22-1

The Cash Management Function

Reasons for holding cash
Risk and return
Cash Management Techniques
Paper based versus electronic payment systems
Speeding the inflows
Controlling the outflows
Interactions
International cash management

Cash and Marketable Securities
22-2
Advances in Payment and Information Systems
Electronic payment systems
Electronic data interchange
Determining the Daily Cash Balance
General procedure
Models for determining the target cash balance
Management of the Marketable Securities
Portfolio
Investment alternatives
Selection criteria
The marketable securities portfolio

Cash and Marketable Securities
(concluded)
22-3
Cash refers to currency on hand plus demand
deposits
Marketable securities are the short-term investments
the firm may temporarily hold that can be quickly
converted into cash

There are three main questions relate to liquid asset
management
How should the firm design its cash-gathering and cash-
disbursing systems?
How should the investment in liquid assets be split
between cash and marketable securities?
How should marketable securities be managed?

The Cash Management Function
assets Liquid securities Marketable Cash = +
22-4
Transaction purposes
Cash is needed to meet requirements as monthly bill
payments, tax payments, cash dividend payments, and
salaries
Hedge against uncertainty
Marketable securities and lines of credit provide
liquidity for unexpected needs, thus, financial slack is
the second reason for holding cash
The Cash Management Function
Reasons for Holding Cash
22-5
Flexibility
Liquidity is useful for weathering bad times when
credit is tight and also in anticipation of taking
advantage of unforeseen opportunities ( growth
options), quickly and easily
Compensating balance requirement
As compensation for lines of credit and other bank
services, firms agree that a compensating balance be
left in a chequing account
The Cash Management Function
Reasons for Holding Cash
(concluded)
22-6

Risk from holding too little cash
Bill payment may have to be deferred
Capital expenditures curtailed
Expensive short-term financing obtained
Growth opportunities bypassed
In an extreme case, the firm may have to file for
protection under the Bankruptcy Act or be forced into
liquidation


The Cash Management Function
Risk and Return
22-7
Risk and return tradeoff for liquid assets involves
Having enough cash and liquid reserves (or financial
slack), in the form of marketable securities and/or lines
of credit, to meet all the firm's obligations and take
advantage of growth opportunities
Not holding excess liquid reserves, because investment
in long-term assets generally provides higher returns
than short-term investments
Maintaining a minimum cash balance while actively
managing the firm's portfolio of marketable securities
to ensure as high a return as possible commensurate
with the risk involved


The Cash Management Function
Risk and Return
(concluded)
22-8
The goal of the cash gathering system is to speed
collections to the level where the increased benefits
equal the increased costs
The goal of the cash disbursement system is to
control and slow down the outflow of cash without
hurting the firm's credit rating
The two decisions cannot be made in isolation--
joint effects, costs, and benefits must be considered
in order to create an efficient cash management
system that balances risk and returns

Cash Management Techniques
22-9
2002 Pearson Education Canada Inc., Toronto, Ontario
In Canada and the U. S. the major means of
making non-cash payments is through cheques
Giro systems
Are employed in most European countries for smaller
transactions, are often run by the postal service and
operate on the basis of direct debits and credits
A seller sends an invoice including a giro acceptance that
is encoded with the seller's bank and account number to
the buyer, the buyer signs the stub, takes it to the local
post office, transmits the information through the
girobank
Cash Management Techniques
Paper Based versus Electronic Payment Systems
22-10
Float
Is the time that elapses from the writing of a cheque
until the recipient receives the funds and can draw upon
them
Mail float
The length of time it takes a firm to receive a cheque
after it is mailed by a customer
Processing float
Is the time that elapses between when the selling firm
receives the cheque and when it deposits the cheque in
its bank
Cash Management Techniques
Speeding the Inflows
22-11
Transit float
Is the time required for the cheque to clear through the
banking system until the recipient can draw upon it
The Bank of Canada and the Canadian Payments
Association are responsible for clearing cheques
through the Canadian payments system
When a firm deposits a customer's cheque into its bank
account, before the firm has access to these funds, the
Canadian payments system must verify that the funds
are in the customer's account, and then it transfers the
funds to the firm's bank account via the Bank of Canada
Cash Management Techniques
Speeding the Inflows
(continued)
22-12
To facilitate this process, the payments system has 10
settlement or clearing centers located in 10 major cities
across Canada, connected to each other and the Bank of
Canada by computer
This computerized network keeps transit float to a
minimum by providing same-day settlement on
cheques
Decentralized collections
Decentralized collections in various parts of the country
can reduce mail float
Cash Management Techniques
Speeding the Inflows
(continued)
22-13
Local offices can receive payments and deposit them in
a local branch of the firm's bank
Benefits: keep mail float to a minimum
Costs: personnel, equipment, and space
Lockboxes (post office boxes) can be set up in specific
cities and customers required to mail their payments to
the closest one. A bank picks up the mail several times
a day for clearance
Benefits: keep mail float to a minimum, reduce the
processing float
Cost: fees charged by the bank either directly or through
a compensating balance agreements


