CHAPTER 19 CASH AND LIQUIDITY MANAGEMENT

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CHAPTER 19
CASH AND LIQUIDITY MANAGEMENT
Answers to Concepts Review and Critical Thinking Questions
1.
Yes. Once a firm has more cash than it needs for operations and planned expenditures, the excess cash
has an opportunity cost. It could be invested (by shareholders) in potentially more profitable ways.
Question 10 discusses another reason.
2.
If it has too much cash it can simply pay a dividend, or, more likely in the current financial
environment, buy back stock. It can also reduce debt. If it has insufficient cash, then it must either
borrow, sell stock, or improve profitability.
3.
Probably not. Creditors would probably want substantially more.
4.
It is debatable whether holding enormous cash reserves is the best way to deal with future economic
downturns. However, it is true that auto manufacturers’ operating cash flows are very sensitive to the
business cycle, and enormous losses have occurred during recent downturns.
5.
Cash management is more associated with the collection and disbursement of cash. Liquidity
management is broader and concerns the optimal level of liquid assets needed by a firm. Thus, for
example, Ford and Chrysler’s stockpiling of cash was liquidity management; whereas, evaluating a
lockbox system is cash management.
6.
Such instruments go by a variety of names, but the key feature is that the dividend adjusts, keeping
the price relatively stable. This price stability, along with the dividend tax exemption, makes so-called
adjustable rate preferred stock very attractive relative to interest-bearing instruments.
7.
Net disbursement float is more desirable because the bank thinks the firm has more money than it
actually does, and the firm is, therefore, receiving interest on funds it has already spent.
8.
The firm has a net disbursement float of $500,000. If this is an ongoing situation, the firm may be
tempted to write checks for more than it actually has in its account.
9.
a.
b.
c.
d.
e.
About the only disadvantage to holding T-bills are the generally lower yields compared to
alternative money market investments.
Some ordinary preferred stock issues pose both credit and price risks that are not consistent with
most short-term cash management plans.
The primary disadvantage of CDs is the normally large transactions sizes, which may not be
feasible for the short-term investment plans of many smaller to medium-sized corporations.
The primary disadvantages of the commercial paper market are the higher default risk
characteristics of the security, and the lack of an active secondary market which may
excessively restrict the flexibility of corporations to meet their liquidity adjustment needs.
If interest rates rise, the bond drops in price.
10. The concern is that excess cash on hand can lead to poorly thought-out investments. The thought is
that keeping cash levels relatively low forces management to pay careful attention to cash flow and
capital spending.
11. A potential advantage is that the quicker payment often means a better price. The disadvantage is that
doing so increases the firm’s cash cycle.
408
12. This is really a capital structure decision. If the firm has an optimal capital structure, paying off debt
moves it to an under-leveraged position. However, a combination of debt reduction and stock buybacks could be structured to leave capital structure unchanged.
Solutions to Questions and Problems
Basic
1.
Average daily float = 8($90,000)/30 = $24,000 (assuming a 30-day month)
2.
a.
b.
Disbursement float = 4($30,000) = $120,000
Collection float = 2($50,000) = –$100,000
Net float = $120,000 – 100,000 = $20,000
Collection float = 1($50,000) = –$50,000
Net float = $120,000 – 50,000 = $70,000
3.
a.
b.
c.
Collection float = 5($6,000) = $30,000
The firm should pay no more than $30,000 to eliminate the float.
Maximum daily charge = $30,000(.00025) = $7.50
4.
a.
b.
c.
Total float = 4($20,000) + 6($4,000) = $104,000
Average daily float = $104,000/30 = $3,466.67 (assuming a 30-day month).
Average daily receipts = ($20,000 + 4,000)/30 = $800
Weighted average delay = 4($20,000/$24,000) + 6($4,000/$24,000) = 4.3 days
5.
Average daily collections = $60(12,000) = $720,000
PV = (3 day reduction)($720,000) = $2,1600,000
Cost = $225/.00018 = $1,250,000 ; the firm should take the lockbox service; NPV = $910,000
Annual savings = $2,160,000(1.00018)365 – 2,160,000 = $146,663.96
Annual cost = $225(FVIFA365,.018%) = $84,874.98
Annual net savings = $146,663.96 – 84,874.98 = $61,788.98
6.
a.
b.
c.
d.
e.
Average daily float = [.6(5,000)($50)(2) + .4(5,000)($70)(3)]/30 = $24,000.
On average, there is $24,000 that is uncollected and not available to the firm.
Total collections = .6(5,000)($50) + .4(5,000)($70) = $150,000 + 140,000 = $290,000
Weighted average delay = 2(150K/290K) + 3(140K/290K) = 2.4828 days
Average daily float = 2.4828[$290K/30 days] = $24,000
The most the firm should pay is the total amount of the average float, or $24,000.
1.08 = (1 + R )365 ; R = .021087% per day
Daily cost of the float = $24,000(.00021087) = $5.06
1.5[$290K/30] = $14,500
7.
a.
b.
c.
PV = 3(300)($1,500) = $1.35M
NPV = $1.35M – [$0.75(300)/.0002] = $225,000
Net cash flow = $1.35M(.0002) – $0.75(300) = $45 per day
Net cash flow = 3($1,500)(.0002) – $0.75 = $0.15 per check
8.
a.
b.
