27-1

CHAPTER
27
Cash
Management

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Chapter Outline
27.1 Reasons for Holding Cash
27.2 Determining the Target Cash Balance
27.3 Managing the Collection and
Disbursement of Cash
27.4 Investing Idle Cash
27.5 Summary & Conclusions

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27.1 Reasons for Holding Cash

Transactions motive
Compensating balances

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27.2 Determining the Target

Cash Balance
The Baumol Model
The Miller-Orr Model
Other Factors Influencing the Target Cash
Balance

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27-5

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
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The Baumol Model

F = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed
K = The opportunity cost of holding cash, a.k.a. the interest rate.
If we start with $C, spend at a
constant rate each period and
C
replace our cash with $C when
we run out of cash, our average
C cash balance will be C .
–2 –2
The opportunity cost
C is C ×K
of holding –
1 2 3 Time 2
–2
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The Baumol Model

F = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed
K = The opportunity cost of holding cash, a.k.a. the interest rate.

As we transfer $C each period

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

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

T
Trading costs F
C
C* Size of cash balance
The optimal cash balance is found where the opportunity
costs equals the trading costs
2T
C  F
*
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The Baumol Model

The optimal cash balance is found where the opportunity
costs equals the trading costs

Opportunity Costs = Trading Costs

C  T 
K F
2 C
Multiply both sides by C
2
C    T F
C 2 
2
K T F
2 K
2TF
C 
*

K
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27-10

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 H cash
is invested elsewhere to get us to the target cash balance Z.
H
When the cash balance
reaches the lower
control limit, L,
investments are sold
Z to raise cash to get
us up to the target
L cash balance.
Time
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The Miller-Orr Model Math

Given L, which is set by the firm, the Miller-Orr
model solves for Z and H
3 Fσ2
*
H  3Z  2 L
*

Z*  3 L
4K
where 2 is the variance of net daily cash flows.
• The average cash balance in the Miller-Orr model
is
4Z *  L
Average cash balance 
3
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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.

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Implications of the Miller-Orr Model

The model clarifies the issues of cash
management:
The best return point, Z, is positively related to
trading costs, F, and negatively related to the interest
rate K.
Z and the average cash balance are positively related
to the variability of cash flows.

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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 management’s
desire to hold low cash balances.

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Other Factors Influencing the Target

Cash Balance
Compensating Balance
Firms have cash in the bank as a compensation for
banking services.
Large corporations have thousands of accounts with
several dozen banks—sometimes it makes more sense
to leave cash alone than to manage each account on a
daily basis.

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Float
The difference between bank cash and book cash
is called float.
Float management involves controlling the
collection and disbursement of cash.

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27.3 Managing the Collection and

Disbursement of Cash
Accelerating Collections
Delaying Disbursements
Disbursement Float
Zero-Balance Accounts
Drafts
Ethical and Legal Questions

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Accelerating Collections
Customer Company Company
Cash
mails receives deposits
received
payment payment payment

time
Mail Processing Clearing
delay delay delay

Mail Processing Clearing

float float float

Collection float
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Overview of Lockbox Processing

Corporate Corporate Corporate Corporate
Customers Customers Customers Customers

Post Office Post Office

Local Bank
Box 1 Collects funds Box 2
from PO Boxes

Envelopes opened;
separation of
checks and receipts

Details of receivables Deposit of checks

go to firm into bank accounts

Firm processes
Bank clears checks
receivables
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Delaying Disbursements
Firm prepares
check to supplier 1. Write check on a distant bank.
2. Hold payment for several days after
Post Office
processing postmarked in office.
3. Call supplier firm to verify
Delivery of check
to supplier
statement accuracy for large
amounts.
Deposit goes to 4. Mail from distant post office.
supplier’s bank
5. Mail from post office that requires a
great deal of handling.
Bank collects funds

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Drafts
Firms sometimes use drafts instead of checks.
Drafts differ from checks because they are not drawn on a bank
but on an issuer (the firm) and are payable by the issuer.
The bank acts only as an agent, presenting the draft to the issuer
for payment.
When the draft is transmitted to a firm’s bank for collection, the
bank must present the draft to the issuing firm for acceptance
before making payment.
After the draft has been accepted, the firm must deposit the
necessary cash to cover the payments.
This allows the firm to keep less cash on hand.

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Ethical and Legal Questions

The financial managers must always work with
collected company cash balances and not with
the company’s book balance, which reflects
checks that have been deposited but not
collected.
If you are borrowing the bank’s money without
their knowledge, you are raising serious ethical
and legal questions.

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27.4 Investing Idle Cash

A firm with surplus cash can park it in the
money market.
Some large firms and many small ones use money
market mutual funds.
Firms have surplus cash for three reasons:
Seasonal or Cyclical Activities
Planned Expenditures
Different Types of Money Market Securities

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Seasonal Cash Demands

Total Financing needs
Bank loans

Marketable Short-term
securities financing

Long-term
financing

J F M A M Time
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27.5 Summary & Conclusions

A firm holds cash to conduct transactions and to
compensate banks for the various services they
render.
The optimal amount of cash for a firm to hold
depends on the opportunity cost of holding cash
and the uncertainty of future cash inflows and
outflows.

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27.5 Summary & Conclusions

Two transactions models that provide rough
guidelines for determining the optimal cash
postion are:
The Miller-Orr model
The Baumol model

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27.5 Summary & Conclusions

The firm can make use of a variety of procedures
to manage the collection and disbursement of
cash in such as way as to speed up the collection
of cash and slow down payments.

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27.5 Summary & Conclusions

Some methods to speed collections are
Lockboxes
Concentration banking
Wire transfers
The financial managers must always work with
collected company cash balances and not with
the company’s book balance.

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27.5 Summary & Conclusions

If you are borrowing the bank’s money without
their knowledge, you are raising serious ethical
and legal questions.
The answers to which you probably know by
now.

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