Chapter
Twenty
Cash and Liquidity
Management
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.1
Key Concepts and Skills
• Understand how firms manage cash
• Understand float
• Understand how to accelerate collections and
manage disbursements
• Understand the characteristics of various
short-term securities
• Appendix: Be able to use the BAT and MillerOrr models and understand the different
assumptions
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.2
Chapter Outline
•
•
•
•
•
•
Reasons for Holding Cash
Understanding Float
Cash Collection and Concentration
Managing Cash Disbursements
Investing Idle Cash
Appendix
–
–
–
–
–
The Basic Idea
The BAT Model
The Miller-Orr Model: A More General Approach
Implications of the BAT and Miller-Orr Models
Other Factors Influencing the Target Cash Balance
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.3
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
• Trade-off between opportunity cost of holding cash
relative to the transaction cost of converting
marketable securities to cash for transactions
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.4
Understanding Float
• Float – difference between cash balance recorded in
the cash account and the cash balance recorded at the
bank
• Disbursement float
– Generated when a firm writes checks
– Available balance at bank – book balance > 0
• Collection float
– Checks received increase book balance before the
bank credits the account
– Available balance at bank – book balance < 0
• Net float = disbursement float + collection float
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.5
Example: Types of Float
• You have $3000 in your checking account.
You just deposited $2000 and wrote a check
for $2500.
–
–
–
–
–
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?
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.6
Example: Measuring Float
• Size of float depends on the dollar amount and the
time delay
• Delay = mailing time + processing delay +
availability delay
• Suppose you mail a check for $1000 and it takes 3
days to reach its destination, 1 day to process and 1
day before the bank will make the cash available
• What is the average daily float (assuming 30 day
months)?
– Method 1: (3+1+1)(1000)/30 = 166.67
– Method 2: (5/30)(1000) + (25/30)(0) = 166.67
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.7
Example: Cost of Float
• Cost of float – opportunity cost of not being
able to use the money
• Suppose the average daily float is $3 million
with a weighted average delay of 5 days.
– What is the total amount unavailable to earn
interest?
• 5*3 million = 15 million
– What is the NPV of a project that could reduce the
delay by 3 days if the cost is $8 million?
• Immediate cash inflow = 3*3 million = 9 million
• NPV = 9 – 8 = $1 million
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.8
Cash Collection
Payment
Mailed
Payment
Received
Mailing Time
Payment
Deposited
Processing Delay
Cash
Available
Availability Delay
Collection Delay
One of the goals of float management is to try and reduce the
collection delay. There are several techniques that can reduce
various parts of the delay.
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.9
Example: Accelerating Collections – Part I
• Your company does business nationally and currently
all checks are sent to the headquarters in Tampa, FL.
You are considering a lock-box system that will have
checks processed in Phoenix, St. Louis and
Philadelphia. The Tampa office will continue to
process the checks it receives in house.
–
–
–
–
–
Collection time will be reduced by 2 days on average
Daily interest rate on T-billls = .01%
Average number of daily payments to each lockbox is 5000
Average size of payment is $500
The processing fee is $.10 per check plus $10 to wire funds
to a centralized bank at the end of each day.
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.10
Example: Accelerating Collections – Part II
• Benefits
– Average daily collections = 3(5000)(500) = 7,500,000
– Increased bank balance = 2(7,500,000) = 15,000,000
• Costs
– Daily cost = .1(15,000) + 3*10 = 1530
– Present value of daily cost = 1530/.0001 = 15,300,000
• NPV = 15,000,000 – 15,300,000 = -300,000
• The company should not accept this lock-box
proposal
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.11
Cash Disbursements
• Slowing down payments can increase
disbursement float – but it may not be ethical
or optimal to do this
• Controlling disbursements
– Zero-balance account
– Controlled disbursement account
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.12
Investing Cash
• Money market – financial instruments with an
original maturity of one-year or less
• 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
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.13
Figure 20.6
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.14
Characteristics of Short-Term Securities
• Maturity – firms often limit the maturity of
short-term investments to 90 days to avoid
loss of principal due to changing interest rates
• Default risk – avoid investing in marketable
securities with significant default risk
• Marketability – ease of converting to cash
• Taxability – consider different tax
characteristics when making a decision
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.15
Quick Quiz
• What are the major reasons for holding cash?
• What is the difference between disbursement
float and collection float?
• How does a lock box system work?
• What are the major characteristics of shortterm securities?
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.