Cash and Liquidity Management Chapter 19 Cash and Liquidity Management McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline Reasons for Holding Cash Understanding Float Cash Collection and Concentration Managing Cash Disbursements Investing Idle Cash

Chapter Outline (Appendix) The Basic Idea The BAT Model The Miller-Orr Model: A More General Approach Implications of the BAT and Miller-Orr Models Other Factors Influencing the Target Cash Balance

Chapter Outline Reasons for Holding Cash Understanding Float Cash Collection and Concentration Managing Cash Disbursements Investing Idle Cash

Reasons for Holding Cash 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

Chapter Outline Reasons for Holding Cash Understanding Float Cash Collection and Concentration Managing Cash Disbursements Investing Idle Cash

Understanding Float Definition: Float – the difference between cash balance recorded in the cash account and the cash balance recorded at the bank

Understanding Float Net float = disbursement float + collection float Generated when a firm writes checks Available balance at bank – book balance > 0 Collection float Checks received increase book balance before the bank credits the account Available balance at bank – book balance < 0 Net float = disbursement float + collection float

Example: Types of Float You have $3,000 in your checking account. You just deposited $2,000 and wrote a check for $2,500. What is the disbursement float? What is the collection float? What is the net float? What is your book balance? What is your available balance?

Example: Measuring Float Size of float depends on the dollar amount and the time delay Delay = mailing time + processing delay + availability delay

Example: Measuring Float Suppose you mail a check each month for $1,000 and it takes 3 days to reach its destination, 1 day to process, and 1 day before the bank makes the cash available What is the average daily float (assuming 30-day months)? Method 1: (3+1+1)(1,000)/30 = $166.67 Method 2: (5/30)(1,000) + (25/30)(0) = $166.67

Example: Cost of Float I 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

Example: Cost of Float II 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 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

Chapter Outline Reasons for Holding Cash Understanding Float Cash Collection and Concentration Managing Cash Disbursements Investing Idle Cash

Cash Collection Payment Payment Payment Cash Mailed Received Deposited Available Mailing Time Processing Delay Availability Delay Collection Delay One of the goals of float management is to try to reduce the collection delay. There are several techniques that can reduce various parts of the delay.

Lockbox System A lockbox system is a service whereby checks are mailed to a local PO Box address. The checks are picked up daily (or even multiple times per day) by the servicing firm. The checks are deposited into the local branch bank. The balances are electronically transferred to the firm’s branch of the bank, available for use immediately.

No Lockbox System 2-3 Days by Mail 2-3 Days by Mail

Lockbox System II 1 Day by Mail 1 Day by Mail Transmitted Electronically (nanoseconds) 1 Day by Mail 1 Day by Mail

Example: Accelerating Collections – Part I Your company does business nationally, and currently, all checks are sent to the headquarters in Tampa, FL. You are considering a lock-box system that will have checks processed in Phoenix, St. Louis and Philadelphia. The Tampa office will continue to process the checks it receives in house.

Example: Accelerating Collections – Part II 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 5,000 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.

Example: Accelerating Collections – Part III Benefits Average daily collections = 3(5,000)(500) = 7,500,000 Increased bank balance = 2(7,500,000) = 15,000,000 Costs Daily cost = .1(15,000) + 3*10 = 1,530 Present value of daily cost = 1,530/.0001 = 15,300,000 NPV = 15,000,000 – 15,300,000 = -$300,000 The company should not accept this lock-box proposal as we would lose money.

Chapter Outline Reasons for Holding Cash Understanding Float Cash Collection and Concentration Managing Cash Disbursements Investing Idle Cash

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

Chapter Outline Reasons for Holding Cash Understanding Float Cash Collection and Concentration Managing Cash Disbursements Investing Idle Cash

Investing Cash Money market – financial instruments with an original maturity of one year or less

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

Investment Timing

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

Ethics Issues Some corporations routinely pay late or take discounts that they do not qualify for. How does this impact the supplier? Does this action have any negative impact on the company itself?

Quick Quiz What are the major reasons for holding cash? What is the difference between disbursement float and collection float? How does a lockbox system work? What are the major characteristics of short-term securities?

Comprehensive Problem A proposed single lockbox system will reduce collection time 2 days on average Daily interest rate on T-bills = .01% Average number of daily payments to the lockbox is 3,000 Average size of payment is $500 The processing fee is $.08 per check plus $10 to wire funds each day. What is the maximum investment that would make this lockbox system acceptable?

Terminology Speculative motive Precautionary motive Transaction motive Disbursement float Collection float Lock Box

Formulas Net float = disbursement float + collection float Delay = mailing time + processing delay + availability delay

Key Concepts and Skills Define float and describe how it affects cash balance Describe the processes to accelerate collections Give examples of the advantages and disadvantages of holding cash Evaluate the options to invest idle cash

What are the most important topics of this chapter? Cash is necessary for funding operations but excess cash is a missed opportunity to earn interest. Float is the difference between the firm’s balance and the bank’s balance. There are numerous options to invest cash in short-term financial instruments.

What are the most important topics of this chapter? A lock-box system speeds up the time that a firm’s gets credit for funds deposited into their business account.

Questions?