advertisement

13 Cash and Liquidity Management McGrawMcGraw-Hill/Irwin Copyright © 2008 by The McGrawMcGraw-Hill Companies, Inc. All rights reserved. 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 13-1 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 13-2 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 13-3 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? 13-4 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 $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 30day months)? Method 1: (3+1+1)(1,000)/30 = 166.67 Method 2: (5/30)(1,000) + (25/30)(0) = 166.67 13-5 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 13-6 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 to reduce the collection delay. There are several techniques that can reduce various parts of the delay. 13-7 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-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. 13-8 Example: Accelerating Collections – Part II Benefits Average daily collections = (5,000)(500) = 2,500,000 Increased bank balance = 2(2,500,000) = 5,000,000 Costs Daily cost = .1(5,000) + 10 = 510 Present value of daily cost = 510/.0001 = 5,100,000 NPV = 5,000,000 – 5,100,000 = -100,000 The company should not accept this lock-box proposal 13-9 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 13-10 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 13-11 Figure 20.6 13-12 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 13-13 Comprehensive Problem A proposed single lockbox system will reduce collection time 2 days on average Daily interest rate on T-bills = .008% 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? 13-14 Target Cash Balances Target cash balance – desired cash level determined by trade-off between carrying costs and shortage costs Flexible policy - if a firm maintains a marketable securities account, the primary shortage cost is the trading cost from buying and selling securities Restrictive policy – generally borrow short-term, so the shortage costs will be the fees and interest associated with arranging a loan 13-15 Figure 20A.1 13-16 BAT Model Assumptions Cash is spent at the same rate every day Cash expenditures are known with certainty Optimal cash balance is where opportunity cost of holding cash = trading cost Opportunity cost = (C/2)*R Trading cost = (T/C)*F Total cost = (C/2)*R + (T/C)*F C* = 2 TF R 13-17 Example: BAT Model Your firm will have $5 million in cash expenditures over the next year. The interest rate is 4% and the fixed trading cost is $25 per transaction. What is the optimal cash balance? What is the average cash balance? What is the opportunity cost? What is the shortage cost? What is the total cost? 13-18 Miller-Orr Model Model for cash inflows and outflows that fluctuate randomly Define an upper limit, a lower limit, and a target balance Management sets lower limit, L (target C* = L + [(3/4)Fσ2/R]1/3 balance) U* = 3C* - 2L (upper limit) Average cash balance = (4C* - L)/3 13-19 Figure 20A.3 13-20 Example: Miller-Orr Model Suppose that we wish to maintain a minimum cash balance of $50,000. Our fixed trading cost is $250 per trade, the interest rate is .5% per month and the standard deviation of monthly cash flows is $10,000. What is the target cash balance? What is the upper limit? What is the average cash balance? 13-21 Conclusions The greater the interest rate, the lower the target cash balance The greater the fixed order cost, the higher the target cash balance It is generally more expensive to borrow needed funds than it is to sell marketable securities Trading costs are usually very small relative to opportunity costs for large firms 13-22