Cash and Liquidity

Management
 Objective
•The main objectives of cash and liquidity
management are:
•1. To free up all the company's cash
whilst minimizing processing costs,
•2. To make this liquidity available when
and where it is required, and
•3. To make the most profitable use of
any cash surpluses and/or if there are
cash deficits to minimize funding costs.
 Reasons for Holding Cash
1. Speculative motive – hold cash to take
advantage of unexpected opportunities.
For example, the prices of shares /securities/
raw materials may be low at a time with an
expectation that these will go up shortly. Such
opportunities can be availed of if a firm has
cash balance with it. 
2. Transaction Motive: A firm needs cash for
making transactions in the day to day
operations.
to make purchases,
pay expenses, taxes,
dividend, etc. 
 Cont.…..
3. Precautionary motive – hold cash in case of
emergencies - cash for meeting various
contingencies.
For example, a debtor who was to pay after 7 days may
inform of his inability to pay; on the other hand a
supplier who used to give credit may not have the stock
to supply or he may not be in a position to give credit at
present.
Trade-off between opportunity cost of holding
cash relative to the transaction cost of
converting marketable securities to cash for
transactions
 Understanding Float
Float – difference between cash balance
recorded in the cash account and the cash
balance recorded at the bank.
Or...the total value of checks you have written or
received, but have not yet come out or been credited to
your bank account.
Two Types
Disbursement float – Positive Float
Generated when a firm writes checks
Available balance at bank – book balance > 0
 Understanding Float
Collection float – Negative Float
Checks received increase book balance
before the bank credits the account
Is the time which elapses between the time
a payer deduct a payment from its
accounts ledger and the time when the
payee actually receives the funds in actual
form.
It is undesirable and should be minimized.
Available balance at bank – book balance
<0
 Understanding Float
Four Types of Collection Float
Invoicing float – the time it takes for a firm to bill
receivables.
Mail float – the time the bill spends in the mail on its
way to the customer and the time the customer’s
cheque spend in the mail on its way to the firm.
Processing Float – the time between a firm’s receipt
of a payment and its deposit of the cheque for
collection.
Clearing Float – the time between the bank accepts
the cheque for deposits and the time it makes
available in the firms’ account.
Net Float is the difference between
payment float and receipt float.

Net float = disbursement float - collection

float
 Managing Float
Speeding up collection
The collection time comprises the mailing time,
cheque processing delay and the bank’s availability
delay.
Strategies
a) Lock Boxes system
- Customers are advised to mail their payments to
special post office boxes called lockboxes, which are
attended by local collection banks.
b) Concentration Banking
- Opening collection centers in different parts of the
country.
 Managing Float
2. Delaying Payment
Zero-Balanced Account – A firm
does not keep any cash in the bank
account – cash is transferred only
when cheque is presented for the
payment to the bank.
 Measuring Float
• Size of float depends on the dollar amount and the time
delay
• Delay = mailing time + processing delay + availability
delay
• Suppose you mail a check for $1000 and it takes 3 days
to reach its destination, 1 day to process and 1 day
before the bank will make the cash available
• What is the average daily float (assuming 30 day
months)?
• Method 1: (3+1+1)(1000)/30 = 166.67
• Method 2: (5/30)(1000) = 166.67
 Cost of Float
• Cost of float – opportunity cost of not being able to use the
money
• Suppose the average daily float is $3 million with a
weighted average delay of 5 days.
• What is the total amount unavailable to earn interest?
• 5*3 million = 15 million
• What is the NPV of a project that could reduce the delay
by 3 days if the cost is $8 million?
• Immediate cash inflow = 3*3 million = 9 million
• NPV = 9 – 8 = $1 million
 Investing Cash
•Money market – financial instruments
with an original maturity of one-year or
less
•Temporary Cash Surpluses
• Seasonal or cyclical activities – buy
marketable securities with seasonal
surpluses, convert securities back to cash
when deficits occur
• Planned or possible expenditures –
accumulate marketable securities in
anticipation of upcoming expenses.
 Characteristics of Short-Term Securities
• Maturity – firms often limit the maturity of
short-term investments to 90 days to avoid
loss of principal due to changing interest
rates
• Default risk – avoid investing in marketable
securities with significant default risk
• Marketability – ease of converting to cash
• Taxability – consider different tax
characteristics when making a decision
 Determining the Target Cash Balance
• The target cash balance involves a trade-off
between the opportunity costs of holding too much
cash and the trading costs of holding too little.
• If a firm tries to keep its cash holdings too low, it
will find itself selling marketable securities (and
perhaps later buying marketable securities to
replace those sold) more frequently than if the
cash balance was higher.
• Thus, trading costs will tend to fall as the cash
balance becomes larger. In contrast, the
opportunity costs of holding cash rise as the cash
holdings rise.
 BAUMOL MODEL
Assumptions
•Assumes that the demand for cash can be
predicted with certainty

