Unit 2.

Cash Management

Learning Objectives:
Upon completing this unit, you will be able
 list and explain the motives for holding cash.
 understand the purpose of efficient cash management.
 describe methods for speeding up the collection of accounts receivable and
methods for controlling cash disbursements.
 discuss factors determining cash needs
 explain the approaches to derive optimal cash balance
 identify the key variables that should be considered before purchasing any
marketable securities.

2.1 Introduction

Cash and marketable securities are the most liquid of the firm’s assets.
 Cash is the ready currency to which all liquid assets can be reduced.
 Marketable securities are short term, interest bearing, money market instruments
that are used by the firm to obtain a return on temporary idle funds.
 Cash and marketable securities are held by the firms to reduce the risk of technical
insolvency by providing a pool of liquid resources for use in making planned as
well as unexpected outlays.
 The desired balances are determined by carefully considering the motives for
holding them. The higher the cash & Marketable securities, the lower the risk of
technical insolvency, and the lower they are, the higher the risk of technical
insolvency.

The term cash with reference to cash management is used in two senses.

1
  In a narrow sense it is used to cover currency and generally accepted equivalents
of cash such as checks, drafts and demand deposit in banks.
 The broader view of cash also includes near cash assets, such as marketable
securities and time deposits in blanks.

As a part of managing its cash, a firm must make arrangements to collect from its
customers, pay its suppliers, and invest any excess cash on hand.

2.2 Motives for Holding Cash

Firms hold cash for four primary reasons:

 Transaction motive: Holding of cash to meet routine cash requirements to
finance the transaction which a firm carries on in the ordinary course of business.
For example, cash payments have to be made for purchases, wages, operating
expenses, financial charges, like interest, taxes, dividends, and so on. The
requirement of cash balances to meet routine cash needs is known as the
transaction motive and such cash balances are termed as transaction balances.

 Precautionary motive. Holding cash as a precaution serves as an emergency fund

for a firm. If expected cash inflows are not received as expected cash held on a
precautionary basis could be used to satisfy short-term obligations that the cash
inflow may have been bench marked for. The cash balances held in reserve for
such random and unforeseen fluctuations in cash flows are called precautionary
balances.

 Speculative motive. Holding cash as to create the ability for a firm to take
advantage of special opportunities that if acted upon quickly will favor the firm.
The speculative motive helps to take advantage of:
 an opportunity to purchases raw materials at reduced price on payment of
immediate cash;

2
  a chance to speculate on interest rate movements by buying securities
when interest rates are expected to decline;
 delay purchases of raw materials on the anticipation of decline in prices;
and to make purchases at favorable prices.

Compensation motive. Banks provide a variety of services to business firms, such as

clearance of check, supply of credit…etc., for which a minimum balance is required
to be kept with the bank; this balance is to compensate banks for services rendered.
Note that most firms do not separate funds for each of these motives, but they do
consider them in setting their overall cash position.

2.3 Objectives of Cash Management

Cash management is one of the key areas of working capital management. Apart from the
fact that it is the most liquid current asset, cash is the common denominator to which all
current assets can be reduces because the other major liquid assets, that is, receivables
and inventory get eventually converted into cash. This underlines the significance of cash
management.

The basic objectives of cash management are two-fold: (a) to meet the cash disbarment
needs (payment schedule); and (b) to minimize funds committed to cash balances. These
are conflicting and mutually contradictory and the task of cash management is to
reconcile them.

 Meeting the cash disbursement needs (payment schedule). In the normal

courses of business firms have to make payments of cash on a continuous and
regular basis to suppliers of goods, employs and so on. A basic objective of cash
management is to meet the cash payment schedule, i.e. to have sufficient cash to
meet the cash disbursement needs of a firm. The advantages of adequate cash are:

 It prevents insolvency or bankruptcy arising out of the inability of a firm

to meet its objectives.

