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CHAPTER

27
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Cash Management
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Chapter Outline
27.1 Reasons for Holding Cash 27.2 Determining the Target Cash Balance 27.3 Managing the Collection and Disbursement of Cash 27.4 Investing Idle Cash 27.5 Summary & Conclusions

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27.1 Reasons for Holding Cash

Transactions motive Compensating balances

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27.2 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, a.k.a. the interest rate.

C
C 2

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 C . 2 The opportunity cost C C of holding is K 2 2

1
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Time

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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, a.k.a. the interest rate.

C
C 2

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 T pay $F times. C T Time The trading cost is F C
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The Baumol Model

C T Total cost K F 2 C

C K Opportunity Costs 2

Trading costs T F

C* Size of cash balance The optimal cash balance is found where the opportunity costs equals the trading costs
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C*

2T F K

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The Baumol Model

The optimal cash balance is found where the opportunity costs equals the trading costs Opportunity Costs = Trading Costs

C T K F 2 C
Multiply both sides by C

C 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
* *

H 3Z 2L 3F 2 Z* 3 L 4K 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. 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.

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Implications of the Miller-Orr Model

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 managements desire to hold low cash balances.

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Other Factors Influencing the Target Cash Balance

Compensating Balance
Firms have cash in the bank as a compensation for banking services. Large corporations have thousands of accounts with several dozen bankssometimes it makes more sense to leave cash alone than to manage each account on a daily basis.

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Float
The difference between bank cash and book cash is called float. Float management involves controlling the collection and disbursement of cash.

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27.3 Managing the Collection and Disbursement of Cash

Accelerating Collections Delaying Disbursements Disbursement Float Zero-Balance Accounts Drafts Ethical and Legal Questions

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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 Corporate Customers Corporate Customers

Post Office Box 1

Local Bank Collects funds from PO Boxes Envelopes opened; separation of checks and receipts

Post Office Box 2

Details of receivables go to firm

Deposit of checks into bank accounts

Firm processes receivables

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Bank clears checks

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Delaying Disbursements
Firm prepares check to supplier Post Office processing

1. Write check on a distant bank. 2. Hold payment for several days after

Delivery of check to supplier

Deposit goes to suppliers bank

postmarked in office. 3. Call supplier firm to verify statement accuracy for large amounts. 4. Mail from distant post office. 5. Mail from post office that requires a great deal of handling.
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Bank collects funds

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Drafts
Firms sometimes use drafts instead of checks. Drafts differ from checks because they are not drawn on a bank but on an issuer (the firm) and are payable by the issuer. The bank acts only as an agent, presenting the draft to the issuer for payment. When the draft is transmitted to a firms bank for collection, the bank must present the draft to the issuing firm for acceptance before making payment. After the draft has been accepted, the firm must deposit the necessary cash to cover the payments. This allows the firm to keep less cash on hand.

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Ethical and Legal Questions

The financial managers must always work with collected company cash balances and not with the companys book balance, which reflects checks that have been deposited but not collected. If you are borrowing the banks money without their knowledge, you are raising serious ethical and legal questions.
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27.4 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.

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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27.5 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.

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27.5 Summary & Conclusions

Two transactions models that provide rough guidelines for determining the optimal cash postion are:
The Miller-Orr model The Baumol model

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27.5 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.

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27.5 Summary & Conclusions

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 companys book balance.

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27.5 Summary & Conclusions

If you are borrowing the banks 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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