1) Ready money

2) Money or its equivalent (such as a check) paid for goods or services at the time of purchase
or delivery.
Cash is legal tender or coins that can be used to exchange goods, debt or services. Sometimes it
also includes the value of assets that can be converted into cash immediately, as reported by a
company.
Cash is also known as money, in physical form. Cash usually includes bank accounts and marketable
securities, such as government bonds and banker's acceptances. Although cash typically refers to
money in hand, the term can also be used to indicate money in banking accounts, checks or any
other form of currency that is easily accessible and can be quickly turned into physical cash.
Cash in its physical form is the simplest, most broadly accepted and reliable form of payment, which
is why many businesses only accept cash. Checks can bounce and credit cards can spring back, but
cash must not.

Motives of Cash Management

John Maynard Keynes suggested three reasons for individuals to hold cash. Keynes labeled these
motives as follows-
1) Transactions Motive: To meet payments, such as purchases, wages, taxes and dividends,
arising in the ordinary course of business.
2) Speculative Motive: To take advantage of temporary opportunities, such as a sudden decline
in the price of a raw material.
3) Precautionary Motive: To maintain a safety cushion or buffer to meet unexpected cash needs.
The more predictable the inflows and outflows of cash for a firm, the less cash that needs to
be held for precautionary needs. Ready borrowing power to meet emergency cash drains
also reduces the need for this type of cash balance.

Cash Management
The corporate process of collecting and managing cash, as well as using it for (short-term) investing.
It is a key component of ensuring a company's financial stability and solvency.
Cash management is the efficient collection, disbursement, and investment of cash in an
organization while maintaining the company's liquidity. In other words, it is the way in which a
particular organization manages its financial operations such as investing cash in different short-
term projects, collection of revenues, payment of expenses and liabilities while ensuring it has
sufficient cash available for future use. The treasurer's department of a company is usually
responsible for the firm's cash management system.
A Cash Budget, instrumental in the process, tells us how much cash we are likely to have, when and
for how long.
Thus, it serves as a foundation for cash forecasting and control. In addition to the cash budget, the
firm needs systematic information on cash as well as some kind of control system.

1
 Cash Management System

Speeding Up Cash Receipts

The various collection and disbursement methods that a firm employs to improve its cash
management efficiency constitute two sides of the same coin. They exercise a joint impact on the
overall efficiency of cash management. The general idea is that the firm will benefit by
"Speeding up" cash receipts and "s-l-o-w-i-n-g d-o-w-n" cash payouts.
The firm wants to speed up the collection of accounts receivable so that it can have the use of
money sooner.
Conversely, it wants to pay accounts payable as late as is consistent with maintaining the firm's
credit standing with suppliers so that it can make the most use of the money it already has.

Collections
We consider first the acceleration of collections, which includes the steps taken by the firm from the
time a product or service is sold until the customers' checks are collected and become usable funds
for the firm.
A number of methods are designed to speed up this collection process by doing one or more of the
following-
1) Expedite preparing and mailing the invoice (Bill prepared by a seller of goods or services
and submitted to the purchaser. It lists the items bought, prices, and terms of sale).
2) Accelerate the mailing of payments from customers to the firm, and
3) Reduce the time during which payments received by the firm remain uncollected funds.

2
Earlier Billing
Customers have different payment habits. Some pay their bills on the discount date or the final due
date (or later), and others pay immediately on receipt of an invoice. In any event, accelerated
preparation and mailing of invoices will result in faster payment because of the earlier invoice
receipt and resulting earlier discount and due dates. In addition, some companies find it
advantageous to enclose invoices with shipped merchandise, send invoices by fax, or even request
advance payment.
Billing can be eliminated entirely through the use of a preauthorized debit (The transfer of funds
from a payor's bank account on a specified date to the payee's bank account; the transfer is initiated
by the payee with the payor's advance authorization). A customer signs an agreement with a firm
allowing the firm to automatically debit the customer's bank account on a specified date and transfer
funds from the customer's bank to the firm's bank.

