Reasons for Holding Cash Is it possible for a firm to have too much cash? Why would shareholders care if a firm accumulates large amounts of cash?
Determining the Target Cash Balance Show, using both the Baumol model and the Miller–Orr model, how a firm can determine its optimal cash balance.
Collection and Disbursement of Cash Which would a firm prefer: a net collection float or a net disbursement float? Why?
Investing Idle Cash What options are available to a firm if it believes it has too much cash? How about too little?
Agency Issues Are shareholders and creditors likely to agree on how much cash a firm should keep on hand?
Cash Management versus Liquidity Management What is the difference between cash management and liquidity management?
Short-Term Investments Why are preference shares with a dividend tied to short-term interest rates an attractive short-term investment for corporations with excess cash?
Float Suppose a firm has a book balance of €2 million. At the automatic teller machine (ATM) the cash manager finds out that the bank balance is €2.5 million. What is the situation here? If this is an ongoing situation, what ethical dilemma arises?
Short-Term Investments For each of the short-term marketable securities given here, provide an example of the potential disadvantages the investment has for meeting a corporations cash management goals:
Negotiable certificates of deposit (NCDs).
Revenue anticipation notes.
Agency Issues It is sometimes argued that excess cash held by a firm can aggravate agency problems (discussed in Chapter 1) and, more generally, reduce incentives for shareholder wealth maximization. How would you frame the issue here?
Use of Excess Cash One option a firm usually has with any excess cash is to pay its suppliers more quickly. What are the advantages and disadvantages of this use of excess cash?
Use of Excess Cash Another option usually available is to reduce the firms outstanding debt. What are the advantages and disadvantages of this use of excess cash?
Float An unfortunately common practice goes like this (warning – dont try this at home). Suppose you are out of money in your bank current account; however, your local grocery store will, as a convenience to you as a customer, cash a cheque for you. So you cash a cheque for £200. Of course, this cheque will bounce unless you do something. To prevent this, you go to the grocery the next day and cash another cheque for £200. You take this £200 and deposit it. You repeat this process every day, and in doing so you make sure that no cheques bounce. Eventually, manna from heaven arrives (perhaps in the form of money from home), and you are able to cover your outstanding cheques.
To make it interesting, suppose you are absolutely certain that no cheques will bounce along the way. Assuming this is true, and ignoring any question of legality (what we have described is probably illegal cheque-kiting), is there anything unethical about this? If you say yes, then why? In particular, who is harmed?
Interpreting Miller–Orr Based on the Miller–Orr model, describe what will happen to the lower limit, the upper limit, and the spread (the distance between the two) if the variation in net cash flow grows. Give an intuitive explanation for why this happens. What happens if the variance drops to zero?
Changes in Target Cash Balances Indicate the likely impact of each of the following on a companys target cash balance. Use the letter I to denote an increase and D to denote a decrease. Briefluy explain your reasoning in each case.
Commissions charged by brokers decrease.
Interest rates paid on money market securities rise.
The compensating balance requirement of a bank is raised.
The firms credit rating improves.
The cost of borrowing increases.
Direct fees for banking services are established.
Using the Baumol Model Given the following information, calculate the target cash balance using the Baumol model:
Annual interest rate: 7%
Fixed order cost: €10
Total cash needed: €5,000
How do you interpret your answer?
Opportunity versus Trading Costs White Whale NV has an average daily cash balance of €400. Total cash needed for the year is €25,000. The interest rate is 5 per cent, and replenishing the cash costs €6 each time. What are the opportunity cost of holding cash, the trading cost, and the total cost? What do you think of White Whales strategy?
Costs and the Baumol Model D&C Accountants needs a total of £4,000 in cash during the year for transactions and other purposes. Whenever cash runs low, the firm sells off £300 in securities and transfers the cash in. The interest rate is 6 per cent per year, and selling off securities costs £25 per sale.
What is the opportunity cost under the current policy? The trading cost? With no additional calculations, would you say that D&C keeps too much or too little cash? Explain.
What is the target cash balance derived using the Baumol model?
Calculating Net Float Each business day, on average, a company writes cheques totalling €25,000 to pay its suppliers. The usual clearing time for the cheques is four days. Meanwhile, the company is receiving payments from its customers each day, in the form of cheques, totalling €40,000. The cash from the payments is available to the firm after two days.
Calculate the companys disbursement float, collection float, and net float.
How would your answer to part (a) change if the collected funds were available in one day instead of two?
Costs of Float Purple Feet Wine Ltd receives an average of £9,000 in cheques per day. The delay in clearing is typically four days. The current interest rate is 0.025 per cent per day.
What is the companys float?
What is the most Purple Feet should be willing to pay today to eliminate its float entirely?
What is the highest daily fee the company should be willing to pay to eliminate its float entirely?
Float and Weighted Average Delay Every month your neighbour receives two cheques, one for €16,000 and one for €3,000. The larger cheque takes four days to clear after it is deposited; the smaller one takes five days.
What is the total float for the month?
What is the average daily float?
What are the average daily receipts and weighted average delay?
NPV and Collection Time Your firm has an average receipt size of £80. A bank has approached you concerning a new service that will decrease your total collection time by two days. You typically receive 12,000 cheques per day. The daily interest rate is 0.016 per cent. If the bank charges a fee of £190 per day, should the new service be accepted? What would the net annual savings be if the service were adopted?
