FMPMC 111 Module 4 PDF

**MODULE 4** **Management of Cash and Marketable Securities** **Learning Objectives:** 1. Discuss how Cash and Marketable Securities are managed 2. Evaluate the reasons for holding cash 3. Compute the needed level of cash using the Baumol Model and Miller Orr 4. Identify the types of M...

**MODULE 4** **Management of Cash and Marketable Securities** **Learning Objectives:** 1. Discuss how Cash and Marketable Securities are managed 2. Evaluate the reasons for holding cash 3. Compute the needed level of cash using the Baumol Model and Miller Orr 4. Identify the types of Marketable Securities and the risk involved **ENGAGE** **EXPLORE** **EXPLAIN** ***Working capital*** is the capital that managers can immediately put to work to generate the benefits of capital investment. Working capital is also known as ***current capital*** or ***circulating capital***. Firms invest in current assets for the same reason they invest in long-term, capital assets: to maximize owners' wealth. But because managers evaluate current assets over a shorter time frame (less than a year), they focus more on their cash flows and less on the time value of money. How much should a firm invest in current assets? That depends on several factors: - The type of business and product - The type of business, whether retail, manufacturing, or service, affects how a firm invests. In some industries, large investments in machinery and equipment are necessary. In other industries, such as retail firms, less is invested in plant and equipment and other long-term assets, and more is invested in current assets such as inventory. - The length of the operating cycle - The firm's operating cycle---the time it takes the firm to turn its investment in inventory into cash---affects how much the firm ties up in current assets. The operating cycle comprises the time it takes to: manufacturer the goods, sell them and collect on their sale. The *net* operating cycle considers the benefit from purchasing goods on credit; the net operating cycle is the operating cycle less the number of days of purchases. The longer the net operating cycle, the larger the investment in current assets. - Customs, traditions, and industry practices - The degree of uncertainty of the business **[CASH MANAGEMENT]** Cash flows *out of* a firm as it pays for the goods and services it purchases from others. Cash flows *into* the firm as customers pay for the goods and services they purchase. When we refer to ***cash***, we mean the amount of cash and cash-like assets---currency, coin, and bank balances. When we refer to ***cash management***, we mean management of cash inflows and outflows, as well as the stock of cash on hand. **Monitoring Cash Needs** We can monitor our cash needs through cash forecasting. ***Cash forecasting*** is analyzing how much and when cash is needed, and how much and when to generate it. Cash forecasting requires pulling together and consolidating the short-term projections that relate to cash inflows and outflows. These cash flows may be a part of your capital budget, production plans, sales forecasts, or collection on accounts. To understand the cash needs and generation, you have to understand how long it takes to generate cash, once an investment in inventory is made. We're referring to the operating cycle---the time it takes to make cash out of cash. If we consider cash disbursements, we get a better picture of the net cash---the ***net operating cycle---***the time it takes to make cash from cash plus the time we delay payment on our purchases: Net operating cycle = Operating cycle -- Number of days of purchases Estimating our net operating cycle gives us information on how long it takes to generate cash from our current assets. The longer the net operating cycle, the more cash we need on hand. To understand our cash flows, we also have to have a fairly good idea of the uncertainty of our cash needs and cash generation. Cash flows are uncertain because sales are uncertain, and so is the uncertainty regarding when we will collect payment on what we do sell, as well as uncertainty about production costs and capital outlays. Forecasting cash flows requires the coordination of marketing, purchasing, production, and financial management. **Reasons for Holding Cash Balances** Firms hold some of their assets in the form of cash for several reasons. They need cash to meet the transactions in their day-to-day operations. Referred to as the ***transactions balance***, the amount of cash needed for this purpose differs from firm to firm, depending on the particular flow of cash into and out of the firm. The amount depends on: There is always *some* degree of uncertainty about future cash needs. Firms typically hold an additional balance, referred to as a ***precautionary balance***, just in case transactions *needs* exceed the transactions *balance*. But how much to keep as a precaution depends on the degree of the transactions uncertainty---how well we can predict our transactions needs. For example, a retail store has a good idea from experience about how much cash to have on hand to meet the typical day's transactions. In addition to what is needed for a typical day, the retail store may keep more