2. ®2002 Prentice Hall Publishing 1 Chapter 14 Liquidity, Cash, and Marketable Securities

3. ®2002 Prentice Hall Publishing 2 Liquidity and Its Role Liquidity has two dimensionsLiquidity has two dimensions –Time necessary to convert the asset into money –Degree of certainty associated with the conversion ratio Most liquid assets of the firmMost liquid assets of the firm –Cash and marketable securities

4. ®2002 Prentice Hall Publishing 3 Liquidity When Perfect Capital Markets Exist Imply liquidity is not a thing of valueImply liquidity is not a thing of value Investors can produce homemade liquidityInvestors can produce homemade liquidity Creditors will be able to realize valueCreditors will be able to realize value –By liquidating assets –By running the company themselves –By effecting a costless reorganization

5. ®2002 Prentice Hall Publishing 4 Liquidity Management with Imperfections “Shortfall” phenomenon“Shortfall” phenomenon Bankruptcy costsBankruptcy costs Higher interest ratesHigher interest rates Maintaining liquidityMaintaining liquidity –Can reduce the probability of bankruptcy –Can reduce contracting costs

6. ®2002 Prentice Hall Publishing 5 Benefits Relative to Cost Cost of liquidityCost of liquidity –Differential in interest earned on the investment of funds in liquid assets and the cost of financing Benefits associated with liquidity Benefits associated with liquidity Trade-offTrade-off Cost of maintaining liquidity Cost of maintaining liquidity In what form should liquidity be held?In what form should liquidity be held? –Transactions balances or marketable securities

7. ®2002 Prentice Hall Publishing 6 Cash Management and Collections Maximize cash availability and interest income on idle fundsMaximize cash availability and interest income on idle funds Cash cycleCash cycle Collection and disbursements methodsCollection and disbursements methods –Acceleration of collections –Pay accounts payable as late as is consistent with maintaining the firm’s credit standing

8. ®2002 Prentice Hall Publishing 7 Transferring Funds Wire transfersWire transfers –Federal Reserve Bank’s wire transfer service (Fedwire) –Clearing House Interbank Payments Systems (CHIPS) Electronic depository transfer checks (DTC)Electronic depository transfer checks (DTC) –Cost less than wire transfers –Takes more time

9. ®2002 Prentice Hall Publishing 8 Concentration Banking Establishing strategic collection centersEstablishing strategic collection centers AdvantagesAdvantages –Time required for mailing is reduced –Time required to collect checks is reduced Cost/benefit analysisCost/benefit analysis –Profits from the investment of released funds –Additional costs of a decentralized system –Differences in total compensating balances

10. ®2002 Prentice Hall Publishing 9 Lockbox System Collection center receives remittances, processes them, and deposits them in a bankCollection center receives remittances, processes them, and deposits them in a bank Usually on a regional basisUsually on a regional basis AdvantageAdvantage –Checks are deposited at banks sooner and become collected balances sooner DisadvantageDisadvantage –Cost of additional services is almost directly proportional to the number of checks deposited

11. ®2002 Prentice Hall Publishing 10 Preauthorized Checks (PAC) Used to reduce mailing and processing timeUsed to reduce mailing and processing time Works wellWorks well –For large customers where payments of a fixed amount are required –When both customer and vendor are well known to each other and completely creditworthy

12. ®2002 Prentice Hall Publishing 11 International Cash Management Foreign lockbox arrangementForeign lockbox arrangement –Not well developed –More costly than U.S. arrangement Giro system permits automatic payments through the postal serviceGiro system permits automatic payments through the postal service Use of checks on the banking system is growingUse of checks on the banking system is growing Cash and marketable securities may be kept in multiple currenciesCash and marketable securities may be kept in multiple currencies

13. ®2002 Prentice Hall Publishing 12 Control of Disbursements Mobilizing funds and slowing disbursementsMobilizing funds and slowing disbursements –Bank drafts –“Playing the float” Zero balance accountZero balance account Payroll and dividend disbursementsPayroll and dividend disbursements –Percentage of checks collected Electronic funds transferElectronic funds transfer –Outsource payable operations including electronic funds transfers

14. ®2002 Prentice Hall Publishing 13 Investment in Marketable Securities Credit riskCredit risk MarketabilityMarketability –Price and time MaturityMaturity Coupon rateCoupon rate –Volatility of a security depends on combined effect of maturity and coupon rate TaxabilityTaxability

15. ®2002 Prentice Hall Publishing 14 Types of Marketable Securities Treasury securitiesTreasury securities Repurchase agreementsRepurchase agreements Agency securitiesAgency securities Bankers’ acceptancesBankers’ acceptances Commercial paperCommercial paper Certificates of deposit Eurodollars Short-term municipals Floating-rate preferred stock

16. ®2002 Prentice Hall Publishing 15 Portfolio Management Investment decisions are interdependentInvestment decisions are interdependent –Amount of cash to invest –Type of security in which to invest Decisions based on an evaluation of expected net cash flows and the uncertainty associated with these cash flowsDecisions based on an evaluation of expected net cash flows and the uncertainty associated with these cash flows

17. ®2002 Prentice Hall Publishing 16 Certainty of Cash-Flow Projections With a high degree of certainty, the maturity of a marketable security becomes the most important characteristicWith a high degree of certainty, the maturity of a marketable security becomes the most important characteristic If cash flows are fairly uncertain, marketability and risk, with respect to fluctuations in market value, become the most important characteristicsIf cash flows are fairly uncertain, marketability and risk, with respect to fluctuations in market value, become the most important characteristics