Chapter
19
Cash and Liquidity
Management
19-1
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
• Reasons for Holding Cash
• Understanding Float
• Cash Collection and Concentration
• Managing Cash Disbursements
• Investing Idle Cash
19-2
Chapter Outline
(Appendix)
• The Basic Idea
• The BAT Model
• The Miller-Orr Model: A More
General Approach
• Implications of the BAT and MillerOrr Models
• Other Factors Influencing the Target
Cash Balance
19-3
Chapter Outline
• Reasons for Holding Cash
• Understanding Float
• Cash Collection and Concentration
• Managing Cash Disbursements
• Investing Idle Cash
19-4
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
19-5
Chapter Outline
•Reasons for Holding Cash
•Understanding Float
•Cash Collection and Concentration
•Managing Cash Disbursements
•Investing Idle Cash
19-6
Understanding Float
Definition: Float – the difference
between cash balance recorded in the
cash account and the cash balance
recorded at the bank
19-7
Understanding Float
 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
19-8
Example: Types of Float
You have $3,000 in your checking
account. You just deposited $2,000 and
wrote a check for $2,500.
 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?
19-9
Example: Measuring Float
 Size of float depends on the dollar
amount and the time delay
 Delay = mailing time + processing
delay + availability delay
19-10
Example: Measuring Float
Suppose you mail a check each month for $1,000 and it
takes 3 days to reach its destination, 1 day to process, and
1 day before the bank makes the cash available
What is the average daily float (assuming 30-day months)?
 Method 1: (3+1+1)(1,000)/30 = $166.67
 Method 2: (5/30)(1,000) + (25/30)(0) = $166.67
19-11
Example: Cost of Float I
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
19-12
Example: Cost of Float II
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 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
19-13
Chapter Outline
•Reasons for Holding Cash
•Understanding Float
•Cash Collection and Concentration
•Managing Cash Disbursements
•Investing Idle Cash
19-14
Cash Collection
Payment
Mailed
Payment
Received
Mailing Time
Payment
Deposited
Processing Delay
Cash
Available
Availability Delay
Collection Delay
19-15
One of the goals of float management is to
try to reduce the collection delay. There are
several techniques that can reduce various
parts of the delay.
Lockbox System
1. A lockbox system is a service whereby checks are
mailed to a local PO Box address.
2. The checks are picked up daily (or even multiple
times per day) by the servicing firm.
3. The checks are deposited into the local branch
bank.
4. The balances are electronically transferred to the
firm’s branch of the bank, available for use
immediately.
19-16
No Lockbox System
2-3 Days
by Mail
19-17
2-3 Days
by Mail
Lockbox System II
Transmitted
Electronically
(nanoseconds)
1 Day by Mail
1 Day by Mail
19-18
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.
19-19
Example: Accelerating
Collections – Part II
 Collection time will be reduced by 2
days on average
 Daily interest rate on T-bills = .01%
 Average number of daily payments to
each lockbox is 5,000
 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.
19-20
Example: Accelerating
Collections – Part III
 Benefits
 Average daily collections = 3(5,000)(500) = 7,500,000
 Increased bank balance = 2(7,500,000) = 15,000,000
 Costs
 Daily cost = .1(15,000) + 3*10 = 1,530
 Present value of daily cost = 1,530/.0001 = 15,300,000
 NPV = 15,000,000 – 15,300,000 = -$300,000
 The company should not accept this lock-box
proposal as we would lose money.
19-21
Chapter Outline
•Reasons for Holding Cash
•Understanding Float
•Cash Collection and Concentration
•Managing Cash Disbursements
•Investing Idle Cash
19-22
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
19-23
Chapter Outline
•Reasons for Holding Cash
•Understanding Float
•Cash Collection and Concentration
•Managing Cash Disbursements
•Investing Idle Cash
19-24
Investing Cash
Money market – financial instruments with an original
maturity of one year or less
19-25
Investing Cash
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
19-26
Investment Timing
19-27
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
19-28
Ethics Issues
Some corporations routinely pay
late or take discounts that they do
not qualify for.
1.
2.
19-29
How does this impact the supplier?
Does this action have any negative
impact on the company itself?
Quick Quiz
 What are the major reasons for holding
cash?
 What is the difference between
disbursement float and collection float?
 How does a lockbox system work?
 What are the major characteristics of
short-term securities?
19-30
Comprehensive Problem
 A proposed single lockbox system will reduce collection time
2 days on average
 Daily interest rate on T-bills = .01%
 Average number of daily payments to the lockbox is 3,000
 Average size of payment is $500
 The processing fee is $.08 per check plus $10 to wire funds
each day.
 What is the maximum investment that would make this
lockbox system acceptable?
19-31
Terminology
•Speculative motive
•Precautionary motive
•Transaction motive
•Disbursement float
•Collection float
•Lock Box
19-32
Formulas
Net float = disbursement float +
collection float
Delay = mailing time + processing delay
+ availability delay
19-33
Key Concepts and Skills
•Define float and describe how it affects
cash balance
•Describe the processes to accelerate
collections
•Give examples of the advantages and
disadvantages of holding cash
•Evaluate the options to invest idle cash
19-34
What are the most important
topics of this chapter?
1. Cash is necessary for funding
operations but excess cash is a missed
opportunity to earn interest.
2. Float is the difference between the
firm’s balance and the bank’s balance.
3. There are numerous options to invest
cash in short-term financial
instruments.
19-35
What are the most
important topics of this
chapter?
4. A lock-box system speeds up the time
that a firm’s gets credit for funds
deposited into their business account.
19-36
19-37