cash on hand to meet a higher than usual level of transactions. In addition to the precautionary balances, firms may keep cash on hand for unexpected future opportunities. Referred to as a ***speculative*** ***balance**,* this is the amount of cash or securities that can be easily turned into cash, above what is needed for transactions and precaution. The speculative balance enables a firm to take advantage of investment opportunities on short notice and to meet extraordinary demands for cash. For example, an automobile manufacturers may need an additional cash cushion to pay its bills in case a wildcat strike closes down a plant. In addition to the cash balances for transactions, precautionary, and speculative needs, a firm may keep cash in a bank account in the form of a ***compensating balance***---a cash balance required by banks in exchange for banking services. By keeping a balance in an account that is noninterest earning or low-interest earning, the firm is effectively compensating the bank for the loans and other services it provides. Some bank loans and bank services require a specified amount or average balance be maintained in an account. **Costs Associated with Cash** There is a cost to holding assets in the form of cash. Because cash does not generate earnings, the cost of holding assets in the form of cash, referred to as the ***holding cost***, is an opportunity cost---what the cash *could* have earned if invested in another asset. If a firm needs cash, it must either sell an asset or borrow cash. There are transactions costs associated with both. Transactions costs are the fees, commissions, or other costs associated with selling assets or borrowing to get cash; they are analogous to the ordering costs for inventory. **Determining the Investment in Cash** How much cash should a firm hold? For transactions purposes, enough to meet the demands of day-to-day operations. To determine how much is enough transactions purposes, we compare the cost of having *too* much cash to the cost getting cash---in other words, we compare the holding cost and transactions cost. As you hold more cash, its holding cost increases. With more cash on hand, the costs of making transactions to meet your cash needs for operations declines. That's because with larger cash balances, you need fewer transactions (selling marketable securities or borrowing from a bank) to meet your cash needs. We want to have on hand the amount of cash that minimizes the sum of the costs of making transactions to get the cash (selling securities or borrowing) and the opportunity cost of holding more cash than we need. We will look at the Baumol Model and the Miller-Orr Model to help us decide on the level of cash we need and when we need it. **The Baumol Model** The Baumol Model is based on the ***Economic Order Quantity*** (EOQ) model developed for inventory management. Applied to the management of cash, the EOQ model determines the amount of cash that minimizes the sum of the holding cost and transactions cost. The holding cost includes the costs of administration (keeping track of the cash) and the opportunity cost of not investing the cash elsewhere. The ***transaction cost*** is the cost of getting more cash---either through selling marketable securities or through borrowing. The economic order quantity is the level of cash infusion (from selling marketable securities or borrowing) that minimizes the total cost associated with cash. Suppose each time our cash balance is zero we generate \$100,000 (borrowing or selling securities). Further suppose that our opportunity cost for holding cash is 5%---we could have invested the cash in something that earns 5% instead of holding it. Our holding costs are the product of the average cash balance and the opportunity cost. If we start with \$0 cash and end up with \$100,000 after an infusion, our average cash balance is = \$50,000, so our holding cost is:  If we did not hold \$50,000 of cash on average, we could have earned \$2,500 by investing it. Now suppose we need \$1,000,000 cash for transactions over a given period. If we need \$1,000,000 in total and we get \$100,000 cash at a time, we need to make 10 transactions during the period. If it costs us \$200 every time we make a cash infusion our transactions cost is \$2,000: Will cash infusions of \$100,000 at a time produce the lowest cost of getting cash? We can't control the cash needed for transactions purposes or the cost per transaction. But we can control how many cash infusions we make. And that number affects both the holding cost and the transactions cost. The holding cost is a function of the amount of the cash infusion: With larger cash infusions, we hold more cash. Holding more cash, we have a greater opportunity cost to holding it. The transactions cost is also a function of the amount of cash infusion: The larger the cash infusion, the fewer the transactions, and therefore the lower our transactions costs. Let's use these considerations and what we know about economic order quantity to determine the minimum cost of cash. If we get cash in the amount of *Q* at the beginning of a period and wait until the cash balance is zero before we get more cash, the average cash balance over the period is *Q*/2. The cost of holding cash during this period is determined by the average cash balance, *Q*/2, and the opportunity cost of holding the cash, *k*:  But each time we get cash, we have to make a transaction. If we demand a total of *S* dollars of cash each period, we end up making *S*/*Q* transactions per period. If it costs *K* to make a transaction, the transactions cost for the period is: Putting the holding cost and the transaction cost together, the total cost associated with the cash balance is:  To calculate the minimum total cost with respect to the amount of inventory we get each time, we: 1\. Calculate the first derivative of the total cost equation with respect to *Q*. 