7.2 Cash Management Flashcards
All of the following can be utilized by a firm in managing its cash outflows except
A. Zero-balance accounts
B. Centralization of payables
C. Controlled disbursement accounts
D. Lockbox system
D. Lockbox system
Lockbox system is a means of managing cash inflows, not outflows.
What is the benefit for a firm with daily cash receipts of $15,000 to be able to speed up collection by 2 days, assuming an 8% annual return on short-term investments and no cost to the company to speed up collections?
A. $2,400 daily benefit
B. $2,400 annual benefit
C. $15,000 annual benefit
D. $30,000 annual benefit
B. $2,400 annual benefit
Speeding up collections by 2 days will raise the firm’s average cash balance by $30,000. At 8% interest, the benefit will be $2,400 annually [($15,000 x 2 days) x 0.08].
A compensating balance
A. Compensates a financial institution for services rendered by providing it with deposits of funds.
B. Is used to compensate for possible losses on a marketable securities portfolio.
C. Is a level of inventory held to compensate for variations in usage and lead time.
D. Is the amount of prepaid interest on a loan.
A. Compensates a financial institution for services rendered by providing it with deposits of funds.
A compensating balance is a minimum amount that the bank requires the firm to keep in its demand account. Compensating balances are noninterest-bearing and are meant to compensate the bank for various services rendered, such as unlimited check writing. These funds are available for investment purposes and thus incur an opportunity cost.
Responsibilities of the cash management function
Planning and controlling cash collections, disbursements, and cash balances in order to maintain liquidity, as well as develop banking relationships.
Identify and describe at least two motives for a company to hold cash.
a) Transactions, because cash is necessary to conduct business, such as purchases, paying wages, taxes, or dividends.
b) Precautions against unexpected needs, as cash inflows and outflows are unpredictable.
Identify and explain at least three characteristics of marketable securities that a company should consider when investing.
Characteristics that a firm should consider when investing in marketable securities include
a) Default risk, as safety of principal is an important concern for investments that are to be included in the short-term portfolio
b) Marketability, as the securities should be easy to sell for cash liquidity needs
c) Maturity, as yields are generally higher, but riskier for long-term investment
A consultant recommends that a company hold funds for the following two reasons:
Reason #1: Cash needs can fluctuate substantially throughout the year.
Reason #2: Opportunities for buying at a discount may appear during the year.
The cash balances used to address the reasons given above are correctly classified as
A. Speculative balances, Speculative balances
B. Speculative balances, Precautionary balances
C. Precautionary balances, Speculative balances
D. Precautionary balances, Precautionary balances
C. Precautionary balances, Speculative balances
The three motives for holding cash are as a medium of exchange, as a precautionary measure, and for speculation. Reason #1 can be classified as a precautionary measure, and Reason #2 can be classified as holding cash for speculation.
A firm has daily cash receipts of $100,000 and collection time of 2 days. A bank has offered to reduce the collection time on the firm’s deposits by 2 days for a monthly fee of $500. If money market rates are expected to average 6% during the year, the net annual benefit (loss) from having this service is
A. $3,000
B. $12,000
C. $0
D. $6,000
D. $6,000
The annual benefit (loss) from using the bank’s proposed service is the excess (deficit) of interest earned on the early deposits over (under) the cost of the service. If the plan is adopted, the firm’s average cash balance will increase by $200,000 ($100,000 x 2 days).
Benefit(loss) = Interest earned – cost
= ($200,000 x 6%) – ($500 x 12 months)
= $12,000 - $6,000
= $6,000
Assume that each day a company writes and receives checks totaling $10,000. If it takes 5 days for the checks to clear and be deducted from the company’s account, and only 4 days for the deposits to clear, what is the float?
A. $(10,000)
B. $0
C. $50,000
D. $10,000
D. $10,000
The float period is the time between when a check is written and when it clears the payor’s checking account. Check float results in an interest-free loan to the payor because of the delay between payment by check and its deduction from the bank account. If checks written require 1 more day to clear than checks received, the net float equals 1 day’s receipts. The company will have free use of the money for 1 day. In this case the amount is $10,000.
A major bank has agreed to provide a lockbox system to a company at a fixed fee of $50,000 per year and a variable fee of $0.50 for each payment processed by the bank. On average, the company receives 50 payments per day, each averaging $20,000. With the lockbox system, the company’s collection float will decrease by 2 days. The annual interest rate on money market securities is 6%. If the company makes use of the lockbox system, what would be the net benefit to the company? Use 365 days per year.
A. $59,125
B. $120,000
C. $50,000
D. $60,875
D. $60,875
The annual benefit from using the lockbox system is the excess of interest earned on the early deposits over the cost of the service. IF the plan is adopted, the firm’s average cash balance will increase by $2,000,000 ($20,000 average payment x 50 per day x 2 days). The annual variable cost will be $9,125 (.50 per payment x 50 per day x 365 days).
Benefit(loss) = Interest earned - Cost
= ($2,000,000 x 6%) - ($50,000 + $9,125)
= $120,000 - $59,125
= $60,875
An entity has received proposals from several banks to establish a lockbox system to speed up receipts. The entity receives an average of 700 checks per day averaging $1,800 each, and its cost of short-term funds is 7% per year. Assuming that all proposals will produce equivalent processing results and using a 360-day year, which one of the following proposals is optimal for the entity?
A. A fee of 0.03% of the amount collected.
B. A $0.50 fee per check.
C. A flat fee of $125,000 per year.
D. A compensating balance of $1,750,000.
D. A compensating balance of $1,750,000.
Multiplying 700 checks times 360 days results in a total of 252,000 checks per year. Accordingly, using a $0.50 fee per check, total annual cost is $126,000 (252,000 checks x $.50), which is less desirable than a $125,000 flat fee. Given that the annual collections equal $453,600,000 (700 checks x $1,800 x 360 days), a fee of 0.03% of the amount collected is also less desirable because the annual fee would be $136,080 ($453,600,000 x .03%). The best option is therefore to maintain a compensating balance of $1,750,000 when the cost of funds is 7%, resulting in a total cost of $122,500 ($1,750,000 x 7%).
