FInance chapter 6

8/7/2019 FInance chapter 6

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Discuss why firms hold cash and marketablesecurities, and how the levels they hold of eachrelate to those motives.

Demonstrate the three basic strategies for theefficient management of cash using the firm’soperating and cash conversion cycles.

Explain float, including its three basiccomponents, and the firm’s major objectives withrespect to collection float and disbursement float.



• Review popular techniques for speeding upcollections and slowing down disbursements, therole of banking relationships, and internationalcash management.

• Understand the basic characteristics of marketable securities and the key features of popular government and non-government issues.

• Describe the Baumol model and Miller-Orr model

and how they can be used to determine theoptimum quantity in which to convert marketablesecurities and cash.



Cash is often called liquid assets ornonearning assets.

It is needed to pay salaries, raw materials,

repayment of loan and others.Specifically there are 3 major motives of holding cash which are:

Transaction Motives

Precautionary Motives

Speculative Motives



Transactionmotives

The level of funds required due to the ordinary course of business

It is needed to meet ordinary payment such as paying

bills, employees’ salaries, creditors and etc

Precautionary

motives

The funds needed to meet contingency requirement

Funds needed to reserve for emergency needs, unforeseen

fluctuation in cash flows or unexpected seasonal needs

It serves as a safety cushion against the unexpected cash

drain that may arise because of risk and uncertainty

regarding the future

Speculative

motives

To hold sufficient cash to enable the firm to take

advantage of any unexpected bargain or opportunitieswhich may arise from time to time such as trade discounts

or some short term investments

Compensating

balances

Are necessary to compensate financial institutions for

providing loans and services.

Requires the firm to maintain a minimum level of money it

its bank account, normally based on a certain percentageof the loans taken.



It involves having the optimum amount of cash in hand at the right time

It will also help the firm hold its cash longerand collect cash more quickly

Reasons to have an efficient cashmanagement techniques are:

To establish proper procedures for collectionfrom debtors and payment to creditors

To establish adequate cash floats andminimum cash balances

To synchronize cash inflows and outflows



The goal of cash management is tominimize the cash balance whilemaintaining a certain level of

liquidity.

Too much liquidity reduces return,whereas too little, increases risk

exposure.



Cash Flow Management

Estimation Cash Requirements

Developing Borrowing/ Investment Strategies



Involves the process of controllingthe movement, inflows, andoutflows, of the firm to minimize the

cash required to support workingcapital.

Slowing disbursements and speeding

up collections can do this.



The estimation of cash requirementsinvolves the preparation of cashbudget, which allow the firm to plan,

coordinate, and control the actualcash flow through the firm.

Once the cash flow has been

estimated, the appropriate level of cash holdings can be established.



With the establishment of theappropriate cash balance, thestrategies to finance any cash

shortfalls can be developed ahead of time.

In case of cash excess, efficientinvestment strategies can bedeveloped to use idle temporaryliquidity and earn return.



Speeding upreceipts

Slowing updisbursement

Maintaininggood bankingrelationship

Management of firm’s cash flow

Determining theoptimal cash

balances

Cashbudgeting

Short-termfinancing

strategies for cashshortfalls

Marketable securitiesinvestment strategies

for cash excess

The cash will take care of the profits if the firm takes care of the cash.



Make all payments as late aspossible. However, take advantageof any favorable discounts offered by

suppliers.

Make all collections as soon aspossible without losing future sales

and use cash discounts to encourageearly payments.



Turn over the inventory as quicklyas possible and avoid stockoutsthat might result in shutting down

the production line or any loss insales.



Raw materialspurchases(payable

generated)

Inventoryprocessing

Finishedgoods

inventory

Payment forpurchases(payable

exonerated)

Sale of goods(receivablegenerated)

Paymentreceived

(receivableexonerated)



The objective of a firm is to run thebusiness effectively without runningout of cash.

Therefore the firm must keep aminimum cash balance.

MOC will allow the firm to invest invarious alternatives and to repaytheir debts when they are due.



