved between accounts without the use of paper (e.g., checks). Three types of EFTs are ATMs, debit cards, and smart cards. ATMs—an acronym for automatic teller machines, ATMs provide cash withdrawals

through the use of credit or debit cards. They are convenient and available worldwide. Fees of up to $4 can be charged per transaction, making ATMs an expensive way to get money if used frequently.

Debit Cards—a cross between a credit card and a checking account, a debit card allows you to spend money on deposit in a specific account linked to them. Unless you have overdraft protection, you can't spend more than you have in the account.

Smart Cards—smart cards magnetically store a specific dollar value that is put into the card when users deposit funds with the issuer. Smart cards can then be used to purchase services from vendors who honor them. Frequent issuers include universities, restaurants, and copy machine services (e.g., Kinko’s).

16. Features of online banking include: 24-hour access, extended customer service hours, and online statements. Disadvantages include: no physical location for problem resolution, any personal relationship with your banker, and lack of features, such as safe deposit boxes.

Features of debit cards include: nearly universal acceptance and check-like convenience. Debit cards have almost no disadvantages, unless you consider super-easy access to your money a disadvantage.

Features of “smart” cards include: 24-hour usage, reduced need for cash, and almost universal acceptance. The only disadvantage may be that you are prepaying for your expenses, which reduces your time value of money.


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There are two primary types of stored value cards: 1) closed-loop, single purpose cards such as prepaid calling cards or gift cards and 2) open-loop, multi-purpose cards like prepaid debit cards. The primary disadvantage of the cards is the wide variety of fees associated with their use. These fees include: activation, maintenance, and transaction fees; all of which should be avoided, if possible.

17. Card blocking occurs when money is “ear-marked” for a purpose even before it is actually billed. For example, a customer uses a debit card to hold a hotel room. Although the customer will not be charged for the room until arrival, the money in the account is blocked so that it may not be spent before the hotel can collect. Blocking policies differ between providers and can be especially cumbersome for customers with little extra balance in their accounts.

PROBLEM AND ACTIVITY ANSWERS

1. Examples could include the following: Money saved for large upcoming expenses (e.g., car insurance). Money being held for upcoming tuition payments. Money being held for upcoming house down payment. Money being held for unexpected emergency expenses. Money being held for upcoming income tax payment. Money being held until more permanent investment decisions are made.

2. Assuming the historical $100,000 insurance limit Tony’s account balance of $75,000 is completely covered, but Cynthia’s account is over the insurance limit by $4,000. She should consider moving some of this money into the joint account or to another institution. The joint account is also fully insured, because the $60,000 balance is well under the limit, even if she were to move the $4,000 from her individual account.

Assuming the new, higher $250,000 insurance limit all account balances are under the limit and are therefore fully insured by the FDIC.

3. The biggest benefit to mixing-and-matching is flexibility. However, by combining the best account types and providers, you can also maximize returns and features, while minimizing service charges and other fees. Also, by having money in various places, you are less likely to jeopardize FDIC or NCUA coverage.



4. This example illustrates the cost associated with having to maintain a high minimum balance in order to earn interest on checking. The forced balance is the amount of money held in the account above what is necessary to pay monthly expenses.

$2,500 – $1,300 = $1,200 Forced balance$1,200 x 3.25% = $39.00 Forgone interest$2,500 x 1.00% = $25.00 Interest earned on checking account$25.00 – $39.00 = -$14.00 Interest earned minus opportunity cost

The opportunity cost is the foregone interest that could have been earned at a higher rate on the forced balance. In this example, $14.00 more could have been earned in an alternative account.

5. 16.66% Annual Percentage Rate = ($400 / $9,600) x 4* $10,000.00 Value at maturity– $9,600 .00 Discounted purchase price $400.00 Total interest earned

* This is 4 because the example was a 3-month T-bill; therefore an investor could do this four times per year. This rate also ignores the effects of compounding.

6. Use the following formula: After-tax return = taxable return (1 – marginal tax bracket) At the 15% marginal tax rate, the after-tax yield on the 6.65% corporate bond is 6.65%

x (1 – 0.15) = 6.65% x 0.85 = 5.65%. Thus, the corporate bond is a better alternative than the 5.25% tax-free municipal bond, ignoring state taxes.

At the 33% marginal tax rate, the after-tax return of the 6.65% corporate bond is 6.65% x (1 – 0.33) = 6.65% x (0.67) = 4.46%. In this case, the 5.25% tax-free municipal bond is a better alternative than the 6.65% corporate bond, ignoring state taxes.

7. Monetary returns are based on a constant $50,000 balance and annual compounding.

Rate $ ReturnNominal = 3.50% $1,750.00After-tax: 3.5% x (1 – 0.28) = 2.52% $1,260.00Real (estimation): 3.5% – 2.5% = 1.00% $500.00Real (actual): [(1 + 0.035) / (1 + 0.025)] -1 = 0.98% $487.80

The following was not asked for but may provide an interesting teaching point.Real, After-tax: [(1 + 0.0252)/(1 + 0.025)] -1 = 0.02% $9.76

The implication is that it is difficult to do any more than keep up with taxes and inflation with liquid assets. Therefore, only the amount needed for financial emergencies and short-term goals should be placed in assets with such a low risk-return ratio. Additional funds


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should be invested elsewhere for a higher return. $50,000 is too much money to be earning a low real rate of return, unless specific circumstances dictate otherwise.

