Concentration banking and lock box system

Corporate Finance

Ross, Westerfield, Jaffe, Jordan (2016). Corporate Finance, 12th Edition, Published by Mcgraw-Hill Education ISBN 978-1-260-13971-6

Q1:Write a summary of the assigned chapters (Chapter15&17) in no less than three pages that explains the main concepts and principles in the chapters. (3pages)

Q2: Find two Financial articles and write a summary of the article in no less than one page for each that represents a a topic covered in this book. (1 Page each)

Q3:Write a summary of the assigned chapters (Chapter19 &20) in no less than three pages that explains the main concepts and principles in the chapters.

(3pages)

Q4:Write a summary of the assigned chapters (Chapter27&30) in no less than three pages that explains the main concepts and principles in the chapters. (3Pages)

When news breaks about a firm’s bank accounts, it’s usu- ally because the company is running low on cash. However, that wasn’t the case for many companies in early 2015. For example, two of the largest cash balances were held by tech giants Cisco and Microsoft, which held about $52.1 billion and $90.2 billion in cash, respectively. Similarly strik- ing was Google’s cash balance of about $61.2 billion, which

amounted to about $90 per share! Other companies also had large amounts of cash. General Electric (GE) had a cash balance of about $137.4 billion. But no company came close to investment bank Goldman Sachs, with a cash hoard of $224 billion. Why would firms such as these hold such large quantities of cash? We examine cash management in this chapter to find out.

Cash Management

27

This chapter is about how firms manage cash. The basic objective of cash management is to keep the investment in cash as low as possible while still keeping the firm operating effi- ciently and effectively. This goal usually reduces to the dictum, “Collect early and pay late.” Accordingly, we discuss ways of accelerating collections and managing disbursements.

In addition, firms must invest temporarily idle cash in short-term marketable securi- ties. As we discuss in various places, these securities can be bought and sold in the finan- cial markets. As a group they have very little default risk, and most are highly marketable. There are different types of these so-called money market securities, and we discuss a few of the most important ones.

Reasons for Holding Cash John Maynard Keynes, in his classic work The General Theory of Employment, Interest, and Money, identified three motives for liquidity: The speculative motive, the precaution- ary motive, and the transaction motive. We discuss these next.

THE SPECULATIVE AND PRECAUTIONARY MOTIVES The speculative motive is the need to hold cash in order to be able to take advantage of, for example, bargain purchases that might arise, attractive interest rates, and (in the case of international firms) favorable exchange rate fluctuations.

For most firms, reserve borrowing ability and marketable securities can be used to satisfy speculative motives. Thus, there might be a speculative motive for maintaining liquidity, but not necessarily for holding cash per se. Think of it this way: If you have a credit card with a very large credit limit, then you can probably take advantage of any unusual bargains that come along without carrying any cash.

27.1

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830 ■■■ PART VII Short-Term Finance

This is also true, to a lesser extent, for precautionary motives. The precautionary motive is the need for a safety supply to act as a financial reserve. Once again, there prob- ably is a precautionary motive for maintaining liquidity. However, given that the value of money market instruments is relatively certain and that instruments such as T-bills are extremely liquid, there is no real need to hold substantial amounts of cash for precaution- ary purposes.

THE TRANSACTION MOTIVE Cash is needed to satisfy the transaction motive: the need to have cash on hand to pay bills. Transaction-related needs come from the normal disbursement and collection activi- ties of the firm. The disbursement of cash includes the payment of wages and salaries, trade debts, taxes, and dividends.

Cash is collected from product sales, the selling of assets, and new financing. The cash inflows (collections) and outflows (disbursements) are not perfectly synchronized, and some level of cash holdings is necessary to serve as a buffer.

As electronic funds transfers and other high-speed, “paperless” payment mechanisms continue to develop, even the transaction demand for cash may all but disappear. Even if it does, however, there will still be a demand for liquidity and a need to manage it efficiently.

COMPENSATING BALANCES Compensating balances are another reason to hold cash. As we discussed in the previous chapter, cash balances are kept at commercial banks to compensate for banking services the firm receives. A minimum compensating balance requirement may impose a lower limit on the level of cash a firm holds.

COSTS OF HOLDING CASH When a firm holds cash in excess of some necessary minimum, it incurs an opportunity cost. The opportunity cost of excess cash (held in currency or bank deposits) is the inter- est income that could be earned by the next best use, such as investment in marketable securities.

Given the opportunity cost of holding cash, why would a firm hold cash in excess of its compensating balance requirements? The answer is that a cash balance must be main- tained to provide the liquidity necessary for transaction needs—paying bills. If the firm maintains too small a cash balance, it may run out of cash. If this happens, the firm may have to raise cash on a short-term basis. This could involve, for example, selling market- able securities or borrowing.

Activities such as selling marketable securities and borrowing involve various costs. As we’ve discussed, holding cash has an opportunity cost. To determine the appropriate cash balance, the firm must weigh the benefits of holding cash against these costs. We discuss this subject in more detail in the sections that follow.

CASH MANAGEMENT VERSUS LIQUIDITY MANAGEMENT Before we move on, we should note that it is important to distinguish between true cash management and a more general subject, liquidity management. The distinction is a source of confusion because the word cash is used in practice in two different ways. First of all, it has its literal meaning, actual cash on hand. However, financial managers frequently use the word to describe a firm’s holdings of cash along with its marketable securities, and marketable securities are sometimes called cash equivalents, or near-cash. In our

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CHAPTER 27 Cash Management ■■■ 831

discussion of various firms’ cash positions at the beginning of the chapter, for example, what was actually being described was their total cash and cash equivalents.