The Operating Cycle (OC) is thetime between ordering materials andcollecting cash from receivables.



The Cash Conversion Cycle (CC) isthe time between when a firm paysit’s suppliers (payables) for inventoryand collecting cash from the sale of the finished product.



OC = 110 days

AAI = 70 days ACP = 40 days

Purchase raw materialson credit

Accounts Payable

Sell finished goods oncredit

Accounts Receivable

APP = 30 days CC = 80 days

Pay accounts payableCash Outflows

Collect accountsreceivable

Cash Inflows

0 11010 20 30 40 50 60 70 80 90 100

Company A



WhereAAI = Average Age of InventoryACP= Average Collection PeriodAPP= Average Payment Period

OC = AAI + ACP

= 70 days + 40 days

= 110 days

CC = OC - APP

= AAI + ACP - APP

= 70 days + 40 days - 30 days

= 80 days



Cash cycle is a measure of theamount of cash tied up, loweroperating cycle (OC) and cash cycle

(CC) is better as the firm couldrecover the cash outlay in a shorterperiod.

A measure of how effective cash ismanaged in the firm is the cashturnover (CTO).



Refers to the number of times eachyear the firm’s cash is actually beingturned over

CTO = 360

CC

= 36080

= 4.5 times



The firm’s cash cycles directly affectthe amount of cash that need to beheld at any given time to support

operations.

This amount represents theminimum operating cash (MOC) to

avoid any cash shortages in meetingall its payments.



It is the minimum amount of moneyneeded by the company per cycle

MOC = Total annual cash outlay

CTO



Lets assume that the firm’s annual cashexpenditures are expected at RM300,000.

Therefore the firm needs RM66,666.67 as a

minimum cash requirement to support thefirm’s day-to-day operations without risk of technical insolvency.

MOC = Total annual cash outlay

CTO

= 300,000

4.5

= RM66,666.67



OC = 110 days



Accounts Payable


Accounts Receivable




Cash Inflows

0 11010 20 30 40 50 60 70 80 90 100

Before

Company A



Lets assume that Company A is ableto negotiate a better credit term withits suppliers from 30 days to 35

days;

Improve production and selling thatreduces AAI to 60 days;

Decrease average collection period to33 days.



OC = 60 days + 33 days

= 93 days

CC = 60 days + 33 days - 35 days

= 58 days

CTO = 360

58

= 6.21 times

MOC = 300,000

6.21

= RM48,309.17

The changesresulted in ashorteroperatingcycle, cashcycle andthus a highercash

turnover.



OC = 93 days



Accounts Payable


Accounts Receivable




Cash Inflows

0 11010 20 30 40 50 60 70 80 90 100

After

Company A



MAX Company, a producer of dinnerware, sells all itsmerchandise on credit.The credit terms require customers to pay within 60 days of a sale.On average, it takes 85 days to manufacture, warehouse,and ultimately sell a finished good. In other words, theaverage age of Inventory (AAI) is 85 days.It also takes an average of 70 days to collect on itsaccounts receivable (ACP).The credit terms for MAX’s raw material purchases currentlyrequire payment within 40 days and employees are paidevery 15 days.

The firm’s weighted average payment period (APP) for rawmaterials and labor is 35 days.Calculate the OC and CC.



It is crucial for a firm to minimize itscash cycle and maximize cashturnover, without sacrificing the

firm’s liquidity and profitability.As the firm increases its CC (throughreducing the AAI and/or ACP and/or

increasing the APP), the CTO willdecrease and MOC cash will increase.



Increasing Average Payment Period

Involves delaying payments as late aspossible without damaging the firm’s

credit rating.Favorable cash discount should not beignored, as the opportunity cost is highif not taken.



Reducing Average Inventory Age

Increase inventory turnover as quicklyas possible by:

Efficient management of inventories

Better production planning, scheduling andcontrol

Effective sales forecasting

Synchronize the production and demand.



Reducing Average Collection Period

Involves speeding up collection of account receivables without losing

potential sales.The use of proper techniques such aschanges in credit policies and collectionpolicies that will improve collectionperiod will benefit the company.



