This document discusses managing cash flows through working capital management. It covers cash inflows and outflows, objectives of cash management, reasons for holding cash and marketable securities, types of money market instruments, and strategies for reducing delays in receiving funds such as lockboxes and electronic collection procedures. The optimal lockbox solution minimizes total costs, which is the sum of opportunity costs of float and lockbox costs. Larger companies may use algorithms to determine the optimal number and locations of lockboxes.

1. Working Capital Management
Course Code: FIN 6407
Fatima Khan
Lecturer in Finance
Northern University
Khulna

2. Managing Cash Inflows and Outflows
Text: Modern Working Capital
Frederick C. Scherr
Chapter 2

3. Cash inflows
• payment for goods or services from your customers
• receipt of a bank loan
• interest on savings and investments
• shareholder investments
Cash outflows
• purchase of stock, raw materials or tools
• wages, rents and daily operating expenses
• purchase of fixed assets - PCs, machinery, office
furniture, etc
• loan repayments
• dividend payments
• Income tax, corporation tax, VAT and other taxes
Managing Cash Flows

4. Cash Management
Encompasses the design of collections and
disbursement systems for cash and the
temporary investment of cash while it
resides with the firm.
Managing Cash Flows

5. Objectives of Cash Management
• Cash doesn’t earn a return
• Want to maintain liquidity
– Take cash discounts
– Maintain firm’s credit rating
– Minimize interest costs
– Avoid insolvency
Good cash management implies
maintaining adequate liquidity with
minimum cash in bank, also a portion of
the cash balance can be placed into
marketable securities

6. Why hold cash and marketable
securities?
Cash and short-term interest-bearing
investments are the least productive
assets, because they are:
Not part of production
Provides no direct return
But still firms need to hold cash and
marketable securities, why?

7. 1. Cash for Transactions:
For transaction demand
For payment to suppliers
To make change for cash sales
Managing Cash Flows

8. 2. Cash and Near-Cash Assets as Hedges:
Unexpected emergencies
Can hold little cash at hand and the
rest in form of near-cash assets
Trade-off between interest revenue
and transaction costs involved
Managing Cash Flows

9. 3. Temporary Investments:
Payout excess cash to security
holders
Make temporary investment
Managing Cash Flows

10. • Transaction demand: need money to pay
bills , wages, etc.
• Precautionary demand: need money to
handle emergencies [unforeseen
expenses]
• Speculative demand: need money to take
advantage of unexpected opportunities
Managing Cash Flows

11. The Money Market
Motivation of holding near-cash assets:
Hedging of cash flow uncertainty
 Temporary investment of surplus funds
Money market provides highly safe and liquid
near-cash assets for investment
Sources of short-term borrowing for larger
corporations
Managing Cash Flows

12. Term structure of interest rates
In finance, the yield curve is a curve
showing several yields or interest rates
across different contract lengths (2 month,
2 year, 20 year, etc...) for a similar debt
contract. The curve shows the relation
between the (level of) interest rate (or cost
of borrowing) and the time to maturity.
The shape of the yield curve is influenced by
supply and demand.

13. • Yield curves are usually upward sloping the longer
the maturity, the higher the yield, with diminishing
marginal increases. There are two common
explanations for upward sloping yield curves.
• First, it may be that the market is anticipating a rise
in the risk-free rate. If investors hold off investing
now, they may receive a better rate in the future.
• Another explanation is that longer maturities entail
greater risks for the investor (i.e. the lender). A risk
premium is needed by the market, since at longer
durations there is more uncertainty and a greater
chance of catastrophic events that impact the
investment.

14. Required return is influenced through:
• Level of inflationary expectation
• Relative levels of supply and demand for
various maturities of securities
• Levels of differences in investors’
perception regarding risks and return
involved in investment
Managing Cash Flows

15. The US dollar yield curve as of February 9, 2005. The
curve has a typical upward sloping shape.

16. August 14, 2015 16Fatima;
Managing Cash Flows
Three most common theories of the
determination of term structure of interest
rates are based on the differences in
inflation, relative demand and risk among
securities of various maturities.
Expectation Theory
Market Segmentation Theory
Maturity Preferences Theory

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Managing Cash Flows
Expectation Theory
Differences in per period required returns
among securities of various maturity dates
reflect expectations that inflation will
change over time.
Expected rise in inflation will raise interest
rates on the short term maturity end of the
yield curve more than on long maturity
end.