2($140,000) = $280,000
Average daily rate = 1.101/365 – 1 = .026116% per day
$280,000(.00026116) = $73.12
Monthly rate = 1.101/12 – 1 = .00797414 per month
NPV = 0 = $280,000 – X/.00797414 ; X = $2,232.76 per month
c.
409
9.
$80,000(7)(52/2)(.0002) = $2,912
10. NPV = $6M – ($600K – 500K) = $5.9M; proceed with the new system.
Net savings = $5.9M(.04) = $236,000
Intermediate
11. PV = 2(700)($1,100) = $1,540,000
Daily interest rate = 1.061/365 –1 = .0159654% per day
NPV = $1,540,000 – [$0.35(700)/.000159654] = $5,431.50; the lockbox system should be accepted.
With the fee, NPV = $5,431.50 – [$1,000/.06] = –$11,235.17; the lockbox system should still not be
accepted.
12. Daily interest rate = 1.051/365 – 1 = .01337% per day
NPV = 0 = ($6,000)(1)N – [$0.10(N)/.0001337] – [$30,000/.05]
N = 114.24  114 customers per day
Challenge
13. a.
b.
c.
FVA = .9985(4)($150,000)(FVIFA14,.015%) = $8,395,582.59
FVA = [4($150,000 – 700)(FVIFA14,.015%)]/1.00015 = $8,367,701.48
Mad Cow should not go ahead with the plan.
[4($150,000 – $X)(FVIFA14,.015%)]/1.00015 = $8,395,582.59; X = $202.53
APPENDIX 19A
1.
a.
b.
c.
d.
e.
f.
D: this will lower the trading costs, which will cause a decrease in the target cash balance.
D: this will increase the holding cost, which will cause a decrease in the target cash balance.
I: this will increase the amount of cash that the firm has to hold in non-interest bearing accounts,
so they will have to raise the target cash balance to meet this requirement.
D: if the credit rating improves, then the firm can borrow easier, allowing it to lower the target
cash balance and borrow if a cash shortfall occurs.
I: if the cost of borrowing increases, the firm will need to hold more cash to protect against cash
shortfalls as its borrowing costs become more prohibitive.
D: this depends somewhat on what the fees apply to, but if direct fees are established, then the
compensating balance may be lowered, thus lowering the target cash balance. If, on the other
hand, fees are charged on the number of transactions, then the firm may wish to hold a higher
cash balance so they are not transferring money into the account as often.
2.
C* = [2($5,000)($9)/.06]1/2 = $1,224.74
The initial balance should be $1,224.74, and whenever the balance drops to $0, another $1,224.74
should be transferred in.
3.
holding cost = ($300)(.05) = $15.00
trading cost = [($30,000)($6)]/[($300)(2)] = $300.00
total cost = $15.00 + 300.00 = $315.00
C* = [2($30,000)($6)/.05]1/2 = $2,683.28
They should increase their average daily cash balance to $2,683.28/2 = $1,341.64, which would
minimize the costs. New total cost = ($1,341.64)(.05) + [($30,000)($6)]/[2($1,341.64)] = $134.16
4.
a.
b.
opportunity cost = ($300)(.06)/2 = $9.00
trading cost = ($4,000)($25)/$300 = $333.33
The firm keeps too little in cash because the trading costs are much higher than the opportunity
costs.
C* = [2($4,000)($25)/.06]1/2 = $1,825.74
410
5.
Total cash = 12($340,000) = $4.08M
C* = [2($4.08M)($500)/.055]1/2 = $272,363.39
The company should invest $600,000 – 272,363.39 = $327,636.61 of its current cash holdings in
marketable securities to bring the cash balance down to the optimal level.
Over the rest of the year, sell securities $4.08M/$272,636.39 = 14.96  15 times.
6.
The lower limit is the minimum balance allowed in the account, and the upper limit is the maximum
balance allowed in the account. When the account balance drops to the lower limit, $45,000 – 30,000
= $15,000 in marketable securities will be sold, and the proceeds deposited in the account. This
moves the account balance back to the target cash level. When the account balance rises to the upper
limit, then $125,000 – 45,000 = $80,000 of marketable securities will be purchased. This expenditure
brings the cash level back down to the target balance of $45,000.
7.
C* = $1,100 + [3/4($100)($50)2/.00019]1/3 = $2,095.59
U* = 3($2,095.59) – 2($1,100) = $4,086.78
When the balance in the cash account drops to $1,100, the firm sells $2,095.59 – 1,100 = $995.59 of
marketable securities. The proceeds from the sale are used to replenish the account back to the
optimal target level of C*. Conversely, when the upper limit is reached, the firm buys $4,086.77 –
2,095.59 = $1,991.18 of marketable securities. This expenditure lowers the cash level back down to
the optimal level of $2,095.59.
8.
As variance increases, the upper limit and the spread will increase, while the lower limit remains
unchanged. The lower limit does not change because it is an exogenous variable set by management.
As the variance increases, however, the amount of uncertainty increases. When this happens, the
target cash balance, and therefore the upper limit and the spread, will need to be higher. If the
variance drops to zero, then the lower limit, the target balance, and the upper limit will all be the
same.
9.
Daily rate = 1.071/365 – 1 = .0185383% per day
C* = $100,000 + [3/4($1.05M)($500)/.000185383] 1/3 = $112,854.35
U* = 3($112,854.35) – 2($100,000) = $138,563.04
10. $1,000 = [2($16,000)($5)/R]1/2 ;
R = 16.00%
411
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