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Chapter Twenty Eight
Cash Management
Corporate Finance
Ross  Westerfield  Jaffe
28
Sixth Edition
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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Executive Summary
• Cash management is not as complex and
conceptually challenging as other topics, such as
capital budgeting and asset pricing.
• Financial managers in many companies, especially
in the retail and services industries, spend a
significant portion of their time on cash
management.
• Most large Canadian corporations hold some of
their assets in cash and marketable securities.
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Chapter Outline
28.1 Reasons for Holding Cash
28.2 Determining the Target Cash Balance
28.3 Managing the Collection and Disbursement of
Cash
28.4 Investing Idle Cash
28.5 Summary & Conclusions
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28.1 Reasons for Holding Cash
• Transactions motive:
– Transactions related needs come from normal
disbursement and collection activities of the firm.
– The disbursement of cash includes the payment of wages
and salaries, trade debts, taxes, and dividends.
– The cash inflows (collections) and outflows
(disbursements) are not perfectly synchronized, and some
level of cash holdings is necessary to serve as a buffer.
– Perfect liquidity is the characteristic of cash that allows it
to satisfy the transactions motive.
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28.2 Determining the Target Cash Balance
• The target cash balance involves a trade-off between
the opportunity costs of holding too much cash (lost
interest) and the trading costs of holding too little.
• If a firm tries to keep its cash holdings too low, it
will find itself selling marketable securities more
frequently than if the cash balance were higher.
• The trading costs will tend to fall as the cash
balance becomes larger.
• The opportunity costs of holding cash rise as the
cash holdings rise.
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28.2 Determining the Target Cash Balance
• The Baumol Model
• The Miller-Orr Model
• Other Factors Influencing the Target Cash Balance
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Costs of Holding Cash
Costs in dollars of
holding cash
Trading costs increase when the firm
must sell securities to meet cash needs.
Total cost of holding cash
Opportunity
Costs
The investment income
foregone when holding cash.
Trading costs
C*
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Size of cash balance
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The Baumol Model
F = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed
K = The opportunity cost of holding cash: this is the interest
rate.
If we start with $C,
spend at a constant rate
each period and replace
C
our cash with $C when
we run out of cash, our
average cash balance
C
will be C .
2
2
The opportunity cost
of holding C is C  K
1
2
3 Time
2
2
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The Baumol Model
F = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed
K = The opportunity cost of holding cash: this is the interest
rate.
As we transfer $C each
period we incur a trading
cost of F each period. If
C
we need T in total over the
planning period we will
pay $F, T ÷ C times.
C
2
1
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2
3
Time
The trading cost is T  F
C
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The Baumol Model
C
T
Total cost   K   F
2
C
C
Opportunity Costs  K
2
Trading costs T  F
C*
C
Size of cash balance
The optimal cash balance is found where the opportunity
costs equal the trading costs
2T
*
C 
F
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K
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The Baumol Model
The optimal cash balance is found where the opportunity
costs equal the trading costs
Opportunity Costs = Trading Costs
C
T
K  F
2
C
Multiply both sides by C
C2
K T F
2
T F
C  2
K
2
2TF
C 
K
*
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The Miller-Orr Model
• The firm allows its cash balance to wander
randomly between upper and lower control limits.
$
When the cash balance reaches the upper control limit H cash
is invested elsewhere to get us to the target cash balance Z.
H
When the cash balance
reaches the lower
control limit, L,
investments are sold
Z
to raise cash to get
us up to the target
cash balance.
L
Time
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The Miller-Orr Model Math
• Given L, which is set by the firm, the Miller-Orr
model solves for Z and H
2
3Fσ
Z 
L
4K
*
3
H *  3Z *  2 L
where s2 is the variance of net daily cash flows.
• The average cash balance in the Miller-Orr model
is
4Z *  L
Average cash balance 
3
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Implications of the Miller-Orr Model
•
To use the Miller-Orr model, the manager must
do four things:
1.
2.
3.
4.
•
Set the lower control limit for the cash balance.
Estimate the standard deviation of daily cash flows.
Determine the interest rate.
Estimate the trading costs of buying and selling
securities.
The model clarifies the issues of cash
management:
–
The best return point, Z, is positively related to
trading costs, F, and negatively related to the interest
rate K.
– Z and the average cash balance are positively related
to the variability of cash flows.
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Other Factors Influencing the
Target Cash Balance
• Borrowing
– Borrowing is likely to be more expensive than selling
marketable securities.
– The need to borrow will depend on management’s desire
to hold low cash balances.
