Cash-Management.ppt

Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,McGraw-Hill/Irwin,Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.,Click here for title,28-,*,Corporate Finance,Ross,Westerfield,Jaffe,Sixth Edition,Sixth Edition,28,Chapter Twenty Eight,Cash Management,Chapter Outline,28.1 Reasons for Holding Cash,28.2 Determining the Target Cash Balance,28.3 Managing the Collection and Disbursement of Cash,28.4 Investing Idle Cash,28.5 Summary&Conclusions,28.1 Reasons for Holding Cash,Transactions motive,Compensating balances,28.2 Determining the Target Cash Balance,The,Baumol,Model,The Miller-Orr Model,Other Factors Influencing the Target Cash Balance,Costs of Holding Cash,Opportunity Costs,Trading costs,Total cost of holding cash,C,*,Costs in dollars of holding cash,Size of cash balance,The investment income foregone when holding cash.,Trading costs increase when the firm must sell securities to meet cash needs.,The,Baumol,Model,F,=The fixed cost of selling securities to raise cash,T,=The total amount of new cash needed,K,=The opportunity cost of holding cash:this is the interest rate.,Time,C,If we start with$,C,spend at a constant rate each period and replace our cash with$,C,when we run out of cash,our average cash balance will be .,1 2 3,The opportunity cost of holding is,The,Baumol,Model,F,=The fixed cost of selling securities to raise cash,T,=The total amount of new cash needed,K,=The opportunity cost of holding cash:this is the interest rate.,Time,C,As we transfer$,C,each period we incur a trading cost of,F,each period.If we need,T,in total over the planning period we will pay,$F,T,C,times,.,1 2 3,The trading cost is,The,Baumol,Model,C,*,Size of cash balance,Opportunity Costs,Trading costs,The optimal cash balance is found where the opportunity costs equals the trading costs,The,Baumol,Model,Opportunity Costs=Trading Costs,The optimal cash balance is found where the opportunity costs equals the trading costs,Multiply both sides by,C,The Miller-Orr Model,The firm allows its cash balance to wander randomly between upper and lower control limits.,$,Time,H,Z,L,When the cash balance reaches the upper control limit,H,cash is invested elsewhere to get us to the target cash balance,Z,.,When the cash balance reaches the lower control limit,L,investments are sold to raise cash to get us up to the target cash balance.,The Miller-Orr Model Math,Given,L,which is set by the firm,the Miller-Orr model solves for,Z,and,H,where,s,2,is the variance of net daily cash flows.,The average cash balance in the Miller-Orr model is,Implications of the Miller-Orr Model,To use the Miller-Orr model,the manager must do four things:,Set the lower control limit for the cash balance.,Estimate the standard deviation of daily cash flows.,Determine the interest rate.,Estimate the trading costs of buying and selling securities.,The model clarifies the issues of cash management:,The best return point,Z,is positively related to trading costs,F,and negatively related to the interest rate,K,.,Z,and the average cash balance are positively related to the variability of cash flows.,Other Factors Influencing the Target Cash Balance,Borrowing,Borrowing is likely to be more expensive than selling marketable securities.,The need to borrow will depend on managements desire to hold low cash balances.,Compensating Balance,Firms have cash in the bank as a compensation for banking services.,Large corporations have thousands of accounts with several dozen bankssometimes it makes more sense to leave cash alone than to manage each account on a daily basis.,Float,The difference between bank cash and book cash is called,float,.,Float management involves controlling the collection and disbursement of cash.,28.3 Managing the Collection and Disbursement of Cash,Accelerating Collections,Delaying Disbursements,Disbursement Float,Zero-Balance Accounts,Drafts,Ethical and Legal Questions,Accelerating Collections,Customer mails payment,Company receives payment,Company deposits payment,Cash received,Mail delay,Mail float,Processing delay,Processing float,Clearing delay,Clearing float,time,Collection float,Overview of Lockbox Processing,Corporate,Customers,Corporate,Customers,Corporate,Customers,Corporate,Customers,Local Bank,Collects funds,from PO Boxes,Envelopes opened;,separation of,checks and receipts,Deposit of checks,into bank accounts,Details of receivables,go to firm,Firm processes,receivables,Bank clears checks,Post Office,Box 1,Post Office,Box 2,Delaying Disbursements,Write check on a distant bank.,Hold payment for several days after