Cash and Marketable Securities Management

Prof. David S. Allen

The Need for Cash• Firms hold cash for at least three reasons:

• Transactions balance: The firm’s day-to-day operations require cash for wages, inventories, rent, utilities, etc.

• Precautionary balance: If the forecast of cash inflows and outflows used to create the cash budget proves to be wrong, the firm needs a safety stock of cash.

• Speculative motive: The firm may hold extra cash in order to quickly take advantage of opportunities that may come along.http://www.zacks.com/research/report.php?type=abs&t=MSFT

The Need for Cash

• In addition, firms may hold cash because:• They have a bank loan outstanding that

requires a compensating (minimum) cash balance.

• This requirement helps ensure that the firm always has some minimum level of liquidity to meet its day-to-day needs.

• They need a temporary “parking place” for the proceeds of a long-term debt issue.

• These proceeds may be used later to build a new factory, for example.

The Need for Cash

• Disadvantages of holding cash:• Cash earns a low rate of return, which reduces

potential profitability.• Since cash is an asset on the left-hand side of

the balance sheet, there must be a corresponding source of financing on the right-hand side, with an associated cost of capital that likely exceeds the return earned by the cash.

The Need for Cash• Recall in the cash budget that we assumed

a target cash balance for the firm. Some cash budgets also use a minimum and maximum cash balance, in addition to a target in between. Where do these numbers come from?• Subjective estimates from management, based

on experience.• Quantitative models such as Baumol, or Miller-

Orr, to be examined later.• Bank required compensating balances.

The Tradeoff• In a typical cash management model, firms

are usually assumed to hold cash (which earns no interest) and marketable securities (interest bearing, short-term securities) to meet their payment needs. • To move funds between the two, a transaction

costs must be incurred. • The transaction cost includes direct costs such

as a brokerage fee to sell a security, as well as indirect costs such as administrative time and effort.

The Tradeoff• If the firm holds a large cash balance, it incurs an

opportunity cost (i.e. loses interest that could be earned on marketable securities). • However, the large cash balance results in less frequent

liquidations (sales) of marketable securities, which lowers the firm’s transactions costs.

• If the firm holds a small cash balance, the firm earns more interest on marketable securities. • However, a small cash balance results in more frequent

liquidations of marketable securities, which raises the firm’s transactions costs.

The Tradeoff

• So, the firm must strike a balance between transactions costs and opportunity costs (i.e. between cash and marketable securities). It seeks to find the cash balance at which the sum of these two costs is minimized.

Characteristics of Marketable Securities• Marketable securities are by definition those that can be

resold from one investor to another in a “secondary” market.

• While many securities fit this general definition, in the area of cash management there are several characteristics that are considered of primary importance.

• Perhaps the most important is safety of principal, followed closely by liquidity. • Firms that invest excess cash on a temporary basis want to be

assured that the full amount of original principal will be available at a later date when needed for some other purpose.

• Liquidity is needed to ensure that the funds are available immediately when the need presents itself.

Characteristics of Marketable Securities• When choosing among alternative marketable

securities, the cash manager must make tradeoffs that affect the rate of return earned. These tradeoffs include:• More or less quality: There is a direct relationship

between the rate of return that is promised on marketable securities, and the likelihood of default.

• Safer securities promise lower returns, and risky securities promise higher returns.

• Note, however, that “promised” returns and “realized” returns can be different. Riskier securities may default, leaving the investor with little or no return.

• http://www.ambest.com/ratings/methodology/commercialpaper.pdf• http://www.dbrs.com/about/ratingScales • http://www.rbcpa.com/Moody%27s_ratings_and_definitions.pdf

Characteristics of Marketable Securities• More or less quality (cont’d)

• The safest securities are those backed by the U.S. government.

• Examples include Treasury bills, notes, and bonds, and bank Certificates of Deposit.

• Riskier securities include corporate securities, such as commercial paper, notes, and bonds.

Characteristics of Marketable Securities• More or less liquidity: Liquidity refers the

ability to quickly sell a security at its true value.

• The degree of liquidity of an asset is largely a function of how many buyers are available, and how well developed is the secondary market for the asset.

• Some assets, such as U.S. Treasury bills, are very liquid.

• Others, such as real estate, are much less liquid.Since lack of liquidity is a source of risk, less liquid investments tend to promise higher returns, all else the same.

Characteristics of Marketable Securities• More or less time to maturity: If a firm ties its

excess money up for a long period of time in a securities investment, then it faces the risk of not being able to use the money for some other opportunity that may come along.