• Relative costs
– For large firms, the trading costs of buying and selling
securities are very small when compared to the
opportunity costs of holding cash.
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28.3 Managing the Collection and
Disbursement of Cash
• The difference between bank cash and book cash is
called float.
• Float management involves controlling the
collection and disbursement of cash.
• The objective in cash collection is to reduce the lag
between the time customers pay their bills and the
time the cheques are collected.
• The objective in cash disbursement is to slow down
payments, thereby increasing the time between
when cheques are written and when cheques are
presented.
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Electronic Data Interchange
• Electronic Data Interchange (EDI) is a general term
that refers to the growing practice of direct,
electronic information exchange between all types
of businesses.
• One important use of EDI is to electronically
transfer financial information and funds between
parties, to eliminate paper invoices, paper cheques,
mailing, and handling.
• One of the drawbacks of EDI is that it is expensive
and complex to set up.
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Accelerating Collections
Customer
mails
payment
Company
receives
payment
Company
deposits
payment
Cash
received
time
Mail
delay
Processing
delay
Clearing
delay
Mail
float
Processing
float
Clearing
float
Collection float
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Overview of Lockbox Processing
Corporate
Customers
Corporate
Customers
Post Office
Box 1
Corporate
Customers
Local Bank
Collects funds
from PO Boxes
Corporate
Customers
Post Office
Box 2
Envelopes opened;
separation of
cheques and receipts
Details of receivables
go to firm
Deposit of cheques
into bank accounts
Firm processes
receivables
Bank clears cheques
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Electronic Collection Systems
• Focus on reducing float virtually to zero by
replacing cheques with electronic funds transfer.
• Examples used in Canada:
–
–
–
–
Preauthorized payments
Point-of-sales transfers
Electronic trade payables
Smart cards.
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Controlling Disbursements
• Firms use zero-balance accounts to avoid carrying
extra balances in each disbursement account.
• With a zero-balance account, the firm, in
cooperation with its bank, transfers in just enough
funds to cover cheques presented that day.
• The firm maintains two disbursement accounts: one
for suppliers and one for payroll.
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Ethical and Legal Questions
• The financial managers must always work with
collected bank cash balances and not with the
company’s book balance, which reflects cheques
that have been deposited but not collected.
• If you are borrowing the bank’s money without their
knowledge, you are raising serious ethical and legal
questions.
• The issue is minor in Canada since there can be a
maximum of only one day’s deposit float.
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28.4 Investing Idle Cash
• A firm with surplus cash can park it in the money
market.
– Some large firms and many small ones use money market
mutual funds.
– Canadian chartered banks compete with money market
funds offering arrangements in which the bank takes all
excess available funds at the close of each business day
and invests them for the firm.
• Firms have surplus cash for three reasons:
– Seasonal or Cyclical Activities
– Planned Expenditures
– Different Types of Money Market Securities
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Seasonal Cash Demands
Total Financing needs
Bank loans
Marketable
securities
Short-term
financing
Long-term
financing
J
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M
A
M
Time
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Characteristics of Short-term Securities
• Maturity
– Longer maturity securities are more exposed to interest
rate risk than shorter maturity securities.
• Default risk
– DBRS compiles and publishes ratings of various
corporate and public securities.
• Marketability
– No price-pressure effect
– Time.
• Taxability
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Some Different Types of Money-Market Securities
• Money-market securities are highly marketable and shortterm.
• They are issued by the federal government, domestic and
foreign banks, and business corporations.
Examples are:
–
–
–
–
T-bills
Commercial paper
Banker’s acceptances
Dollar swaps
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28.5 Summary & Conclusions
• A firm holds cash to conduct transactions and to
compensate banks for the various services they
render.
• The optimal amount of cash for a firm to hold
depends on the opportunity cost of holding cash and
the uncertainty of future cash inflows and outflows.
• Two transactions models that provide rough
guidelines for determining the optimal cash position
are:
– The Miller-Orr model
– The Baumol model
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28.5 Summary & Conclusions
• The firm can make use of a variety of procedures to
manage the collection and disbursement of cash in
such as way as to speed up the collection of cash
and slow down payments.
• Some methods to speed collections are
– Lockboxes
– Concentration banking
– Wire transfers
• The financial managers must always work with
collected company cash balances and not with the
company’s book balance.
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28.5 Summary & Conclusions
• If you are borrowing the bank’s money without their
knowledge, you are raising serious ethical and legal
questions.
• The answers to which you probably know by now.
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