FINANCIAL MANAGEMENT - II

Session 20

Working Capital - Cash Management

 Cash Management
• Cash management is concerned with the
managing of:

– cash flows into and out of the firm

– cash flows within the firm

• cash balances held by the firm at a point of

time by financing deficit or investing surplus
cash
Cash management cycle
 Motives for Holding Cash

• The transactions motive

• The precautionary motive

• The speculative motive

• The Compensation motive

 Objectives of Cash Management

• Meeting payment schedule

• Minimizing funds committed to cash balance

Factors determining Cash balances
• Synchronization of cash flows
• Short costs
• Excess cash balance
• Procurement and management
• Uncertainty
 Facets of Cash Management

• Cash planning

• Managing the cash flows

• Optimum cash level

• Investing surplus cash

• Accelerating Cash Collections

• Decentralized Collections
 Cash Planning
Cash planning is a technique to plan and control
the use of cash.

Cash budget Is the most significant device to

plan for and control cash receipts and payments.

Cash forecasts are needed to prepare cash

budgets.
 Controlling Disbursements

• Delaying disbursement results in maximum availability of

funds. However, the firms that delay in making payments may
endanger its credit standing.

• While, for accelerated collections a decentralized collection

procedure may be followed, for a proper control of
disbursements, a centralized system may be advantageous.

• Some firms use the technique of ‘playing the float’ to

maximize the availability of funds. When the firm’s actual
bank balance is greater than the balances how in the firm’s
books, the difference is called disbursement or payment
float.
 Optimum Cash Balance

• Optimum Cash Balance under Certainty:

Baumol’s Model

• Optimum Cash Balance under Uncertainty:

The Miller–Orr Model
 Baumol’s Model–Assumptions

• The firm is able to forecast its cash needs with certainty.

• The firm’s cash payments occur uniformly over a period of

time.

• The opportunity cost of holding cash is known and it does

not change over time.

• The firm will incur the same transaction cost whenever it

converts securities to cash.
 Case let 1 -Baumol’s Model
A Firm has estimated that total disbursements
during the coming year will be Rs. 720 lakhs. The
outflows will be incurred steadily over the
period. The firm has been parking its surplus
cash in portfolio of securities, with an average
yield of 12% per annum. The cost per
transaction (disinvestment or investment) for
the firm has been Rs.1000. Find the optimal
working balance.
 Solution
•   Optimal working balance as per Baumol’s model is :
The

b=cost per transaction; T=total cash needed during the

year; K=Opportunity cost of holding the cash balance

= Rs. 10,95,445

The number of transactions during the year will be:

7,20,00,000 / 10,95,445 = 65 transactions
 Case let 2 -Baumol’s Model
Advani chemicals limited estimates its total cash
requirements is Rs.2 crore next year. The company's
opportunity cost of funds is 15 per cent per annum.
The company will have to incur Rs. 150 per
transaction when it converts its short term securities
to cash. Determine the optimum cash balance.
How much is the total annual cost of the demand for
the optimum cash balance? How many deposits will
have to be made during the year
 Solution
•The
  Optimal working balance as per Baumol’s model
is :

b=cost per transaction; T=total cash needed

during the year; K=Opportunity cost of holding
the cash balance
= Rs. 2,00,000

The number of transactions during the year will be:

2,00,00,000 / 2,00,000 = 100 transactions
 Case let 3 -Baumol’s Model
The ABC limited requires Rs. 30 lakh in cash to meet its
transaction needs during the next three months cash planning
period. It holds marketable securities of an equal amount. The
annual yield on these marketable securities is 20 per cent. The
conversion of these securities into cash entails a fixed cost of Rs.
3000 per transaction. Using the Baumol model compute the
amount of marketable securities converted into cash per order.
Assuming ABC limited can sell its marketable securities in any of
the five lot sizes: Rs. 1,50,000, Rs. 2,00,000, Rs. 6,00,000, Rs.
7,50,000 and Rs. 15,00,000.

