Cash & Marketable Securities

Cash & Marketable Securities Balances

Estimating Desirable Cash Balances
Like other financial decisions, the goal of the firm is to maintain the level of cash and marketable securities that maximizes shareholder and firm value. Balances that are too high will diminish profitability -and balances that are too low will accentuate risk. Although the more sophisticated mathematical estimation models are beyond our scope, the overriding objective is to balance risk against return.

Cash & Marketable Securities Balances

The Level of Marketable Securities Investment
In addition to earning a return on temporarily idle funds, marketable securities serve as a safety stock of cash that can be deployed to satisfy unexpected demands for funds. For example, if a company wishes to maintain $70,000 of liquid funds and a transactions balance of $50,000 -$20,000 would be held as marketable securities. In addition, a firm could use a line of credit in lieu of marketable securities -- or a combination of both.

The Efficient Management of Cash

Recall the Operating Cycle from the Last Chapter...
raw materials purchases (payable generated) inventory processing

finished goods inventory

payment for purchases (payable exonerated)

sale of goods (receivable generated)

Payment received (receivable exonerated)

The Efficient Management of Cash

The Operating Cycle (OC) is the time between ordering materials and collecting cash from receivables. The Cash Conversion Cycle (CCC) is the time between when a firm pays its suppliers (payables) for inventory and collecting cash from the sale of the finished product.

The Efficient Management of Cash

Both the OC and CCC may be computed mathematically as shown below.
Operating Cycle (OC) = Average Age of Inventory (AAI) + Average Collection Period (ACP) Cash Conversion Cycle (CCC) = Operating Cycle (OC) Average Payment Period (APP)

The Efficient Management of Cash

Managing the Cash Conversion Cycle
Most companies) has a positive CCC. As a result, the company will have to finance this period using some combination of short-term financing such as a line of credit or revolving credit agreement. By looking at the model, we can also see that the firm could improve its financial condition by (1) shortening the AAI, (2) Shortening the ACP, (3) lengthening the APP, or (4) some combination of the above.

Cash Management Techniques

Float
Collection float is the delay between the time when a payer deducts a payment from its checking account ledger and the time when the payee actually receives the funds in spendable form. Disbursement float is the delay between the time when a payer deducts a payment from its checking account ledger and the time when the funds are actually withdrawn from the account. Both the collection and disbursement float have three separate components.

Cash Management Techniques

Float
Mail float is the delay between the time when a payer places payment in the mail and the time when it is received by the payee. Processing float is the delay between the receipt of a check by the payee and the deposit of it in the firms account. Clearing float is the delay between the deposit of a check by the payee and the actual availability of the funds which results from the time required for a check to clear the banking system.

Cash Management Techniques

Float

Cash Management Techniques

Speeding Collections
Concentration Banking
Concentration banking is a collection procedure in which payments are made to regionally dispersed collection centers. Checks are collected at these centers several times a day and deposited in local banks for quick clearing. It reduces the collection float by shortening both the mail and clearing float components.

Cash Management Techniques

Speeding Collections
Lockboxes
A lockbox system is a collection procedure in which payers send their payments to a nearby post office box that is emptied by the firms bank several times a day. It is different from and superior to concentration banking in that the firms bank actually services the lockbox which reduces the processing float. A lockbox system reduces the collection float by shortening the processing float as well as the mail and clearing float.

Cash Management Techniques

Speeding Collections
Direct Sends and Other Techniques A direct send is a collection procedure in which the payee presents checks for payment directly to the banks on which they are drawn, thus reducing the clearing float. Pre-authorized checks (PAC) is a check written against a customers account for a previously agreed upon amount avoiding the need for the customers signature. Depository transfer checks (DTC) are unsigned checks drawn on one of the firms accounts and deposited at a concentration bank to speed up transfers.

Cash Management Techniques

Speeding Collections
Direct Sends and Other Techniques Wire transfers is a telecommunications bookkeeping device that removes funds from the payers bank and deposits them into the payees bank -- thereby reducing collections float. Automated clearinghouse (ACH) debits are preauthorized electronic withdrawals from the payers account that are transferred to the payees account via a settlement among banks by the automated clearinghouse. ACHs clear in one day, thereby reducing mail, processing, and clearing float.

Cash Management Techniques

Slowing Disbursements
Controlled disbursing involves the strategic use of mailing points and bank accounts to lengthen mail float an clearing float. Playing the float is a method of consciously anticipating the resulting float or delay associated with the payment process and using it to keep funds in an account as long as possible. Staggered funding is a method of playing the float by depositing a certain portion of a payroll into an account on several successive days following the issuance of checks.

Cash Management Techniques

Slowing Disbursements
With an overdraft system, if the firms checking account balance is insufficient to cover all checks presented, the bank will automatically lend money to cover the account. A zero-balance account is an account in which a zero balance is maintained and the firm is required to deposit funds to cover checks drawn on the account only as they are presented for payment.

The Role of Banking Relationships

Maintaining strong banking relationships is one of the most important elements of an effective cash management system. In recent years, banks have become a source for a wide variety of cash management services which are designed to help financial managers maximize day-today cash availability and facilitate short-term investing.

Marketable Securities
Marketable securities are short-term, interest bearing money market instruments that can easily be converted into cash Securities that are most commonly-held as part of a marketable securities portfolio can be segmented into two groups -- government issues and non-government issues.

Marketable Securities
Characteristics
To qualify as a marketable securities investment, the instruments must have a ready market -- which means it must be both broad and deep. The breadth of a market is determined by the number of participants (buyers). The depth of a market is determined by its ability to absorb the purchase or sale of a large dollar amount of a particular security. A ready market must have both of these characteristics.