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Managing Cash Flows
Market Segmentation Theory
Investors prefer securities of different
maturities
Yield curve’s level and shape reflect the
availability of various maturities relative to
these preferences
Larger supply of a particular maturity
security, declines the price and the YTM
rises

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Fatima;
Managing Cash Flows
Upslopping yield curve represents when there
are relatively larger supplies of longer
maturities securities
Downslopping yield curve represents when
there are relatively larger supplies of shorter
maturities securities
Longer maturities are said to contain more
interest rate risk, so these have higher
required rates o return

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Managing Cash Flows
Maturity Preference Theory
The shape of the yield curve is merely a
reflection of the differences in interest rate
risk among maturities
Longer maturities are said to contain more
interest rate risk, and have higher required
rates of return than shorter maturities
Interest rate risk is the relationship between the
interest rate prevailing at the time and the
trading price of the security

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Managing Cash Flows
Prices of longer-term securities fluctuate
much more with changes in interest rate
levels than do the prices of short-term
securities, so it is riskier, and investors
require a higher rate of return.

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Managing Cash Flows
The best of these three theories?
Expectation Theory
Or
Market Segmentation Theory
Or
Maturity Preferences Theory

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Managing Cash Flows
Maturity preference theory is substantially
important, because
it explains empirical observation about
yield curve
 yield curve is positively slopped most of
the times (also may be negatively slopped
or even flat)
 the longer the maturity the higher the per-
period rate of return

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Managing Cash Flows
Other than yield curve effect, default
risk is also engaged with money market
investment

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Managing Cash Flows
Treasury Bills
• U.S Government securities with maturities of 91,
182 or 365 days
• Free of default risk but interest rate risk occurs for
longer maturities
• Sold at discount and redeemed at principle at the
maturity
• A very active secondary market for t-bills of any
maturity
• Earns a lower return

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Managing Cash Flows
Commercial Papers
• Large-denomination unsecured debt matures
about in 30 days
• Issued by large firms and financial
institutions
• Some default risks involved, yield higher
than T-bills

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Managing Cash Flows
Certificates of Deposit
A very large-denomination debt instrument
issued by banks
Maturities differ with pre specified or semi-
variable interest rates
May be placed directly with investors, or
traded in the secondary market with dealers

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Managing Cash Flows
Banker’s Acceptance
• Issued by banks, traded through dealers,
quite liquid
• Generated in course of international trade

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Managing Cash Flows
Repurchase Agreements
• Very short-term investments and financing
• Seller agrees to sell a security to the buyer
and the seller agrees to repurchase the
security at a higher price

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Managing Cash Flows
Eurodollars
• Dollar-denominated loans and certificates
of deposit in non-U.S. banks
• In a large denominations, commonly of
one week or six months maturities
• Entails a modest default risks, carry a
slightly higher interest rates than domestic
securities

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Managing Cash Flows
Hedged Dividend Capture Strategy
• Holding adjustable rate preferred stock
• Holding common shares of firms and
hedging with call options (firms expected to
pay dividend as well as sells the option to
sell the stock at a specific price)
• Holding shares of an index fund and
hedging with index fund call options

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Fatima;
Managing Cash Flows
Flotation and Check Clearing
• It is the management of cash when it is not
in the firm’s hand, it is in transit to and from
the firm
– Mail Float
– At-firm Float
– Clearing Float
• Only after this entire process is completed does
the receiving firm receive credit for the cash so
that it is able to use the money.

33. August 14, 2015 33Fatima;
Managing Cash Flows
Suppose a firm receives $ 2 million per day via the
transit system, assume that checks were in mail an
average of 4 days, that the firm takes 0.5 days to
process checks and get them to the bank, and that
the firm’s bank takes 1.3 days to obtain funds for
the checks. If the firm could accelerate the transit
process and had these funds at hand, it could
invest them at the firms cost of capital of 10%,
What is the opportunity cost of the float?

