CHAPTER 5

CASH MANAGEMENT MODEL

CHAPTER 5
CASH MANAGEMENT MODEL

1
 CHAPTER 5
CASH MANAGEMENT MODEL

Cash flows planning

Cash management model

Budget handling

Case study

2
 CHAPTER OUTLINE

Make a cash plan based on addition fund needed

Reasons for Holding Cash

Understanding Float

Cash Collection and Concentration

Managing Cash Disbursements

Investing Idle Cash

3
 MAKE OPTIMAL CASH BALANCE

Reasons for Holding Cash: (Lý do giữ tiền mặt)

Speculative motive – hold cash to take advantage of unexpected
opportunities (Động cơ đầu cơ – giữ tiền mặt để tận dụng những cơ hội bất
ngờ)

Precautionary motive – hold cash in case of emergencies ( Động cơ

phòng ngừa - giữ tiền mặt trong trường hợp khẩn cấp)

Transaction motive – hold cash to pay the day-to-day bills (Động

cơ giao dịch – giữ tiền mặt để thanh toán các hóa đơn hàng ngày )

Trade-off between opportunity cost of holding cash relative to

the transaction cost of converting marketable securities to cash
for transactions (Đánh đổi giữa chi phí cơ hội của việc nắm giữ tiền mặt so
với chi phí giao dịch chuyển đổi chứng khoán có thể bán được thành tiền mặt
4
 Understanding Float

Float – difference between cash balance recorded in the cash

account and the cash balance recorded at the bank
Disbursement float
Generated when a firm writes checks
Available balance at bank – book balance > 0
Collection float
Checks received increase book balance before the bank
credits the account.
Available balance at bank – book balance < 0
Net float = disbursement float + collection float
 Example: Types of Float

You have $3,000 in your checking account. You just deposited

$2,000 and wrote a check for $2,500.

What is the disbursement float?

What is the collection float?
What is the net float?
What is your book balance?
What is your available balance?
 key
• Section 19.2
• Disbursement float = $2500
• Collection float = -$2000
• Net float = 2500 – 2000 = $500
• Book balance = $3000 + 2000 – 2500 =
$2500
• Available balance = $3000

7
 Example: Measuring Float

Size of float depends on the dollar amount and the time delay.
Delay = mailing time + processing delay + availability delay
Suppose you mail a check each month for $1,000 and it takes
3 days to reach its destination, 1 day to process, and 1 day
before the bank makes the cash available.

What is the average daily float (assuming 30-day months)?

Method 1: (3+1+1)(1,000)/30 = 166.67
Method 2: (5/30)(1,000) + (25/30)(0) = 166.67
 Example: Cost of Float
Cost of float – opportunity cost of not being able to use the
money
Suppose the average daily float is $3 million with a weighted
average delay of 5 days.
What is the total amount unavailable to earn interest?
5 × $3 million = $15 million
What is the NPV of a project that could reduce the delay by
3 days if the cost is $8 million?
Immediate cash inflow = 3 × $3 million = $9 million
NPV = $9 – $8 = $1 million
 Cash Collection

Payment Payment Payment Cash

Mailed Received Deposited Available

Mailing Processing Delay Availability Delay

Time

Collection Delay

One of the goals of float management is to try to reduce the

collection delay. There are several techniques that can reduce
various parts of the delay.
Section 19.3 (A)

Reducing mailing time – Figure 19.3 illustrates how lockboxes can reduce mail
delay by having customers mail their payments to PO boxes that are closer to
where they live. The processing delay is also reduced because bank employees
process the checks instead of the company doing it and then taking the checks to
the bank.

Cash concentration – reduce management time by having a systematic process for

moving cash received in the lock-boxes to a central account. Allows the company
to maintain smaller cash balances overall.

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 Lockbox System
1.A lockbox system is a service whereby
checks are mailed to a local PO Box
address.
2.The checks are picked up daily (or
even multiple times per day) by the
servicing firm.
3.The checks are deposited into the
local branch bank.
4.The balances are electronically
transferred to the firm’s branch of the
No Lockbox System

2-3 Days
2-3 Days by Mail
by Mail
1.You have a business in Texas
2. You have one customer in California
3.You have a second customer in Virginia
4.Each customer mails their check to you via US
Mail taking 2-3 days.
5.The firm deposits the checks in their local
Texas bank.
6.Total time: 3-4 days

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 Lockbox System II

Transmitted
Electronically
(nanoseconds)

1 Day by Mail

1 Day by Mail
1.You have a business in Texas
2. You have one customer in California
3.You have a second customer in Virginia
4.Each customer mails their check to a LOCAL Post office
branch with a Lockbox system taking one day.
5.The checks are removed daily from the Post Office and
deposited into a LOCAL branch of the bank the firm deals with.
6.The local bank electronically transfers the funds into the Texas
firm’s branch and the funds are now available to the business.
7.Total time: 1-2 days thus saving 1-2 days of float!

