CHAPTER 18 CASH AND MARKETABLE SECURITIES MANAGEMENT INTRODUCTION ash is becoming even more sophisticated in the global and electronic age of the 21° century as financed managers try to squeeze the last peso of profit gut of their cash management strategies. Despite whatever lifelong teachings About the virtues of having cash, the corporate financial manager actively seeks to keep this nonearning asset to a minimum. Minimizing cash balances as well as having accurate knowledge of when cash moves into and out of the company can improve overall corporate profitability. Howevel, a business firm would not want to get caught without cash when it is needed. Cash management involves control over the receipts and payments of cash so as to minimize nonearning cash balances. OBJECTIVE OF CASH MANAGEMENT + objective in cash management is to keep the investment in cash as low II keeping the firm operating efficiently and effectively. \ financial officer can use the following strategies in monitoring cash balances: ig cash 1. Accelerate cash inflows by optimizing mechanisms for coll 1 the cash disbursement needs or payments schedule ize the amount of idle cush or funds committed to transactions-and onary balances: and .d handling losses in the normal course of, b a. f£ peeeiecan aac ive cash manage flows which nals enon Cah nde eae orto Sees 423 et any OPE Planning of ray og of cash ows is sede i. np others the folowing POPE MaNAGEMER of esh Improving forecasts of cash Nows Using floats Synchronizing cash inflows and outtows Accelerating collections Controlling disbursements ‘Obtaining additional funds when and where they are needed REASONS FOR HOLDING CASH BALANCES A. business enterprise may keep part of its capital tied up in cash for several reasons. These are: Transaction Facilitation. This involves the use cash to pay for planned business expenditures suchas supplies, pa; es! bills, interest on debts, cash dividends and acquisitions of long-term fixed assets. “Motive. Although the firm expects cash to come in from day-to-day opera ‘other financing activities, the inflows and outflow are not usually perfectly synchronized tenough cash for emergency purposes. Precautonsry cash ‘more likely to be important in seasonal or cyelical industries ay eore uncertain. Finns with precautionary nests usally ey nce with Creditors’ Covena ‘cash is to be able to comply ping & & in and other reditors of Keeping & borrowed funds in their bank accounts (¢B~ compensahapter 424__Chopter 18. ment Opportunities. Having excess ay allow the firm wo 4. Investmemrageof investment pport ® impossible fe iransact. Example is when a block of raw materials is “inpesd at discounted prices if purchased on cash basis shortage costs of not DETERMINING THE TARGET CASH BALANCE ‘The target cash balance may be derived with the use of the following approaches, namely: 1. Cash Budget Cash Break-even Chart Optimal Cash Balance using the Baumol Model ller-Orr Model 2 CASH BUDGET The cash budget is the tool used to present the expected cash inflows and cash outflows. The preparation of the Cash Budget is discussed and illustrated in detail in Unit 1V, Chapter 16 of this textbook. ASH BREAK-EVEN CHART (Figure 18-1) This chart shows the jionship between the company’s cash needs and the minimum amount of cash that should be mpany to meet its obligations. To illustrate, the le for XYZ Company. XYZ Company manufactures plastic which ‘The monthly production capacity of the company price is P2 per kilo. Its cash requirements have been determined as follows: a) Fixed monthly payments amounting to 250,000 while b)_ Variable cash payments are 50% of sales. . Determine the Cash Break-e 1 caBeanen tin « HEM Pe ae foo" 7 Sales es os fo ON oe a = : = p500,000 or 250,000 kilos Figure 18-1. Cash Break-even Chart Cash Variable Coss Cash Fined Cons 00 925 125 250 375 500 625 VOLUME (000's KILOS)426 Chapter 18 OrrmaLcasiBatance SSS The Baumol Modet In most medium or large-sized c assumed a greater role over the ‘orporations, liquidity man ast decade. in pookea ett has little itself. In managing the ns Purposes versus i Costs must be considered: 1. Fixed and variable brokerage fees, and 2. Opportunity costs such as interest foregone by holding cash instead of near cash, One of the models that can be used to help determine the balance is the “Baumol model”. This hol by borrowing. The optimal cash balance can be found by using the following variables and ‘equations: |. The total costs of cash balances consist of a holding (or opportunity) cost plus a transaction cost: Total Costs = Holding costs. + Transaction costs ‘arma ocean), {nmin tf omc balance Cost transactions | \transaction = -£< (ky) + TF) ic © ‘ash and Marketable Secwrities.. 427 Lathan arteable Securies.. 