Working Capital Management

By Assoc. Prof. VO THI QUY

9/19/2016

Assoc. Prof. Vo Thi Quy

Corporate Valuation and Working

Capital Management

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Assoc. Prof. Vo Thi Quy

Cash Managegement and Fraud

preventation
Lecture 2

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Key Concepts and Skills

Understand the importance of float
and how it affects the cash balance
Understand how to accelerate
collections and manage disbursements
Understand the advantages and
disadvantages of holding cash and
some of the ways to invest idle cash

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Contents

Forms of Cash
Reasons for Holding Cash
Understanding Float
Cash Collection and Concentration
Managing Cash Disbursements
Investing Idle Cash
Lock boxing
Bank Products Used for Electronic Transactions

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Form of cash
Bank cash or float
Bank line of credit
Marketable securities (cash equivalents)

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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

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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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Float
Time exists between the moment a check is
written and the moment the funds are deposited in
the recipients account
This time spread is called Float
Payment Float: Check written by a company that
have not yet cleared.
Availability Float: Check already deposited that
have not yet cleared.
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Float
Payment Float illustration : The company issues a $200,000
check that has not yet cleared
Companys ledger balance
+
$800,000

Payment float
$200,000

equals

Banks ledger balance

$1,000,000
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Float
Availability Float illustration: The company deposit
a $120,000 check that has not yet cleared.
Companys ledger balance
+
$920,000

Payment float
$200,000

equals
Banks ledger balance
$1,120,000
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Float
Net Float illustration:
Net float = payment float availability float
Banks ledger balance
$ 1,120,000
equals
Available balance
$ 1,000,000
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Availability float
$120,000

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Valuing Float
Playing the float: The process of accelerating
your deposit and delaying your payments, so as
to generate more net float.

Example: What is the value to Ford Motor

company if they can increase their net float by
1 day? We can assume that their daily average
sales is $ 250 mil and they earn .02% per day
(7.3 % annually) on their float.
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Valuing Float
Example: What is the value to Ford Motor company if
they can increase net float 1 day? We can assume that
their daily average sales is $250 mil and they earn 0.2
% per day (7.3 annually) on their float.
Extra daily earnings due to float
0.0002 * $ 250 mil = $ 50,000 per day
Perpetuity value of extra float earnings
$50,000 per days

0.0002
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= $250,000,000

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Managing Float
Payers attempt to create delays in the check
clearing process.
Recipients attempt to remove delays in the check
clearing process
Sources of delay
Time it take to mail check
Time for recipient to process check
Time for bank to check

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Managing Float
Check mailed
Mail float

Check received
Processing float

Availability
float

Check deposited
Presentation float

Cash available
to recipient
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Check charged to
payers account
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Managing Float
Concentration
Banking:
System
whereby
customers maker payments to regional collection
center which transfer the fund to a principal bank.
Lock box system: System where by customers send
payments to a post office box and local bank
collect and processes checks.
Zero Balance Accounts: Regional bank accounts
to which just enough funds are transferred daily to
pay each days bills.
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Example: Types of Float

You have $3,000 in your checking account which is also
reflected in your books. You just deposited $2,000 and wrote a
check for $2,500.
What is the collection float?
For the check deposited: Float = available balance book balance = $2,000

What is the disbursement float?

For the check written: Float = available balance book balance=
$2500

What is the net float?

Net float = 2500 2000 = $500

What is your book balance?

Book balance = $3000 + 2000 2500 = $2500

What is your available balance?

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Available

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balance = $3000

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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 each month for $1,000
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)(1,000)/30 = 166.67
Method 2: (5/30)(1,000)
= 166.67
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Example: Cost of Float

Cost of float is the 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
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Cash Collection
Payment
Mailed

Payment
Received

Mailing Time

Payment
Deposited

Processing Delay

Cash
Available

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.

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Example: Accelerating Collections Part I

Your company does business nationally, and currently, all
checks are sent to the headquarters in Kuala Lumpur. You are
considering a lock-box system that will have checks
processed in three different states: Johor, Penang and
Sarawak. The Kuala Lumpur office will continue to process
the checks it receives in house.

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Collection time will be reduced by 2 days on average

Daily interest rate on government bills = .01%
Average number of daily payments to each lockbox is 5,000
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(5,000)(500) = 7,500,000
Increased bank balance = 2(7,500,000) = 15,000,000

Costs
Daily cost = .1(15,000) + 3*10 = 1,530
Present value of daily cost = 1,530/.0001 = 15,300,000

NPV = 15,000,000 15,300,000 = -300,000

The company should not accept this lock-box
proposal
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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 19.6

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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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Ethics Issues
Some corporations routinely pay late or take
discounts that they do not qualify for.
How does this impact the supplier?
Does this action have any negative impact on
the company itself?

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Comprehensive Problem
A proposed single lockbox system will reduce
collection time 2 days on average
Daily interest rate on T-bills = .01%
Average number of daily payments to the lockbox is
3,000
Average size of payment is $500
The processing fee is $.08 per check plus $10 to wire
funds each day.
What are the benefits of using the lockbox? What are the
costs of using the lockbox? What is the maximum
investment that would make this lockbox system
acceptable?
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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 lockbox system work?
What are the major characteristics of short-term
securities?

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