Chapter 6 management of working capital - Cash

Question 1

what are the reasons for holding cash?

Answer 1

Transaction motive - day to day running expenses. Cash needed to pay the bills

Precautionary motive - hold extra cash to be safe, against unexpected expenses

Speculative motive - holding extra cash to be able to take advantage of ‘special deal’ like purchasing more goods than needed as fx is favourable

Question 2

methods of dealing with cash shortage ?

Answer 2

1. Reduce inventory
2. Defer capital expenditure
3. Defer or reduce dividends
4. Chase receivables to pay earlier
5. Postpone payment of payables
6. Using short term borrowing (overdraft)
7. Sell surplus assets
8. Sale and leaseback

Question 3

what are the cash management models

Answer 3

1. The baumol model
2. The miller Orr model

Question 4

what is the Baumol model ?

Answer 4

Similar to EOQ and uses same formula

Suppose company has cash but it is invested, it is earning interest, this model gives the optimum transfer amount to be taken from investments to cover cash flow in order to optimise the interest as when you take it out it loses interest

Economic quantity of cash = ( (2 x annual cash received) x (cost of ordering cash) ) / net interest cost of holding cash

Question 5

what is the Miller Orr model ?

Answer 5

In practice cash flows are likely to fluctuate from day to day and balances are likely to wander upwards or downwards over a period and the miller Orr model fixes limits on the upper and lower levels

The lower limit is the lowest the company goes below, at msm lowest limit is usually 1.5m - decided by the company

The Upper limit is the lower limit + the spread (formula to get the spread)

The return point is the lower limit + 1/3 of spread

Question 6

what are the steps to follow for the Miller Orr model

Answer 6

1. A safety level or lower limit of cash is decided upon
2. A statistical calculation is made based on the variations of the cash flow in order to agree an allowable range of fluctuations
3. Using this calculation range, an upper level of cash is fixed
4. The cash balance is managed to ensure that the balance is always kept between the upper and lower limits

Question 7

What is the Miller Orr formula ?

Answer 7

Spread = 3( (3/4 x transaction cost) x (Variance of cash flows) ) / interest rates 1/3

Transaction cost is is cost of moving money into investments when surplus or moving if require cash

Variance of the cash flow is the standard deviation2 (squared)

Daily interest rate - remember that even though the daily % might be 0.014% in the equation you put the amount without multiplying 100 so in the equation it is 0.00014