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Key Concepts and Skills

Chapter 19 • Understand the importance of float and how it

affects the cash balance
• Understand how to accelerate collections and
manage disbursements
Cash and Liquidity
• Understand the advantages and
Management disadvantages of holding cash and some of
the ways to invest idle cash

Copyright © 2012 by McGraw-Hill Education (Asia). All rights reserved. 19-1

McGraw-Hill/Irwin

Chapter Outline Reasons for Holding Cash

• Reasons for Holding Cash • Speculative motive
• Understanding Float – hold cash to take advantage of unexpected
opportunities
• Cash Collection and Concentration
• Precautionary motive
• Managing Cash Disbursements – hold cash in case of emergencies
• Investing Idle Cash • Transaction motive
– hold cash to pay the day-to-day bills

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Investing Cash Figure 19.6

• 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

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Characteristics of Short-Term
Securities
• Maturity Chapter 19
– firms often limit the maturity of short-term investments
to 90 days to avoid loss of principal due to changing Appendix
interest rates
• Default risk
– avoid investing in marketable securities with significant
default risk
Cash and Liquidity
• Marketability Management
– ease of converting to cash
• Taxability
– consider different tax characteristics when making a
decision

19-6 Copyright © 2012 by McGraw-Hill Education (Asia). All rights reserved.

McGraw-Hill/Irwin

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Costs of Holding Cash The BAT Model

F = The fixed cost of selling securities to raise cash
Trading costs increase when the or buying securities
Costs in dollars firm must sell securities to meet
T = The total amount of new cash needed
of holding cash cash needs.
R = The opportunity cost of holding cash, i.e., the
interest rate
Total cost of holding
cash If we start with C = $ 1.2
Opportunity million, spend at a constant rate
Costs C each period and replace our
The investment income cash with $C when we run out
foregone when holding cash.
–C2 of cash, our average cash
balance will be C/2 = $
Trading costs 600.000 ($ 0 + $ 1.2 million)/2
C* Size of cash balance Time
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The BAT Model – The Trading Cost

The BAT Model – The Opportunity Cost
The Trading Cost is T/C x F
The opportunity cost of holding is C/2 x R To determine the total trading cost for the year, we need to know how many
times the company will have to sell marketable securities during the year.
The total amount of cash disbursed during the year is $600,000 per week, so T
Initial Average Opportunity = $600,000 x 52 weeks = $31.2 million.
Cash Cash Cost (R = If the initial cash balance is set at C = $1.2 million, the company will sell 26
Balance Balance 10%) times per year (31.2 million / 1.2 million).
C C/2 (C/2) x R
If F were $ 1,000, the trading costs would be $ 26,000 for the year.
4,800,000 2,400,000 240,000
2,400,000 1,200,000 120,000 Total Amount of Initial Cash Trading Cost
C= Disbursements during Balance (F = $ 1,000)
1,200,000 600,000 60,000 Relevant Period
1200000
600,000 300,000 30,000 T C (T/C) x F
300,000 150,000 15,000 $ 31,200,000 4,800,000 $ 6,500
C/2 = Average
600000 Cash
31,200,000 2,400,000 13,000
31,200,000 1,200,000 26,000
31,200,000 600,000 52,000
2 4 6 Time
31,200,000 300,000 104,000

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The BAT Model – The Total Cost The BAT Model – The Solution
Total Cost = Opportunity Costs + Trading Costs How to Find the Minimum Costs :
= (C / 2) x R + (T / C) x F Opportunity Costs = Trading Costs
(C/2) x R = (T/C) x F
Cash Opportunity Trading Total
+ = (C/2) x R x C = (T/C) x F x C
Balance Costs Costs Costs
4,800,000 240,000 6,500 246,500 C2/2 x R = T x F
2,400,000 120,000 13,000 133,000
1,200,000 60,000 26,000 86,000 C2 = 2T x F / R
600,000 30,000 52,000 82,000 C = √2T x F / R = √2 x 31.2 million x 1,000 / 10% = $ 789,937
300,000 15,000 104,000 119,000 Cash Opportunity Trading Total
+ =
Balance Costs Costs Costs
Notice how the total cost starts out at almost $ 250,000 and 850,000 42,500 36,706 79,206
declines to about $82,000 before starting to rise again.
800,000 40,000 39,000 79,000
789,937 39,497 39,497 78,994
750,000 37,500 41,600 79,100
700,000 35,000 44,571 79,571

The BAT Model - Conclusion The Miller-Orr Model

• The firm allows its cash balance to wander
The BAT Model is possibly the simplest and most stripped down randomly between upper and lower control limits.
sensible model for determining the optimal cash position. Its chief
weakness is that it assumes steady, certain cash outflows.

We next discuss a more involved model designed to deal with $ When the cash balance reaches the upper control limit U, cash
this limitation. 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
C raise cash to get us up
to the target cash
L balance.

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Time

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The Miller-Orr Model Math Implications of the Miller–Orr Model Part I

• Given L, which is set by the firm, the Miller-Orr • To use the Miller-Orr model, the manager
model solves for C* and U must do four things:
1. Set the lower control limit for the cash
3Fσ 2 U *  3C *  2 L balance.
C*  3 L
4R 2. Estimate the standard deviation of daily
cash flows.
where σ2 atau s2 is the variance of net daily cash 3. Determine the interest rate.
flows. 4. Estimate the trading costs of buying and
• The average cash balance in the Miller-Orr model is: selling securities.
4C *  L
Average cash balance 
3
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Implications of the Miller–Orr Model Part I Implications of the Miller–Orr Model Part II
For example, suppose F = $ 10, the interest rate is 1%
per month, and the standard deviation of the monthly • The model clarifies the issues of cash
net cash flows is $ 200. We also assume a minimum management:
cash balance of L = $ 100. – The optimal cash position, C*, is
We can calculate the cash balance target, C*, as positively related to trading costs, F, and
follows : negatively related to the interest rate R.
3Fσ 2 3 x10 x (200) 2 – C* and the average cash balance are
C*  3 L3  100  311  100  $411 positively related to the variability of
4R 4 x1%
cash flows.
The upper limit, U*, is thus :
U* = 3 x C* - 2 x L = 3 x 411 – 2 x 100 = $ 1033

Average Cash Balance = (4 x C* - L)/3 = (4 x 411 –

100)/3 = $ 515
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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 End of Chapter
management’s desire to hold low cash
balances.

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