Advanced Corporate

Finance
Cash Management

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

Chapter Outline
27.1 Reasons for Holding Cash
27.2 Understanding Float
27.3 Cash Collection and
Concentration
27.4 Managing Cash Disbursements
27.5 Investing Idle Cash

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-today bills
Trade-off between opportunity cost of holding
cash relative to the transaction cost of converting
marketable securities to cash for transactions and
costs of insolvency (paying bills on time)
Payments and receipts not synchronized
Stay solvent, pay bills
Compensatory balance

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

Net float = Available balance at bank book balance
Firm with a +ve float
Lower cash balance
Issue more checks

Example: Types of Float

You have Rs.3,000 in your checking
account. You just deposited Rs.2,000 and
wrote a check for Rs.2,500.
What is the disbursement float?
What is the collection float?
What is the net float?
What is your available balance?

Example: Types of Float

Suppose you have $5,000 on deposit. One
day, you write a check for $1,000 to pay
for books, and you deposit $2,000. What
are your disbursement, collection, and net
floats? After you write the $1,000 check,
you show a balance of $4,000 on your
books, but the bank shows $5,000 while
the check is clearing
What is the disbursement float?
What is the collection float?
What is the net float?
What is your available balance?

Example: Measuring Float

Size of float depends on the rupees amount and
the time delay
Delay = mailing time + processing delay +
availability delay
Suppose you mail a check each month for
Rs.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 30day months)?
Method 1: (3+1+1)(1,000)/30 = 166.67
Method 2: (5/30)(1,000) + (25/30)(0) = 166.67

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.
10

Cash Collection
mailing time is an important component in
disbursement float
when collection float is calculated, mailing
time should not be considered
availability delay can be a matter of
negotiation between the bank and a
customer

 Generates an extra $3,000 on Day t by eliminating the

float
PV of eliminating the float is simply equal to the total
float.
If it costs $2,000 to eliminate the float, then the NPV is
$3,000 2,000 = $1,000; so firm should do it.

Example
Instead of eliminating the float,
suppose Lambo can reduce it to one
day. What is the maximum Lambo
should be willing to pay for this?

Example
A large bank is willing to provide the
float reduction service for $175 per
year, payable at the end of each
year. The relevant discount rate is 8
percent. Should Lambo hire the
bank? What is the NPV of the
investment? How do you interpret
this discount rate? What is the most
per year that Lambo should be
willing to pay?

Example: Cost of Float

Cost of float opportunity cost of not being able
to use the money
Suppose the average daily float is Rs.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 Rs.8 million?
Immediate cash inflow = 3*3 million = 9 million
NPV = 9 8 = Rs.1 million

Cash Collection and Concentration

Adopt procedures to speed up
collections and thereby decrease
collection times
Need procedures to funnel, or
concentrate, that cash where it can
be best used
When some or all of the payments a
company receives are checks that
arrive through the mail, all three
components of collection time
become relevant

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-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.

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

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

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
the cash for a plant construction program,
dividend payment, or other large expenditure

Figure 27.6

Characteristics of Short-Term
Securities
Maturity firms often limit the maturity of shortterm 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

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?