3
  The relationship with the bank is not stained.
 It helps in fostering good relations with trade creditors and suppliers of
raw materials, as prompt payment may help their own management.
 A trade discount can be availed if payment is made with in the discount
period.
 It leads to a strong credit rating which enables the firm to purchase goods
on favorable terms and to maintain its line of credit with banks and other
sources of credit.
 To take advantage of favorable business opportunities that may be
availability periodically.
To meet unexpected cash expenditure with a minimum strain during
emergencies, such as strikes, fires or a new marketing campaign by
competitors.

 Minimizing funds committed to cash balances. The second objective of cash

management is minimizing cash balances. In minimizing the cash balances, two
conflicting aspects have to be reconciled. A high level of cash balances will ensure
prompt payment together with all the advantages. But it also implies that large
funds will remain idle, as cash is a non-earning asset and the firm will have to
forego profits. A low level of cash balances, on the other hand, may mean failure
to meet the payment schedule. The aim of cash management, therefore, should be
to have an optimal amount of cash balance.

2.4 Factors Determining Cash Needs

4
The factors that determine the required cash balances are: synchronization of cash flows,
short costs, excess cash balance, procurement and management and uncertainty.
 Synchronization of cash flows. The need for maintaining cash balances
arising from the non-synchronization of the inflows and outflows of cash: if the
receipts and payments of cash perfectly coincide or balance each other, there
would be no need for cash balances. The first consideration in determining the
cash needs is therefore, the extent of non-synchronization of cash receipts and
disbursements.
 Short costs. Another general factor to be considered in determining cash needs
is the cost associated as shortfall in the firm’s cash needs. Expenses incurred as
a result of shortfall are called short costs. Included in the short costs are:
 Transaction costs. These are associated with raising cash to tide
over the shortage. This is usually the brokerage incurred in
relation to the sale of some short-term near-cash assets such as
marketable securities.
 Borrowing costs. Borrowing costs are costs associated with
borrowing to cover the shortage. These include items such as
interest on loan, commitment charges and other expenses relating
to the loan.
 Loss of trade-discount
 Costs associated with deterioration of the firm’s credit rating.
This is reflected in higher bank charges on loans, stoppage of
supplies, demands for cash payment, refusal to sell, loss of image
and the attendant decline in sales and profits.
 Penalty rates by banks to meet a shortfall in compensating
balances.
 Excess cash balances Costs. The costs of having excessively large cash
balances is known as the excess cash balance cost. If large funds are idle, the

5
 implication is that the firm has missed opportunities to invest those funds and
has thereby lost interest which it would otherwise have earned. This loss of
interest is primarily the excess cost.
 Procurement and management. These are the costs associated with
establishing and operating cash management staff and activities. They are
generally fixed and are mainly accounted for by salary, storage, handling of
securities, and so on.

 Uncertainty on cash management. Finally, the impact of uncertainty on cash

management strategy is also relevant as cash flows cannot be predicted with
complete accuracy. The first requirement is a precautionary caution to cope
with irregularities in cash flow, unexpected delays in collections and
disbursement, defaults and unexpected cash needs.

The impact of uncertainty on cash management can, however, is mitigated

through (1) improved forecasting of tax payments, capital expenditure,
dividends, and so on; and (2) increased ability to borrow through overdraft
facility.

2.5 Determining Cash Needs

After the examination of the pertinent considerations and cost that determine cash needs,
the next question deals with the determination of a firm’s cash needs. There are two
approaches to derive an optimal cash balance, namely, (a) cash budget and (b) cash
management models.

2.5.1 Cash Budget: Management Tool

Cash budget is the most significant device to plan and control receipt and payment. A
cash budget is a summary statement of the given firm’s expected cash inflows and

6
outflows over the projected period. It gives information on the timing and magnitude of
expected cash flows and the end balances over the planning period.