Lockbox
A post office box maintained by a firm's bank that is used as a receiving point for customer
remittances. Retail lockbox systems cater for the receipt and processing of low to moderate-dollar,
high volume remittances, whereas wholesale lock-box systems are designed to handle high-dollar,
low-volume remittances.
A company rents a local post office box and authorizes its bank to pick up remittances in the box.
Customers are billed with instructions to mail their remittances to the lockbox. The bank picks up
the mail several times a day and deposits the checks directly into the company's account. The
checks are recorded and cleared for collection. The company receives a deposit slip and a list of
payments, together with any material in the envelopes.
The benefit of this system is that checks are deposited before, rather than after, any processing and
accounting work is done. In short, the lockbox arrangement eliminates processing float.
Today, because of modern technology, lockbox system users also benefit from improvements in data
entry efficiency and the automation of information flows.
Many businesses have multiple collection locations in the form of a lockbox network. With a lockbox
network, mail float and availability float are reduced by locating lockboxes close to customer’s
mailing points. This type of lockbox arrangement is usually on a regional basis, with the company
choosing regional banks according to its billing patterns.
Before determining the regions to be used and the number of collection points, a feasibility study is
made of the availability of checks that would be deposited under alternative plans. Generally, the
best collection points are cities that have a high volume of air traffic, since most mail travels by air.
The main advantage of a lockbox arrangement is that checks are deposited at a bank sooner and
become collected balances sooner than if they were processed by the company prior to deposit.
The principal disadvantage of a lockbox arrangement is the cost. Because the bank is providing a
number of services in addition to the usual clearing of checks, it requires compensation for them.
Because the cost is almost directly proportional to the number of checks deposited, lockbox
arrangements are usually not profitable for the firm if the average remittance is small.

Accounts Receivable Conversion (ARC): A process by which paper checks are converted into
Automated Clearing House (ACH) debits at lockboxes or other collection sites. It reduces availability
float associated with check clearing.

Problem
Discount Music Stores is evaluating a lockbox system which will reduce float by 3 days. The lockbox
system costs $15,000 per year. The firm's daily collections average $1,50,000, and its opportunity
cost of funds is 6% per year.
Should the firm utilize this lockbox system?

3
Solution
Funds freed up due to a reduction in float = (3 days) x ($1,50,000 per day) or $4,50,000.
Annual value of float reduction = $(4,50,000 x 6%) = $27,000.
After deducting the $15,000 cost of the lockbox system, the firm nets $12,000 before taxes.

Problem
XYZ limited is currently following a centralized collection system. Most of its customers are located
in the remote cities. The remittances mailed by customers to the central location take four days to
reach. Before depositing the remittances in the bank, the firm loses two days in processing them.
The average collection of the firm is $2,50,000. The company is thinking of establishing a lock box
system. It is expected that such a system will reduce mailing time by one day and processing time by
one day.
i. Find out the reduction in cash balances expected to result from the adoption of the
lockbox system.
ii. Determine the opportunity cost of the present centralized collection system if the
interest rate is assumed to be 18%.
iii. Should the lockbox system be established if its annual cost is $75,000?

Solution
i. The total time saved by the firm by establishing the lockbox system is (1+1) = 2 days.
Reduction in cash balances = Time saved x daily average collection = $(2×2,50,000) =
$5,00,000.
ii. Opportunity cost = $(5,00,000 x 18%) = $90,000.
iii. Incremental benefit = $(90,000 - 75,000) = $15,000.
The lockbox system should be established.

Collections Improvements
ACH: A nationwide electronic funds transfer system. Payroll direct deposit and direct payment of
mortgage bills are examples of typical ACH payments. Technology enables check payments sent to a
lockbox or other collection site to be converted in Automated Clearing House (ACH) debits. They
clear electronically through the ACH infrastructure and are reported as ACH items.
The original paper checks, once converted, are destroyed. This practice speeds up the collection of
funds by eliminating the costly and time-consuming physical movement of checks between financial
institutions that occurs during the regular paper-check clearing process.

Concentration Banking
The firm that uses a lockbox network as well as the one having numerous sales outlets that receive
funds over the counter have something in common. Both firms will find themselves with deposit
balances at a number of regional banks. Each firm may find it advantageous to move part or all of
these deposits to one central location, which is known as a concentration bank. This process of cash
concentration (The movement of cash from lockbox or field banks into the firm's central cash pool
residing in a concentration bank) has several effects-
 It improves control over inflows and outflows of corporate cash. The idea is to put all of your
eggs (or in this case, cash) into one basket and then to watch the basket.
 It reduces idle balances, keeps deposit balances at regional banks no higher than necessary
to meet transactions needs or alternatively, minimum compensating balance (Compensating
balance is the demand deposits maintained to compensate a bank for services provided,
credit line or loans) requirements. Excess funds would be moved to the concentration bank.

4
  It allows for more effective investments. Pooling excess balances provides the larger cash
amounts needed for some of the higher yielding, short-term investment opportunities that
require a larger minimum purchase.

Concentration Services for Transferring Funds

The concentration process is dependent on the timely transfer of funds between financial institutions.
There are three principal methods employed to move funds between banks-
1) Depository transfer checks,
2) Electronic transfer checks through automated clearinghouses; and
3) Wire transfers.

