CHAPTER ' CASH AND MARKETABLE SECURITIES MANAGEMENT Exnected Learning Outcomes Atfer studying Chapter 12, you should be able to: 1. Understand the concept of cash management. Learn the objectives of cash management. 'dentify the reasons for holding cash balances, -° OM Know how to determine the target cash balance using @) Cash buaget ' b). Cash Break-even Chart ¢) Optimal Cash Balance 5. Understand the other fac ictors that influence the target Cash balance, 6. Know the cash management techni iques to manage Properly the cash flows of the firm. Understand the objective of marketable securities management. 8. Realize the reason for holding marketable securities, 9. Identity the factors influencing the choice of marketable securities, 10. Leam the types of marketable securities. 4404CHAPTER 12 CASH AND MARKETABL! SECURITIES MANAGEMENT oO INTRODUCTION Managing cash is becoming even more sophisticated in the global and electronic age of the 21" century as finance managers try to squeeze. the last peso of profit: out 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. However, 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 The basic objective in cash management is to keep the investment in cash as low as possible while still keeping the firm operating efficiently and effectively. A financial officer can use the following strategies in monitoring cash balances: 1. Accelerate cash inflows by optimizing mechanisms for collecting cash 2. Monitor the cash disbursement needs or payments schedule 3. Minimize the amount of idle cash or funds committed to transactions and precautionary balances: and 4. Avoid mi: iatic i ii Avoid miseppropriation and handling losses. in the normal course of> Cash and Marketable Securities Management _279 Toachieve'the. above objectives, proper, planning of cash flows is needed. Effective cash management generally encompasses proper management of cash flows which entails among others the following: a. b. c. d. e f. Improving forecasts of cash flows Using floats Synchronizing cash inflows and outflows 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: t Transaction Facilitation. This involves the use of cash to pay for planned business expenditures such as supplies, payrolls, taxes, suppliers" bills, interest on debts, cash dividends and acquisitions of long-term fixed ” assets. a Precautionary Motive. Although the firm expects cash to come in from day-to-day operations and other financing activities, the inflows and outflows are not usually perfectly synchronized. It will need to keep enough cash for emergency purposes. Precautionary cash balances are more likely to be important in seasonal or cyclical industries where cash inflows are more uncertain. Firms with precautionary needs usually rely ‘on unused lines of bank credit. Compliance with Creditors” Covenant. Another major reason for holding cash is to be able to comply the requirement of lending institutions and other creditors of keeping a certain percentage of borrowed funds in > their bank accounts (e.g., compensating balance). Investment Opportunities. Having excess cash may allow the firm to take advantage of investment opportunities that would otherwise be impossible to transact. Example is when a block of raw materials is offered at discounted prices if purchased on cash basis. :280 Chapter 12 ss st know the trade-off i i firms mu: To determine he h cash to keep on jand, fi % * between ib oppartity costs associated with holding too much cash against the shortage costs of not having enough cash. DETERMINING THE TARGET CASH BALANCE ‘The target cash balance may be derived with the use of the following approaches, namely: i, Cash Budget 2. Cash Break-even Chart 3. Optimal Cash Balance using the a) Baumol Model b)_Miller-Orr Model (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 II], Chapter 10 of this textbook. (CASH BREAK-EVEN CHART (Figure 12-1) This chart shows the relationship between the company’s cash needs and cash sources. It indicates the minimum amount of cesh-that should be maintained to enable the company to meet its obligations. To illustrate, the following data are available for XYZ Company. = XYZ Company manufactures plastic which it sells to other industrial users. ‘The monthly production capacity of the company is 1,200,000 kilos. Selling price is P2 per kilo. Its cash requirements have been determined as follows: a) Fixed monthly payments amounting to P250,000 while b) Variable cash payments are 50% of sales. Required: - - : 1... Determine the Cash Break-even poi i t point (mathematical approach). 2. Prepare a Cash Break-even Chart to project the relationship between the company’s cash needs and cash sources.Cash and Marketable Securities Management 281 Solution: Fixed Monthly Pz It 4 a Mnthly Payments _ 1. Cash Break-even Point = Variable Co 7 Sales - —Yarlable Costs _ i Sales 250,000. = 50% 100% — 0% To0% — 250,000 50% = £500,000 or 250,000 kilos of plastic Figure 12-1. Cash Break-even Chart 156 Total Cash Receipts 1,500 Total Disbursements 1,250 1.000 Cash Break-even Ss (000’s) 750 sO ——> Cash Variable Costs 250 Cash Fixed Costs 375 500 625° 800 VOLUME (000’s KILOS)282 Chapter 12 OPTIMAL CASH BALANCE The Baumol Model it i: i iquidity management has In most medium or large-sized corporations, liquidity _ assumed.a greater role over the past decade. Since cash is needed for both transactions and precautionary needs in‘all companies, it must be available in some form, (cash, marketable securities borrowing, capacity) all of the time. The liquidity