Summary of the Chapters

CHAPTER 9
Cash and Marketable Securities
Management

Firms, as well as individuals, hold cash to meet

transactions.Cash management involves the efficient
collection and disbursement of cash and any temporary
investment of cash while it resides with the firm.

The firm will generally benefit by “speeding up” cash

receipts and “s-l-o-w-i-n-g d-o-w-n” cash payouts.
The firm wants to speed up the collection of accounts
receivable so that it can have the use of money sooner.
It wants to pay accounts payable as late as is consistent
with maintaining the firm’s credit standing with suppliers so
that it can make the most use of the money it already has.

To accelerate collections, the firm may utilize a

number of methods, including computerized billing,
pre authorized debits, and lockboxes.
Large firms are likely to engage in the process of cash
concentration to improve control over corporate cash,
reduce idle cash balances, and provide for more
effective short-term investing.

The concentration process depends on three principal

methods to move funds between banks:
(1) depository transfer checks (DTCs)
(2) automated clearing house (ACH) transfers
(3) wire transfers.

Methods used by corporations to control disbursements

include the use of payable through drafts (PTDs), the
maintenance of separate disbursement accounts, zero
balance accounts (ZBAs), and controlled (or possibly
remote) disbursing.

Electronic data interchange (EDI), and two of its subsets,

electronic funds transfer (EFT) and financial EDI (FEDI),
are all key elements of electronic commerce (EC).

All the major areas of cash management – collections,

disbursements, and marketable-securities management
are candidates for outsourcing.

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In business process outsourcing (BPO), an entire
business process, such as finance and accounting, is
handed over to a third-party service provider.

The optimal level of cash should be the larger of

(1) the transactions balances required when cash
management is efficient or (2) the compensating
balance requirements of commercial banks with
which the firm has deposit accounts.

It is useful to think of the firm’s portfolio of short-term

marketable securities as if it were a pie cut into
three (not necessarily equal) pieces:
1. Ready cash segment (R$): optimal balance of
marketable securities held to take care of probable
deficiencies in the firm’s cash account.
2. Controllable cash segment (C$): marketable
securities held for meeting controllable (knowable)
outflows, such as taxes and dividends.
3. Free cash segment (F$): “free” marketable securities
(i.e., available for as yet unassigned purposes).

When considering the purchase of marketable securities,

the firm’s portfolio manager must understand how each
potential security relates to safety of principal,

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marketability, yield, and maturity. The firm’s marketable
securities portfolio manager usually restricts purchases to
money market instruments.

Common money market instruments include:

● Treasury securities,
● repurchase agreements,
● federal agency securities,
● bankers’ acceptances (BAs),
● Commercial paper,
● Negotiable certificates of deposit (CDs),
● Euro-dollars,
● Short-term municipals,
● Money market preferred stock (MMP).

In selecting securities for the various marketable

securities portfolio segments (R$, C$, and F$), the
portfolio manager tries to match alternative money
market instruments with the specific needs relating
to each segment, after taking into account such
considerations as safety, marketability, yield, and
maturity. In short, the composition of the firm’s
short-term marketable securities account is deter-
mined while keeping in mind the trade-off that exists
between risk and return.

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Money market mutual funds (MMFs) make it possible
for even small firms (and individuals) to hold a well-
diversified portfolio of marketable securities.

CHAPTER 5
The Time Value of Money

Most financial decisions, personal as well as business,

involve the time value of money. We use the rate of
interest to express the time value of money.

Simple interest is interest paid (earned) on only the

original amount, or principal, borrowed (lent).
Compound interest is interest paid (earned) on any
previous interest earned, as well as on the principal
borrowed (lent). The concept of compound interest
can be used to solve a wide variety of problems in
finance.

Two key concepts – future value and present value

underlie all compound interest problems. Future
value is the value at some future time of a present
amount of money, or a series of payments, evaluated
at a given interest rate. Present value is the current
value of a future amount of money, or a series of payments,

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evaluated at a given interest rate.

It is very helpful to begin solving time value of money

problems by first drawing a timeline on which you
position the relevant cash flows.

An annuity is a series of equal payments or receipts

occurring over a specified number of periods.

