managing cash flows

Working Capital ManagementCourse Code: FIN 6407

Fatima Khan

Lecturer in Finance

Northern University

Khulna

Managing Cash Inflows and Outflows

Text: Modern Working Capital Frederick C. Scherr

Chapter 2

Cash inflows• payment for goods or services from your customers• receipt of a bank loan• interest on savings and investments• shareholder investmentsCash outflows• purchase of stock, raw materials or tools• wages, rents and daily operating expenses• purchase of fixed assets - PCs, machinery, office

furniture, etc• loan repayments• dividend payments• Income tax, corporation tax, VAT and other taxes

Managing Cash Flows

Cash Management

Encompasses the design of collections and disbursement systems for cash and the temporary investment of cash while it resides with the firm.

Managing Cash Flows

Objectives of Cash Management

• Cash doesn’t earn a return• Want to maintain liquidity

– Take cash discounts– Maintain firm’s credit rating– Minimize interest costs– Avoid insolvencyGood cash management implies

maintaining adequate liquidity with minimum cash in bank, also a portion of the cash balance can be placed into marketable securities

Why hold cash and marketable securities?

Cash and short-term interest-bearing investments are the least productive assets, because they are:

Not part of production Provides no direct returnBut still firms need to hold cash and

marketable securities, why?

1. Cash for Transactions: For transaction demand For payment to suppliers To make change for cash sales

Managing Cash Flows

2. Cash and Near-Cash Assets as Hedges: Unexpected emergencies Can hold little cash at hand and the

rest in form of near-cash assets Trade-off between interest revenue

and transaction costs involved

Managing Cash Flows

3. Temporary Investments: Payout excess cash to security

holders Make temporary investment

Managing Cash Flows

• Transaction demand: need money to pay bills , wages, etc.

• Precautionary demand: need money to handle emergencies [unforeseen expenses]

• Speculative demand: need money to take advantage of unexpected opportunities

Managing Cash Flows

The Money Market

Motivation of holding near-cash assets:Hedging of cash flow uncertainty Temporary investment of surplus fundsMoney market provides highly safe and liquid

near-cash assets for investmentSources of short-term borrowing for larger

corporations

Managing Cash Flows

Term structure of interest rates

In finance, the yield curve is a curve showing several yields or interest rates across different contract lengths (2 month, 2 year, 20 year, etc...) for a similar debt contract. The curve shows the relation between the (level of) interest rate (or cost of borrowing) and the time to maturity.

The shape of the yield curve is influenced by supply and demand.

• Yield curves are usually upward sloping the longer the maturity, the higher the yield, with diminishing marginal increases. There are two common explanations for upward sloping yield curves.

• First, it may be that the market is anticipating a rise in the risk-free rate. If investors hold off investing now, they may receive a better rate in the future.

• Another explanation is that longer maturities entail greater risks for the investor (i.e. the lender). A risk premium is needed by the market, since at longer durations there is more uncertainty and a greater chance of catastrophic events that impact the investment.

Required return is influenced through:

• Level of inflationary expectation• Relative levels of supply and demand for

various maturities of securities• Levels of differences in investors’

perception regarding risks and return involved in investment

Managing Cash Flows

The US dollar yield curve as of February 9, 2005. The

curve has a typical upward sloping shape.

May 1, 2023 16Fatima;

Managing Cash Flows

Three most common theories of the determination of term structure of interest rates are based on the differences in inflation, relative demand and risk among securities of various maturities.

Expectation TheoryMarket Segmentation TheoryMaturity Preferences Theory


Managing Cash Flows

Expectation TheoryDifferences in per period required returns

among securities of various maturity dates reflect expectations that inflation will change over time.

Expected rise in inflation will raise interest rates on the short term maturity end of the yield curve more than on long maturity end.


Managing Cash Flows

Market Segmentation Theory

Investors prefer securities of different maturities

Yield curve’s level and shape reflect the availability of various maturities relative to these preferences

Larger supply of a particular maturity security, declines the price and the YTM rises


Managing Cash Flows

Upslopping yield curve represents when there are relatively larger supplies of longer maturities securities

Downslopping yield curve represents when there are relatively larger supplies of shorter maturities securities

Longer maturities are said to contain more interest rate risk, so these have higher required rates o return


Managing Cash Flows

Maturity Preference Theory

The shape of the yield curve is merely a reflection of the differences in interest rate risk among maturities

Longer maturities are said to contain more interest rate risk, and have higher required rates of return than shorter maturities

Interest rate risk is the relationship between the interest rate prevailing at the time and the trading price of the security


Managing Cash Flows

Prices of longer-term securities fluctuate much more with changes in interest rate levels than do the prices of short-term securities, so it is riskier, and investors require a higher rate of return.


Managing Cash Flows

The best of these three theories?

Expectation TheoryOr

Market Segmentation TheoryOr

Maturity Preferences Theory


Managing Cash Flows

Maturity preference theory is substantially important, because

it explains empirical observation about yield curve

yield curve is positively slopped most of the times (also may be negatively slopped or even flat)

the longer the maturity the higher the per-period rate of return


Managing Cash Flows

Other than yield curve effect, default risk is also engaged with money market investment


Managing Cash Flows

Treasury Bills

• U.S Government securities with maturities of 91, 182 or 365 days• Free of default risk but interest rate risk occurs for longer maturities• Sold at discount and redeemed at principle at the maturity• A very active secondary market for t-bills of any maturity• Earns a lower return


Managing Cash Flows

Commercial Papers

• Large-denomination unsecured debt matures about in 30 days• Issued by large firms and financial institutions• Some default risks involved, yield higher than T-bills


Managing Cash Flows

Certificates of Deposit

A very large-denomination debt instrument issued by banksMaturities differ with pre specified or semi-variable interest ratesMay be placed directly with investors, or traded in the secondary market with dealers