2.5.2 Cash Management Model

The key purpose of cash management is to hold optimal balance of cash that is just
enough to meet the demand for cash. Cash balance more than the optimum level will cost
the firm’s profitability, whereas cash balance that is below the optimum level will result
in poor liquidity. Thus, the crux of cash management is to determine the level of cash
which will provide sufficient liquidity without adversely affecting profitability.

Firms can use quantitative models to determine appropriate transactional cash balances.
Two quantitative models that management can use to determine desirable level of cash
balance are Baumol Model and Miller-Orr Model.

Baumol Model. The Baumol model enables companies to find out their desirable level
of cash balance under certainty. There are certain assumptions or ideas that are critical
with respect to the Baumol model of cash management:

Assumptions of Baumol’s model

 The firm is able to forecast it cash need with certainty

 The firms cash payments occur uniformly over a period of time

 The opportunity cost of holding cash is known and it does not change over a
period of time

 The firm will incur the same transaction cost whenever it converts its securities to
cash.

Limitations of Baumol Model.

 It does not allow the cash flows to fluctuate.

7
  Firms in practice do not use their cash balance uniformly nor are they able to
predict daily cash inflows and outflows.

2  annual cash flow  cost of selling securities

Cash balance 
interest rate

2T F
Cash balance 
K

Where:
F = the fixed cost of selling securities to raise cash
T = the total amount of new cash needed
K = the opportunity cost of holding cash: this is the interest rate.
The optimal cash balance is found where the opportunity costs equal the trading costs.
Opportunity Costs = Trading Costs
(C/2)K = (T/C) F
Thus,
 Opportunity cost = K(C/2)
 Transaction or trading Cost = F (T/C)
 Total cost = K(C/2) + F(T/C)

Example 1: A firm utilizes Br165, 000 a week to pay bills. The fixed cost of transferring
funds is Br48. The applicable interest rate is 6%. Answer these five questions using the
Baumol model:

Instruction:
a. What is the optimal initial cash balance?
b. What is the optimal average cash balance?
c. What is the opportunity cost of holding cash?
d. What is the trading cost of holding cash?

8
 e. What is the total cost of holding cash?
Solution:
a. Optimal initial cash balance

( 2T  F )
C* 
K
2  $165,000  52  $48

.06
$823,680,000

.06
 $117 ,166.55
 $117 ,167

b. Optimal average cash balance

C * $117 ,167
  $58,583.50  $58,584
2 2

c. Opportunity cost of holding cash

$58,584  .06  $3,515.04  $3,515

d. Trading cost of holding cash

Number of transfer per year = Annual cash needed / Optimal cash balance
= T/C*
= Br 8,580,000/ Br 117,167
= 73.229
73.229 is the number of transfers per year.
Thus, the trading cost of holding cash equals
= Cost of transfer x Number of transfer per year
=Br48 x 73.229
= Br 3,515
e. Total cost of holding cash
Total cost  Opportunity cost  Trading cost
 $3,515  $3,515
 $7,030

9
Example 2. ABC Company estimates that annual cash usage of Br3.75 million will occur
uniformly throughout the year. The firm's marketable securities earn 12% per year.
ABC's management plans to meet the cash demands by selling the marketable securities
periodically. The transaction cost is Br40.
Instruction: Use the Baumol model to determine the optimal transaction size.
a. What is the optimal cash balance?
b. What is the average cash balance
c. How many transfers per year will be required?
Solution
a. Optimal cash balance(C*)

(2T  F )
C* 
K
2  $3, 750, 000  $40

.12
$300, 000, 000

.12
 $50, 000

b. Average cash balance

Average C* = C*/2= $50,000/2 = $25,000

c. Number of transfers per year

Number of transfers per year = Annual cash flow

C*
=$3,750,000 / $50,000
= 75 transfers

10
Miller- Orr Model. The Miller -Orr model of cash management is one of the various
cash management models in operation. It is an important cash management model as
well. It helps the present day companies to manage their cash while taking into
consideration the fluctuations in daily cash flow.