managers must utilize some formal models or techniques to maintain the optimal amount at each moment in time because too much liquidity brings down the rate of return on total assets employed and too little liquidity jeopardizes the very existence of the firm itself. In managing the level of cash (currency plus demand deposits) for transaction purposes versus near cash (marketable securities), the following 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 optimal cash balance is the “Baumol model”. This model balances the opportunity cost of holding - cash against the transactions costs associated with replenishing the cash account by selling off marketable securities or by borrowing. The optimal cash balance can be found by using the following variables and equations: 1. The total costs of cash balances consist of a holding (or opportunity) cost plus a transaction cost: Total Costs = Holding costs + Transaction costs _ [Average a Cash ‘Opportunity : Number of |{ Cost per balance. Cost transactions | \transaction = Cc OR oP)Cash and Marketable Securities Management 283 wher re: slo a amount of cash rai ised by i iti or by borrowing y selling marketable securities 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 securities trade or of obtaining aloan total amount of net new cash needed for transactions during the period (usually a:year) opportunity cost of holding cash, net equal to the rate of return foregone on marketable securities or the cost of borrowing to hold cash ee 2. The minimum costs of cash balances are achieved when C is set equal to C*, the optimal cash transfer or optimal cash replenishment level. The formula to find C* is as follows: ct = Total amount Fixed Costs of 2 | of net new cash | | trading securities or required cost of borrowing opportunity cost of holding cash or o VIO Figure 12-2 shows the graphical approach in determining the Target cash balance.284 Chapter 12 Figure 12-2. Determination of the Target Cash Balance Costs of Holding Cash (P) Total Costs of Holding Cash c ‘Opportunity cost Transactions Cost ‘Cash Ordered (P) Illustrative Case I. Determination of Optimal Average Cash Balance for Baumol Model . To illustrate, consider a business with total payments of P10 million for one year, cost per transaction of P100, and the interest rate on marketable securities is 8 percent. The optimal cash balance is calculated as follows: cr.- V 2G0M)(100) 8% PIS8,114 P1S8,114 2 Optimal average cash balance 279,057} } Cash and Marketable Securities Management 285 The firm may also want to hold a safe Stock of ili Tosh Wdrings 8 some tea afety of cash to reduce the probability of The Miller-Orr Model The Miller-Orr model takes a different approach to calculating the optimal cash management strategy. It assumes that the distribution of daily net cash flows is normally distributed and allows for both cash inflows and outflows: This model bases its computations where: the lower control limit F = "the trading cost for marketable securities per transaction o = the standard deviation in net daily cash flows ig et te daily interest rate on marketable securities z 5 optimal cash return point Heo upper control limit for cash balances To compute for Z*, the’ following formula is applied: ze = V 3 Fo? tight * To compute for H*, the following formula is used: Ht: = 3Z* -2L286 Chapter 12 Note that the firm determines L and the firm can set to a non-zero number to recognize the use of safety stock. The optimal cash return point z is comparable to the replenishment level C* in Baumol’s model but with one key difference. Since Baumol’s model only allowed for cash disbursement, C* was always “replenished to” from a level of zero. In the Miller-Orr model, Z* will be the replenishment level to which cash is replenished when the cash level hits L, but it will also be the return level that cash is brought back down to when cash hits H*._ IMlustrative Case II. Calculation of Optimal Return Point and Upper Limit for Miller-Orr Model Suppose that ABC Inc., would like to maintain its cash account at a minimum level of 100,000, but expects the ‘standard deviation in net daily cash flows to be 5,000; the effective annual rate on marketable securities will be 8 percent per year, and the trading cost per sale or purchase of marketable securities will be P200 per transaction. What will be ABC”s optimal cash return point and upper limit? Solution: The daily interest rate on marketable securities will equal to: . = 8% fae = “S65 deyg 7 00021 Ze Ni 3 (200) (5,000)? 4x01 * 100,000 101.72 H* == —3(126,101.72) - 2 (100,000) - 378,305.16 —- 200,000 a 178,305.16Cash and Marketable Securities Management _ 287 As shown in the above computation, the firm will reduce cash to P126,101.72 by buying marketable securities when the cash balance gets up to P178,305.16, and it will increase cash to P126,101.72 by selling marketable securities when the cash balance gets down to P100,000. OTHER FACTORS INFLUENCING THE TARGET CASH BALANCE 1. Option to incur short-term borrowing to meet unexpected demands for cash. If the probability of an unexpected demand for cash causing the firm to borrow in the short-term is low enough, or if the amount of interest to be earned by investing in longer-term securities is higher than that to be earned on marketable securities; then it might be worth it for the firm to risk occasionally paying a relatively high interest rate on short-term borrowing. : 2. Transaction Costs and Time Element. Transaction costs as well as time associated with trading