Chapter 24

CASH AND LIQUIDITY

MANAGEMENT
 OUTLINE

• Motives for Holding Cash

• Cash Budgeting
• Cash Management Models
 Baumol Model
 Miller & Orr Model
 MOTIVES FOR HOLDING CASH
Keynes identified three possible motives for holding cash :
• Transaction Motive: Collection of cash is not perfectly
synchronized with the disbursement of cash.
• Precautionary Motive: Existence of uncertainty about the
magnitude and timing of cash inflows and cash outflows.
• Speculative Motive: Tapping profitable opportunities arising from
fluctuations in commodity prices, security prices, interest rates and
foreign exchange rates.
TYPES OF SHORT TERM INVESTMENT OPPORTUNITIES

• Treasury Bills (TBs).

• Commercial Papers (CPs).
• Certificate of Deposits (CDs).
• Bank Deposits.
• Inter-Corporate Deposits (ICDs).
• Money Market Mutual Funds (MMMFs)
 CASH BUDGETING
• Cash Budgets constitute principal tool of cash management.
• Cash budgets are helpful in:
 Estimating cash requirements,
 Planning short term financing,
 Scheduling capital expenditures,
 Planning materials purchases,
 Developing credit policies, and
 Checking accuracy of long-term forecasts.
• Multiple short-term forecasts, of varying length and detail, can be
used to meet different needs. Commonly used designs for short-
term forecasts are:
 One year divided into quarters or months
 One quarter divided into months
 One month divided into weeks
 CASH BUDGET
The principal method of cash budgeting is the Receipts and Payments method. Cash
forecast under this method shows the timing and magnitude of cash receipts, and
disbursements over the forecast period.
Illustration:
The following information about Hawkins Ltd. is given:
• The estimated sales for the period January 2015 through June 2015 are as
follows: Rs.1,00,000 a month from January through March and Rs.120,000 a
month from April through June.
• The sales for November and December of the previous year have been
Rs.1,00,000 each.
• Cash and credit sales are expected to be 20 % and 80 % respectively.
• The receivables from credit sales are expected to be collected as follows:
50% after one month and the balance 50 % after two months from the date of
sale.
• Other anticipated receipts are: Rs.5,000 from the sale of a machine in March
and Rs.2000 interest on securities in June.
 CASH BUDGETING

January February March April May June

1. Sales 100,000 100,000 100,000 120,000 120,000 120,000
2. Credit sales 80,000 80,000 80,000 96,000 96,000 96,000
3. Collection of
accounts
receivables 80,000 80,000 80,000 80,000 88,000 96,000
4. Cash sales 20,000 20,000 20,000 24,000 24,000 24,000
5. Receipt from
machine sale - - 5,000 - - -
6. Interest - - - - - 2,000
Total cash
receipts 100,000 100,000 105,000 104,000 112,000 122,000
(3+4+5+6)
 CASH BUDGETING
Relevant information for cash payments
• Hawkins Ltd. plans to purchase materials worth Rs.40,000 in January and
February and materials worth Rs.48,000 each month from March through June.
Payments will be made a month after the purchase.
• A payment of Rs.40,000 will be made in January for purchases in the previous
December.
• Miscellaneous cash purchases of Rs.2,000 per month are planned from January
through June
• Wage payments will be Rs.15,000 per month, January through June
• Payments for manufacturing expenses will be Rs.20,000 per month and for
general administrative expenses will be Rs.10,000 per month, January through
June
• Dividend payment of Rs.20,000 and a tax payment of Rs.20,000 are planned for
June
• A machine will be bought in cash for Rs. 50,000 in March
 CASH BUDGETING
January February March April May June
1. Material
purchases 40,000 40,000 48,000 48,000 48,000 48,000
2. Credit material
purchases 40,000 40,000 48,000 48,000 48,000 48,000
3. Payment of 40,000 40,000 40,000 48,000 48,000 48,000
accounts
payable
4. Miscellaneous 2,000 2,000 2,000 2,000 2,000 2,000
cash purchases
5. Wages 15,000 15,000 15,000 15,000 15,000 15,000
6. Manufacturing
exp. 20,000 20,000 20,000 20,000 20,000 20,000
7. General admn.
expense 10,000 10,000 10,000 10,000 10,000 10,000
8. Dividend - - - - - 20,000
9. Tax - - - - - 20,000
10. Capital - - 50,000 - - -
expenditure
Total payments 87,000 87,000 137,000 95,000 95,000 135,000
(3+4+5+6+7+8+9+10)
 CASH BUDGETING
Assuming that the cash balance on 1st January 2015 is Rs.22,000 and the minimum cash
balance required by the firm is Rs.20,000, the summary cash forecast is given below.
January February March April May June
1. Opening cash
balance 22,000
2. Receipts 100,000 100,000 105,000 104,000 112,000 122,000
3. Payments 87,000 87,000 137,000 95,000 95,000 135,000
4. Net cash flow (2 –3) 13,000 13,000 (32,000) 9,000 17,000 (13,000)
5. Cumulative net
cash flow 13,000 26,000 (6,000) 3,000 20,000 7,000
6. Opening cash
balance +
Cumulative net flow (1 + 5) 35,000 48,000 16,000 25,000 42,000 29,000
7. Minimum cash balance
required 20,000 20,000 20,000 20,000 20,000 20,000
8. Surplus or deficit in 15,000 28,000 (4,000) 5,000 22,000 9,000
relation to the minimum
cash balance required
(6 – 7)
 CASH MANAGEMENT MODELS

Cash management models primarily address the issue of split

between marketable securities and cash holdings. Two such popular
models are:

• Baumol model

• Miller and Orr model

 BAUMOL MODEL

• Based on the concept of Economic Order Quantity (EOQ).

