finance chapter 6
TRANSCRIPT
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Discuss why firms hold cash and marketablesecurities, and how the levels they hold of eachrelate to those motives.
Demonstrate the three basic strategies for theefficient management of cash using the firm’soperating and cash conversion cycles.
Explain float, including its three basiccomponents, and the firm’s major objectives withrespect to collection float and disbursement float.
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• Review popular techniques for speeding upcollections and slowing down disbursements, therole of banking relationships, and internationalcash management.
• Understand the basic characteristics of marketable securities and the key features of popular government and non-government issues.
• Describe the Baumol model and Miller-Orr model
and how they can be used to determine theoptimum quantity in which to convert marketablesecurities and cash.
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Cash is often called liquid assets ornonearning assets.
It is needed to pay salaries, raw materials,
repayment of loan and others.Specifically there are 3 major motives of holding cash which are:
Transaction Motives
Precautionary Motives
Speculative Motives
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Transactionmotives
The level of funds required due to the ordinary course of business
It is needed to meet ordinary payment such as paying
bills, employees’ salaries, creditors and etc
Precautionary
motives
The funds needed to meet contingency requirement
Funds needed to reserve for emergency needs, unforeseen
fluctuation in cash flows or unexpected seasonal needs
It serves as a safety cushion against the unexpected cash
drain that may arise because of risk and uncertainty
regarding the future
Speculative
motives
To hold sufficient cash to enable the firm to take
advantage of any unexpected bargain or opportunitieswhich may arise from time to time such as trade discounts
or some short term investments
Compensating
balances
Are necessary to compensate financial institutions for
providing loans and services.
Requires the firm to maintain a minimum level of money it
its bank account, normally based on a certain percentageof the loans taken.
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It involves having the optimum amount of cash in hand at the right time
It will also help the firm hold its cash longerand collect cash more quickly
Reasons to have an efficient cashmanagement techniques are:
To establish proper procedures for collectionfrom debtors and payment to creditors
To establish adequate cash floats andminimum cash balances
To synchronize cash inflows and outflows
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The goal of cash management is tominimize the cash balance whilemaintaining a certain level of
liquidity.
Too much liquidity reduces return,whereas too little, increases risk
exposure.
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Cash Flow Management
Estimation Cash Requirements
Developing Borrowing/ Investment Strategies
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Involves the process of controllingthe movement, inflows, andoutflows, of the firm to minimize the
cash required to support workingcapital.
Slowing disbursements and speeding
up collections can do this.
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The estimation of cash requirementsinvolves the preparation of cashbudget, which allow the firm to plan,
coordinate, and control the actualcash flow through the firm.
Once the cash flow has been
estimated, the appropriate level of cash holdings can be established.
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With the establishment of theappropriate cash balance, thestrategies to finance any cash
shortfalls can be developed ahead of time.
In case of cash excess, efficientinvestment strategies can bedeveloped to use idle temporaryliquidity and earn return.
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Speeding upreceipts
Slowing updisbursement
Maintaininggood bankingrelationship
Management of firm’s cash flow
Determining theoptimal cash
balances
Cashbudgeting
Short-termfinancing
strategies for cashshortfalls
Marketable securitiesinvestment strategies
for cash excess
The cash will take care of the profits if the firm takes care of the cash.
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Make all payments as late aspossible. However, take advantageof any favorable discounts offered by
suppliers.
Make all collections as soon aspossible without losing future sales
and use cash discounts to encourageearly payments.
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Turn over the inventory as quicklyas possible and avoid stockoutsthat might result in shutting down
the production line or any loss insales.
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Raw materialspurchases(payable
generated)
Inventoryprocessing
Finishedgoods
inventory
Payment forpurchases(payable
exonerated)
Sale of goods(receivablegenerated)
Paymentreceived
(receivableexonerated)
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The objective of a firm is to run thebusiness effectively without runningout of cash.
Therefore the firm must keep aminimum cash balance.
MOC will allow the firm to invest invarious alternatives and to repaytheir debts when they are due.
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The Operating Cycle (OC) is thetime between ordering materials andcollecting cash from receivables.
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The Cash Conversion Cycle (CC) isthe time between when a firm paysit’s suppliers (payables) for inventoryand collecting cash from the sale of the finished product.
