Cash Management quiz

Speeding up collections by 2 days will raise the firm’s average cash balance by $30,000. At 8% interest,

the benefit will be $2,400 annually [($15,000 × 2 days) × .08].

The three motives for holding cash are as a medium of exchange, as a precautionary measure, and for speculation. Reason #1 can be classified as a precautionary
measure, and Reason #2 can be classified as holding cash for speculation.

John Maynard Keynes, founder of Keynesian economics, concluded that there were three major motives for holding cash: for transactional purposes as a medium of exchange, precautionary purposes, and speculative purposes (but only during deflationary periods) .

The difference between collections and payables is $5,000 daily. Five days’ worth amounts to $25,000 of float.

The most direct way of preparing a cash budget requires incorporation of sales projections and credit terms, collection percentages, estimated purchases and payment terms, and other cash receipts and disbursements.

In other words, preparation of the cash budget requires consideration of both inflows and outflows.

The annual benefit (loss) from using the lockbox system is the excess (deficit) of interest earned on the early deposits over (under) the cost of the service. If the plan is adopted, average cash balance will increase by $750,000 [$90,000,000 × (3 days ÷ 360 days)].

Benefit (loss) = Interest earned – Cost

                            = ($750,000 × 8%) – $80,000

                           = $60,000 – $80,000

                           = $(20,000)

Multiplying 700 checks times 360 days results in a total of 252,000 checks per year. Accordingly, using a $0.50 fee per check, total annual cost is $126,000 (252,000 × $.50), which is less desirable than a $125,000 flat fee.

Given that the annual collections equal $453,600,000 (700 checks × $1,800 × 360 days), a fee of 0.03% of the amount collected is also less desirable because the annual fee would be $136,080 ($453,600,000 × .03%). The best option is therefore to maintain a compensating balance of $1,750,000 when the cost of funds is 7%, resulting in a total cost of $122,500 ($1,750,000 × 7%).

An ACH electronic funds transfer (EFT is an electronic payment to a company’s account at a concentration bank. A concentration bank is a large bank to which a
company transfers funds from local depository banks. These local banks operate the company’s lockboxes and thus serve as collection points. The transfer of funds to the concentration bank allows the company to take advantage of economies of scale in cash management. The use of ACHs facilitates concentration banking. ACHs are electronic networks operated by the Federal Reserve (except for the New York regional ACH association) that guarantee 1-day clearing.

The float period is the time between when a check is written and when it clears the payor’s checking account. Check float results in an interest-free loan to the payor because of the delay between payment by check and its deduction from the bank account. If checks written require 1 more day to clear than checks received, the net float equals 1 day’s receipts. The company will have free use of the money for 1 day. In this case, the amount is $10,000.

If cash outflows are $3 million per day, holding cash 2 extra days means that average balances should increase by $6 million. At a 10% interest rate, the additional $6 million would generate interest revenue of $600,000 per year. Thus, if the system can be acquired for $600,000 or less, it would be beneficial to do so.

Compensating balances are either (1) an absolute minimum balance or (2) a minimum average balance that bank customers must keep at the bank. These are
generally required by the bank to compensate for the cost of services rendered. Maintaining compensating balances will not accelerate a company’s cash inflows
because less cash will be available even though the amount of cash coming in remains unchanged.

The three motives for holding cash are :

(1) as a medium of exchange (the transactions motive),

(2) to provide a reserve for contingencies (the precautionary motive), and

(3) to take advantage of unexpected opportunities (the speculative motive).

A draft is a three-party instrument in which one person (the drawer) orders a second person (the drawee) to pay money to a third person (the payee). A check is the most common form of draft. It is an instrument payable on demand in which the drawee is a bank. Consequently, a draft can be used to delay the outflow of cash. A draft can be dated on the due date of an invoice and will not be processed by the drawee until that date, thereby eliminating the necessity of writing a check earlier than the due date or using an EFT. Thus, the outflow is delayed until the check clears the drawee bank.

The annual benefit from using the lockbox system is the excess of interest earned on the early deposits over the cost of the service. If the plan is adopted, the firm’s average cash balance will increase by $2,000,000 ($20,000 average payment × 50 per day × 2 days).

The annual variable cost will be $9,125 ($.50 per payment × 50 per day × 365 days).

Benefit (loss) = Interest earned – Cost

                           = ($2,000,000 × 6%) – ($50,000 + $9,125)

                           = $120,000 – $59,125

                           = $60,875

Cash disbursements for the month of April are calculated as follows:

April purchases: $130,000 × 50% = $ 65,000

March purchases: 150,000 × 25% = 37,500

February purchases: 150,000 × 25% = 37,500

April payroll: 250,000 × 10% = 25,000

April op. expenses: 300,000 × 15% = 45,000

Interest = 25,000

Total April disbursements = $235,000

Cash disbursements for the month of April are calculated as follows:

April purchases:  $140,000× 40% = $ 56,000

March purchases:  $160,000× 30% = 48,000

February purchases:  $160,000× 30% = 48,000

April payroll:  $300,000× 10% = 30,000

April op. expenses:  $260,000× 20% = 52,000

Interest = 20,000

Total April disbursements = $254,000

The additional annual income (loss) from using the bank’s proposed service is the excess (deficit) of interest earned on the early deposits over (under) the cost of the service. If the plan is adopted, the firm’s average cash balance will increase by $600,000 ($300,000 × 2 days).

Benefit (loss) = Interest earned – Cost

                             = ($600,000 × 11%) – ($3,000 × 12 months)

                             = $66,000 – $36,000

                             = $30,000

The total cost of each of the four methods being considered can be calculated as follows:

Lockbox: $25 per-bank fee × 170 banks = $ 4,250

Drafts: $2 per-draft fee × 4,000 drafts = $ 8,000

Bank Float: $1,000,000 in checks written × 2% fee = $20,000

Electronic Transfer: $18 per-transfer fee × 700 items = $12,600

These costs are subtracted from the interest that could be earned under each method to arrive at the relevant gain or loss:

Lockbox: $5,240 – $4,250 = $ 990

Drafts: $6,500 – $8,000 = $(1,500)

Bank Float: $22,000 – $20,000 = $ 2,000

Electronic Transfer: $14,000 – $12,600 = $ 1,400

The lockbox system, the bank float, and the electronic transfer are costeffective.

The additional annual income (loss) from using the lockbox service is the excess (deficit) of interest earned on the early deposits over (under) the cost of the
service. If the plan is adopted, the firm’s average cash balance will increase by $900,000 ($300,000 × 3 days).

Benefit (loss)= Interest earned – Cost

                           = ($900,000 × 6%) – ($2,000 × 12 months)

                            = $54,000 – $24,000

                            = $30,000

The additional annual income (loss) from using the bank’s proposed service is the excess (deficit) of interest earned on the early deposits over (under) the cost of the service. If the plan is adopted, the firm’s average cash balance will increase by $600,000 ($200,000 × 3 days).

Benefit (loss) = Interest earned – Cost

                           = ($600,000 × 12%) – ($4,000 × 12 months)

                           = $72,000 – $48,000

                           = $24,000