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Chapter 19 Cash and Marketable Securities Management

Liquid Asset Management

CASH- motives for holding cash:

Transactions: to meet cash needs that

arise from doing business. Precautionary: having cash on hand for unexpected needs. Speculative: to take advantage of potential profit-making situations.

Cash Management

Trade Off: cash decreases risk of insolvency, but earns no returns!

Cash Management

Objectives: have enough cash on hand to meet disbursal needs. minimize investment in idle cash balances.

Cash Management System


Marketable securities investment

Control through information reporting

= Funds Flow

= Information Flow

Collection Float

Mail Float

Processing Float

Availability Float

Deposit Float Collection Float: total time between the mailing of the check by the customer and the availability of cash to the receiving firm.

Mail Float

Customer mails check

Firm receives check

Mail Float: time the check is in the mail until the firm receives check.

Processing Float

Firm receives check

Firm deposits check

Processing Float: time it takes a company to process the check internally.

Availability Float

Firm deposits check

Firms bank account credited

Availability Float: time consumed in clearing the check through the banking system.

Deposit Float

Processing Float

Availability Float

Deposit Float: time during which the check received by the firm remains uncollected funds.

Cash Management
Managing Cash Inflow Reducing Float can speed up cash
receipts. Transit Float: time required for a check to clear through the banking system and become usable funds. Disbursing Float: occurs because funds are available in a firms bank account until its payment check has cleared through the banking system.

Cash Management
Managing Cash Inflow

Lockbox System
Instead of mailing checks to the firm,
customers mail checks to a nearby P.O. Box. A commercial bank collects and deposits the checks. This reduces mail float, processing float and transit float.

Cash Management
Lockbox System benefits:
Increased working cash - reduces
time required to convert receivables to cash. Elimination of clerical functions - bank handles receiving, endorsing, totaling and depositing. Early knowledge of dishonored checks firm learns of customers bad checks faster.

Cash Management
Managing Cash Inflow

Preauthorized Checks (PACs)

Arrangement that allows firms to create
checks to collect payments directly from customer accounts. This reduces mail float and processing float.

Cash Management
PAC System benefits:
Highly predictable cash flows. Reduced expenses - eliminates
billing and postage costs; reduces clerical processing costs. Customer preference - eliminates regular billing for customers. Increased working cash dramatically reduces mail float and processing float.

Cash Management
Managing Cash Inflow

Depository Transfer Checks (DTCs)

Moves cash from local banks to concentration bank accounts. Firms avoid having idle cash in multiple banks in different regions of the country.

Cash Management
DTC System benefits:
Lower levels of excess cash. Reduced expenses - eliminates billing
and postage costs; reduces clerical processing costs. Customer preference - eliminates regular billing for customers. Increased working cash - dramatically reduces mail float and processing float.

Cash Management
Managing Cash Inflow

Wire Transfers
Moves cash quickly between banks. Eliminates transit float.

Cash Management
Managing Cash Outflow

Zero Balance Accounts (ZBAs)

Different divisions of a firm may write
checks from their own ZBA. Division accounts then have negative balances. Cash is transferred daily from the firms master account to restore the zero balance. Allows more control over cash outflows.

Cash Management
Managing Cash Outflow

Payable-Through Drafts (PTDs)

Allows the firm to examine checks
written by the firms regional units. Checks are passed on to the firm, which can stop payment if necessary.

Cash Management
Managing Cash Outflow

Remote Disbursing
Firm writes checks on a bank in a distant
town. This extends disbursing float.

Cash Collection Methods How?

Lock box system

Reduce mail float, processing float, and transit float

Strategic locations of lock

boxes, firms commercial banks access to lock boxes

Pre Authorized Checks

Reduce mail float and processing float

The firm writes the checks (the

PACs) to be charged against their demand deposit accounts

(Ordinary)Depository transfer
checks Eliminates excess funds in regional banks

Transfer of checks from local

banks to concentrated bank

Cash Collection Methods How?

Automated depository transfer

checks Eliminates mail float

Telecom company transmits

deposit data to the firms concentration bank

Wire transfers
Moves funds immediately between banks

Use of bank wire

Cash Disbursal Methods How?

Zero balance accounts

better control over cash payments reduce cash balances held in regional banks

Zero balance for all of the

firms disbursing units

Payable-through drafts
effective central office control over field authorized payments

Field office issues drafts rather

than checks

Evaluating the costs of cash management services

A. Whether a cash management system will provide
an economic benefit can be evaluated by: added costs = added benefits B. If the benefits exceed the costs, the system is economically feasible. C. On a per unit basis, this relationship can be expressed as follows: P = (D) (S) (i)

Evaluating the costs of cash management services

P where P = = = = = (D) (S) (i) increase in per-check processing cost, if new system is adopted days saved in the collection process average check size in dollars the daily, before-tax opportunity cost of carrying cash.