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 Example: Accelerating Collections – Part I

Your company does business nationally, and currently all

checks are sent to the headquarters in Tampa, FL. You are
considering a lock-box system that will have checks processed
in Phoenix, St. Louis, and Philadelphia. The Tampa office will
continue to process the checks it receives in house.
Collection time will be reduced by 2 days on average.
Daily interest rate on T-bills = 0.01%.
Average number of daily payments to each lockbox is
5,000.
Average size of payment is $500.
The processing fee is $0.10 per check plus $10 to wire
funds to a centralized bank at the end of each day.
 Example: Accelerating Collections – Part II

Benefits
Average daily collections = 3(5,000)(500) = 7,500,000
Increased bank balance = 2(7,500,000) = 15,000,000

Costs
Daily cost = 0.10(15,000) + 3 × 10 = 1,530
Present value of daily cost = 1,530 / 0.0001 = 15,300,000

NPV = 15,000,000 – 15,300,000 = -300,000

The company should not accept this lock-box
proposal.
 Cash Disbursements

Slowing down payments can increase

disbursement float – but it may not be ethical or
optimal to do this.
Controlling disbursements
Zero-balance account
Controlled disbursement account
Section 19.4 (A)
Slowing payments: not ethical to systematically pay bills late; may
lose cash discounts by paying late and this can be very expensive
Zero-balance account: maintain a master account; when checks
are written on sub-accounts, cash is transferred from the master
account to the sub-account to cover the checks; can maintain a
smaller overall cash balance by utilizing this technique
Controlled disbursement account: cash is transferred to bank
account to cover the day’s anticipated payments

(Thanh toán chậm lại: không có đạo đức khi thanh toán hóa
đơn muộn một cách có hệ thống; có thể mất chiết khấu tiền
mặt do trả chậm và điều này có thể rất tốn kém
Tài khoản số dư bằng không: duy trì tài khoản chính; khi séc
được ghi trên tài khoản phụ, tiền mặt được chuyển từ tài
khoản chính sang tài khoản phụ để trang trải séc; có thể duy
trì số dư tiền mặt tổng thể nhỏ hơn bằng cách sử dụng kỹ
thuật này
Tài khoản giải ngân có kiểm soát: tiền mặt được chuyển vào 20
 Investing Cash

Money market – financial instruments with an

original maturity of one year or less
Temporary Cash Surpluses
Seasonal or cyclical activities – buy marketable
securities with seasonal surpluses, convert securities
back to cash when deficits occur
Planned or possible expenditures – accumulate
marketable securities in anticipation of upcoming
expenses
Seasonal Cash Demands
 Characteristics of Short-Term Securities
Maturity – firms often limit the maturity of short-term investments
to 90 days to avoid loss of principal due to changing interest rates
Default risk – avoid investing in marketable securities with
significant default risk
Marketability – ease of converting to cash
Taxability – consider different tax characteristics when making a
decision
(For taxability: Money market preferred stock is becoming more popular. Like
traditional preferred, corporations receive a dividend exclusion (at least 50
percent under the new law). Unlike traditional preferred, the dividend is
variable, which keeps the price more stable (more like a money market).)
(Đối với khả năng chịu thuế: Cổ phiếu ưu đãi thị trường tiền tệ đang trở nên phổ
biến hơn. Giống như ưu tiên truyền thống, các công ty nhận được loại trừ cổ tức
(ít nhất 50% theo luật mới). Không giống như ưu tiên truyền thống, cổ tức có thể
thay đổi, giúp giá ổn định hơn (giống như thị trường tiền tệ hơn).)
 Quick Quiz

What are the major reasons for holding cash?

What is the difference between disbursement float
and collection float?
How does a lockbox system work?
What are the major characteristics of short-term
securities?
 CASH MANAGEMENT MODEL

Boumol model
Miller – Orr model
Stone model

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 Comprehensive Problem

– A proposed single lockbox system will reduce

collection time 2 days on average
– Daily interest rate on T-bills = .01%
– Average number of daily payments to the lockbox is
3,000
– Average size of payment is $500
– The processing fee is $.08 per check plus $10 to wire
funds each day.
– What is the maximum investment that would make
this lockbox system acceptable?
Benefits:
Daily collections: 3,000 * $500 = $1.5M
Increased bank balance = 2 * $1.5M = $3M

Costs:
(3,000 * $0.08) + $10 = $250
PV = $250 / .0001 = $2.5M

Anything less than $500,000 would make this a

positive NPV project.