The distinction between liquidity management and cash management is straightfor- ward. Liquidity management concerns the optimal quantity of liquid assets a firm should have on hand, and it is one particular aspect of the current asset management policies we discussed in our previous chapter. Cash management is much more closely related to optimizing mechanisms for collecting and disbursing cash, and it is this subject that we primarily focus on in this chapter.

In general, the firm needs to balance the benefits of holding cash to meet transactions and avoid insolvency against the opportunity costs of lower returns. A sensible cash man- agement policy is to have enough cash on hand to meet the obligations that may arise in the ordinary course of business and to invest some excess cash in marketable securities for precautionary purposes. All other excess cash should be invested in the business or paid out to investors.1

Understanding Float As you no doubt know, the amount of money you have according to your checkbook can be very different from the amount of money that your bank thinks you have. The reason is that some of the checks you have written haven’t yet been presented to the bank for payment. The same thing is true for a business. The cash balance that a firm shows on its books is called the firm’s book, or ledger, balance. The balance shown in its bank account as available to spend is called its available, or collected, balance. The difference between the available balance and the ledger balance, called the float, represents the net effect of checks in the process of clearing (moving through the banking system).

DISBURSEMENT FLOAT Checks written by a firm generate disbursement float, causing a decrease in the firm’s book balance but no change in its available balance. For example, suppose General Mechanics, Inc. (GMI), currently has $100,000 on deposit with its bank. On June 8, it buys some raw materials and pays with a check for $100,000. The company’s book balance is immedi- ately reduced by $100,000 as a result.

GMI’s bank, however, will not find out about this check until it is presented to GMI’s bank for payment on, say, June 14. Until the check is presented, the firm’s available bal- ance is greater than its book balance by $100,000. In other words, before June 8, GMI has a zero float:

Float 5 Firm’s available balance 2 Firm’s book balance 5 $100,000 2 100,000 5 $0

GMI’s position from June 8 to June 14 is:

Disbursement float 5 Firm’s available balance 2 Firm’s book balance 5 $100,000 2 0 5 $100,000

27.2

1There is some evidence that corporate governance has some role in the cash holdings of U.S. firms. Jarrad Harford, Sattar A. Mansi, and William F. Maxwell, in “Corporate Governance and Firm Cash Holdings in the U.S.,” Journal of Financial Economics 87, no. 3 (2008), pp. 535–55, find that firms with weaker corporate governance systems have smaller cash reserves. The combination of excess cash and weak governance leads to more capital spending and more acquisitions.

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832 ■■■ PART VII Short-Term Finance

While the check is clearing, GMI has a balance with the bank of $100,000. It can obtain the benefit of this cash during this period. For example, the available balance could be temporarily invested in marketable securities and thus earn some interest. We will return to this subject a little later.

COLLECTION FLOAT AND NET FLOAT Checks received by the firm create collection float. Collection float increases book balances but does not immediately change available balances. For example, suppose GMI receives a check from a customer for $100,000 on October 8. Assume, as before, that the company has $100,000 deposited at its bank and a zero float. It deposits the check and increases its book balance by $100,000 to $200,000. However, the additional cash is not available to GMI until its bank has presented the check to the customer’s bank and received $100,000. This will occur on, say, October 14. In the meantime, the cash position at GMI will reflect a collection float of $100,000. We can summarize these events. Before October 8, GMI’s position is:

Float 5 Firm’s available balance 2 Firm’s book balance 5 $100,000 2 100,000 5 $0

GMI’s position from October 8 to October 14 is:

Collection float 5 Firm’s available balance 2 Firm’s book balance 5 $100,000 2 200,000 5 2$100,000

In general, a firm’s payment (disbursement) activities generate disbursement float, and its collection activities generate collection float. The net effect—that is, the sum of the total collection and disbursement floats—is the net float. The net float at a point in time is simply the overall difference between the firm’s available balance and its book balance. If the net float is positive, then the firm’s disbursement float exceeds its collection float, and its available balance exceeds its book balance. If the available balance is less than the book balance, then the firm has a net collection float.

A firm should be concerned with its net float and available balance more than with its book balance. If a financial manager knows that a check written by the company will not clear for several days, that manager will be able to keep a lower cash balance at the bank than might be possible otherwise. This can generate a great deal of money.

For example, take the case of ExxonMobil. The average daily sales of ExxonMobil are about $1 billion. If ExxonMobil’s collections could be sped up by a single day, then ExxonMobil could free up $1 billion for investing. At a relatively modest .01 percent daily rate, the interest earned would be on the order of $100,000 per day.

EXAMPLE 27.1 Staying Afloat Suppose you have $5,000 on deposit. One day, you write a check for $1,000 to

pay for books, and you deposit $2,000. What are your disbursement, collection, and net floats? After you write the $1,000 check, you show a balance of $4,000 on your books, but the bank

shows $5,000 while the check is clearing. The difference is a disbursement float of $1,000. After you deposit the $2,000 check, you show a balance of $6,000. Your available balance

doesn’t rise until the check clears. This results in a collection float of −$2,000. Your net float is the sum of the collection and disbursement floats, or −$1,000.

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CHAPTER 27 Cash Management ■■■ 833

FLOAT MANAGEMENT Float management involves controlling the collection and disbursement of cash. The objective of cash collection is to speed up collections and reduce the lag between the time customers pay their bills and the time the cash becomes available. The objective of cash disbursement is to control payments and minimize the firm’s costs associated with making payments.

Total collection or disbursement times can be broken down into three parts: Mailing time, processing delay, and availability delay:

1. Mailing time is the part of the collection and disbursement processes during which checks are trapped in the postal system.

2. Processing delay is the time it takes the receiver of a check to process the payment and deposit it in a bank for collection.

3. Availability delay refers to the time required to clear a check through the banking system.

Speeding up collections involves reducing one or more of these components. Slowing up disbursements involves increasing one of them. We will describe some procedures for managing collection and disbursement times later. First, we need to discuss how float is measured.

