T19.1 Chapter Outline

Chapter 19Cash and Liquidity Management

Chapter Organization

19.1 Reasons for Holding Cash

19.2 Understanding Float

19.3 Cash Collection and Concentration

19.4 Managing Cash Disbursements

19.5 Investing Idle Cash

19.6 Summary and Conclusions

Appendix: Determining the Target Cash Balance

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T19.2 Key Issues: Cash and Liquidity Management

Key issues: What is the tradeoff between carrying a large versus a small cash

balance?

What is the proper management of the cash balance?

Preliminaries: understanding float Identifying the opportunity cost of float

Decreasing the collection float

Increasing disbursement float

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T19.3 Reasons for Holding Cash

Speculative Motive - the need to hold cash to take advantage of additional investment opportunities, such as bargain purchases.

Precautionary Motive - the need to hold cash as a safety margin to act as a financial reserve.

Transaction Motive - the need to hold cash to satisfy normal disbursement and collection activities associated with a firm’s ongoing operations.

Compensating Balance Requirements - cash balances kept at commercial banks to compensate for banking services the firm receives.

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T19.4 Understanding Float

Preliminaries: what is float?

The difference between book cash and bank cash, representing the net effect of checks in the process of clearing.

Types of Float

Disbursement float

The result of checks written; decreases book balance but does not immediately change available balance

Collection float

The result of checks received; increases book balance but does not immediately change available balance

Net float

The overall difference between the firm’s available balance and its book balance

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T19.5 Check Clearing Illustrated

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Payor writes check Payee receives check

Federal Reserve Bank or Correspondent Bankor Local Clearinghouse

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Payor’s bank Payee’s bank

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T19.6 Overview of Lockbox Processing (Figure 19.3)

Envelopes opened;separation ofchecks and receipts

Local bankcollects funds frompost office boxes

Deposit of checksinto bank account

Bank check-clearing process

Firm processesreceivables

Details of receivablesgo to firm

Post officebox 1

Post officebox 2

Customerpayments

Customerpayments

Customerpayments

Customerpayments

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T19.7 Lockboxes and Concentration Banks in a Cash Management System (Figure 19.4)

Maintenance ofcompensatingbalance atcreditor bank

Short-terminvestment of cash

Disbursementsactivity

Maintenance ofcash reserves

Firm cashmanager

Concentrationbank

Local bank deposits

Post officelockbox receipts

Customerpayments

Customerpayments

Firm salesoffice

Customerpayments

Customerpayments

Cash manager analyzes bank balance and depositinformation and makes cash allocation revision.

Statements are sent by mail to firmfor receivables processing

Funds are transferred to concentration bank

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T19.8 Zero-Balance Accounts (Figure 19.5)

With zero-balance accounts, the firm keeps a single safety stock of cash in a master account. Funds are transferred into disbursement accounts as needed. With no zero-balance accounts, separate safety stocks must be maintained, thereby tying up cash unnecessarily.

Payroll account Supplier account Master account

Safetystocks

Cash transfers Cash transfers

Payroll account Supplier account

No zero-balance accounts Two zero-balance accounts

Safety stock

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T19.9 Money Market SecuritiesRisk

Money Market MarketabilityInstrument Issuer Maturity Denomination

U.S. Treasury Bills U.S. Government at issue: 90, 180, no default risk270, 360 days good secondary market

$1,000 minimum

Short-term municipal State & local 1 week to 1 year some default risksecurities governments good secondary market

$5,000 and up

Commercial paper Finance companies few weeks to backed with credit linesLarge companies 270 days no secondary marketBanks $100,000 and up

Negotiable CDs Banks at issue: 30, 60, no deposit insurance90, 180, 270, and good secondary market360 days $100,000 minimum

Repurchase U.S. security overnight to securedAgreements (repos) dealers, banks several weeks no secondary market

$1 million and up

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T19.10 Chapter 19 Quick Quiz

1. What are some reasons for firms holding cash?

Classical motives: precautionary, transactions, speculative

2. What is the difference between liquidity management and cash management?

Liquidity management concerns the optimal quantity of liquid assets to hold; cash management concerns the optimal collection and disbursement of cash

3. What is a controlled-disbursement account?

A controlled disbursement account is an account to which the firm transfers an amount that is sufficient to cover demands for payment.