1) Depository Transfer Check (DTC): A non-negotiable check payable to a single company account
at a concentration bank. The depository transfer check (DTC) arrangement moves funds through
the use of a preprinted depository check drawn on a local bank and payable to a single company
account at a concentration bank. Funds are not immediately available on receipt of the DTC,
however, because the check must still be collected through the usual channels.
Today, more and more companies are transmitting deposit information via telephone to their
concentration banks, which prepare and deposit the DTCs into the firm’s accounts. Of course,
any savings that result from the use of the DTCs must be measured and compared with the
costs of using this arrangement.

2) Automated Clearinghouse (ACH) Electronic Transfer: This item is an electronic check image
version of the depository transfer check, which can be used between banks that are members of
the automated clearing house system. Transferred funds become available one business day
later. As the cost is not significant, ACH electronic transfers have been replacing many mail-
based DTC transfers.

3) Wire Transfer: The fastest way to move money between banks. A wire transfer is simply a
telephone-like communication, which, via bookkeeping entries, removes funds from a payer
bank account and deposits them in an account of a payee bank. Funds are considered available
upon receipt of the wire transfer.

Though a DTC costs only 50 cents or so for processing, sending, and receiving, charges for a wire
transfer typically range around $15. As a result of their relatively high cost, wire transfers are
generally reserved for moving only large sums of money or when speed is of the essence.

Cash Collection Instruments

The main cash collection instruments are given below with its pros and cons-
Instruments Pros Cons
Cheques  No/Negligible charge.  Can bounce.
 Payable through clearing.  Collection times can be long.
 Can be discounted after receipt.  Collection charge.
 Low discounting charge.
 Requires customers limits which
are inter chargeable with
overdraft limits.
Drafts  Payable in local clearing.  Cost of collection.
 Chances of bouncing are less.  Buyer’s account debited on day one.
Documentary  Low discounting charge.  Not payable through clearing.

5
 Bills  Theoretically, goods are not  High collection cost.
released till payments are made  Long delays.
or the bill is accepted.
Trade Bills  No charge except stamp duty.  Procedure is relatively
 Can be discounted. cumbersome.
 Discipline of payments on due  Buyers are reluctant to accept the
date. due date discipline.
Letter of  Good credit control as goods is  Opening charges.
Credit released on payment or  Transit period interest.
acceptance of bill.  Negotiation charges.
 Seller forced to meet delivery  Need bank lines to open LC Stamp
schedule because of expiry date. duty on usance bills.

S-l-o-w-i-n-g D-o-w-n Cash Payouts

"Playing the Float"
In fact, the funds available in the bank are generally greater than the dollar difference between the
company's bank balance and its book balance of cash is called net float (or sometimes, just plain
float). Net float is the result of delays between the time checks are written and their eventual
clearing by the bank. It is highly possible for a company to have a negative cash balance on its books
and a positive bank balance, because the checks just written by the company may still be
outstanding.
If the size of net float can be estimated accurately, bank balances can be reduced and the funds
invested to earn a positive return. This activity has been referred to by corporate treasurers as
"playing the float".

Payable Through draft (PTD)

A check-like instrument that is drawn against the payer and not against a bank as is a check. A
means for delaying disbursements is through the use of payable through drafts (PTDs). Unlike an
ordinary check, the payable through draft is not payable on demand. When it is presented to the
issuer's bank for collection, the bank must present it to the issuer for acceptance. The funds are
then deposited by the issuing firm to cover payment of the draft.
The advantage of the draft arrangement is that it delays the time the firm actually has to have funds
on deposit to cover the draft. Consequently, it allows the firm to maintain smaller balances at its
banks.
A disadvantage of a draft system is that certain suppliers may prefer checks. Also, banks do not like
to process drafts because they often require special manual attention. As a result, banks typically
impose a higher service charge to process drafts than they do to process checks.

Zero Balance Account (ZAB)

A corporate checking account in which a zero balance is maintained. The account requires a master
(parent) account from which funds are drawn to cover negative balances or to which excess
balances are sent. The use of a ZBA system, which is offered by many major banks, eliminates the
need to accurately estimate and fund each individual disbursement account. Under such a system,
one master disbursing account services all other subsidiary accounts. When checks are cleared at
the end of each day, the bank automatically transfers just enough funds from the master account to
each disbursement account (e.g., one for payroll, one for payable, etc.) to just cover checks
presented.
Besides improving control over disbursements, a zero balance account system eliminates idle cash
balances from all subsidiary accounts. The firm’s cash manager still needs to forecast anticipated

6
check clearing times so that the master account will have sufficient cash to service the subsidiary
disbursement accounts.

