1. © 2003 The McGraw-Hill Companies, Inc. All rights reserved. Prepared by Anne Inglis, Ryerson University Cash and Liquidity Management Chapter Nineteen

2. 19.1 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Key Concepts and Skills Understand how firms manage cash Understand float Understand how to accelerate collections and manage disbursements Understand the characteristics of various short-term securities Appendix: Be able to use the BAT and Miller- Orr models and understand the different assumptions

3. 19.2 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Outline Reasons for Holding Cash Determining the Target Cash Balance Understanding Float Investing Idle Cash Appendix – Cash Management Models

4. 19.3 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Reasons for Holding Cash 19.1 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

5. 19.4 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Target Cash Balance 19.2 A firm’s desired cash level as determined by the trade-off between carrying costs and shortage costs Adjustment costs (shortage costs) – costs associated with holding too little cash

6. 19.5 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Understanding Float 19.3 Float – difference between cash balance recorded in the cash account and the cash balance recorded at the bank Disbursement float –Generated when a firm writes cheques –Available balance at bank – book balance > 0 Collection float –Cheques received increase book balance before the bank credits the account –Available balance at bank – book balance < 0 Net float = disbursement float + collection float

7. 19.6 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Quick Quiz I You have $3000 in your checking account. You just deposited $2000 and wrote a check for $2500. –What is the disbursement float? –What is the collection float? –What is the net float? –What is your book balance? –What is your available bank balance?

8. 19.7 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example: Measuring Float Size of float depends on the dollar amount and the time delay Delay = mailing time + processing delay + availability delay Suppose you mail a check for $1000 and it takes 3 days to reach its destination, 1 day to process and 1 day before the bank will make the cash available What is the average daily float (assuming 30 day months)? –Method 1: (3+1+1)(1000)/30 = 166.67 –Method 2: (5/30)(1000) + (25/30)(0) = 166.67

9. 19.8 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example: Cost of Float 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 –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

10. 19.9 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Cash Collection Payment PaymentPayment Cash Mailed ReceivedDeposited Available Mailing TimeProcessing DelayAvailability Delay Collection Delay One of the goals of float management is to try and reduce the collection delay. There are several techniques that can reduce various parts of the delay.

11. 19.10 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example: Accelerating Collections – Part I Your company does business nationally and currently all cheques are sent to the headquarters in Toronto. You are considering a lock-box system that will have cheques processed in Vancouver and Halifax. The Toronto office will continue to process the cheques it receives in house. –Collection 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 5000 –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.

12. 19.11 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example: Accelerating Collections – Part II Benefits –Average daily collections = 3(5000)(500) = 7,500,000 –Increased bank balance = 2(7,500,000) = 15,000,000 Costs –Daily cost =.1(15,000) + 3*10 = 1530 –Present value of daily cost = 1530/.0001 = 15,300,000 NPV = 15,000,000 – 15,300,000 = -300,000 The company should not accept this lock-box proposal

13. 19.12 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Cash Disbursements Slowing down payments can increase disbursement float – but it may not be ethical or optimal to do this Controlling disbursements –Zero-balance account –Controlled disbursement account

14. 19.13 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Investing Idle Cash – 19.4 Money market – financial instruments with an original maturity of one-year or less Temporary Cash Surpluses –Seasonal 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

15. 19.14 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 19.6 – Seasonal Cash Demands

16. 19.15 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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 cash Taxability – consider different tax characteristics when making a decision

17. 19.16 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Cash Management Models Appendix 19A Baumol-Allais-Tobin (BAT) Model – classic means of analyzing the cash management problem Miller-Orr Model – Also concentrates on the cash balance, but assumes that the balance fluctuates up and down randomly –Assumes the average change is zero

18. 19.17 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Quick Quiz What are the major reasons for holding cash? What is the difference between disbursement float and collection float? How does a lock box system work? What are the major characteristics of short- term securities?

19. 19.18 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Summary 19.5 By moving cash efficiently and maximizing the amount available for short-term investment, the treasurer adds value to the firm A firm holds cash to conduct transactions Net float is the difference between a firm’s available balance and its book balance Optimal cash levels depend on the opportunity cost of holding cash and the uncertainty of future cash flows The money market offers vehicles for parking idle cash