Outline: Chapter 22 Cash and Marketable Securities

1. Outline: Chapter 22Cash and Marketable Securities • The Cash Management Function • Reasons for holding cash • Risk and return • Cash Management Techniques • Paper based versus electronic payment systems • Speeding the inflows • Controlling the outflows • Interactions • International cash management

2. Outline: Chapter 22Cash and Marketable Securities(concluded) • Advances in Payment and Information Systems • Electronic payment systems • Electronic data interchange • Determining the Daily Cash Balance • General procedure • Models for determining the target cash balance • Management of the Marketable Securities Portfolio • Investment alternatives • Selection criteria • The marketable securities portfolio

3. The Cash Management Function • Cash refers to currency on hand plus demand deposits • Marketable securities are the short-term investments the firm may temporarily hold that can be quickly converted into cash • There are three main questions relate to liquid asset management • How should the firm design its cash-gathering and cash-disbursing systems? • How should the investment in liquid assets be split between cash and marketable securities? • How should marketable securities be managed?

4. The Cash Management FunctionReasons for Holding Cash • Transaction purposes • Cash is needed to meet requirements as monthly bill payments, tax payments, cash dividend payments, and salaries • Hedge against uncertainty • Marketable securities and lines of credit provide liquidity for unexpected needs, thus, financial slack is the second reason for holding cash

5. The Cash Management FunctionReasons for Holding Cash(concluded) • Flexibility • Liquidity is useful for weathering bad times when credit is tight and also in anticipation of taking advantage of unforeseen opportunities ( growth options), quickly and easily • Compensating balance requirement • As compensation for lines of credit and other bank services, firms agree that a compensating balance be left in a chequing account

6. The Cash Management FunctionRisk and Return • Risk from holding too little cash • Bill payment may have to be deferred • Capital expenditures curtailed • Expensive short-term financing obtained • Growth opportunities bypassed • In an extreme case, the firm may have to file for protection under the Bankruptcy Act or be forced into liquidation

7. The Cash Management FunctionRisk and Return(concluded) • Risk and return tradeoff for liquid assets involves • Having enough cash and liquid reserves (or financial slack), in the form of marketable securities and/or lines of credit, to meet all the firm's obligations and take advantage of growth opportunities • Not holding excess liquid reserves, because investment in long-term assets generally provides higher returns than short-term investments • Maintaining a minimum cash balance while actively managing the firm's portfolio of marketable securities to ensure as high a return as possible commensurate with the risk involved

8. Cash Management Techniques • The goal of the cash gathering system is to speed collections to the level where the increased benefits equal the increased costs • The goal of the cash disbursement system is to control and slow down the outflow of cash without hurting the firm's credit rating • The two decisions cannot be made in isolation--joint effects, costs, and benefits must be considered in order to create an efficient cash management system that balances risk and returns

9. Cash Management Techniques Paper Based versus Electronic Payment Systems • In Canada and the U. S. the major means of making non-cash payments is through cheques • Giro systems • Are employed in most European countries for smaller transactions, are often run by the postal service and operate on the basis of direct debits and credits • A seller sends an invoice including a giro acceptance that is encoded with the seller's bank and account number to the buyer, the buyer signs the stub, takes it to the local post office, transmits the information through the girobank

10. Cash Management Techniques Speeding the Inflows • Float • Is the time that elapses from the writing of a cheque until the recipient receives the funds and can draw upon them • Mail float • The length of time it takes a firm to receive a cheque after it is mailed by a customer • Processing float • Is the time that elapses between when the selling firm receives the cheque and when it deposits the cheque in its bank

11. Cash Management Techniques Speeding the Inflows(continued) • Transit float • Is the time required for the cheque to clear through the banking system until the recipient can draw upon it • The Bank of Canada and the Canadian Payments Association are responsible for clearing cheques through the Canadian payments system • When a firm deposits a customer's cheque into its bank account, before the firm has access to these funds, the Canadian payments system must verify that the funds are in the customer's account, and then it transfers the funds to the firm's bank account via the Bank of Canada

12. Cash Management Techniques Speeding the Inflows(continued) • To facilitate this process, the payments system has 10 settlement or clearing centers located in 10 major cities across Canada, connected to each other and the Bank of Canada by computer • This computerized network keeps transit float to a minimum by providing same-day settlement on cheques • Decentralized collections • Decentralized collections in various parts of the country can reduce mail float