As per the Miller -Orr Model of cash management, the companies let their cash balance
move within two limits - the upper limit and the lower limit. The companies buy or sell
the marketable securities only if the cash balance is equal to any one of these.

When the cash balances of a company touches the upper limit it purchases a certain
number of salable securities that helps them to come back to the desired level. If the cash
balance of the company reaches the lower level then the company trades its salable
securities and gathers enough cash to fix the problem.

It is normally assumed in such cases that the average value of the distribution of net cash
flows is zero. It is also understood that the distribution of net cash flows has a standard
deviation. The Miller and Orr model of cash management also assumes that distribution
of cash flows is normal.
To use the Miller-Orr model, the manager must do four things:
 Set the lower control limit. It refers to deciding of the minimum possible levels of
desired cash balance
 Estimate the standard deviation of regular cash flows.
 Determine the interest rate.
 Estimate the trading costs at which the salable securities could be sold or bought

The Miller-Orr Model follows:

Z=
1/ 3
 3 F   2 
 4 xI 
 

1/ 3
 3 F   2 
C*  L  
 

 4 xI 


U  3  C*   2  L 

11
 4C *  L
AvgC * 
3
Where Z = the amount of securities that should be converted into cash
when the cash balance hits the lower control limit
U = upper control limit
L = lower control limit (i.e. the minimum cash balance)
F = fixed cost of converting securities into cash
C* = target cash balance
 = the standard deviation of the net cash flows

 2 = the variance of the net cash flows

I = interest rate per period (the opportunity cost of holding cash)
Avg C* =average cash balance

Example 1. The standard deviation of the firm’s cash flows is $ 15,000. The fixed cost of
transferring funds is $ 51 a transfer. The firm has established a lower cash balance limit
of $ 80,000. The weekly interest rate is .067%.
Instruction: Use the Miller-Orr model to answer these three questions:
a. What is the optimal initial cash balance?

b. What is the optimum upper limit?

c. What is the average cash balance?

Solution:
a. Optimal initial cash balance
1/ 3
 3 F   2 

C*  L   

 4 xI 

C*= $ 80,000 +
1/3
 3  $51 $15,0002 
 
 4 x0.00067 

C*=$ 80,000 + $ 23, 417.26

C* = $103,417
b. Optimum upper limit

12
 U *  (3  C *)  ( 2  L)
 (3  $103,417)  ( 2  $80,000)
 $310,251  $160,000
 $150,251

Or computed alternatively
U* = L+3Z
= $ 80,000 + 3($23,417)
= $150,251
U* = C*+2Z
= $ 103417 + 2($23,417)
= $150,251

c. Average cash balance

(4  C*) - L
Average cash balance 
3
(4  $103,417)  $80,000

3
 $111,222.67
 $111,223

Or computed alternatively
Average Cash Balance = L + (4/3) Z
= $ 80,000 + (4/3 x $ 23,417.26)
= $ 111,223
Example 2. Suppose that short-term securities yield 5% per year and it costs the firm Br
50 each time it buys or sells securities. The variance of daily cash flows is Br 100,000
and your bank requires Br 1,000 minimum checking account balance.
Instruction: Use the Miller-Orr model to answer these three questions:
a. What is the optimal initial cash balance?
b. What is the optimum upper limit?

13
 c. What is the average cash balance?
d. Compute the opportunity costs of holding the cash.
Solution:
a. Optimal cash balance
1/ 3
 3  $50  $100, 000 
C*= $ 1,000 +  
 4 x0.05 / 365 
C*= $ 1,000 + $ 3,013.8
C* = $ 4,013.8
b. The upper limit for the cash account (U*) is determined by the equation:

U* = 3C* - 2L
= 3(4,013.8) -2(1,000)
= $10.041.4

c. Opportunity costs of holding cash

Average Cash Balance = L + (4/3) Z
= $ 1,000 + (4/3 x 3,013.8)
= $ 1,000 + $4,018.4
= $ 5,018.4
Opportunity costs = Average C* x Annual interest
= $ 5,018.4 x 0.05= $ 250.92

2.6 Cash Management Strategies

The cash management strategies are intended to minimize the operating balance
requirement. The basic strategies that can be employed are
a. Stretching accounts payable without affecting the credit of the firm
b. Efficient inventory-production management
c. Speedy collection of accounts receivable.

