Week 14 Chapter 20

Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e

Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
13-1
Week 14 - Chapter Twenty

Cash and Liquidity Management
13-2

13.1 Reasons for Holding Cash
13.2 Determining the Target Cash Balance
13.3 Managing the Collection and Disbursement of Cash
13.4 Investing Idle Cash
13.6 Summary and Conclusions
Chapter Organization
13-3
Chapter Objectives

Understand the various reasons for holding cash.
Explain and apply both the BAT model and the
MillerOrr model.
Explain what float is and the different types of float.
Discuss various ways of managing float.
Outline ways that firms overcome temporary
surpluses/deficits of cash.
Discuss the role of the various regulators of
financial markets.

13-4
Reasons for Holding Cash
Speculative motivethe need to hold cash to take advantage
of additional investment opportunities, such as bargain
purchases.

Precautionary motivethe need to hold cash as a safety
margin to act as a financial reserve.

Transaction motivethe need to hold cash to satisfy normal
disbursement and collection activities associated with a firms
ongoing operations.

Compensating balance requirementscash balances kept at
commercial banks to compensate for banking services the firm
receives.
13-5
Target Cash Balance
Key issues:

What is the trade-off between carrying a large cash
balance versus a small cash balance? That is,
carrying costs versus shortage costs.

What is the proper management of the cash
balance? BAT model versus MillerOrr model.
13-6
The BAT Model
4 8 Weeks
Average cash
0
Starting cash
C=$2 000 000
$500 000=C/4
13-7
The BAT Model
( )/R F T =
-
2 C
F = fixed cost of making a securities trade to replenish cash
T = total amount of new cash needed for transactions purposes over
the relevant planning period
R = the opportunity cost of holding cash (the interest rate on
marketable securities)
Assumptions
-Cash is spent at the same rate every day
-Cash expenditures are known with certainty

Optimal cash balance is where opportunity cost of holding
cash ([C/2]*R) = trading cost ([T/C]*F):
13-8
MillerOrr Model
Assumes that, if left unmanaged, a companys cash balance
would follow a random walk with zero drift.
Cash balance is allowed to wander freely between an upper
limit (U*) and a lower limit (L).
If cash holdings reach U*, management intervenes by
withdrawing U* C* dollars to return the cash balance to the
target level C*.
If cash balance reaches L, management intervenes by
injecting C* L dollars to return the cash balance to the
target level C*.
13-9
MillerOrr Model
U* is the upper control limit. L is the lower control limit. The target
cash balance is C*. As long as cash is between L and U*, no
transaction is made.
Cash
Time
X Y
L
C*
U*
13-10
MillerOrr Model
( ) 3 4 balance cash Avg.
2 3
firm by the set

3
1
2
/ L C
L C U
R
F
4
3
L C
L
=
=
|
.
|
\
|
+ =
=
-
- -
-
13-11
ExampleMillerOrr Model
( ) ( )
( )
$2423
/3 $0 817 $1 4 balance cash Avg.
$5451
$0 2 817 $1 3
817 $1
0.005
2000 $
$10
4
3
$0
3
1
2
=
=
=
=
=
|
.
|
\
|
+ =
-
-
U
C
Assume L = $0, F = $10, i = 0.5 per cent per month and
the standard deviation of monthly cash flows is $2000.
13-12
MillerOrr Model Implications
Considers the effect of uncertainty (through o
2
in
net cash flows).
The higher the o
2
, the greater the difference between C*
and L.
The higher the o
2
, the higher is the upper limit and the
average cash balance.

All things being equal:
the greater the interest rate, the lower is the C*
the greater the order costs, the higher is the C*.
13-13
MillerOrr Model With Overdraft
Yield on short-term investments < cost of bank
overdraft < yield on long-term investments.

A dollar invested in short-term assets earns less
than the costs saved by applying that dollar to
reduce overdraft usage.

The company invests nothing in short-term assets
and as much as possible in long-term assets, while
meeting its liquidity needs through using the
overdraft facility.
13-14
MillerOrr Model With Overdraft
( )
-
-
-
-
=
=
(

|
.
|
\
|
o =
=
C
C L
d R F C
U
2 level overdrawn Target
3
/
4
3

0
3
1
2
Where:
d = cost of bank overdraft
13-15
Understanding Float
What is float?
The difference between book cash and bank cash,
representing the net effect of cheques in the process of
being cleared.
Types of float:
Disbursement floatthe result of cheques written;
decreases book balance but does not immediately
change available balance.
Collection floatthe result of cheques received; increases
book balance but does not immediately change available
balance.
Net floatthe overall difference between the firms
available balance and its book balance.
13-16
Float Management
Objectives:
In cash collectionspeed up cheque collections (reduce
float components).
In cash disbursementcontrol payments and minimize
costs (increase float components).
Components of float:
Mail floatcheques trapped in postal system.
Processing floatuntil receiver of cheque deposits
cheque.
Availability floatuntil cheque clears in the banking
system.
Mail float + processing float + availability float = total time
delay.
13-17
Measuring and Costing the Float
delay avg. weighted receipts daily Avg. float daily Average
or
days Total
float Total
float daily Average
=
=
The cost of collection float to the firm is the
opportunity cost from not being able to use that
cash.
13-18
Managing the Float

Factoringthe selling of receivables to a financial
institution (the factor), usually without recourse.

Credit insuranceprotection against the risk of bad
debt losses.

Delaying disbursementsincreases the
disbursement float.
13-19
Investing Idle Cash

Temporary cash surpluses can be invested in
marketable securities.

Temporary cash deficitssell marketable
securities or use short-term bank financing.

The temporary surpluses/deficits are a result of:
seasonal or cyclical activities
planned or possible expenditures.
13-20
The Securities Markets
Temporary cash surplus
Long-term
debt market
Futures
market
Options
market
Sharemarket

Short-term
money market
Foreign exchange
market
Financial
intermediaries
13-21
Short-term Securities

Characteristics of short-term securities include:

Maturity maturities usually less than 90 days. Investments
then avoid interest rate risk but have low returns.

Default risk idle cash generally invested in less risky
securities (e.g. government issues).

Marketability idle funds usually invested in highly liquid
securities.
13-22
Investing Cash
Temporary Cash Surpluses

-Seasonal or cyclical activitiesbuy marketable
securities with seasonal surpluses, convert
securities back to cash when deficits occur.

-Planned or possible expendituresaccumulate
marketable securities in anticipation of upcoming
expenses.
13-23
Financing Seasonal or Cyclical
Activities
13-24
Conclusion
Cash Management

Collect Early

Pay late (as legally possible)
13-25
Regulation of Financial
Intermediaries
Council of
Financial
Regulators
Australian Prudential Regulation Authority (APRA)
Prudential supervision of all deposit-taking entities,
insurance and superannuation funds.
Australian Securities and Investments Commission
(ASIC)
Corporate regulation, consumer protection, market
integrity.
Reserve Bank of Australia (RBA)
Payments system, monetary policy, stability of the
financial system.
Source: Australian Financial Review, 18 March 1998, p.4.
13-26
Regulation of Financial
Intermediaries

Terminology to know:
CGS Commonwealth Government Securities
ESAs exchange settlement accounts
RTGS real-time gross settlement
ADIs authorised deposit-taking institutions
CAR capital adequacy ratio
PAR prime assets ratio

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PPTs t/a Fundamentals of Corporate Finance 3e

firm by the set

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