2\. Set this first derivative equal to zero. 3\. Solve for *Q*. The first derivative of the total cost with respect to *Q* (where "*d*" indicates "change") is: What does this mean? If we look at the relations among *Q*\* and *K*, *S*, and *k* in this equation, we see that: The larger the cost per transaction, *K*, the greater the amount of cash, *Q*\*, infused in a single transaction---the larger the transaction cost, the fewer transactions we make. The larger the demand for cash, *S*, the larger the amount of cash, *Q*\*, infused in a single transaction. The larger the opportunity cost of holding cash, *k*, the smaller the amount of cash, *Q*\*, infused in a single transaction. In our example, *K* = \$200 per transaction, *S* = \$1,000,000, *k* = 5%, and  If every time we need a cash infusion, we get \$89,443, the costs associated with cash will be minimized. We can check our work by looking at the total costs of cash for levels of *Q* on either side of *Q*\* = \$89,443. If *Q* = \$100,000, as we saw before. If *Q* = \$50,000: If *Q* = \$89,443,  We can see in Exhibit below that the minimum of the total cost curve is at a cash infusion level of \$89,443, which corresponds to a total cost of \$4,472. If the level of cash infusion is less than or more than \$89,443, the cost of cash will be higher. The EOQ model can be applied to any time framework---whether the period is a year, a month, a week, or any other unit of time. It is only necessary to make sure that all the elements that depend on the unit of time---the holding costs, *k*, and transactions demand, *S*---are in that same unit of time. The economic order quantity model can be modified to suit the circumstances of different cash situations. For example, the EOQ model for cash can be modified to include a ***safety stock***---a balance of cash for precautionary purposes. The safety stock is a level of cash balance that acts as a cushion in case our cash needs are suddenly greater than expected. The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the period. The Miller-Orr Model recognizes that cash flows vary throughout the period in an unpredictable manner. To see how the Miller-Orr model takes account of changes in the need for cash, consider the three key levels of inventory: the ***lower limit***, below which inventory does not fall the ***return point***, the level of inventory that is the target if either the lower or upper limit is reached the ***upper limit***, above which inventory does not rise The lower limit is really a safety stock of cash---the cash on hand must never fall below this level. We need to apply experience and judgment in determining the lower level. Based on (a) how much needs are expected to vary each day, (b) the cost of a transaction, and (c) the opportunity cost of cash expressed on a daily basis, this model tells us: The return point and the upper limit are determined by the model as the levels necessary to minimize costs of cash, considering (a) daily swings in cash needs, (b) the transactions cost, and (c) the opportunity cost of cash. The Miller-Orr model provides us with a few decision rules: Our cash balance can be any level between the upper and lower limit. There is a cash balance (the return point) that we aim for if our cash balance exceeds the upper limit or if our cash balance is below the lower limit: If our cash balance *exceeds the upper limit*, any cash in excess of the return point is invested in marketable securities. If our cash balance is *below the lower limit*, any deficiency up to the return point is made up by selling marketable securities or borrowing. The return point is a function of: the lower limit the cost per transactions the opportunity cost of holding cash (per day) the variability of daily cash flows, which we measure as the variance of daily cash flows and is determined mathematically as follows:  In this equation, we see that: The higher the safety stock (the lower limit), the higher the return point. The higher the cost of making a transaction, the higher the return point. The greater the variability of cash flows, the higher the return point. The greater the holding cost of cash, the lower the return point. The upper limit is the sum of the lower limit and three times the rightmost term of the return point equation: To see how this model works, suppose we estimate the following items: Then: Opportunity cost per day = 0.01% Variance of daily cash flows = \$20,000 Cost per transaction = \$200 Lower limit = \$10,000 Lower limit = \$10,000  What we have just