securities have fallen so dramatically low that many business firms decide to sell marketable securities as needed in order to meet any unforeseen demand for cash during the day. 3. Many firms must keep certain average minimum balances in their deposit accounts as part of borrowing agreements with their bank. Some firms occasionally meet unforeseen demand for cash that causes their deposit account to temporarily fall below the minimum compensating balance. To offset this, they keep a corresponding amount of excess cash in the account in a later period. Thus, enabling them to cover up the earlier deficiency and meeting the required average minimum balance. CASH MANAGEMENT TECHNIQUES, Although cash management activities are performed jointly by the firm and. its depository bank, the financial manager is primarily responsible for the effectiveness of the cash management program. A major business enterprise may have hundreds or even thousands of bank accounts and since it is impractical to think that inflows and outflows will balance in each account, the finance department should be able to develop and implement system where furids can be transferred from where they currently are, to where they are needed, to arrange lodins, to cover net cash shortage and to invest cash Surpluses without delay.288 Chapter 12 Effective cash management encompasses the proper management of cash inflow. and outflows, which involve: Synchronizing cash flows Using floats i i ‘Accelerating cash collections Getting available funds to where they are needed Controlling disbursements BPepyr ‘SYNCHRONIZING CASH FLOWS is a situation in which inflows coincide with outflows transactions balances. A thorough review of cycle and cash budget discussed in the Synchronized cash flows | thereby permitting a firm to hold low the cash flow analysis, cash conversion previous chapters would be most helpful. By improving the forecasts of cash receipts and disbursements and arranging things so that cash receipts coincide or occur at an earlier time than the timing of required cash outflows, firms can reduce their cash balance to meet transactional requirements to a: minimum. If the firm is able to reduce its cash balance,. bank loans will. be reduced together with thé corresponding interest expense, thus boosting 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. It arises from the delays in mailing, processing and clearing checks through the banking system. Once a check is received and a deposit is made, the deposited funds are not available for use until the check has cleared the banking system (about 3 to 6 days) and credited to the corporate bank account. This works both for checks written t0 pay. suppliers as well as checks deposited from customers. This means float can be managed to some extent through a combination of disbursement and collection strategies. a Disbursement float represents the value of the checks the firm has written but which are still being processed and thus have not been deducted from the firm’s account balance by the bank. For exampie, suppose a firm writes on the average checks amounting to P50,000 each day, and it takes 5 days for these checks to cleat and to be deducted from the firm’s bank account. This will cause the firm's O"- Cash and Marketable Securities Management _289 checkbook to show a balance of 250,000 smaller than the balance on the bank’s records. Collections float represents the amount of checks that have been received but which have not yet been credited to the firm’s account by the bank: Suppose that the firm also receives checks in the amount of 50,000 but it loses four days while they are being deposited and cleared. This will result in P200,000 of collections float. In total, the firm's net float, the difference between 250,000 positive disbursement float and the ®200,000 negative collection float, will be P50,000. If, the net float is positive, that is, disbursement float is more than collection float, then the available bank balance exceeds the book balance. A firm with a positi net float can use it to its advantage and maintain a smaller cash balance than it would have in the absence of the float. But the firm must be able to forecast its disbursements and collections accurately in order to make much héavy use of float. Basically, the size of a firm’s net float is a function of its ability to speed up collections on checks received and to slow down collections 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. 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 built-in mechanism for timely recovery from the debtors such as: |, Prompt billing 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. 3. Prompt deposit. Once the checks/drafts are received from customers, no delay should occur in depositing these receipts with the bank. ee...290__ Chapter 12 4. Direct deposit to firm’s bank account. Customers may also be advised to deposit their checks or cash directly into the bank account of the firm and furnish details to the firm. 5. Electronic depository transfer or payment by wire. With the developments taking place in the computer technology, the present booking system is also being switched over to the computer network of banks to offer efficient banking services and cash management services to their customers. The network will be linked to the different branches, banks and the transfer of funds will take place very fast that will result to substantial reduction of float. 