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    Ross 7 e CH 27

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    Meddy Yogastoro
    The document summarizes chapter 27 of a corporate finance textbook on cash management. It covers reasons for holding cash, models for determining optimal cash balances like the Baumol and Miller-Orr models, managing cash collections and disbursements, investing idle cash, and provides concluding remarks on cash management. The chapter uses examples, equations, and diagrams to explain key concepts in cash management.

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    Ross 7 e CH 27

    Uploaded by

    Meddy Yogastoro
    54 views29 pages
    The document summarizes chapter 27 of a corporate finance textbook on cash management. It covers reasons for holding cash, models for determining optimal cash balances like the Baumol and Miller-Orr models, managing cash collections and disbursements, investing idle cash, and provides concluding remarks on cash management. The chapter uses examples, equations, and diagrams to explain key concepts in cash management.

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    The document summarizes chapter 27 of a corporate finance textbook on cash management. It covers reasons for holding cash, models for determining optimal cash balances like the Baumol and Miller-Orr models, managing cash collections and disbursements, investing idle cash, and provides concluding remarks on cash management. The chapter uses examples, equations, and diagrams to explain key concepts in cash management.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    54 views29 pages

    Ross 7 e CH 27

    Uploaded by

    Meddy Yogastoro
    The document summarizes chapter 27 of a corporate finance textbook on cash management. It covers reasons for holding cash, models for determining optimal cash balances like the Baumol and Miller-Orr models, managing cash collections and disbursements, investing idle cash, and provides concluding remarks on cash management. The chapter uses examples, equations, and diagrams to explain key concepts in cash management.

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    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
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    You are on page 1of 29

    27-0

    CHAPTER

    27
    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    Cash Management
    McGraw-Hill/Irwin Corporate Finance, 7/e

    27-1

    Chapter Outline
    27.1 Reasons for Holding Cash 27.2 Determining the Target Cash Balance 27.3 Managing the Collection and Disbursement of Cash 27.4 Investing Idle Cash 27.5 Summary & Conclusions

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-2

    27.1 Reasons for Holding Cash


    Transactions motive Compensating balances

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-3

    27.2 Determining the Target Cash Balance


    The Baumol Model The Miller-Orr Model Other Factors Influencing the Target Cash Balance

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-4

    Costs of Holding Cash


    Costs in dollars of holding cash

    Trading costs increase when the firm must sell securities to meet cash needs.
    Total cost of holding cash

    Opportunity Costs The investment income foregone when holding cash.


    Trading costs C*
    McGraw-Hill/Irwin Corporate Finance, 7/e

    Size of cash balance


    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-5

    The Baumol Model


    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, a.k.a. the interest rate.

    C
    C 2

    If we start with $C, spend at a constant rate each period and replace our cash with $C when we run out of cash, our average cash balance will be C . 2 The opportunity cost C C of holding is K 2 2

    1
    McGraw-Hill/Irwin Corporate Finance, 7/e

    Time

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-6

    The Baumol Model


    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, a.k.a. the interest rate.

    C
    C 2

    As we transfer $C each period we incur a trading cost of F each period. If we need $T in total over the planning period we will T pay $F times. C T Time The trading cost is F C
    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    1
    McGraw-Hill/Irwin Corporate Finance, 7/e

    27-7

    The Baumol Model


    C T Total cost K F 2 C

    C K Opportunity Costs 2

    Trading costs T F

    C* Size of cash balance The optimal cash balance is found where the opportunity costs equals the trading costs
    McGraw-Hill/Irwin Corporate Finance, 7/e

    C*

    2T F K

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-8

    The Baumol Model


    The optimal cash balance is found where the opportunity costs equals the trading costs Opportunity Costs = Trading Costs

    C T K F 2 C
    Multiply both sides by C

    C K T F 2

    T F C 2 K
    2

    2TF C K
    *
    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    McGraw-Hill/Irwin Corporate Finance, 7/e

    27-9

    The Miller-Orr Model


    The firm allows its cash balance to wander randomly between upper and lower control limits. $ When the cash balance reaches the upper control limit H cash
    is invested elsewhere to get us to the target cash balance Z.

    H
    When the cash balance reaches the lower control limit, L, investments are sold Z to raise cash to get us up to the target cash balance. L

    Time
    McGraw-Hill/Irwin Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-10

    The Miller-Orr Model Math


    Given L, which is set by the firm, the Miller-Orr model solves for Z and H
    * *

    H 3Z 2L 3F 2 Z* 3 L 4K where s2 is the variance of net daily cash flows. The average cash balance in the Miller-Orr model is 4Z * L Average cash balance 3
    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    McGraw-Hill/Irwin Corporate Finance, 7/e

    27-11

    Implications of the Miller-Orr Model


    To use the Miller-Orr model, the manager must do four things:
    1. Set the lower control limit for the cash balance.

