Chapter 3: Other Flashcards
Reasons to hold cash
Meet foreseeable cash requirements, eg. paying suppliers and staff
Meet unforeseeable cash requirements eg paying an unexpected fine
Benefit from one off opportunities, eg taking advantage of early settlement discount offer
Centralised treasury management and cash control benefits
Internal netting off of local surpluses and deficits which is cheaper.
Lower bank charges due to increased volumes through a single point
Better interest rates on borrowing and lending
reduced external foreign exchange due to internal netting off
Allows employment of experts dur to the volume if work required
Baumol model identifies the optimal cash holding level.
What is the formula?
Amount of cash to be raised (Q) can be calculated by:
Q=√ (2FS)/I
F = Cost of obtaining funds
S=Amount of cash required per annum
I=Cost of holding $1 for one year
Baumol model identifies the optimal cash holding level.
What is the total annual cost (TAC)
F(S/Q) + I(Q/2)
F = Cost of obtaining funds
S=Amount of cash required per annum
I=Cost of holding $1 for one year
Miller-Orr Model is more realistic and allows for varying cash balances and sets lower and upper limits.
What happens when cash reaches the upper and lower limit?
Upper - Cash is invested (in e.g treasury’s) to reduce cash balance
Lower - Cash is raised (by liquidating investments) to increase cash held
Miller-Orr Model is more realistic and allows for varying cash balances and sets lower and upper limits.
Return point formula
Spread formula
Both given in the exam
Miller-Orr Model is more realistic and allows for varying cash balances and sets lower and upper limits.
How to get the variance if given standard deviation?
How to get a daily interest rate if given an annual interest rate?
Need to square the standard deviation to get the variance.
Annual interest rate / 365 = daily interest rate
Key factors in determining working capital funding strategies
- The distinction between permanent and fluctuating current assets
- The relative cost and risk of short-term and long-term finance and the matching principle
Determining working capital funding strategies
The aggressive approach
As short-term funding is the cheapest source of finance, the most cost effective approach is to finance all of your current assets with short term finance. This will result in lower finance costs and higher
profits compared to the other strategies.
There is no guarantee that this finance will be available when required, this is a very high risk strategy which should only be used if the organisation is confident of always being able to raise the required short-term finance.
Non-current assets - long term funding
Permanent current assets - short-term funding
Fluctuating current assets - short-term funding
Determining working capital funding strategies
The conservative approach
Long-term finance could be used to fund all of your current assets, this would be more expensive, but the organisation will know that it will not run out of funding and so is safe. This will lead to higher finance costs and lower profits compared to the aggressive policy.
Non-current assets - long term funding
Permanent current assets - long term funding
Fluctuating current assets - long term funding
Determining working capital funding strategies
The matching approach
The matching funding policy uses long term funding for the minimum permanent current assets and uses short term finance for the range between the minimum and maximum. The finance costs and
profits will probably be somewhere between those of the conservative and aggressive strategies
Non-current assets - long term funding
Permanent current assets - long term funding
Fluctuating current assets - short term funding