8. The first tax rate at which the 2.78% municipal bond offers the better after-tax return is 33%.

After-tax = nominal x (1 – marginal tax bracket)10% MTB 3.63% = 4.03% (1 – 0.10)15% MTB 3.43% = 4.03% (1 – 0.15)25% MTB 3.02% = 4.03% (1 – 0.25)28% MTB 2.90% = 4.03% (1 – 0.28)33% MTB 2.70% = 4.03% (1 – 0.33)

9. Student answers will vary but should include some of the following. Convenience factors

1. Efficiency—easy access if internet savvy, availability of specific services such as online “bill-pay.”

2. Effectiveness—additional on-line services such as stock quotes, personal financial management software

Higher return—given the lack of “overhead” bank without physical location typically can pay higher rates of return.



DISCUSSION CASE 1 ANSWERS

1. Examples could include the following:For retirement Participate in employer 401(k) plan. Obtain employer match of 401(k) plan contribution. Sign up for U.S. savings bond purchase program.For savings Direct deposit of paycheck into savings account. Authorize automated money market mutual fund or CD deposits.For convenience Direct deposit of paycheck into checking or savings account. Join credit union savings plan.

2. Shu should consider the "3 Cs" when selecting an account: Cost—fees, minimum balances, per-check charges, etc. Convenience—location, availability of specific services, etc. Consideration—personal attention, services provided, etc.It is advisable to compare the characteristics of at least three different accounts and select the one that comes closest to her personal criteria for a liquid asset account.

3. Without an emergency fund, Shu might have to borrow funds to handle an emergency (e.g., use of credit cards) or liquidate a long-term investment at an inopportune time. The rule of thumb is three to six months of expenses; therefore, Shu should keep $4,800 ($1,600 x 3) to $9,600 ($1,600 x 6) in liquid assets not subject to fluctuations in the value of principal.

4. Wen's after-tax monthly income is $4,000, so an emergency fund of $12,000 to $24,000 maybe advisable. However, this is based on his earnings rather than his expenses so this maybe erring to the high end – which may not be a bad thing given his employment history.

Instead, Todd has nearly 9 months of after-tax income earning a relatively low rate of return. In the 25 percent marginal tax bracket, he'll net only 3.0 percent after taxes; and after accounting for 3.0% inflation the return is basically zero. Wen should reinvest the excess $11,000 in a higher-yielding asset designed to be compatible in maturity with one of his financial goals.

5. For handling monthly expenses, Shu's options include a standard checking account, a bank money market deposit account, and a money market mutual fund. All of these accounts have advantages and disadvantages. MMDA’s have a limit of three checks per month, and MMMF’s have minimum dollar requirements on check amounts, which makes neither of these accounts very suitable for paying monthly bills. However, the basic checking account does not generate a very high return. For short-term savings, typically liquidity is more


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important than return; therefore, the lowest cost, most flexible account would be best for her monthly expense account.

Conversely, for the account Shu is using to save for her car, either of the money market accounts would provide more return without sacrificing accessibility. Neither the minimum check amount nor the monthly check writing limitation is of consequence given that she will theoretically be making only one withdrawal – at the time of purchase. So choosing the highest yielding account would be best.

6. Cashier’s checks can be preferable to certified checks because they are purchased from a bank and drawn on the bank’s funds. Whereas a certified check is a check drawn on your account and the institution “certifies” that the check is good by placing a hold on your account for that specific check amount. There can be instances, though very rare, that the institution, probably due to an account closure, may not honor a certified check.

DISCUSSION CASE 2 ANSWER

To balance his checkbook, Jarod should follow the steps in Figure 5.2, Worksheet for Balancing Your Checking Account, as outlined below or Worksheet 8, Worksheet for Balancing Your Checking Account.

Step 1: In reviewing the bank statement, Jarod noted three entries that were not recorded in his checkbook register: $4.50 service charge; a $30 ATM withdrawal; and a $39 check card purchase. Subtracting these from the $1,645.11 balance on his register resulted in an adjusted balance of $1,571.61.

Step 2: The statement deposits and Jarod's checkbook register agree.

Step 3: No additional deposits were made since the date of the statement.

Step 4: Four checks were outstanding, for a total of $219.28, as listed below:1079 $37.871083 $125.001085 $47.251086 $9.16

Step 5: Enter $1,797.39 from the statement.

Step 6: Enter 0.

Step 7: Add entries from steps 5 and 6, or $1,797.39.



Step 8: Enter (subtract) the total of the outstanding checks, or $219.28.

Step 9: Calculate the Adjusted Statement Balance of $1,578.11.

Compare this amount to the adjusted checkbook register balance from Step 1, or $1,571.61. Because the numbers are out of balance – the checkbook is under by $6.50 – Jarod has other problems which he can discover by completing the remaining Steps A, B, and C.

A) Since the account balanced last month, there should not be outstanding checks from the past and all deposits have been included.

B) The final step is to check the math. Upon review Jarod made two common mistakes. 1. For check number 1076 he subtracted $59.75 rather than $69.75; resulting in a $10

overstatement. 2. For check number 1078 he transposed $320.20 for $302.20; resulting in an $18

understatement. Making the appropriate correction for these mistakes, results in a July 29 balance of $1,579.61; unfortunately, now Jarod is over by $1.50.

C) In one final check of the statement Jarod notices that he neglected to enter the $1.50 ATM charge associated with his $50.00 withdrawal on June 29th. Making the final correction leaves his checkbook with a balance of $1,578.11; in perfect agreement with his bank statement.


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