Cash Management

CorporateFinanceRossWesterfieldJaffeSixthEditionSixthEdition28ChapterTwentyEightCashManagementChapterOutline28.1ReasonsforHoldingCash28.2DeterminingtheTargetCashBalance28.3ManagingtheCollectionandDisbursementofCash28.4InvestingIdleCash28.5Summary&Conclusions28.1ReasonsforHoldingCashTransactionsmotiveCompensatingbalances28.2DeterminingtheTargetCashBalanceTheBaumolModelTheMiller-OrrModelOtherFactorsInfluencingtheTargetCashBalanceCostsofHoldingCashOpportunityCostsTradingcostsTotalcostofholdingcashC*CostsindollarsofholdingcashSizeofcashbalanceTheinvestmentincomeforegonewhenholdingcash.Tradingcostsincreasewhenthefirmmustsellsecuritiestomeetcashneeds.TheBaumolModelC*SizeofcashbalanceOpportunityCostsTradingcostsTheoptimalcashbalanceisfoundwheretheopportunitycostsequalsthetradingcostsTheBaumolModelOpportunityCosts=TradingCostsTheoptimalcashbalanceisfoundwheretheopportunitycostsequalsthetradingcostsMultiplybothsidesbyCTheMiller-OrrModelThefirmallowsitscashbalancetowanderrandomlybetweenupperandlowercontrollimits.$TimeHZLWhenthecashbalancereachestheuppercontrollimitHcashisinvestedelsewheretogetustothetargetcashbalanceZ.Whenthecashbalancereachesthelowercontrollimit,L,investmentsaresoldtoraisecashtogetusuptothetargetcashbalance.TheMiller-OrrModelMathGivenL,whichissetbythefirm,theMiller-OrrmodelsolvesforZandHwheres2isthevarianceofnetdailycashflows.TheaveragecashbalanceintheMiller-OrrmodelisImplicationsoftheMiller-OrrModelTousetheMiller-Orrmodel,themanagermustdofourthings:Setthelowercontrollimitforthecashbalance.Estimatethestandarddeviationofdailycashflows.Determinetheinterestrate.Estimatethetradingcostsofbuyingandsellingsecurities.Themodelclarifiestheissuesofcashmanagement:Thebestreturnpoint,Z,ispositivelyrelatedtotradingcosts,F,andnegativelyrelatedtotheinterestrateK.Zandtheaveragecashbalancearepositivelyrelatedtothevariabilityofcashflows.OtherFactorsInfluencingtheTargetCashBalanceBorrowingBorrowingislikelytobemoreexpensivethansellingmarketablesecurities.Theneedtoborrowwilldependonmanagement’sdesiretoholdlowcashbalances.CompensatingBalanceFirmshavecashinthebankasacompensationforbankingservices.Largecorporationshavethousandsofaccountswithseveraldozenbanks—sometimesitmakesmoresensetoleavecashalonethantomanageeachaccountonadailybasis.FloatThedifferencebetweenbankcashandbookcashiscalledfloat.Floatmanagementinvolvescontrollingthecollectionanddisbursementofcash.28.3ManagingtheCollectionandDisbursementofCashAcceleratingCollectionsDelayingDisbursementsDisbursementFloatZero-BalanceAccountsDraftsEthicalandLegalQuestionsAcceleratingCollectionsCustomermailspaymentCompanyreceivespaymentCompanydepositspaymentCashreceivedMaildelayMailfloatProcessingdelayProcessingfloatClearingdelayClearingfloattimeCollectionfloatOverviewofLockboxProcessingCorporateCustomersCorporateCustomersCorporateCustomersCorporateCustomersLocalBankCollectsfundsfromPOBoxesEnvelopesopened;separationofchecksandreceiptsDepositofchecksintobankaccountsDetailsofreceivablesgotofirmFirmprocessesreceivablesBankclearschecksPostOfficeBox1PostOfficeBox2DelayingDisbursementsWritecheckonadistantbank.Holdpaymentforseveraldaysafterpostmarkedinoffice.Callsupplierfirmtoverifystatementaccuracyforlargeamounts.Mailfromdistantpostoffice.Mailfrompostofficethatrequiresagreatdealofhandling.FirmprepareschecktosupplierPostOfficeprocessingDeliveryofchecktosupplierDepositgoestosupplier’sbankBankcollectsfundsDraftsFirmssometimesusedraftsinsteadofchecks.Draftsdifferfromchecksbecausetheyarenotdrawnonabankbutonanissuer(thefirm)andarepayablebytheissuer.Thebankactsonlyasanagent,presentingthedrafttotheissuerforpayment.Whenthedraftistransmittedtoafirm’sbankforcollection,thebankmustpresentthedrafttotheissuingfirmforacceptancebeforemakingpayment.Afterthedrafthasbeenaccepted,thefirmmustdepositthenecessarycashtocoverthepayments.Thisallowsthefirmtokeeplesscashonhand.EthicalandLegalQuestionsThefinancialmanagersmustalwaysworkwithcollectedcompanycashbalancesandnotwiththecompany’sbookbalance,whichreflectschecksthathavebeendepositedbutnotcollected.Ifyouareborrowingthebank’smoneywithouttheirknowledge,youareraisingseriousethicalandlegalquestions.28.4InvestingIdleCashAfirmwithsurpluscashcanparkitinthemoneymarket.Somelargefirmsandmanysmallonesusemoneymarketmutualfunds.Firmshavesurpluscashforthreereasons:SeasonalorCyclicalActivitiesPlannedExpendituresDifferentTypesofMoneyMarketSecuritiesSeasonalCashDemandsLong-termfinancingShort-termfinancingTimeTotalFinancingneedsJFMAMMarketablesecuritiesBankloans28.5Summary&ConclusionsAfirmholdscashtoconducttransactionsandtocompensatebanksforthevariousservicestheyrender.Theoptimalamountofcashforafirmtoholddependsontheopportunitycostofholdingcashandtheuncertaintyoffuturecashinflowsandoutflows.Twotransactionsmodelsthatprovideroughguidelinesfordeterminingtheoptimalcashpostionare:TheMiller-OrrmodelTheBaumolmodel28.5Summary&ConclusionsThefirmcanmakeuseofavarietyofprocedurestomanagethecollectionanddisbursementofcashinsuchaswayastospeedupthecollectionofcashandslowdownpayments.SomemethodstospeedcollectionsareLockboxesConcentrationbankingWiretransfersThefinancialmanagersmustalwaysworkwithcollectedcompanycashbalancesandnotwiththecompany’sbookbalance.28.5Summary&ConclusionsIfyouareborrowingthebank’smoneywithouttheirknowledge,youareraisingseriousethicalandlegalquestions.Theanswerstowhichyouprobablyknowbynow.CorporateFinanceRossWesterfieldJaffeSixthEditionSixthEdition29ChapterTwentyNineCreditManagementChapterOutline29.1TermsoftheSale29.2TheDecisiontoGrantCredit:RiskandInformation29.3OptimalCreditPolicy29.4CreditAnalysis29.5CollectionPolicy29.6HowtoFinanceTradeCredit29.7Summary&ConclusionsIntroductionAfirm’screditpolicyiscomposedof:TermsofthesaleCreditanalysisCollectionpolicyThischapterdiscusseseachofthecomponentsofcreditpolicythatmakesupthedecisiontograntcredit.TheCashFlowsofGrantingCreditCreditsaleismadeCustomermailscheckFirmdepositscheckBankcreditsfirm’saccountAccountsreceivableCashcollectionTime29.1TermsoftheSaleThetermsofsaleofcomposedofCreditPeriodCashDiscountsCreditInstrumentsCreditPeriodCreditperiodsvaryacrossindustries.Generallyafirmmustconsiderthreefactorsinsettingacreditperiod:Theprobabilitythatthecustomerwillnotpay.Thesizeoftheaccount.Theextenttowhichgoodsareperishable.LengtheningthecreditperiodgenerallyincreasessalesCashDiscountsOftenpartofthetermsofsale.Tradeoffbetweenthesizeofthediscountandtheincreasedspeedandrateofcollectionofreceivables.Anexamplewouldbe“3/10net30”Thecustomercantakea3%discountifhepayswithin10days.Inanyevent,hemustpaywithin30days.TheInterestRateImplicitin3/10net30Afirmofferingcredittermsof3/10net30isessentiallyofferingtheircustomersa20-dayloan.Toseethis,considerafirmthatmakesa$1,000saleonday0Somecustomerswillpayonday10andtakethediscount.Othercustomerswillpayonday30andforgothediscount.01030$97001030$1,00001030+$970-$1,000Acustomerthatforgoesthe3%discounttopayonday30isborrowing$970for20daysandpaying$30interest:TheInterestRateImplicitin3/10net30CreditInstrumentsMostcreditisofferedonopenaccount—theinvoiceistheonlycreditinstrument.PromissorynotesareIOUsthataresignedafterthedeliveryofgoodsCommercialdraftscallforacustomertopayaspecificamountbyaspecificdate.Thedraftissenttothecustomer’sbank,whenthecustomersignsthedraft,thegoodsaresent.Banker’sacceptancesallowabanktosubstituteitscreditworthinessforthecustomer,forafee.Conditionalsalescontractsletthesellerretainlegalownershipofthegoodsuntilthecustomerhascompletedpayment.29.2TheDecisiontoGrantCredit:RiskandInformationConsiderafirmthatischoosingbetweentwoalternativecreditpolicies:“InGodwetrust—everybodyelsepayscash.”Offeringtheircustomerscredit.TheonlycashflowofthefirststrategyisTheexpectedcashflowsofthecreditstrategyare:01Weincurcostsupfront……andgetpaidin1periodbyh%ofourcustomers.29.2TheDecisiontoGrantCredit:RiskandInformationTheNPVofthecashonlystrategyisTheNPVofthecreditstrategyisThedecisiontograntcreditdependsonfourfactors:Thedelayedrevenuesfromgrantingcredit,Theimmediatecostsofgrantingcredit,Theprobabilityofrepayment,hThediscountrate,rBExampleoftheDecisiontoGrantCreditAfirmcurrentlysells1,000itemspermonthonacashbasisfor$500each.Iftheyofferedtermsnet30,themarketingdepartmentbelievesthattheycouldsell1,300itemspermonth.Thecollectionsdepartmentestimatesthat5%ofcreditcustomerswilldefault.Thecostofcapitalis10%perannum.ExampleoftheDecisiontoGrantCreditTheNPVofcashonly:TheNPVofNet30:ExampleoftheDecisiontoGrantCreditHowhighmustthecreditpricebetomakeitworthwhileforthefirmtoextendcredit?TheNPVofNet30mustbeatleastasbigastheNPVofcashonly:TheValueofNewInformationaboutCreditRiskThemostthatweshouldbewillingtopayfornewinformationaboutcreditriskisthepresentvalueoftheexpectedcostofdefaults:Inourearlierexample,withacreditpriceof$500,wewouldbewillingtopay$26,000foraperfectcreditscreen.FutureSalesandtheCreditDecisionDonotgivecreditGivecreditCustomerpaysh=100%Customerpays(Probability=h)Customerdefaults(Probability=1–h)GivecreditDonotgivecreditOurfirstdecision:Werefusefurthersalestodeadbeats.Wefaceamorecertaincreditdecisionwithourpayingcustomers:Informationisrevealedattheendofthefirstperiod:29.3OptimalCreditPolicyCarryingCostsTotalcostsC*CostsindollarsLevelofcreditextendedAttheoptimalamountofcredit,theincrementalcashflowsfromincreasedsalesareexactlyequaltothecarryingcostsfromtheincreaseinaccountsreceivable.Opportunitycosts29.3OptimalCreditPolicyTradeCreditismorelikelytobegrantedif:Thesellingfirmhasacostadvantageoverotherlenders.Thesellingfirmcanengageinpricediscrimination.Thesellingfirmcanobtainfavorabletaxtreatment.Thesellingfirmhasnoestablishedreputationforqualityproductsorservices.Thesellingfirmperceivesalong-termstrategicrelationship.Theoptimalcreditpolicydependsonthecharacteristicsofparticularfirms.29.4CreditAnalysisCreditInformationFinancialStatementsCreditReportsonCustomer’sPaymentHistorywithOtherFirmsBanksCustomer’sPaymentHistorywiththeFirmCreditScoring:Thetraditional5C’sofcreditCharacterCapacityCapitalCollateralConditionsSomefirmsemploysophisticatedstatisticalmodels29.5CollectionPolicyCollectionreferstoobtainingpaymentonpast-dueaccounts.CollectionPolicyiscomposedofThefirm’swillingnesstoextendcreditasreflectedinthefirm’sinvestmentinreceivables.CollectionEffortAverageCollectionPeriodMeasurestheaverageamountoftimerequiredtocollectanaccountreceivable.Forexample,afirmwithaveragedailysalesof$20,000andaninvestmentinaccountsreceivableof$150,000hasanaveragecollectionperiodofAccountsReceivableAgingScheduleShowsreceivablesbyageofaccount.Thelongeranaccounthasbeenunpaid,thelesslikelyitistobepaid.CollectionEffortMostfirmsfollowaprotocolforcustomersthatarepastdue:Sendadelinquencyletter.Makeatelephonecalltothecustomer.Employacollectionagency.Takelegalactionagainstthecustomer.Thereisapotentialforaconflictofinterestbetweenthecollectionsdepartmentandthesalesdepartment.Youneedtostrikeabalancebetweenantagonizingacustomerandbeingtakenadvantageofbyadeadbeat.