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OC = 110 days
AAI = 70 days ACP = 40 days
Purchase raw materialson credit
Accounts Payable
Sell finished goods oncredit
Accounts Receivable
APP = 30 days CC = 80 days
Pay accounts payableCash Outflows
Collect accountsreceivable
Cash Inflows
0 11010 20 30 40 50 60 70 80 90 100
Company A
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WhereAAI = Average Age of InventoryACP= Average Collection PeriodAPP= Average Payment Period
OC = AAI + ACP
= 70 days + 40 days
= 110 days
CC = OC - APP
= AAI + ACP - APP
= 70 days + 40 days - 30 days
= 80 days
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Cash cycle is a measure of theamount of cash tied up, loweroperating cycle (OC) and cash cycle
(CC) is better as the firm couldrecover the cash outlay in a shorterperiod.
A measure of how effective cash ismanaged in the firm is the cashturnover (CTO).
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Refers to the number of times eachyear the firm’s cash is actually beingturned over
CTO = 360
CC
= 36080
= 4.5 times
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The firm’s cash cycles directly affectthe amount of cash that need to beheld at any given time to support
operations.
This amount represents theminimum operating cash (MOC) to
avoid any cash shortages in meetingall its payments.
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It is the minimum amount of moneyneeded by the company per cycle
MOC = Total annual cash outlay
CTO
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Lets assume that the firm’s annual cashexpenditures are expected at RM300,000.
Therefore the firm needs RM66,666.67 as a
minimum cash requirement to support thefirm’s day-to-day operations without risk of technical insolvency.
MOC = Total annual cash outlay
CTO
= 300,000
4.5
= RM66,666.67
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OC = 110 days
AAI = 70 days ACP = 40 days
Purchase raw materialson credit
Accounts Payable
Sell finished goods oncredit
Accounts Receivable
APP = 30 days CC = 80 days
Pay accounts payableCash Outflows
Collect accountsreceivable
Cash Inflows
0 11010 20 30 40 50 60 70 80 90 100
Before
Company A
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Lets assume that Company A is ableto negotiate a better credit term withits suppliers from 30 days to 35
days;
Improve production and selling thatreduces AAI to 60 days;
Decrease average collection period to33 days.
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OC = 60 days + 33 days
= 93 days
CC = 60 days + 33 days - 35 days
= 58 days
CTO = 360
58
= 6.21 times
MOC = 300,000
6.21
= RM48,309.17
The changesresulted in ashorteroperatingcycle, cashcycle andthus a highercash
turnover.
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OC = 93 days
AAI = 60 days ACP = 33 days
Purchase raw materialson credit
Accounts Payable
Sell finished goods oncredit
Accounts Receivable
APP = 35 days CC = 58 days
Pay accounts payableCash Outflows
Collect accountsreceivable
Cash Inflows
0 11010 20 30 40 50 60 70 80 90 100
After
Company A
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MAX Company, a producer of dinnerware, sells all itsmerchandise on credit.The credit terms require customers to pay within 60 days of a sale.On average, it takes 85 days to manufacture, warehouse,and ultimately sell a finished good. In other words, theaverage age of Inventory (AAI) is 85 days.It also takes an average of 70 days to collect on itsaccounts receivable (ACP).The credit terms for MAX’s raw material purchases currentlyrequire payment within 40 days and employees are paidevery 15 days.
The firm’s weighted average payment period (APP) for rawmaterials and labor is 35 days.Calculate the OC and CC.
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It is crucial for a firm to minimize itscash cycle and maximize cashturnover, without sacrificing the
firm’s liquidity and profitability.As the firm increases its CC (throughreducing the AAI and/or ACP and/or
increasing the APP), the CTO willdecrease and MOC cash will increase.
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Increasing Average Payment Period
Involves delaying payments as late aspossible without damaging the firm’s
credit rating.Favorable cash discount should not beignored, as the opportunity cost is highif not taken.
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Reducing Average Inventory Age
Increase inventory turnover as quicklyas possible by:
Efficient management of inventories
Better production planning, scheduling andcontrol
Effective sales forecasting
Synchronize the production and demand.
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Reducing Average Collection Period
Involves speeding up collection of account receivables without losing
potential sales.The use of proper techniques such aschanges in credit policies and collectionpolicies that will improve collectionperiod will benefit the company.