14
Firms can manage cash in virtually all areas of operations that involve the use of cash.
The goal is to receive cash as soon as possible while at the same time waiting to pay out
cash as long as possible.
Ways to Speedup Collections of Cash

o Earlier billing. Accelerate preparation and mailing of invoices through

 computerized billing
 invoices included with shipment
 invoices are faxed
 advance payment requests
o Offering trade discounts
o Obtaining computerized fund transfers from customers
o Using concentration banking. Concentration banking is a means of
accelerating the flow of funds of a firm by establishing strategic collection
centers instead of a single
o Using a lockbox system. In lockbox system
 Customers are instructed to mail their remittances to the lockbox
location.
 Bank picks up remittances several times daily from the lockbox.
 Bank deposits remittances in the customers account and provides a
deposit slip with a list of payments.
 Company receives the list and any additional mailed items.
Ways to slow down cash disbursements
o Delaying the payment of bills
o Using remote disbursement banks. A system in which the firm directs
checks to be drawn on a bank that is geographically remote from its
customer so as to maximize check-clearing time.

15
Example 1. Ramsey Manufacturing uses a continuous billing system that results in an
average receipt of Br 4,000,000. It is contemplating the institution of concentration
banking instead of the current system of centralized billing and collection. It is estimated
that such a system would reduce the collection period of accounts receivable by 2 days.

Concentration banking would cost Br 75,000 annually and 8 percent can be earned by the
firm on its investments. It is also found that a lockbox system could reduce its overall
collection time by 4 days and could cost Br 120, 000 annually.
Instruction:
a. How much cash would be released with the concentration banking system?
b. How much money can be saved due to reduction in the collection period by 2
days? What is the net advantage if the firm implements the concentration
banking system?
c. How much cash would be freed up by lockbox system?
d. Between concentration banking and lockbox system, which is better?

Solution
a. Cash freed up/released by using concentration banking
= average daily receipts x Reduction in collection time
=Br 4,000,000 x 2
=Br 8,000,000
b. Saving by using concentration banking
=Cash freed up X Annual interest
= Br 8,000,000 x 0.08
=Br 640,000
Savings of the concentration banking ……………………. Br 640,000
Costs of the concentration banking ………………………. 75,000
Net advantage of the system…………..……………… Br565,000
c. Cash freed up/released by using lock box system

16
 = average daily receipts x Reduction in collection time
=Br 4,000,000 x 4
=Br 16,000,000
d. Saving by using lock box system
=Cash freed up X Annual interest
= Br 16,000,000 x 0.08
=Br 1,280,000
Savings of using lock box system ……………………. Br 1,280,000
Costs of using lock box system ………………………. 120,000
Net advantage of the system…………..……………Br1,160,000
Therefore, the lock box system is better as compared to the concentration
banking. It has a net Br 595,000 (Br 1,160,000 less Br 565,000) advantage.

Example 2. Century Oil Company uses a continuous billing system that result in average
daily receipts of Br 600,000. The company treasurer estimates that a proposed lockbox
system could reduce its collection time by 2 days.
Instruction:
a. How much cash would the lockbox system free up for the company?
b) What is the maximum amount that Century would be willing to pay for the
lockbox system if it can earn 6% on available short term funds?
c) If the lockbox system could be arranged at annual cost of Br 40,000, what
would be the net gain from instituting the system?
Solution:
a. Cash freed up/released
= average daily receipts x Reduction in collection time
=Br 600,000 x 2
=Br 1,200,000

