Chapter 5

CASH MANAGEMENT
Dr. Nguyen Quynh Tho
 Chapter Outline
1. Tracing Cash and Net Working Capital
2. The Operating Cycle and Cash Cycle
3. Understanding Float
4. Managing Cash Collection and Disbursement
5. Investing Idle Cash
6. The BAT and Miller-Orr Model
Part 1.
Tracing Cash
and Net Working Capital
 Balance Sheet Model of the Firm

Current
Liabilities
Current
Assets Net Working Long-Term
Capital
Debt

How much short-

Fixed Assets
term cash flow does
1. Tangible a company need to
Shareholders’
pay its bills?
2. Intangible Equity
 Tracing Cash and Net Working Capital

• Current Assets are cash and other assets that are expected to be
converted to cash within the year.
 Cash
 Marketable securities
 Accounts receivable
 Inventory
• Current Liabilities are obligations that are expected to require cash
payment within the year.
 Accounts payable
 Accrued wages
 Taxes
Defining Cash in Terms of Other Elements

Long-
Net Working Fixed
+ = Term + Equity
Capital Assets
Debt

Other
Net Working Current
= Cash + Current –
Capital Liabilities
Assets

Long- Net Working

Fixed
Cash = Term + Equity – Capital –
Assets
Debt (excluding 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-to-day bills

● Trade-off between opportunity cost of holding cash relative to the

transaction cost of converting marketable securities to cash for
transactions
Part 2.
The Operating Cycle and
the Cash Cycle
The Operating Cycle and the Cash Cycle

Raw material
Cash
purchased Finished goods sold
received
Order Stock
Placed Arrive
s

Inventory period Accounts receivable period

Time
Accounts payable period

Firm receives invoice Cash paid for materials

Operating cycle

Cash cycle
 The Operating Cycle and the Cash Cycle

Accounts
Cash cycle = Operating cycle – payable
period

●In practice, the inventory period, the accounts receivable

period, and the accounts payable period are measured by
days in inventory, days in receivables, and days in payables,
respectively.
 The Operating Cycle and the Cash Cycle

● Inventory:
○ Beginning = 200,000 Ending = 300,000

Example ● Accounts Receivable:

○ Beginning = 160,000 Ending = 200,000

● Accounts Payable:
○ Beginning = 75,000 Ending = 100,000

● Net sales = 1,150,000

● Cost of Goods sold = 820,000

Part 3.
Understanding Float
 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

 Example: Types of Float

● You have $3,000 in your checking account. You just deposited

$2,000 and wrote a check for $1,500.

○ What is the disbursement float?

○ What is the collection float?

○ What is the net float?

○ What is your book balance?

○ What is your available balance?

 Example: Measuring Float

● Size of float depends on the dollar amount and the time delay

● Delay = mailing time + processing delay + availability delay

Which component is important?

 Example: Measuring Float

● Suppose you mail a check each month for $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 30-day months)?
 Example: Measuring Float

● Suppose the company receives two items each month as follows:

Amount Processing and

availability Delay
Item 1: $ 6,000,000 10
Item 2: $ 12,000,000 8

What is the average daily float?

 Example: Cost of Float
●Cost of float – opportunity cost of not being able to use the money

Suppose the average daily float is $1,000 with a weighted average delay of 3 days.
 Example: Cost of Float

●Cost of float – opportunity cost of not being able to use the money
●Suppose the average daily float is $3 million with a weighted
average delay of 5 days.
○What is the total amount unavailable to earn interest?

○What is the NPV of a project that could reduce the delay by 3 days if the
cost is $8 million?
Part 4.
Managing Cash Collection and
Cash Disbursements
 Managing Cash Collection

Payment Payment Payment Cash

Mailed Received Deposited Available

Mailing Time Processing Delay 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.
 Example: Accelerating Collections

●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.
 Managing 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

Part 5.
Investing Idle Cash
 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
Figure 27.6
 Characteristics of Short-Term Securities

●Maturity – firms often limit the maturity of short-term 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
Part 6.
Optimal Cash Balance
 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* Size of cash balance
 The Baumol-Allais-Tobin (BAT) Model

F = The fixed cost of selling securities to raise cash

T = The total amount of new cash needed

R = The opportunity cost of holding cash, i.e., the interest rate.

If we start with $C, spend at a constant rate each
period and replace our cash with $C when we run out
of cash, our average cash balance will be C
C –
2

C
–
2
The opportunity cost of holding C/2 cash is
C
– ×R
2
1 2 3 Time
 The BAT Model

As we transfer $C each
period we incur a trading
C cost of F.

If we need $T in total
–
C
over the planning period
2
we will pay $F times.
T
C –
1 2 3 Time
The trading cost is –
T ×F
C
 The BAT Model

C T
Total cost  R F
2 C
C
Opportunity Costs R
2

T
Trading costs F
C
C* Size of cash balance

2T
C*  F
R
 The BAT Model

The optimal cash balance is found where the opportunity costs

equals the trading costs.
Opportunity Costs = Trading Costs
C T
R  F
2 C

Multiply both sides by C

C2 TF
R T F C  2
2

2 R
2TF
C* 
R
 The BAT Model: Example

Hermes Co. has cash outflows of $500 per day, the

interest rate is 10% and the fixed transfer cost is $25.

What is optimal cash balance for the company?

 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 U, cash is invested
elsewhere to get us to the target cash balance C.
U
When the cash balance
reaches the lower control limit,
L, investments are sold to raise
cash to get us up to the target
C cash balance.

Time
 The Miller-Orr Model Math

●Given L, which is set by the firm, the Miller-Orr model

solves for C* and U
3F 2 U *  3C *  2L
C*  3 L
4R
where s2 is the variance of net daily cash flows.
 in the Miller-Orr model is:
• The average cash balance

4C *  L
Average cash balance 
3
 Implications of the Miller-Orr Model

● To use the Miller-Orr model, the manager must do four things:

1. Set the lower control limit for the cash balance.

2. Estimate the standard deviation of daily cash flows.

3. Determine the interest rate.

4. Estimate the trading costs of buying and selling securities.

 Implications of the Miller-Orr Model

● The model clarifies the issues of cash management:

○ The optimal cash position, C*, is positively related to trading

costs, F, and negatively related to the interest rate R.

○ C* and the average cash balance are positively related to the

variability of cash flows.
 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.
 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?