Topic 14: Short-term Cash Management (Sem 2)

Question 1

Business Failure Reasons

Answer 1

Poor financial planning and cash management

Companies with excellent products and fast growth could also fail if they run out of cash.

Question 2

The Operating Cycle

Answer 2

The period from the arrival of stock until the receipt of cash.

NOTE: CHECK EXAMPLE IN NOTES

Question 3

The Cash Cycle

Answer 3

The period from paying for stock until the receipt of cash.

NOTE: CHECK EXAMPLE IN NOTES

Question 4

The speculative motive

Answer 4

The need to hold cash to tae advantage of additional investment opportunities, such as bargain purchases.

Question 5

The precautionary motive

Answer 5

The need to hold cash as a safety margin to act as a financial reserve

Question 6

The transaction motive

Answer 6

The need to hold cash to satisfy normal disbursement and collection activities associated with a firm’s ongoing operations.

Question 7

Costs of holding cash

Answer 7

Opportunity cost which in this case is the lost interest income that would have been gained on this cash if it was invested.

Question 8

Understanding Float (and formula)

Answer 8

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

Float = Bank Cash - Book Cash

Question 9

Types of Float

Answer 9

1) Disbursement Float: Cheques that are written by a firm. Cause a decrease in the firms book balance but no change in it’s available balance.

2) Collection float: Cheques received by a firm cause increases on book balances but does not immediately change available balances.

3) Net Float: The sum of the collection and disbursement floats

Question 10

Float Management

Answer 10

Involved the collection and disbursement of cash.

In cash collection the objective is to speed cash up collections and reduce the lag between the time customers pay their bills and the time the cash becomes available.

In cash disbursement the objective is to control payments and minimise the firm’s costs associated with making payments.

Question 11

Investing Idle Cash

Answer 11

NOTE: CHECK EXAMPLE IN NOTES

Question 12

Trading Costs

Answer 12

The costs of buying and selling marketable securities. Trading costs include commissions, fees and the bid / ask spread.

Question 13

Target Cash Balance

Answer 13

A firm’s desired cash level as determined by the tradeoff between opportunity costs of holding too much cash and the trading costs of holding too little.

NOTE: CHECK EXAMPLE IN NOTES

Question 14

The Baumol (BAT) Model (Including Formulas in model)

Answer 14

Model for cash management

Opportunity costs = (C/2) * R
Where:
C = Initial Cash Balance
R = The opportunity cost of holding cash; this is the interest rate on marketable securities.

Trading Costs = (T/C) * F
Where:
T = Total amount of new cash needed for transaction purposes over the relevant planning period. (ex: one year)
F = The fixed cost of selling securities to replenish cash.

Total Costs = Opportunity costs + Trading Costs
Therefor: Total Costs = [(C/2) * R] + [(T/C) * F]

Baumol Model Formula:
C* = [(2T * F) / R]^(1/2)
Where:
C* = The target cash balance
T = Total cash needed
F = fixed trading cost
R = Opportunity cost of holding cash

Trading costs other formula: (T * C*) * F

Note: Baumol Formulawill be given in the exam.
Note: This model assumes the firm has a constant disbursement rate and there are no cash receipts during the projected period. Also no safety stock is allowed
NOTE: CHECK EXAMPLE IN NOTES

Question 15

The Miller-Orr Model (Including formulas in model)

Answer 15

Cash model that deals with cash inflows and outflows that fluctuate randomly between upper (U) and lower (L) control limits.

When the cash balance hits the upper limit, the excess cash over the target balance (C*) is invested buying some marketable insecurities.

When the cash balance hits the lower limit, the cash needed to restore the balances to the target cash balance (C*) is recovered by selling some marketable securities.

Miller-ORR Model Formulas: (These will be given in exam)

Target Cash Balance:
C* = L + ([3/4 * F * σ^2 ]/ R)^1/3
* Denotes Optimal Values
σ^2 is the variance of net cash flows

Upper Limit (U):
U = 3 * C* - 2 * L

Average Cash balance:
Avg. = (4 * C* - L) / 3

Where:
L = lower limit set by company
F = Fixed trading costs
R = Opportunity Cost
σ^2 is the variance of net cash flows

NOTE: CHECK EXAMPLE IN NOTES

Question 16

Baumol and Miller-Orr Models General implications

Answer 16

From Both models we can see that:
Higher opportunity costs result in a lower target cash balance

Higher trading costs result in a higher target cash balance

Higher uncertainty results in:
A bigger difference between the lower limit and the target cash balance and a higher upper limit and target cash balance.