CHAPTER19 CASH AND LIQUIDITY MANAGEMENT

Learning Objectives LO1 The importance of float and how it affects the cash balances. LO2 How firms manage their cash and some of the collection, concentration, and disbursement techniques used. LO The advantages and disadvantages to holding cash and some of the ways to invest idle cash. Ans!ers t" C"nce#ts $evie! an% Critica& T'in(ing Q)esti"ns 1* +LO Yes. Once a firm has more cash than it needs for operations and planned expenditures, the excess cash has an opportunity cost. It could be invested by shareholders! in potentially more profitable ways. "uestion # discusses another reason. +LO , If it has too much cash it can simply pay a dividend, or, more li$ely in the current financial environment, buy bac$ stoc$. It can also reduce debt. If it has insufficient cash, then it must either borrow, sell stoc$, or improve profitability. +LO , %robably not. &reditors would probably want substantially more. +LO , It is debatable whether holding enormous cash reserves is the best way to deal with future economic downturns. However, it is true that auto manufacturers' operating cash flows are very sensitive to the business cycle, and enormous losses have occurred during recent downturns. +LO , &ash management is more associated with the collection and disbursement of cash. (iquidity management is broader and concerns the optimal level of liquid assets needed by a firm. Thus, for example, )ord and &hrysler's stoc$piling of cash was liquidity management* whereas, evaluating a loc$box system is cash management. +LO , +uch instruments go by a variety of names, but the $ey feature is that the dividend ad,usts, $eeping the price relatively stable. This price stability, along with the dividend tax exemption, ma$es so-called ad,ustable rate preferred stoc$ very attractive relative to interest-bearing instruments. +LO2, .et disbursement float is more desirable because the ban$ thin$s the firm has more money than it actually does, and the firm is, therefore, receiving interest on funds it has already spent. +LO , a. /bout the only disadvantage to holding T-bills are the generally lower yields compared to alternative money mar$et investments. b. +ome ordinary preferred stoc$ issues pose both credit and price ris$s that are not consistent with most short-term cash management plans. c. The primary disadvantage of &0s is the normally large transactions si1es, which may not be feasible for the short-term investment plans of many smaller to medium-si1ed corporations. d. The primary disadvantages of the commercial paper mar$et are the higher default ris$ characteristics of the security, and the lac$ of an active secondary mar$et which may excessively restrict the flexibility of corporations to meet their liquidity ad,ustment needs. e. If interest rates rise, the bond drops in price. +LO , The concern is that excess cash on hand can lead to poorly thought-out investments. The thought is that $eeping cash levels relatively low forces management to pay careful attention to cash flow and capital spending.

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13* +LO , / potential advantage is that the quic$er payment often means a better price. The disadvantage is that doing so increases the firm's cash cycle. 11* +LO , This is really a capital structure decision. If the firm has an optimal capital structure, paying off debt moves it to an under-leveraged position. However, a combination of debt reduction and stoc$ buy-bac$s could be structured to leave capital structure unchanged. S"&)ti"ns t" Q)esti"ns an% 4r"b&e5s NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. ue to space and readability constraints! when these intermediate steps are included in this solutions manual! rounding may appear to have occurred. "owever! the final answer for each problem is found without rounding during any step in the problem. Basic 1* +LO1, The average daily float is the amount of receipts times the average number of days delay, divided by the number of days in a month. /ssuming 23 days in a month, the average daily float is4 /verage daily float 5 6 782#,333!923 /verage daily float 5 78:,;22.22 2* +LO1, a. The disbursement float is the average monthly chec$s written times the average number of days for the chec$s to clear, so4 0isbursement float 5 6 78<,333! 0isbursement float 5 76:,333 The collection float is the average monthly chec$s received times the average number of days for the chec$s to clear, so4 &ollection float 5 < =7<2,333! &ollection float 5 =76>,333 The net float is the disbursement float plus the collection float, so4 .et float 5 76:,333 = 6>,333 .et float 5 7<,333 b. The new collection float will be4 &ollection float 5 8 =7<2,333! &ollection float 5 =7<2,333 /nd the new net float will be4 .et float 5 76:,333 = <2,333 .et float 5 7<;,333

+LO1, a. The collection float is the average daily chec$s received times the average number of days for the chec$s to clear, so4 &ollection float 5 2 78?,333! &ollection float 5 7;8,333 b. The firm should pay no more than the amount of the float, or 7;8,333, to eliminate the float.