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

Figure

Cash Conversion Models

Cash conversion models are used to help determine the optimal quantity of marketable securities to convert into cash when needed (and vice versa). The cash conversion quantity depends on a number of factors, including the fixed cost of transferring funds between cash and marketable securities, the rate of interest, and the firms demand for cash. The objective of these models is to balance the costs and benefits of holding cash versus investing in marketable securities.

Maintaining Cash Balance

Assuming that liquidity is maintained in the form of cash, bank balances and a portfolio of marketable securities. It is necessary for a finance manager to know what should be the optimum cash and bank balances he must maintain and for that purposes how often and in what quantity securities should be purchased and sold The following models addresses these issues

The models
The models are divided in two parts Certainty model- Baumol* Uncertainty model-Miller and Orr*
*Baumol, W.J., The Transactions Demand for Cash: An Inventory Theoretic Approach, Quarterly Journal of Economics, November 1952, pp. 545-556 *Miller, M. H. and Daniel, Orr, A Model of the Demand for Money by Firms. Quarterly Journal of Economics, August 1966,pp. 413-435

Cash Conversion Models

Baumol Model
The Baumol model is a simple approach that provides for cost-efficient cash balances by determining the optimal cash conversion quantity. The firm manages its cash inventory by calculating two costs:

the cost of converting marketable securities into cash and vice versa, and the cost of holding cash rather than marketable securities.

Baumol Model
Total Cost = b(T/C)+i(C/2)

iC2= 2bT C2= 2bT i

C=

2bT i

Where T/C= cash turnover ratio or the no. of transactions effected during a period, when this is multiplied by b, the fixed charge per unit of transaction we obtain total transaction cost during the period. C/2 represents the average cash balance which when multiplied by i gives the opportunity cost of foregone investment opportunity. Our purpose is to find out C that minimizes the total cost

Cash Conversion Models

Baumol Model
The Baumol model may be written as shown in Equation below:

Cash Conversion Models

Baumol Model
The Baumol model may be described graphically as shown in Figure below.

Cash Conversion Models Baumol Model

A firm estimates that it is required to make cash disbursements of Rs 567 lakh in a year which is spread over uniformly at Rs 47.25 lakh per month. The firm invests only in treasury bills for cash management purposes. The present yield is 8% p.a. It costs the firm Rs. 900 for every transaction in Treasury Bills. Calculate 2x900x567,00,000 0.08 = 11,29,491or say 11.30 lakh C=

Cash Turnover Ratio

567,00,000/11,29,491=50.20 or 50 times a year 47,25,000/11,29,491=4.18 or 4 times a month

Short-comings of Baumols model

Specification of cost- Rate of interest on securities particularly on TBs are fairly known, fixed cost associated with security transaction is difficult to estimate as majority parts are overheads e.g brokerage, storage cost etc. Assumption of steady usage of cash during the period under consideration Under high uncertainty in the cash flows this model does not work Under moderate degree of uncertainty a cushion viz safety stock may be factored

Uncertainty Model Miller-Orr

When uncertainty of cash flows is very high resulting in random fluctuations in cash balances, EOQ-Cash model may not work and one has to find a solution in stochastic models. Miller and Orr set up two control limits of cash holding: upper limit and lower limit When cash balances reaches the upper limit, a transfer of cash to market securities takes place by purchasing securities and when it reaches a lower limit, a transfer from market securities to cash takes place by selling securities When cash balance stays within these bounds, no transaction takes place.

Cash Conversion Models

Uncertainty Model Miller-Orr
The Miller-Orr model is generally more realistic than the Baumol model. It provides for cost-efficient cash balances by determining an upper limit (maximum amount) and a return point (target cash balance).

Miller-Orr Model

Cash Conversion Models

Miller-Orr Model
Example It costs JanCo $30 to convert marketable securities to cash and vice versa; the firms marketable securities portfolio earns an 8% annual return, which is 0.0222 daily (8%/360 days). The variance of JanCos daily net cash flow is estimated to be $27,000. Substituting into Equation 16.5 yields the return point:

Miller and Orr Model

A company projects the daily net cash flows for the next seven days as follows:
Day
Cash Flow Forecast

1 2 3 +24 +13 -16

4 5 -12 +36

6 7 +4 -28

The policy of the company is to maintain a minimum cash balance of Rs. 10,000 at all the times. Fixed cost for every security transaction is Rs. 1,600 and return on marketable securities is 10% p.a. The company desires to know the return point (Z) and the upper limit of cash holding that would trigger a purchase order for securities.

Solution
Calculation of the variance of cash flows forecast Daily CFF (Xi) (X) (Xi- X) (Xi- X)2 Variance (S2) 24 x/n=21/7 21 441 (Xi- X)2/n
13 -16 -12 36 4 -28 21 =Rs.3 10 -19 -15 33 1 -31 0 100 361 225 1089 1 961 3178 = 3178/7 = Rs. 454

 Return Point (Z) =10,000+33x1600x454,00,000 4x(0.10)/365 = Rs. 10,000+58,368 = RS. 68,368 Upper Limit = Rs. 10,000+3x58,368 = Rs. 1,85,104

Interpretation
These two findings signify that the finance manager will allow the daily cash balance to fluctuate till it reaches the upper limit of Rs.1,85,104. When the balance becomes greater than this figure, he will purchase sufficient worth of securities to reduce the cash balance to the return point of Rs.68,368. On the lower side, when the cash balance drops to the minimum balance of Rs.10,000 he will sell the adequate amount of securities to raise the cash balance to Rs.68,368.