1. INTRODUCTION TO FINANCE Instructor: MICHAEL E. ASAMOAH 1

2. L ECTURE 11 Cash and Marketable Securities Management 2

3. Candidates should be able to: Identify the motives for holding cash; Purpose of efficient cash management; Methods for speeding-up cash collections; Methods for controlling disbursement; Identify money market instruments; Know the factors to consider when purchasing marketable securities; Segments of marketable securities portfolio 3 Lecture Objectives

4. The need to hold cash balance to meet payments in the ordinary course of business. The need to hold some days’ cash to bridge the gap between timing of receipts and timing of payments. Transactions Motive The need to hold cash balance to meet unforeseen cash needs. The degree of uncertainty determines the level of cash balance to be held as buffer Precautionary Motive The need to hold cash balance to take advantage of opportunities as and when they show up. Speculative Motive 4 Motives for Holding Cash

5. CASH MANAGEMENT Cash management is concerned with managing cash flows and cash balances. It involves the efficient collection, disbursement, and temporary investment of cash In effect, cash management is directed at exercising control over cash position in order to keep the firm sufficiently liquid and profitable. In most firms there is a dedicated treasury department that is responsible for the firm’s cash management system 5

6. Efficient management of cash involves: Speeding up cash receipts Slowing down cash payments with no default. Temporary investment of idle cash. 6

7. Acceleration of Collections This includes methods employed from the time a product or service is sold until cash or cheques are collected from customers. The methods include: Early billing and quick sending of invoices Reducing cash collection float: Use of the lockbox system Eliminating cash collection float: Use of preauthorized debit. Direct deposit by customers into the firm’s bank account Use of electronic payment systems (e.g. e-zwich, Visa, mobile money) 7 Speeding up Cash Receipts

8. Collection float refers to the total time between when a customer sends cheque and when the value on the cheque becomes available to the receiving firm. Mail float The time between the sending of a cheque and the receipt of it. The total value on cheques in the mail. Deposit float The time taken to process the cheque internally (processing float). The time taken for the cheque to be cleared (availability float). 8 Collection Float

9. The following steps can be taken to reduce collection float: Accelerating the sending of payments from customers to the firm; and Reducing the time during which payments made by customers remain uncollected funds. 9 Reducing Collection Float

10. The firm rents a local post office box. The firm directs its customers to send cheques to the designated local post office box. The firm authorises its bank to pick up the mailed cheques several time during the day and deposit the same in its bank account. The bank sends paying slips together with a list of payments and any material in the envelop to the firm. This arrangement eliminates processing float( ie, the time btn the receipt remittances by the company and their deposit in the bank). 10 Lockbox System

11. Customer signs agreement with the firm to automatically debit his/her bank account on an agreed date. The agreement authorises the customer’s bank to transfer funds from the customer’s account to the firm’s account. This arrangement eliminates collection float. 11 Preauthorised Debits

12. Ways of slowing down cash disbursements include: Increasing disbursement float. Control of disbursements. Remote disbursement. 12 Slowing Down Cash Payments

13. Cheques issued for payments may stay in the mail, in the payees office, and in the banking system for some time before funds are transferred from the firm’s account. Disbursement float refers to the value of the cheques that have been issued but have not yet been fully cleared and paid over to the payee. The treasurer of the firm can employ legal and fair tactics to increase disbursement float. 13 Disbursement Float

14. All payables are done and monitored by a central department, preferable at the head office. Payables Concentration A special demand deposit account used for disbursement. It has zero balance when there is no disbursement activity. It requires a master account from which funds are drawn to cover negative balances or to which excess balances are sent. Zero-balance Accounts A special demand deposit account in which funds are deposited only when cheques are presented for payment. Controlled Disbursement Accounts 14 Disbursement Control

15. This is a system where a firm directs that cheques are drawn on a bank that is geographically remote from the payee so as to maximise clearing time. The firm therefore takes advantage of delays or inefficiencies in the bank clearing system to enjoy disbursement float. 15 Remote Disbursement

16. Cash in local lockboxes and banks are moved into the firm’s central cash pool in one bank. The benefits of this arrangement include the following: Greater control over inflows and outflows of cash. Reduction in idle balances. More effective investment. 16 Concentration Banking