postmarked in office.,Call supplier firm to verify statement accuracy for large amounts.,Mail from distant post office.,Mail from post office that requires a great deal of handling.,Firm prepares,check to supplier,Post Office,processing,Delivery of check,to supplier,Deposit goes to,suppliers bank,Bank collects funds,Drafts,Firms sometimes use drafts instead of checks.,Drafts differ from checks because they are not drawn on a bank but on an issuer(the firm)and are payable by the issuer.,The bank acts only as an agent,presenting the draft to the issuer for payment.,When the draft is transmitted to a firms bank for collection,the bank must present the draft to the issuing firm for acceptance before making payment.,After the draft has been accepted,the firm must deposit the necessary cash to cover the payments.,This allows the firm to keep less cash on hand.,Ethical and Legal Questions,The financial managers must always work with collected company cash balances and not with the companys book balance,which reflects checks that have been deposited but not collected.,If you are borrowing the banks money without their knowledge,you are raising serious ethical and legal questions.,28.4 Investing Idle Cash,A firm with surplus cash can park it in the money market.,Some large firms and many small ones use money market mutual funds.,Firms have surplus cash for three reasons:,Seasonal or Cyclical Activities,Planned Expenditures,Different Types of Money Market Securities,Seasonal Cash Demands,Long-term financing,Short-term financing,Time,Total Financing needs,JFMAM,Marketable securities,Bank loans,28.5 Summary&Conclusions,A firm holds cash to conduct transactions and to compensate banks for the various services they render.,The optimal amount of cash for a firm to hold depends on the opportunity cost of holding cash and the uncertainty of future cash inflows and outflows.,Two transactions models that provide rough guidelines for determining the optimal cash,postion,are:,The Miller-Orr model,The,Baumol,model,28.5 Summary&Conclusions,The firm can make use of a variety of procedures to manage the collection and disbursement of cash in such as way as to speed up the collection of cash and slow down payments.,Some methods to speed collections are,Lockboxes,Concentration banking,Wire transfers,The financial managers must always work with collected company cash balances and not with the companys book balance.,28.5 Summary&Conclusions,If you are borrowing the banks money without their knowledge,you are raising serious ethical and legal questions.,The answers to which you probably know by now.,Corporate Finance,Ross,Westerfield,Jaffe,Sixth Edition,Sixth Edition,29,Chapter Twenty Nine,Credit Management,Chapter Outline,29.1 Terms of the Sale,29.2 The Decision to Grant Credit:,Risk and Information,29.3 Optimal Credit Policy,29.4 Credit Analysis,29.5 Collection Policy,29.6 How to Finance Trade Credit,29.7 Summary&Conclusions,Introduction,A firms credit policy is composed of:,Terms of the sale,Credit analysis,Collection policy,This chapter discusses each of the components of credit policy that makes up the decision to grant credit.,The Cash Flows of Granting Credit,Credit sale is made,Customer mails check,Firm deposits check,Bank credits firms account,Accounts receivable,Cash collection,Time,29.1 Terms of the Sale,The terms of sale of composed of,Credit Period,Cash Discounts,Credit Instruments,Credit Period,Credit periods vary across industries.,Generally a firm must consider three factors in setting a credit period:,The probability that the customer will not pay.,The size of the account.,The extent to which goods are perishable.,Lengthening the credit period generally increases sales,Cash Discounts,Often part of the terms of sale.,Tradeoff between the size of the discount and the increased speed and rate of collection of receivables.,An example would be“3/10 net 30”,The customer can take a 3%discount if he pays within 10 days.,In any event,he must pay within 30 days.,The Interest Rate Implicit in 3/10 net 30,A firm offering credit terms of 3/10 net 30 is essentially offering their customers a 20-day loan.,To see this,consider a firm that makes a$1,000 sale on day 0,Some customers will pay on day 10 and take the discount.,Other customers will pay on day 30 and forgo the discount.,0,10,30,$970,0,10,30,$1,000,0,10,30,+$970,-$1,000,A customer that forgoes the 3%discount to pay on day 30 is borrowing$970 for 20 days and paying$30 interest:,The Interest Rate Implicit in 3/10 net 30,Credit Instruments,Most credit is offered on,open