Corporate Finance

Handouts
Financial Planning and Management in Public Organizations by Alan
Walter Steiss and Chukwuemeka O'C Nwagwu
CASH MANAGEMENT AND INVESTMENT STRATEGIES
CASH MANAGEMENT
Cash management is the process of maximizing the liquid assets through the
acceleration of receivables and the disciplined control of disbursements.
The amount of cash to be held can be determined by balancing two kinds of
cost decisions:
(1) Opportunity cost of not investing, which increases as cash balances
increase.
(2) Information costs involved in making the decisions to invest,
disinvest, borrow, or repay loans, which decrease as the amount of
cash balance increases.
Elements of Cash Management
Cash management is made up of four elements: (1) forecasting, (2)
mobilizing and managing the cash flow, (3) maintaining banking relations,
and (4) investing surplus cash.
Forecasting can be defined as the ability to calculate, predict, or plan future
events or conditions using current or historical data.
A cash budget monitors how much money will be available for investment,
when it will become available, and for how long.
Cash mobilization involves techniques used to assemble funds and make
them readily available for investment
Maintaining good relations with banks, savings and loan associations,
investment bankers, commercial paper dealers, and security analysts is an
important part of cash management.
Bankers prefer compensating balances to fee payments because deposits
are the main source of a bank's loanable funds.

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A cash budget should provide an estimate of the organization's cash
requirements for disbursement by months, weeks, or days.
The most attractive instruments are securities supported by the full faith and
credit of the federal government.
Other relatively risk-free securities are: time deposits, time certificates of
deposit (CDs), commercial paper, banker acceptances, and repurchase
agreements.
Cash Flow Forecasting
To ensure that sufficient funds are available to meet organizational needs at
a minimum cost:
(1) Cash flow forecasts must be made to minimize the cost of shortterm borrowing.
(2) Receivables must be collected efficiently from point of receipt to
the place where funds can be invested or spent.
(3) Reimbursements must be scheduled to ensure that obligations are
paid on time, but not ahead of payment deadlines.
Management decisions that elicit the flow of cash include:
(1) Operating decisions stem from the policies of the organization, e.g.,
creation or elimination of a service unit or department, increases in the
tax rate or charges for services, changes in the salaries and fringe
benefits extended to staff.
(2) Capital expenditure decisions involve the construction, repair, and
maintenance of fixed, physical assets.
(3) Credit decisions involve the length of time to make payments to
vendors, as well as the length of time clients/customers take to make
payment without penalty.
(4) Investment decisions result in use of inactive cash to purchase
assets or liberation of funds by the sale of such assets.

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(5) Financing decisions involve the acquisition of new money by selling
bonds, borrowing, or increasing revenues (as by raising taxes, user
charges, or prices).
An astute manager uses a cash budget to identify early signs of an
impending cash problem and to indicate appropriate steps to avert the
problem.
Forecasting provides a basis on which to measure the differences between
actual events and the plan, so that the nature and extent of corrective
actions can be more clearly defined.
(1) Short-term forecasts, usually covering a period of less than one
year, assist in day-to-day operations by highlighting daily, weekly, or
monthly peaks and troughs.
(2) Long-term forecasts gauge the impact on the cash flow position of
new services/ products, proposed acquisitions/investments and
determine future cash needs, especially working capital requirements.
Local governments must develop reliable estimates of their cash flow
positions to take full advantage of the securities market and to maximize the
returns on whatever financial assets they are able to purchase.
Cash Mobilization
Cash mobilization involves: (1) acceleration of receivables and (2) control of
disbursements.
The flow and availability of cash to the organization can be expedited by
collection systems that provide for advance billing and payment on or before
receipt of goods and services.
Techniques used to accelerate receipts include:
(1) Lockbox services involve the use of special post office boxes to
intercept payments and accelerate deposits.
(2) A preauthorized check (PAC) is a signatureless demand instrument
used to accelerate the collection of fixed payment types of obligations.