The effects of lower cash cycle arequite significant for large firms withcash reserves and cash outlays that

run in millions of Ringgit.

Proper cash management will have adirect impact on the firm’s liquidity

and profits.



Determining a firm’s desired cashlevel involves a tradeoff between theopportunity costs of holding too

much cash and the costs of holdingtoo little cash.



Cost RM

Trading Cost

Carrying CostTotal Cost

Size of Cash Balance

The morea firm

holdscash, thelower is

thetradingcost.

The minimumtotal costs

occur wherethe carrying

cost andtrading cost isequal. This isthe optimal

cash balancethat the firmshould have.



• Cash conversion models are used to helpdetermine the optimal quantity of marketablesecurities to convert into cash when needed (andvice versa).

• The cash conversion quantity depends on anumber of factors, including the fixed cost of transferring funds between cash and marketablesecurities, 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 versusinvesting in marketable securities.



William J. Baumol developed a model “Thetransactions Demand for Cash: An

Inventory Theoretic Approach” which isusually used in inventory management and

cash management.It is a trade off between opportunity cost/carrying cost/ holding cost and thetransaction cost.

As such firm attempts to minimize the sumof the holding cash & the cost of convertingmarketable securities to cash.



Assumptions:Cash inflow and outflow are certain;

It does not take into account any

seasonal or cyclical trends.Implications:

The higher the interest rate (opportunitycost), the lower will be the optimal cash

balances;The higher the trading cost, the higherwill be the optimal cash balance.



Let us assume that the firm sells securitiesand starts with a cash balance of C Ringgit.

When the firm spends cash, its cashbalance starts decreasing and reaches zero.

The firm again gets back its money byselling marketable securities.

As the cash balance decreases gradually,the average cash balance will be:

Average Cash Balance = C

2



This can be shown in following figure.



The firm incurs a cost known asholding cost for maintaining the cashbalance.

It is known as opportunity cost, thereturn inevitable on the marketablesecurities.

If the opportunity cost is k, then thefirm’s holding cost for maintaining anaverage cash balance is as follows:

Holding cost = k (C )

2



Whenever the firm converts its marketablesecurities to cash, it incurs a cost known astransaction cost.

Total number of transactions in a particular

year will be total funds required (T), dividedby the cash balance (C) i.e. T/C.

The assumption here is that the cost pertransaction is constant.

If the cost per transaction is c, then thetotal transaction cost will be:

Transaction cost = c (T)

C



Here,

k, is the opportunity costT is the total funds requirementC is the cash balancec is per transaction cost

Holding cost = k (C )2

Transaction cost = c (T)

C

Total cost k (C) x c (T)

2 C



Optimum level of cash balance

As the demand for cash, ‘C’ increases, theholding cost will also increase and the

transaction cost will reduce because of adecline in the number of transactions.

Hence, it can be said that there is arelationship between the holding cost

and the transaction cost.The optimum cash balance, C* is obtainedwhen the total cost is minimum.



Formula for optimum cash balance

Where,C* is the optimum cash balance.T is the total cash needed during the year.

k is the opportunity cost of holding cashbalances.

C* = √ (2cT)

k



The management of JanCo, a small distributorof sporting goods, anticipates $1,500,000 incans outlays (demand) during the comingyear.

The firm has determined that it costs $30 toconvert marketable securities into cash andvice versa.

The marketable securities portfolio currentlyearns an 8% rate of return.

What is the firm’s optimal cash balance?



• Like other financial decisions, the goal of the firmis to maintain the level of cash and marketablesecurities that maximizes shareholder and firmvalue.

• Balances that are too high will diminishprofitability -- and balances that are too low willaccentuate risk.

• Although the more sophisticated mathematical

estimation models are beyond our scope, theoverriding objective is to balance risk againstreturn.



• 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 unexpecteddemands 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.



Are near-cash items and consideredas part of cash.

Acts as a cushion against technical

insolvency.

It is as liquid as cash as it takes arelatively short time for conversion

to cash without losing face value.



