15. Cash Management

Question 1

Define treasury management.

Answer 1

The efficient management of liquidity and risk in a business including the management of funds (generated from internal and external sources), currencies and cash flow.

Question 2

What are 5 benefits of centralised treasury management?

Answer 2

1. Management by specialised staff with appropriate qualifications, expertise and experience.
2. Economies of scale (eg less staff required in total), as specialists are employed centrally, reducing duplication and maximising the use of skilled Human Resources and financial management systems.
3. Ability to use “pooling”, which is the netting of cash deficits against surpluses to save interest expense from short-term financing.
4. Increased negotiating power with banks as the amounts borrowed or deposited would be more substantial as a group.
5. More efficient foreign exchange risk management because the treasury department at head office can find the group’s net position on each currency and then consider an external hedge on this balance.

Question 3

The aim of good cash management is to have the right amount of cash available at the right time. What are some functions that a treasurer may be involved in?

Answer 3

• accurate cash flow forecasting, so that shortfalls and surpluses can be anticipated.
• planning short-term borrowing when necessary.
• planning investments of surpluses when necessary
• cost efficient cash transmission
• dealing with foreign currency issues
• optimising banking arrangements
• planning major finance-raising exercises
• accounts receivable/payables policies.
• risk assessment
• insurance

Question 4

What are the 3 motives for holding cash?

Answer 4

1. Transaction motive - where cash is held to provide sufficient liquidity to meet current day-to-day financial obligations (eg payroll, the purchase of raw materials, etc).
2. Precautionary motive - where a cash reserve is held in order to give a cushion against unplanned expenditure, rather like a buffer/safety level of inventory. This reserve may be held in the form of cash equivalents, which are short-term, low risk, highly liquid investments (eg treasury bills).
3. Speculative motive - where cash is held to be able to quickly take advantage of investment opportunities that may arise (eg a “war chest” of cash ready to use if a suitable takeover target appears).

Question 5

Rather than leaving it in a bank, how should a company utilise:
- long-term surpluses
- short-term surpluses

Answer 5

1. Long term surpluses should be invested into positive NPV projects, or used to pay a dividend.
2. Short term surpluses should generally be invested in short-term, low-risk, highly liquid investments (eg treasury bills).

Question 6

Outline the Baumol Model. What is its formula?

Answer 6

The Baumol model is the EOQ equivalent for cash. It assumes that:
1. Cash requirements are funded by the sale of short-term investments.
2. Constant annual demand for cash
3. Constant interest rates.
4. Constant cost of each transfer.

The formula:

x = √[(2C_oD)/C_h]

Where:

x = economic transfer
C_h = opportunity cost of holding cash
D = annual requirement for cash
C_o = transaction costs (brokerage, commission, etc) of selling a “parcel” of short-term investments

Question 7

What are some weaknesses of the Baumol Model?

Answer 7

1. The assumption of constant demand for cash is unrealistic. A cash management model which can accommodate a variable demand for cash, such as the Miller-Orr model, may be more relevant.
2. In reality interest rates and transaction costs are not constant and interest rates, in particular, can change frequently.
3. The model assumes that the business is constantly using cash and must finance this by selling investments. However, any worthwhile business must, at some point, generate cash rather than burn it.

Question 8

Outline the Miller-Orr Model. What are some of its underlying assumptions?

Answer 8

The Miller-Orr takes account of uncertainty in relation to cash receipts and payments. The cash balance is allowed to vary between a lower limit set by management judgement and an upper limit calculated by the model:

• if the lower limit is reached, an amount of cash equal to the difference between a default “return point” and the lower limit is raised by selling short-term investments.
• if the upper limit is reached, an amount of cash equal to the difference between the upper limit and the return point is used to buy short-term investments.

The model therefore helps decrease the risk of running out of cash, while avoiding the loss of profit caused by having unnecessarily high cash balances.

Similar to the Baumol model, the Miller-Orr model still assumes:
- cash requirements are funded by the sale of short-term investments.
- there is a fixed transaction cost per sale/purchase of short-term investments.

Question 9

What are the relevant formulas for the Miller-Orr model?

Answer 9

Return point = lower limit + (1/3*spread)

Spread = 3 * [(3/4 * transaction cost * variance of cash flows)/interest rate]^1/3

Where:

Spread = the difference between the upper and lower limits.

Trans cost = fixed cost of buying or selling marketable securities

Variance = variance (ie std dev * std dev) of the net Daily Cash flows

Interest rate = daily interest rate on marketable securities (ie the daily opportunity cost of holding cash)

Note that the upper limit is the lower limit plus the spread.

Question 10

What are 3 weaknesses of the Miller-Orr model?

Answer 10

1. Subjectivity in setting lower limit.
2. In practice commissions for buying/selling short-term investments are likely to be at least partly variable.
3. Complexity of estimating future volatility of cash flows.