account,the invoice is the only credit instrument.,Promissory notes,are IOUs that are signed after the delivery of goods,Commercial drafts,call for a customer to pay a specific amount by a specific date.The draft is sent to the customers bank,when the customer signs the draft,the goods are sent.,Bankers acceptances,allow a bank to substitute its creditworthiness for the customer,for a fee.,Conditional sales contracts let the seller retain legal ownership of the goods until the customer has completed payment.,29.2 The Decision to Grant Credit:Risk and Information,Consider a firm that is choosing between two alternative credit policies:,“In God we trusteverybody else pays cash.”,Offering their customers credit.,The only cash flow of the first strategy is,The,expected,cash flows of the credit strategy are:,0,1,We incur costs up front,and get paid in 1 period by,h,%of our customers.,29.2 The Decision to Grant Credit:Risk and Information,The NPV of the cash only strategy is,The NPV of the credit strategy is,The decision to grant credit depends on four factors:,The delayed revenues from granting credit,The immediate costs of granting credit,The probability of repayment,h,The discount rate,r,B,Example of the Decision to Grant Credit,A firm currently sells 1,000 items per month on a cash basis for$500 each.,If they offered terms net 30,the marketing department believes that they could sell 1,300 items per month.,The collections department estimates that 5%of credit customers will default.,The cost of capital is 10%per annum.,Example of the Decision to Grant Credit,The NPV of cash only:,The NPV of Net 30:,Example of the Decision to Grant Credit,How high must the credit price be to make it worthwhile for the firm to extend credit?,The NPV of Net 30 must be at least as big as the NPV of cash only:,The Value of New Information about Credit Risk,The most that we should be willing to pay for,new,information about credit risk is the present value of the expected cost of defaults:,In our earlier example,with a credit price of$500,we would be willing to pay$26,000 for a,perfect,credit screen.,Future Sales and the Credit Decision,Do not give credit,Give credit,Customer pays,h=,100%,Customer pays(Probability=,h,),Customer defaults,(Probability=1,h,),Give credit,Do not give credit,Our first decision:,We refuse further sales to deadbeats.,We face a more certain credit decision with our,paying,customers:,Information is revealed at the end of the first period:,29.3 Optimal Credit Policy,Carrying Costs,Total costs,C,*,Costs in dollars,Level of credit extended,At the optimal amount of credit,the incremental cash flows from increased sales are exactly equal to the carrying costs from the increase in accounts receivable.,Opportunity costs,29.3 Optimal Credit Policy,Trade Credit is more likely to be granted if:,The selling firm has a cost advantage over other lenders.,The selling firm can engage in price discrimination.,The selling firm can obtain favorable tax treatment.,The selling firm has no established reputation for quality products or services.,The selling firm perceives a long-term strategic relationship.,The optimal credit policy depends on the characteristics of particular firms.,29.4 Credit Analysis,Credit Information,Financial Statements,Credit Reports on Customers Payment History with Other Firms,Banks,Customers Payment History with the Firm,Credit Scoring:,The traditional 5 Cs of credit,C,haracter,C,apacity,C,apital,C,ollateral,C,onditions,Some firms employ sophisticated statistical models,29.5 Collection Policy,Collection,refers to obtaining payment on past-due accounts.,Collection Policy is composed of,The firms willingness to extend credit as reflected in the firms investment in receivables.,Collection Effort,Average Collection Period,Measures the average amount of time required to collect an account receivable.,For example,a firm with average daily sales of$20,000 and an investment in accounts receivable of$150,000 has an average collection period of,Accounts Receivable Aging Schedule,Shows receivables by age of account.,The longer an account has been unpaid,the less likely it is to be paid.,Collection Effort,Most firms follow a protocol for customers that are past due:,Send a delinquency letter.,Make a telephone call to the customer.,Employ a collection agency.,Take legal action against the customer.,There is a potential for a conflict of interest between the collections department and the sales department.,You need to strike a balance between antagonizing a customer and being taken advantage of by a deadbeat.,