CHAPTER 12
CASH AND MARKETABLE
SECURITIES MANAGEMENT
INTRODUCTION
• Managing cash is becoming even more sophisticated in the global and electronic
age of the 21st Century as finance managers try to squeeze the last peso of profit
out of their cash management strategies. Despite whatever lifelong teachings
about the virtues of having cash, the corporate financial manager actively seeks
to keep this non earning assets to a minimum. Minimizing cash balances as well
as having accurate knowledge of when cash moves into and out of the company
can improve overall corporate profitability. However, a business firm would not
want to get caught without cash when it is needed. Cash management involves
control the receipts and payments of cash so as to minimize non earning cash
balances.
OBJECTIVE OF CASH MANAGEMENT
A financial officer can use the following strategies in monitoring cash
balances:
1. Accelerate cash inflows by optimizing mechanisms for collecting cash
2. Monitor the cash disbursement needs or payments schedule
3.Minimize the amount of idle cash or funds committed to transactions and
precautionary balances; and
4. Avoid misappropriation and handling losses in the normal course of
business to determine how much cash to keep on hand, firms must Know
the trade-off between the opportunity costs associated with holding too
much cash against the shortage costs of not having enough cash.
DETERMINING THE TARGET CASH BALANCE
• The target cash balance may be derived with the use of the following
approaches, namely:
• 1.Cash budget
• 2.Cash Break-even Chart
• 3.Optional Cash Balance using the
• a.) Baumol Model
• b.) Miller-Orr Model
Cash budget
The cash budget is a tool used to present the expected cash inflows and cash
outflows. The preparation of the cash budget is discussed and illustrated in detail in
Unit lll, Chapter 10 of this textbook.
Cash Break-Even Chart (Figure 12-1)
This chart shows the relationship between the company’s cash needs and cash sources. It indicates
the minimum amount of cash that should be maintained to enable the company to meet its
obligations. To illustrate, the following data are available for XYZ Company.
XYZ Company manufactured plastic which it sells to other industrial users. The monthly production
capacity of the company is 1,200,000 kilos. Selling price is 2 per kilo.
It cash requirements have been determined as follows:
a.) Fixed monthly payments amounting to 250,000 while
b.) Variable cash payments are 50% of sales.
Required:
1.Determine the cash Break-even point (mathematical approach).
2.Prepare a Cash Break-even Chart to project the relationship between the
company’s can needs and cash sources.
OPTICAL CASH BALANCE
The Baumol Model
In the most medium or large-sized corporations, liquidity management has assumed a greater role
over the past decade. Since cash is needed for both transactions and precautionary needs in all
companies, it must be available in some form, ( cash, marketable securities, borrowing capacity) all of
the time. The liquidity managers must utilize some formal models or techniques to maintain the
optimal amount at each moment in time because to much liquidity jeopardizes the very existence of
the firm itself. In managing the level of cash (currency plus demand deposits) for transaction
purposes versus near cash (marketable securities), the following coats must be considered:
1.Fixed and variable brokerage fees, and
2.Opportunity costs such as interest foregone by holding cash instead of near cash.
One of the models that can be used to help determine the optimal cash balance is the
“Baumol model”. This model balances the opportunity cost of holding cash against the
transactions costs associated with replenishing the cash account by selling off marketable
securities or by borrowing.
The optimal cash balance can be found by using the following variables and equations:
1.The total costs of cash balances consist of a holding (or opportunity) cost plus a
transaction cost:
Where:
C = amount of cash raised by selling marketable securities or by borrowing
C= Average Cash balance
2
C*= optical amount of cash to be raised by selling marketable securities or by
borrowing
C*= optimal average cash balance
2
F= fixed costs of making a securities trade or of obtaining a loan
T= total amount of a net new cash needed for transactions during the period (usually a
year)
K= opportunity cost of holding cash, net equal to the rate of return foregone on
marketable securities or the cost of borrowing to hold cash
2.The minimum costs of cash balances are achieved when C is set equal
to C* is as follows:
Illustrative Case I. Determine of Optimal Average Cash balance for Baumol
Model
To illustrate, consider a business with total payments of 10 million for one year, cost per
transaction of 100, and the interest rate on marketable securities is 8 percent. The
optimal cash balance is calculated as follows:
The firm may also want to hold a safety stock of cash to reduce the probability of a cash shortage
to some specified level. The Baumol model is simple in many respects. Other models have been
developed to deal both with uncertainty in the cash flows and with trends. All of the models,
including the Baumol models,
can provide a useful starting point for establishing a target cash balance, but all of them have
limitations and must be applied with judgement.
The Miller-Orr Model
The miller-Orr model takes a different approach to calculating the optimal cash management
strategy. I assumes that the distribution of daily net cash flows
is normally distributed and allows for both cash inflows and outflows. This model bases its
computations where:
OTHER FACTORS INFLUENCING THE TARGET CASH BALANCE
1. Option to incur short-term borrowing to meet unexpected demands for cash. If the probability
of an unexpected demand for cash causing the firm to borrow in the short-term is low enough,
or if the amount of interest to be earned by investing in longer-term securities is higher than
that to be earned on marketable securities, then it might be worth it for the firm to risk
occasionally paying a relatively high interest rate on short-term borrowing.
2. Transaction Cost and time Element. Transaction costs as well as time associated with trading
securities have fallen so dramatically low that many business firms decide to sell marketable
securities as needed in order to meet any unforeseen demand for cash during the day.
3.Many firms must keep certain average minimum balances in their deposit accounts as part of
borrowing agreements with their bank. Some firms occasionally meet unforeseen demand for
cash that causes their deposit account to temporarily. Fall below the minimum compensating
balance. To offset this, they keep a corresponding amount of excess cash in the account in a later
period. Thus, enabling them to cover up the earlier deficiency and meeting the required average
minimum balance.