Measuring Float The size of the float depends on both the dollars and the time delay involved. For example, suppose you mail a check for $500 to another state each month. It takes five days in the mail for the check to reach its destination (the mailing time) and one day for the recipient to get over to the bank (the processing delay). The recipi- ent’s bank holds out-of-state checks for three days (availability delay). The total delay is 5 1 1 1 3 5 9 days.

In this case, what is your average daily disbursement float? There are two equivalent ways of calculating the answer. First, you have a $500 float for nine days, so we say that the total float is 9 3 $500 5 $4,500. Assuming 30 days in the month, the average daily float is $4,500/30 5 $150.

Alternatively, your disbursement float is $500 for 9 days out of the month and zero the other 21 days (again, assuming 30 days in a month). Your average daily float is thus:

Average daily float 5 (9 3 $500 1 21 3 $0)/30 5 9/30 3 $500 1 21/30 3 $0 5 $4,500/30 5 $150

This means that, on an average day, your book balance is $150 less than your available balance, representing a $150 average disbursement float.

Overall, you show $6,000 on your books. The bank shows a $7,000 balance, but only $5,000 is available because your deposit has not been cleared. The discrepancy between your available balance and your book balance is the net float (−$1,000), and it is bad for you. If you write another check for $5,500, there may not be sufficient available funds to cover it, and it might bounce. This is why financial managers have to be more concerned with available balances than book balances.

For a real-world example of float management services, visit www.carreker .fiserv.com.

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Things are only a little more complicated when there are multiple disbursements or receipts. To illustrate, suppose Concepts, Inc., receives two items each month as follows:

Amount

Processing and availability delay

Total float

Item 1: $5,000,000 Item 2: $3,000,000 Total: $8,000,000

3 9 3 5

= $45,000,000 = $15,000,000 $60,000,000

The average daily float is equal to:

Average daily float 5 Total float _________ Total days (27.1) 5 $60 million __________ 30 5 $2 million

So, on an average day, there is $2 million that is uncollected and not available. Another way to see this is to calculate the average daily receipts and multiply by the

weighted average delay. Average daily receipts are:

Average daily receipts 5 Total receipts

____________ Total days 5 $8 million _________ 30 5 $266,666.67

Of the $8 million total receipts, $5 million, or 5⁄8 of the total, is delayed for nine days. The other 3⁄8 is delayed for five days. The weighted average delay is thus:

Weighted average delay 5 (5y8) 3 9 days 1 (3y8) 3 5 days 5 5.625 1 1.875 5 7.50 days

The average daily float is thus:

Average daily float 5 Average daily receipts 3 Weighted average delay (27.2)

5 $266,666.67 3 7.50 days 5 $2 million

Some Details In measuring float, there is an important difference to note between collection and disbursement float. We defined float as the difference between the firm’s available cash balance and its book balance. With a disbursement, the firm’s book balance goes down when the check is mailed, so the mailing time is an important component in disbursement float. However, with a collection, the firm’s book balance isn’t increased until the check is received, so mailing time is not a component of collection float.

This doesn’t mean that mailing time is not important. The point is that when collection float is calculated, mailing time should not be considered. As we will discuss, when total collection time is considered, the mailing time is a crucial component.

Also, when we talk about availability delay, how long it actually takes a check to clear isn’t really crucial. What matters is how long we must wait before the bank grants availability—that is, use of the funds. Banks actually use availability schedules to determine how long a check is held based on time of deposit and other factors. Beyond this, availability delay can be a matter of negotiation between the bank and a customer. In a similar vein, for outgoing checks, what matters is the date our account is debited, not when the recipient is granted availability.

Cost of the Float The basic cost of collection float to the firm is simply the oppor- tunity cost of not being able to use the cash. At a minimum, the firm could earn interest on the cash if it were available for investing.

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CHAPTER 27 Cash Management ■■■ 835

Suppose the Lambo Corporation has average daily receipts of $1,000 and a weighted average delay of three days. The average daily float is thus 3 3 $1,000 5 $3,000. This means that, on a typical day, there is $3,000 that is not earning interest. Suppose Lambo could eliminate the float entirely. What would be the benefit? If it costs $2,000 to eliminate the float, what is the NPV of doing so?

Figure 27.1 illustrates the situation for Lambo. Suppose Lambo starts with a zero float. On a given day, Day 1, Lambo receives and deposits a check for $1,000. The cash will become available three days later on Day 4. At the end of the day on Day 1, the book balance is $1,000 more than the available balance, so the float is $1,000. On Day 2, the firm receives and deposits another check. It will collect three days later on Day 5. At the end of Day 2, there are two uncollected checks, and the books show a $2,000 bal- ance. The bank, however, still shows a zero available balance; so the float is $2,000. The same sequence occurs on Day 3, and the float rises to a total of $3,000.

On Day 4, Lambo again receives and deposits a check for $1,000. However, it also collects $1,000 from the Day 1 check. The change in book balance and the change in avail- able balance are identical, 1$1,000; so the float stays at $3,000. The same thing happens every day after Day 4; the float therefore stays at $3,000 forever.2

Figure 27.2 illustrates what happens if the float is eliminated entirely on some Day t in the future. After the float is eliminated, daily receipts are still $1,000. The firm collects the same day because the float is eliminated, so daily collections are also still $1,000. As Figure 27.2 illustrates, the only change occurs the first day. On that day, as usual, Lambo collects $1,000 from the sale made three days before. Because the float is gone, it also collects on the sales made two days before, one day before, and that same day, for an addi- tional $3,000. Total collections on Day t are thus $4,000 instead of $1,000.