c. The maximum daily charge the firm should be willing to pay is the collection float times the daily interest rate, so4 @aximum daily charge 5 7;8,333 .3338?! Maximum daily charge = $8.67 -* +LO1, a. Total float 5 6 786,333! A 2 7;,333! Total float 5 7?8,333 b. The average daily float is the total float divided by the number of days in a month. /ssuming 23 days in a month, the average daily float is4 /verage daily float 5 7?8,333923 /verage daily float 5 7<,2>>.>? c. The average daily receipts are the average daily chec$s received divided by the number of days in a month. /ssuming a 23 day month4 /verage daily receipts 5 786,333 A ;,333!923 /verage daily receipts 5 7>22.22 The weighted average delay is the sum of the days to clear a chec$, times the amount of the chec$ divided by the total receipts, so4 Beighted average delay 5 6 786,333978#,333! A 2 7;,333978#,333! Beighted average delay 5 2.?6 days .* +LO2, The average daily collections are the number of chec$s received times the average value of a chec$, so4 /verage daily collections 5 78<; >,633! /verage daily collections 5 7:33,333 The present value of the loc$box service is the average daily receipts times the number of days the collection is reduced, so4 %C 5 < day reduction! 7:33,333! %C 5 78,>33,333 The daily cost is a perpetuity. The present value of the cost is the daily cost divided by the daily interest rate. +o4 %C of cost 5 78?;9.3338> %C of cost 5 78,3#2,?;3

The firm should ta$e the loc$box service. The .%C of the loc$box is the cost plus the present value of the reduction in collection time, so4 .%C 5 =78,3#2,?;3 A 8,>33,333 .%C 5 7;3>,<;3 The annual savings excluding the cost would be the future value of the savings minus the annual costs, so4 /nnual savings 5 78,>33,333 8.3338>!2>; = 8,>33,333 /nnual savings 5 7#>,<86.6< /nd the annual cost would be the future value of the daily cost, which is an annuity, so4 /nnual cost 5 78?; )CI)/ 2>;,.38>D! /nnual cost 5 7>;,??8.;: +o, the annual net savings would be4 /nnual net savings 5 7#>,<86.6< = >;,??8.;: /nnual net savings 5 723,66<.:6 /* +LO1, a. The average daily float is the sum of the percentage each chec$ amount is of the total chec$s received times the number of chec$s received times the amount of the chec$ times the number of days until the chec$ clears, divided by the number of days in a month. /ssuming a 23 day month, we get4 /verage daily float 5 E.>3 ;,233! 762! <! A .63 ;,233! 7?;! 2!F923 /verage daily float 5 7<;,38> On average, there is 7<;,38> that is uncollected and not available to the firm. b. The total collections are the sum of the percentage of each chec$ amount received times the total chec$s received times the amount of the chec$, so4 Total collections 5 .>3 ;,233! 762! A .63 ;,233! 7?;! Total collections 5 7<#;,?63 The weighted average delay is the sum of the average number of days a chec$ of a specific amount is delayed, times the percentage that chec$ amount ma$es up of the total chec$s received, so4 Beighted average delay 5 <E.>3 ;,233! 762!97<#;,?63F A 2E.63 ;,233! 7?;! 97<#;,?63F Beighted average delay 5 <.;2?>2663: days The average daily float is the weighted average delay times the average chec$s received per day. /ssuming a 23 day month, we get4 /verage daily float 5 <.;2?>2663: 7<#;,?63923 days! /verage daily float 5 7<;,38> c. d. The most the firm should pay is the total amount of the average float, or 7<;,38>. The average daily interest rate is4 8.3? 5 8 A G!2>; G 5 .38:;6D per day

The daily cost of float is the average daily float times the daily interest rate, so4 0aily cost of the float 5 7<;,38> .3338:;6! 0aily cost of the float 5 76.>6 e. The most the firm should pay is still the average daily float. Hnder the reduced collection time assumption, we get4 .ew average daily float 5 8.; 7<#;,?63923! .ew average daily float 5 786,?:? 0* +LO2, a. The present value of adopting the system is the number of days collections are reduced times the average daily collections, so4 %C 5 2 2:;! 7#?;! %C 5 78,8<>,8<; b. The .%C of adopting the system is the present value of the savings minus the cost of adopting the system. The cost of adopting the system is the present value of the fee per transaction times the number of transactions. This is a perpetuity, so4 .%C 5 78,8<>,8<;= E73.2; 2:;!9.333>:F .%C 5 7#<?,#>2.<2 c. The net cash flows is the present value of the average daily collections times the daily interest rate, minus the transaction cost per day, so4 .et cash flow per day 5 78,8<>,8<; .333>:! = 73.2; 2:;! .et cash flow per day 5 7>28.3< The net cash flow per chec$ is the net cash flow per day divided by the number of chec$s received per day, or4 .et cash flow per chec$ 5 7>28.3<92:; .et cash flow per chec$ 5 78.>2# /lternatively, we could find the net cash flow per chec$ as the number of days the system reduces collection time times the average chec$ amount times the daily interest rate, minus the transaction cost per chec$. 0oing so, we confirm our previous answer as4 .et cash flow per chec$ 5 2 7#?;! .333>:! = 73.2;3 .et cash flow per chec$ 5 78.>2# per chec$ 1* +LO2, a. The reduction in outstanding cash balance from adopting the loc$box is the number of days the system reduces collection time times the average daily collections, so4 &ash balance reduction 5 2 7823,333! &ash balance reduction 5 72#3,333 b. The dollar return that can be earned is the average daily interest rate times the cash balance reduction. The average daily interest rate is4

