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Defined as demand deposits plus currency. Cash is often called a nonearningasset.

Sufficient cash is required (1) to take trade discounts,

(2) to maintain its credit rating, and (3) to meet unexpected cash needs.

Cash management is concerned with themanaging of: cash flows into and out of the firm, cash flows within the firm, and cash balances held by the firm at a point of time by

financing deficit or investing surplus cash

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Transactions Balance A cash balance associated with payments and

collections; the balance necessary for day-to-dayoperations.

Precautionary Balance A cash balance held in reserve for random,

unforeseen fluctuations in cash inflows and outflows. The less predictable the firms cash flows, the larger

such balances should be.

firms that would need large precautionary balancestend to hold highly liquid marketable securities ratherthan cash.

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Speculative Balance A cash balance that is held to enable the firm

to take advantage of any bargain purchasesthat might arise.

Firms today are more likely to rely on reserveborrowing capacity and/or marketable

securities portfolios than on cash per se forspeculative purposes.

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Optimum Cash Balance under Certainty:aumols Model

Optimum Cash Balance under Uncertainty:The MillerOrr Model

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The firm is able to forecast its cash needswith certainty.

The firmscash payments occur uniformlyover a period of time.

The opportunity cost of holding cash isknown and it does not change over time.

The firm will incur the same transactioncost whenever it converts securities tocash.

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The firm incurs a holding costfor keeping the cash balance.It is an opportunity cost; that is, the return foregone on themarketable securities. If the opportunity cost is k, then thefirmsholding cost for maintaining an average cash balanceis as follows:

The firm incurs a transaction cost whenever it converts itsmarketable securities to cash. Total number of transactionsduring the year will be total funds requirement, T, divided bythe cash balance, C, i.e., T/C. The per transaction cost isassumed to be constant. If per transaction cost is c, then thetotal transaction cost will be:

The total annual cost of the demand for cash will be:

The optimum cash balance, C*, is obtained when the totalcost is minimum. The formula for the optimum cash balanceis as follows:

Holding cost = ( / 2)k C

Transaction cost = ( / )c T C

* 2cTC

k

Total cost = ( / 2) ( / )k C c T C

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Baumol s model for cash balance Cost trade-off: Baumol s model

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The MO model provides for two control limitsthe upper control limit and the lower controllimit as well as a return point.

If the firms cash flows fluctuate randomly andhit the upper limit, then it buys sufficientmarketable securities to come back to a normallevel of cash balance (the return point).

When the firms cash flows wander and hit thelower limit, it sells sufficient marketablesecurities to bring the cash balance back to thenormal level (the return point).

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The difference between the upper limit andthe lower limit depends on the followingfactors: the transaction cost (c)

the interest rate, (i)

the standard deviation (s) of net cash flows.

The formula for determining the distance

between upper and lower control limits(called Z) is as follows:

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1/ 3(Upper Limit Lower Limit) = (3/ 4 Transaction Cost Cash Flow Variance/ Interest Rate)

Upper Limit = Lower Limit + 3

Return Point = Lower Limit +

The net effect is that the firms hold the average the cash balance equal to:

Average C

Z

Z

ash Balance = Lower Limit + 4/3Z

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Treasury bills Commercial papers Certificates of deposits Bank deposits Inter-corporate deposits Money market mutual funds http://www.fimmda.org

http://www.fimmda.org/http://www.fimmda.org/

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Ready Cash Segment: Optimal balance ofmarketable securities held to take care ofprobable deficiencies in the firms cash account.

Controllable Cash Segment: Marketable securitiesheld for meeting controllable (knowable)outflows, such as taxes and dividends.

Free cash segment :Free marketable securities(that is, available for as yet unassignedpurposes).

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Cash planning Managing the cash flows Optimum cash level Investing surplus cash

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Cash planning is a technique to plan andcontrol the use of cash. Cash Forecasting and Budgeting

Cash budgetis the most significant device to planfor and control cash receipts and payments. Cash forecastsare needed to prepare cash

budgets.

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A table showing cash flows (receipts,disbursements, and cash balances) for a firmover a specified period.

Target Cash Balance The desired cash balance that a firm plans to

maintain in order to conduct business.

You dont have to worry about predictingshort-term fluctuations in cash flow, if youhave solid bank commitments.

Cash budget page 8

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Selecting Investment Opportunities: Safety Maturity and Marketability.

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Realistically, the management of cash and marketable securitiescannot be separated

Benefits and costs associated with holding cash and marketablesecurities.

The benefits are twofold:

(1) the firm reduces transactions costs because it wont have to issuesecurities or borrow as frequently to raise cash; and

(2) it will have ready cash to take advantage of bargain purchases orgrowth opportunities.

The primary disadvantage is that the after-tax return on cash andshort-term securities is very low. Thus, firms face a trade-off betweenbenefits and costs.

Capital markets

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Ready Cash Segment:Safety and ability to convert to cash is most important.

Select TB for this segment.

Controllable Cash Segment:

Marketability less important. Possibly match time needs.

May select CD, REPOS for this segment.

Free cash segment :

Base choice on yield subject to risk-return trade-offs.

Any money market instrument may be selected for thissegment.