Managing Cash Flows

Banker’s Acceptance

• Issued by banks, traded through dealers, quite liquid

• Generated in course of international trade


Managing Cash Flows

Repurchase Agreements

• Very short-term investments and financing• Seller agrees to sell a security to the buyer

and the seller agrees to repurchase the security at a higher price


Managing Cash Flows

Eurodollars

• Dollar-denominated loans and certificates of deposit in non-U.S. banks

• In a large denominations, commonly of one week or six months maturities

• Entails a modest default risks, carry a slightly higher interest rates than domestic securities


Managing Cash Flows

Hedged Dividend Capture Strategy

• Holding adjustable rate preferred stock• Holding common shares of firms and

hedging with call options (firms expected to pay dividend as well as sells the option to sell the stock at a specific price)

• Holding shares of an index fund and hedging with index fund call options


Managing Cash Flows

Flotation and Check Clearing

• It is the management of cash when it is not in the firm’s hand, it is in transit to and from the firm– Mail Float– At-firm Float– Clearing Float• Only after this entire process is completed does

the receiving firm receive credit for the cash so that it is able to use the money.


Managing Cash Flows

Suppose a firm receives $ 2 million per day via the transit system, assume that checks were in mail an average of 4 days, that the firm takes 0.5 days to process checks and get them to the bank, and that the firm’s bank takes 1.3 days to obtain funds for the checks. If the firm could accelerate the transit process and had these funds at hand, it could invest them at the firms cost of capital of 10%, What is the opportunity cost of the float?


Managing Cash Flows

Float Type Float Time(days)

Receipts(per day)

Float in Dollars

Mail Float 4.0 $ 2 mil. $ 8.0 mil

At-Firm Float 0.5 $ 2 mil. $1.0 mil

Clearing Float 1.3 $ 2 mil. $2.6 mil

Total Transit Time

5.8 Total Float $ 11.6 mil

Required Return 0.10 per year$1.16 mil per year

Opportunity Cost of Float


Managing Cash Flows

Strategies to reduce delays in receiving funds

• Selection of banks with accelerated clearing capabilities through

Clearing houses Correspondent banks


Managing Cash Flows

Acceleration of Check Processing at the Firm

• Checks are received at various locations and the eventful deposit of these items

• Adopt processing procedures that speed checks into the clearing process


Managing Cash Flows

Use of Electronic Collection Procedures

• An electronic message of payment for the check

• Posses substantial costs and benefits for the firms involved


Managing Cash Flows

Uses of Lockbox

• Lockboxes allow organization to streamline receipts

• A “lockbox” is a post office number to which some or all of the firm’s customers are instructed to send their checks, banks are permitted to take these checks and immediately start them in clearing process

• In this way, at-firm float is eliminated


Managing Cash Flows

• Two mailing addresses can lead to misrouting of some documents.

• Delay, errors and cost entailed for these misrouting documents.

Lock-boxes are not a problem-free panacea for flotation problems, their proper uses can reduce all types of flotation on incoming checks


Managing Cash Flows

Decisions in formulation of lockbox strategies

• Where should the firm locate it’s lockboxes?

• To which lockboxes should each of the firms customers send their checks?


Managing Cash Flows

Lockbox Location Problem• Mathematical and programming procedures for

solving lockbox location problems• Firms use both mathematical solution and

programming suggestions for determining lockbox location

• Firms seek to minimizes the sum of a) Opportunity costs of float on incoming cashb) The costs of the lockbox systemA trade-off between these two sets of costs, additional

lockboxes reduce opportunity costs of float, but adds additional fixes costs

Managing Cash Flows

Fatima; May 1, 2023

Number of Lockboxes in System


Managing Cash Flows

The firm must collect four sets of data:

• The mail and clearing times for sending checks from each part of the firm’s geographic sales area to each possible lockbox.

• The total amount of daily funds and number of checks received by the firm from each part of the sales area


Managing Cash Flows

• The required rate of return• The variable and fixed costs of each

proposed lockbox site

The firm must collect four sets of data:

The optimal solution is the lockbox which has the lowest total cost, defined as the sum of opportunity cost of float and the costs of the lockbox


Managing Cash Flows


Managing Cash Flows

• The optimal solution to the one lockbox problem is the lockbox which has the lowest total cost

• But what about a larger corporation operating in big country like USA?


Managing Cash Flows

A lockbox location problem algorithm

• Some lockbox and customer assignment routines will find the optimum [least cost] combination of lockbox and assignments

• Routines that lead to optimum solutions are more difficult to calculate

• Trade-off between ease of computation versus the guarantee of and optimum solution


Managing Cash Flows

The variables represent here:i. Whether a lockbox is in use [open] or not

[close]?ii. Whether customers from a particular

region are assigned to a particular lockbox or not?


Managing Cash Flows

Here, j = prospective lockbox bank location i = the zone which the customers

check originates n = the number of possible lockboxes m = the number of zones


Managing Cash Flows

To evaluate a lockbox at location j. we need to know the charges from opening and using the lockbox.

Fixed charges of opening lockboxes+ check processing charges + opportunity cost of float on checks from customers who send their remittances to lockbox


Managing Cash Flows

• Some logical constraints are:– Checks from each customer zone must be

received at a lockbox somewhere– Lockbox must be open for receipts from a

customer zone to be received there– There should be only one lockbox open at

location j and customers from zone i may send their checks to one and only lockbox

– To constraint the solution to the problem to the best solution for a maximum of k lockboxes


Managing Cash Flows

Some warnings about lockbox location decisions

• Determining customer zone• Obtaining bank cost data• Obtaining a representative sample of

check volume and origination• The costing of float• Interaction with availability on borrowing

capacity

managing cash flows

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