What we see is that Lambo generates an extra $3,000 on Day t by eliminating the float. On every subsequent day, Lambo receives $1,000 in cash just as it did before the

Figure 27.1 Buildup of the Float

Beginning float Checks received Checks cleared (cash available) Ending float

$ 0 1,000

2 0 $1,000

1 2 3 54

Day

$1,000 1,000

2 0 $2,000

$2,000 1,000

2 0 $3,000

$3,000 1,000

2 1,000 $3,000

$3,000 1,000

2 1,000 $3,000

. . .

. . .

. . .

. . .

. . .

Beginning float Checks received Checks cleared (cash available) Ending float

$3,000 1,000

2 4,000 $ 0

t t 1 1 t 1 2

Day

$ 0 1,000

2 1,000 $ 0

$ 0 1,000

2 1,000 $ 0

. . .

. . .

. . .

. . .

. . .

Figure 27.2 Effect of Eliminating

the Float

2This permanent float is sometimes called the steady-state float.

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836 ■■■ PART VII Short-Term Finance

float was eliminated. Thus, the only change in the firm’s cash flows from eliminating the float is this extra $3,000 that comes in immediately. No other cash flows are affected, so Lambo is $3,000 richer.

In other words, the PV of eliminating the float is simply equal to the total float. Lambo could pay this amount out as a dividend, invest it in interest-bearing assets, or do anything else with it. If it costs $2,000 to eliminate the float, then the NPV is $3,000 2 2,000 5 $1,000; so Lambo should do it.

EXAMPLE 27.2

EXAMPLE 27.3

Reducing the Float: Part I Instead of eliminating the float, suppose Lambo can reduce it to one day. What is the maximum Lambo should be willing to pay for this?

If Lambo can reduce the float from three days to one day, then the amount of the float will fall from $3,000 to $1,000. From our immediately preceding discussion, we see right away that the PV of doing this is equal to the $2,000 float reduction. Lambo should thus be willing to pay up to $2,000.

Reducing the Float: Part II Look back at Example 27.2. A large bank is willing to provide the float reduction service for $175 per year, payable at the end of each year. The relevant discount rate is 8 percent. Should Lambo hire the bank? What is the NPV of the investment? How do you interpret this discount rate? What is the most per year that Lambo should be willing to pay?

The PV to Lambo is still $2,000. The $175 would have to be paid out every year forever to maintain the float reduction; so the cost is perpetual, and its PV is $175/.08 5 $2,187.50. The NPV is $2,000 2 2,187.50 5 2$187.50; therefore, the service is not a good deal.

Ignoring the possibility of bounced checks, the discount rate here corresponds most closely to the cost of short-term borrowing. The reason is that Lambo could borrow $1,000 from the bank every time a check was deposited and pay it back three days later. The cost would be the interest that Lambo would have to pay.

The most Lambo would be willing to pay is whatever charge results in an NPV of zero. This zero NPV occurs when the $2,000 benefit exactly equals the PV of the costs—that is, when $2,000 5 C / .08, where C is the annual cost. Solving for C, we find that C 5 .08 3 $2,000 5 $160 per year.

Ethical and Legal Questions The cash manager must work with collected bank cash balances and not the firm’s book balance (which reflects checks that have been deposited but not collected). If this is not done, a cash manager could be drawing on uncol- lected cash as a source of funds for short-term investing. Most banks charge a penalty rate for the use of uncollected funds. However, banks may not have good enough accounting and control procedures to be fully aware of the use of uncollected funds. This raises some ethical and legal questions for the firm.

ELECTRONIC DATA INTERCHANGE AND CHECK 21: THE END OF FLOAT? Electronic data interchange (EDI) is a general term that refers to the growing practice of direct, electronic information exchange between all types of businesses. One important use of EDI, often called financial EDI, or FEDI, is to electronically transfer financial information and funds between parties, thereby eliminating paper invoices, paper checks, mailing, and

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handling. For example, it is now possible to arrange to have your checking account directly debited each month to pay many types of bills, and corporations now routinely directly deposit paychecks into employee accounts. More generally, EDI allows a seller to send a bill electronically to a buyer, thereby avoiding the mail. The buyer can then authorize payment, which also occurs electronically. Its bank then transfers the funds to the seller’s account at a different bank. The net effect is that the length of time required to initiate and complete a business transaction is shortened considerably, and much of what we normally think of as float is sharply reduced or eliminated. As the use of FEDI increases (which it will), float management will evolve to focus much more on issues surrounding computerized informa- tion exchange and funds transfers.

One of the drawbacks of EDI (and FEDI) is that it is expensive and complex to set up. However, with the growth of the Internet, a new form of EDI has emerged: Internet e-commerce. For example, networking giant Cisco Systems books millions in orders each day on its website from resellers around the world. Firms are also linking to critical sup- pliers and customers via “extranets,” which are business networks that extend a company’s internal network. Because of security concerns and lack of standardization, don’t look for e-commerce and extranets to eliminate the need for EDI anytime soon. In fact, these are complementary systems that will most likely be used in tandem as the future unfolds.

On October 29, 2004, the Check Clearing for the 21st Century Act, also known as Check 21, took effect. Before Check 21, a bank receiving a check was required to send the physical check to the customer’s bank before payment could be made. Now a bank can transmit an electronic image of the check to the customer’s bank and receive payment immediately. Previously, an out-of-state check might take three days to clear. But with Check 21, the clearing time is typically one day; and often a check can clear the same day it is written. Thus, Check 21 promises to significantly reduce float.

Cash Collection and Concentration From our previous discussion, we know that collection delays work against the firm. All other things being the same, a firm will adopt procedures to speed up collections and thereby decrease collection times. In addition, even after cash is collected, firms need procedures to funnel, or concentrate, that cash where it can be best used. We discuss some common collection and concentration procedures next.

