1. © 2003 The McGraw-Hill Companies, Inc. All rights reserved. Cash and Liquidity Management - Appendix Chapter Twenty A

2. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 20A.1 Target Cash Balances Target cash balance – desired cash level determined by trade-off between carrying costs and shortage costs Flexible policy - If a firm maintains a marketable securities account, the primary shortage cost is the trading cost from buying and selling securities Restrictive policy – Generally borrow short- term, so the shortage costs will be the fees and interest associated with arranging a loan

3. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 20A.2 Figure 20A.1

4. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 20A.3 BAT Model 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 = trading cost –Opportunity cost = (C/2)*R –Trading cost = (T/C)*F –Total cost = (C/2)*R + (T/C)*F

5. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 20A.4 Example: BAT Model Your firm will have $5 million in cash expenditures over the next year. The interest rate is 4% and the fixed trading cost is $25 per transaction. –What is the optimal cash balance? –What is the average cash balance? –What is the opportunity cost? –What is the shortage cost? –What is the total cost?

6. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 20A.5 Miller-Orr Model Model for cash inflows and outflows that fluctuate randomly Define an upper limit, a lower limit and a target balance –Management sets lower limit, L –C* = L + [(3/4)F 2 /R] 1/3 (target balance) –U* = 3C* - 2L(upper limit) –Average cash balance = (4C* - L)/3

7. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 20A.6 Figure 20A.3

8. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 20A.7 Example: Miller-Orr Model Suppose that we wish to maintain a minimum cash balance of $50,000. Our fixed trading cost is $250 per trade, the interest rate is.5% per month and the standard deviation of monthly cash flows is $10,000. –What is the target cash balance? –What is the upper limit? –What is the average cash balance?

9. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 20A.8 Conclusions The greater the interest rate, the lower the target cash balance The greater the fixed order cost, the higher the target cash balance It is generally more expensive to borrow needed funds than it is to sell marketable securities Trading costs are usually very small relative to opportunity costs for large firms