27
 BAUMOL MODEL

Baumol model: The cash management model follows the

discrete method, applying the same principles as the inventory
management model (Economic ordering quantity_EOQ)
Assumptions :
Over a certain period of time, net cash flows appear at a constant rate,
the cash balance will be periodically added by selling short-term
securities at a fixed cost of transaction;
There is no collection in the planning period;
There are no cash reserves for safety purposes;
Additional cash management.

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 Costs of Holding Cash

Trading costs increase when the firm

Costs in dollars of must sell securities to meet cash needs.
holding cash

Total cost of holding cash

Opportunity
Costs
The investment income
foregone when holding cash.

Trading costs
C* Size of cash balance
 The Baumol Model – I

F = The fixed cost of selling securities to raise cash

T = The total amount of new cash needed
R = The opportunity cost of holding cash, i.e., the interest rate

If we start with $C, spend at a

constant rate each period, and
replace our cash with $C when
C we run out of cash, our average
cash balance will be
C
–
–C2 2
The opportunity cost of holding
is C C
–2 –2 ×R
Time
1 2 3
 The Baumol Model – II
As we transfer $C each period we
incur a trading cost of F.

C
If we need $T in total over the
planning period, we will pay $F
times. T
C –C
–2
The trading cost is –CT× F
1 2 3 Time
The Baumol Model – III

C T
Total cost   R   F
2 C
Opportunity C R
Costs 2

T
Trading costs F
C
C* Size of cash balance
* 2T
C  F
R
 The Baumol Model – IV
The optimal cash balance is found where the opportunity costs equals
the trading costs.

Opportunity Costs = Trading Costs

C T
R  F
2 C
Multiply both sides by C.

C2 2TF T F
R T F *
C  2
C 2 
2 R R
Example: Hermes Co. has cash
outflows of $500 per day, the interest
rate is 10% and the fixed transfer cost
is $25.

T = 365 × 500 = 182,500

F = 25
R = .1

C* = $9,552.49
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 MILLER – ORR MODEL

Miller - Orr model: A model of money management that

follows a continuous method and applies the same principles as
the inventory management model (EOQ).

Overcoming the limitation of discrete money management,

which does not fully reflect the fluctuation and intertwining of
cash flows.

35
 MILLER – ORR MODEL

Assumptions:
The net cash flow of the business fluctuates completely randomly;
An enterprise holds two types of assets: corporate bonds and liquid assets,
such as liquidity securities with a yield of k;
Transaction costs are fixed. This transaction cost is the same for buying
and selling liquid securities;
Matured securities are automatically reinvested or not mentioned as part
of cash flow;
The budget will not fall below the lower limit of money reserves;
Based on the principles of inventory management, Miller - Orr
hypothesizes that the goal of the business is to minimize the cost of
holding money.

36
 The Miller-Orr Model
• The firm allows its cash balance to wander randomly between
upper and lower control limits.

When the cash balance reaches the upper control limit U, cash is invested
$ elsewhere to get us to the target cash balance C.

U 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.
C

L
Time
 The Miller-Orr Model: Math

• Given L, which is set by the firm, the Miller-Orr

model solves for C* and U
2
* 3 Fσ
C 3 L U *  3C *  2 L
4R
where s2 is the variance of net daily cash flows.
• The average cash balance in the Miller-Orr model is:

4C *  L
Average cash balance 
3
Section 19A.3

L (U) is a lower (upper) limit on the amount of cash to

be held, while C* is the optimal cash balance.

Example: Suppose F = $25, R = 1% per month,

and the variance of monthly cash flows is
$25,000,000 per month. Assume a minimum cash
balance of $10,000.