COMPONENTS OF COLLECTION TIME Based on our previous discussion, we can depict the basic parts of the cash collection pro- cess as follows. The total time in this process is made up of mailing time, check-processing delay, and the bank’s availability delay.

27.3

Customer mails

payment

Company receives payment

Mailing time

Processing delay

Availability delay

Collection time

Time

Company deposits payment

Cash available

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The amount of time that cash spends in each part of the cash collection process depends on where the firm’s customers and banks are located and how efficient the firm is in collecting cash.

CASH COLLECTION How a firm collects from its customers depends in large part on the nature of the business. The simplest case would be a business such as a restaurant chain. Most of its customers will pay with cash, check, or credit card at the point of sale (this is called over-the-counter collection), so there is no problem with mailing delay. Normally, the funds will be depos- ited in a local bank, and the firm will have some means (discussed later) of gaining access to the funds.

When some or all of the payments a company receives are checks that arrive through the mail, all three components of collection time become relevant. The firm may choose to have all the checks mailed to one location; more commonly, the firm might have a number of different mail collection points to reduce mailing times. Also, the firm may run its col- lection operation itself or might hire an outside firm that specializes in cash collection. We discuss these issues in more detail in the following pages.

Other approaches to cash collection exist. One that is becoming more common is the preauthorized payment arrangement. With this arrangement, the payment amounts and payment dates are fixed in advance. When the agreed-upon date arrives, the amount is automatically transferred from the customer’s bank account to the firm’s bank account, which sharply reduces or even eliminates collection delays. The same approach is used by firms that have online terminals, meaning that when a sale is rung up, the money is immediately transferred to the firm’s accounts.

LOCKBOXES When a firm receives its payments by mail, it must decide where the checks will be mailed and how the checks will be picked up and deposited. Careful selection of the number and locations of collection points can greatly reduce collection times. Many firms use special post office boxes called lockboxes to intercept payments and speed up cash collection.

Figure 27.3 illustrates a lockbox system. The collection process is started by cus- tomers mailing their checks to a post office box instead of sending them to the firm. The lockbox is maintained by a local bank. A large corporation may actually maintain more than 20 lockboxes around the country.

In the typical lockbox system, the local bank collects the lockbox checks several times a day. The bank deposits the checks directly to the firm’s account. Details of the operation are recorded (in some computer-usable form) and sent to the firm.

A lockbox system reduces mailing time because checks are received at a nearby post office instead of at corporate headquarters. Lockboxes also reduce processing time because the corporation doesn’t have to open the envelopes and deposit checks for collec- tion. All in all, a bank lockbox system should enable a firm to get its receipts processed, deposited, and cleared faster than if it were to receive checks at its headquarters and deliver them itself to the bank for deposit and clearing.

Some firms have turned to what are called “electronic lockboxes” as an alternative to traditional lockboxes. In one version of an electronic lockbox, customers use the telephone or the Internet to access their account—say, their credit card account at a bank—review their bill, and authorize payment without paper ever having changed hands on either end of the transaction. Clearly, an electronic lockbox system is far superior to traditional bill

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payment methods, at least from the biller’s perspective. Look for systems like this to con- tinue to grow in popularity.

CASH CONCENTRATION As we discussed earlier, a firm will typically have a number of cash collection points; as a result, cash collections may end up in many different banks and bank accounts. From here the firm needs procedures to move the cash into its main accounts. This is called cash concentration. By routinely pooling its cash, the firm greatly simplifies its cash manage- ment by reducing the number of accounts that must be tracked. Also, by having a larger pool of funds available, a firm may be able to negotiate or otherwise obtain a better rate on any short-term investments.

In setting up a concentration system, firms will typically use one or more concentra- tion banks. A concentration bank pools the funds obtained from local banks contained within some geographic region. Concentration systems are often used in conjunction with lockbox systems. Figure 27.4 illustrates how an integrated cash collection and cash con- centration system might look. As Figure 27.4 illustrates, a key part of the cash collection and concentration process is the transfer of funds to the concentration bank. There are sev- eral options available for accomplishing this transfer. The cheapest is a depository transfer

Figure 27.3 Overview of Lockbox

Processing

The flow starts when a corporate customer mails remittances to a post office box instead of to the corporation. Several times a day, the bank collects the lockbox receipts from the post office. The checks are then put into the company bank accounts.

Post office box 1

Post office box 2

Customer payments

Customer payments

Customer payments

Customer payments

Firm processes receivables

Local bank collects funds from

post office boxes

Bank begins check-clearing

process

Envelopes opened; separation of

checks and receipts

Deposit of checks into bank accounts

Details of receivables go to firm

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840 ■■■ PART VII Short-Term Finance

check (DTC), which is a preprinted check that usually needs no signature and is valid only for transferring funds between specific accounts within the same firm. The money becomes available one to two days later. Automated clearinghouse (ACH) transfers are basically electronic versions of paper checks. These may be more expensive, depending on the circumstances, but the funds are available the next day. The most expensive means of transfer are wire transfers, which provide same-day availability. Which approach a firm will choose depends on the number and size of payments. For example, a typical ACH transfer might be $200, whereas a typical wire transfer would be several million dollars. Firms with a large number of collection points and relatively small payments will choose the cheaper route, whereas firms that receive smaller numbers of relatively large payments may choose more expensive procedures.

ACCELERATING COLLECTIONS: AN EXAMPLE The decision of whether or not to use a bank cash management service incorporating lock- boxes and concentration banks depends on where a firm’s customers are located and the speed of the U.S. postal system. Suppose Atlantic Corporation, located in Philadelphia, is consider- ing a lockbox system. Its collection delay is currently eight days.

The Association for Financial Professionals has current info about cash management, www.afponline.org.