Cash Balances to Maintain

Most business firms establish a target level of cash balances to maintain. They do not want to
maintain excess cash balances because interest can be earned when these funds are invested in
marketable securities. The greater the interest rate available on marketable securities, of course,
the greater the opportunity cost to maintaining idle cash balances. The optimal level of cash should
be the larger of-
1) The transactions balances required when cash management is efficient, or
2) The compensating balance requirements of commercial banks with which the firm has
deposit accounts.

Compensating Balances and Fees

Establishing a minimum level of cash balances depends, in part, on the compensating balance
requirements of banks. The requirements for the firm to maintain a certain amount of demand
deposits to compensate a bank for services provided are based on the profitability of the account.
If a firm has a lending arrangement with a bank, the firm may well be required to maintain balances
in excess of those required to compensate the bank for the activity in its account.

Investment in Marketable Securities

In general, firms try to maintain some target level of cash to meet their needs for transactions
and/or compensating balances requirements. But beyond that we often find firms investing in short
term marketable securities. It is mentioned that, for accounting purposes, short-term marketable
securities are often shown on the balance sheet as "short-term investments”.

The Marketable Securities Portfolio: Three Segments

FCS

RCS
CCS

One portion of the pie would consist of marketable securities acting as a reserve for the company's
cash account. If the firm found that its daily opening cash balance was less than desired, some of
these particular securities could be sold quickly to build up cash. Unless a firm's cash inflows were
always greater than or equal to its cash outflows each day, the firm would probably need to cash in
some securities from time to time. This segment is called Ready Cash Segment (RCS).
Still other controllable outflows would be loans coming due and interest payments. The firm can
prepare for these controllable outflows by gradually accumulating funds. This gradual accumulation
could remain in the cash account but could just as easily be earning interest if invested temporarily
in marketable securities instead. Thus, another portion of the firm's securities portfolio, the
Controllable Cash Segment (CCS), could be earmarked for meeting controllable (knowable) outflows,
such as taxes and dividends.
Finally, we have the Free Cash Segment (FCS). This is an amount of marketable securities that is set
aside to service neither the cash account nor the firm's controllable outlays. It is basically extra

7
cash that the firm has simply invested short term. Because the firm has no immediate use for these
funds, it is better to keep these funds invested than to have them lie idle in the cash account.
Before deciding which marketable securities are most appropriate for the three portfolio segments,
we need to become acquainted with the variables that must be considered in the process of
selecting marketable securities. We also need to become familiar with the alternative securities
themselves.

Variables in Marketable Securities Selection

When considering the purchase of marketable securities, the firm's portfolio manager must first
understand how each potential security purchase relates to certain key variables. Among the most
important of these variables are Safety, Marketability, Yield, And Maturity.
Safety is the most basic test that marketable securities must pass concerns safety of principal. This
refers to the likelihood of getting back the same number of dollars originally invested. Safety is
judged relative to US Treasury securities, which are considered certain if held to maturity. For
securities other than Treasury issues, the safety of these securities will vary depending on the
issuer and the type of security issued. A relatively high degree of safety is a must for a security to be
seriously considered for inclusion in the firm's short-term marketable securities portfolio.
Maturity simply refers to the life of the security. Some marketable securities have a specific life.
Treasury bills, for example, have original lives of 4, 13, or 26 weeks. Other securities, such as
commercial paper and negotiable certificates of deposit, can have lives tailored to meet specific
needs. Usually, the longer the maturity, the greater the yield, but also the more exposure to yield
risk.

Common Money Market Instruments

The firm's marketable securities portfolio manager usually restricts securities purchases to money
market instruments. These instruments are generally short-term (original maturity of less than one
year), high-quality government and corporate debt issues.
We will explore the most common types of money market instruments available to the company as
near-cash investments.

1. Treasury Securities: Treasury securities are direct obligations of the government and carry its
full faith and credit. The principal treasury securities are-
 Treasury Bills,
 Treasury Notes, and
 Treasury Bonds.

Treasury bills (T-bills) with maturities of 4, 13, 26, and 52 weeks are auctioned weekly by the
Treasury (All sales of the Treasury are by auctions). Smaller investors can enter a "non-competitive"
bid, which is filled at the market-clearing price.
Treasury bills carry no coupon but are sold on a discount basis. Bills are now sold in minimum
amounts of $100 and multiples of $100 above the minimum.
These securities are very popular with companies, in part because of the large and active market in
them. In addition, transactions costs involved in the sale of Treasury bills in the secondary market
are small.
The government does not actually pay interest on Treasury bills. Instead, they are issued at a
discount from par. The investor's yield comes from the increase in the value of the security between
the time it was purchased and the time it matures.

