7.2 Cash Management

Question 1

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

Answer 1

D. Lockbox system

Lockbox system is a means of managing cash inflows, not outflows.

Question 2

What is the benefit for a firm with daily cash receipts of $15,000to 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

Answer 2

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].

Question 3

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.

Answer 3

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.

Question 4

Responsibilities of the cash management function

Answer 4

Planning and controlling cash collections, disbursements, and cash balances in order to maintain liquidity, as well as develop banking relationships.

Question 5

Identify and describe at least two motives for a company to hold cash.

Answer 5

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.

Question 6

Identify and explain at least three characteristics of marketable securities that a company should consider when investing.

Answer 6

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

Question 7

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

            Reason #1                Reason #2 A. Speculative balances, Speculative balances B. Speculative balances, Precautionary balances C. Precautionary balances, Speculative balances D. Precautionary balances, Precautionary balances

Answer 7

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.

Question 8

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

Answer 8

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