determined using the Miller-Orr model is that the cash balance is allowed to fluctuate between \$13,107 and \$19,321. If the cash balance exceeds \$19,321, we invest the difference between the cash balance and the return point, restoring the cash balance to the return point. If the cash balance is below the lower limit, marketable securities are sold to bring the cash balance to the return point. Each time the cash balance is outside either the lower or the upper limit, we bounce back to the return point. This "bouncing" is illustrated in the exhibit below. In part (a) of this figure, the cash flow per day is graphed against time---sometimes cash flows in, sometimes cash flows out. In part (b) this figure, the cash balance is plotted for each day using the Miller-Orr model. Each time the balance is hits \$10,000, it bounces back to \$13,107 and each time the balance is hits \$19,321, it bounces back to \$13,107. **Other Considerations** The Baumol and Miller-Orr models both try to help us minimize the costs of cash. The Baumol model assumes a predictable, steady use of cash. The Miller-Orr model incorporates an estimate of the variability of cash flows. But there are other factors that affect cash management. One is the seasonality of our cash needs. If our sales and collections on sales are seasonal, we must factor the pattern of cash into our cash balance---the Baumol model does not consider changing cash needs. Another factor is doing business in other countries. If we do business in a foreign country, we have added complications, including: keeping cash in different currencies; restrictions on transferring currencies across borders; laws in many countries requiring holdings in that country's domestic currency; and the risk that the value of the foreign currency may change, relative to your domestic currency. We must look very closely at our cash flows and the factors that affect our cash needs. Once we understand our cash flow needs and the predictability of these needs, we can use the basis of either model to determine cash infusions and holdings to minimize costs. **Cash Management Techniques** Cash management has very simple goals: Have enough cash on hand to meet immediate needs, but not too much. Get cash from those who owe it to you as soon as possible and pay it out to those you owe as late as possible. The Baumol and Miller-Orr models help firms manage cash to satisfy the first goal. But the second goal requires methods that speed up in- coming cash and slow down outgoing cash. To understand these methods, we need to first understand the check clearing process. **The Check Clearing Process** The process of receiving cash from customers involves several time consuming steps: The customer sends the check. The check is processed within the firm---so the customer can be credited with paying. The check is sent to the firm's bank. The bank sends the check through the clearing system. The firm is credited for the amount of the check. Several days may elapse between the time when the firm receives the check and the time when the firm is credited with the amount of the check. During that time, the firm cannot use the funds. The amount of funds tied up in transit and in the banking system is referred to as the ***float***. The float occurs because of the time tied up in the mail, in check processing within the firm, and in check processing in the banking system. The float can be costly to those who are on the receiving end. Suppose on average your customers make \$1 million in payments each day. If your float is seven days, you therefore have 7 times \$1,000,000 = \$7,000,000 coming to you that you cannot use. If you can speed up your collections to five days, you can reduce our float to \$5 million--- and use the freed-up \$2 million for other things. But the float can be beneficial to the payer. Suppose you make payments to your suppliers, on average, \$1 million per day. And suppose it takes your suppliers five days after they receive your checks to complete the check processing system. You have \$5 million in float per day. If you could slow down the check processing by one day, you increase the float to \$6 million. That's \$1 million more cash available for you to use each day. There are several ways we can speed up incoming cash: ***Lockbox system*** A system where customers send their checks to post office boxes and banks pick up and begin processing these checks immediately. ***Selection of banks*** Choosing banks that are well connected in the banking system, such as clearinghouse banks or correspondent banks, can speed up the collection of checks. ***Check processing within the firm*** Speed up processing of checks within the firm so that deposits are made quickly. ***Electronic collection*** Avoid the use of paper checks, dealing only with electronic entries. ***Concentration banking*** The selection of a bank or banks that are located near customers, reducing the mail float. A ***clearinghouse*** is a location where banks meet to exchange checks drawn on each other, and a ***clearinghouse bank*** is a participant in a clearinghouse. Clearinghouses may involve local banks or local and other banks. A ***correspondent bank*** is a bank that has an agreement with