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%).
The cash manager for a large kitchen appliance retailer has been approached by a bank representative offering to set up a lockbox collection system. Analysis of the firm’s receipts shows that, on average, the system will reduce collection time by 2 days. The firm receives approximately 2,500 checks per day with an average value of $600 per check. The bank would charge $0.28 per check for operating the system. The firm currently invests short-term funds at an average rate of 7%. How much would the firm gain or lose annually by entering the lockbox agreement?
A. $(45,500)
B. $45,500
C. $210,000
D. $(150,500)
A. $(45,500)
The additional annual income (loss) from using the lockbox 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 $3,000,000 ($600 value per check x 2,500 checks received per day x 2 days). Benefit (loss) = interest earned - cost. Thus, the loss of $45,500 is calculated from the interest earned of $210,000 ($3,000,000 x 7%) minus the cost of $255,500 ($0.28 per check x 2,500 checks per day x 365 days in a year).
Average daily cash outflows are $3 million. A new cash management system can add 2 days to the disbursement schedule. Assuming that 10% can be earned on excess funds, how much should the firm be willing to pay per year for this cash management system?
A. $600,000
B. $6,000,000
C. $1,500,000
D. $3,000,000
A. $600,000
If cash outflows are $3 million per day, holding cash 2 extra days means that average balances should increase by $6 million. At a 10% interest rate, the additional $6 million would generate interest revenue of $600,000 per year. Thus, if the system can be acquired for $600,000 or less, it would be beneficial to do so.
All of the following are valid reasons for a business to hold cash and marketable securities except to
A. Earn maximum returns on investment assets.
B. Satisfy compensating balance requirements.
C. Maintain adequate cash needed for transactions.
D. Meet future needs.
A. Earn maximum returns on investment assets.
A company will hold cash and marketable securities to facilitate business transactions; cash is a medium of exchange. Cash and near-cash items are also held to meet future needs, to satisfy compensating balance requirements imposed by lenders, and to provide a precautionary balance for security purposes. Cash is usually not held in an attempt to earn maximum returns on investment because cash and marketable securities are not usually the highest paying investments.
A typical firm doing business nationally cannot expect to accelerate its cash inflow by
A. Initiating controls to accelerate the deposit and collection of large checks.
B. Employing a lockbox arrangement.
C. Maintaining compensating balances rather than paying cash for bank services.
D. Establishing multiple collection centers throughout the country.
C. Maintaining compensating balances rather than paying cash for bank services.
Compensating balances are either (1) an absolute minimum balance or (2) a minimum average balance that bank customers must keep at the bank. These are generally required by the bank to compensate for the cost of services rendered. Maintaining compensating balances will not accelerate a company’s cash inflows because less cash will be available even though the amount of cash coming in remains unchanged.
Methods of accelerating cash collections include all of the following except
A. Compensating balances.
B. Electronic funds transfers.
C. Decentralized collections.
D. Lockbox systems.
A. Compensating balances.
Various methods of accelerating cash collections include decentralized collection outposts (normally one in each Federal Reserve District), electronic funds transfers, centralized banking for all company branches to avoid having to maintain minimum balances in several locations, and lockbox systems. A compensating balance is a minimum average or absolute amount that must be maintained in a bank account. Hence, it is not a means of accelerating cash collections. This requirement means that less cash is available to the depositor.
Average daily collection of checks for a firm is $40,000. The firm also writes on the average $35,000 of checks daily. If the collection period for checks is 5 days, calculate the net float.
A. $175,000
B. $40,000
C. $25,000
D. $200,000
C. $25,000
The difference between collections and payables is $5,000 daily. Five days’ worth amounts to $25,000 of float.
A firm has daily cash receipts of $300,000. A commercial bank has offered to reduce the collection time by 2 days. The bank requires a monthly fee of $3,000 for providing this service. If the money market rates will average 11% during the year, the annual pretax income (loss) from using the service is
A. $(30,000)
B. $66,000
C. $30,000
D. $63,000
C. $30,000
The additional annual income (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 $600,000 ($300,000 × 2 days).
Benefit (loss) = Interest earned – Cost
= ($600,000 × 11%) – ($3,000 × 12 months)
= $66,000 – $36,000
= $30,000
A company holding cash for a speculative motive is holding cash to
A. Pay bills.
B. Protect against uncollectible receivables.
C. Provide a safety margin.
D. Take advantage of future investment opportunities.
D. Take advantage of future investment opportunities.
Motives for holding cash can be (1) transactional, (2) precautionary, or (3) speculative. Taking advantage of future investment opportunities is an example of a speculative motive.
A retail mail order firm currently uses a central collection system that requires all checks to be sent to its headquarters. An average of 6 days is required for mailed checks to be received, 3 days to process them, and 2 days for the checks to clear through its bank. A proposed lockbox system would reduce the mailing and processing time to 2 days and the check clearing time to 1 day. The firm has an average daily collection of $150,000. If the firm adopts the lockbox system, its average cash balance will increase by
A. $1,200,000
B. $600,000
C. $450,000
D. $750,000
A. $1,200,000
Checks are currently tied up for 11 days (6 for mailing, 3 for processing, and 2 for clearing). If that period were reduced to 3 days, the firm’s cash balance would increase by $1,200,000 ($150,000 per day × 8 days).
