1. 28-0 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Corporate Finance Ross  Westerfield  Jaffe Sixth Edition 28 Chapter Twenty Eight Cash Management Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut

2. 28-1 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Executive Summary Cash management is not as complex and conceptually challenging as other topics, such as capital budgeting and asset pricing. Financial managers in many companies, especially in the retail and services industries, spend a significant portion of their time on cash management. Most large Canadian corporations hold some of their assets in cash and marketable securities.

3. 28-2 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Chapter Outline 28.1 Reasons for Holding Cash 28.2 Determining the Target Cash Balance 28.3 Managing the Collection and Disbursement of Cash 28.4 Investing Idle Cash 28.5 Summary & Conclusions

4. 28-3 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 28.1 Reasons for Holding Cash Transactions motive: –Transactions related needs come from normal disbursement and collection activities of the firm. –The disbursement of cash includes the payment of wages and salaries, trade debts, taxes, and dividends. –The cash inflows (collections) and outflows (disbursements) are not perfectly synchronized, and some level of cash holdings is necessary to serve as a buffer. –Perfect liquidity is the characteristic of cash that allows it to satisfy the transactions motive.

5. 28-4 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 28.2 Determining the Target Cash Balance The target cash balance involves a trade-off between the opportunity costs of holding too much cash (lost interest) and the trading costs of holding too little. If a firm tries to keep its cash holdings too low, it will find itself selling marketable securities more frequently than if the cash balance were higher. The trading costs will tend to fall as the cash balance becomes larger. The opportunity costs of holding cash rise as the cash holdings rise.

6. 28-5 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 28.2 Determining the Target Cash Balance The Baumol Model The Miller-Orr Model Other Factors Influencing the Target Cash Balance

7. 28-6 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Costs of Holding Cash Opportunity Costs Trading costs Total cost of holding cash C*C* Costs in dollars of holding cash Size of cash balance The investment income foregone when holding cash. Trading costs increase when the firm must sell securities to meet cash needs.

8. 28-7 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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: this is the interest rate. Time 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. 1 2 3 The opportunity cost of holding is

9. 28-8 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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: this is the interest rate. Time C 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 pay $F, T ÷ C times. 1 2 3 The trading cost is

10. 28-9 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The Baumol Model C*C* Size of cash balance Opportunity Costs Trading costs The optimal cash balance is found where the opportunity costs equal the trading costs

11. 28-10 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The Baumol Model Opportunity Costs = Trading Costs The optimal cash balance is found where the opportunity costs equal the trading costs Multiply both sides by C

12. 28-11 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The Miller-Orr Model The firm allows its cash balance to wander randomly between upper and lower control limits. $ Time H Z L When the cash balance reaches the upper control limit H cash is invested elsewhere to get us to the target cash balance Z. When the cash balance reaches the lower control limit, L, investments are sold to raise cash to get us up to the target cash balance.

13. 28-12 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The Miller-Orr Model Math Given L, which is set by the firm, the Miller-Orr model solves for Z and H where  2 is the variance of net daily cash flows. The average cash balance in the Miller-Orr model is

14. 28-13 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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. 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.

15. 28-14 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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 management’s desire to hold low cash balances. Relative costs –For large firms, the trading costs of buying and selling securities are very small when compared to the opportunity costs of holding cash.

16. 28-15 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 28.3 Managing the Collection and Disbursement of Cash The difference between bank cash and book cash is called float. Float management involves controlling the collection and disbursement of cash. The objective in cash collection is to reduce the lag between the time customers pay their bills and the time the cheques are collected. The objective in cash disbursement is to slow down payments, thereby increasing the time between when cheques are written and when cheques are presented.

17. 28-16 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Electronic Data Interchange Electronic Data Interchange (EDI) is a general term that refers to the growing practice of direct, electronic information exchange between all types of businesses. One important use of EDI is to electronically transfer financial information and funds between parties, to eliminate paper invoices, paper cheques, mailing, and handling. One of the drawbacks of EDI is that it is expensive and complex to set up.

18. 28-17 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Accelerating Collections Customer mails payment Company receives payment Company deposits payment Cash received Mail delay Mail float Processing delay Processing float Clearing delay Clearing float time Collection float

19. 28-18 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Overview of Lockbox Processing Corporate Customers Corporate Customers Corporate Customers Corporate Customers Local Bank Collects funds from PO Boxes Envelopes opened; separation of cheques and receipts Deposit of cheques into bank accounts Details of receivables go to firm Firm processes receivables Bank clears cheques Post Office Box 1 Post Office Box 2

20. 28-19 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Electronic Collection Systems Focus on reducing float virtually to zero by replacing cheques with electronic funds transfer. Examples used in Canada: –Preauthorized payments –Point-of-sales transfers –Electronic trade payables –Smart cards.

21. 28-20 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Controlling Disbursements Firms use zero-balance accounts to avoid carrying extra balances in each disbursement account. With a zero-balance account, the firm, in cooperation with its bank, transfers in just enough funds to cover cheques presented that day. The firm maintains two disbursement accounts: one for suppliers and one for payroll.

22. 28-21 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Ethical and Legal Questions The financial managers must always work with collected bank cash balances and not with the company’s book balance, which reflects cheques that have been deposited but not collected. If you are borrowing the bank’s money without their knowledge, you are raising serious ethical and legal questions. The issue is minor in Canada since there can be a maximum of only one day’s deposit float.

23. 28-22 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 28.4 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. –Canadian chartered banks compete with money market funds offering arrangements in which the bank takes all excess available funds at the close of each business day and invests them for the firm. Firms have surplus cash for three reasons: –Seasonal or Cyclical Activities –Planned Expenditures –Different Types of Money Market Securities

24. 28-23 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Seasonal Cash Demands Long-term financing Short-term financing Time Total Financing needs JFMAMJFMAM Marketable securities Bank loans

25. 28-24 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Characteristics of Short-term Securities Maturity –Longer maturity securities are more exposed to interest rate risk than shorter maturity securities. Default risk –DBRS compiles and publishes ratings of various corporate and public securities. Marketability –No price-pressure effect –Time. Taxability

26. 28-25 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Some Different Types of Money-Market Securities Money-market securities are highly marketable and short- term. They are issued by the federal government, domestic and foreign banks, and business corporations. Examples are: –T-bills –Commercial paper –Banker’s acceptances –Dollar swaps

27. 28-26 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 28.5 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. Two transactions models that provide rough guidelines for determining the optimal cash position are: –The Miller-Orr model –The Baumol model

28. 28-27 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 28.5 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. 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 company’s book balance.

29. 28-28 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 28.5 Summary & Conclusions If you are borrowing the bank’s money without their knowledge, you are raising serious ethical and legal questions. The answers to which you probably know by now.