20 Appendix Cash and Liquidity Management Appendix Mc

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20 Appendix Cash and Liquidity Management Appendix Mc. Graw-Hill/Irwin Copyright © 2008 by The

20 Appendix Cash and Liquidity Management Appendix Mc. Graw-Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Target Cash Balances § Target cash balance – desired cash level determined by trade-off

Target Cash Balances § Target cash balance – desired cash level determined by trade-off between carrying costs and shortage costs § Flexible policy - if a firm maintains a marketable securities account, the primary shortage cost is the trading cost from buying and selling securities § Restrictive policy – generally borrow short -term, so the shortage costs will be the fees and interest associated with arranging a loan 20(Appendix)-1

Figure 20 A. 1 20(Appendix)-2

Figure 20 A. 1 20(Appendix)-2

BAT Model § Assumptions § Cash is spent at the same rate every day

BAT Model § Assumptions § Cash is spent at the same rate every day § Cash expenditures are known with certainty § Optimal cash balance is where opportunity cost of holding cash = trading cost § Opportunity cost = (C/2)*R § Trading cost = (T/C)*F § Total cost = (C/2)*R + (T/C)*F 20(Appendix)-3

Example: BAT Model § Your firm will have $5 million in cash expenditures over

Example: BAT Model § Your firm will have $5 million in cash expenditures over the next year. The interest rate is 4% and the fixed trading cost is $25 per transaction. § § § What is the optimal cash balance? What is the average cash balance? What is the opportunity cost? What is the shortage cost? What is the total cost? 20 (Appendix)-4

Miller-Orr Model § Model for cash inflows and outflows that fluctuate randomly § Define

Miller-Orr Model § Model for cash inflows and outflows that fluctuate randomly § Define an upper limit, a lower limit, and a target balance § Management sets lower limit, L § C* = L + [(3/4)F 2/R]1/3 (target balance) § U* = 3 C* - 2 L (upper limit) § Average cash balance = (4 C* - L)/3 20(Appendix)-5

Figure 20 A. 3 20(Appendix)-6

Figure 20 A. 3 20(Appendix)-6

Example: Miller-Orr Model § Suppose that we wish to maintain a minimum cash balance

Example: Miller-Orr Model § Suppose that we wish to maintain a minimum cash balance of $50, 000. Our fixed trading cost is $250 per trade, the interest rate is. 5% per month and the standard deviation of monthly cash flows is $10, 000. § What is the target cash balance? § What is the upper limit? § What is the average cash balance? 20(Appendix)-7

Conclusions § The greater the interest rate, the lower the target cash balance §

Conclusions § The greater the interest rate, the lower the target cash balance § The greater the fixed order cost, the higher the target cash balance § It is generally more expensive to borrow needed funds than it is to sell marketable securities § Trading costs are usually very small relative to opportunity costs for large firms 20 -8 (Appendix)

Appendix End of Chapter Mc. Graw-Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies,

Appendix End of Chapter Mc. Graw-Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.