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

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

3. 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

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

5. 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

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

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

8. 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

9. 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?

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

11. 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

12. 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

13. 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

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

15. 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.

16. 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.

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

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

19. 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.

20. 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.

21. 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.

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

23. 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

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

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

26. 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

27. Investment Timing

28. 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

29. 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?

30. 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?

31. 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?

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

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

34. 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

35. 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.

36. 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.

37. Questions?