Figure 27.4 Lockboxes and Concentration

Banks in a Cash Management System

Funds are transferred to concentration bank

Cash manager analyzes bank balance and deposit information and makes cash allocation revision

Statements are sent by mail to firm for receivables processing

Customer payments

Customer payments

Maintenance of cash reserves

Disbursement activity

Short-term investment of cash

Maintenance of compensating

balance at creditor bank

Firm sales office

Concentration bank

Local bank deposits

Post office lockbox receipts

Customer payments

Customer payments

Firm cash manager

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CHAPTER 27 Cash Management ■■■ 841

Atlantic does business in the southwestern part of the country (New Mexico, Arizona, and California). The proposed lockbox system would be located in Los Angeles and oper- ated by Pacific Bank. Pacific Bank has analyzed Atlantic’s cash-gathering system and has concluded that it can decrease collection time by two days. Specifically, the bank has come up with the following information on the proposed lockbox system:

Reduction in mailing time 5 1.0 day Reduction in clearing time 5 .5 day Reduction in firm processing time 5 .5 day

Total 5 2.0 days

The following is also known:

Daily interest on Treasury bills 5 .025% Average number of daily payments to lockboxes 5 2,000 Average size of payment 5 $600

The cash flows for the current collection operation are shown in the following cash flow time chart:

0

Customer mails check

Mailing time

Processing delay

Availability delay

Check is

received

Deposit is

made

Cash is

available

Day 1 2 3 4 5 6 7 8

0

Customer mails check

Mailing time

Processing delay

Availability delay

Check is

received

Deposit is

made

Cash is

available

1 2 3 3.5 Day

4 5 6

The cash flows for the lockbox collection operation will be as follows:

Pacific Bank has agreed to operate this lockbox system for a fee of 25 cents per check processed. Should Atlantic give the go-ahead?

We first need to determine the benefit of the system. The average daily collections from the southwestern region are $1.2 million (52,000 3 $600). The collection time will be decreased by two days, so the lockbox system will increase the collected bank balance by $1.2 million 3 2 5 $2.4 million. In other words, the lockbox system releases $2.4 million to the firm by reducing processing, mailing, and clearing time by two days. From our earlier discussion, we know that this $2.4 million is the PV of the proposal.

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842 ■■■ PART VII Short-Term Finance

To calculate the NPV, we need to determine the PV of the costs. There are several different ways to proceed. First, at 2,000 checks per day and $.25 per check, the daily cost is $500. This cost will be incurred every day forever. At an interest rate of .025 percent per day, the PV is therefore $500y.00025 5 $2 million. The NPV is thus $2.4 million 2 $2 million 5 $400,000, and the system appears to be desirable.

Alternatively, Atlantic could invest the $2.4 million at .025 percent per day. The interest earned would be $2.4 million 3 .00025 5 $600 per day. The cost of the system is $500 per day; so running it obviously generates a profit in the amount of $100 per day. The PV of $100 per day forever is $100y.00025 5 $400,000, just as we calculated before.

Finally, and most simply, each check is for $600 and is available two days sooner if the system is used. The interest on $600 for two days is 2 3 $600 3 .00025 5 $.30. The cost is 25 cents per check, so Atlantic makes a nickel (5$.30 2 .25) on every check. With 2,000 checks per day, the profit is $.05 3 2,000 checks 5 $100 per day, as we previously calculated.

EXAMPLE 27.4 Accelerating Collections In our example concerning the Atlantic Corporation’s proposed lock-

box system, suppose Pacific Bank wants a $20,000 fixed fee (paid annually) in addition to the 25 cents per check. Is the system still a good idea?

To answer, we need to calculate the PV of the fixed fee. The daily interest rate is .025 percent. The annual rate is therefore 1.00025365 2 1 5 9.553%. The PV of the fixed fee (which is paid each year forever) is $20,000y.09553 5 $209,358. Because the NPV without the fee is $400,000, the NPV with the fee is $400,000 2 $209,358 5 $190,642. It’s still a good idea.

Managing Cash Disbursements From the firm’s point of view, disbursement float is desirable, so the goal in managing disbursement float is to slow down disbursements. To do this, the firm may develop strate- gies to increase mail float, processing float, and availability float on the checks it writes. Beyond this, firms have developed procedures for minimizing cash held for payment purposes. We discuss the most common of these in this section.

INCREASING DISBURSEMENT FLOAT As we have seen, slowing down payments comes from the time involved in mail delivery, check processing, and collection of funds. Disbursement float can be increased by writ- ing a check on a geographically distant bank. For example, a New York supplier might be paid with checks drawn on a Los Angeles bank. This will increase the time required for the checks to clear through the banking system. Mailing checks from remote post offices is another way firms slow down disbursement.

Tactics for maximizing disbursement float are debatable on both ethical and economic grounds. First, as we discuss in some detail in the next chapter, payment terms frequently offer a substantial discount for early payment. The discount is usually much larger than any possible savings from “playing the float game.” In such cases, increasing mailing time will be of no benefit if the recipient dates payments based on the date received (as is common) as opposed to the postmark date.

27.4

For a free cash budgeting spreadsheet, go to www.bizfilings.com /toolkit/tools-forms .aspx.

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CHAPTER 27 Cash Management ■■■ 843

Beyond this, suppliers are not likely to be fooled by attempts to slow down dis- bursements. The negative consequences of poor relations with suppliers can be costly. In broader terms, intentionally delaying payments by taking advantage of mailing times or unsophisticated suppliers may amount to avoiding paying bills when they are due—an unethical business procedure.

CONTROLLING DISBURSEMENTS We have seen that maximizing disbursement float is probably a poor business practice. However, a firm will still wish to tie up as little cash as possible in disbursements. Firms have therefore developed systems for efficiently managing the disbursement process. The general idea in such systems is to have no more than the minimum amount necessary to pay bills on deposit in the bank. We discuss some approaches to accomplishing this goal next.