a clearinghouse bank to exchange its checks in the clearinghouse. In addition, there are several methods you can use to slow up our payment of cash: ***Controlled disbursements*** Minimizing bank balances by depositing only what is needed to make immediate demands on the account. ***Remote disbursement*** Paying what is owed with checks drawn on a bank that is not readily accessible to the payee, increasing the check processing float. Whichever way you speed up the receipt of cash or slow down the payment of cash there is a cost. Firms must weigh the benefits with the cost of altering the float. We will look closely at one speed-up device---the lockbox system--- and one slow-down device---controlled disbursements---to see how the float can be altered. The lockbox system may reduce the mail float (due to the placement of the lockboxes near the customer) and changes what was the "firm float" to a "bank float" since the bank now processes the checks received from customers. Lockbox System With a ***lockbox system*** a firm's customers send their payments directly to a post office box controlled by the firm's bank. This skips the step where the firm receives and handles the check and paperwork. The lockbox system can cut down on the time it takes to process checks in two ways. First, the firm can use post office boxes (and collecting banks) throughout the country, reducing the time a check spends in the mail---reducing the mail float. Second, because the bank processes the checks and paperwork, the lockbox avoids the time the checks spend at the receiving firm---eliminating the time it takes to process checks in the firm. To see the savings using a lockbox, suppose it can reduce our total float from eight to five days. If we collect \$1.5 million per year through the lockbox system, three days worth of collections (\$1,500,000/365 × 3 days = \$12,329) freed up for investment during the year. If we can earn 12% a year investing in marketable securities, this amounts to an increase in earnings of \$12,329 × 0.12 = \$1,479. As long as the cost of the lockbox system is less than \$1,479 per year, there is a benefit to using it. We can state the increased earnings from the lockbox system as: Benefit from lockbox system = (collections per day) x (reduction of float in days) x( opportunity costs of funds per year) To decide whether or not to use such a system involves comparing the benefit obtained from the lockbox system with the lockbox fees charged by the bank. There are a couple of drawbacks to a lockbox system. Because the bank receives the check and documents, it takes longer for the firm to record who has paid---the bank must forward the documents to the firm. Also, customers may become confused, since payments are sent to the lockbox's address and all other correspondence is sent to the firm's business address. Setting up a lockbox system requires the answers to several questions: 1\. How many lockboxes? 2\. Where to locate the lockboxes to cut down on mail time? 3\. Where to direct which customers to send their payments? Determining the optimal lockbox set-up requires evaluating the cost of each lockbox and the opportunity cost of having checks in the mail. CURRENT ADVANCES IN LOCKBOXES There are a number of recent advances in lockbox systems that need to be considered in selecting a lockbox system, including: ***Lockbox networks***---collections of banks that link lockboxes from different parts of the country to speed up the bank float. ***Image-based processing***---computer coding, such as bar-coding of envelopes, that speeds up processing by the bank. ***Mail interception***---banks picking up mail at the post office to reduce the mail float. ***Nonbank lockbox systems***---firms other than banks that establish lockbox systems. In selecting a lockbox system, we need to evaluate the speed in which we have access to funds, the recordkeeping of accounts paid, and the costs of the system. **Controlled Disbursements** If you want to have more cash available for your own use, you can slow down the payments you make---increasing the float to others. ***Controlled disbursements*** is an arrangement with a bank to minimize the amount that you hold in bank balances to pay what you owe. Under this system, you minimize your bank balance to only the funds you need for immediate disbursing. To make this work, you need to work closely with the bank---the bank notifies you of checks being cashed on your account and you immediately wire the necessary funds. An extreme disbursement method is referred to as a ***zero-balance*** ***account*** (ZBA). In an ZBA arrangement, you keep no funds in the bank--- you simply deposit funds as the checks you wrote out are presented for payment through the banking system. As this account can save you two to three days of float and cost anywhere from \$20 to \$200 per month in bank fees, zero-balance accounts are attractive. Some banks will even automatically invest funds in excess of the firm's payments needs into short-term securities---insuring that there are no idle funds. As you can imagine, a controlled disbursements system requires coordination between you and your bank. If you are off just a little bit, you can lose goodwill with your suppliers