Cash Management Techniques
Speeding the Inflows
(continued)
22-14
The purpose of both local office and lockbox collection
points is to keep mail float to a minimum
Managers must weight the costs of using these systems versus
the benefits of reduced mail float
Banking network
Large firms use a tiered banking network by employing
more than one bank
Local offices process cheques and then deposit them to local
bank branches who, in turn, make a transfer to the firm's head
office account at its central concentration branch
Lockboxes are maintained by a regional bank branch,
forwards the funds to the firm's central concentration branch,
and sends the supporting documents to the firm
Cash Management Techniques
Speeding the Inflows
(continued)
22-15
Funds at the firm's central concentration bank can be
used to meet the cash outflows of the firm, any extra
funds can be quickly invested in marketable securities or,
if the firm is short of cash, it can draw on its lines of
credit
Other approaches
Special handling
Such as a hired courier
Preauthorized cheques
The customer authorizes the firm to draw cheques
directly on the customer's demand deposit account
Cash Management Techniques
Speeding the Inflows
(continued)
22-16

Receipt of payment required
The firm demands payment by a certain date
Customer wants to take advantage of a cash discount
Receipt of payment approach eliminates mail float

Payment by an electronic transfer
This also eliminates float
Cash Management Techniques
Speeding the Inflows
(continued)
22-17
Analysis of cash-gathering techniques
Compares the incremental costs with the incremental
benefits

Cash Management Techniques
Speeding the Inflows
(continued)
rate tax marginal s Firm' T
rate interest Daily I
on transacti the of Size TS
changed is float that days) (in Time t
method existing an to compared method new a of
benefits tax - after l Incrementa B
method existing an to compared method new a of
costs tax - after l Incrementa C
where
T) - )(1 t)(TS)(I ( benefits tax - After B
costs tax - After C
daily
daily
=
=
=
= A
= A
= A
A = = A
= A
22-18
Decision criteria





An NPV approach
is simply NPV where there is no discounting,
due to the short time periods involved
Cash Management Techniques
Speeding the Inflows
(continued)
t indifferen are you B, C If
method proposed the switch to B, C If
method present the stay with B, C If
A = A
A < A
A > A
C B A A
22-19
Lockbox example
You estimate that the reduction in float (both mail and
processing) will be 3 days, the average cheque size is
$500, the yearly rate of interest is 10 percent, and T =
40 percent. Using Equation 22.1, what is the
approximate per unit benefits of the lockbox?
Answer:




To convert from a per unit basis to a daily basis multiply
average cheque size by the number of cheques per day

Cash Management Techniques
Speeding the Inflows
(continued)
$0.24658
0.60) 0.10/365)( (3)($500)(
T) - )(1 t)(TS)(I ( B
daily
=
=
A = A
22-20
To convert per day figures to per year figures
Convert daily volume to a yearly basis by multiplying
the daily volume (TS) by 365 OR
Convert the daily interest rate to a yearly rate by
multiplying by 365
Suppose there are 300 cheques per day and the present
cost per day is $158. Should the firm change to
lockboxes?
Answer:

Cash Management Techniques
Speeding the Inflows
(continued)
change not should firm the Thus,
$73.97 4658) (300)($0.2 B
or $73.97 ) days)(0.60 365 300)(0.10/ (3)($500)( B
$94.80 0.40) - $158(1 C
= = A
= = A
= = A
22-21
What if the after-tax cost is $24,000 per year, should
the firm now change?
Answer:





Now, the firm should change.

Cash Management Techniques
Speeding the Inflows
(continued)
( )
( )( )( )( ) $27,000 0.60 10 . 0 $150,000 3 B
or
$27,000 97) (365)($73. B
or
$27,000 (0.60) (0.10/365) $150,000 (3)($365) B
= = A
= = A
= = A
22-22

If we already know what the incremental costs, C, are
then we must determine what the reduction in the float
time, t, the average size, TS, or the yearly interest
rate, I, would have to be for us to be indifferent
between the two methods.