Zero-Balance Accounts With a zero-balance account system, the firm, in cooperation with its bank, maintains a master account and a set of subaccounts. When a check written on one of the subaccounts must be paid, the necessary funds are transferred in from the master account. Figure 27.5 illustrates how such a system might work. In this case, the firm maintains two disbursement accounts, one for suppliers and one for payroll. As shown, if the firm does not use zero-balance accounts, then each of these accounts must have a safety stock of cash to meet unanticipated demands. If the firm does use zero- balance accounts, then it can keep one safety stock in a master account and transfer the funds to the two subsidiary accounts as needed. The key is that the total amount of cash held as a buffer is smaller under the zero-balance arrangement, which frees up cash to be used elsewhere.

Controlled Disbursement Accounts With a controlled disbursement account system, almost all payments that must be made in a given day are known in the morning. The bank informs the firm of the total, and the firm transfers (usually by wire) the amount needed.

Figure 27.5 Zero-Balance Accounts

No zero-balance accounts Payroll account Supplier account

Two zero-balance accounts Master account

Safety stock

Cash transfers

Cash transfers

Payroll account Supplier account

With no zero-balance accounts, separate safety stocks must be maintained, which ties up cash unnecessarily. With zero- balance accounts, the firm keeps a single safety stock of cash in a master account. Funds are transferred into disbursement accounts as needed.

Safety stocks

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844 ■■■ PART VII Short-Term Finance

Investing Idle Cash If a firm has a temporary cash surplus, it can invest in short-term securities. As we have men- tioned at various times, the market for short-term financial assets is called the money market. The maturity of short-term financial assets that trade in the money market is one year or less.

Most large firms manage their own short-term financial assets, carrying out transac- tions through banks and dealers. Some large firms and many small firms use money market mutual funds. These are funds that invest in short-term financial assets for a management fee. The management fee is compensation for the professional expertise and diversification provided by the fund manager.

Among the many money market mutual funds, some specialize in corporate custom- ers. In addition, banks offer arrangements in which the bank takes all excess available funds at the close of each business day and invests them for the firm.

TEMPORARY CASH SURPLUSES Firms have temporary cash surpluses for various reasons. Two of the most important are the financing of seasonal or cyclical activities of the firm and the financing of planned or possible expenditures.

Seasonal or Cyclical Activities Some firms have a predictable cash flow pat- tern. They have surplus cash flows during part of the year and deficit cash flows the rest of the year. For example, Toys “ ” Us, a retail toy firm, has a seasonal cash flow pattern influenced by the holiday season.

A firm such as Toys “ ” Us may buy marketable securities when surplus cash flows occur and sell marketable securities when deficits occur. Of course, bank loans are another short-term financing device. The use of bank loans and marketable securities to meet tempo- rary financing needs is illustrated in Figure 27.6. In this case, the firm is following a compro- mise working capital policy in the sense we discussed in the previous chapter.

27.5

Figure 27.6 Seasonal Cash

Demands

Time (quarters)

Total financing needsBank

loans Marketable securities

Short-term financing

Long-term financing

Time 1: A surplus cash flow exists. Seasonal demand for assets is low. The surplus cash flow is invested in short-term marketable securities. Time 2: A deficit cash flow exists. Seasonal demand for assets is high. The financial deficit is financed by selling marketable securities and by bank borrowing.

Do lla

rs

0 1 2 3

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CHAPTER 27 Cash Management ■■■ 845

Planned or Possible Expenditures Firms frequently accumulate temporary investments in marketable securities to provide the cash for a plant construction pro- gram, dividend payment, or other large expenditure. Thus, firms may issue bonds and stocks before the cash is needed, investing the proceeds in short-term marketable securi- ties and then selling the securities to finance the expenditures. Also, firms may face the possibility of having to make a large cash outlay. An obvious example would involve the possibility of losing a large lawsuit. Firms may build up cash surpluses against such a contingency.

CHARACTERISTICS OF SHORT-TERM SECURITIES Given that a firm has some temporarily idle cash, a variety of short-term securities are available for investing. The most important characteristics of these short-term marketable securities are their maturity, default risk, marketability, and taxability.

Maturity From Chapter 8, we know that for a given change in the level of interest rates, the prices of longer-maturity securities will change more than those of shorter- maturity securities. As a consequence, firms that invest in long-term securities are accept- ing greater risk than firms that invest in securities with short-term maturities.

We called this type of risk interest rate risk. Firms often limit their investments in market- able securities to those maturing in less than 90 days to avoid the risk of losses in value from changing interest rates. Of course, the expected return on securities with short-term maturities is usually less than the expected return on securities with longer maturities.

Default Risk Default risk refers to the probability that interest and principal will not be paid in the promised amounts on the due dates (or will not be paid at all). In Chapter 8, we observed that various financial reporting agencies, such as Moody’s Investors Service and Standard and Poor’s, compile and publish ratings of various corporate and other pub- licly held securities. These ratings are connected to default risk. Of course, some securities have negligible default risk, such as U.S. Treasury bills. Given the purposes of investing idle corporate cash, firms typically avoid investing in marketable securities with significant default risk.

Marketability Marketability refers to how easy it is to convert an asset to cash; so marketability and liquidity mean much the same thing. Some money market instruments are much more marketable than others. At the top of the list are U.S. Treasury bills, which can be bought and sold very cheaply and very quickly.

Taxes Interest earned on money market securities that are not some kind of govern- ment obligation (either federal or state) is taxable at the local, state, and federal levels. U.S. Treasury obligations such as T-bills are exempt from state taxation, but other government- backed debt is not. Municipal securities are exempt from federal taxes, but they may be taxed at the state level.