or other payees. Also, this system is not costless; the bank is performing a service and charges a fee. **[MARKETABLE SECURITIES]** An integral part of cash management is storing excess cash in an asset that earns a return---such as marketable securities. Precautionary and speculative needs for cash can often be satisfied by funds stored in marketable securities, selling them as needs for cash arise. Models of cash management assume that managers stash cash they don't need right away into marketable securities and convert them to cash as needed. In this way, marketable securities are a substitute for cash. If cash flows of a firm are uneven---perhaps seasonal---the firm can deal with the uneven demands for cash by either borrowing for the short-term or selling marketable securities. If short-term borrowing is not possible or is costly, marketable securities can be used: Buy marketable securities when cash inflows exceed outflows; sell marketable securities when cash inflows are less than outflows. In this way, marketable securities are a temporary investment. Aside from the uneven cash demands from operations, marketable securities may be a convenient way of storing funds for planned expenditures. If you generate cash from operations or from the sale of securities for an investment in the near future, the funds can be kept in marketable securities until needed. **Marketable Securities and Risk** The primary role of marketable securities is to store cash that isn't needed immediately, but may be needed soon. We should therefore consider only marketable securities that provide safety and liquidity. In evaluating safety, we need to look at the risks we accept in investing in securities. The relevant risks for you to consider are: ***Default risk:*** The risk that the issuer will not pay interest and/ or principal as promised. ***Purchasing power risk:*** The risk that inflation will erode the purchasing power of the money you receive in the form of interest and principal in the future. ***Interest rate risk:*** The risk that interest rates will change, changing the value of your investment. ***Reinvestment rate risk:*** The risk that interest rates will change, affecting the rate of return you can earn on reinvesting the interest and principal from your investment. ***Liquidity risk:*** Also referred to as marketability risk, the risk that the security will not be marketable, at least at its true value, due to the lack of investor interest in the security. **EXPLORE** **Types of Marketable Securities** The marketable securities that satisfy the criteria of safety and liquidity are most likely money market securities. Some money market securities, such as government securities, have no default risk; the ones that do have very little default risk. Due to the short maturity of money market securities and the fact that they are generally issued by large banks or corporations (who are not likely to get into deep financial trouble in a short time), their default risk is low. Even so, you can look at the credit ratings by Moody's, Standard & Poor's, and Fitch for an evaluation of the default risk of any particular money market security. Money market securities have relatively little purchasing power risk. The chance of inflation changing over the short horizon is slight, though a possibility. Money market securities also have relatively little interest rate risk. Since these securities are short-term, their values are not as affected by changes in interest rates as, say, a thirty-year corporate bond. The short maturities of money market securities, however, subject the investor to reinvestment rate risk. If rates fall and the security matures, the investor must roll over---or reinvest---the funds in another security with lower rates. But since this investment's purpose is short-term, this is a risk that we must bear. **EVALUATE** **EVALUATE** **QUIZ. Compute for the following problems. Show all necessary computations. ( 30 points)** 1. The Lettuce Company has cash needs of P5 million per month. If Lettuce needs more cash, it can sell marketable securities, incurring a fee of P300 for each transaction. If Bulldog leaves its funds in marketable securities, it expects to earn approximately 0.50% per month on their investment. a. If Lettuce gets a cash infusion of P1 million each time it needs cash, what are the holding costs associated with its cash investment? b. If Lettuce gets a cash infusion of P1 million each time it needs cash, what are the transactions costs per month associated its cash infusions? c\. Using the EOQ model, what level of cash infusion minimizes Lettuce's costs associated with cash? 2. Suppose you start each month with a cash balance of P100,000 and you use cash evenly throughout the month, ending each month with a zero cash balance. a\. What is the average cash balance each month? b\. If you could earn 1% per month investing your cash, what is the opportunity cost, per month, associated with your cash balance? 3. The Pear Company is applying the Miller-Orr model to their cash management. They determined that the return point is P12,000, the lower limit is P5,000, and the upper limit is P26,000. Explain what this information means to Pear's cash management.