Ross7eCh27

7/31/2019 Ross7eCh27

1/29

McGraw-Hill/Irwin

Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

27-0

CHAPTER

27

Cash

Management

7/31/2019 Ross7eCh27

2/29

7/31/2019 Ross7eCh27

3/29

McGraw-Hill/Irwin


27-2

27.1 Reasons for Holding Cash

Transactions motive

Compensating balances

7/31/2019 Ross7eCh27

4/29

McGraw-Hill/Irwin


27-3

27.2 Determining the TargetCash Balance

The Baumol Model

The Miller-Orr Model

Other Factors Influencing the Target CashBalance

7/31/2019 Ross7eCh27

5/29

McGraw-Hill/Irwin


27-4

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.

7/31/2019 Ross7eCh27

6/29

McGraw-Hill/Irwin


27-5

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, a.k.a. the interest rate.

Time

C

1 2 3

C

2

If we start with $C, spend at a

constant rate each period and

replace our cash with $Cwhen

we run out of cash, our average

cash balance will be .C

2The opportunity cost

of holding isC

2 C

2K

7/31/2019 Ross7eCh27

7/29

McGraw-Hill/Irwin


27-6

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, a.k.a. the interest rate.

Time

CAs we transfer $Ceach periodwe incur a trading cost ofF

each period.

1 2 3

C

2

TC

If we need $Tin total over

the planning period we willpay $F times.

The trading cost is FTC

7/31/2019 Ross7eCh27

8/29

McGraw-Hill/Irwin


27-7

The Baumol Model

C* Size of cash balance

FTKC C2

costTotal

FT

C

Trading costs

The optimal cash balance is found where the opportunity

costs equals the trading costs

FK

TC

2*

Opportunity Costs KC

2

7/31/2019 Ross7eCh27

9/29

McGraw-Hill/Irwin


27-8

The Baumol Model

Opportunity Costs = Trading Costs

The optimal cash balance is found where the opportunitycosts equals the trading costs

Multiply both sides by C

FCTKC

2

FTKC 2

2

KFTC

22

K

TFC

2*

7/31/2019 Ross7eCh27

10/29

McGraw-Hill/Irwin


27-9

The Miller-Orr Model

The firm allows its cash balance to wander randomly 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.

7/31/2019 Ross7eCh27

11/29

McGraw-Hill/Irwin


27-10

The Miller-Orr Model Math

GivenL, which is set by the firm, the Miller-Orr

model solves forZandH

LK

FZ 3

2

*

43

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

7/31/2019 Ross7eCh27

12/29

McGraw-Hill/Irwin


27-11

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 cash flows.

3. Determine the interest rate.

4. Estimate the trading costs of buying and selling

securities.

7/31/2019 Ross7eCh27

13/29

McGraw-Hill/Irwin


27-12

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 K.

Zand the average cash balance are positively related

to the variability of cash flows.

7/31/2019 Ross7eCh27

14/29

McGraw-Hill/Irwin


27-13

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.

27 14

7/31/2019 Ross7eCh27

15/29

McGraw-Hill/Irwin


27-14

Other Factors Influencing the Target

Cash Balance

Compensating Balance

Firms have cash in the bank as a compensation for

banking services.

Large corporations have thousands of accounts with

several dozen bankssometimes it makes more sense

to leave cash alone than to manage each account on a

daily basis.

27 15

7/31/2019 Ross7eCh27

16/29

McGraw-Hill/Irwin


27-15

Float

The difference between bank cash and book cash

is calledfloat.

Float management involves controlling thecollection and disbursement of cash.

27 16

7/31/2019 Ross7eCh27

17/29

McGraw-Hill/Irwin


27-16

27.3 Managing the Collection andDisbursement of Cash

Accelerating Collections

Delaying Disbursements

Disbursement FloatZero-Balance Accounts

Drafts

Ethical and Legal Questions

27 17

7/31/2019 Ross7eCh27

18/29

McGraw-Hill/Irwin


27-17

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

27 18

7/31/2019 Ross7eCh27

19/29

McGraw-Hill/Irwin


27-18

Overview of Lockbox Processing

Corporate

Customers

Corporate

Customers

Corporate

Customers

Corporate

Customers

Local Bank

Collects funds

from PO Boxes

Envelopes opened;

separation of

checks and receipts

Deposit of checksinto bank accounts

Details of receivablesgo to firm

Firm processes

receivablesBank clears checks

Post Office

Box 1

Post Office

Box 2

27 19

7/31/2019 Ross7eCh27

20/29

McGraw-Hill/Irwin


27-19

Delaying Disbursements

1. Write check on a distant bank.

2. Hold payment for several days after

postmarked in office.

3. Call supplier firm to verifystatement accuracy for large

amounts.

4. Mail from distant post office.

5. Mail from post office that requires a

great deal of handling.

Firm preparescheck to supplier

Post Office

processing

Delivery of check

to supplier

Deposit goes to

suppliers bank

Bank collects funds

27 20

7/31/2019 Ross7eCh27

21/29

McGraw-Hill/Irwin


27-20

Drafts

Firms sometimes use drafts instead of checks.Drafts differ from checks because they are not drawn on a bankbut 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.When the draft is transmitted to a firms bank for collection, thebank must present the draft to the issuing firm for acceptancebefore 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.

27 21

7/31/2019 Ross7eCh27

22/29

McGraw-Hill/Irwin


27-21

Ethical and Legal Questions

The financial managers must always work with

collected company cash balances and not with

the companys book balance, which reflectschecks 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.

27-22

7/31/2019 Ross7eCh27

23/29

McGraw-Hill/Irwin


27-22

27.4 Investing Idle Cash

A firm with surplus cash can park it in the

money market.

Some large firms and many small ones use moneymarket mutual funds.

Firms have surplus cash for three reasons:

Seasonal or Cyclical Activities

Planned Expenditures

Different Types of Money Market Securities

27-23

7/31/2019 Ross7eCh27

24/29

McGraw-Hill/Irwin


27-23

Seasonal Cash Demands

Long-termfinancing

Short-term

financing

Time

Total Financing needs

J F M A M

Marketable

securities

Bank loans

27-24

7/31/2019 Ross7eCh27

25/29

McGraw-Hill/Irwin


27 24

27.5 Summary & Conclusions

A firm holds cash to conduct transactions and to

compensate 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.

27-25

7/31/2019 Ross7eCh27

26/29

McGraw-Hill/IrwinCorporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

27 25


Two transactions models that provide rough

guidelines for determining the optimal cash

postion are:

The Miller-Orr model

The Baumol model

27-26

7/31/2019 Ross7eCh27

27/29


27 26


The firm can make use of a variety of procedures

to manage the collection and disbursement of

cash in such as way as to speed up the collection

of cash and slow down payments.

27-27

7/31/2019 Ross7eCh27

28/29


27 27


Some methods to speed collections are

Lockboxes

Concentration bankingWire transfers

The financial managers must always work with

collected company cash balances and not withthe companys book balance.

27-28

7/31/2019 Ross7eCh27

29/29

McGraw-Hill/Irwin 2005 Th M G Hill C i I All Ri ht R d


If you are borrowing the banks money without

their knowledge, you are raising serious ethical

and legal questions.

The answers to which you probably know by

now.

Ross7eCh27

Documents