13. Cash Management Techniques Speeding the Inflows(continued) • Local offices can receive payments and deposit them in a local branch of the firm's bank • Benefits: keep mail float to a minimum • Costs: personnel, equipment, and space • Lockboxes (post office boxes) can be set up in specific cities and customers required to mail their payments to the closest one. A bank picks up the mail several times a day for clearance • Benefits: keep mail float to a minimum, reduce the processing float • Cost: fees charged by the bank either directly or through a compensating balance agreements

14. Cash Management Techniques Speeding the Inflows(continued) • The purpose of both local office and lockbox collection points is to keep mail float to a minimum • Managers must weight the costs of using these systems versus the benefits of reduced mail float • Banking network • Large firms use a tiered banking network by employing more than one bank • Local offices process cheques and then deposit them to local bank branches who, in turn, make a transfer to the firm's head office account at its central concentration branch • Lockboxes are maintained by a regional bank branch, forwards the funds to the firm's central concentration branch, and sends the supporting documents to the firm

15. Cash Management Techniques Speeding the Inflows(continued) • Funds at the firm's central concentration bank can be used to meet the cash outflows of the firm, any extra funds can be quickly invested in marketable securities or, if the firm is short of cash, it can draw on its lines of credit • Other approaches • Special handling • Such as a hired courier • Preauthorized cheques • The customer authorizes the firm to draw cheques directly on the customer's demand deposit account

16. Cash Management Techniques Speeding the Inflows(continued) • Receipt of payment required • The firm demands payment by a certain date • Customer wants to take advantage of a cash discount • Receipt of payment approach eliminates mail float • Payment by an electronic transfer • This also eliminates float

17. Cash Management Techniques Speeding the Inflows(continued) • Analysis of cash-gathering techniques • Compares the incremental costs with the incremental benefits

18. Cash Management Techniques Speeding the Inflows(continued) • Decision criteria • An NPV approach • is simply NPV where there is no discounting, due to the short time periods involved

19. Cash Management Techniques Speeding the Inflows(continued) • Lockbox example • You estimate that the reduction in float (both mail and processing) will be 3 days, the average cheque size is $500, the yearly rate of interest is 10 percent, and T = 40 percent. Using Equation 22.1, what is the approximate per unit benefits of the lockbox? Answer: To convert from a per unit basis to a daily basis multiply average cheque size by the number of cheques per day

20. Cash Management Techniques Speeding the Inflows(continued) To convert per day figures to per year figures Convert daily volume to a yearly basis by multiplying the daily volume (TS) by 365 OR Convert the daily interest rate to a yearly rate by multiplying by 365 • Suppose there are 300 cheques per day and the present cost per day is $158. Should the firm change to lockboxes? Answer:

21. Cash Management Techniques Speeding the Inflows(continued) • What if the after-tax cost is $24,000 per year, should the firm now change? Answer: Now, the firm should change.

22. Cash Management Techniques Speeding the Inflows(concluded) • If we already know what the incremental costs, C, are then we must determine what the reduction in the float time, t, the average size, TS, or the yearly interest rate, I, would have to be for us to be indifferent between the two methods.

23. Cash Management Techniques Controlling the Outflows • The firm's cash-disbursement system should be designed so the firm pays just before the due date • Controlled disbursing • Canada's branch banking system leaves little opportunity to extend the length of time a cheque takes to be cleared • Canadian banks provide firms with cash on the same day that the cheques are deposited, even though it takes 24 hours for them to clear

24. Cash Management Techniques Controlling the Outflows(continued) • Although Canadian firms can set up a controlled disbursing system to increase mail float by mailing cheques to suppliers from a distant location, the wisdom of such actions is questionable • The firm increase its cash level but, at the same time, creates ill will among suppliers who will be without payment for an additional number of days • The better thing to do is to design a system that calls for the timing of payments so that they arrive at suppliers just before the due date or just before any discounts expire

25. Cash Management Techniques Controlling the Outflows(continued) • Zero balance accounts • Zero balance accounts are like individual demand deposit accounts, except they contain no funds • Zero balance accounts at the firm's central concentration branch allow all of the firm's divisions to drawn on individual disbursing accounts at the concentration branch • This creates negative balances that are restored to zero by a credit from the firm's positive balance master account at the central concentration branch at the end of each day • Excess cash balances do not build up • Allow much more control, while maintaining divisional autonomy for payments