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The effects of lower cash cycle arequite significant for large firms withcash reserves and cash outlays that
run in millions of Ringgit.
Proper cash management will have adirect impact on the firm’s liquidity
and profits.
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Determining a firm’s desired cashlevel involves a tradeoff between theopportunity costs of holding too
much cash and the costs of holdingtoo little cash.
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Cost RM
Trading Cost
Carrying CostTotal Cost
Size of Cash Balance
The morea firm
holdscash, thelower is
thetradingcost.
The minimumtotal costs
occur wherethe carrying
cost andtrading cost isequal. This isthe optimal
cash balancethat the firmshould have.
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• Cash conversion models are used to helpdetermine the optimal quantity of marketablesecurities to convert into cash when needed (andvice versa).
• The cash conversion quantity depends on anumber of factors, including the fixed cost of transferring funds between cash and marketablesecurities, the rate of interest, and the firms
demand for cash.• The objective of these models is to balance the
costs and benefits of holding cash versusinvesting in marketable securities.
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William J. Baumol developed a model “Thetransactions Demand for Cash: An
Inventory Theoretic Approach” which isusually used in inventory management and
cash management.It is a trade off between opportunity cost/carrying cost/ holding cost and thetransaction cost.
As such firm attempts to minimize the sumof the holding cash & the cost of convertingmarketable securities to cash.
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Assumptions:Cash inflow and outflow are certain;
It does not take into account any
seasonal or cyclical trends.Implications:
The higher the interest rate (opportunitycost), the lower will be the optimal cash
balances;The higher the trading cost, the higherwill be the optimal cash balance.
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Let us assume that the firm sells securitiesand starts with a cash balance of C Ringgit.
When the firm spends cash, its cashbalance starts decreasing and reaches zero.
The firm again gets back its money byselling marketable securities.
As the cash balance decreases gradually,the average cash balance will be:
Average Cash Balance = C
2
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This can be shown in following figure.
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The firm incurs a cost known asholding cost for maintaining the cashbalance.
It is known as opportunity cost, thereturn inevitable on the marketablesecurities.
If the opportunity cost is k, then thefirm’s holding cost for maintaining anaverage cash balance is as follows:
Holding cost = k (C )
2
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Whenever the firm converts its marketablesecurities to cash, it incurs a cost known astransaction cost.
Total number of transactions in a particular
year will be total funds required (T), dividedby the cash balance (C) i.e. T/C.
The assumption here is that the cost pertransaction is constant.
If the cost per transaction is c, then thetotal transaction cost will be:
Transaction cost = c (T)
C
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Here,
k, is the opportunity costT is the total funds requirementC is the cash balancec is per transaction cost
Holding cost = k (C )2
Transaction cost = c (T)
C
Total cost k (C) x c (T)
2 C
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Optimum level of cash balance
As the demand for cash, ‘C’ increases, theholding cost will also increase and the
transaction cost will reduce because of adecline in the number of transactions.
Hence, it can be said that there is arelationship between the holding cost
and the transaction cost.The optimum cash balance, C* is obtainedwhen the total cost is minimum.
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Formula for optimum cash balance
Where,C* is the optimum cash balance.T is the total cash needed during the year.
k is the opportunity cost of holding cashbalances.
C* = √ (2cT)
k
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The management of JanCo, a small distributorof sporting goods, anticipates $1,500,000 incans outlays (demand) during the comingyear.
The firm has determined that it costs $30 toconvert marketable securities into cash andvice versa.
The marketable securities portfolio currentlyearns an 8% rate of return.
What is the firm’s optimal cash balance?
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• Like other financial decisions, the goal of the firmis to maintain the level of cash and marketablesecurities that maximizes shareholder and firmvalue.
• Balances that are too high will diminishprofitability -- and balances that are too low willaccentuate risk.
• Although the more sophisticated mathematical
estimation models are beyond our scope, theoverriding objective is to balance risk againstreturn.
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• In addition to earning a return on
temporarily idle funds, marketable
securities serve as a safety stock of cash
that can be deployed to satisfy unexpecteddemands for funds.
• For example, if a company wishes to
maintain $70,000 of liquid funds and a
transactions balance of $50,000 -- $20,000
would be held as marketable securities.