17
 b. Maximum amount that Century would be willing to pay for the
lockbox system
=Cash freed up X Annual interest
= Br 1,200,000 x 0.06
=Br 72,000
c. Savings of the lockbox system……………………. Br 72,000
Costs of the lockbox system………………………. 40,000
Net advantage of the system…………..………. Br32,000

Example 3 . XYZ presently maintains a centralized billing system at its home office to
handle average daily collections of Br300,000. The total time for mailing, processing, and
clearing is about 5 days.
Instruction:
a. If the opportunity cost on short-term funds is 12%, how much is the time lag of 5
days costing the firm?
b. If the firm designs a lockbox system with a regional bank that will reduce float by
2.5 days and will also reduce the annual expenses of the credit department by
Br30,000, what is the maximum acceptable compensating balance the firm should
be willing to keep?
Solution
a. Annual float = (Br300,000/day × 5 days) = Br1,500,000
Annual cost = (0.12/yr) × Br1, 500,000 = Br180,000/yr
b. Reduced float expense
= (0.12/yr) × (2.5 days × Br300,000/day)
= Br90,000/yr
Total reduced costs = Br90,000/yr + Br30,000/yr = Br120,000/yr

Maximum compensating balances

= (Br120, 000/year) / (0.12/year)
= Br 1,000,000

18
2.7 Investing Surplus Cash

If a firm has a temporary cash surplus, it can invest in short-term securities. The market
for short-term financial assets is called the money market. The maturity of short-term
financial assets that trade in the money market is one year or less.

2.7.1 Temporary Cash Surpluses

Firms have temporary cash surplus for various reasons. Two of the most important are
the financing of seasonal or cyclical activities of the firm and the financing of planned or
possible expenditures.

 Seasonal or cyclical activities. Some firms have a predictable cash flow pattern.
They have surplus cash flows during part of the year and deficit cash flows the rest
of the year. For example, a retail toy firm has a seasonal cash flow pattern
influenced by Christmas. A firm like this may buy marketable securities when
surplus cash occur and sell marketable securities when deficits occur. Of course,
bank loans are another short-term financing device.

 Planned or possible expenditures. Firms frequently accumulate temporary

investments in marketable securities to provide the cash for a plant construction
program, dividend payment, or other large expenditure. Thus, firms may issue
bonds and stocks before the cash is needed, investing the proceeds in short –term
marketable securities and then selling the securities to finance the expenditures.
Also, firms may face the possibility of having to make a large cash outlay. An
obvious example would be the possibility of losing a large lawsuit. Firms may
build up cash surplus against such a contingency.

2.7.2 Types of Short-Term Investment Opportunities

In this section, the more important marketable/near-cash securities available for

investment are briefly discussed. Here, the concern is with money market securities.

19
Money market is the market for short-term financial assets. The maturity of short-term
financial assets that trade in the money market is one year or less.

 Treasury bills: Treasury bills are short-term government securities. Usually, they
are sold at a discount and redeemed at par. The difference is the return on security.
They can be bought & sold any time; thus they have liquidity. Also, they do not
have the default risk.

 Commercial paper. A commercial paper is a promissory note issued by large

financially secure firms/corporations, which have high credit ratings. They are
issued with a maturity of three months to one year. Commercial paper is not
“secured,” which means that the issuer is not pledging any assets to the lender in
the event of default. However, most commercial paper is backed by a credit line
from a commercial bank. Therefore, the default rate on commercial paper is very
low, resulting in an interest rate that is usually lower than what a bank would
charge on a direct loan.

Commercial papers can be sold either directly or through dealers. Companies with
high credit rating can sell directly to investors. The denominations in which they
can be bought vary over a wide range.

 Certificates of deposits: Certificates of deposit (CDs) are short-term loans to

commercial banks. These are marketable receipts for funds that have been
deposited in a bank for a fixed period of time. The CDs are offered by banks on a
basis different from treasury bills, that is, they are not sold at a discount. Rather,
when certificates of deposit mature, the owner receives the full amount deposited
plus the earned interest. The default risk is that of the bank failure, a possibility
that is low most cases.

