Chapter 19 – Cash and Liquidity Management
1. Managing Cash Disbursements
A. Increasing Disbursement Float
Slowing payments by increasing mail delay, processing time, or
collection time. May not want to do this from both an ethical
standpoint and a valuation standpoint. Slowing payment could
cause a company to forgo discounts on its accounts payable. As we
will see later in the chapter, the cost of forgoing discounts can be
extremely high.
Ethics Note: You may wish to emphasize the importance of ethical
behavior in this area of cash management. Because transactions
occur frequently and in large amounts, unscrupulous financial
managers tend to “cut corners” in this area more often than in
some others. Some corporations routinely pay late or take
discounts that they do not qualify for. This hurts the suppliers that
the company does business with and may ultimately hurt the
company through a loss of reputation or credit.
Ethical behavior can be summed up in the following rule of thumb
proposed by a top executive at a financial management seminar.
When asked about a practice similar to the one described above,
he responded that he followed the “mother rule” when faced with
a decision with ethical consequences – “If you would be
comfortable telling your mother what you did, it’s probably
ethical.” Of course, this doesn’t work for everyone, but it does hit
home with a lot of students.
B. Controlling Disbursements
Minimize liquidity needs by keeping a tight rein on disbursements
through any ethical means possible
Zero-balance accounts – maintain several sub-accounts at regional
banks and one master account. Funds are transferred from the
master account when checks are presented for payment at one of
the regional accounts. This reduces the firm’s liquidity needs.
Controlled disbursement accounts – the firm is notified on a daily
basis how much cash is required to meet that day’s disbursements
and the firm wires the necessary funds.
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Chapter 19 – Cash and Liquidity Management
2. Investing Idle Cash
A. Temporary Cash Surpluses
-seasonal or cyclical activities
-planned or possible expenditures
B. Characteristics of Short-Term Securities
Corporate treasurers seek to acquire assets with the following
characteristics:
-short maturity
-low default risk
-high marketability
Lecture Tip: “Marketability” suggests that large amounts of an
asset can be bought or sold quickly with little effect on the current
market price. This characteristic is usually associated with
financial markets that are “broad” and “deep.” Broad markets
have a large number of participants; deep markets have
participants that are willing and able to engage in large
transactions. The market for U.S. T-bills epitomizes these
characteristics. There are millions of potential buyers and sellers
world-wide, and multi-million dollar transactions are common.
C. Some Different Types of Money Market Securities
U.S. treasury bills, short-term tax exempts, commercial paper,
CDs, and repos are among the most common money market
securities.
Lecture Tip: Current money market rates are available on a daily
basis in The Wall Street Journal. Various money market
instruments and their current rates can be found on the “Credit
Markets” page in Section C, under the title “Money Rates.”
Remind students that these rates change on a daily basis
depending on market conditions. This is also a good place to
discuss the impact of Fed decisions on short-term rates.
3. Summary and Conclusions
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Chapter 19 – Cash and Liquidity Management
APPENDIX 19A
DETERMINING THE TARGET CASH BALANCE
Target cash balance – the desired cash balance as determined by
the trade-off between carrying costs and storage costs.
Adjustment costs – costs associated with holding low levels of
cash; shortage costs.
With a flexible working capital policy, the trade-off is between the
opportunity cost of cash balances and the adjustment costs of
buying, selling, and managing securities.
A. The Basic Idea
There is an optimal cash level that minimizes the total costs of
holding cash.
B. The BAT (Baumol-Allais-Tobin) Model
Define:
C = optimal cash transfer amount (amount of marketable
securities to sell to raise cash)
F = fixed cost of selling securities
T = cash needed for transactions over entire planning period
R = opportunity cost of cash (interest rate on marketable
securities)
Assume that cash is paid out at a constant rate through time.
Opportunity cost = average cash balance * interest rate
= [(C)/2]*R
Trading cost = # of transactions*cost per transfer = (T/C)*F
Total cost = opportunity cost + trading cost = (C/2)R + (T/C)F
To find the optimal transfer amount, take a first derivative of
the cost function relative to C and set it equal to zero. You can
also find it by setting opportunity cost = trading cost and
solving for C.
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Chapter 19 – Cash and Liquidity Management
Method 1:
∂TC
∂C=R
2+−FT
C2=0
R
2=FT
C2
C2=2FT
R
C=
√
2FT
R
Method 2:
C
2R=T
CF
C2=2TF
R
C=
√
2FT
R
Example: Hermes Co. has cash outflows of $500 per day, the
interest rate is 10% and the fixed transfer cost is $25.
T = 365*500 = 182,500
F = 25
R = .1
C=
√
2(25)(182 ,500 )
.1
C=$9,552 . 49
C. The Miller-Orr Model: A More General Approach
The Miller-Orr model offers a general approach to handling
uncertain cash flows.
The basic idea:
U* = upper limit on cash balance
L = lower limit on cash balance
C* = target cash balance
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Chapter 19 – Cash and Liquidity Management
When cash reaches U*, the firm transfers cash (buys securities)
in the amount of U* – C*. If cash falls below L, the firm sells
C* – L worth of securities to add to cash.
Using the model:
Given the variance (2) of cash flow (“cash flow” refers to both
the amounts that go into and come out of the cash balance) per
period, the interest rate per period (period may be a day, week,
or month as long as the two are consistent), and L, the target
balance and upper limit, are given by:
C* = L + ( ¾ * F * 2/R)1/3
U* = 3C* – 2L
Example: Suppose F = $25, R = 1% per month, and the
variance of monthly cash flows is $25,000,000 per month.
Assume a minimum cash balance of $10,000.
C* = 10,000 + ( ¾ (25)(25,000,000)/.01)1/3 = $13,605.62
U* = 3(13,605.62) – 2(10,000) = $20,816.86
D. Implications of the BAT and Miller-Orr Models
From both:
-The higher the interest rate (opportunity cost), the lower the
target balance
-The higher the transaction cost, the higher the target balance
From Miller-Orr:
-The greater the variability of cash flows, the higher the target
balance
E. Other Factors Influencing the Target Cash Balance
-Flexible versus restrictive short-term financing policy
-Compensating balance requirements
-The number and complexity of checking accounts
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