Cash Management quiz

The additional annual income (loss) from using the bank’s proposedservice 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 averagecash 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

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

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

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

A compensating balance is a minimum amount that the bank requires thefirm to keep in its demand account. Compensating balances arenoninterest-bearing and are meant to compensate the bank for variousservices rendered, such as unlimited check writing. These funds areobviously unavailable for short-term investment and thus incur anopportunity cost.

An ACH electronic funds transfer (EFT is an electronic payment to a company’saccount 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 thecompany’s lockboxes and thus serve as collection points. The transfer of funds tothe concentration bank allows the company to take advantage of economies of scalein cash management. The use of ACHs facilitates concentration banking. ACHs areelectronic networks operated by the Federal Reserve (except for the New Yorkregional ACH association) that guarantee 1-day clearing.

Investment risk is analyzed in terms of the probability that the actual returnon an investment will be lower than the expected return. Comparing aproject’s expected return with the return on an asset of similar risk helpsdetermine whether the project is worth investing in. If the expected returnon a project exceeds the return on an asset of comparable risk, the projectshould be pursued.

Checks are currently tied up for 10.5 days (5 for mailing, 4 forprocessing, and 1.5 for clearing). If that were reduced to 4 days, thefirm’s cash balance would increase by $650,000 ($100,000 per day × 6.5days).

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

The annual variablecost 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

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 theservice. 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)

A company will hold cash and marketable securities to facilitate businesstransactions; cash is a medium of exchange. Cash and near-cash items are also heldto meet future needs, to satisfy compensating balance requirements imposed bylenders, and to provide a precautionary balance for security purposes. Cash isusually not held in an attempt to earn maximum returns on investment because cashand marketable securities are not usually the highest paying investments.

The firm can compare the costs of the two alternatives as follows:

Standard account= Variable cost + Fixed cost

                                   = [(80 checks × $.10) + $10] × 12 months

                                   = $18 × 12 months

                                   = $216 per year

Premium account = Variable cost + Fixed cost

                                     = [$0 + ($2,500 reqd. – $500 projected)] × 10%

                                     = $2,000 × 10%

                                     = $200 per year

Thus, the premium account should be selected because it is cheaper by$16 per year.

Cash inflows for March would consist of 50% of March credit sales ($90 × 50% =$45), plus 30% of February credit sales ($120 × 30% = $36), plus 20% of January
credit sales ($100 × 20% = $20), plus cash sales for March of $18. Consequently,total collections equal $119,000.

The additional annual income (loss) from using the bank’s proposedservice 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 averagecash 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

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

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 three motives for holding cash are :

(1) as a medium of exchange (thetransactions motive),

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

(3) to take advantage of unexpectedopportunities (the speculative motive).

A lockbox system is a means of managing cash inflows, not outflows.

The additional annual income (loss) from using the lockbox service is the excess(deficit) of interest earned on the accelerated deposits over (under) the cost of theservice. If the plan is adopted, the company’s average cash balance will increaseby $600,000 ($150,000 × 4 days).

Benefit (loss)= Interest earned – Cost

                           = ($600,000 × 4%) – ($2,500 × 12 months)

                           = $24,000 – $30,000

                           = $(6,000)