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Managing Cash Flows
Float Type Float Time
(days)
Receipts
(per day)
Float in
Dollars
Mail Float 4.0 $ 2 mil. $ 8.0 mil
At-Firm Float 0.5 $ 2 mil. $1.0 mil
Clearing Float 1.3 $ 2 mil. $2.6 mil
Total Transit
Time
5.8 Total Float $ 11.6 mil
Required Return 0.10 per
year
$1.16 mil
per year
Opportunity Cost of Float

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Managing Cash Flows
Strategies to reduce delays in receiving
funds
• Selection of banks with accelerated
clearing capabilities through
 Clearing houses
 Correspondent banks

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Managing Cash Flows
Acceleration of Check Processing at the
Firm
• Checks are received at various locations
and the eventful deposit of these items
• Adopt processing procedures that speed
checks into the clearing process

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Managing Cash Flows
Use of Electronic Collection Procedures
• An electronic message of payment for the
check
• Posses substantial costs and benefits for
the firms involved

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Managing Cash Flows
Uses of Lockbox
• Lockboxes allow organization to streamline
receipts
• A “lockbox” is a post office number to which
some or all of the firm’s customers are
instructed to send their checks, banks are
permitted to take these checks and
immediately start them in clearing process
• In this way, at-firm float is eliminated

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Managing Cash Flows
• Two mailing addresses can lead to
misrouting of some documents.
• Delay, errors and cost entailed for these
misrouting documents.
Lock-boxes are not a problem-free panacea
for flotation problems, their proper uses can
reduce all types of flotation on incoming
checks

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Managing Cash Flows
Decisions in formulation of lockbox
strategies
• Where should the firm locate it’s
lockboxes?
• To which lockboxes should each of the
firms customers send their checks?

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Managing Cash Flows
Lockbox Location Problem
• Mathematical and programming procedures for
solving lockbox location problems
• Firms use both mathematical solution and
programming suggestions for determining lockbox
location
• Firms seek to minimizes the sum of
a) Opportunity costs of float on incoming cash
b) The costs of the lockbox system
A trade-off between these two sets of costs, additional
lockboxes reduce opportunity costs of float, but
adds additional fixes costs

42. Managing Cash Flows
Fatima; August 14, 2015
Number of Lockboxes in System

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Managing Cash Flows
The firm must collect four sets of data:
• The mail and clearing times for sending
checks from each part of the firm’s
geographic sales area to each possible
lockbox.
• The total amount of daily funds and number
of checks received by the firm from each part
of the sales area

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Managing Cash Flows
• The required rate of return
• The variable and fixed costs of each
proposed lockbox site
The firm must collect four sets of data:
The optimal solution is the lockbox which has the lowest total
cost, defined as the sum of opportunity cost of float and the
costs of the lockbox

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Managing Cash Flows

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Managing Cash Flows
• The optimal solution to the one lockbox
problem is the lockbox which has the
lowest total cost
• But what about a larger corporation
operating in big country like USA?

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Managing Cash Flows
A lockbox location problem
algorithm
• Some lockbox and customer assignment
routines will find the optimum [least cost]
combination of lockbox and assignments
• Routines that lead to optimum solutions
are more difficult to calculate
• Trade-off between ease of computation
versus the guarantee of and optimum
solution

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Managing Cash Flows
The variables represent here:
i. Whether a lockbox is in use [open] or not
[close]?
ii. Whether customers from a particular
region are assigned to a particular
lockbox or not?

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Managing Cash Flows
Here, j = prospective lockbox bank location
i = the zone which the customers
check originates
n = the number of possible lockboxes
m = the number of zones

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Managing Cash Flows
To evaluate a lockbox at location j. we need
to know the charges from opening and
using the lockbox.
Fixed charges of opening lockboxes+ check
processing charges + opportunity cost of
float on checks from customers who send
their remittances to lockbox

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Managing Cash Flows
• Some logical constraints are:
– Checks from each customer zone must be
received at a lockbox somewhere
– Lockbox must be open for receipts from a
customer zone to be received there
– There should be only one lockbox open at
location j and customers from zone i may
send their checks to one and only lockbox
– To constraint the solution to the problem to
the best solution for a maximum of k
lockboxes

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Managing Cash Flows
Some warnings about lockbox location
decisions
• Determining customer zone
• Obtaining bank cost data
• Obtaining a representative sample of
check volume and origination
• The costing of float
• Interaction with availability on borrowing
capacity