The results of a typical Treasury bill auction as reported on the Treasury direct Web site. If we look
at the first listing, we see that the 28-day Treasury bill sold for $99.999222 per $100. This means that

8
a $1,000 bill was discounted to $999.89. The table also reports the discount rate% and the investment
rate%. The discount rate% is computed as-

i F−P 360
discount = ×
F n
Where,
�������� = annualized discount rate%
P = purchase price
F = face or maturity value
n = number of days until maturity

Problem
You submit a noncompetitive bid in April 2013 to purchase a 28-day $1,000 Treasury bill and you find
that you are buying the bond for $999.99222.
What is the discount rate % and the investment rate%?

Solution
$1000 − $999.99222 360
Discount rate% = idiscount = × = 0.0001 = 0.01%
$1000 28

$1000 − $999.99222 365

Investment rate% = iinvestment = × = 0.00010 = 0.01%
$999.9922 28

These solutions for the discount rate% and the investment rate% match those reported by Treasury
direct for the first Treasury bill.

Risk in Treasury Bill

Treasury bills have virtually zero default risk because even if the government ran out of money, it
could simply print more to redeem them when they mature. The risk of unexpected changes in
inflation is also low because of the short term to maturity. The market for Treasury bills is extremely
deep and liquid.
A deep Market is one with many different buyers and sellers.
A liquid market is one in which securities can be bought and sold quickly and with low transaction
costs.
Investors in markets that are deep and liquid have little risk that they will be able to sell their
securities when they want to.

Treasury Bill Auctions

As an alternative to the competitive bidding procedure just outlined, the Treasury also permits non-
competitive bidding.
When competitive bids are offered, investors state both the number of securities desired and the
price they are willing to pay. By contrast, non-competitive bids include only the number of securities
the investor wants. The Treasury accepts all non-competitive bids. The price is set as the highest
yield paid to any accepted competitive bid. Thus, non-competitive bidders pay the same price paid by
competitive bidders. The significant difference between the two methods is that competitive bidders
may or may not end up buying securities whereas the non-competitive bidders are guaranteed to do
so.

9
The original maturity on Treasury notes is 2 to 10 years, whereas the original maturity on Treasury
bonds is over 10 years. With the passage of time, a number of these securities have maturities of
less than one year and serve the needs of short-term investors.
Notes and bonds are coupon issues and there is an active market for them. Overall, Treasury
securities are the safest and most marketable money market investments.
Therefore, they provide the lowest yield for a given maturity of the various instruments that we
consider (Once again, we see the tradeoff between risk and return). The interest income on these
securities is taxed at the federal level, but it is exempt from state and local to income taxes.

2. Repurchase Agreements: In an effort to finance their inventories of securities, government

security dealers offer repurchase agreements (RPs; repos) to corporations. The repurchase
agreement or repo, is the sale of short-term securities by the dealer to the investor whereby the
dealer agrees to repurchase the securities at an established higher price at a specified future
time. The investor thereby receives a given yield while holding the securities. The length of the
holding period itself is tailored to the needs of the investor.
Repurchase agreements give the investor a great deal of flexibility with respect to maturity.
Rates on repurchase agreements are related to rates on Treasury bills, federal funds and loans
to government security dealers by commercial banks. There is limited marketability to
repurchase agreements, but the most common maturities run from overnight to only a few days.

3. Bankers' Acceptances (BAs): They are time drafts (short term promissory notes) drawn on a
bank by a firm to help finance foreign and domestic trade. By "accepting" the draft, a bank
promises to pay the holder of the draft a stated amount of money at maturity. The bank ends up
substituting its own credit for that of a borrower. Therefore, the creditworthiness of banker’s
acceptances is primarily judged relative to the bank accepting the draft.

4. Commercial Paper: They consists of short-term, unsecured promissory notes issued by finance
companies and certain industrial firms. It constitutes the largest dollar volume instrument in the
money market. Commercial paper can be sold by the issuing firm directly or through dealers
acting as intermediaries. Paper sold through dealers is issued by industrial companies and
smaller finance companies. Dealers carefully screen the creditworthiness of potential issuers.
In a sense, dealers stand behind the paper they place with investors.