•The firm’s cash payment occur uniformly

over a period of time
•The opportunity cost holding cash is known
and does not change
•The firm will incur the same transaction cost
whenever it converts securities to cash
 Costs of Holding Cash
Comprising total conversion costs and
opportunity cost of keeping idle 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
Assuming that the firm require cash balance of
“C” and it sells marketable securities and
realize “C” and its cash balance decreases and
reaches to zero, Again the firm sell securities
and have a balance and so. This pattern
continues over time. The average cash balance
will be C/2.
 BAUMOL MODEL
Deriving the optimum cash balance formula:
TC = T/C*F (Transaction cost)
where: T= Total amount of cash we want
C = Optimum cash balance
F = Transaction cost
OC = C/2*R (Opportunity cost)
where: C = Cash flow
R = Opportunity Cost

Total cost = C/2*R + T/C*F

 BAUMOL MODEL

To get the formula:

CR/2 = TF/C
C2R=2TF
C2 = 2TF/R
C= 2TF
R
Where: C = Optimum Cash Balance
T = Projected cash requirements during the planning period
R = interest rate per planning period on investment in marketable securities
F = Transaction cost
 Example
Annual cash requirement Br. 1,000,000
Fixed conversion cost Br. 1,000
Opportunity cost of holding cash Br. 5%

C= Square root of (2*1,000,000*1,000)/0.05

= Br. 200,000
Opportunity Cost = C/2* R = 200,000/2*0.05
= 5,000
TC = T/C*F = 1,000,000/200,000*1,000
= 5,000
TOTAL COSTS = TC + OC
= 5,000 + 5,000
= 10,000
Limitations of the Baumol Model
1.Does not allow the cash flows
to fluctuate
2.Firms in practice do not use
their cash evenly
3.Not possible to predict daily
cash inflow or outflow
 MILLER-ORR MODEL
Assumptions
•The cash flows are stochastic – it fluctuates.
•The daily cash balance is normally distributed, i.e.
it occurs randomly.
•There is a possibility to invest idle cash in
marketable securities.
•There is transaction cost when marketable
securities are bought or sold.
•A business maintains the minimum acceptable cash
balance – lower limit.
 The model provides two control limits for cash
balance The point in between
1. The upper limit is the Return Point.
2. Lower limit
• Cash balance is not allowed to go beyond
upper limit and fall below lower limit.
• If the cash balance hit the upper limit, the
firm has too much cash and should buy
securities to bring back the cash level to the
return point.
• When the cash balance hit the lower limit, it
sells sufficient marketable securities to bring
the cash back to the return level.
 The model requires the following steps:
1. Specifying lower control limit – determining
minimum cash balance.
Fixed by the management and dependent on:
• Credit worthiness
• Expected cash flows
2. Estimating the variability in cash flows
3. Computing the spread – distance between
Lower & Upper limit
 Formula
1. Spread = 3T𝛔
3 4i
2

Where; T = Transaction cost

𝛔2 = Variance of the cash flow
I = The daily interest rate

2. Return Point = Lower Limit + (1/3 x Spread)

3. Upper Limit = Lower Limit + Spread

 Example
1. A company has set its lower limit at 10,000.
the standard deviation of the daily cash
flows is 1,500. The cost of buying or selling
securities is 40. the interest rate is 0.02
percent per day.
a) What is the spread?
b) What is the lower limit?
c) What is the return point?
 Cont..
a) What is the spread?

3 ( 3 4 x 0.02 )
3 x 40 x 1,500 x 1,500 = 4,500

b) Lower Limit = 10,000

c) Return Point = Lower Limit + (1/3 x Spread)
= (10,000 + (1/3 x 4,500))
= 11,500
d) Upper Limit = Lower Limit + Spread
= 10,000 + 4,500
= 14,500
 Exercise
The management of Horizon Co. has set a
safety cash balance of $67,000. The standard
deviation (σ) of the daily cash balance during
the last year was $32,500, and the transaction
cost was $85. The company also has the
opportunity to invest idle cash in marketable
securities at an annual interest rate of 9%.
a)What is the spread?
b)What is the return point?
c)What is the upper limit?