26. Cash Management Techniques Controlling the Outflows(concluded) • Other approaches • Centralized payables • Invoices are received and verified at the divisional level but actually paid at the firm's headquarters • Timing cheque issuance • By issuing cheques at certain times during the week, the firm may increase its mail or transit float

27. Cash Management Techniques Interactions • In medium- to large-size firms, with various plants and offices, gathering and disbursing problems quickly become complex • If the firm decides to employ lockboxes and/or have collections made by local offices, numerous bank branches and possibly more than one bank will be involved • In the end the two decisions, gathering and disbursing, cannot be made in isolation. Rather, their joint effects, costs, and benefits must be considered in order to create an efficient cash management system that balances the risks and returns involve

28. Cash Management Techniques International Cash Management • Some of the major international money movement techniques are • Concentration banking • To control the flow of funds internationally, firms concentrate their cash at a single bank within a country or on a regional level within a zero balance type of procedure • International transfer • Using banks, firms can arrange for same-day settlement or other kinds of settlement procedures when funds move across country borders

29. Cash Management Techniques International Cash Management(concluded) • International lockbox • This technique involves establishing one or more lockboxes in a country so that payments can be settled in the country where the currency is legal tender • Intracompany netting • Many firms have large sums of money tied up in intracompany transactions so to avoid the physical transfer of funds they "net" the funds flowing between subsidiaries once a month • In addition, because of fluctuating foreign exchange rates, many firms follow a practice of leading or lagging

30. Advances in Payment and Information Systems • Electronic payment systems • Electronic payment systems or electronic funds transfer, EFT, replaces paper cheques with an electronic payment system, e. g., debit cards • Firms using this system are able to eliminate accounts receivables and to have virtually immediate use of the cash • Essentially eliminate float

31. Advances in Payment and Information Systems(concluded) • Electronic data interchange (EDI) • EDI, affects everything from the ordering and manufacturing cycle to the flow of documents related to shipment and payment • EDI refers to the exchange of all transaction-related information between two firms in computer-readable form • Interfacing EDI with EFT enables firms to move from a paper based system to a non-paper based system

32. Determining the Daily Cash BalanceGeneral Procedure • Firms want to keep as little cash in demand deposits as possible, they would rather have the funds invested in a marketable securities portfolio • How should the investment in liquid assets be split between cash and marketable securities? • Five step general procedure • Prepare cash budgets on a monthly basis • Break out major cash items such as taxes, dividends, lease payments, interest, wages into cash inflows and outflows

33. Determining the Daily Cash BalanceGeneral Procedure(continued) • Identify the timing of the major inflows and outflows for the month so you can estimate when daily transfers into or out of the marketable securities portfolio may be necessary • Use modeling to predict routine inflows and outflows to detect cash surpluses and cash needs • Compare the actual routine cash inflows and outflows with those projected to evaluate the planning process and to fine-tune it • The goal is to maintain the actual cash balance at some predetermined level

34. Determining the Daily Cash BalanceGeneral Procedure(continued) • Model for estimating and controlling firm’s cash balance Actual major cash inflows and outflows Major Monthly Daily forecasting items Actual cash cash model for routine balance budget inflows and outflows Routine items Actual routine Marketable inflows and securities outflows portfolio

35. Determining the Daily Cash BalanceGeneral Procedure(continued) • Daily cash balance example • Suppose it costs $35.71 to move funds into or out of the marketable securities portfolio, the incremental interest from having funds in marketable securities is 6%, and T = 30%. What should be the average size of a transaction (TS)? Answer:

36. Determining the Daily Cash BalanceGeneral Procedure(concluded) Thus, there is $217,262 that can be left in marketable securities for at least 1 day before the transfer is made • If we estimate, based on our daily cash balance model, that funds can be transferred from cash to marketable securities and left for 4 days, should the transfer be made if there is $60,000 in excess funds? Answer: In this case the transfer should be made.