6. Maintenance of regional collection office. The above techniques can minimize the tithe lag between the time the customers send.the checks to the firm and the time when the firm can make use of the funds. This system 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 disbursement of funds lessens the use for cash balance. This can be done by: 1. Centralized processing of payables. This permits the finance manager to evaluate the payments coming due for the entire firm and to schedule the availability of funds to meet these needs on a company-wide basis. It also results to more efficient monitoring of payables and float balances. Care however should be taken so as not to create ill will among suppliers of goods and services or raise the company’s cost if bills are not paid on time. 2. Zero balance accounts (ZBA). These are special disbursement accounts having a zero peso balance on which checks are written. As checks are. presented to a ZBA for payment, funds are automatically transferred from the master account. 3. Delaying payment. If one is not going to take advantage of any offered trade discount for early payment, pay on the last day of the credit period.Cash and Marketable Securities Management 291 4, “Play the float”. This involves taking advantage of the time it takes for the company’s check to clear the banking system. 5. Less frequent payroll. Instead of paying the workers weekly, they may just be paid semi-monthly, : REDUCING THE NEED FOR PRECAUTIONARY BALANCE Since the transaction and precautionary motives are the important determinants of the cash requirement, factors influencing their combined level in the firm must be analyzed. - 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 wheie the company can withdraw anytime within the period agreed upon. 3. Temporary investments. Investments in highly liquid secu: maintained instead of holding idle precautionary cash balances. Illustrative Case III. Acceleration of Cash Receipts Abubot Fashion Designs is evaluating a special processing system as a cash Feceipts acceleration device. In a typical year, this firm receives remittances totaling P7 million by check. The firm will record and process 4,000 checks over the same time period. Fitst National Bank has informed the management of Abubot Fashion Designs that it will process checks and associated documents through the special processing system for a unit cost of 0.25 per check. Abubot Fashion Designs’ financial manager has projected that cash freed by adoption of the system can be invested in a portfolio of near-cash assets that will yield an ° annual before-tax return of 8 percent. Abubot Fashion Designs’ financial analysts Use a 365-day year in their procedures. Required: What reduction in check collection is necessary for Abubot Fashion Designs to be neither better nor worse off for having adopted the proposed system?292» Chapter 12 b. How would your solution to (a) be affected if Abubot Fashion Designs could ted annual return of 5.5 percent? invest the freed balances only at an expect c. What is the logical explanation for the differences in your answers to (a) and (b) above? Solution: a. Initially, it is necessary to calculate Abubot Fashion. Designs’ average remittance check amount and the daily opportunity cost of carrying cash. The average check size is 7,000,000 4000 = £1,750 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 ' addedcosts = added benefits or Pp = (D) (S) (i) 0.25 = (D) (P1,750) (0.0002192) 0.6517 days = D : ‘ Abubot Fashion Designs therefore will experience a financial gain if it implements the special processing system and by doing so will speed.up its collection by more than 0.6517 days. b. Here the daily opportunity cost of carrying cash is 0.055 365 im 0.0001507 per dayCash and Marketable Securities Management 293 Designs to break-even, ‘stem, cash collections For Abubot Fashion special Processing sy; Should it choose to install the days, as follows; must be accelerated by 0.9480 7025 = (Dy iIs0)(0 0.9480 days = (1750) (0.0001507) c. The break-even cash-acceleration period of 0.9480 days is greater than the er yield available on near-cash 'y, versus 8.0 percent. Since the alternative rate of lances is lower in the second situation, more funds the cost of operating the special processing system. ion period generates this increased level of required return on the freed-up bal must be invested to cover The greater cash-accelerati funds. Illustrative Case IV. Valuing Float Reduction Next year, Miguel Motors expects its gross revenues from sales to be P80 million. The firm’s treasurer has'projected that its marketable securities portfolio will eam 6.50 percent over the coming buidget year. | What is the value of one day’s float reduction to the company? Miguel Motors uses a 365-day year in all of its financial analysis procedures: Solution: Value of one day’s float’ = . _P80M_— xg guy, reduction : 365 = * Pl4247 The company will earn P14,247 per year if it is able to invest its one day sales at 6.5%, ©294 Chapter 12 MARKETABLE SECURITIES MANAGEMENT OBJECTIVE OF MARKETABLE SECURITIES MANAGEMENT Realistically, management of cash and marketable securities cannot be separated, Management of one implies management of the other. The firm may hold excess funds in anticipation of a cash outlay. When funds are being held for other than immediate transaction purposes, they should be converted from cash into interest-earning marketable securities. Marketable securities which should be of highest investment grade usually consist of treasury bills, commercial paper, certification of time deposits from commercial banks, and money market notes. REASONS FOR HOLDING MARKETABLE SECURITIES There are several basic reasons for holding marketable securities such as 1. They serve as a substitute for cash balances. Many firms prefer to hold marketable securities as a substitute for transaction balances, precautionary balances, for speculative balances or for all three. In most cases, however, the securities are held primarily for precautionary purposes or as a guard against a possible shortage of bank credit. 