Using Weighted Average Delay A mail-order firm processes 5,000 cheques per month. Of these, 65 per cent are for €50 and 35 per cent are for €70. The €50 cheques are delayed two days on average; the €70 cheques are delayed three days on average.
What is the average daily collection float? How do you interpret your answer?
What is the weighted average delay? Use the result to calculate the average daily float.
How much should the firm be willing to pay to eliminate the float?
If the interest rate is 7 per cent per year, calculate the daily cost of the float.
How much should the firm be willing to pay to reduce the weighted average float by 1.5 days?
Value of Lockboxes Paper Submarine Manufacturing is investigating a lockbox system to reduce its collection time. It has determined the following:
Average number of payments per day: 400
Average value of payment: £1,400
Variable lockbox fee (per transaction): £0.75
Daily interest rate on money market securities: 0.02%
The total collection time will be reduced by three days if the lockbox system is adopted.
What is the PV of adopting the system?
What is the NPV of adopting the system?
What is the net cash flow per day from adopting? Per cheque?
Collections It takes Modular Homes AB about six days to receive and deposit cheques from customers. Modular Homes management is considering a new system to reduce the firms collection times. It is expected that the new system will reduce receipt and deposit times to three days total. Average daily collections are NKr140,000, and the required rate of return is 9 per cent per year.
What is the reduction in outstanding cash balances as a result of implementing the new system?
What monetary return could be earned on these savings?
What is the maximum monthly charge Modular Homes should pay for this new system?
Value of Delay No More Pencils plc disburses cheques every two weeks that average £70,000 and take seven days to clear. How much interest can the company earn annually if it delays transfer of funds from an interest-bearing account that pays 0.02 per cent per day for these seven days? Ignore the effects of compounding interest.
NPV and Reducing Float No More Books SA has an agreement with National Bank whereby the bank handles €8 million in collections a day and requires a €500,000 compensating balance. No More Books is contemplating cancelling the agreement and dividing its Belgian activities so that two other banks will handle its business. Banks A and B will each handle €4 million of collections a day, and each requires a compensating balance of €300,000. No More Books financial management expects that collections will be accelerated by one day if the Belgian activities are divided between two banks. Should the company proceed with the new system? What will be the annual net savings? Assume that the T-bill rate is 5 per cent annually.
Determining Optimal Cash Balances The Tommy Byrne Company is currently holding €700,000 in cash. It projects that over the next year its cash outflows will exceed cash inflows by €360,000 per month. How much of the current cash holding should be retained, and how much should be used to increase the companys holdings of marketable securities? Each time these securities are bought or sold through a broker, the company pays a fee of €500. The annual interest rate on money market securities is 6.5 per cent. After the initial investment of excess cash, how many times during the next 12 months will securities be sold?
Using Miller–Orr SlapShot plc has a fixed cost associated with buying and selling marketable securities of £100. The interest rate is currently 0.021 per cent per day, and the firm has estimated that the standard deviation of its daily net cash flows is £75. Management has set a lower limit of £1,100 on cash holdings. Calculate the target cash balance and upper limit using the Miller–Orr model. Describe how the system will work.
Using Miller–Orr The variance of the daily cash flows for the Pele Bicycle Shop is €960,000. The opportunity cost to the firm of holding cash is 7 per cent per year. What should be the target cash level and the upper limit if the tolerable lower limit has been established as €150,000? The fixed cost of buying and selling securities is €500 per transaction.
Using Baumol All Night Ltd has determined that its target cash balance if it uses the Baumol model is €2,200. The total cash needed for the year is €21,000, and the order cost is €10. What interest rate must All Night be using?
Lockboxes and Collection Time Birds Eye Treehouses Ltd, a Scottish company, has determined that a majority of its customers are located in the Highlands area. It therefore is considering using a lockbox system offered by a bank located in Inverness. The bank has estimated that use of the system will reduce collection time by two days. Based on the following information, should the lockbox system be adopted?
Average number of payments per day: 600
Average value of payment: £1,100
Variable lockbox fee (per transaction): £0.35
Annual interest rate on money market securities: 6.0%
How would your answer change if there were a fixed charge of £1,000 per year in addition to the variable charge?
Calculating Transactions Required Leon Dung SA, a large fertilizer distributor based in the north of Spain, is planning to use a lockbox system to speed up collections from its customers located in the Castille y Leon region. A Vallidolid-area bank will provide this service for an annual fee of €25,000 plus 10 cents per transaction. The estimated reduction in collection and processing time is one day. If the average customer payment in this region is €5,500, how many customers each day, on average, are needed to make the system profitable for Leon Dung? Treasury bills are currently yielding 5 per cent per year.
Baumol Model Lisa Tylor, CFO of Purple Rain Co., concluded from the Baumol model that the optimal cash balance for the firm is $10 million. The annual interest rate on marketable securities is 5.8 per cent. The fixed cost of selling securities to replenish cash is $5,000. Purple Rains cash flow pattern is well approximated by the Baumol model. What can you infer about Purple Rains average weekly cash disbursement?
Miller–Orr Model Gold Star Ltd and Silver Star Ltd both manage their cash flows according to the Miller–Orr model. Gold Stars daily cash flow is controlled between £95,000 and £205,000, whereas Silver Stars daily cash flow is controlled between £120,000 and £230,000. The annual interest rates Gold Star and Silver Star can get are 5.8 per cent and 6.1 per cent, respectively, and the costs per transaction of trading securities are £2,800 and £2,500, respectively.
What are their respective target cash balances?
Which firms daily cash flow is more volatile?