• This implies that long-term investments are riskier than short-term investments.

• Note that this type of risk is not the same as default (quality) risk.

• In general, for a given level of default risk, long-term investments promise a higher rate of return than short-term investments.http://bonds.yahoo.com/rates.html

The Baumol Model• Baumol developed a model of cash management that

recognizes the tradeoff between foregone interest (from holding too much cash in non-interest bearing accounts) and transactions costs (from liquidating marketable securities). • He did this by applying an existing inventory management

model (Economic Order Quantitiy, EOQ) to cash balances.• The Baumol model makes a number of simplifying

assumptions (inherited from the EOQ model):• The firm’s annual demand for cash is known (perhaps

derived from the cash budget), and constant over time.• The cost to move funds from the marketable securities

account to the cash account in fixed, i.e. independent of the amount transferred.

The Baumol Model• Note that these assumptions are often violated in

practice. • As a result, the model’s main attractions are its ease of

application and straightforward portrayal of the foregone interest (i.e. holding cost) versus transaction cost tradeoff.

• The firm begins with its optimal cash balance (to be determined by the model), which is then used up until it runs out of funds. • At that time the firm again liquidates marketable

securities to return its cash balance to its original value.

Baumol Model Cash Balances

-

5,000.00

10,000.00

15,000.00

20,000.00

25,000.00

1 7 13 19 25 31 37 43 49 55 61 67 73 79 85

Day

Cas

h B

alan

ce

The Baumol Model• The total costs of a given starting cash

balance, C, is given by:• total costs = holding costs + transactions costs

= (C/2)k + (T/C)F• where:

• C = cash raised by selling marketable securities or borrowing (i.e. the beginning cash balance)

• F = fixed transaction cost of moving cash to/from mkt. sec.

• T = total annual cash needs• k = opportunity cost of holding cash (return on

marketable securities)

The Baumol Model• The goal is to find the value for C (amount transferred from

marketable securities to the cash account) that minimizes total costs:

-

500.00

1,000.00

1,500.00

2,000.00

2,500.00

- 10,000.00 20,000.00 30,000.00 40,000.00 50,000.00

Cash Transferred

Cos

ts

Holding Costs Transactions Costs Total Costs

The Baumol Model

• Minimizing the total cost, with respect to C results in:

The firm liquidates (or borrows) C* each time its cash balance hits zero.

k)T)(F(2C *

Example

• A firm has annual cash needs of T = $360,000.

• The cost to transfer funds from its marketable securities account to its cash account is F = $30.

• The opportunity cost of cash (i.e. the rate of interest it loses by not leaving the funds in its marketable securities account is k = 5%.

Example (cont’d)• To minimize the total cost of its cash holdings, the firm

should transfer cash from its marketable securities account to its cash account in the amount:

• Note that in practice, the firm may find it beneficial to round the amount to the nearest $1,000.

• The total annual cost of its cash holdings would be:• TC = (C/2)k + (T/C)F = (20,785/2).05 + (360,000/20,785)30 =

$1,039• (Note: these values correspond to the charts presented above).

785,20$.05

)000,360)(30(2C *

The Miller-Orr Model• Miller and Orr developed a model that attempts to

overcome some of the shortcomings of the Baumol model. • They assume that the firm’s daily cash flow is random. • It may increase or decrease on any given day. • They set an upper and lower limit on the firm’s cash

balance. • If the balance hits the lower limit, the firm needs cash and

will liquidate marketable securities. • If the balance hits the upper limit, the firm has excess

cash, and will invest the excess in marketable securities. • In either case, the firm will transfer funds in an amount

that returns its cash balance to a target level.

The Miller-Orr Model• H = upper limit• Z = target cash balance• L = lower limit, set by firm’s management• 2 = variance of daily cash flow• k = daily opportunity cost (= annual rate / 365)• F = fixed transaction cost• The target balance (Z) and upper limit (H) are:

• Z = [3F 2 /4k]1/3 + L• H = 3[3F 2 /4k]1/3 + L = 3Z - 2L

Example

• A firm wants to determine the optimal range for its cash balance.

• Its management has decided that the firm needs at least $10,000 cash on hand each day in order to meet its daily cash needs (L = $10,000).

• The firm has recorded its daily cash flows over the past year, and will use them to estimate the variance of daily cash flows:

The Miller-Orr Model

• The variance was calculated using the =var(first cell : last cell) function in Excel.

