27-1 CHAPTER 27 Cash Management McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 27-2 Chapter Outline 27.1 Reasons for Holding Cash 27.2 Determining the Target Cash Balance 27.3 Managing the Collection and Disbursement of Cash 27.4 Investing Idle Cash 27.5 Summary & Conclusions McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 27-3 27.1 Reasons for Holding Cash Transactions motive Compensating balances McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 27-4 27.2 Determining the Target Cash Balance The Baumol Model The Miller-Orr Model Other Factors Influencing the Target Cash Balance McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 27-5 Costs of Holding Cash Costs in dollars 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* McGraw-Hill/Irwin Corporate Finance, 7/e Size of cash balance © 2005 The McGraw-Hill Companies, Inc All Rights 27-6 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 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 C –2 C C –2 McGraw-Hill/Irwin Corporate Finance, 7/e Time The opportunity cost C is C ×K of holding – –2 © 2005 The McGraw-Hill Companies, Inc All Rights 27-7 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 As we transfer $C each period we incur a trading cost of F each period C C –2 McGraw-Hill/Irwin Corporate Finance, 7/e If we need $T in total over the planning period we will T pay $F times – C T ×F Time The trading cost is – C © 2005 The McGraw-Hill Companies, Inc All Rights 27-8 The Baumol Model C T Total cost K F C C Opportunity Costs K Trading costs T F C C* Size of cash balance The optimal cash balance is found where the opportunity costs equals the trading costs * C McGraw-Hill/Irwin Corporate Finance, 7/e 2T F K © 2005 The McGraw-Hill Companies, Inc All Rights 27-9 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 C Multiply both sides by C F T C 2 K C K T F 2 2TF C K * McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 10 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 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 L Time McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 15 Other Factors Influencing the Target Cash Balance Compensating Balance Firms have cash in the bank as a compensation for banking services Large corporations have thousands of accounts with several dozen banks—sometimes it makes more sense to leave cash alone than to manage each account on a daily basis McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 16 Float The difference between bank cash and book cash is called float Float management involves controlling the collection and disbursement of cash McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 17 27.3 Managing the Collection and Disbursement of Cash Accelerating Collections Delaying Disbursements Disbursement Float Zero-Balance Accounts Drafts Ethical and Legal Questions McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 18 Accelerating Collections Customer mails payment Company receives payment Company deposits payment Cash received time Mail delay Processing delay Clearing delay Mail float Processing float Clearing float Collection float McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 19 Overview of Lockbox Processing Corporate Customers Corporate Customers Post Office Box Corporate Customers Local Bank Collects funds from PO Boxes Corporate Customers Post Office Box Envelopes opened; separation of checks and receipts Details of receivables go to firm Deposit of checks into bank accounts Firm processes receivables Bank clears checks McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 20 Delaying Disbursements Firm prepares check to supplier Post Office processing Delivery of check to supplier Deposit goes to supplier’s bank Bank collects funds McGraw-Hill/Irwin Corporate Finance, 7/e Write check on a distant bank Hold payment for several days after postmarked in office Call supplier firm to verify statement accuracy for large amounts Mail from distant post office Mail from post office that requires a great deal of handling © 2005 The McGraw-Hill Companies, Inc All Rights 21 Drafts Firms sometimes use drafts instead of checks Drafts differ from checks because they are not drawn on a bank but on an issuer (the firm) and are payable by the issuer The bank acts only as an agent, presenting the draft to the issuer for payment When the draft is transmitted to a firm’s bank for collection, the bank must present the draft to the issuing firm for acceptance before making payment After the draft has been accepted, the firm must deposit the necessary cash to cover the payments This allows the firm to keep less cash on hand McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 22 Ethical and Legal Questions The financial managers must always work with collected company cash balances and not with the company’s book balance, which reflects checks 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 23 27.4 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 Firms have surplus cash for three reasons: Seasonal or Cyclical Activities Planned Expenditures Different Types of Money Market Securities McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 24 Seasonal Cash Demands Total Financing needs Bank loans Marketable securities Short-term financing Long-term financing J McGraw-Hill/Irwin Corporate Finance, 7/e F M A M Time © 2005 The McGraw-Hill Companies, Inc All Rights 25 27.5 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 26 27.5 Summary & Conclusions Two transactions models that provide rough guidelines for determining the optimal cash postion are: The Miller-Orr model The Baumol model McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 27 27.5 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 28 27.5 Summary & Conclusions 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 29 27.5 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights ... McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 19 Overview of Lockbox Processing Corporate Customers Corporate Customers Post Office Box Corporate Customers... McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 27-3 27.1 Reasons for Holding Cash Transactions motive Compensating balances McGraw-Hill/Irwin Corporate Finance, ... Costs The investment income foregone when holding cash Trading costs C* McGraw-Hill/Irwin Corporate Finance, 7/e Size of cash balance © 2005 The McGraw-Hill Companies, Inc All Rights 27-6 The