Corporate Finance

PGDM – Div C - Trim III Part I

January 16, 2023
Tapas Mitra
Liquidity, Cash and Marketable
Securities

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Liquidity and its role
• The term liquid assets is used to describe money and assets that are
readily convertible into money.
• Money itself is the most liquid, other assets have varying degrees of
liquidity.
• For assets other than money, liquidity has two dimensions:
1. The time necessary to convert the asset into money; and
2. The degree of certainty associated with the conversion ratio, or price
realized for the asset.

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Liquidity when perfect capital markets exist
• Under the assumptions of perfect capital markets, a firm could not alter its value
by varying its capital structure, its dividend policy or the diversification of the
assets it holds.
• The degree of liquidity of the firm would be matter of indifference to equity
holders. Presumably, investors would manage their portfolios of common stocks
and other assets as well as liabilities, in a way that satisfied their utility for
liquidity.
• As a result, liquidity of individual firms would not be a factor enhancing
shareholder wealth.
• As a result, excess cash cannot be justified. Allow the equity holders to use the
funds for investment in other endeavours providing appropriate returns.
• The assumptions of perfect capital markets imply that if the firm becomes
insolvent and unable to pay its bills, creditors will step in instantaneously and
realise value either by liquidating assets, by running the company themselves or
by effecting a costless reorganization.
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Liquidity management with imperfections
• When we allow for market imperfections, liquidity may become a
desirable characteristic affecting value.
• Two dimensions of bankruptcy costs:
1. “Shortfall” arising from the liquidation of assets at “distress” prices below
their economic values as well as productivity lost in going into bankruptcy;
and
2. Out-of-pocket fees paid to lawyers, trustees in bankruptcy, referees,
receivers, liquidators and so forth.
Embodied in the shortfall phenomenon are considerable delays in bankruptcy
proceedings during which the firm and its value can continue to deteriorate.

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Liquidity management with imperfections –
contd.
• This drain works to the disadvantage of equity holders who have a residual claim
on assets in liquidation.
• Higher interest rates are another result as creditors seek ways of passing on all or
part of the ex ante costs of bankruptcy.
• Investors are unable to diversify away the costs of bankruptcy. The firm can
reduce the probability of bankruptcy, however, by maintaining liquidity.
• Making bankruptcy less probable now and in the future may bestow some
benefits on stockholders as residual owners of the company.
• Another imperfection has to do with contracting cost of managers, workers,
suppliers and customers. If these firms are unable to diversify their claims on the
firm properly, they may require additional incentive the riskier the firm.
This incentive, whether it be higher compensation, higher prices to suppliers or lower prices to
customers, represents a cost to the firm’s equity holders. By increasing liquidity, the risk to
these parties can be reduced and the aforementioned costs lowered.

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Benefits relative to cost
• Against the benefits associated with maintaining liquidity, one must
balance the cost.
• Liquid assets, like all other assets, have to be financed. Accordingly, the
cost of liquidity may be thought of as the differential in interest earned on
the investment of funds in liquid assets and the cost of financing.
• If imperfections in capital markets result in borrowing rate exceeding the
lending rate, there is a “cost” to maintaining liquidity.
• Quantification of this trade-off is complex. Our purpose is to explore the
problem in concept.
• The important thing in establishing a case for a company maintaining any
liquidity is the presence of market imperfections that make liquidity a
thing of value.

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Cash management and collections
• Cash management involves managing the monies of the firm to
maximise cash availability and interest income on idle funds.
• At one end, the function starts when a customer writes a cheque to
pay the firm on its accounts receivable. The function ends when a
supplier, an employee or the government realizes collected funds
from the firm on an account payable or accrual. All activities between
these two points fall within the realm of cash management.
• The idea is to collect as soon as possible but pay accounts payable as
late as is consistent with maintaining the firm’s credit standing with
suppliers.

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Cash management and collections – contd.
• Accelerate collections
1. Speed the mailing time for payments from customers to the firm;
2. Reduce the time during which payments received by the firm remain
uncollected funds; and
3. Speed the movement of funds to disbursement banks.
• The second item representing float, needs to be the minimum.
• Transferring funds
• Increasing cash availability also involves moving funds among banks through
1. Online transfers
2. Wire transfer;
3. Electronic depository transfer cheques.

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Cash management and collections – contd.
• Concentration banking
– It means accelerating the flow of funds of a firm by establishing strategic
collection centres.
– Instead of a single collection centre located at the company headquarters,
multiple collection centres are established.
– A bank of concentration is one with which the company has a major account –
usually disbursement account.
– The advantage of a system of decentralized billings and collections over a
centralized system is twofold.
1. The mailing time is reduced;
2. The time required to collect cheques is reduced because remittances deposited in the
collection centre’s local bank usually are drawn of banks in that general area.
– Profits from the investment of the released funds must be compared with any
additional costs of a decentralized system over a centralised one.

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Cash management and collections – contd.
• Lockbox system
– The company rents a local post office box and authorises its bank in each of the selected
cities to pick up remittances in the box.
– Customers are billed with instructions to mail their remittances to the lockbox.
– The bank picks up the mail several times a day and deposits the cheques in the company’s
account for collection.
– The lag between the time cheques are received by the company and the time they are
actually deposited at the bank is eliminated.
– Because the cost is almost directly proportional to the number of cheques deposited, lockbox
arrangements usually are not profitable if the average remittance is small.
• Preauthorised cheques (PAC)
– It works well for certain large customers where payments of a fixed amount are required.
– The PAC is like an ordinary cheque but it does not require the drawer to sign it. Rather, the
customer has given legal authorization to the vendor to draw cheques on its bank account
– This system works only when both the customer and the vendor are well known to each
other and completely creditworthy.