C* = 10,000 + ( ¾ (25)(25,000,000)/.01)1/3 =
$13,605.62
U* = 3(13,605.62) – 2(10,000) = $20,816.86

39
 Implications of the
Miller-Orr Model
To use the Miller-Orr model, the manager must do four
things:
1. Set the lower control limit for the cash balance.
2. Estimate the standard deviation of daily cash flows.
3. Determine the interest rate.
4. Estimate the trading costs of buying and selling
securities.
 Implications of the
Miller-Orr Model (ctd.)
• The model clarifies the issues of cash management:

– The optimal cash position, C*, is positively related

to trading costs, F, and negatively related to the
interest rate R.
– C* 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 management’s
desire to hold low cash balances.
 CASE STUDY
CASH FLOW MANAGEMENT OF 123 COMPANY

123 company (Chapter 2)

Requirement:
Determine cash inflow
Determine cash outflow
Planning cash flow
Make a cash flow management model
Make a cash management and budget management model

43
 PRESENTATION

GROUP PRESENTATION

44
 CONCLUSION

Focus on clarifying some fundamental theories about cash

management.
Cash management needs to build a corporate governance model
and determine the optimal level of cash balance. Some cash
management models such as Baumol model, Miller - Orr
model, Stone model.
Deficit and surplus budget needs to be done to reduce the cost
of the business’s cash balance. The model building and budget
handling help optimize the cash flow management of the
business.
Understand and implement cash management applications on
the software to increase the efficiency of cash flow
management of businesses.
45
 Chapter
20

Credit Management

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline

• Credit and Receivables

• Terms of the Sale
• Analyzing Credit Policies
• Optimal Credit Policy
• Credit Analysis
• Collection Policy
• Inventory Management
• Inventory Management
Techniques
 Chapter Outline
(Appendix)
• Alternative Credit Policy
Analysis
The One-Shot Approach
The AR Approach
• Discounts and Default model
 Chapter Outline

• Credit and Receivables

• Terms of the Sale
• Analyzing Credit Policies
• Optimal Credit Policy
• Credit Analysis
• Collection Policy
• Inventory Management
• Inventory Management
Techniques
 Credit Management: Key Issues
• Granting credit generally increases
sales
• Costs of granting credit
– Chance that customers
will not pay
– Financing receivables
• Credit management examines the
trade-off between increased sales
and the costs of granting credit
 Components of Credit Policies
• Terms of sale
– Credit period
– Cash discount and discount period
– Type of credit instrument
• Credit analysis
Distinguishing between “good”
customers that will pay and “bad”
customers that will default
 Components of Credit Policies
• Collection policy
Effort expended on collecting receivables
 The Cash Flows from
Granting Credit

Credit Sale Check Mailed Check Deposited Cash

Available

Cash Collection
Accounts Receivable

Obviously, the timeline is not drawn to scale, and the distance

between each point would differ across companies.
 Chapter Outline

• Credit and Receivables

• Terms of the Sale
• Analyzing Credit Policies
• Optimal Credit Policy
• Credit Analysis
• Collection Policy
• Inventory Management
• Inventory Management
Techniques
 Terms of Sale
Basic Form: 2/10 net 45
– 2% discount if paid in 10 days
– Total amount due in 45 days if discount not
taken
Buy $500 worth of merchandise with the
credit terms given above
– Pay $500(1 - .02) = $490 if you pay in 10 days
– Pay $500 if you pay in 45 days
 Example: Cash Discounts
• Finding the implied interest rate when
customers do not take the discount
• Credit terms of 2/10 net 45
– Period rate = 2 / 98 = 2.0408%
– Period = (45 – 10) = 35 days
– 365 / 35 = 10.4286 periods per year
• EAR = (1.020408)10.4286 – 1 = 23.45%
• The company benefits when customers choose
to forgo discounts
(Cash discounts are designed to shorten the receivables period; however, you reduce
your net sales level when discounts are taken, unless the discount entices new customers
to purchase.)
 Chapter Outline

• Credit and Receivables

• Terms of the Sale
• Analyzing Credit Policies
• Optimal Credit Policy
• Credit Analysis
• Collection Policy
• Inventory Management
• Inventory Management
Techniques
 Credit Policy Effects
• Revenue Effects:
– Delay in receiving cash
from sales
– May be able to increase
price
– May increase total sales
 Credit Policy Effects
• Cost Effects:
– Cost of the sale is still incurred even though the
cash from the sale has not been received