Cash Management Techniques
Speeding the Inflows
(concluded)
) t)(TS)(I ( C
B C
daily
A = A
A = A
A
A
22-23
The firm's cash-disbursement system should be
designed so the firm pays just before the due date
Controlled disbursing
Canada's branch banking system leaves little
opportunity to extend the length of time a cheque takes
to be cleared
Canadian banks provide firms with cash on the same
day that the cheques are deposited, even though it takes
24 hours for them to clear
Cash Management Techniques
Controlling the Outflows
22-24
Although Canadian firms can set up a controlled
disbursing system to increase mail float by mailing
cheques to suppliers from a distant location, the
wisdom of such actions is questionable
The firm increase its cash level but, at the same time,
creates ill will among suppliers who will be without
payment for an additional number of days
The better thing to do is to design a system that calls for
the timing of payments so that they arrive at suppliers
just before the due date or just before any discounts
expire
Cash Management Techniques
Controlling the Outflows
(continued)
22-25
Zero balance accounts
Zero balance accounts are like individual demand
deposit accounts, except they contain no funds
Zero balance accounts at the firm's central
concentration branch allow all of the firm's divisions to
drawn on individual disbursing accounts at the
concentration branch
This creates negative balances that are restored to zero by
a credit from the firm's positive balance master account
at the central concentration branch at the end of each day
Excess cash balances do not build up
Allow much more control, while maintaining divisional
autonomy for payments

Cash Management Techniques
Controlling the Outflows
(continued)
22-26
Other approaches
Centralized payables
Invoices are received and verified at the divisional level
but actually paid at the firm's headquarters
Timing cheque issuance
By issuing cheques at certain times during the week, the
firm may increase its mail or transit float
Cash Management Techniques
Controlling the Outflows
(concluded)
22-27
In medium- to large-size firms, with various plants
and offices, gathering and disbursing problems
quickly become complex
If the firm decides to employ lockboxes and/or have
collections made by local offices, numerous bank
branches and possibly more than one bank will be
involved
In the end the two decisions, gathering and disbursing,
cannot be made in isolation. Rather, their joint effects,
costs, and benefits must be considered in order to create
an efficient cash management system that balances the
risks and returns involve
Cash Management Techniques
Interactions
22-28

Some of the major international money movement
techniques are
Concentration banking
To control the flow of funds internationally, firms
concentrate their cash at a single bank within a country
or on a regional level within a zero balance type of
procedure
International transfer
Using banks, firms can arrange for same-day settlement
or other kinds of settlement procedures when funds move
across country borders

Cash Management Techniques
International Cash Management
22-29
International lockbox
This technique involves establishing one or more
lockboxes in a country so that payments can be settled in
the country where the currency is legal tender
Intracompany netting
Many firms have large sums of money tied up in
intracompany transactions so to avoid the physical
transfer of funds they "net" the funds flowing between
subsidiaries once a month
In addition, because of fluctuating foreign exchange
rates, many firms follow a practice of leading or
lagging
Cash Management Techniques
International Cash Management
(concluded)
22-30
Electronic payment systems
Electronic payment systems or electronic funds
transfer, EFT, replaces paper cheques with an electronic
payment system, e. g., debit cards
Firms using this system are able to eliminate accounts
receivables and to have virtually immediate use of the
cash
Essentially eliminate float

Advances in Payment and Information Systems
22-31
Electronic data interchange (EDI)
EDI, affects everything from the ordering and
manufacturing cycle to the flow of documents related to
shipment and payment
EDI refers to the exchange of all transaction-related
information between two firms in computer-readable
form
Interfacing EDI with EFT enables firms to move from a
paper based system to a non-paper based system

Advances in Payment and Information Systems
(concluded)
22-32
Firms want to keep as little cash in demand
deposits as possible, they would rather have the
funds invested in a marketable securities portfolio
How should the investment in liquid assets be split
between cash and marketable securities?
Five step general procedure
Prepare cash budgets on a monthly basis
Break out major cash items such as taxes, dividends,
lease payments, interest, wages into cash inflows and
outflows
Determining the Daily Cash Balance
General Procedure
22-33
Identify the timing of the major inflows and outflows for
the month so you can estimate when daily transfers into
or out of the marketable securities portfolio may be
necessary
Use modeling to predict routine inflows and outflows to
detect cash surpluses and cash needs
Compare the actual routine cash inflows and outflows
with those projected to evaluate the planning process and
to fine-tune it
The goal is to maintain the actual cash balance at some
predetermined level
Determining the Daily Cash Balance
General Procedure
(continued)
22-34
Determining the Daily Cash Balance
General Procedure
(continued)
Model for estimating and controlling firms cash
balance
Actual cash
balance
Daily forecasting
model for routine
inflows and outflows
Actual major cash
inflows and outflows
Marketable
securities
portfolio
Actual routine
inflows and
outflows
Routine
items
Major
items
Monthly
cash
budget
22-35
Daily cash balance example
Suppose it costs $35.71 to move funds into or out of the
marketable securities portfolio, the incremental interest
from having funds in marketable securities is 6%, and T
= 30%. What should be the average size of a transaction
(TS)?
Answer:


Determining the Daily Cash Balance
General Procedure
(continued)
have we TS, for Solving interest. in gain s day' 1 as
specified is t and $25 0.30) - $35.71(1 C where
T) - Idaily)(1 t)(TS)( ( C
B C
A = = A
A = A
A = A
22-36


Thus, there is $217,262 that can be left in marketable
securities for at least 1 day before the transfer is made

If we estimate, based on our daily cash balance model,
that funds can be transferred from cash to marketable
securities and left for 4 days, should the transfer be
made if there is $60,000 in excess funds?
Answer:


In this case the transfer should be made.
Determining the Daily Cash Balance
General Procedure
(concluded)
262 , 217 $ TS
0.30) - )(1 1(0.06/365
$25
= =
315 , 54 $ TS
0.30) - )(1 4(0.06/365
$25
= =
22-37
Miller-Orr model
Cash inflows and outflows are assumed to be uncertain
and fluctuate randomly day-to-day, i. e., the distribution
of the daily net cash flow is normally described
Model sets upper and lower control limits and a target
cash balance
The lower cash balance is set by management
The following variables are needed for the model

Determining the Daily Cash Balance
Models for Determining the Target Cash Balance
limit control Lower L
limit control Upper H
balance cash Target Z
=
=
=
22-38







Upper control limit = H = 3Z - 2L
Average cash balance = (4Z - L)/3
Determining the Daily Cash Balance
Models for Determining the Target Cash Balance
(continued)
flows cash daily net the of Variance
basis daily a on cash holding of cost y Opportunit k
securities selling or buying of cost Fixed F
2
daily
=
=
=
o
L
4k
3F
Z balance cash Target
3 / 1
daily
2
+
(
(

= =
o
22-39

Miller-Orr model example
M-O Ltd. has a lower control limit, L = $2,000, F =
$200, k = 0.09 per year, and the standard deviation, ,
of the daily cash flows is $3,000.
The daily compound opportunity cost is



The variance of the net daily cash flows is


Determining the Daily Cash Balance
Models for Determining the Target Cash Balance
(continued)
( ) 0.000236 1 (1.09) k 0.09 1 k 1
1/365
365
daily
= = = +
$9,000,000 ($3,000)
2 2
= =
o
22-40
The target cash balance is




The upper control limit is

H = 3($19,884.38) - 2($2,000) = $55,653.14

The average cash balance is

[4($19,884.38) - $2,000]/3 = $25,845.84
Determining the Daily Cash Balance
Models for Determining the Target Cash Balance
(continued)
$19,884.38
000 , 2 $
) 4(0.000236
00,000 3(200)$9,0
Z
3 / 1
=
+
(

=
22-41
Assumptions for the Miller-Orr model
Daily cash flows are random and cannot be predicted
Transfers to and from marketable securities are
instantaneous
Seasonal and/or cyclical trends are not considered
The cost of buying or selling securities is fixed
regardless of the size of the transaction
The term structure of interest rates is flat and the level of
interest rates does not change


Determining the Daily Cash Balance
Models for Determining the Target Cash Balance
(continued)
22-42
Miller-Orr model works reasonably well if
The distribution of net daily cash flows is approximately
normal
The cash flows are random from day-to-day
Only one source of investment is available
Stone look ahead model
Similar to the Miller-Orr model, except it focuses on
managing cash balances instead of determining the
optimal transaction size
Uses upper and lower control limits, but "looks ahead"
a few days at the anticipated cash balances
Determining the Daily Cash Balance
Models for Determining the Target Cash Balance
(concluded)
22-43
Funds which represent very temporary excess cash
are invested in marketable securities

Funds that are not likely to be needed for a long
period of time will be invested in long-term
instruments