2. They are held as a temporary investment where a return is earned while funds are temporarily idle. 3. They are built up to meet known financial requirements stich as tax payments, maturing bond issue and so on. FACTORS INFLUENCING THE CHOICE OF MARKETABLE SECURITIES Among the factors that will influence the choice of marketable securities are: 1, Risks such as a. Default risk. The risk that the issuer of the secutity can not pay the principal or interest at due dates. The funds invested in short-term marketable instruments should be safe and secure as regards repayment of principal and interest as and when it matures since the return on short-term investments is offered less than long-termCash and Marketable Securities Management 295 investments, the acc fered with credit ratings. The government S acceptance and certifi treasury bills, banker’: icate of deposits carry minimum default risk. b. Interest rate risk. The risk of declines in market values of the security due to rising interest rates, Inflation risk. The risk that inflation will reduce the “real” value of the investment. In periods of rising Prices, inflation risk is lower on investments (e.g., common stock, real estate) whose retums tend to rise with inflation than on investment whose returns are fixed. Marketability (liquidity) risk. This refers to the risk that securities cannot be sold at close to the quoted market price and is closely associated with liquidity risk. The liquidity is the’ basic objective of investment in these instruments. It should offer the facility of quick sale in the market as and when need arises for cash, with low transaction cost, without loss of time and no erosion of amounts invested with fall in price of investments. e.. Event risk. The probability that some event (such as merger, recapitalization or a leverage buyout) will occur and suddenly will increase a firm’s default risk. Bonds issued by regulated companies as banks or electric utilities generally have lesser event risk that bonds issued by industrial and service companies. Treasury securities usually do not carry any risk, barring national disaster. Also, long-term securities are affected more by unfavorable events than are short-term securities. . Maturity. Marketable securities held should mature or can be sold at the same time cash is required. Firms generally invest in marketable securities that have relatively short maturities. The maturity periods of different investments should match with the payment obligations like dividend payments, tax payments, capital expenditure and interest payments on debt instruments. Many firms restrict their temporary investments to those maturing in less than 90 days. Short-term investments relatively carry lesser return than long-term investments, since the default risk and interest rate risk are minimized with short-term instruments.296 _Chapter 12 3. rities. Generally, the higher a security’s tisk, the nab hs rated Corporate investors, like other investors must make a trade-off between risk and return when choosing marketable securities, Because these securities are generally held either fora specific known need or for use in emergencies, the portfolio should consist of highly liquid short-term securities issued by the government or very strong corporations. Treasurers should not sacrifice safety for higher rates of return. TYPES OF MARKETABLE SECURITIES 1. Money Market Instruments. These are the most suitable investment for idle funds. The money market is the market for short-term debt instruments. Money market instruments are high-grade securities . characterized by, a high-degree of safety of principal and maturity of one year or less. The two major types of. money market instruments are a) Discount Paper. A money market instrument which sells for less than its par or face value. The difference between the security’s purchase pricé and par value represents the investor’s income. At maturity, the investor receives the face: value or par value of the instrument. 6) Interest-bearing securities. These are instruments which pay * interest based on the par value or face value of the security and the period (days/months) of investment. 2. Treasury Bills. These are short-term government securities with a maturity of one year or less, issued at a discount from face value often called risk-free security. These securities are tax exempt with high degree of marketability. Other Short-term Commercial Papers Issued. by Finance Companies, Banks and Other Corporations. These are typically unsecured and ‘maturities range from ‘a. few days to. 270 days. Commercial paper is usually discounted but it can be interest bearing.Cash and Marketable Securities Managemen 297 Negotiable Certificates of Deposit. Certificate of | deposits are short- term loans to commercial banks with maturities ranging from a few weeks to several years. Certificate of deposits contain some default and interest rate risks but can easily be sold prior to maturity. Repurchase Agreements (REPOS). These are sale