37. Determining the Daily Cash BalanceModels for Determining the Target Cash Balance • Miller-Orr model • Cash inflows and outflows are assumed to be uncertain and fluctuate randomly day-to-day, i. e., the distribution of the daily net cash flow is normally described • Model sets upper and lower control limits and a target cash balance • The lower cash balance is set by management • The following variables are needed for the model

38. Determining the Daily Cash BalanceModels for Determining the Target Cash Balance(continued) Upper control limit = H = 3Z - 2L Average cash balance = (4Z - L)/3

39. Determining the Daily Cash BalanceModels for Determining the Target Cash Balance(continued) • Miller-Orr model example • M-O Ltd. has a lower control limit, L = $2,000, F = $200, k = 0.09 per year, and the standard deviation, , of the daily cash flows is $3,000. The daily compound opportunity cost is The variance of the net daily cash flows is

40. Determining the Daily Cash BalanceModels for Determining the Target Cash Balance(continued) The target cash balance is The upper control limit is H = 3($19,884.38) - 2($2,000) = $55,653.14 The average cash balance is [4($19,884.38) - $2,000]/3 = $25,845.84

41. Determining the Daily Cash BalanceModels for Determining the Target Cash Balance(continued) • Assumptions for the Miller-Orr model • Daily cash flows are random and cannot be predicted • Transfers to and from marketable securities are instantaneous • Seasonal and/or cyclical trends are not considered • The cost of buying or selling securities is fixed regardless of the size of the transaction • The term structure of interest rates is flat and the level of interest rates does not change

42. Determining the Daily Cash BalanceModels for Determining the Target Cash Balance(concluded) • Miller-Orr model works reasonably well if • The distribution of net daily cash flows is approximately normal • The cash flows are random from day-to-day • Only one source of investment is available • Stone look ahead model • Similar to the Miller-Orr model, except it focuses on managing cash balances instead of determining the optimal transaction size • Uses upper and lower control limits, but "looks ahead" a few days at the anticipated cash balances

43. Management of the Marketable Securities Portfolio • Funds which represent very temporary excess cash are invested in marketable securities • Funds that are not likely to be needed for a long period of time will be invested in long-term instruments • Long-term bonds or common stock generally are not part of the marketable securities portfolio

44. Management of the Marketable Securities PortfolioInvestment Alternatives • Short-term investment alternatives include • Treasury bills • Short-term obligation of the federal government • Bankers' acceptances • Promissory note for payment by a corporation and guaranteed by a bank • Commercial paper • Short-term promissory note issued by a corporation • Sales finance paper • Short-term paper issued by finance companies

45. Management of the Marketable Securities PortfolioInvestment Alternatives(concluded) • Repurchase agreements • Dealer sells government securities and agrees to repurchase on a set date • Bank certificates of deposit • Promissory note from a bank or trust to repay a deposit • Negotiable certificates of deposit • Promissory note from a bank or trust company to repay a deposit • Eurodollar • Dollar-denominated time deposits at foreign banks • Money market mutual funds • Pool of money market instruments

46. Management of the Marketable Securities PortfolioSelection Criteria • The firm's risk-return posture determines the specific composition of the marketable securities portfolio after taking into consideration the interaction of • Risk • Liquidity • Because firms use their marketable securities portfolio as a source of ready cash, the liquidity aspect of the investment also requires careful consideration

47. Management of the Marketable Securities PortfolioSelection Criteria(continued) • Maturity • Most large firms keep some cash invested overnight in repurchase agreements and other shorter-maturity securities • Then they follow a layered approach of matching longer cash availability with investments in longer term marketable securities • Yield • Treasury bills, are the least risky of the securities and consequently always have the lowest yield • Other securities have higher returns, depending on their risk and liquidity

48. Management of the Marketable Securities PortfolioSelection Criteria(continued) • Yields on three-months money market instruments

49. Management of the Marketable Securities PortfolioSelection Criteria(continued) • T-Bill pricing example • Suppose you purchase a 182-day treasury bill with a face value of $10,000 at a price of $9,400. What is your bond equivalent yield? Answer:

50. Management of the Marketable Securities PortfolioSelection Criteria(continued) • If you are told that the bond equivalent yield on a 182-day $10,000 T-Bill was 9.8%. How much should you pay? Answer: If you buy the 182-day T-Bill for $9,534.11 and hold it until maturity your bond equivalent yield is 9.8%.