OUTLINE• Motives for Holding Cash• Cash Budgeting• Long-term Cash Forecasting• Reports for Control• Cash Collection and Disbursement• Optimal Cash Balance• Investment of Surplus Funds• Cash Management Models

MOTIVES FOR HOLDING CASH

Possible motives for holding cash :

• Transaction motive

• Precautionary motive

• Speculative motive

CASH BUDGETThe principal method of cash budgeting is the receipts and disbursements method. Under this method, the cash forecast shows the timing and magnitude of cash receipts and disbursements over the forecast period.

IllustrationThe following information about Beta Company is given:• The estimated sales for the period January 20X1 through June 20X1 are as follows: Rs.100,000 a month from January through March and Rs.120,000 a month from April through June.• The sales for November and December of the previous year have been Rs.100,000 each.• Cash and credit sales are expected to be 20 percent and 80 percent respectively.• The receivables from credit sales are expected to be collected as follows: 50 percent after one month and the balance 50 percent after two months.• Other anticipated receipts are: Rs.5,000 from the sale of a machine in March and Rs.2000 interest on securities in June.

CASH BUDGETING January February March April

May June1. Sales 100,000 100,000 100,000 120,000

120,000 120,0002. Credit sales 80,000 80,000 80,000 96,000

96,000 96,0003. Collection of accounts receivables 80,000 80,000 80,000 80,000 88,000 96,0004. Cash sales 20,000 20,000 20,000 24,000 24,000 24,0005. Receipt from machine sale 5,0006. Interest 2,000 Total cash receipts 100,000 100,000 105,000 104,000 112,000 122,000 (3+4+5+6)

CASH BUDGETINGRelevant information for cash payments· Beta Company plans to purchase materials worth Rs.40,000 in January and February and materials worth Rs.48,000 each month from March through June. Payments will be made a month after the purchase· A payment of Rs.40000 will be made in January for purchases in the previous December· Miscellaneous cash purchases of Rs.2000 per month are planned from January through June· Wage payments will be Rs.15000 per month, January through June· Payments for manufacturing expenses will be Rs.20,000 per month and for general administrative expenses will be Rs.10,000 per month, January through June· Dividend payment of Rs.20,000 and a tax payment of Rs.20,000 are planned for June· A machine will be bought in cash for Rs. 50,000 in March

CASH BUDGETING January February March April

May June 1. Material purchases 40,000 40,000 48,000 48,000 48,000 48,000 2. Credit material purchases 40,000 40,000 48,000 48,000 48,000 48,000 3. Payment of 40,000 40,000 40,000 48,000 48,000 48,000 accounts payable 4. Miscellaneous 2,000 2,000 2,000 2,000 2,000 2,000 cash purchases 5. Wages 15,000 15,000 15,000 15,000 15,000 15,000 6. Manufacturing exp. 20,000 20,000 20,000 20,000 20,000 20,000 7. General admn. expense 10,000 10,000 10,000 10,000 10,000 10,000 8. Dividend - - - - - 20,000 9. Tax - - - - - 20,00010. Capital - - 50,000 - - - expenditure Total payments 87,000 87,000 137,000 95,000 95,000 135,000 (3+4+5+6+7+8+9+10)

CASH BUDGETINGAssuming that the cash balance on 1st January is Rs.22,000 and the minimum cash

balancerequired by the firm is Rs.20,000, the summary cash forecast is given below.

January February March April May June

1. Opening cash balance Rs.22,000 2. Receipts 100,000 100,000 105,000 104,000

112,000 122,000 3. Payments 87,000 87,000 137,000 95,000

95,000 135,000 4. Net cash flow (2 –3) 13,000 13,000 (32,000) 9,000

17,000 (13,000) 5. Cumulative net cash flow 13,000 26,000 (6,000) 3,000 20,000 7,000 6. Opening cash balance + Cumulative net flow (1 + 5) 35,000 48,000 16,000 25,000 42,000 29,000 7. Minimum cash balance required 20,000 20,000 20,000 20,000 20,000 20,000 8. Surplus or deficit in 15,000 28,000 (4,000) 5,000

22,000 9,000 relation to the minimum cash balance required (6 – 7)

LONG-TERM CASH FORECASTINGAdjusted net income method is generally used for long-term cash forecasting.

20 X 0 20 X 1 20 X 2 20 X 3 20 X 4 Source Net income after taxes Non-cash charges (Depreciation, amortisation, etc.)

Increase in borrowings Sale of equity shares Miscellaneous Uses Capital expenditures Increase in current assets Repayment of borrowings Dividend payment Miscellaneous Surplus/ Deficit Opening cash balance Closing cash balance

REPORTS FOR CONTROL

• Daily Cash Report

• Daily Treasury Report

• Monthly Cash Report

CASH COLLECTION AND DISBURSEMENT

• Float

• Speeding up Collections

• Delaying Payments

• EDI : Will the Float Disappear

FLOAT

• The cash balance shown by a firm on its books is called the book, or ledger, balance whereas the balance shown in its bank account is called the available, or collected, balance. The difference between the available balance and the ledger balance is referred to as float.

• There are two kinds of float viz., disbursement float and payment float

OPTIMAL CASH BALANCE

•

C*

Costs

Total costs

Opportunity cost

Transaction cost

Cash balance

INVESTMENT OF SURPLUS FUNDS

A firm’s short-term investment portfolio can be divided into

• Ready cash segment

• Controllable cash segment

• Free cash segment

CRITERIA FOR EVALUATING INVESTMENT OPTIONS

• Safety

• Liquidity

• Yield

• Maturity

INVESTMENT OPTIONS• Fixed deposits with banks• Treasury bills• Mutual fund schemes

• Money market schemes• Commercial paper• Certificates of deposit• Inter-corporate deposits• Ready forwards• Bill discounting

CASH MANAGEMENT MODELS

Several cash management models have addressed this issue of split between marketable securities and cash holdings.

Two such models are :

• Baumol model

• Miller and Orr model

The Baumol ModelF = The fixed cost of selling securities to raise

cashT = The total amount of new cash neededK = The opportunity cost of holding cash: this is

the interest rate.

Time

C

If we start with RsC, spend at a constant rate each period and replace our cash with RsC when we run out of cash, our average cash balance will be . And Cost will be C/2 X K

2C

2C

1 2 3

The Baumol Model

C* Size of cash balance

FTKC

C2cost Total

Opportunity Costs

KC

2

FT

CTrading costs

The optimal cash balance is found where the opportunity costs equal the trading costs

FKTC

2*

The Baumol Model

Opportunity Costs = Trading Costs

FCTKC

2

The optimal cash balance is found where the opportunity costs equal the trading costs

KTFC 2*

Multiply both sides by C

FTKC

2

2

KFTC

22

The Miller-Orr ModelThe firm allows its cash balance to wander

randomly between upper and lower control limits.

Rs

Time

H

Z

L

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.

The Miller-Orr Model MathGiven L, which is set by the firm, the

Miller-Orr model solves for Z and H

LKFσZ 3

2*

43 LZH 23 **

where s2 is the variance of net daily cash flows.

• The average cash balance in the Miller-Orr model is

34balancecash Average

* LZ

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. The model clarifies the issues of cash

management:◦ The best return point, Z, is positively related to

trading costs, F, and negatively related to the interest rate K.

◦ Z and the average cash balance are positively related to the variability of cash flows.