of government securities (¢.g., treasury bills) or other securities by a bank or securities dealer with an agreement to repurchase. REPOS usually involve a very: short-term overnight to a few days. These are attractive to corporations because of the flexibility or maturities. These agreements have little risk because of their short maturity and the commitment of the borrower to repurchase the securities as a fixed or higher specified price. * Banker’s Acceptance. A time draft drawn on, and accepted by a bank usually used as a source of financing in international trade. Banker’s acceptances are sold as discount paper with maturities ranging from a few weeks to 9 months. The yields on acceptance are competitive because of low default risk owing to as many as three parties who may be Jiable.for payment at maturity. Money Market Mutual Fund. This is an open-ended mutual fund that invests in money-market instruments. Money market mutual funds (MMMF) sell shares to investors and then accumulate the funds to acquire money market instruments. These funds allow small investors to participate directly in high-yielding seourities that are often denominated in large amounts. The MMMF shares are highly liquid because they can be sold back to the fund at any time. Returns or yields depend on the money market instruments held in the portfolio ofthe fund.298 Chapter I2 REVIEW QUESTIONS AND PROBLEMS Questions I. In the management of primary concer be for cash and marketable securities, why should the safety and liquidity rather than maximization of profit? 2. Why does float exist and what effect would electronic funds transfer systems have on float? 3. How can a firm operate with a negative cash balance on its corporate books? 4. Why would a financial manager want to slow down disbursements? 5. Briefly explain how a corporation may use float to its advantage. 6. In the management of cash and marketable securities, why should the primary concern be for safety and liquidity rather than maximization of profit? 7. How can a firm operate with a negative cash balance on its corporate books? 8. Whatare the principles to be considered while investing short-term surplus funds in marketable securities? 9. “Efficient cash management will aim at maximizing the availability of cash inflows by decentralizing collections and decelerating cash outflows by centralizing disbursements”. Discuss. 10. What is meant by the cash flow process? 11. Identify the principal motives for holding cash and near-cash assets. Explain the purpose of each motive. 12. What are the two major objectives of the firm’s cash-management system? 13. Would it be possible for a decision to deny credit to your customers to be value maximizing? How?20. . What will be the shortage cost associated Cash and Marketable Securities Management 299 ~ Would it be possible for a firm to have a negative cash cycle? How? . What will be the carryin, roquiremea? 1B Cost associated with a compensating balance eee with a compensating balance . What effect ‘will increase the trading costs associated with selling marketable securities have on the optimal replenishment level in the Baumol model? Why? . What effect will an incréase in the standard deviation of daily cash flows have on the return point in the Miller-Orr model? Why? . Could a firm ever have negative collection float? Why or why not? Could a firm ever have negative disbursement float? Why or why not? Problems Problem 1 (Determining Float) Watermelon Company shows the following values on its corporate books. Corporate Books Initial amount 10,000 Add: Deposits. 80,000 Less: Checks 50,000 Balance 240,000 The initial amount on the bank’s books is also P10,000. However, only ®70,000 in deposits have been recorded and only P25,000 in checks have cleared. Required: a, Fill in the table below and indicate the amount of float. Bank's Books Initial amount P10,000 ‘Add: Deposits Less: Checks Balance [Float _____300 Chapter 12 ee Problem 2 (Determining Float) Oscar's checkbook shows a balance of 6,000. A recent statement from the bank (received last week) shows that all checks written as of the date of the statement have been paid except numbers 423 and 424, which were for P620 and ?400, respectively. Since the statement date, checks 425, 426 and 427 have been written for #320, 700 and P440, respectively. There is a 75 percent probability that checks 423 and 424 have been paid by this time. There is a.40 percent probability that checks 425, 426 and 427 have been paid. Required: ‘a. What is the total value of the five checks outstanding? b. What is the expected value of payments for the five checks outstanding? c. What is the difference between parts (a) and (b)? This represents a type of float. Problem 3 (Cost-benefit Analysis of Cash Management) Beth’s Society Inc. has collection centers across the country to speed up collections. The company also makes payments from remote disbursement centers so the firm’s checks will take longer to clear the bank. Collection time has been reduced by two and one-half days and disbursement time increased by one and ‘one-half days because of these policies. Excess funds are being invested in short- term instruments yielding 6 percent per annum. - Required: a. If the firm has P4 million per day in collections and P3 million per day in disbursements, how much money has the cash management system freed up? b. How much can the firm earn per year on short-term investments made possible by the freed-up cash? Problem 4 (Determination of Optimal Average Cash Balance