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Cash and Liquidity Management - Appendix

Chapter Twenty A. Cash and Liquidity Management - Appendix. Target Cash Balances. Target cash balance – desired cash level determined by trade-off between carrying costs and shortage costs

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Cash and Liquidity Management - Appendix

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  1. Chapter Twenty A Cash and Liquidity Management - Appendix

  2. Target Cash Balances • Target cash balance – desired cash level determined by trade-off between carrying costs and shortage costs • Flexible policy - If a firm maintains a marketable securities account, the primary shortage cost is the trading cost from buying and selling securities • Restrictive policy – Generally borrow short-term, so the shortage costs will be the fees and interest associated with arranging a loan

  3. Figure 20A.1

  4. BAT Model • Assumptions • Cash is spent at the same rate every day • Cash expenditures are known with certainty • Optimal cash balance is where opportunity cost of holding cash = trading cost • Opportunity cost = (C/2)*R • Trading cost = (T/C)*F • Total cost = (C/2)*R + (T/C)*F

  5. Example: BAT Model • Your firm will have $5 million in cash expenditures over the next year. The interest rate is 4% and the fixed trading cost is $25 per transaction. • What is the optimal cash balance? • What is the average cash balance? • What is the opportunity cost? • What is the shortage cost? • What is the total cost?

  6. Miller-Orr Model • Model for cash inflows and outflows that fluctuate randomly • Define an upper limit, a lower limit and a target balance • Management sets lower limit, L • C* = L + [(3/4)F2/R]1/3 (target balance) • U* = 3C* - 2L (upper limit) • Average cash balance = (4C* - L)/3

  7. Figure 20A.3

  8. Example: Miller-Orr Model • Suppose that we wish to maintain a minimum cash balance of $50,000. Our fixed trading cost is $250 per trade, the interest rate is .5% per month and the standard deviation of monthly cash flows is $10,000. • What is the target cash balance? • What is the upper limit? • What is the average cash balance?

  9. Conclusions • The greater the interest rate, the lower the target cash balance • The greater the fixed order cost, the higher the target cash balance • It is generally more expensive to borrow needed funds than it is to sell marketable securities • Trading costs are usually very small relative to opportunity costs for large firms

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