D S i

D. The product of (D) x (S) x (i) must exceed P for the

system to be beneficial to the firm.

Evaluating the cost of cash management services

Concentration banking system: Cost: $40,000 to operate the Collection $40M/annum system Savings: Mail Float 4 days Processing Float 3 days Clerical Costs $35,000/annum Money Market rate 5% per annum Number of days/year 365 days

Average daily float

Annual Revenues Days in Year

$40,000,000 365
$ 109,589

[(Average daily float) x (Number of days of float reduction)] = Amount that can be invested
[($109,589) x (7)] = $767,123 x Interest rate on investment)]

[(Amount that can be invested) Annual interest forgone [($767,123) x (.05)]

= $38,358

Thus, the cost of the Healthy Herbal's current billing system is: Annual interest forgone $38,356 Plus: Clerical costs 35,000 Cost of current system $73,356

And, the net annual gain from adoption of the proposed concentration banking system is: Cost of current system $73,356 Less: cost of concentration banking system 40,000 Net annual gain from proposed system $33,356

Annual collection = ($6,232,375) (12 regions) = $74,788,500 Daily collections = $74,788,500 / 365 = $204,900 Use of the lock-box system will reduce Marino Rug Company's float by 3 days The value of the float reduction is found by presuming the freed funds will be added to the marketable securities portfolio and will earn the 9.75% yield. Monthly cost per region to operate the lock-box system =$325

($204,900) (3) (.0975) = $59,933 The annual cost of operating the lock-box system is: ($325 per month) (12 regions) (12 months) = $46,800 The net annual savings are: ($59,933) - ($46,800) = $13,133 Marino's management should approve the use of the proposed lock-box system and, thereby, save $13,133 per year.

Marketable Securities

Financial Risk - uncertainty of

expected returns due to changes in issuers ability to pay. Interest rate risk - uncertainty of expected returns due to changes in interest rates.

Marketable Securities

Liquidity - ability to transform

securities into cash. Taxability - taxability of interest income and capital gains. Yield - influenced by the previous four considerations.

Marketable Securities

Treasury Bills - short-term securities

issued by the government (Central Bank).

Marketable Securities
Types Federal Agency Securities - Debt issued by agencies, including:
Federal National Mortgage Association (Fannie Mae) Federal Home Loan Banks Federal Land Banks Federal Intermediate Credit Banks Banks for the Cooperatives

Marketable Securities
Types Bankers Acceptances - short-term securities used in international trade. Sold on discount basis. Negotiable CDs - short-term securities issued by banks, with typical deposits of $100,000, $500,000 and $1 million.

Marketable Securities
Types Commercial Paper - short-term unsecured IOUs sold by large reputable firms to raise cash. Repurchase Agreements - an investor acquires short-term securities subject to a commitment from a bank to repurchase the securities on a specific date.

Marketable Securities
Types Money Market Mutual Funds - a pool of money market securities, divided into shares, which are sold to investors.

Example :Buying and Selling of Securities

CCC Company has $2M excess cash that it might invest in marketable securities. In order to buy and sell securities, the firm must pay transaction fee of $45,000. Would you recommend purchasing the securities if they yield 12% annually and are held for: a. One month d. Six months b. Two months e. One year. c. Three months

Calculate the value of the estimated return for each holding period and compare it with the transaction fee if a gain can be made by investing in the securities
Recommendation 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000 0.12 0.12 0.12 0.12 0.12 1/12 2/12 3/12 6/12 12/12 20,000 40,000 60,000 120,000 240,000 < < > > > 45,000 45,000 45,000 45,000 45,000 No No Yes Yes Yes

What minimum required yield would the securities

have to return for the firm to hold them for three months (what is the break-even yield for a threemonth holding period)

Let (x) be the required yield. With $2M to invest for

three months we have
$2M(x)(3/12) = $ 45,000 $2M(x) = $180,000 $2M(x) = $180,000/$2,000,000 = 9%

Example 2
The Company has $4M in excess cash to invest in a
marketable securities portfolio. Its broker will charge $10,000 to invest the entire $4M. The president wants at least half of the $4M invested at a maturity period of three months or less; the remainder can be invested in securities with maturities not to exceed six months. The relevant term structure of shortterm yield follows:
Maturity Period 1 month 2 months 3 months 4 months 5 months 6 months Available Yield (annual) 6.20% 6.40% 6.50% 6.70% 6.90% 7.00%

a. What would be the maturity periods of the securities purchased
with the excess $4M to maximize the before-tax income from the added investment? What will be the amount of the income from such investment.

b. Suppose that the President of the company relaxes his constraint on

the maturity structure of the added investments. What would be your profit maximizing investment recommendation?

c. If one-sixth of the excess cash is invested in each of the preceding

maturity categories, what would be the before-tax income generated from such an action?