ADVANCED CORPORATE FINANCE
Class -1 of Unit-2- CASH MANAGEMENT
Cash Management
Meaning
Cash management is the key area of WCM .
Cash is the most liquid asset in the entire set of assets of the
firm
Cash is the common denominator to all current assets
through which we measure .
Cash Management
Meaning of cash:
Narrow sense “coin or currency, and generally accepted
equivalents of the cash, such as cheques, drafts and DDs
in banks.
Broader sense includes, near cash assets, such as
marketable securities, and time deposits.
Cash Management
Motives of Holding Cash
Transaction motives
Precautionary motives ( flood , strikes, failure of important customers,
unexpected slow down in collections )
Speculative motives
( holding cash to quickly take the advantage of opportunities typically outside the
natural course of business)
Compensation motives ( generally to provide to banks )
Cash Management
Objectives of Cash management
To Meet the cash disbursement needs (payment schedule)
To minimize funds committed to cash balances.
Cash Management
Objectives of Cash management
It prevents insolvency or bankruptcy
The relationship with the bank is not strained
It helps in fostering good relations with trade creditors and suppliers
Cash discount can be availed of if payment is made within the due date,
Cash Management
Objectives of Cash management
It leads to strong credit rating,
Advantage of favorable business opportunities
Enables the firms to meet the unanticipated cash expenditures.
THANK YOU
Dr C Sivashanmugam
Department of Management Studies (PG)
sivashanmugam@pes.edu
+91 80 2672 1983 Extn :317
Dr.Sivashanmugam,Professor,MBA-PESU
ADVANCED CORPORATE FINANCE
Class-2 -Unit-2- Factors Determining
Cash Needs
Cash Management
Factors determining cash needs
I. Synchronization of cash flows (or) managing the cash
inflows and outflows :
II. Short costs
cost associated with shortfall in cash needs. Every
shortage of cash –expected or unexpected involves cost ,
Cash Management
Factors determining cash needs
II. Short costs
Transaction costs- broking cost
Borrowing costs – interest cost
Loss of cash –discounts
Cost associated with deterioration of the cash rating-
reflected in higher bank charges.
Penalty rates.
Cash Management
Factors determining cash needs
III. Cost of Excess cash balance ,
IV. Procurement and Management- administrative
expenses
V. Uncertainty and Cash Management.
THANK YOU
Dr C Sivashanmugam
Department of Management Studies (PG)
sivashanmugam@pes.edu
+91 80 2672 1983 Extn :317
Dr.Sivashanmugam,Professor,MBA-PESU
ADVANCED CORPORATE FINANCE
Class-4-Unit-2-Optimum Cash Balance – Baumol
Model
Cash Management
Determining Cash needs: Cash management Models
Baumol Model
Miller-Orr Model and
Cash Management
The Baumol Model
Purpose of this model is to determine the minimum cost amount of
cash that a financial manager can obtain by converting securities to
cash, considering the cost of conversion and the counter-balancing
cost of keeping idle cash balances which otherwise could have been
invested in marketable securities.
Cash Management
The Baumol Model
Baumol Model is a model that provides for cost-efficient
transactional balances and assumes that the demand for
cash can be predicted with certainty and determines the
optimal conversion size/ lot
Cash Management
The Baumol Model
The total cost associated with cash management,
according to this model, has
Two elements:
(i) cost of converting marketable securities into cash and
(ii) the lost opportunity cost.
Cash Management
The Baumol Model- conversion costs
The conversion costs are incurred each time marketable
securities are converted into cash.
Symbolically,
Total conversion cost per period =Tb/ C
Where b = cost per conversion assumed to be independent of
the size of the transaction,
T = total transaction cash needs for the period,
C = value of marketable securities sold at each conversion
Cash Management
The Baumol Model- opportunity cost
opportunity cost is derived from the lost/forfeited interest
rate
(i) that could have been earned on the investment of
cash balances.
(ii) The total opportunity cost is the interest rate times
the average cash balance kept by the firm
Cash Management
The Baumol Model- opportunity cost
The model assumes a constant and a certain pattern of
cash outflows.
At the beginning of each period, the firm starts with a cash
balance which it gradually spends until at the end of the
period it has a zero cash balance and must replenish its
each supply to the level of cash balance in the beginning.
Cash Management
The Baumol Model- opportunity cost
Symbolically,
the average lost opportunity cost= i( C/ 2 )
Where i = interest rate that could have been earned.
C/2 = the average cash balance
(the beginning cash (C) + the ending cash balance of the
period (zero) /2)
Cash Management
The Baumol Model-Opportunity Cost
C T
i b
2 C
Multiply both sides
C 2
i T b
C *
2bt / i
2
T b
C 2
2
i
Cash Management
The Baumol Model-Opportunity Cost
2bT
C *
i
b = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed
i = The opportunity cost of holding cash/
this is the interest rate.
Cash Management
The Baumol Model-Opportunity Cost
C
2
1 2 3 Time
Cash Management
The Baumol Model-Optimum Cash balance
C T
Total cost i b
2 C
Cost of cash
C
Opportunity Costs= i
2
T
Trading costs b
C
C Size of cash balance
Cash Management
The Baumol Model-Optimum Cash Balance
The optimal cash balance is found where the opportunity
costs equal the trading costs
l
Opportunity Costs = Trading Costs
C T
i b
2 C
cash balance is found where the opportunity costs curve
intersects the trading costs curve.