/verage daily rate 5 8.3#892>; = 8 /verage daily rate 5 .3<2>828D per day The daily dollar return that can be earned from the reduction in days to clear the chec$s is4 0aily dollar return 5 72#3,333 .333<2>! 0aily dollar return 5 7#<.3# c. If the company ta$es the loc$box, it will receive three payments early, with the first payment occurring today. Be can use the daily interest rate from part b, so the savings are4 +avings 5 7823,333 A 7823,333 %CI)/.3<2>D,<! +avings 5 72:#,#3?.#6 If the loc$box payments occur at the end of the month, we need the effective monthly interest rate, which is4 @onthly interest rate 5 8.3#898< = 8 @onthly interest rate 5 3.?<3?D /ssuming the loc$box payments occur at the end of the month, the loc$box payments, which are a perpetuity, will be4 %C 5 &9G 72:#,#3?.#6 5 & 9 .33?<3? & 5 7<,:83.8# It could also be assumed that the loc$box payments occur at the beginning of the month. If so, we would need to use the %C of a perpetuity due, which is4 %C 5 & A & 9 G +olving for &4 & 5 %C I G! 9 8 A G! & 5 2:#,#3?.#6I .33?<3?! 9 8 A .33?<3?! & 5 7<,?#3.3: 2* +LO2, The interest that the company could earn will be the amount of the chec$s times the number of days it will delay payment times the number of wee$s that chec$s will be disbursed times the daily interest rate, so4 Interest 5 7:>,333 ?! ;<9<! .33388! Interest 5 78,?<8.?< 13* +LO2, The benefit of the new arrangement is the 7; million in accelerated collections since the new system will speed up collections by one day. The cost is the new compensating balance, but the company will recover the existing compensating balance, so4 .%C 5 7;,333,333 = 7633,333 = 2;3,333! .%C 5 76,#;3,333 The company should proceed with the new system. The savings are the .%C times the annual interest rate, so4 .et savings 5 76,#;3,333 .3<;! .et savings 5 78<2,?;3

Intermediate 11* +LO2, To find the .%C of ta$ing the loc$box, we first need to calculate the present value of the savings. The present value of the savings will be the reduction in collection time times the average daily collections, so4 %C 5 8.; :33! 7?;3! %C 5 7#33,333 /nd the daily interest rate is4 0aily interest rate 5 8.3;;892>; = 8 0aily interest rate 5 .33386>? or .386>?D per day The transaction costs are a perpetuity. The cost per day is the cost per transaction times the number of transactions per day, so the .%C of ta$ing the loc$box is4 .%C 5 7#33,333 = E73.8; :33!9.33386>?F .%C 5 7:8,##8.?: Bithout the fee, the loc$box system should be accepted. To calculate the .%C of the loc$box with the annual fee, we can simply use the .%C of the loc$box without the annual fee and subtract the addition cost. The annual fee is perpetual, so, with the fee, the .%C of ta$ing the loc$box is4 .%C 5 7:8,##8.?: = E7>,3339.3;;F .%C 5 -7<?,3##.82 Bith the fee, the loc$box system should not be accepted. 12* +LO2, To find the minimum number of payments per day needed to ma$e the loc$box system feasible is the number of chec$s that ma$es the .%C of the decision equal to 1ero. The average daily interest rate is4 0aily interest rate 5 8.3;892>; = 8 0aily interest rate 5 .333822>:8 or .3822>:8D per day The present value of the savings is the average payment amount times the days the collection period is reduced times the number of customers. The costs are the transaction fee and the annual fee. Joth are perpetuities. The total transaction costs are the transaction costs per chec$ times the number of chec$s. The equation for the .%C of the pro,ect, where . is the number of chec$s transacted per day, is4 .%C 5 3 5 7;,?33! 8!. = 73.83 .!9.333822>:8 = 783,3339.3; 7<33,333 5 7;,?33. = 7?6:.3;. 76,#;8.#;. 5 7<33,333 . 5 63.2# 63 customers per day