Swiss-franc denominated commercial paper issued by General Motors in Switzerland would be an

example. Euro-commercial paper gives the issuer the added flexibility to borrow in a variety of
currencies.
Though Euro-commercial paper is similar to domestic (US) commercial paper, there are some
differences-
 US commercial paper usually matures in less than 270 days, the maturity of Euro
commercial paper can be considerably longer owing to its freedom from certain US
securities regulations.
 Because of the generally longer maturity of Euro-commercial paper compared with US
commercial paper, a more active secondary market has developed for Euro-commercial
paper than for US commercial paper.

5. Negotiable Certificates of Deposit: A short-term investment that originated in 1961, the negotiable
certificate of deposit (CD) is a large-denomination, negotiable time deposit at a commercial bank
or savings institution paying a fixed or variable rate of interest for a specified time. Original
maturities usually range from 30 days to 12 months. For it to be negotiable (able to be sold in the
secondary market), most money-center banks require a minimum denomination of $1,00,000.

10
 A secondary market for CDs issued by large money center banks does exist. However, this
market is not as liquid as Treasury issues, because CDs are more heterogeneous than Treasury
issues.
CDs differ widely with respect to the quality of the issuing bank, the maturity of the instrument,
and the stated interest rate. Because of less liquidity and slightly higher risk, yields on CDs are
greater than those on Treasury bills of similar maturity, but about the same as those on banker’s
acceptances and commercial paper.

There are three other types of large CD-

a) Eurodollar CDs (or Euro CDs): Dollar-denominated CDs issued by foreign branches of US
banks and foreign banks, primarily in London.
b) Yankee CDs: CDs issued by US branches of foreign banks.
c) Thrift CDs: CDs issued by savings and loan associations, savings banks, and credit unions.

Thus, the firm's securities portfolio manager has quite a selection of CDs to choose from when it
comes to making a short-term investment.

Eurodollars: Eurodollars are bank deposits, denominated in US dollars, not subject to US bank
regulations. Although most Eurodollars are deposited in banks in Europe, the term applies to any
dollar deposit in foreign banks or in foreign branches of US banks. Eurodollars generally take the
form of either
i. Eurodollar time deposits (Euro TDs) or
ii. Eurodollar certificates of deposit (Euro CDs).

Although Euro TDs is non-negotiable, most have relatively short maturities ranging from overnight
to a few months. The Euro CDs on the other hand, is a negotiable instrument like its domestic
counterpart. For the large corporation having ready access to international money centers, the
Eurodollar deposit is usually an important investment option.

Selecting Securities for the Portfolio Segments

For securities constituting the firm’s ready cash segment (RCS), safety and an ability to convert
quickly inro cash are primary concerns.
Because they are both the safest and the most marketable of all money market instruments,
Treasury bills make an ideal choice to meet the firm’s unexpected needs for ready cash. Short-term,
high-quality repos and certain highly liquid, short-term municipals can also play a role.

Determination of the firm’s portfolio of short-term marketable securities.

Firm’s Needs Major Consideration Money Market Securities

 Safety  Treasury Issues

RCS  Marketability  Federal Agency
 Yield Issues
FCS  Maturity  Commercial Papers
CCS
 CDs

To determine composition of short-term marketable securities account,

keeping in mind the trade-off between risk and return, match “securities”
with “needs” after taking “consideration” into account.
11
Money Market Mutual Funds
The creation of money market mutual funds (MMFS) made it possible for even small firms and
individuals to hold a well-diversified portfolio of marketable securities. Money market funds sell
shares to raise cash and by pooling the funds of a large number of small investors they can invest in
large-denomination money market instruments. Unlike other mutual funds, money market funds
declare daily dividends, which may be reinvested automatically or withdrawn in cash. Many of these
funds allow an account to be started with as little as a $500 initial investment.
Large firms are also increasingly drawn to money market mutual funds for at least some of their
marketable securities portfolio needs. The reason is a combination of strong safety, liquidity and
yield plus the opportunity to reduce workloads and operational costs within their own treasury
departments.