    2. Estimate the standard deviation of daily cash flows.


    3. Determine the interest rate. 4. Estimate the trading costs of buying and selling

    securities.

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-12

    Implications of the Miller-Orr Model


    The model clarifies the issues of cash management:
    The best return point, Z, is positively related to trading costs, F, and negatively related to the interest rate K. Z and the average cash balance are positively related to the variability of cash flows.

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-13

    Other Factors Influencing the Target Cash Balance


    Borrowing
    Borrowing is likely to be more expensive than selling marketable securities. The need to borrow will depend on managements desire to hold low cash balances.

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-14

    Other Factors Influencing the Target Cash Balance


    Compensating Balance
    Firms have cash in the bank as a compensation for banking services. Large corporations have thousands of accounts with several dozen bankssometimes it makes more sense to leave cash alone than to manage each account on a daily basis.

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-15

    Float
    The difference between bank cash and book cash is called float. Float management involves controlling the collection and disbursement of cash.

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-16

    27.3 Managing the Collection and Disbursement of Cash


    Accelerating Collections Delaying Disbursements Disbursement Float Zero-Balance Accounts Drafts Ethical and Legal Questions

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-17

    Accelerating Collections
    Customer mails payment Company receives payment Company deposits payment Cash received

    time
    Mail delay Processing delay Clearing delay

    Mail float

    Processing float

    Clearing float

    Collection float
    McGraw-Hill/Irwin Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-18

    Overview of Lockbox Processing


    Corporate Customers Corporate Customers Corporate Customers Corporate Customers

    Post Office Box 1

    Local Bank Collects funds from PO Boxes Envelopes opened; separation of checks and receipts

    Post Office Box 2

    Details of receivables go to firm

    Deposit of checks into bank accounts

    Firm processes receivables


    McGraw-Hill/Irwin Corporate Finance, 7/e

    Bank clears checks


    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-19

    Delaying Disbursements
    Firm prepares check to supplier Post Office processing

    1. Write check on a distant bank. 2. Hold payment for several days after

    Delivery of check to supplier

    Deposit goes to suppliers bank

    postmarked in office. 3. Call supplier firm to verify statement accuracy for large amounts. 4. Mail from distant post office. 5. Mail from post office that requires a great deal of handling.
    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    Bank collects funds


    McGraw-Hill/Irwin Corporate Finance, 7/e

    27-20

    Drafts
    Firms sometimes use drafts instead of checks. Drafts differ from checks because they are not drawn on a bank but on an issuer (the firm) and are payable by the issuer. The bank acts only as an agent, presenting the draft to the issuer for payment. When the draft is transmitted to a firms bank for collection, the bank must present the draft to the issuing firm for acceptance before making payment. After the draft has been accepted, the firm must deposit the necessary cash to cover the payments. This allows the firm to keep less cash on hand.

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-21

    Ethical and Legal Questions


    The financial managers must always work with collected company cash balances and not with the companys book balance, which reflects checks that have been deposited but not collected. If you are borrowing the banks money without their knowledge, you are raising serious ethical and legal questions.
    McGraw-Hill/Irwin Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-22

    27.4 Investing Idle Cash


    A firm with surplus cash can park it in the money market.
    Some large firms and many small ones use money market mutual funds.

    Firms have surplus cash for three reasons:


    Seasonal or Cyclical Activities Planned Expenditures Different Types of Money Market Securities
    McGraw-Hill/Irwin Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-23

    Seasonal Cash Demands


    Total Financing needs Bank loans Marketable securities Short-term financing

    Long-term financing J
    McGraw-Hill/Irwin Corporate Finance, 7/e

    Time

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-24

    27.5 Summary & Conclusions


    A firm holds cash to conduct transactions and to compensate banks for the various services they render. The optimal amount of cash for a firm to hold depends on the opportunity cost of holding cash and the uncertainty of future cash inflows and outflows.

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-25

    27.5 Summary & Conclusions


    Two transactions models that provide rough guidelines for determining the optimal cash postion are:
    The Miller-Orr model The Baumol model

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-26

    27.5 Summary & Conclusions


    The firm can make use of a variety of procedures to manage the collection and disbursement of cash in such as way as to speed up the collection of cash and slow down payments.

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-27

    27.5 Summary & Conclusions


    Some methods to speed collections are
    Lockboxes Concentration banking Wire transfers

    The financial managers must always work with collected company cash balances and not with the companys book balance.

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

    27-28

    27.5 Summary & Conclusions


    If you are borrowing the banks money without their knowledge, you are raising serious ethical and legal questions. The answers to which you probably know by now.

    McGraw-Hill/Irwin Corporate Finance, 7/e

    2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

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