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(3) Concentration banking mobilizes funds from decentralized receiving
locations into a central cash pool, enabling the cash manager to
monitor only a few cash pools, thereby facilitating better cash control.
Disbursements are the outflow of funds in the form of checks issued and
cash payments made.
Delaying cash outflows enables an organization to optimize earnings on
available funds.
(1) Centralize, to the extent practical, the management of an
organization's payables, particularly those involving large dollar
amounts.
(2) Establish administrative limits on the amount of disbursements
particular organizational units are authorized to make within specified
time periods.
Consolidation of accounts reduces compensating balance, provides better
control over the timing of payments, increases the effective use of surplus
cash, and permits the streamlining of banking relations.
Zero balance accounts are concentration accounts that are "zeroed out" at
the end of each banking day, thereby (1) eliminating the need to maintain
excess amounts in disbursement accounts; (2) relieving the cash manager of
the burden of estimating when checks will be presented for payment; and (3)
permitting the pooling of resources for investment purposes.
Cash management must be artfully blended with the need to maintain good
public relations with the vendors that serve the jurisdiction.
Revenue Enhancement Initiatives
Tax diversification is difficult for local governments because, in most cases, it
is not within their authority to determine their sources of revenue.
Amnesty programs for delinquent taxes, coupled with enforcement of stiffer
penalties for tax evasion have been enacted to provide inducements for the
recovery of back taxes.

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Compensatory payment programs are designed to reimburse local
governments for revenues lost because of tax-exempt provisions attached to
properties and for cost of providing services.
Service charges promote revenue stability by diversifying local revenue
sources and by reaching beneficiaries of local services who would otherwise
escape taxation.
Tax exportation is the shifting of the local revenue burden to non-residents
through such measures as taxes on hotel, motel, and restaurant bills,
entertainment taxes, commuter taxes, airport taxes, and taxes on businesses
that sell their products or services to customers outside the taxing
jurisdictions.
Reciprocity involves a mutual exchange of enforcement and/or collection
responsibilities between jurisdictions.
Gambling and lotteries offer cash-strapped state and local governments the
prospect of raising significant revenues without increases taxes.
Fiscal note legislation requires independent cost estimates of the fiscal
impact on localities of mandated costs.
Local governments have the option of commercializing services which
previously were rendered free of charge.
INVESTMENT STRATEGIES
Cash flow projections should enable the fiscal manager to arrive at
reasonable predictions as to how much money will be available to invest and
for how long.
Public Investment Criteria
The principal criteria considered in selecting a specific security include:
o Safety is accorded the highest priority by most public officials
o Liquidity involves managing investments so that cash will be
available when needed.

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o Yield, the ultimate measure of successful fiscal management, is
conditioned by interest rates, minimum investment requirements, and
the maturity dates of investments.
o Marketability varies among money market instruments, depending
on the price stability of the instrument and on the extent of the
secondary trading market available to it.
o Risk characteristics of securities must be understood before decisions
are made about which specific instruments to purchase.
o Price stability of investments underlines the desire to avoid financial
loss in the event of an unexpected cash shortage.
The maturities of the various securities and how these would affect the
portfolio mix must be understood before a fiscal manager decides to invest
in them.
In general, securities with little risk, high liquidity, and short maturities also
have low yields; for an investment to provide a high yield, the other criteria
must be compromised.
Many state legislatures restrict the investments of local governments to
securities that are collateralized or backed by the United States government.
Types of Securities
Local governments and other public organizations often hold short-term
securities that can be readily converted into cash either through the market
or through maturity.
U.S. Treasury bills (T-bills) represent an obligation of the federal government
to pay a fixed sum of money after a specified period of time from date of
issue.
T-bills have no default risk and can be sold quickly for relatively predictable
prices in the secondary market.
Zero Coupon Treasury securities represent ownership of interest or principal
payments on United States notes or bonds purchased at a discount of 20% to
90% off the $1,000 face value.
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Certificates of deposit (CD) are receipts for funds that have been deposited
in a commercial bank for an agreed upon period of time.
o The owner of the CD receives both principal and interest on the
maturity date.
o CDs are sold according to specified maturity periods, ranging from 14
to 180 days.
Two types of CDs: (1) negotiable, which the original investor can sell to
another party on the secondary market; and (2) non-negotiable, which must
be retained by the original investor until maturity.
Federal agency securities are issued by government-sponsored, privatelyowned agencies established to implement federal policies and include
Federal Farm Credit bonds, Federal Home Loan Bank bonds and discount
notes, and Federal National Mortgage Association bonds.
Repurchase agreement are contracts between two parties whereby one party
sells an instrument (e.g., T-bill) to the other and agrees to buy it back at a
later date at a specified higher price.
Two types of repurchase agreements: (1) fixed--a specific interest rate and
maturity period are established at the outset and a penalty levied if
liquidated prior to maturity; and (2) open--agreement may be liquidated at
any time, with the interest rate dependent on the duration of the transaction.
Banker's acceptances, usually created in conjunction with foreign trade
transactions, are time drafts negotiated by commercial banks to finance the
shipment or storage of goods.
o The bank guarantees to honor the draft on the due date and sells the
draft at a discount to an importer.
o On the due date (typically ninety days after issue), the bank honors
the draft for the full face value and debits the account of the issuing
company.
Commercial paper includes promissory notes of finance corporations or
industrial firms which offer higher yields than T-bills.