Prepare a table indicating the economic lot size using numerical

analysis.
 Solution
•The
  Optimal working balance as per Baumol’s model
is :

b=cost per transaction; T=total cash needed

during the year; K=Opportunity cost of holding
the cash balance
= Rs. 6,00,000

The number of transactions during the year will be:

30,00,000 / 6,00,000 = 5 transactions
 Solution Contd..
optimal cash conversion
size/log
total cash requirement 3000000 3000000 3000000 3000000 3000000

lot size 150000 200000 600000 750000 1500000

No. of. Lots (Cash/Lot Size) 20 15 5 4 2

conversion cost per lot 3000 3000 3000 3000 3000

total conversion cost 60000 45000 15000 12000 6000

interest cost @0.05 on lot size 7500 10000 30000 37500 75000

total cost 67500 55000 45000 49500 81000

 The Miller–Orr Model

• The MO model provides for two control limits–the

upper control limit and the lower control limit as
well as a return point.

• If the firm’s cash flows fluctuate randomly and hit

the upper limit, then it buys sufficient marketable
securities to come back to a normal level of cash
balance (the return point).

• Similarly, when the firm’s cash flows wander and hit

the lower limit, It sells sufficient marketable
securities to bring the cash balance back to the
normal level (the return point).
The Miller–Orr Model
 The Miller–Orr Model

•  
• The Upper Control limit is defined as follows:
• Upper Control Limit

b=Transaction Cost
K=Opportunity Cost
S2 = Variance of the cash flows
 Case let 4 -The Miller–Orr Model
Projected cash flows of Zeta Ltd for the coming week are as
follows:
Day 1 2 3 4 5 6 7
Projected 48 15 20 -26 -32 10 -30
Cash Flow

The firm incurs a fixed cost of Rs. 2000 per transaction every time
it invests or disinvests. The average return that the firm earned
during the previous year by investing its surplus in marketable
securities was 12%. The company management always keeps a
minimum cash balance of Rs. 25000. Based on the above
information, find the return point and the upper control limit using
the MO model.
 Solution
Variance of Projected Cash Flows =
Var.P (48 15 20 -26 -32 10 -30 ) = 804 –EXCEL

Minimum Cash Balance (L) = 25,000

Transaction Cost (b) = Rs. 2000

Opportunity Cost (K) = 0.12

 Solution Contd..
•  

• 0.25 + 33.27 = Rs. 33.52 Lakh

 Solution Contd..
•  Upper Control Limit

= 3*R + L

= 3 * 33.52 +0.25 = Rs. 100.68 Lakhs

 Case let 5 – do it by your own
• PKG company has a policy of maintaining a
minimum cash balance of Rs. 500,000. the
standard deviation of the company's daily cash
flows is Rs. 200,000. the annual interest rate is
14%. The transaction cost of buying and
selling securities is Rs. 150 per transaction.
Determine PKG's upper control limit and the
return point as per the Miller-Orr model.
 Strategic Aspects
Strategy for efficient cash management is to collect accounts
receivable as quickly as possible without losing future sales
because of high-pressure collection techniques.

Strategic aspects of efficient cash management are

 
• Efficient inventory management
• Speedy collection of accounts receivable
• Delaying payments on accounts payable
 Strategic Aspects
EFFICIENT INVENTORY MANAGEMENT
Refer inventory management module

SPEEDY COLLECTION OF ACCOUNTS RECEIVABLE

Prompt payment by customers
  Early conversion of payments

SLOWING DISBURSEMENTS
 INVESTING SURPLUS CASH IN MARKETABLE SECURITIES

Selecting Investment Opportunities

– Safety

– Maturity

– Marketability
 Short-term Investment Opportunities

• Treasury bills

• Commercial papers

• Certificates of deposits

• Bank deposits

• Inter-corporate deposits
•
• Money market mutual funds
 Features of Instruments of Collection in
India in addition to Real Time Settlements