Long-term bonds or common stock generally are
not part of the marketable securities portfolio
Management of the Marketable
Securities Portfolio
22-44
Short-term investment alternatives include
Treasury bills
Short-term obligation of the federal government
Bankers' acceptances
Promissory note for payment by a corporation and
guaranteed by a bank
Commercial paper
Short-term promissory note issued by a corporation
Sales finance paper
Short-term paper issued by finance companies

Management of the Marketable
Securities Portfolio
Investment Alternatives
22-45
Repurchase agreements
Dealer sells government securities and agrees to
repurchase on a set date
Bank certificates of deposit
Promissory note from a bank or trust to repay a deposit
Negotiable certificates of deposit
Promissory note from a bank or trust company to repay a
deposit
Eurodollar
Dollar-denominated time deposits at foreign banks
Money market mutual funds
Pool of money market instruments
Management of the Marketable
Securities Portfolio
Investment Alternatives
(concluded)
22-46
The firm's risk-return posture determines the
specific composition of the marketable securities
portfolio after taking into consideration the
interaction of
Risk
Liquidity
Because firms use their marketable securities portfolio as
a source of ready cash, the liquidity aspect of the
investment also requires careful consideration
Management of the Marketable
Securities Portfolio
Selection Criteria
22-47
Maturity
Most large firms keep some cash invested overnight in
repurchase agreements and other shorter-maturity
securities
Then they follow a layered approach of matching longer
cash availability with investments in longer term
marketable securities
Yield
Treasury bills, are the least risky of the securities and
consequently always have the lowest yield
Other securities have higher returns, depending on their
risk and liquidity
Management of the Marketable
Securities Portfolio
Selection Criteria
(continued)
22-48

Yields on three-months money market instruments

Management of the Marketable
Securities Portfolio
Selection Criteria
(continued)
Year
Instrument 1995 1996 1997 1998 1999
Treasury bills 7.05 4.21 3.20 4.72 4.69
Bankers' acceptances 7.15 4.34 3.60 5.04 4.91
Commercial paper 7.19 4.50 3.61 5.15 5.02
Source: CANSIM series B14060, B14057 and B114010.
22-49
T-Bill pricing example
Suppose you purchase a 182-day treasury bill with a
face value of $10,000 at a price of $9,400. What is your
bond equivalent yield?
Answer:




Management of the Marketable
Securities Portfolio
Selection Criteria
(continued)
12.03%
182
365
$10,000
$9,400 - $10,000
k
maturity until days of Number n
price Discounted P
bill Treasury the of alue Maturity v P
yield equivalent Bond k
where
n
365
P
P P
k
BE
0
M
BE
0
0 M
BE
=
|
.
|

\
|
|
.
|

\
|
=
=
=
=
=
|
.
|

\
|
|
|
.
|

\
|

=
22-50

If you are told that the bond equivalent yield on a 182-
day $10,000 T-Bill was 9.8%. How much should you
pay?
Answer:




If you buy the 182-day T-Bill for $9,534.11 and hold it
until maturity your bond equivalent yield is 9.8%.


Management of the Marketable
Securities Portfolio
Selection Criteria
(continued)
$9,534.11
365
182
0.098 1
$10,000
365
n
k 1
P
P
BE
M
0
=
|
.
|

\
|
+
=
|
.
|

\
|
+
=
22-51

What happens if you are forced to sell after 60 days,
when the bond equivalent yield at that time is 10%.
What will be the actual bond equivalent yield received?
Answer:
Using Equation 22.5 you must first determine the price
of the treasury bill with 122 (i.e., 182 - 60) days to
maturity as follows
Management of the Marketable
Securities Portfolio
Selection Criteria
(continued)
56 . 676 , 9 $
365
122
10 . 0 1
000 , 10 $
P
0
=
|
.
|

\
|
+
=
22-52

Then the actual bond equivalent yield over the 60 days
the treasury bill was owned can be determined

Management of the Marketable
Securities Portfolio
Selection Criteria
(concluded)
( )( )
( )( )
( )( )
( )( )
% 09 . 9
60 $9,534.11
365 $9,534.11 - $9,676.56
owned Days price Purchase
365 price Purchase - price Selling
k
BE
=
=
=
22-53
Management of the Marketable
Securities Portfolio
The Marketable securities Portfolio
The interaction of risk, liquidity, and maturity
determines the returns
The firm's risk-return posture then determines the
specific composition of the marketable securities
portfolio
Very risk-averse firms might have a marketable
securities portfolio composed almost entirely of
treasury bills
More aggressive firms will opt for a large portion in
higher-yielding Eurodollars or certificates of deposit
issued by overseas branches of Canadian-based banks