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Cash and Liquidity Management

Chapter 19

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Chapter Outline

• Reasons for Holding Cash

• Understanding Float

• Cash Collection and Concentration

• Managing Cash Disbursements

• Investing Idle Cash

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Chapter Outline(Appendix)

• The Basic Idea• The BAT Model• The Miller-Orr Model: A

More General Approach• Implications of the BAT and

Miller-Orr Models• Other Factors Influencing

the Target Cash Balance

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Chapter Outline

• Reasons for Holding Cash

• Understanding Float

• Cash Collection and Concentration

• Managing Cash Disbursements

• Investing Idle Cash

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Reasons for Holding Cash

Speculative motive – hold cash to take advantage of unexpected opportunities

Precautionary motive – hold cash in case of emergencies

Transaction motive – hold cash to pay the day-to-day bills

Trade-off between opportunity cost of holding cash relative to the transaction cost of converting marketable securities to cash for transactions

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Chapter Outline

• Reasons for Holding Cash

• Understanding Float

• Cash Collection and Concentration

• Managing Cash Disbursements

• Investing Idle Cash

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Understanding FloatDefinition: Float – the difference between cash balance recorded in the cash account and the cash balance recorded at the bank

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Understanding FloatDisbursement float

Generated when a firm writes checksAvailable balance at bank – book balance > 0

Collection floatChecks received increase book balance

before the bank credits the accountAvailable balance at bank – book balance < 0

Net float = disbursement float + collection float

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Example: Types of Float

You have $3,000 in your checking account. You just deposited $2,000 and wrote a check for $2,500.What is the disbursement float?What is the collection float?What is the net float?What is your book balance?What is your available balance?

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Example: Measuring Float

Size of float depends on the dollar amount and the time delay

Delay = mailing time + processing delay + availability delay

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Example: Measuring Float

Suppose you mail a check each month for $1,000 and it takes 3 days to reach its destination, 1 day to process, and 1 day before the bank makes the cash available

What is the average daily float (assuming 30-day months)?Method 1: (3+1+1)(1,000)/30 = $166.67

Method 2: (5/30)(1,000) + (25/30)(0) = $166.67

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Example: Cost of Float I

Cost of float – opportunity cost of not being able to use the money

Suppose the average daily float is $3 million with a weighted average delay of 5 days.

What is the total amount unavailable to earn interest?

5*3 million = $15 million

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Example: Cost of Float II

Cost of float – opportunity cost of not being able to use the money

Suppose the average daily float is $3 million with a weighted average delay of 5 days.What is the NPV of a project that could

reduce the delay by 3 days if the cost is $8 million?Immediate cash inflow = 3*3 million = $9 million

NPV = 9 – 8 = $1 million

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Chapter Outline

• Reasons for Holding Cash

• Understanding Float

• Cash Collection and Concentration

• Managing Cash Disbursements

• Investing Idle Cash

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Cash Collection

Payment Payment Payment CashMailed Received Deposited Available

Mailing Time Processing Delay Availability Delay

Collection Delay

One of the goals of float management is to try to reduce the collection delay. There are several techniques that can reduce various parts of the delay.

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Lockbox System1.A lockbox system is a service whereby

checks are mailed to a local PO Box address.

2.The checks are picked up daily (or even multiple times per day) by the servicing firm.

3.The checks are deposited into the local branch bank.

4.The balances are electronically transferred to the firm’s branch of the bank, available for use immediately.

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No Lockbox System

2-3 Days by Mail

2-3 Days by Mail

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Lockbox System II

1 Day by Mail

1 Day by Mail

Transmitted Electronically(nanoseconds)

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Example: Accelerating

Collections – Part IYour company does business nationally, and currently, all checks are sent to the headquarters in Tampa, FL. You are considering a lock-box system that will have checks processed in Phoenix, St. Louis and Philadelphia. The Tampa office will continue to process the checks it receives in house.

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Example: Accelerating

Collections – Part IICollection time will be reduced by 2 days on average

Daily interest rate on T-bills = .01%

Average number of daily payments to each lockbox is 5,000

Average size of payment is $500

The processing fee is $.10 per check plus $10 to wire funds to a centralized bank at the end of each day.

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Example: Accelerating

Collections – Part IIIBenefits

Average daily collections = 3(5,000)(500) = 7,500,000

Increased bank balance = 2(7,500,000) = 15,000,000

CostsDaily cost = .1(15,000) + 3*10 = 1,530Present value of daily cost = 1,530/.0001 =

15,300,000

NPV = 15,000,000 – 15,300,000 = -$300,000

The company should not accept this lock-box proposal as we would lose money.

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Chapter Outline

• Reasons for Holding Cash

• Understanding Float

• Cash Collection and Concentration

• Managing Cash Disbursements

• Investing Idle Cash

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Cash DisbursementsSlowing down payments can increase disbursement float – but it may not be ethical or optimal to do this

Controlling disbursementsZero-balance accountControlled disbursement account

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Chapter Outline

• Reasons for Holding Cash

• Understanding Float

• Cash Collection and Concentration

• Managing Cash Disbursements

• Investing Idle Cash

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Investing CashMoney market – financial instruments with an original maturity of one year or less

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Investing Cash

Temporary Cash SurplusesSeasonal or cyclical activities – buy marketable securities with seasonal surpluses, convert securities back to cash when deficits occur

Planned or possible expenditures – accumulate marketable securities in anticipation of upcoming expenses

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Investment Timing

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Characteristics of Short-Term Securities

Maturity – firms often limit the maturity of short-term investments to 90 days to avoid loss of principal due to changing interest rates

Default risk – avoid investing in marketable securities with significant default risk

Marketability – ease of converting to cashTaxability – consider different tax

characteristics when making a decision

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Ethics Issues

Some corporations routinely pay late or take discounts that they do not qualify for.

1. How does this impact the supplier?

2. Does this action have any negative impact on the company itself?

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Quick Quiz

What are the major reasons for holding cash?

What is the difference between disbursement float and collection float?

How does a lockbox system work?

What are the major characteristics of short-term securities?

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Comprehensive Problem

A proposed single lockbox system will reduce collection time 2 days on average

Daily interest rate on T-bills = .01%Average number of daily payments to the

lockbox is 3,000Average size of payment is $500The processing fee is $.08 per check plus $10

to wire funds each day.What is the maximum investment that would

make this lockbox system acceptable?

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Terminology

• Speculative motive• Precautionary motive• Transaction motive• Disbursement float• Collection float• Lock Box

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Formulas

Net float = disbursement float + collection float

Delay = mailing time + processing delay + availability delay

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Key Concepts and Skills

•Define float and describe how it affects cash balance

•Describe the processes to accelerate collections

•Give examples of the advantages and disadvantages of holding cash

•Evaluate the options to invest idle cash

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1. Cash is necessary for funding operations but excess cash is a missed opportunity to earn interest.

2. Float is the difference between the firm’s balance and the bank’s balance.

3. There are numerous options to invest cash in short-term financial instruments.

What are the most important topics of this chapter?

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4. A lock-box system speeds up the time that a firm’s gets credit for funds deposited into their business account.

What are the most important topics of this chapter?

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Questions?