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Control of disbursements
• Effective management of disbursements can also result in more
availability of cash.
• Whereas the underlying objective of collections is maximum
acceleration, the objective in disbursements is to slow them down as
much as possible. The combination of fast collections and slow
disbursements will result in maximum availability of funds.
• One way of maximizing cash availability is “playing the float”.
• If the size of the float can be estimated accurately, bank balances can
be reduced and the funds invested to earn a positive return.

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Control of disbursements – contd.
• Zero Balance Account (ZBA)
– ZBA is offered by a number of banks and it eliminates the need to estimate and fund
each disbursement account.
– At the end of each day, the bank automatically transfers just enough funds to cover
the cheques presented for collection.
– As a result a zero balance is maintained in each of the special disbursing accounts.
– While balances must be maintained in the master account, increased efficiency
works to reduce the total balances that must be maintained.
• Payroll and Dividend Disbursements
– Many companies have a separate account for payroll disbursements.
– In order to minimize balance in this account, one must predict when the payroll
cheques issued will be presented for payment.
– Many firms establish a separate account for dividends, similar to the payroll account.
Here too the idea is to predict when such cheques will be presented for payment, to
minimize the cash balance in the account.

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Control of disbursements – contd.
• Electronic Funds Transfers
– Accelerating collections and slowing disbursements increasingly are being
done electronically.
– Electronic funds transfer is a subset of electronic commerce, the exchange of
business information in an electronic format.
– Internationally it may be effected through CHIPS, the Clearing House
Interbank Payments System and through SWIFT, the Society of Worldwide
Interbank Financial Telecommunications.
– Electronic Funds Transfer is capital intensive, the cost per transaction is
reduced as volume increases.
– Domestically there are various methods of funds transfers managed by banks
governed by India’s central bank – the RBI:
– NEFT (National Electronic Funds Transfer)/RTGS (Real Time Gross Settlement)/IMPS
(Immediate Payment Service), etc.

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Investment in Marketable Securities
• The financial manager will want to invest the portion of liquid assets
in excess of transactions cash needs.
• Yields of marketable securities vary with differences
i. in the Default risk;
ii. in marketability;
iii. in length of time to maturity,
iv. in coupon rate; and
v. in taxability.

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Investment in Marketable Securities – contd.
• Credit risk
– By credit risk or default risk we mean the risk that the borrower will not satisfy the
contractual obligation to make principal and interest payments.
– The greater the possibility that the borrower will default, the greater the financial
risk and the premium demanded by the marketplace.
– Treasury securities(bills) are usually regarded as default free and other securities are
judged in relation to them. The Central Government of India issues Treasury Bills –
for all practical purposes these securities are default free.
– The credit worthiness of other obligations is frequently judged on the basis of
security ratings. Moody’s Investors Service, Standard & Poor’s, Crisil, ICRA, Fitch, etc.,
grade the corporate and other securities.
– The greater the default risk of the borrower, the greater the yield of the security
should be, all other things held constant.
– By investing in riskier securities the firm can achieve higher returns but it faces the
familiar trade-off between expected return and risk.

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Investment in Marketable Securities – contd.
• Marketability
– Marketability of securities relates to the ability of the owner to convert it into
cash.
– There are two dimensions: the price realized and the amount of time required
to sell the asset. The two are interrelated in that it is often possible to sell an
asset in a short period of time if enough price concession is given.
– For financial instruments, marketability is judged in relation to the ability to
sell a significant volume of securities in a short period of time without
significant price concession.
– The more marketable the security, the greater the ability to execute a large
transaction near the quoted price.
– In general, the lower the marketability of a security, the greater the yield
necessary to attract investors.
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Investment in Marketable Securities – contd.
• Maturity
– The relationship between yield and maturity can be studied graphically by
plotting yield and maturity for securities differing in length of time to
maturity. In practice, this means holding constant the degree of default risk.
– Generally, when interest rates are expected to rise, the yield curve is upward
sloping, whereas it is humped or somewhat downward sloping when they are
expected to fall significantly.
– In general, the longer the maturity, the greater the risk of fluctuation in the
market value of the security. Consequently, investors need to be offered a risk
premium to induce them to invest in long-term securities.
– Only when interest rates are expected to fall significantly are they willing to
invest in long-term securities yielding less than short- and intermediate-term
securities.

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Investment in Marketable Securities – contd.
• Coupon Rate
– In addition to maturity, price fluctuations also depend on the level of the coupon.
– For a given fixed-income security, the lower the coupon rate, the greater the price
change for a given shift in interest rates.
– In effect investors realise their return sooner with high-coupon bonds than with low-
coupon ones.
– Thus the volatility of a security depends on the combined effect of maturity and
coupon rate.
• Taxability
– Another factor affecting observed differences in market yields is the differential
impact of taxes.
– The securities income from which are tax exempt, will sell in the market at lower
yields to maturity than other and corporate securities.

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