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Are near-cash items and consideredas part of cash.
Acts as a cushion against technical
insolvency.
It is as liquid as cash as it takes arelatively short time for conversion
to cash without losing face value.
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Marketable securities are short-term,interest bearing money marketinstruments that can easily be
converted into cash.Securities that are most commonly-held as part of a marketablesecurities portfolio can be segmented
into two groups -- government issuesand non-government issues.
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Reasons for holding marketablesecurities:
As a substitute for cash
For precautionary purposes as a cushionagainst unexpected shortage of bank creditand other emergency cash outflows.
As a temporary investment
Investments in marketable securities to:
Finance seasonal or cyclical need for cash; and
Meet known future financial requirements.
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Marketable securities portfolioconsists of different types of securities that differ in:
Maturity Liquidity
Returns
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The choice of securities in theportfolio is in accordance to thenature of cash available for
investment:
• For immediate cash needsReady CashSegment
• For expenditures that arepredictable
ControllableCash Segment
• For speculative purposesFree CashSegment
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• Concerned with the safety of principalinvestment due to the risk of default inprincipal or interest payment and capitalloss.
Security
• Refers to the ease of converting thesecurities to cash without losing the facevalue.
Liquidity
• Represents the tradeoff between risk andreturns.Yields
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Treasury Bills (T-Bills)
Treasury Notes (T-Notes)
Negotiable Certificate of Deposits(NCDs)
Commercial Paper (CP)
Banker’s Acceptance (BA)
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It is a Government Issue andrepresents the obligation of theTreasury Department.Maturities not exceeding one year;most of the T-bills mature in 91 – 182days, with longer maturity such as 9months and one year.The treasury holds weekly acution at adiscount with the smallestdenomination of RM1,000 and areconsidered as risk-free.
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Payable to order and entitle the holderthe payment of a fixed deposit sum onmaturity.Provides investment outlets for shortterm surplus funds of commercialbanks, merchant banks, discounthouses and finance companies.Evaluation: High liquidity with strongsecondary market, lowest risk, and lowreturn.
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A certificate of deposit, USA, 1932
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A document which certifies that acertain sum of Ringgit has been
deposited with a financial institutionat a specified rate of interest with aspecified maturity period.
Is a negotiable instrument as anevidence of deposit in a commercialbank.
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The amount (smallest RM100,000)and the maturity (commonly 30
days) are dependant on theinvestor’s (depositor’s) needs.)
Evaluation: High liquidity with strong
secondary market, moderate riskthat depends on the bank involvedand high return.
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A short-term unsecured promissorynote issued by a large firm with highcredit standing.
Maturity ranging from 3 – 270 days.Longer maturity requires a formalregistration.
Evaluation: Low liquidity with weak
weak secondary market, moderate risk(depending on the issuer) and return isslightly lower than NCDs.
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Bills of exchange which are drawn onand accepted by commercial ormerchant banks in Malaysia.Created out of a bona fide tradetransaction such as to finance importand export of goods to/from Malaysiaand sale and purchase of goods and
services within Malaysia.Similar to cashier’s check payable inthe future with typical maturity of 30days or 180 days.
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Arises from a short-term arrangementbetween a purchaser and its bank for
financing of certain transactions.The purchaser with its bank approval,issues a draft, on which payment iscontingent on some events, to the seller
for the amount purchased.The seller who holds the BA may then sellit at a discount in the secondary market toobtain immediate funds.
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In the Malaysian money market,major securities are:
Bankers Acceptance
Negotiable Money Market Instruments
Malaysian Government Securities
Malaysian Government Treasury Bills
Cagamas Bonds
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The cash management andmarketable securities are highlydependant on each other, therefore it
must be managed concurrently.These two liquid assets represent thefirm’s liquidity that will determine its
long-term viability and ability toincrease stockholders’ wealth.
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1. Financial Analysis by Omar Samadand Mohd Sabri Hj Mohd Amin,InED, UiTM Shah Alam.
2. Financial Management by Rohani A.Ghani and Mohd Sabri Hj MohdAmin, InED, UiTM Shah Alam.
3. Financial Market and Institution byRohani A. Ghani and Ibrahim Ab.Rahman, InED, UiTM.
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End of Chapter 6