17. The optimal level of cash depends on: The transactions balance required when cash management is efficient and The compensating balance requirements of commercial banks with which the firm has deposit accounts. Note that there is an opportunity cost for holding cash (i.e. interest forgone). The higher the interest rate, the greater the opportunity cost of holding cash. 17 Cash Balance to Maintain

18. Baumol Model Miller-Orr Model 18 Cash Management Models

19. Opportunity cost for holding cash instead of investing (measured by interest sacrificed) Trading cost associated with selling securities to raise cash (measured by fixed cost of selling securities) Cash Management Costs The optimal cash level to hold is that amount at which total costs associated with cash is at its minimum. Thus, to get the optimal level of cash, find the cash level when the total cost curve is at a minimum. Determining Optimal Cash Level 19 Baumol Model

20. Cedi costs of holding cash Total Cost Opportunity Cost Trading Cost C* size of cash balance 20 Baumol Model – Cost of Holding Cash

21. Amount of interest sacrificed Opportunity Cost The opportunity cost of holding cash (OC) is the average cash holding (C/2) multiplied by interest rate (K). OC = C/2 * K Computation of Opportunity Cost 21 Baumol Model: Opportunity Cost

22. Trading cost is the cost of selling securities to raise cash Meaning of Trading Cost TC = T/C * F Where: T = total amount of new cash needed F = the fixed cost of selling securities to raise cash C = cash balance Computation of Trading Cost 22 Baumol Model: Trading Cost

23. When the optimal cash balance is held, opportunity costs is equal to trading costs (C/2)*K = (T/C)*F Solving the equation for C you get: 23 Baumol Model: Optimal Cash Balance

24. Organisations allow their cash balance to move within two limits (i.e. an upper and lower limits) When the cash balance touches the maximum level, the organisation buys a certain number of marketable securities that would help it come back to a desired cash level. When the cash balance hits the lower level, the organisation sells its marketable securities to gather enough cash to bring it back to a desired cash level. 24 Miller-Orr Model

25. M ILLER O RR - M ODEL 25

26. The average value of the distribution of net cash flows is zero The distribution of cash flows has a standard deviation Distribution of cash flows is normal 26 Miller-Orr Model - Assumptions

27. To use the model effectively, the manager has to: Set the lower cash control level (L) Estimate the standard deviation (s) Check the interest rate (K) Find the prices at which the marketable securities could be sold Estimate the trading costs (F) 27 Miller-Orr Model – Implications

28. Spread between lower limit and return pointSpread between lower limit and upper limit 28 Miller-Orr Model: Cash Spreads

29. The optimal cash balance or cash return point is the sum of the lower cash limit (L) and the spread between the lower cash limit and return point With L, set by the firm, the Miller-Orr model solves for the optimal cash balance, Z* (i.e. Cash return point) using the following formula: 29 Miller-Orr Model: Cash Return Point

30. The highest cash level is the sum of the lower limit and the spread between lower limit and highest cash limit: Alternatively with L set and Z computed, the highest cash limit can be computed using the following formula: 30 Miller-Orr Model: Highest Cash Level

31. 31 Miller-Orr Model: Average Cash Balance

32. These are short-term money market securities that has ready market and can be sold with no significant loss in value. For accounting purposes marketable securities are shown in the Statement of Financial Position as: Cash equivalents if their maturities are three months or less at the time of acquisition. Short-term investments if their remaining maturities are more than three months but less than one year. 32 Investment in Marketable Securities

33. They serve as substitute for cash balance. They serve as temporary investment to: Finance seasonal or cyclical operations Raise funds to meet future requirements. 33 Rationale for Holding Marketable Securities

34. Treasury Bills Repurchase Agreements Banker’s Acceptance Commercial Paper Negotiable Certificate of Deposit Eurocurrencies 34 Common Money Market Instruments

35. Optimal balance of marketable securities held to take care of probable deficiencies in the firm's cash account. Ready cash Marketable securities held for meeting controllable (knowable) outflows (e.g. Taxes and dividends). Controllable Cash This is neither held to meet cash deficiencies nor controllable outlays. This is extra cash invested in the short term. Free Cash 35 Segments of Market Securities Portfolio

36. The variables to consider in the selection of marketable securities include: Safety of the principal Marketability or liquidity Maturity Risk Return (Yield) 36 Selection of Marketable Securities