Cash Management
Limitations of Baumol’s Model
Model assumes constant rate of use of cash . Generally, the
cash outflows in any firm are not regular and hence this
model may not give correct results.
The transaction cost will also be difficult to be measured
since these depend upon the type of investment as well as
the maturity period.
THANK YOU
Dr C Sivashanmugam
Department of Management Studies (PG)
sivashanmugam@pes.edu
+91 80 2672 1983 Extn :317
Dr.Sivashanmugam,Professor,MBA-PESU
ADVANCED CORPORATE FINANCE
Class- 5-Unit-2-Optimum Cash Balance – Miller
ORR Model
Cash Management
The Miller-Orr Model
This method is also called as Stochastic Model-1966
Expanded model of Baumol’s model and which is
not applicable if the demand for cash is not steady.
The firm allows its cash balance to wander randomly
between upper and lower control limits.
Cash Management
The Miller-Orr Model
This model tries to answer two questions :
a) When should transfer be effected
between cash and marketable securities?
And
b) How much cash be converted into
marketable securities and vice versa?
Cash Management
The Miller-Orr Model
To use the Miller-Orr model, the manager must
do four things:
Set the lower control limit for the cash balance.
Estimate the standard deviation of daily cash flows.
Determine the interest rate.
Estimate the trading costs of buying and selling
securities.
Cash Management
The Miller-Orr Model
H-Higher limit
H
Level of cash
Z
Z- Target cash balance
L
L- lower limit
Time
Cash Management
The Miller-Orr Model continued…
When the cash balance reaches the Upper
Control Limit (H) cash is invested elsewhere to
get us to the Target Cash Balance (Z).
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 , Return Level(R).
Cash balances are allowed to move within the
limits.
Cash Management
The Miller-Orr Model
2
3bσ
Z
3 4i
Z=Return Point , b- transaction cost,
s2- is the variance of net daily cash flows.
i- interest rate per day,
Cash Management
The Miller-Orr Model
Upper Limit =3(z)
Cash Management
Limitations
It assumes a constant variability of cash flows and hence cannot
cope with large transactions such as payment of dividend
Cash Management
The Miller-Orr Model
Sum:The management of Popular Traders anticipates Rs 15 lakh in cash
outlays (demand) during the next year. The recent experience has been
that it costs Rs 30 to convert marketable securities to cash and vice
versa. The marketable securities currently earns 8 per cent annual
return. The daily cashflow variance is 27,000.
Cash Management
The Miller-Orr Model
2
3bσ
Z
4i
Z=Return Point , b- transaction cost=30 per
transaction
s2- is the variance of net daily cash flows=27,000.
i- interest rate per day=8% or 0.08/360
days=0.000222
Cash Management
The Miller-Orr Model
Z=Return Point= lower control limit =1,399
Upper limit = 3 X Rs 1,399 = Rs 4,197
Cash Management
The Miller-Orr Model
SUM: A firm which purchases raw materials on credit is required by the
credit terms to make payments within 30 days. On its side, the firm allows its
credit buyers to pay within 60 days. Its experience has been that it takes, on
an average, 35 days to pay its accounts payable and 70 days to collect its
accounts Cash cycle is the amount of time cash is tied up between payment
for production inputs and receipt of payment from the sale of the resulting
finished product; calculated as average age of inventory plus average
collection period minus average accounts payable period. Cash turnover is
the number of times cash is used during the year; calculated by dividing
number of days in a year by the cash cycle receivables. Moreover, 85 days
elapse between the purchase of raw materials and the sale of finished
goods, that is to say, the average age of inventory is 85 days. What is the
firm’s cash cycle? Also, estimate the cash turnover
Cash cycle= average Age of inventory+ accounts payable- accounts
payable
• Cash turnover = Assumed number of days in a year divided by the
cash cycle
Cash cycle = 85 days + 70 days – 35 days = 120 days
Cash turnover = 365/120 = 3times
Sum:
The following information is available in respect of a trading firm:
On an average, debtors are collected after 45 days; inventories have
an average holding period of 75 days and creditors payment period on
an average is 30 days.
The firm spends a total of Rs 120 lakh annually at a constant rate.
It can earn 10 per cent on investments.
From the above information, compute: (a) the cash cycle and cash turnover,
(b) minimum amounts of cash to be maintained to meet payments as they
become due, (c) savings by reducing the average inventory hold- ing period
by 30 days.
Cash cycle= average Age of inventory+ accounts receivables- accounts
payable
• Cash turnover = Assumed number of days in a year divided by the
cash cycle
• Minimum operating cash = Total operating annual outlay/cash
turnover,
Solution:
• Cash cycle = 45 days + 75 days – 30 days = 90 days (3 months) Cash
turnover = 12 months (360 days)/3 months (90 days) = 4.
• (b) Minimum operating cash = Total operating annual outlay/cash
turnover, that is, Rs 120 lakh/4 = Rs 30 lakh.
• (c) Cash cycle = 45 days + 45 days – 30 days = 60 days (2 months)
Cash turnover = 12 months (360 days)/2 months (60 days) = 6.
Minimum operating cash = Rs 120 lakh/6 = Rs 20 lakh
Reduction in investments = Rs 30 lakh – Rs 20 lakh = Rs 10 lakh Savings
= 0.10 3 Rs 10 lakh = Rs 1 lakh
THANK YOU
Dr C Sivashanmugam
Department of Management Studies (PG)
sivashanmugam@pes.edu
+91 80 2672 1983 Extn :317
Dr.Sivashanmugam,Professor,MBA-PESU
