Chapter 20

•Cash and Liquidity

Management

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Key Concepts and Skills
• Understand how firms manage cash
• Understand float
• Understand how to accelerate collections
and manage disbursements
• Understand the characteristics of various
short-term securities
• Appendix: Be able to use the BAT and
Miller-Orr models and understand the
different assumptions
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 Chapter Outline
• Reasons for Holding Cash
• Understanding Float
• Cash Collection and Concentration
• Managing Cash Disbursements
• Investing Idle Cash
• 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
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 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
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 Understanding Float
• Float – difference between cash balance
recorded in the cash account and the cash
balance recorded at the bank
• Disbursement 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
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 Example: Types of Float
• You have $3000 in your checking account.
You just deposited $2000 and wrote a
check for $2500.
• 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?

20-6
 Example: Measuring Float
• Size of float depends on the dollar amount and the
time delay
• Delay = mailing time + processing delay +
availability delay
• Suppose you mail a check for $1000 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)(1000)/30 = 166.67
• Method 2: (5/30)(1000) + (25/30)(0) = 166.67

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 Example: Cost of Float
• 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
• 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

20-8
 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.

20-9
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.
• Collection time will be reduced by 2 days on average
• Daily interest rate on T-billls = .01%
• Average number of daily payments to each lockbox is
5000
• 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.
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Example: Accelerating Collections –
Part II
• Benefits
• Average daily collections = 3(5000)(500) = 7,500,000
• Increased bank balance = 2(7,500,000) = 15,000,000
• Costs
• Daily cost = .1(15,000) + 3*10 = 1530
• Present value of daily cost = 1530/.0001 = 15,300,000
• NPV = 15,000,000 – 15,300,000 = -300,000
• The company should not accept this lock-box
proposal

20-11
 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

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 Investing Cash
• Money market – financial instruments with
an original maturity of one year or less
• 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
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Figure 20.6

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 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
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 Quick Quiz
• What are the major reasons for holding
cash?
• What is the difference between
disbursement float and collection float?
• How does a lock box system work?
• What are the major characteristics of short-
term securities?

20-16
Chapter 20

•End of Chapter

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.