There are some characteristics that should help you

to identify and solve the various types of annuity
problems:
1. Present value of an ordinary annuity – cash flows
occur at the end of each period, and present value is
calculated as of one period before the first cash flow.
2. Present value of an annuity due – cash flows occur
at the beginning of each period, and present value is
calculated as of the first cash flow.
3. Future value of an ordinary annuity – cash flows
occur at the end of each period, and future value is
calculated as of the last cash flow.
4. Future value of an annuity due – cash flows occur
at the beginning of each period, and future value is
calculated as of one period after the last cash flow.

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Financial analysis, though varying according to the
particular interests of the analyst, always involves
the use of various financial statements – primarily the
balance sheet and income statement.

The balance sheet summarizes the assets, liabilities,

and owners’ equity of a business at a point in time,
and the income statement summarizes revenues and
expenses of a firm over a particular period of time.

Financial ratios are the tools used to analyze

financial condition and performance. We calculate ratios
because in this way we get a comparison that may prove
more useful than the raw numbers by themselves.

Financial ratios can be divided into five basic types:

liquidity, leverage (debt), coverage, activity, and
profitability. No one ratio is itself sufficient for realistic
assessment of the financial condition and
performance of a firm. With a group of ratios, however,
reasonable judgments can be made.

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The usefulness of ratios depends on the ingenuity and
experience of the financial analyst who employs them.
By themselves, financial ratios are fairly meaning-
less; they must be analyzed on a comparative basis.
Comparing one company with similar companies and
industry standards over time is crucial. Such a com-
parison uncovers leading clues in evaluating changes
and trends in the firm’s financial condition and pro-
fitability. This comparison may be historical, but it
may also include an analysis of the future based on
projected financial statements.

Additional insights can be gained by common-size and

index analysis. In the former, we express the various
balance sheet items as a percentage of total assets and
the income statement items as a percentage of net
sales. In the latter, balance sheet and income state-
ment items are expressed as an index relative to an
initial base year.

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CHAPTER 11
The Basis of Capital Budgeting

Capital budgeting is the process of analysing a project

and deciding which one to choose and to discard.

Four alternative methods of project evaluation and

selections are discussed. The first was a simple
additive method for assessing the worth of a project called
the payback period. The remaining three methods
(internal rate of return, net present value, and profit-
ability index) were all discounted cash flow techniques.

The payback period (PBP) of an investment tells us the

number of years required to recover our initial cash
investment. Although this measure provides a rough
guide to the liquidity of a project, it is a poor gauge of
profitability. It falls short as a measure of profitability
because it:
(1) ignores cash flows occurring after expiration of the
payback period,
(2) ignores the time value of money, and
(3) makes use of a crude acceptance criterion, namely, a
subjectively determined cutoff point.

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The internal rate of return (IRR) for an investment
proposal is the discount rate that equates the present
value of the expected net cash flows with the initial cash
outflow. If a project’s IRR is greater than or equal to a
required rate of return, the project should be accepted.

The net present value (NPV) of an investment

proposal is the present value of the proposal’s net cash
flows less the proposal’s initial cash outflow. If a
project’s NPV is greater than or equal to zero, the
project should be accepted.

The profitability index (PI), or benefit-cost ratio, of a

project is the ratio of the present value of future net
cash flows to the initial cash outflow. If a project’s PI
is greater than or equal to 1.00, the project should be
accepted.

When two or more investment proposals are mutually

exclusive, so that we can select only one, ranking pro-
posals on the basis of the IRR, NPV, and PI methods
may give contradictory results. If a conflict in rank-
ings occurs, it will be due to one or a combination

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of the following three project differences: (1) scale of
investment, (2) cash-flow pattern and (3) project life.
In every case, the net present value rankings can be
shown to lead to the correct project selection. In
short, if net present value rankings are used, projects
that are expected to add the greatest increment in
dollar value to the firm will be chosen.

A potential problem with the internal rate of return

method is that multiple internal rates of return might
occur for nonconventional projects – projects whose
cash-flow streams show multiple changes in sign.
When there are multiple rates of return, an alternative
method of analysis must be used.

Capital rationing occurs any time there is a budget

ceiling, or constraint, on the amount of funds that can
be invested during a specific period, such as a year.

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