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o Liquidity is low, as secondary trading market does not exists for
commercial paper, and as a result of the higher default risks, many
states have restrictions against investment by local governments in
commercial paper.
o Local governments use commercial paper to (1) meet cash
management needs, (2) finance equipment, to provide interim
construction financing for capital projects, and to provide loans to
business entities.
Derivative securities derive their value from some form of investment, such
as Treasury bonds, corporate stocks and bonds, foreign currencies, or
commodities contracts.
o Derivatives offer higher yields which makes them attractive at times
when short-term interest rates are low.
o Like many rapidly rising investment schemes, the fall can be even
more rapid, and for unsuspecting municipal governments, the
consequences can be devastating.
Arbitrage occurs when a jurisdiction issues bonds at one rate of interest and
invests the proceeds at a higher rate of interest; the resulting gain is referred
to as arbitrage earnings.
o Advantages: Governments can make money by investing bond
proceeds at higher interest rates than the interest rate on the bonds;
however, the arbitrage earnings on tax-exempt bonds are constrained
by federal tax laws.
o Disadvantages: Arbitrage earnings that exceed limits imposed by
federal regulations must be rebated to the federal government; failure
to adhere to federal provisions can, in certain circumstances, cause
municipal bonds to lose their tax-exempt status.
Portfolio Management
The fund manager should possess both formal education and releated
experience in investment banking, financial counseling, or related fields.

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o Fund managers are expected to handle public funds in a responsible,
generally conservative, manner so as to minimize the likelihood of loss
of principal.
o A fund manager may be held accountable, however, if the earnings
on the invested funds do not achieve their maximum potential.
The fundamental objective of cash management is to maximize yield and
minimize risk.
o Cash flow projections should be made to determine the availability of
funds for investment under various economic conditions.
o The fund manager should investigate the investment instruments
available in the market, determine their relative yields for the
maturities required, and evaluate the associated risks.
It is important to design an investment portfolio whereby each security will
mature close to the time when the money invested will be needed.
Constraints on Public Investments
Local government investments are regulated by state statutes presumed to
reflect public policy.
Local jurisdictions impose additional limitations on their investments to
mitigate risk, to diversify investment holdings, and to avoid weak financial
institutions.
Banks are required to pledge securities as collateral to secure public
investments, the costs of which usually are passed on to the public entity in
the form of reduced rates of return.
State-managed investment pools resemble money market mutual funds in
their portfolio composition and provide professional management,
diversification, and money market rates of return which minimizes the risk to
smaller jurisdictions.
Summary and Conclusions

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Primary benefits of an investment strategy must be measured in terms of the
increased interest earned through the investment of temporarily idle cash.
o Yield, or return on investment, is the paramount criterion for
measuring the success or failure of an investment strategy.
o Liquidity can be built into an investment strategy through careful
planning and structuring of the portfolio mix.
State laws protect public funds by: (1) limiting banks with which local
governments can do business, (2) determining the amounts that can be left
on deposit in each bank, and (3) requiring collateral for uninsured funds.
Local governments confront (1) the need to expand revenues if public
demands are to be met, (2) already heavily burdened taxpayers, and (3)
narrow restrictions on their ability to borrow to finance public expenditures.
The investment portfolio is a source of additional revenue that does not
involve increased taxation or additional debt.

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