Marketable securities are short-term,interest bearing money marketinstruments that can easily be

converted into cash.Securities that are most commonly-held as part of a marketablesecurities portfolio can be segmented

into two groups -- government issuesand non-government issues.



Reasons for holding marketablesecurities:

As a substitute for cash

For precautionary purposes as a cushionagainst unexpected shortage of bank creditand other emergency cash outflows.

As a temporary investment

Investments in marketable securities to:

Finance seasonal or cyclical need for cash; and

Meet known future financial requirements.



Marketable securities portfolioconsists of different types of securities that differ in:

Maturity Liquidity

Returns



The choice of securities in theportfolio is in accordance to thenature of cash available for

investment:

• For immediate cash needsReady CashSegment

• For expenditures that arepredictable

ControllableCash Segment

• For speculative purposesFree CashSegment



• Concerned with the safety of principalinvestment due to the risk of default inprincipal or interest payment and capitalloss.

Security

• Refers to the ease of converting thesecurities to cash without losing the facevalue.

Liquidity

• Represents the tradeoff between risk andreturns.Yields



Treasury Bills (T-Bills)

Treasury Notes (T-Notes)

Negotiable Certificate of Deposits(NCDs)

Commercial Paper (CP)

Banker’s Acceptance (BA)



It is a Government Issue andrepresents the obligation of theTreasury Department.Maturities not exceeding one year;most of the T-bills mature in 91 – 182days, with longer maturity such as 9months and one year.The treasury holds weekly acution at adiscount with the smallestdenomination of RM1,000 and areconsidered as risk-free.



Payable to order and entitle the holderthe payment of a fixed deposit sum onmaturity.Provides investment outlets for shortterm surplus funds of commercialbanks, merchant banks, discounthouses and finance companies.Evaluation: High liquidity with strongsecondary market, lowest risk, and lowreturn.



A certificate of deposit, USA, 1932



A document which certifies that acertain sum of Ringgit has been

deposited with a financial institutionat a specified rate of interest with aspecified maturity period.

Is a negotiable instrument as anevidence of deposit in a commercialbank.



The amount (smallest RM100,000)and the maturity (commonly 30

days) are dependant on theinvestor’s (depositor’s) needs.)

Evaluation: High liquidity with strong

secondary market, moderate riskthat depends on the bank involvedand high return.



A short-term unsecured promissorynote issued by a large firm with highcredit standing.

Maturity ranging from 3 – 270 days.Longer maturity requires a formalregistration.

Evaluation: Low liquidity with weak

weak secondary market, moderate risk(depending on the issuer) and return isslightly lower than NCDs.



Bills of exchange which are drawn onand accepted by commercial ormerchant banks in Malaysia.Created out of a bona fide tradetransaction such as to finance importand export of goods to/from Malaysiaand sale and purchase of goods and

services within Malaysia.Similar to cashier’s check payable inthe future with typical maturity of 30days or 180 days.



Arises from a short-term arrangementbetween a purchaser and its bank for

financing of certain transactions.The purchaser with its bank approval,issues a draft, on which payment iscontingent on some events, to the seller

for the amount purchased.The seller who holds the BA may then sellit at a discount in the secondary market toobtain immediate funds.



In the Malaysian money market,major securities are:

Bankers Acceptance

Negotiable Money Market Instruments

Malaysian Government Securities

Malaysian Government Treasury Bills

Cagamas Bonds



The cash management andmarketable securities are highlydependant on each other, therefore it

must be managed concurrently.These two liquid assets represent thefirm’s liquidity that will determine its

long-term viability and ability toincrease stockholders’ wealth.



1. Financial Analysis by Omar Samadand Mohd Sabri Hj Mohd Amin,InED, UiTM Shah Alam.

2. Financial Management by Rohani A.Ghani and Mohd Sabri Hj MohdAmin, InED, UiTM Shah Alam.

3. Financial Market and Institution byRohani A. Ghani and Ibrahim Ab.Rahman, InED, UiTM.



End of Chapter 6

FInance chapter 6

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