427 equal ‘amount of cash raised by selling marketable securities or by borrowing = average cash balance ‘optimal amount of cash to be raised by selling ‘marketable securities or by borrowing = optimal average cash balance fixed costs of making a sec loan trade or of obtaining = total amount of net during the period ( ceash needed for transactions a year) i : yal the ie = opporniy ost of ating ety gs Ye ‘Fret fregone on marketable series the cos Sf bonowing to bold ash balances are achieved when C is st soma cah waster or optimal cash replenishes level. The formula to find C* is as follows: ‘Total amount ined Costs of of net new cash | {trading securities 2 orravied cost of borrowing, ees ‘opportunity cost of holding cash or 2(T)(F) K 2mFigure 18-2 shows the balance. Cash and Marketable Securities 429 “The firm may also want to hold a safety stock of cash to reduce the probability of Theah shortage to Some specified level. The Baumol model is simple in many * Spent Other models have been developed to dal both with uncertainty in the reepeflows and with tends, Ul of these modes, including the Baumol models. igre 182. Determination ofthe Tarset Cash Balance cast jrovide a useful starting point for establishing a target eash balance, but all eee Cf them have limitations and must be applied with judgment. 1 The Miller-Orr Model “The Miller-Orr model takes a different approach to calculating the optimal cash qranagement strategy. It assumes thatthe distribution of daily net cash flows normally distributed and allow: 's for both cash inflows and outflows. This mode ' bases its computations where: L the lower control fimit F = the trading cost for marketable securities per transact o = ‘the standard deviation in net daily cash flows ide the daily interest rate on marketable securities Tk i inatic a a iene Coe tee ot Orel ree: Cok Dahan Z* = optimal cash return point To ill a H* = upper control limit for cash balances Touma: comier a basoes wih tl payecas of 10 milion for ons yer th tion of P100, and the interest rate on marketable securities is 8 { To compute for Le The optimal cash balance is calculated as follow: | Z®, the following formula is applied: ce = V 200M)(100) . \__3Fo 8% | Be = *— a tk Aha - PLS84 : To compute for H*, the following formuta is used: Optimal average cash balance = —P/S8.1!4 2 = a2 £79,057en to a non-zero number to. Chapter 18. e fim can set to a non-zero | en sain | aD compete ee eh del but with one key difference, rmecgnig yment eve C* in Ba to the replenish model only allowed for cash disbursement, C* was always Since Baum ya level of Ze. rished = Ore mol, Z* will be the replenishment level to which cash is tn the Mite the cash level hits L, but it will also be the return level that ished when the ba sai bck downto when a its H Iustrative Case II. Calculation of Optimal Return Point and Upper Limit for Miller-Orr Model Suppose that ABC In, would like to maintain its cash account at a minimum it P1000, but experts the standard deviation n net daly ech Ne 5.000; the effective annual rate on marketable securities will be & percent per eat and the trading cost per sale or purchase of marketable securities will be £200 per wansstion. What will be ABC"s optimal cash retum point and upper lint? Solution: ‘The dally iterestrateon marketable securities will equal to: Ca 365 days = 00021 NI 3 (200) Gacy? a NT 3200) (6,000)? 4x.00021 — + 100,000 = 126,101.72 OPH Oth pOLomee M = 3(-26101.22) - 2 (100000) = 378305.16 - 209,000 © (9B 306 16- Wolo) Pa indy woe wasdeseuity eee As shown in the above computation, the fi buying marketable securities when the c it will increase cash to 126,101.72 b ‘cash balance gets down to 100,000, Cash and Marketable Securities 431 im will reduce cash to 126,101.72 by ash balance gets up to 178,305.16, and selling marketable securities when the OTHER FACTORS INFLUENCING THE TARGET CASH BALANCE Option to incur short for cash. If the proba the firm to borrow in hat en eo Ce cared by investing in longer-term securities i higher then that tbe eared on marketable securities, then it might be week i ee Lhe firm to Fisk occasionally paying a relatively high interest wae oy short-term borrowing. ‘Transaction Costs and Time time associated with tradin; that many business firms order to meet any unfore Element. Transaction costs as well as 1g securities have fallen so dramatically low decide to sell marketable securities as needed in seen demand for cash during the day. Many firms must keep certain averag accounts as part of borrowing agr occasionally meet unforeseen dei account to temporarily fall belo To offset this, they keep a account in a later deficiency and meeting ge minimum balances in their deposit. sreements with their bank. Some firms "mand for cash that causes their deposit the minimum compensating balance. corresponding amount of excess cash in the iod. Thus enabling them to cover up the earlier 1g the required average