Learning ObjectivesUnderstand how firms manage cashUnderstand how to accelerate collections and manage disbursementsUnderstand the characteristics of various short-term securitiesUnderstand the major components of inventory managementBe able to use the EOQ model to determine optimal inventory levels
20-*Reasons for Holding CashSpeculative motive hold cash to take advantage of unexpected opportunitiesPrecautionary motive hold cash in case of emergenciesTransaction motive hold cash to pay the day-to-day billsTrade-off between opportunity cost of holding cash relative to the transaction cost of converting marketable securities to cash for transactions
20-*Understanding FloatFloat difference between cash balance recorded in the cash account and the cash balance recorded at the bankDisbursement floatGenerated when a firm writes checksAvailable balance at bank book balance > 0Collection floatChecks received increase book balance before the bank credits the accountAvailable balance at bank book balance < 0Net float = disbursement float + collection float
20-*Example: Types of FloatYou have $3000 in your checking account. You just deposited $2000 and wrote a check for $2500.What is the disbursement float?What is the collection float?What is the net float?What is your book balance?What is your available balance?
20-*Example: Measuring FloatSize of float depends on the dollar amount and the time delayDelay = mailing time + processing delay + availability delaySuppose you mail a check for $1000 and it takes 3 days to reach its destination, 1 day to process and 1 day before the bank makes the cash availableWhat is the average daily float (assuming 30-day months)?Method 1: (3+1+1)(1000)/30 = 166.67Method 2: (5/30)(1000) + (25/30)(0) = 166.67
20-*Example: Cost of FloatCost of float opportunity cost of not being able to use the moneySuppose the average daily float is $3 million with a weighted average delay of 5 days.What is the total amount unavailable to earn interest?5*3 million = 15 millionWhat is the NPV of a project that could reduce the delay by 3 days if the cost is $8 million?Immediate cash inflow = 3*3 million = 9 millionNPV = 9 8 = $1 million
20-*Cash CollectionOne of the goals of float management is to try to reduce the collection delay. There are several techniques that can reduce various parts of the delay.
20-*Example: Accelerating Collections Part IYour company does business nationally and currently all checks are sent to the headquarters in Tampa, FL. You are considering a lock-box system that will have checks processed in Phoenix, St. Louis and Philadelphia. The Tampa office will continue to process the checks it receives in house. Collection time will be reduced by 2 days on averageDaily interest rate on T-billls = .01%Average number of daily payments to each lockbox is 5000Average size of payment is $500The processing fee is $.10 per check plus $10 to wire funds to a centralized bank at the end of each day.
20-*Example: Accelerating Collections Part IIBenefitsAverage daily collections = 3(5000)(500) = 7,500,000Increased bank balance = 2(7,500,000) = 15,000,000CostsDaily cost = .1(15,000) + 3*10 = 1530Present value of daily cost = 1530/.0001 = 15,300,000NPV = 15,000,000 15,300,000 = -300,000The company should not accept this lock-box proposal
20-*Cash DisbursementsSlowing down payments can increase disbursement float but it may not be ethical or optimal to do thisControlling disbursementsZero-balance accountControlled disbursement account
20-*Investing CashMoney market financial instruments with an original maturity of one year or lessTemporary Cash SurplusesSeasonal or cyclical activities buy marketable securities with seasonal surpluses, convert securities back to cash when deficits occurPlanned or possible expenditures accumulate marketable securities in anticipation of upcoming expenses
20-*Characteristics of Short-Term SecuritiesMaturity firms often limit the maturity of short-term investments to 90 days to avoid loss of principal due to changing interest ratesDefault risk avoid investing in marketable securities with significant default riskMarketability ease of converting to cashTaxability consider different tax characteristics when making a decision
21-*Inventory ManagementInventory can be a large percentage of a firms assetsThere can be significant costs associated with carrying too much inventoryThere can also be significant costs associated with not carrying enough inventoryInventory management tries to find the optimal trade-off between carrying too much inventory versus not enough
21-*Types of InventoryManufacturing firmRaw material starting point in production processWork-in-progressFinished goods products ready to ship or sellRemember that one firms raw material may be another firms finished goodDifferent types of inventory can vary dramatically in terms of liquidity
21-*Inventory CostsCarrying costs range from 20 40% of inventory value per yearStorage and trackingInsurance and taxesLosses due to obsolescence, deterioration or theftOpportunity cost of capitalShortage costsRestocking costsLost sales or lost customersConsider both types of costs and minimize the total cost
21-*Inventory Management - ABCClassify inventory by cost, demand and needThose items that have substantial shortage costs should be maintained in larger quantities than those with lower shortage costsGenerally maintain smaller quantities of expensive itemsMaintain a substantial supply of less expensive basic materials
21-*EOQ ModelThe EOQ model minimizes the total inventory costTotal carrying cost = (average inventory) x (carrying cost per unit) = (Q/2)(CC)Total restocking cost = (fixed cost per order) x (number of orders) = F(T/Q)Total Cost = Total carrying cost + total restocking cost = (Q/2)(CC) + F(T/Q)
21-*Example: EOQConsider an inventory item that has carrying cost = $1.50 per unit. The fixed order cost is $50 per order and the firm sells 100,000 units per year.What is the economic order quantity?
21-*ExtensionsSafety stocksMinimum level of inventory kept on handIncreases carrying costsReorder pointsAt what inventory level should you place an order?Need to account for delivery timeDerived-Demand InventoriesMaterials Requirements Planning (MRP)Just-in-Time Inventory
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*17.*The available balance is more important than the book balance. The firm doesnt want to bounce checks, but they also dont want to carry excess cash.17.*Disbursement float = $2500Collection float = -$2000Net float = 2500 2000 = $500Book balance = $3000 + 2000 2500 = $2500Available balance = $3000
17.*Reducing mailing time lockboxes, Figure 20.3 illustrates how lockboxes can reduce mail delay by having customers mail their payments to PO boxes that are closer to where they live. The processing delay is also reduced because bank employees process the checks instead of the company doing it and then taking the checks to the bank.
Cash concentration reduce management time by having a systematic process for moving cash received in the lock-boxes to a central account. Allows the company to maintain smaller cash balances overall.17.*Slowing payments not ethical to systematically pay bills late; may lose cash discounts by paying late and this can be very expensive
Zero-balance account: maintain a master account, when checks are written on sub-accounts, cash is transferred from the master account to the sub-account to cover the checks; can maintain a smaller overall cash balance by utilizing this technique
Controlled disbursement account cash is transferred to bank account to cover the days anticipated payments*The optimal order quantity is where the cost function is minimized. This will occur where total carrying cost = total restocking cost. If your students have had calculus, you can have them verify that taking the derivative, setting it equal to zero and solving for Q provides the same result.
CC/2 FT/Q2 = 0CC/2 = FT/Q2Q2 = 2TF/CC*Total carrying costs = (2582/2)(1.50) = 1936.50Total restocking costs = 50(100,000)/2582 = 1936.48