• Determines the cash conversion size, which majorly influences

the average cash holdings of the firm.

• It attempts to balance the income foregone when the firm holds

cash balances (instead of investing in marketable securities)
against the transaction costs incurred when marketable
securities are converted into cash.
 Baumol Model – Determination of Ideal Cash Conversion Size
1 Cash conversion size (C)
(the amount of marketable securities that will 1,00,000 2,00,000 3,00,000 4,00,000 5,00,000
be converted into cash) (in Rs.)
2 Number of conversions during the planning
15 7.50 5 3.75 3
period of 3 months (15,00,000 ÷ Line 1)
3 Average cash balance (Line 1 ÷ 2) (in Rs.) 50,000 1,00,000 1,50,000 2,00,000 2,50,000
4 Interest (I) income foregone (Line 3 x 0.04)
2,000 4,000 6,000 8,000 10,000
(in Rs.)
5 Cost of cash conversion (b) (Rs. 500 x line 2)
7,500 3,750 2,500 1,875 1,500
(in Rs.)
6 Total cost of ordering and holding cash
(Line 4 + line 5) (in Rs.)
9,500 7,750 8,500 9,875 11,500

Baumol's model for cash balance

Baumol’s Model
• The firm incurs a holding cost for keeping the cash balance. It is an opportunity
cost; that is, the return foregone on the marketable securities. If the opportunity
cost is I, then the firm’s holding cost for maintaining an average cash balance is
as follows:
Holding Cost = I(C/2)
• The firm incurs a transaction cost whenever it converts its marketable securities
to cash. Total number of transactions during the year will be total funds
requirement, T, divided by the cash balance, C, i.e., T/C. The per transaction cost
is assumed to be constant. If per transaction cost is b, then the total transaction
cost will be:
Transaction Cost = b(T/C)
The total annual cost (S) of the demand for
cash will be:
S = Interest income foregone + Conversion
costs
S = I(C/2) + b(T/C)
The optimum cash balance, C*, is obtained
when the total cost is minimum. The formula
for the optimum cash balance is as follows:

Cost trade-off: Baumol's model

 BAUMOL MODEL
• C = amount of marketable securities converted into cash per order
• I = Interest rate per planning period on investment in marketable securities.
• T = Projected cash requirements during the planning period
• S = Total of conversion & holding costs
• S = Interest income foregone + Conversion costs
S = I(C/2) + b(T/C)
Value of C which minimizes S is to be determined
b = Rs. 500, T = Rs. 15,00,000 (or 1.5 million)
I = 0.04 (or 4%)
C* = [(2 x 500 x 15,00,000) ÷ 0.04]1/2
= Rs. 1,93,600

At the beginning of planning period, firm should convert only Rs. 1,93,600 of
its marketable securities into cash. The remaining amount should be
converted into cash in lots of Rs. 1,93,600 as per the needs of firm.
 MILLER & ORR MODEL
• Miller and Orr consider a stochastic generating process for periodic changes in
cash balance.
• A probabilistic model assuming changes in cash balance over a given period are
random, both in size and direction. This is unlike Baumol model which includes
deterministic assumptions.
• As the number of periods increases, the cash balances changes assume a normal
distribution.
• The model seeks to answer the following questions:
 When should transfers be effected between marketable securities and
cash.
 What should be the magnitude of these transfers.
• The MO model provides for two control limits–the ‘Upper Control Limit’ (UL) and the
Lower Control Limit’ (LL) as well as a ‘Return Point’ (RP).
• If the firm’s cash flows fluctuate randomly and hit the upper limit, then it buys sufficient
marketable securities to come back to a normal level of cash balance (the return point).
• Similarly, when the firm’s cash flows wander and hit the lower limit, it sells sufficient
marketable securities to bring the cash balance back to the normal level (the return
point).
• Value of LL is set by firm’s management based on what it considers to be the minimum
cash balance acceptable at any point of time.
• Values of RP & UL are derived by the model with a view to minimize the sum of
ordering and holding costs.
 MILLER AND ORR MODEL
3b 2
RP = 3 + LL
4I
UL = 3RP – 2LL
where:
• RP = return point
• b = fixed cost per order for converting marketable securities into cash.
• I = daily interest rate earned on marketable securities
•  2 = variance of daily changes in the expected cash balance
• LL = the lower control limit
• UL = the upper control limit

• As long as cash balance lies between the upper control limit and the lower
control limit, no securities transaction should be undertaken.
• Such a course of action results in minimizing the sum of transaction costs and
interest income foregone.
 Miller and Orr Model

Ans: RP = Rs. 94,964 UL = Rs. 184,892

Ans: RP = Rs. 287,718 UL = Rs. 463,154