 Bank deposits: A firm can deposit its temporary cash in a bank for a fixed period
of time. The interest rate depends on the maturity period.

20
 2.7.3 Characteristics of Short-Term Securities

Given that a firm has some temporarily idle cash, there are a variety of short-term
securities available for investing. The most important characteristics of these short term
marketable securities are their maturity, default risk, marketability, and taxability.

 Maturity. Maturity refers to the time period over which interest and principal
payments are due. The longer the maturity, the greater the interest rates risk. As a
consequence, firms often limit their investments in marketable securities to those
maturing in less than 90 days to avoid the risk of losses in value from changing
interest rate.

 Default risk: Default risk refers to the probability that interest and principal will
not be paid in the promised amounts on the due dates. Government and bank
issued securities generally have lowest risk.

 Marketability (liquidity): Marketability refers to how easy it is to convert an

asset to cash; so marketability and liquidity mean much the same thing. Should
unforeseen event require that a significant amount of cash be immediately
available, a sizable portion of the portfolio might have been sold.

 Taxability
 interest income is heavily taxed
 capital gains and dividends are preferred, but these arise on risky
securities
 creative strategies include dividend capture and floating rate preferred
shares

21
Discussion Questions
1. What are the four motives for holding cash?
2. What are the objectives of cash management?
3. What is the cost to the firm of holding excess cash?
4. Discuss the utility of cash budget as a tool of cash management?
5. What is the significance of speedy receivables collection? In this context briefly
explain concentration banking system and lockbox system.
6. What is the benefit from reducing float?
7. What specific strategies can be adapted to slow disbursements of account payable?
8. Which would a firm prefer: a net collection float or a net disbursement float? Why?

Problems

1. Discount Music Stores is evaluating a lockbox system which will reduce float by 3
days. The lockbox system costs Br15,000 per year. The firm’s daily collections
average Br150,000, and its opportunity cost of funds is 6% per year. Should the firm
utilize this lockbox system?

2. Suppose you receive on average 150 daily payments to lock box. Average payment is
Br1200. Daily interest rate is 0.02 percent. Time savings from using lockbox is 1.2

22
 days for mailing and 0.2 days for processing. What is the maximum amount that you
are willing to pay for the lock box? The bank changes for operating the lock box by
the number of checks processed.

3. CB Inc. receives a number of checks each day. The average amount of each check is
Br125:00. Management estimates that mail delay, processing delay, and clearing
delay for these checks are 4 days, 2 days, and 2 days respectively. CB Inc. is
considering implementing a lockbox banking system. The implementation is expected
to reduce mail delay by 2 days, processing delay by 1 day, and clearing delay by 1
day. The cost of the lockbox system includes an annual fee of Br25;000 (payable at
the start of the year) and a per check fee of 2 cents. If the interest rate on short term
marketable securities is 4:5% compounded annually, how many checks does CB Inc.
need to receive each day in order to justify implementing the lockbox system?

4. The daily standard deviation of SSS’s net cash flows is Br40,000. The fixed cost of
converting securities into cash is Br264.50 per conversion. The annual opportunity
cost of funds is 9%. Use 9% / 365 for the daily interest rate. SSS has set a lower
control limit of Br100,000.
Instruction: Using the Miller-Orr Model
a. What would SSS’s upper control limit and return point?
b. What is SSS’s average cash balance?

5. DEF Corp. wishes to manage its cash using the Miller-Orr model. The variance of its
expected daily net cash flow is Br2.5 million. DEF Corp. can invest idle cash at an
annual rate of 7%, pays Br1, 000 commissions on all security transactions, and doesn't
want its cash level to drop below Br100, 000.
Instruction:
a. At which cash level should DEF Corp. invest its idle resources? What
amount should be invested at this level?
b. What is the expected annual opportunity cost of idle resources?

23
24