1. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-0 CHAPTER 27 Cash Management

2. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-1 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 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

3. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-2 27.1 Reasons for Holding Cash Transactions motive Compensating balances Transactions motive Compensating balances

4. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-3 27.2 Determining the Target Cash Balance The Baumol Model The Miller-Orr Model Other Factors Influencing the Target Cash Balance The Baumol Model The Miller-Orr Model Other Factors Influencing the Target Cash Balance

5. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-4 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.

6. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-5 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. 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. Time C 1 2 3 C 2 – 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 – The opportunity cost of holding is C 2 – C 2 – ×K×K

7. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 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. 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. Time C As we transfer $C each period we incur a trading cost of F each period. 1 2 3 C 2 – – T C If we need $T in total over the planning period we will pay $F times. The trading cost is× F – T C

8. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-7 The Baumol Model C*C* Size of cash balance Trading costs The optimal cash balance is found where the opportunity costs equals the trading costs F K T C  2 * Opportunity Costs K C  2

9. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-8 The Baumol Model Opportunity Costs = Trading Costs The optimal cash balance is found where the opportunity costs equals the trading costs Multiply both sides by C F C T K C  2 FTK C  2 2 K FT C   2 2 K TF C 2 * 

10. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-9 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.

11. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-10 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

12. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-11 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. 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.

13. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-12 Implications of the Miller-Orr Model 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. 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.

14. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-13 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. 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.

15. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-14 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. 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.

16. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-15 Float The difference between bank cash and book cash is called float. Float management involves controlling 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.

17. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-16 27.3 Managing the Collection and Disbursement of Cash Accelerating Collections Delaying Disbursements Disbursement Float Zero-Balance Accounts Drafts Ethical and Legal Questions Accelerating Collections Delaying Disbursements Disbursement Float Zero-Balance Accounts Drafts Ethical and Legal Questions

18. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-17 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. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-18 Overview of Lockbox Processing Corporate Customers Corporate Customers Corporate Customers Corporate Customers Local Bank Collects funds from PO Boxes Envelopes opened; separation of checks and receipts Deposit of checks into bank accounts Details of receivables go to firm Firm processes receivables Bank clears checks Post Office Box 1 Post Office Box 2

20. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-19 Delaying Disbursements 1. Write check on a distant bank. 2. Hold payment for several days after postmarked in office. 3. Call supplier firm to verify statement accuracy for large amounts. 4. Mail from distant post office. 5. Mail from post office that requires a great deal of handling. 1. Write check on a distant bank. 2. Hold payment for several days after postmarked in office. 3. Call supplier firm to verify statement accuracy for large amounts. 4. Mail from distant post office. 5. Mail from post office that requires a great deal of handling. Firm prepares check to supplier Post Office processing Delivery of check to supplier Deposit goes to supplier’s bank Bank collects funds

21. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-20 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. 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.

22. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-21 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. 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.

23. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-22 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 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

24. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-23 Seasonal Cash Demands Long-term financing Short-term financing Time Total Financing needs JFMAMJFMAM Marketable securities Bank loans

25. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-24 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. 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.

26. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-25 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 Two transactions models that provide rough guidelines for determining the optimal cash postion are: The Miller-Orr model The Baumol model

27. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-26 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.

28. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-27 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. 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. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 27-28 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. 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.