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McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Corporate Finance Ross Westerfield Jaffe Sixth Edition

28Chapter Twenty Eight

Cash Management

Prepared by

Gady JacobyUniversity of Manitoba

and

Sebouh AintablianAmerican 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 Cash28.2 Determining the Target Cash Balance28.3 Managing the Collection and Disbursement of

Cash28.4 Investing Idle Cash28.5 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

Opportunity Costs

Trading costs

Total cost of holding cash

C*

Costs in dollars of holding cash

Size of cash balance

The investment income foregone when holding cash.

Trading costs increase when the firm must sell securities to meet cash needs.

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The Baumol Model

F = The fixed cost of selling securities to raise cashT = The total amount of new cash neededK = The opportunity cost of holding cash: this is the interest

rate.

Time

C

If we start with $C, spend at a constant rate each period and replace our cash with $C when we run out of cash, our average cash balance will be .

2

C2

C

1 2 3

The opportunity cost of holding is

2

CK

C

2

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The Baumol Model

F = The fixed cost of selling securities to raise cashT = The total amount of new cash neededK = The opportunity cost of holding cash: this is the interest

rate.

Time

C

As we transfer $C each period we incur a trading cost of F each period. If we need T in total over the planning period we will pay $F, T ÷ C times.

2

C

1 2 3The trading cost is F

C

T

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The Baumol Model

C* Size of cash balance

FT

KC

C2

cost Total

Opportunity Costs KC

2

FT

C

Trading costs

The optimal cash balance is found where the opportunity costs equal the trading costs

FK

TC

2*

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The Baumol Model

Opportunity Costs = Trading Costs

FC

TK

C

2

The optimal cash balance is found where the opportunity costs equal the trading costs

K

TFC

2*

Multiply both sides by C

FTKC

2

2

K

FTC

22

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The Miller-Orr Model

• The firm allows its cash balance to wander randomly between upper and lower control limits.

$

Time

H

Z

L

When the cash balance reaches the upper control limit H cash is invested elsewhere to get us to the target cash balance Z.

When the cash balance reaches the lower control limit, L, investments are sold to raise cash to get us up to the target cash balance.

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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

LK

FσZ 3

2*

4

3 LZH 23 **

where 2 is the variance of net daily cash flows.• The average cash balance in the Miller-Orr model

is

3

4balancecash Average

* LZ

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Implications of the Miller-Orr Model

• To use the Miller-Orr model, the manager must do four things:

1. Set the lower control limit for the cash balance.2. Estimate the standard deviation of daily cash flows.3. Determine the interest rate. 4. 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

Mail delay

Mail float

Processing delay

Processing float

Clearing delay

Clearing float

time

Collection float

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Overview of Lockbox Processing Corporate Customers

Corporate Customers

Corporate Customers

Corporate Customers

Local Bank Collects funds from PO Boxes

Envelopes opened; separation of

cheques and receipts

Deposit of cheques into bank accounts

Details of receivables go to firm

Firm processes receivables

Bank clears cheques

Post Office Box 1

Post Office Box 2

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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

Long-term financing

Short-term financing

Time

Total Financing needs

J F M A M

Marketable securities

Bank loans

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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 short-term.

• 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.