• Using the Miller-Orr model, the firm has determined its target cash balance (Z), and upper limit (H): Inputs:

L $10,000.002 2,085,784.83 k 5%F $30.00

Outputs:Z $16,997.21H $30,991.63

The Miller-Orr Model• Whenever its cash balance falls below

$10,000, it will liquidate enough marketable securities to bring the cash balance back up to $16,997.21.

• Whenever its cash balance rises above $30,991.63, it will purchase enough marketable securities to bring the cash balance back down to $16,997.21.

• A typical cash balance over a year might look like this:

0

5000

10000

15000

20000

25000

30000

35000

0 100 200 300 400

Day

Cas

h B

alan

ce

Marketable Securities Management

• If firms are going to use marketable securities as a temporary storage place for excess cash balances, then the firm should establish written investment objectives and guidelines.

• These help to ensure that the cash manager’s actions are within permissible bounds.

Developing Investment Objectives

• Written investment objectives are needed in order to judge the appropriateness of any specific marketable security.

• They also helps demonstrate to senior management that the cash manager is carrying out his/her duties with due diligence.

Developing Investment Objectives

• A given investment is not inherently good or bad. Instead, each involves a particular tradeoff between:• More or less liquidity.• More of less quality.• More or less time to maturity.

• Without written objectives, it is hard to know which side of a given tradeoff to emphasize.

Factors Influencing Investment Objectives

• Cash management decisions should not constrain operational decisions.

• Normally, it should be the other way around.• Cash investment management objectives

should reflect the firm’s business plan. That is, the firm should build a cash budget first, then a set of investment objectives to fit the plan. Sensitivity analysis can help set boundaries for the investment objectives.

Factors Influencing Investment Objectives

• Other issues that can affect investment objectives:• Regulatory requirements.• Alternative sources for satisfying unexpected

cash needs.• The probability of unexpected cash needs.• Plans for business acquisition or internal

capacity expansion.

Factors Influencing Investment Objectives

• Tax status - has a major impact on investment objectives

• The firm needs to know its marginal tax rate in order to compare yields on taxable and tax-exempt investments.

• The firm must compare the after-tax return from alternative investments:• Returnafter-tax = Returnbefore-tax(1 – firm’s marginal tax rate)

Taxation of Interest Income• The marginal tax rate is the tax rate for the next

dollar of income. • It varies by type of investment, and is the sum of the

applicable federal and state tax rates.

Issuer Federal Tax on interest income

State Tax on interest income

U.S. Treasury Yes No

Municipal government No No

Corporation Yes Yes

The Role of Investment Management

• Is the portfolio being viewed as a profit center?• Recall that the principal purpose is to provide a

safe, temporary parking place for excess funds.• Is management relying on the return to meet

earnings goals?• Shareholders might question why the firm is

using its investment portfolio, rather than its operations, to meet earnings goals.

The Role of Investment Management• If management emphasizes a preset level of

returns, then the portfolio manager might engage in activities that are sub-optimal, such as:• Using maturities longer than the anticipated storage

period.• Using lower quality issues.• Using less liquid issues.

• If the portfolio manager’s compensation is tied to the return realized, then a higher risk strategy is likely to result.

How Objectives Are Expressed

• Qualitative objectives provide guidance.• Some examples:

• To ensure the availability of cash on a schedule consistent with the firm’s cash flow forecast.

• To maintain complete portfolio liquidity at all times.• To hold only highly rated issues.• To invest primarily in tax-exempt (or taxable,

depending on the marginal tax rate) issues.

How Objectives Are Expressed• If quantitative returns are specified, they should be

relative to a benchmark rather than in absolute terms, e.g. 50 basis points above the average yield on 3 month t-bills during the period.• (Note: 100 basis points = 1%, so 50 basis points =

0.5%)• Other components of objectives:

• Are targets to be met absolutely, or worked towards?• What is the time horizon for accomplishing and

evaluating the goals?

Investment Guidelines• Spell out specific parameters that will guide and

restrict the latitude of the portfolio manager.• For each purchase of marketable securities, they

specify:• Maximum maturity.• Maximum average maturity over all investments.• Minimum quality standards.• Tax considerations.• Prohibited assets.• Diversification standards.

Management Controls and Reporting• Procedures are needed to monitor the

marketable securities investment process.• The firm needs to specify responsibilities,

the chain of reporting, and the division of duties.

• A monthly report should detail: positions, market value, original cost, and expected cash flow.

• A quarterly report should give a comparison of actual performance relative to objectives.