19.1 Reasons for Holding Cash
The basic objective of cash management is to keep the investment in cash as low as possible while ensuring the firm can operate efficiently. Economist John Maynard Keynes identified three primary motives for holding cash:
- Speculative Motive: To take advantage of unexpected opportunities, such as bargain purchases or favorable interest rates.
- Precautionary Motive: To have a safety supply of cash to act as a financial reserve for unexpected events.
- Transaction Motive: To have cash on hand to pay for day-to-day expenses, such as wages, trade debts, and taxes. This is the most important motive for holding cash.
The Opportunity Cost of Holding Cash
When a firm holds cash in excess of its necessary minimum, it incurs an opportunity cost. This is the interest income that could have been earned by investing the cash in marketable securities. The goal is to find a balance between the cost of holding too much cash (opportunity cost) and the cost of holding too little (potential cash shortages).
19.2 Understanding Float
Float is the difference between the cash balance on a firm's books (the ledger balance) and the balance in its bank account (the available balance). It represents the net effect of checks in the clearing process.
Types of Float
- Disbursement Float: This is generated by checks the firm has written. It causes the firm's available balance to be higher than its book balance. (Float > 0)
- Collection Float: This is generated by checks the firm has received but which have not yet cleared. It causes the firm's available balance to be lower than its book balance. (Float < 0)
- Net Float: The sum of disbursement and collection float. A firm's goal is to manage its float to maximize available cash.
Measuring and Valuing Float
The size of the float depends on the dollar amount and the time delay. Average daily float is calculated as: Average Daily Receipts × Weighted Average Delay. The value of eliminating float is the one-time increase in cash that becomes available for investment. For example, reducing a 3-day collection float on \$1,000 of daily receipts frees up \$3,000 in cash immediately. The NPV of a float reduction project is this one-time cash benefit minus the present value of the costs.
19.3 Cash Collection and Concentration
The objective in cash collection is to reduce the delay between the time customers pay and the time the cash is available. This delay has three components: mailing time, processing delay, and availability delay.
Lockbox Systems
A lockbox system is a common method for speeding up collections. Customers mail their payments to a special post office box that is managed by a bank. The bank collects the checks several times a day, deposits them directly into the firm's account, and sends the firm the transaction details. This system reduces mailing time and the firm's internal processing delay.
Cash Concentration
Cash concentration is the process of moving cash from multiple collection points into a central account (a concentration bank). This simplifies cash management and allows the firm to pool its funds for short-term investing. Funds can be transferred using Depository Transfer Checks (DTCs), Automated Clearinghouse (ACH) transfers, or wire transfers, with wire transfers being the fastest and most expensive option.
19.4 Managing Cash Disbursements
While maximizing disbursement float by intentionally delaying payments is often considered unethical and poor business practice, firms can still control disbursements to minimize the amount of cash tied up for payments.
Disbursement Control Systems
- Zero-Balance Accounts: A firm maintains a master account and several subaccounts (e.g., for payroll, suppliers). Funds are transferred from the master account to the subaccounts only when checks need to be paid. This allows the firm to keep a single safety stock of cash in the master account, reducing the total amount of idle cash.
- Controlled Disbursement Accounts: A system where the bank informs the firm in the morning of the total amount of checks that will be presented for payment that day. The firm then transfers the exact amount needed, minimizing idle balances.
19.5 Investing Idle Cash
Firms with temporary cash surpluses can invest in short-term, highly liquid securities in the money market. The choice of investment depends on its maturity, default risk, marketability, and taxability.
Common Money Market Securities
- U.S. Treasury Bills (T-bills): Short-term obligations of the U.S. government with negligible default risk.
- Commercial Paper: Unsecured short-term debt issued by corporations.
- Certificates of Deposit (CDs): Short-term loans to commercial banks.
- Repurchase Agreements (Repos): Short-term sales of government securities with an agreement to repurchase them at a later date.