Using Baumol Model) < Jaypee Inc., has two dates when it receives its cash inflows (February 15 and August 15). On each of these dates, it, expects to receive P30 million. Cash expenditure are expected to be steady throughout the subsequent 6 month period. Presently, the ROI in marketable securities is 8% per annum, and the cost of transfer from securities to cash is P125 each time a transfer occurs.Cash and Marketable Securities Management 301 Required: a, What is the optimal transfer size using the Baumol model? What is the average cash balance? b, What would be the answer to (a) if the ROI were 12% per annum and the transfer costs were P75? Why do they differ from those in (a)? Problem 5 (Preparation of Cash Budget) The sales forecast for January to May 20X4 and actual sales for November and December 20X3 for Purple Company are as follows: Month Sales (P) Actual (20X3) November 80,000 December 70,000 Forecast (20X4) January 80,000 February 100,000 March 80,000 April 100,000 May 90,000 The 20% of sales is in cash and the rest is on credit, payment on which is realized on the third month. The following other information are also available. a. Amount of purchase is budgeted at 60% of the sales turnover of a month and paid on the third month of purchase, Variable expenses is 5% of turmover— time lag of payment half month. Commission on credit sales at 5% is payable on the third month. Rent and other expenses amounting to P3,000 paid every month. Payment for purchase of fixed assets amounting to P50,000 on March 20X4. Payment for taxes on April 20X4 amounting to P20,000. There will be an opening cash balance of P25,000, mmeaos Required: 8. Prepare a cash budget for five months from January to May 29X4.302 Chapter 12 ating Balance Interest Rate) ~ | Suppose a firm is seeking @ seven-year, amortizing 800,000 loan with annual payments and a bank is offering you the choice between an 850,000 loan with a 50,000 compensating balance and an 800,000 loan without a compensating balance. If the interest rate on the 800,000 loan is 8.5 percent, how low would the interest rate on the loan with the compensating balance have to be in order for you to choose it? Problem 6 (Compens Problem 7 (Optimal Cash Replenishment Level) faces a smooth annual demand for cash of P5 million; of P225 every time they sell marketable securities, and can le securities. What will be their optimat cash Apple Berry Company incurs transaction costs earn 4.3 percent on their marketabl replenishment level? Problem 8 (Optimal Cash Replenishment Level) Grapefruit Company faces a smooth annual demand for cash of P1.5 million; P75 every time it sells marketable securities, and can incurs transaction costs o' earn 3.7 percent on their marketable securities. What will be their optimal cash replenishment level? Problem 9 (Optimal Cash Return Point) Hot Foot Enterprises would like to maintain its cash account at a minimum level of P25,000, but expect the standard deviation in net daily cash flows to be 2,000; the effective annual rate on marketable securities to be 6.5 percent per year; and the trading cost per sale or purchase of marketable securities to be 200 per transaction. What will be their optimal cash return point? ~ Problem 10 (Optimal Upper Cash Limit) Hot Foot Enterprises would like to maintain their cash account at a minimum level of 25,000, but expect the standard deviation in net daily cash flows to be 2,000; the effective annual rate on marketable securities to be 6.5 percent per year, and the trading cost per sale or purchase of marketable securities to be 200 per transaction. What will be their optimal upper cash limit? +Cash and Marketable Securities Management 303 Multiple Choice Questions > Matrix Company's current assets increased by P120, n ies decreased by P50, and net working capital a. increased by P70. ©. decreased by P170. b. did not change. d. increased by P170. MBC Corporation had income before taxes of 60,000 for the year. Included in this amount was depreciation of 5,000, a charge of 6,000 for the amortization of bond discounts, and P4,000 for interest expense. The estimated cash flow for the period is a. 60,000. c. 49,000. b. 766,000. d. 71,000. The most direct way to prepare a cash budget for a manufacturing firm is to include a. projected sales, credit terms and net income. b. projected net income, depreciation and goodwill amortization. ©. projected purchases, percentages of purchase paid and net income. d. projected sales and purchases, percentages of collections and terms of payments. Kassandra Corporation had income before taxes of 60,000 for the year. Included in this amount was depreciation of P5,000, a charge of 6,000 for the amortization of bond discounts, and P4,000 for interest expense. The estimated cash flow for the period is a. 760,000. c. P49,000. b. 66,000. 4. P71,000. Shown below is a forecast of sales for Cooper Inc., for the first 4 months of the year (all amounts are in thousands of pesos). January February March April Cash sales PIS P24 PIs Pld Sales on credit 100 120 90 70 On average, 50% of credit sales are paid for in the month of sale, 30% in the month following the sale, and the remainder is paid 2 months after the month of sale. Assuming there are no bad debts, the expected cash inflow for Cooper in March is a. P138,000. c. P119,000. b. P122,000. d. P108,000.304 Chapter 12, 6. £100,000 and collection time fori2 collection time on the firm’s If money market rates the net annual benefit A firm has daily cash receipts of days. A bank has offered to reduce th deposits by 2 days for a monthly fee of P500. are expected to average’ 6% during the year, (loss) from having this service is a. 3,000. oc. PO. b. _ 712,000. d, 6,000. The treasury analyst for. Gwen Corporation has estimated the cash flows for the first half of next year (ignoring any short-term borrowings) as follows: : Cash (P millions) Inflows Outflows January P2 Pl February 2 4 March 2. 