27-0
Chapter Twenty Seven
Corporate Finance
Cash Management
Ross  Westerfield  Jaffe
27
Seventh Edition
Seventh Edition
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Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
27-1
Chapter Outline
27.1 Reasons for Holding Cash
27.2 Determining the Target Cash Balance
27.3 Managing the Collection and Disbursement of Cash
27.4 Investing Idle Cash
27.5 Summary & Conclusions
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27-2
27.1 Reasons for Holding Cash
• Transactions motive
• Compensating balances
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27-3
27.2 Determining the Target Cash Balance
• The Baumol Model
• The Miller-Orr Model
• Other Factors Influencing the Target Cash Balance
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27-4
Costs of Holding Cash
Costs in dollars of
holding cash
Trading costs increase when the firm
must sell securities to meet cash needs.
Total cost of holding cash
Opportunity
Costs
The investment income
foregone when holding cash.
Trading costs
C*
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Size of cash balance
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27-5
The Baumol Model
F = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed
K = The opportunity cost of holding cash, a.k.a. the interest rate.
If we start with $C,
spend at a constant rate
each period and replace
C
our cash with $C when
we run out of cash, our
average cash balance
C
C.
–2
will be –
2
The opportunity cost
C is C ×K
of holding –
–2
Time
2
1
2
3
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The Baumol Model
F = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed
K = The opportunity cost of holding cash, a.k.a. the interest rate.
As we transfer $C each
period we incur a
trading cost of F each
period.
C
C
–2
1
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2
3
If we need $T in total
over the planning
T
period we will pay $F –
C
times.
T ×F
The trading cost is –
Time
C
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27-7
The Baumol Model
C
T
Total cost   K   F
2
C
C
Opportunity Costs  K
2
Trading costs T  F
C*
C
Size of cash balance
The optimal cash balance is found where the opportunity
costs equals the trading costs
2T
*
C 
F
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K
27-8
The Baumol Model
The optimal cash balance is found where the opportunity
costs equals the trading costs
Opportunity Costs = Trading Costs
C
T
K  F
2
C
Multiply both sides by C
C2
K T F
2
T F
C  2
K
2
2TF
C 
K
*
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27-9
The Miller-Orr Model
• The firm allows its cash balance to wander
randomly between upper and lower control limits.
$
When the cash balance reaches the upper control limit H cash
is invested elsewhere to get us to the target cash balance Z.
H
When the cash balance
reaches the lower
control limit, L,
investments are sold
Z
to raise cash to get
us up to the target
cash balance.
L
Time
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27-10
The Miller-Orr Model Math
• Given L, which is set by the firm, the Miller-Orr
model solves for Z and H
2
3Fσ
Z 
L
4K
*
3
H *  3Z *  2 L
where s2 is the variance of net daily cash flows.
• The average cash balance in the Miller-Orr model
is
4Z *  L
Average cash balance 
3
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27-11
Implications of the Miller-Orr Model
•
To use the Miller-Orr model, the manager must
do four things:
1.
2.
3.
4.
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Set the lower control limit for the cash balance.
Estimate the standard deviation of daily cash flows.
Determine the interest rate.
Estimate the trading costs of buying and selling
securities.
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27-12
Implications of the Miller-Orr Model
•
The model clarifies the issues of cash
management:
–
The best return point, Z, is positively related to
trading costs, F, and negatively related to the interest
rate K.
– Z and the average cash balance are positively related
to the variability of cash flows.
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27-13
Other Factors Influencing the
Target Cash Balance
• Borrowing
– Borrowing is likely to be more expensive than selling
marketable securities.
– The need to borrow will depend on management’s desire
to hold low cash balances.
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27-14
Other Factors Influencing the
Target Cash Balance
• Compensating Balance
– Firms have cash in the bank as a compensation for
banking services.
– Large corporations have thousands of accounts with
several dozen banks—sometimes it makes more sense to
leave cash alone than to manage each account on a daily
basis.
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27-15
Float
• The difference between bank cash and book cash is
called float.
• Float management involves controlling the
collection and disbursement of cash.
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27-16
27.3 Managing the Collection and
Disbursement of Cash
•
•
•
•
•
•
Accelerating Collections
Delaying Disbursements
Disbursement Float
Zero-Balance Accounts
Drafts
Ethical and Legal Questions
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27-17
Accelerating Collections
Customer
mails
payment
Company
receives
payment
Company
deposits
payment
Cash
received
time
Mail
delay
Processing
delay
Clearing
delay
Mail
float
Processing
float
Clearing
float
Collection float
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27-18
Overview of Lockbox Processing
Corporate
Customers
Corporate
Customers
Post Office
Box 1
Corporate
Customers
Local Bank
Collects funds
from PO Boxes
Corporate
Customers
Post Office
Box 2
Envelopes opened;
separation of
checks and receipts
Details of receivables
go to firm
Deposit of checks
into bank accounts
Firm processes
receivables
Bank clears checks
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Delaying Disbursements
Firm prepares
check to supplier
Post Office
processing
Delivery of check
to supplier
Deposit goes to
supplier’s bank
1. Write check on a distant bank.
2. Hold payment for several days
after postmarked in office.
3. Call supplier firm to verify
statement accuracy for large
amounts.
4. Mail from distant post office.
5. Mail from post office that
requires a great deal of handling.
Bank collects funds
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27-20
Drafts
• Firms sometimes use drafts instead of checks.
• Drafts differ from checks because they are not
drawn on a bank but on an issuer (the firm) and are
payable by the issuer.
• The bank acts only as an agent, presenting the draft
to the issuer for payment.
• When the draft is transmitted to a firm’s bank for
collection, the bank must present the draft to the
issuing firm for acceptance before making payment.
• After the draft has been accepted, the firm must
deposit the necessary cash to cover the payments.
• This allows the firm to keep less cash on hand.
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27-21
Ethical and Legal Questions
• The financial managers must always work with
collected company cash balances and not with the
company’s book balance, which reflects checks that
have been deposited but not collected.
• If you are borrowing the bank’s money without their
knowledge, you are raising serious ethical and legal
questions.
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27-22
27.4 Investing Idle Cash
• A firm with surplus cash can park it in the money
market.
– Some large firms and many small ones use money market
mutual funds.
• Firms have surplus cash for three reasons:
– Seasonal or Cyclical Activities
– Planned Expenditures
– Different Types of Money Market Securities
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27-23
Seasonal Cash Demands
Total Financing needs
Bank loans
Marketable
securities
Short-term
financing
Long-term
financing
J
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F
M
A
M
Time
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27-24
27.5 Summary & Conclusions
• A firm holds cash to conduct transactions and to
compensate banks for the various services they
render.
• The optimal amount of cash for a firm to hold
depends on the opportunity cost of holding cash and
the uncertainty of future cash inflows and outflows.
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27.5 Summary & Conclusions
• Two transactions models that provide rough
guidelines for determining the optimal cash postion
are:
– The Miller-Orr model
– The Baumol model
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27.5 Summary & Conclusions
• The firm can make use of a variety of procedures to
manage the collection and disbursement of cash in
such as way as to speed up the collection of cash
and slow down payments.
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27-27
27.5 Summary & Conclusions
• Some methods to speed collections are
– Lockboxes
– Concentration banking
– Wire transfers
• The financial managers must always work with
collected company cash balances and not with the
company’s book balance.
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27-28
27.5 Summary & Conclusions
• If you are borrowing the bank’s money without their
knowledge, you are raising serious ethical and legal
questions.
• The answers to which you probably know by now.
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