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Cash Management

Prof. b.p.mishra
XIMB

Why hold cash?

An idle investment.
Used for both operating and non operating
purposes
A tradeoff between no / less cash or
shortfall in critical value.
Motives
Transaction
Precautionary
speculative
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Transaction motive
Firms have sequential transaction
Cash balance by use gets to zero, then
get replenished.
It has two cost =>
(a) Opportunity cost for balance held
In respect to cash holding (a) has direct &
(b) has inverse relationship
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Baumal model of optimum cash Balance

Assumptions:The firm is able to forecast correctly and precisely the amount of
cash required by it. Element of certainty.

The firm makes its cash payment uniformly over time.

The firm very well understands the opportunity cost of the cash
held by it.
The opportunity cost is known, constant and does not change
over a period of time.
The transaction cost of the firm is constant and known.
( the transaction cost is the cost incurred whenever the firm
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converts STS to cash.)

Opportunity (OC) & Trading cost (TC)

OC = C/2 * r
where C/2 = Average cash balance
r = Return obtained by non cash investment

TC = T / C* tc
T = Total amount of cash needed in the
reference period
C = cash balance
Total cost C/2 * r = T / C * tc
=> C = 2 * T * tc /r
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Example
If tc = Rs 1000
T = Rs 12,00,000
r = 10%
C = ( 2 * T * tc /r)
= (2 * 12,00,000* 1000/ 0.10)
= Rs 1,54,919.33
Opportunity cost is => C /2* r = Rs 1,54,919.33 / 2 * 0.10
= Rs 7745.97
Transaction Cost => TC = T / C* tc
= (Rs 12,00,000 / Rs 1,54,919.33 ) x Rs 1000
= Rs 7745.96
Hence total Cost = Rs 7745.97 + Rs 7745.96
= Rs 15491.93
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Cash
Cost
Initial cash balance

Total cost

C/2

Opportunity
cost

Average cash

time

C*

Cash

Baumol model

If the firm has high cash holding activity ,

has to have superior average cash balances
If the opportunity cost of holding cash is high, the lower the
cash balance firm holds
Cash to asset ratio be negatively correlated to size
Limitation arises from assumptions of
disbursement of cash being predictable &
performed at constant rate
Firms can not predict their daily cash in flow & out flow.
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Miller & Orr (MO) model

Precautionary View :This model assumes that
the net cash flows are normally distributed
With a zero value of mean and standard deviation.
Cash balances take too erratic pattern of distribution
over a period of time.
However, over long periods,
they tend to show normal distribution.

Precautionary motive
To cover adverse shocks or simple
fluctuations around expected cash flow
Finance manager determine optimal, lower
and higher limits
Once limit is reached, firms rebalance
cash balance to target level
A positive relation between optimal cash
balances and variance of daily cash flows.
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When through random movement,

the cash flow upper limit is reached
The firm purchases STS to reduce free cash flow.( Return point)
When lower limit is reached,
the firm liquidate its investment
The cash balances returns to its average level
From its lowest point .( Return point)

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Stochastic Model of Miller & Orr:Baumal model fails if the demand for cash is not steady.
If Uncertainty is high, Inventory model can not be used.
If Balances fluctuate randomly, the model can not explain

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Cash VS Marketable Securities(MS):oCash Demand fluctuates with irregularity

oMarketable securities has marginal yield.
oConversion cost exists for converting MS to cash

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Cash

Upper

Target
Return Point
Lower

time
Miller & Orr model
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Three StepsI.A minimum Cash balance Specified, May be Zero balance.

II.Estimating variability of future cash flows on the basis of
Historical data.
III. Determine the Spread which is =
f (Variability, Transaction cost, interest rate)

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Z = { ( 3 F 2 ) / 4K } 1/3 + L
Z = Return Cash Point or target Cash balance
F = Transfer Cost from MS TO CASH
= SD of average daily cash balance
K = Holding cost in Percentage
L = Lower cash balance limit set by the firm

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If U is upper control limit or Optimum cash balance limit,

Then ,
U = 3(Z + L) & Average cash balance is = (4Z-L) / (3)
If F is Rs 2500, variance of daily cash flow is Rs 8000, K =20%, L=0
Then the target cash balance will be:
Z = [ (3 x 2500 x 8000) 4( 0.2 360) ] 1/3
= Rs 2769.17
U = 3z + 3L = ( 3 x 2769.17 ) + 3 x 0
=Rs 8307.51
The average cash balance =>
(4 x2769.17 ) 3 = Rs 3692.22

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STONE MODEL
Cash

Upper
Inner upper level
Target
Inner Lower level
Lower

time
Miller & Orr model
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Stone Model
Limitation:Forecast of the Cash flow in the near Future
Can be successfully predicted.
Rely more on the historical cash flow data of the firm

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Compensating Motive:Banks usually impose a minimum cash balance

In no-interest paid account, to provide
Banking facility which the firms has to
Perforce maintain.

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Speculative motive
Firms wish to profit from positive shocks such as
favorable investment or growth opportunities as
CASH gives them that option.
Option value of cash increases with uncertainty.
Firms with variable cash flows have incentive to
hold more cash.
Uncertainty can be measured from SD of cash
flow or sales.
Recent studies confirmed option value of cash
holding pattern.
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Cash holding as Hedging tool

Numerous variables are not under the control of
the firm , bundled as risk factors.
High financial slack ( adequate cash) to manage
unexpected reduction in cash flow.
Conservative Capital structure with low / no
leverage- financial slack is a hedging tool.
It allows to raise funds, but non optimal financial
structure giving up some value.
Its a corporate risk management strategy.

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Presence of financial friction

Firms financing constraint at the time of
need.
Extent of relationship of the firm
developed with financial system.
The closer the relationship. Friction will be
less if everything else is constant.

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Summary
Firm's maintain higher cash balance if-- High level of cash based transaction
They are small in size
Have volatile cash flows
Their MTB ratio is high
Their R&D investment is high
They have weak relationship with financial
system.
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higher cash balances to

High cash flow to asset ratio

Low net working capital to asset
Low leverage if cash is used to cancel debt
High leverage if cash is used as a hedging tool
against risk of financial distress

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thanks
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