SOME DIFFERENT TYPES OF MONEY MARKET SECURITIES Money market securities are generally highly marketable and short-term. They usually have low risk of default. They are issued by the U.S. government (e.g., U.S. Treasury bills), domestic and foreign banks (e.g., certificates of deposit), and business corporations (e.g., commercial paper). There are many types in all, and we illustrate only a few of the most common here.

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846 ■■■ PART VII Short-Term Finance

U.S. Treasury bills are obligations of the U.S. government that mature in 30, 90, or 180 days. Bills are sold by auction every week.

Short-term tax-exempts are short-term securities issued by states, municipalities, local housing agencies, and urban renewal agencies. Because these are all considered municipal securities, they are exempt from federal taxes. RANs, BANs, and TANs, for example, are revenue, bond, and tax anticipation notes, respectively. In other words, they represent short-term borrowing by municipalities in anticipation of cash receipts.

Short-term tax-exempts have more default risk than U.S. Treasury issues and are less marketable. Because the interest is exempt from federal income tax, the pretax yield on tax-exempts is lower than that on comparable securities such as Treasury bills. Also, cor- porations face restrictions on holding tax-exempts as investments.

Commercial paper consists of short-term securities issued by finance companies, banks, and corporations. Typically, commercial paper is unsecured. Maturities range from a few weeks to 270 days.

There is no especially active secondary market in commercial paper. As a consequence, the marketability can be low; however, firms that issue commercial paper will often repurchase it directly before maturity. The default risk of commercial paper depends on the financial strength of the issuer. Moody’s and S&P publish quality ratings for commercial paper. These ratings are similar to the bond ratings we discussed in Chapter 8.

Certificates of deposit (CDs) are short-term loans to commercial banks. The most common are jumbo CDs—those in excess of $100,000. There are active markets in CDs of 3-month, 6-month, 9-month, and 12-month maturities.

Repurchase agreements (repos) are sales of government securities (e.g., U.S. Treasury bills) by a bank or securities dealer with an agreement to repurchase. Typically, an investor buys some Treasury securities from a bond dealer and simultaneously agrees to sell them back at a later date at a specified higher price. Repurchase agreements usually involve a very short term—overnight to a few days.

Because 70 to 80 percent of the dividends received by one corporation from another are exempt from taxation, the relatively high dividend yields on preferred stock provide a strong incentive for investment. The only problem is that the dividend is fixed with ordinary preferred stock, so the price can fluctuate more than is desirable in a short-term investment. However, money market preferred stock is a fairly recent innovation featuring a floating dividend. The dividend is reset fairly often (usually every 49 days); so this type of preferred has much less price volatility than ordinary preferred, and it has become a popular short-term investment.

Check out short-term rates online at www.bloomberg .com.

Summary and Conclusions In this chapter, we have examined cash and liquidity management. We saw the following:

1. A firm holds cash to conduct transactions and to compensate banks for the various services they render.

2. The difference between a firm’s available balance and its book balance is the firm’s net float. The float reflects the fact that some checks have not cleared and are thus uncollected. The financial manager must always work with collected cash balances and not with the company’s book balance. To do otherwise is to use the bank’s cash without the bank knowing it, which raises ethical and legal questions.

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CHAPTER 27 Cash Management ■■■ 847

3. The firm can make use of a variety of procedures to manage the collection and disbursement of cash in such a way as to speed up the collection of cash and slow down the payments. Some methods to speed up the collection are the use of lockboxes, concentration banking, and wire transfers.

4. Because of seasonal and cyclical activities, to help finance planned expenditures, or as a contingency reserve, firms temporarily hold a cash surplus. The money market offers a variety of possible vehicles for “parking” this idle cash.

Concept Questions 1. Cash Management Is it possible for a firm to have too much cash? Why would

shareholders care if a firm accumulates large amounts of cash?

2. Cash Management What options are available to a firm if it believes it has too much cash? How about too little?

3. Agency Issues Are stockholders and creditors likely to agree on how much cash a firm should keep on hand?

4. Cash Management versus Liquidity Management What is the difference between cash management and liquidity management?

5. Short-Term Investments Why is a preferred stock with a dividend tied to short-term interest rates an attractive short-term investment for corporations with excess cash?

6. Collection and Disbursement Floats Which would a firm prefer: A net collection float or a net disbursement float? Why?

7. Float Suppose a firm has a book balance of $2 million. At the automatic teller machine (ATM), the cash manager finds out that the bank balance is $2.5 million. What is the situation here? If this is an ongoing situation, what ethical dilemma arises?

8. Short-Term Investments For each of the short-term marketable securities given here, provide an example of the potential disadvantages the investment has for meeting a corporation’s cash management goals:

a. U.S. Treasury bills. b. Ordinary preferred stock. c. Negotiable certificates of deposit (NCDs). d. Commercial paper. e. Revenue anticipation notes. f. Repurchase agreements.

9. Agency Issues It is sometimes argued that excess cash held by a firm can aggravate agency problems (discussed in Chapter 1) and, more generally, reduce incentives for shareholder wealth maximization. How would you describe the issue here?

10. Use of Excess Cash One option a firm usually has with any excess cash is to pay its suppliers more quickly. What are the advantages and disadvantages of this use of excess cash?

11. Use of Excess Cash Another option usually available is to reduce the firm’s outstanding debt. What are the advantages and disadvantages of this use of excess cash?

12. Float An unfortunately common practice goes like this (Warning: Don’t try this at home): Suppose you are out of money in your checking account; however, your local grocery store will, as a convenience to you as a customer, cash a check for you. So, you cash a check for $200. Of course, this check will bounce unless you do something. To prevent this, you go to the grocery the next day and cash another check