Management of Cash

Cash Management
Cash management: the collection, concentration, and disbursement of funds

Cash manager responsible for

Cash management Financial relationships with banks Cash flow forecasting Investing and borrowing Development and maintenance of information systems for cash management

Float: funds that have been sent by the payer but not yet usable funds to the company
Time

Mail float

Processing Availability float Maroof Hussain Sabri float

Clearing float
2

Costs of Holding Cash

Costs 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*
Maroof Hussain Sabri

Size of cash balance

3

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 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
1 2 3 Time
Maroof Hussain Sabri

2
The opportunity cost of holding is C C

K 2
4

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 As we transfer C each period we incur a trading cost of F each period.

2
1 2 3 Time

If we need T in total over the planning period we will pay F times. T

C The trading cost is F T C

Maroof Hussain Sabri

The Baumol Model

C T Total cost K F 2 C
Opportunity Costs

C K 2

Trading costs C* Size of cash balance

T F C

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

C*

2T K

Maroof Hussain Sabri

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
*
Maroof Hussain Sabri 7

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 L cash balance.
Time
Maroof Hussain Sabri 8

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 2 3 F 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
Maroof Hussain Sabri 9

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.

Maroof Hussain Sabri

10

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.

Maroof Hussain Sabri

11

Cash Position Management

Cash position management: collection, concentration, and disbursement of funds on a daily basis

Management of short-term investing if the company has a surplus of funds and borrowing arrangements if company has a temporary deficit of funds

Smaller companies set target cash balance for their current (Checking) accounts.

Bank account analysis statement

Bank provides report to its customers to show recent activity in firms accounts. Banks cannot pay interest on corporate Current (checking) account balances. Firms use earnings credit for balances to offset charges. Maroof Hussain Sabri 12

Collections
Primary objective: speeding up collections

Collection systems: function of the nature of the business

Field-banking system

Collections are made over the counter (retail) or at a collection office (utilities).

Mail-based system

Mail payments are processed at companies collection centers.

Electronic payments

Becoming increasingly popular because they offer advantages to both parties.

Maroof Hussain Sabri 13

Collections
Speeds up collections because it affects all components of float. Customers mail payments to a post office box. Firms bank empties the box and processes each payment and deposits the payments in the firms account. Lockboxes reduce mail and clearing time.

Lockbox system (USA)

Perform cost-benefit analysis to determine if lockbox system worth using

Net benefit ( cos t) (FVR ra ) - LC , where

FVR = float value reduction in dollars ra = cost of capital Maroof Hussain Sabri LC = annual operating cost of the lockbox system
14

Funds Transfer Mechanisms

Depository transfer checks (USA)

Unsigned check drawn on one of the firms bank accounts and deposited in another of the firms bank accounts Preauthorized electronic withdrawal from the payers account Settle accounts among participating banks. Individual accounts are settled by respective bank balance adjustments. Transfers clear in one day.
Electronic communication that, via bookkeeping entries, removes funds from the payers bank and deposits the funds in the payees bank. Bacs bankers automated clearing system (4 days) Chaps Clearing Houses Automated payment system (Same day transfers) Maroof Swift International Payments Mechanism Hussain Sabri 15

Automated direct debit transfers

BACS / Chaps/ Swift transfers