– Cost of debt – must finance receivables

– Probability of nonpayment – some percentage of

customers will not pay for products purchased
– Cash discount – some customers will pay early and
pay less than the full sales price
 Example: Evaluating a
Proposed Policy – Part I
• Your company is evaluating a switch from a
cash only policy to a net 30 policy. The price
per unit is $100, and the variable cost per
unit is $40. The company currently sells 1,000
units per month. Under the proposed policy,
the company expects to sell 1,050 units per
month. The required monthly return is 1.5%.
• What is the NPV of the switch?
• Should the company offer credit terms of net
30?
 Example: Evaluating a
Proposed Policy – Part II
• Incremental cash inflow
(100 – 40)(1,050 – 1,000) = $3,000
• Present value of incremental cash inflow
3,000/.015 = $200,000
• Cost of switching
100(1,000) + 40(1,050 – 1,000) = $102,000
• NPV of switching
200,000 – 102,000 = $98,000
• Yes, the company should switch!
(100*1000=amount of immediate CF needed to cover the extension in time to pay.)
 Total Cost of Granting Credit
• Carrying costs
– Required return on receivables
– Losses from bad debts
– Costs of managing credit and collections
• Shortage costs
– Lost sales due to a restrictive credit policy
• Total cost curve
– Sum of carrying costs and shortage costs
– Optimal credit policy is where the total cost
curve is minimized
 Chapter Outline
• Credit and Receivables
• Terms of the Sale
• Analyzing Credit Policies
• Optimal Credit Policy
• Credit Analysis
• Collection Policy
• Inventory Management
• Inventory Management
Techniques
Carrying and Opportunity
Costs
 Chapter Outline

• Credit and Receivables

• Terms of the Sale
• Analyzing Credit Policies
• Optimal Credit Policy
• Credit Analysis
• Collection Policy
• Inventory Management
• Inventory Management
Techniques
 Credit Analysis
• The process of deciding which customers
receive credit
• Gathering information
– Financial statements
– Credit reports
– Banks
– Payment history with the firm
• Determining Creditworthiness
– 5 Cs of Credit
– Credit Scoring
Credit scoring is less subjective than the five Cs, but firms
have to be careful with the information they choose to include
in the score. For example, race, gender and geographic
location cannot be included in the score.

67
 One-Time Sale Model
NPV = -v + (1 - )P / (1 + R)
where: v = variable cost per unit
 = probability of default
P = Current Price
R = Monthly required
return
 Example: One-Time Sale
• Your company is considering granting credit
to a new customer.
• The variable cost per unit is $50; the
current price is $110;
• The probability of default is 15%;
• The monthly required return is 1%.
 One-Time Sale Model
NPV = -v + (1 - )P / (1 + R)
• NPV = -50 + (1-.15)(110)/(1.01)
= $42.57
• What is the break-even probability?
NPV = $0 = -50 + (1 - )(110)/(1.01)
 = .5409 or 54.09%
 Example: Repeat Customers
In the previous example, what is the
NPV if we are looking at repeat
business?
• NPV = -v + (1-)(P – v)/R
• NPV = -50 + (1-.15)(110 – 50)/.01
= $5,050
 Example: Repeat Customers
Interpretation
• Repeat customers can be very valuable
(hence the importance of good customer
service)
• It may make sense to grant credit to almost
everyone once, as long as the variable cost is
low relative to the price
• If a customer defaults once, you don’t grant
credit again
 Credit Information
• Financial statements
• Credit reports with customer’s
payment history to other firms
• Banks
• Payment history with the company
 Five Cs of Credit
• Character – willingness to
meet financial obligations
• Capacity – ability to meet financial obligations
out of operating cash flows
• Capital – financial reserves
• Collateral – assets pledged as security
• Conditions – general economic conditions

CCCCC
related to customer’s business
 Chapter Outline

• Credit and Receivables

• Terms of the Sale
• Analyzing Credit Policies
• Optimal Credit Policy
• Credit Analysis
• Collection Policy
• Inventory Management
• Inventory Management
Techniques
 Collection Policy
Monitoring receivables
Keep an eye on average
collection period relative
to your credit terms
Use an aging schedule
to determine percentage
of payments that are
being made late
 Collection Policy
• Collection policy
–Delinquency letter
–Telephone call
–Collection agency
–Legal action
If the average collection period is well outside your credit
terms, then there is definitely a problem. If you offer a discount
and the ACP is not less than your “net” terms, then there is
probably a problem. An aging schedule can help you pinpoint
if you have customers paying late across the board or if there
are a few customers that are paying really late.

(Nếu thời gian thu nợ trung bình nằm ngoài

điều khoản tín dụng của bạn, thì chắc chắn
có vấn đề. Nếu bạn giảm giá và ACP không
thấp hơn các điều khoản "ròng" của bạn, thì
có thể có vấn đề. Lịch trình lão hóa có thể
giúp bạn xác định xem bạn có khách hàng
thanh toán trễ hay có một vài khách hàng
trả tiền thực sự muộn hay không.)
78