Chapter Review and Critical Thinking Questions
Solution: Yes, a firm can have too much cash. While cash provides a safety buffer, it is a low-return (or no-return) asset. Shareholders would care because excess cash that is not being productively invested represents an opportunity cost—the money could have been returned to shareholders (via dividends or share buybacks) to invest elsewhere for a higher return, or it could have been invested by the firm in positive-NPV projects.
Solution: If a firm has too much cash, it can invest in marketable securities, pay down debt, buy back stock, pay dividends, or acquire another company. If a firm has too little cash, it can sell marketable securities or borrow on a short-term basis.
Solution: Not necessarily. Creditors generally prefer the firm to hold more cash, as it increases the firm's liquidity and reduces the probability of default on its loans. Stockholders, on the other hand, may prefer less cash and more investment in higher-return projects to maximize their wealth, even if it means taking on more risk.
Solution: Large, successful firms might hold large cash balances for several reasons: as a precautionary measure against economic downturns (like the COVID-19 pandemic), to fund large, ongoing R&D projects, to maintain flexibility for strategic acquisitions, or because they generate so much cash from operations that they accumulate it faster than they can reinvest it or return it to shareholders.
Solution: Liquidity management is a broader concept concerning the optimal level of liquid assets a firm should hold (both cash and marketable securities). Cash management is a narrower part of liquidity management, focused specifically on optimizing the mechanisms for collecting and disbursing cash to minimize the need for non-earning cash balances.
Solution: It is attractive for two main reasons: (1) A significant portion (50% or more) of the dividends received by a corporation is exempt from federal taxes, which provides a higher after-tax return compared to fully taxable interest income. (2) Tying the dividend to short-term rates (as in auction rate preferred stock) reduces the stock's price volatility, making it a safer investment for temporarily idle cash.
Solution: A firm would prefer a net disbursement float. A disbursement float means the firm's available bank balance is higher than its book balance, which is a source of interest-free financing. A net collection float means the available balance is lower than the book balance, which represents an opportunity cost of tied-up funds.
Solution: The situation is a \$500,000 net disbursement float. This means the firm has written checks that have not yet cleared. The ethical dilemma arises if the firm knowingly and systematically writes checks against uncollected funds or funds that are not yet in its account, a practice known as check kiting, which is illegal and unethical.
Solution:
a. U.S. Treasury bills: The primary disadvantage is their low return.
b. Ordinary preferred stock: Significant price volatility due to interest rate risk.
c. NCDs: Higher default risk than T-bills and less marketability.
d. Commercial paper: Can have low marketability and higher default risk.
e. Revenue anticipation notes: Higher default risk than T-bills.
f. Repurchase agreements: Risk that the other party may default on the agreement to repurchase the securities.
Solution: The issue is that a large cash balance can give management a great deal of discretion. Instead of returning the cash to shareholders, management might be tempted to spend it on value-destroying acquisitions or "pet projects" that benefit their own prestige rather than create shareholder value. A large cash hoard can reduce the pressure on management to run the firm efficiently, thus aggravating the agency conflict between managers and shareholders.
Solution: The primary advantage is improving relationships with suppliers, which could lead to better terms or more reliable service in the future. Many suppliers also offer a cash discount for early payment, which can be a very high-return "investment." The main disadvantage is the opportunity cost of the cash; the firm gives up the ability to earn interest on that cash for the period of early payment.
Solution: The advantage is a reduction in interest expense and a lowering of the firm's financial risk. This could improve the firm's credit rating and financial flexibility. The disadvantage is the loss of the tax shield on the interest payments and the opportunity cost of the cash, which might have been used for a higher-return investment.
Solution: Yes, this is unethical. The practice described is check kiting. Even if no checks bounce, it is a form of fraud based on deception. The party being harmed is the grocery store (or its bank), which is unknowingly providing an interest-free loan based on funds that do not exist in the check writer's account. The store bears the risk that the "manna from heaven" never arrives.