CASH MANAGEMENT

NATURE OF CASH In cash management the term cash has been used in two senses:- Narrow Sense: Under this cash covers currency and generally accepted equivalents of cash, viz., cheques, demand drafts and banks demand deposits. Broad Sense: Here, cash includes not only the above stated but also near cash assets. There are Bank’s time deposits and marketable securities.

MOTIVES FOR HOLDING CASH J M Keynes identified three possible motives for holding cash : Transaction motive Precautionary motive Speculative motive

Objectives of Cash Management To meet Cash Payments To quote Bollen,”Cash is an oil to lubricate the ever turning wheels of business: without it , the process grinds to a stop”. To maintain Minimum Cash Balance (Reserve)

Features of Cash Management Cash Planning (estimate Cash Surplus/ Deficit through Cash Budget) Cash Flows Management (Cash Inflows & Cash Outflows) Determination of Optimum Cash Balance (cost of excess cash and danger of cash deficiency will match) Investment of Surplus Cash (properly invested in marketable securities, to earn profits)

CASH MANAGEMENT MODELS Several cash management models have addressed this issue of split between marketable securities and cash holdings. Two such models are : Baumol model Miller and Orr model

BAUMOL MODEL Provides for Cost efficient transactional balances Assumes that the demand for cash can be predicted with certainty determines the optimal conversion size/lot focus of the model is to minimise the total cost associated with cash management comprising total conversion costs (that is, costs incurred each time marketable securities are converted into cash) and the opportunity cost of keeping idle cash balances which otherwise could have been invested in marketable securities

Costs of Holding Cash Costs in dollars of holding cash Trading costs increase when the firm must sell securities to meet cash needs. Trading costs Total cost of holding cash Opportunity Costs The investment income foregone when holding cash. C* Size of cash balance

BAUMOL MODEL 2CF ECL= O where: ECL = Economic Conversion lot or Optimum Cash Balance C = Cost per conversion F = Projected cash requirements during the planning period O= interest rate per planning period on investment in marketable securities

BAUMOL MODEL-Example V ltd.’s estimated cash need for the year are Rs. 20 Lakhs. Cost of transaction is Rs.2000/lot & the opportunity cost is 20%. Calculate Economic Conversion Lot? Here, C= Rs.2000, F= Rs.20 Lakhs & O= 20% or 0.20 2 x 2000 x 20 lakhs = Rs. 2 Lakhs EOL= 0.20

MILLER & ORR MODEL Provides for cost-efficient transactional balances assumes uncertain cash flows determines an upper limit and return point for cash balances. Objective of Model is to determine the optimum cash balance level which minimises the cost of cash management

Implications of the Miller-Orr Model To use the Miller-Orr model, the manager must do four things: Set the lower control limit for the cash balance. Estimate the standard deviation of daily cash flows. Determine the interest rate. Estimate the trading costs of buying and selling securities.

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 U, cash is invested elsewhere to get us to the target cash balance Z. U 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. Z L Time

MILLER AND ORR MODEL 3b 2 RP = 3 + LL 4I UL = 3RP – 2LL where: RP = return point b = fixed cost per order for converting marketable securities into cash. I = daily interest rate earned on marketable securities  2 = variance of daily changes in the expected cash balance LL = the lower control limit UL = the upper control limit

MILLER AND ORR MODEL- Example X Ltd. has a policy of maintaining a minimum cash balance of Rs. 500,000. The standard deviation of the company’s daily cash flows is Rs.200,000 & the annual interest rate is 14%. The transaction cost of buying or selling securities is Rs. 150 per transaction. Calculate X Ltd.’s return point & upper control limit? Return point = 3 3 x 150 x 200,000 x 200,000 + 500,000 4 x 0.14 365 = Rs. 727,227 Upper Control Limit = 3 RP – 2LL= 3 x727,227 – 2 x 500,000 = Rs. 16,81,681

FLOAT The cash balance shown by a firm on its books is called the book, or ledger, balance whereas the balance shown in its bank account is called the available, or collected, balance. The difference between the available balance and the ledger balance is referred to as float. There are two kinds of float :- disbursement float - cheque issued but not debited in the customer’s A/c payment float- cheque deposited but not credited in the customer’s A/c

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

MONEY MARKET INSTRUMENTS OR MARKETABLE SECURITIES Mutual fund scheme (Money market schemes) Treasury bills Commercial paper Certificates of deposit Inter-corporate deposits (Call deposits, 3 months and 6 months deposits) Bill discounting