minimum balance CASH MANAGEMENT TECHNIQUES. Although cash management activities are depository. bank, the fin: effectiveness of the cash m: Performed jointly by the firm and its wancial_manager is primarily responsible for the anagement program. ‘A major business enterprise may have hundreds or even thousands of bank accounts and since it is impractical 10 balance in each account, the finance de; implement a system where funds can are, to where they are needed, to arrany invest cash surpluses without delay, think that inflows and outflows will partment should be able to develop and be transferred from where they currently iB loans, to cover net cash shortage and foa cash management encompasses the proper management of cash inflows fective cash manageme ews, which vole 1. Synchronizing cash flows 2. Using floats io where they are needed bursements [SYNCHRONIZING CASH FLOWS Synchronized cash flows is a situ in which inflows coincide with outflows thereby permiting a firm to hold low transactions balances. A thorough review of thecash low analysis, cash conversion eyele and cash budget discussed in the previous chapters would be most helpful By improving the forecasts of cash receipts and Sank be reduced together with the corresponding interest expense, thus 8 profits UsING FLOATS Float is defined as the difference between the balance shown in a firm’s books and the balance on the banks record, s from the delays in mailing, processing and clearing checks through the banking system. check is received and a deposit is made, the deposited funds are not le for use until the check has cleared the banking system (about 3 to 6 ) and credited to the corporate bank account. This works both for checks writen to pay suppliers as well as checks deposited i float can be managed to some extent through a combi collection strategies, F the checks the firm has written but rocessed and thus have not been deducted from the firm’s account balance by the bank. For example, suppose a firm writes on the average, checks amounting to 50,000 each day, and it takes $ days for these checks to lear and to be deducted from the firm’s bank account. This will cause the firm's was Bo ‘undue Cash and Marketable Securities. 433 ‘own checkbook to show a bank’s records balance of 250,000 smaller than the balance on the - Cont Ne, Collections float represents which have not yet been credited t 00 than mount of checks that have been received but ‘Suppose that the firm also receives checks in the amour four days while they are being deposited and cleared. This 0 but I result in P200, of collections float. be eae) In total, the firm's net float, the difference between P250,000 positive disbursement float 00,000 negative collection float, will be 50,000. If posi disbursement float is more than collection float, then the available bank balance exceeds the book balance. A firm with a positive net float can use it to its advantage and maintain a smaller cash balance than it ‘would have in the abseince of the float. iplees oe But the firm must be able to forecast its disbursements and col ns accurately . Basically, the sizeof a firm's net float lectins on checks Tecsived and to slow ns on checks written. Efficient firms go to great lengths to speed up the processing of incoming checks thus putting the funds to work faster and they try to stretch their own payments out as long as possible. POL loka 1AM ddaycy due ACCELERATING CASH COLLECTIONS The finance manager should take steps for speedy recovery from debtors and for this purpose, proper internal control should be installed in the firm. Once the credit sales have been effected, there should be a mechanism for timely recovery from the debtors such as: “1 Prompt if and periodic statements prepared to show the outstanding bills. 2. Incentives such as trade and cash discounts offered to the customers for early/prompt payments. These should be well communicated to them. Sit are received from customers 3. Prompt deposit. Once the checks/drafts are rec no delay should occur in depositing these receipts with the bank: 'o the firm's account by the bank. oscnet 6 -ppank account. CUSTOMETS May alse ae eet deposi to fens Tash dicetly into the bank account of Advisgy 4, Diteesit their Hee Me frm. thes earaanibe apastory eranster OF papment DY wire, gc sane er ae in the computer technology, ng tt te pwd develo alo being switched over t0 the Computer nen hem bok int banking services and cash managemen, Work of tas pers The network wil be linked 10 the different services sot arr of fds wil take place very fast that yt to substantial reduction of fioat. result 4 Maintenance of regional collection office, ‘The above techniques can minimize the time lag between the time the cust Ste checks othe frm and he time when the firm can make use of the fn’ his gatem of cash collection will accelerate the