1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-1 Chapter Thirteen Cash and Liquidity Management

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-2 13.1 Reasons for Holding Cash 13.2 Determining the Target Cash Balance 13.3 Managing the Collection and Disbursement of Cash 13.4 Investing Idle Cash 13.5 Regulation of Financial Intermediaries 13.6 Summary and Conclusions Chapter Organisation

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-3 Chapter Objectives Understand the various reasons for holding cash. Explain and apply both the BAT model and the Miller–Orr model. Explain what float is and the different types of float. Discuss various ways of managing float. Outline ways that firms overcome temporary surpluses/deficits of cash. Discuss the role of the various regulators of financial markets.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-4 Reasons for Holding Cash Speculative motive—the need to hold cash to take advantage of additional investment opportunities, such as bargain purchases. Precautionary motive—the need to hold cash as a safety margin to act as a financial reserve. Transaction motive—the need to hold cash to satisfy normal disbursement and collection activities associated with a firm’s ongoing operations. Compensating balance requirements—cash balances kept at commercial banks to compensate for banking services the firm receives.

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-5 Target Cash Balance Key issues : What is the trade-off between carrying a large cash balance versus a small cash balance? That is, carrying costs versus shortage costs. What is the proper management of the cash balance? BAT model versus Miller–Orr model.

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-6 The BAT Model 48Weeks Average cash 0 Starting cash C=$2 000 000 $500 000=C/4

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-7 The BAT Model F = fixed cost of making a securities trade to replenish cash T = total amount of new cash needed for transactions purposes over the relevant planning period R = the opportunity cost of holding cash (the interest rate on marketable securities) Assumptions -Cash is spent at the same rate every day -Cash expenditures are known with certainty Optimal cash balance is where opportunity cost of holding cash ([C/2]*R) = trading cost ([T/C]*F):

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-8 Miller–Orr Model Assumes that, if left unmanaged, a company’s cash balance would follow a random walk with zero drift. Cash balance is allowed to wander freely between an upper limit (U*) and a lower limit (L). If cash holdings reach U*, management intervenes by withdrawing U* – C* dollars to return the cash balance to the target level C*. If cash balance reaches L, management intervenes by injecting C* – L dollars to return the cash balance to the target level C*.

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-9 Miller–Orr Model U* is the upper control limit. L is the lower control limit. The target cash balance is C*. As long as cash is between L and U*, no transaction is made. Cash Time XY L C* U*

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-10 Miller–Orr Model

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-11 Example—Miller–Orr Model Assume L = $0, F = $10, i = 0.5 per cent per month and the standard deviation of monthly cash flows is $2000.

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-12 Miller–Orr Model Implications Considers the effect of uncertainty (through  2 in net cash flows). – The higher the  2, the greater the difference between C* and L. – The higher the  2, the higher is the upper limit and the average cash balance. All things being equal: – the greater the interest rate, the lower is the C* – the greater the order costs, the higher is the C*.

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-13 Miller–Orr Model With Overdraft Yield on short-term investments < cost of bank overdraft < yield on long-term investments. A dollar invested in short-term assets earns less than the costs saved by applying that dollar to reduce overdraft usage. The company invests nothing in short-term assets and as much as possible in long-term assets, while meeting its liquidity needs through using the overdraft facility.

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-14 Miller–Orr Model With Overdraft Where: d = cost of bank overdraft

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-15 Understanding Float What is float? – The difference between book cash and bank cash, representing the net effect of cheques in the process of being cleared. Types of float: – Disbursement float—the result of cheques written; decreases book balance but does not immediately change available balance. – Collection float—the result of cheques received; increases book balance but does not immediately change available balance. – Net float—the overall difference between the firm’s available balance and its book balance.

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-16 Float Management Objectives: – In cash collection—speed up cheque collections (reduce float components). – In cash disbursement—control payments and minimise costs (increase float components). Components of float: – Mail float—cheques trapped in postal system. – Processing float—until receiver of cheque deposits cheque. – Availability float—until cheque clears in the banking system. Mail float + processing float + availability float = total time delay.

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-17 Measuring and Costing the Float The cost of collection float to the firm is the opportunity cost from not being able to use that cash.

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-18 Managing the Float Factoring—the selling of receivables to a financial institution (the factor), usually ‘without recourse’. Credit insurance—protection against the risk of bad debt losses. Delaying disbursements—increases the disbursement float.

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-19 Investing Idle Cash Temporary cash surpluses can be invested in marketable securities. Temporary cash deficits—sell marketable securities or use short-term bank financing. The temporary surpluses/deficits are a result of: – seasonal or cyclical activities – planned or possible expenditures.

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-20 The Securities Markets Temporary cash surplus Long-term debt market Futures market Options market Sharemarket Short-term money market Foreign exchange market Financial intermediaries

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-21 Short-term Securities Characteristics of short-term securities include: Maturity  maturities usually less than 90 days. Investments then avoid interest rate risk but have low returns. Default risk  idle cash generally invested in less risky securities (e.g. government issues). Marketability  idle funds usually invested in highly liquid securities.

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-22 Investing Cash 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.

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-23 Financing Seasonal or Cyclical Activities

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-24 Regulation of Financial Intermediaries Council of Financial Regulators Australian Prudential Regulation Authority (APRA) Prudential supervision of all deposit-taking entities, insurance and superannuation funds. Australian Securities and Investments Commission (ASIC) Corporate regulation, consumer protection, market integrity. Reserve Bank of Australia (RBA) Payments system, monetary policy, stability of the financial system. Source: Australian Financial Review, 18 March 1998, p.4.

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13-25 Regulation of Financial Intermediaries Terminology to know: CGS  Commonwealth Government Securities ESAs  exchange settlement accounts RTGS  real-time gross settlement ADIs  authorised deposit-taking institutions CAR  capital adequacy ratio PAR  prime assets ratio