8.9 The need for cash and cash management

Question 1

Why is cash essential to a business?

Answer 1

Cash is the most liquid asset to help a business survive and meet its organisational goals.

Question 2

What is cash management?

Answer 2

The process of collecting and managing payments in the due course of business.

Question 3

What is the goal of cash management?

Answer 3

To prevent a surplus of deficit of cash by ensuring:

• adequate cash at times of need
• investment of surplus cash

Question 4

According to Keynes general theory of economics (1396), what are the three basic motives for holding cash?

Answer 4

1 Transaction motive - maintaining cash for day-to-day transactions
2 Precautionary motive - holding cash to meet contingencies and unexpected situations
3 Speculative motive - using cash to take advantage of profitable investment opportunities.

Question 5

Why is payment of company loans often a more preferable use of cash than investment?

Answer 5

Payment of loans gives a guaranteed benefit, whereas investment if more risky.

Question 6

There are various models for management of cash - name three.

Answer 6

1 Use of cash budget in management of cash
2 William J Baumol’s (1952) economic order quantity (EOQ) model
3 The Miller-Orr (1966) cash management model

Question 7

According the Baumol’s economic order quantity model, what is the optimum cash level?

Answer 7

That level of cash where the carrying costs and transaction costs are minimal.

Question 8

What is the calculation for optimum cash level under Baumol’s model?

Answer 8

Q = sq. root (2 x U x P / S) where:

Q = optimum cash balance
U = Annual cash demand
P = Fixed costs per transactions
S = Opportunity cost (interest rate) of holding cash

Question 9

What are the limitations of Baumol’s model cash management?

Answer 9

Its unrealistic assumptions of cash predictability.

Question 10

What is the Miller Orr model of cash management? (remember: three control limits)

Answer 10

Miller Orr sets out three control limits::
- upper (h)
- return point or a target cash balance (z)
- lower limit (o)
When cash reaches h, cash is invested in securities.
When cash reaches o, cash is transferred from marketable securities to cash.

Question 11

What is the formula for calculation of the return point in Miller-Orr?

Answer 11

Return point = lower limit + spread /3

Question 12

What is the formula for calculation of spread in Miller-Orr?

Answer 12

S = 3(3/4 x transaction costs x variance or cash flows / interest rate)^1/3