cash inflows of the firm, ‘SLOWING DISBURSEMENTS Any action on the part of the finance officer which slows the disbi funds lessens the use for cash balance. This van be done by: eu 1. Centratized processing of payables. This permits the finance manager the a 7 1 ae coming due for the entire firm and to schedule causal of fands to meet these needs on a company-wide basis. It 2.0 Rails fo more efficient monitoring of payables and float balances. ver should be taken so as not to create ill will among suppliers of goods and ting nd S™¥ices or raise the company’s cost if bills are not paid on Zero bal accounts rer accounts (ZBA). These are special disbursement are presen ea Peso balance on which checks are written. As resented to a ZBA for payment, funds are automaticaly fos och Me mater account. Delaying oe ing payment, : : trade discount for eal on8 HOt going to take advantage of any offered rly payment, pay on the last day of the credit pevo® - Cash and Marketable Securities 435 4 “Play the Moat”. This involves taking ad compan chee rantage of the time it takes for ‘banking system. 5. Less frequent payroll, tn: stead of paying the just be paid semicmontny of PINS the workers weekly, they may [REDUCING THE NEED FOR PRECAUTIONARY BALANCE. Since the transaction and precaut inants cautionary motives are the important determi of the cash requirement, factors influencing their combi i eon: 8 ined level inthe firm must ‘There are techniques that are available for reducing the need for precautionary balances. These include: 1. More accurate cash budgeting. Most critical is the accuracy of the cash budget or forecast. The closer the fit between cash inflows and ‘outflows, the more certain the forecasts the less need for precautionary balances. 2. Lines of credit. This is a pre-arranged loan where the company can ‘withdraw anytime within the period agreed upon. 3, Temporary investments. Investments in highly liquid securities may be maintained instead of holding idle precautionary cash balances. Illustrative Case III. Acceleration of Cash Receipts evaluating a special processing system as @ cash this firm receives remittances ‘and process 4,000 checks over ‘Abubot Fashion Design: receipts acceleration device. In a al a totaling P7 million by check. The firm will recor i the same time period. First National Bank has informed the manage of ‘Abubot Fashion Designs that it will process chesks and a ments ‘through the special processing system for a unit cos! of bo pashion Designs’ financial manager has projected thet cash sd by edo Ci the system can be invested in a portfolio of near cash A ae err before-tax return of & percent. Abubot Fash analysts use a 365-day year in thetr procedures.is necessary for Abubot Fashion Desigis — imeneck collection ia Die ‘adopted the proposed system? for worst O ater better te affected if Abubot Fashion Designs coulg ee expected annual return of 5.5 percent? ya at ion swt yur © Ho pe red bales 0 explanation forthe dferenes in YOUr answers 10 (@) and isthe logical © ie accesary 10 calculate Abubot Fashion Designs’ average i peck amount and the daily opportunity cost of eamying cash, remit ‘The average check size is 7,000,000 4,000 = P1,750 per check ‘The daily opportunity cost of carrying cash is 0.08 = 0,0002192 per day 365 [Next the days saved in the collection process can be evaluated according to the general format of added costs added benefits oF an.toge Cuil, reer 2 Begs age 0.25 (D) (P1,750) (0.00021$2) 0.6517 days * Abubot Fashi : : : : inmplenean poiiaes a therefore will experience a financial gain i Processing system and by doing so will speed up its ion by more han 6517 days a OM = My D Rls ¢ shan Mor b. Here the daily opportunity cost of carrying cash is 0.055 365 0.001507 per day For Abubot Fashion Designs to break-even, shoul special processing system, cash collections must days. as follows: 0.25 7 = (D) (P1,750) (0.0001507) 0.9480 days. = D ‘The break-even cashracceleration period of 0.9480 days is greater than the 0.6517 days found in (a). This is due to the lower yield av cash assets of 5.5 percent annually, versus 8.0 percent. Since the al rate of return on the freed-up balances is lower in the second funds must be invested to cover the cost of operating the special process system, The greater cash-acceleration period generates this increased level of required funds. IMlustrative Case IV. Valuing Float Reduction Motors expects its gross revenues from sa . The firm’s treasurer has projected that its marketable sect earn 6.50 percent over the coming b to be PRO pontfolio year. What is the value of one the company? Miguel Motors uses a 365-day year in of its financial analysis procedures. Solution: Value of one day's float = _ P80 x 65% reduction 365 = Pld2d7 “The company will earn P14,247 per year if it is able to invest its one day sales at 6.5%.