Cash Management

Basic objective: Is to keep the investment in cash as low as possible while operating the firm's activities efficiently and effectively.

Three Steps
Determining the appropriate cash balance Collecting and disbursing cash efficiently Investing excess cash in marketable securities

Determining the appropriate cash balance

Involves an assessment of the tradeoff between the benefit and cost of liquidity. The benefit of holding cash is the convenience in liquidity it gives the firm. The cost of holding cash is the interest income that the firm could have received from investing in Treasury bills and other marketable securities.

The cost of holding cash is the opportunity cost of lost interest

Cash Management
After the optimal amount of liquidity is determined, the firm must establish procedures so that cash is collected and disbursed as efficiently as possible.

Collect early and pay late

Cash
Currency Checking account deposits at commercial banks. Undeposited checks. Short-term marketable securities

Short-term marketable securities or cash equivalent include:

Treasury bills, certificates of deposit and repurchase agreements,

Reasons for holding cash

Cash is needed to satisfy the Transactions motive: Disbursement (outflows). Payment of wages and salaries, trade debts, taxes and dividends. And collection (inflows). Sales from operation, sales of assets and new financing. Inflows and outflows are no synchronized

Reasons for holding cash

Cash is needed to satisfy the Compensating balances: Cash balances are kept at commercial banks to compensate for banking services rendered to the firm.

It is a good idea for firms to figure out first how much cash To hold to satisfy the transactions needs

Determining the Target Cash Balance

Involves a trade-off between the opportunity cost of holding too much cash and the trading costs of holding too little. If a firm tries to keep its cash holdings too low, it will find itself selling marketable securities or borrowings.

Costos of Holding Cash

Cost in dollars

Total costs of Holding cash Opportunity Costs

Trading Costs

C* Optimal size of cash balance

Size of cash balance

Determining the Target Cash Balance

The sum of both costs, depicted as the total cost curve, is at minimum. This is the target of optimal cash balance. The William Baumol model can be used to establish the target cash balance.

The Baumol Model

William Baumol was the first to provide a format model of cash management incorporating opportunity costs and trading costs.

Trading costs
Trading costs can be determined calculating the number of times that the firm must sell marketable securities during the year. The general formula is: T.C. = (T C) * F

Opportunity Costs
The total opportunity costs of cash balances, in dollars, must be equal to the average cash balance multiplied by the interest rate. The formula is: O.C. = ( C / 2 ) * K

Total Cost
The Total cost of cash balances consists of the opportunity costs plus the trading costs. The formula is: Total Cost = ( C / 2 ) * K + ( T / C ) * F

Where:
F = The fixed cost of selling securities to replenish cash. T = Total amount of new cash needed for transactions purposes over the relevant planning period, say, one year. K = The opportunity cost of holding cash; this is the interest rate on marketable securities. C = The amount of cash balance of the firm

The Optimal cash balance

To determine minimum total cost precisely and the target cash balance we will use the next formula: C* = (( 2* T * F ) / K ) The Target cash balance should be the point where the two offset each other. ( Opportunity costs = Trading costs )

Example
T. C. = 26,000 = 31200 / 1200 * 1,000 T = 31200,000 F = 1,000 K = 10% C = 1200,000 O. C. = 120,000 ( 1200 / 2 ) * 0.10 Total cost = 186,000 26,000 + 120,000

The Optimal cash balance

C* = (( 2* T * F ) / K ) T = 31200,000 F = 1,000 K = 10% C* = ? C* = (( 2* 31200,000 * 1,000)/0.10) C* = 789, 936.71

The Optimal cash balance

T. C. = 39,496.84 = 31200 / 789,936 * 1,000 T = 31200,000 F = 1,000 K = 10% C* = ? O. C. = 39,496.84 = (789,936 / 2 ) * 0.10 Total cost = 39,496.84 + 39,496.84 = 78,993.68

Limitations
The model assumes the firm has a constant disbursement rate. Disbursements can be only partially managed, because due dates differ and costs cannot be predicted with certainty. There are no cash receipts during the projected period. No safety stock is allowed for Firms will probably want to hold a safety stock of cash designed to reduce the possibility of a cash shortage or cash-out