5 April 2 4.3) May ‘4 2 June 4 3 Gwen has a line of credit of up to P4 million on which it pays interest monthly at a rate of 1% of the amount utilized. Gwen is expected to have a cash balance of P2 million on January | and. no amount utilized on its line of credit. Assuming all cash flows occur at the end of the month, approximately how much will Gwen pay in interest during the first half of the year? a PO c. 80,000 b. 61,000 d. P132,000 Helpful Services is a newly established janitorial firm, and the owner is deciding what type of checking account to open. Helpful is planning to keep a P500 minimum balance in the account for emergencies and plans to write roughly 80 checks per month. The bank charges P10 per month plus a PO.10 per check chatge for a standard business checking account with no minimum balance. Helpful also has the option of a premium business checking account that requires a P2,500° minimum balance but has no monthly fees-or per check charges. If Helpful’s cost of funds is 10 %, which account should Helpful choose? a. Standard account, because the savings is P34 b. Premium account, because the maviogs is P34 per yearCash and Marketable Securities Management _305 ©. — Standard account, because the savings is P16 per year. 4. Premium account, because the savings is P16 per year. If the average age of inventory is 60 days, the average age of the accounts payable. is 30 days, and the average age of accounts receivable is 45 days, the number of days in the cash flow cycle is a. 135 days. ©. 75 days. b.. 90 days. d. 105 days. Blue Magic Toys is a retailer operating in several cities. The individual store managers deposit daily collections at a local bank in 4 noninterest-bearing checking account. Twice per week, the local bank issues a depository transfer check (DTC) to the central bank at headquarters. The controller of the company is considering using a wire transfer instead, The additional cost of each transfer would be P25; collections would be accelerated by 2 days; and the annual interest rate paid by the central bank is 7.2% (0.02% per day). At what amount of pesos transferred would it be economically feasible to use a wire transfer instead of the DTC? Assume a 350-day year. a. It would never be economically feasible. b. — P125,000 or above. ; c. Any amount greater than P173. d. Any amount greater than P65,500. A working capital technique that increases the payable float and therefore delays the outflow of cash is a concentration banking. b. adraft. ©. \ electronic data interchange (EDI). 4, _alockbox system. Assume that each day a company writes and receives checks totaling P10,000. If it takes 5 days for the checks to clear‘and be deducted from the company’s account, and only 4 days for the deposits to clear, what is the float? : a. P10,000 c. (10,000) b. PO d. 50,000308! Chapter 12 ee 306!" Chapter 12" ___— compensating balance oe : . * nae’ ‘a financial: institution for services rendered by i Fading it with deposits of funds. b. aap compensate for ‘possible losses on a marketable securities portfolio. oe cc. is'a level of inventory held to compensate for variations in usage raté and lead time. : d_ is'the’amount of prepaid interest on a Joan. 14° Four’ Season Company’s bank requires a compensating: balance of 20% on'4 P100,000 loan. If the stated interest on the loan is 7%, what jg'the effective cost of the loan? a 5.83% b. 7.00% c. 8.40% d 8.75% 15. A company uses the following formula in determining its optimal level of cash. oe af i F = fixed cost per transaction i = interest rate on marketable securities T = total demand of cash over a period of time Where: This formula is a modification of the economic order quantity (EOQ) formula used for inventory management. Assume that the fixed cost of selling marketable securities is 6% per year. The company estimates that it will make cash payments of P12,000 over a one- month period. What is the average cash balance? a. PI,000 b. 92,000 ©. £3,464 d. 76,928Cash and Marketable Securities Management 307 16. “Which one of the followin is nota istic i certificate of deposit? Negotiable Cae ceteraen haritaars a. havea Secondary market for investors, b. are regulated by the BSP System. Sate usually sold in denominations of a minimum of 100,000. di have yields considerably greater than banker's acceptance and commercial paper. 17. When managing cash and short-term investments, a corporate treasurer is primarily concerned with a. maximizing rate of retum. b. minimizing taxes. c: _ investing in Treasury bonds since hey have no default risk. d. liquidity and safety, 18. All of the following are alternative marketable securities suitable for investment except a. Treasury bills. c. Commercial paper. b: — Eurodollars. d. Convertible bonds. 19. The term “short selling” is the a. selling of a security that was purchased by borrowing money from a broker. © b. _ selling of a security that is not owned by the seller: c. _ selling of all the shares you own in a company in anticipation that the price will decline dramatically. a d. betting that a stock will increase by a certain amount within a given period of time.