Mathematical Problems
Problem 01
A $1,000, 26-week Treasury bill might be purchased for $956. In this case, the yield (or appreciation)
of $44 can be expressed in several ways. Bond Equivalent Yield (BEY) Method This method produces
a nominal yield, quoted on a 365-day basis and is commonly used in reporting yields on T-bills of
various maturities.
FA − PP 365
��� = ×
PP DM

Where,
BEY = bond equivalent yield
FA = face amount
PP = purchase price
DM = days to maturity

For the T-bill described above, we would calculate the bond equivalent yield as follows-

1000 − 956 365

��� = × = 0.0923 = 9.23%
956 182

Effective Annual Yield (EAY) Method

This method assumes compounding and is calculated on a 365-day basis. (It is based on the effective
annual interest rate calculation -
365
DM
BEY
EAY = 1 + 365 − 1
DM

Where, EAY = effective annual yield, and the other variables are as previously defined.
For the T-bill in our example, the effective annual yield calculation gives us-

365
182
0.0923
��� = 1 + − 1 = 0.0944 = 9.44%
365
182

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Problem 02
The Zindler Company currently has a centralized billing system. Payments are made by all
customers to the central billing location. It requires, on average, four days for customer’s mailed
payments to reach the central location. An additional day and a half are required to process
payments before a deposit can be made. The firm has a daily average collection of $5,00,000. The
company has recently investigated the possibility of initiating a lockbox system. It has estimated that
with such a system customer’s mailed payments would reach the receipt location two and one-half
days sooner. Further, the processing time could be reduced by an additional day because each
lockbox bank would pick up mailed deposits twice daily.
a) Determine how much cash would be freed up (released) through the use of a lockbox
system.
b) Determine the annual gross dollar benefit of the lockbox system, assuming the firm could
earn a 5% return on the released funds by investing in short-term instruments.
c) If the annual cost of the lockbox system will be $75,000, should such a system be initiated?

Solution:
a) Total time savings = 2.5 + 1 = 3.5 days
Cash released = Time savings x daily average collection
= 3.5 × $5,00,000 = $1,750,000
b) 5% x $1,750,000 = $87,500
c) Since the dollar gross benefit of the lockbox system ($87,500) exceeds the annual cost of
the lockbox system ($75,000), the system should be initiated.

Problem 03
Over the next year, El Pedro Steel Company, a California corporation, expects the following returns
on continual investment in the following marketable securities-
Treasury bills 8.00%

Commercial paper 8.50%

Money market preferred stock 7.00%

The company's marginal tax rate for federal income tax purposes is 30% (after allowance for the
payment of state income taxes) and its marginal, incremental tax rate with respect to California
income taxes is 7%. On the basis of after-tax returns, which is the most attractive investment? Are
there other considerations?
Security Federal tax State tax rate Combined Effect After-tax Expected
rate Return
Treasury bills 0.30 0.00 0.30 (1-0.30) x 8.00% = 5.60%
Commercial 0.30 0.07 0.37 (1-0.37) x 8.50% = 5.36%
paper
Money market
Preferred . 09∗ 0.07 0.16 (1-0.16) x 7.00% = 5.88%
stock
*(1-0.70) x (0.30) = 0.09

The money market preferred is the most attractive after taxes, owing to the 70% exemption for
federal income tax purposes. Commercial paper is less attractive than Treasury bills because of the
state income tax from which Treasury bills are exempt (In states with no income taxes, the after-tax
yield on commercial paper would be higher).

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Preferred stock may not be the most attractive investment when risk is taken into account. There is
the danger that interest rates will rise above the ceiling and the market value will fall. There also is
default risk with respect to dividend payment, whereas Treasury bills have no default risk.

Problem 04
Assume that we have just purchased the 26-week Treasury bill described in the previous example.
Further assume that we suddenly have a need to cash in this investment and that for some reason
interest rates have risen such that investors now demand a 10% bond equivalent yield before they
will purchase a 26-week Treasury bill.
Market price Face amount Bond equivalent yield
This morning: $956.00 $1.000 ($1,000 - $956.00)/($956.00) x (365/182) = 0.0923
Later the same day: $952.50 $1.000 ($1,000 - $952.50)/($952.50) x (365/182) = 0.1000

If we sold our Treasury bill later that same day - after interest rates had risen - we would
experience a loss of $3.50 ($956.00 - $952.50).
Now you should better understand that when security prices are volatile (owing to changing interest
rates), the firm's marketable securities portfolio manager may try to avoid having to sell securities
before they mature.

Optimal Cash Balance Under Certainty

Baumol's Model
The Baumol Model of cash management provides a formal approach for determining a firm's
optimum cash balance under certainty.
It considers cash management similar to an inventory management problem. As such, the firm
attempts to minimize the sum of the cost of holding cash (inventory of cash) and the cost of
converting marketable securities to cash.

Assumption of Baumol Model:

 The firm is able to forecast its cash needs with certainty.
 The firm's cash payments occur uniformly over a period of time.
 The opportunity cost of holding cash is known and it does not change over time.
 The firm will incur the same transaction cost whenever it converts securities to cash.
 According to Baumol Model, there are two types of costs for cash management.

1. Holding Cost: The firm incurs holding cost for keeping the cash balance. It is an opportunity cost;
that is, the return foregone on the marketable securities. If the opportunity cost is k, then the
firm's holding cost for maintaining an average cash balance is as follows
C
Holding Cost = k 2

2. Transaction Cost: The firm incurs transaction cost whenever it converts its marketable
securities to cash. Total number of transactions during the year will be total funds requirement.
T divided by the cash balance, C. The per transaction cost is assumed to be constant. If per
transaction cost is m, then the total transaction cost will be:
T
Transaction Cost = m C

The total annual cost of the demand cash will be-

C T
Total Cost = k 2 + m C

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What is the optimum level of cash balance, C*?
We know that the holding cost increases as demand for cash, C, increases. However, the transaction
cost reduces with increasing C, the number of transactions declines.
Thus, there is trade-off between the holding cost and the transaction cost. The optimum cash
balance, C*, is obtained when the total cost is minimum.

2mT
�∗ =
k

Where,
C* = the optimum cash balance,
m = the cost per transaction,
T = the total cash requirement during the period and
k = the opportunity cost of holding cash balance.

Problem
A company estimates its total cash requirement as Tk. 10,00,00,000 next year. The company's
opportunity cost of funds is 15% p.a. The company will have incurred Tk. 200 per transaction when it
converts its short-term securities to cash.
a) Determine the optimum cash balance.
b) How much is the total annual cost of the demand for the optimum cash balance?
c) How many deposits will have to be made during the year?

Solution
2mT 2×200×10,00,00,000
a) Optimum Cash Balance, C∗ = = = 5,16,398
K 0.15
5,16,398 10,00,00,000
b) Total Cost = 0.15 2 + 200 5,16,398 = 38,730 + 38,730 = 77,460
c) The company will have to make (77,460/200) = 387.3 or 388 deposits.

Miller-Orr Model
The limitation of the Baumol model is that it does not allow the cash flows to fluctuate. Firms in
practice do not use their cash balance uniformly nor are they able to predict daily cash inflows and
outflows.
The Miller-Orr (MO) model overcomes this shortcoming and allows for daily cash flow variation. It
assumes that net cash flows are normally distributed with a zero value of mean and a standard
deviation.
The figure in the next slide, MO model provides for two control limits- the upper limit and the lower
limit as well as a return point. If the firm's cash flows fluctuate randomly and hit the upper limit,
then it buys sufficient marketable securities to come back to a normal level of cash balance (the
return point).

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 Cash
Balance

Upper Limit

Purchase of
Securities

Return Point
Sale of
Securities

Time
Figure: Miller-Orr Model

Similarly, when the firm's cash flows wander and hit the lower limit, it sells sufficient marketable
securities to bring the cash balance back to the normal level. The firm sets the lower control limits
as per its requirement of maintaining minimum cash balance.
The difference between the upper limit and the lower limit depends on the following factors-
 The transaction cost,
 The interest rate,
 The standard deviation of net cash flows.

The formula for determining the distance between upper and lower control limits (Z) is as follows-
1
3 Cash flow variance 3
Upper Limit-Lower Limit = × Transaction cost ×
4 Interest rate per day
1
3
3 σ
z= c
4 i
365

The limits will come closer as the interest rate increases. Z is inversely related to the interest rate.
It is noticeable that the upper control limit is three times of lower control limit and return point lies
between upper and lower limit. Thus,
Upper Limit = Lower Limit + 3Z and
Return Point = Lower Limit + Z

The net effect is that the firms hold the average cash balance equal to-
4
Average cash balance = Lower Limit+3 z

The MO model is more realistic since it allows variation in cash balance within lower and upper
limits. The financial manager can set the lower limit according to the firm's liquidity requirement. The
past data of the cash flow behavior can be used to determine the standard deviation of net cash
flows.

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Problem
A company has a policy of maintaining a minimum cash balance of Tk. 5,00,000. The standard
deviation of the company's daily cash flows is Tk. 2,00,000. The annual interest rate is 14%. The
transaction cost of buying or selling securities is Tk. 150 per transaction.
Determine the company's upper control limit, the return point and average cash balance as per the
Miller-Orr model.

Solution:
Here,
1 1
3 3
3 � 3 200000
Z= � � = × 150 × .14 = ��. 2,27,227
4 4
365 365

Upper Limit = Lower Limit + 3Z = 500000 + (3x227227) = 1181681

Return Point = Lower Limit + Z = 500000 + 227227 = 727227
4 4
Average Cash Balance = Lower Limit + 3Z = 500000 + 3
x 227227 = 802969

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