Brealey−Meyers: Principles of Corporate Finance, 7th Edition - Chapter 31 ppsx

Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
CHAPTER THIRTY-ONE
880
CASH MANAGEMENT
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
CHAPTER 30 PROVIDED an overall idea of what is involved in short-term financial management. Now it
is time to get down to detail. We begin in this chapter by looking at how companies manage their
holdings of cash and marketable securities. Then in the next chapter we look at the terms on which
firms sell their goods and how they ensure that their customers pay promptly.
Out first task is to explain how cash is collected and paid out. In the United States small routine
payments are commonly made by check. You want to ensure that when customers pay by check, you
can convert these payments into usable cash in the bank quickly and cheaply. The use of checks is on
the decline and large payments are almost always made electronically. You therefore need to under-
stand how electronic payment systems work.
Our second task is to consider how much cash the firm should hold. Companies have a choice be-
tween holding cash in the bank and investing it in short-term securities. There is a trade-off here. Cash
gives you a store of liquidity, which can be used to pay employees and suppliers. However, cash has

the disadvantage that it does not pay interest. As we explain in the second section of this chapter,
the trick is to strike a sensible balance.
In the last chapter we explained how companies raise short-term loans to tide them over a tem-
porary cash shortage. If you are in the opposite position and have surplus cash, you need to know
where you can park it to earn interest. So in the final section of this chapter we look at the menu of
short-term investments that are available to the financial manager.
881
31.1 CASH COLLECTION AND DISBURSEMENT
The majority of small face-to-face purchases are made with coins or dollar bills.
The most popular alternative in the United States for retail purchases is to pay by
check. Each year individuals and firms write about 70 billion checks.
Notice that the United States is unusual in this heavy use of checks. For exam-
ple, Figure 31.1 compares retail payment methods in the United States and Hol-
land. You can see that checks are almost unknown in Holland: Most payments
there are made by debit cards, direct debit, or credit transfer.
1
How Checks Create Float
How does the firm’s cash balance change when it writes or deposits a check? Suppose
that the United Carbon Company has $1 million on demand deposit with its bank. It
now pays one of its suppliers by writing and mailing a check for $200,000. The com-
pany’s ledgers are immediately adjusted to show a cash balance of $800,000. But the
company’s bank won’t learn anything about this check until it has been received by
the supplier, deposited at the supplier’s bank, and finally presented to United Car-
bon’s bank for payment.
2
During this time United Carbon’s bank continues to show
1
Debit cards allow the cardholder to transfer money directly to the receiver’s bank account. With a
credit transfer the payer initiates the transaction, for example by giving her bank a standing order to
make a regular payment. With a direct debit the transaction is initiated by the payee and is usually

processed electronically.
2
Checks deposited with a bank are cleared through the Federal Reserve clearing system, through a cor-
respondent bank, or through a clearinghouse of local banks.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
in its ledger that the company has a balance of $1 million. The company obtains the
benefit of an extra $200,000 in the bank while the check is clearing. This sum is often
called payment, or disbursement float.
882 PART IX
Financial Planning and Short-Term Management
Check
Direct debit
Debit card
Credit card
Credit transfer
2%
19%
4%
1%
74%
52%
0%
18%

27%
3%
Check
Direct debit
Debit card
Credit card
Credit transfer
USA Holland
FIGURE 31.1
Shares of noncash retail payments in the USA and Holland in 1997. Notice the heavy use of checks in the USA.
Source: “Retail Payments in Selected Countries: A Comparative Study,” Bank for International Settlements, Basel, 1999.
Company's ledger balance
$800,000
+
Bank's ledger balance
$1,000,000
equals
Payment float
$200,000
Float sounds like a marvelous invention, but unfortunately it can also work in
reverse. Suppose that in addition to paying its supplier, United Carbon receives a
check for $100,000 from a customer. It deposits the check, and both the company
and the bank increase the ledger balance by $100,000:
Company's ledger balance
$900,000
+
Bank's ledger balance
$1,100,000
equals
Payment float

$200,000
But this money isn’t available to the company immediately. The bank doesn’t ac-
tually have the money in hand until it has sent the check to, and received pay-
ment from, the customer’s bank. Since the bank has to wait, it makes United Car-
bon wait too—usually one or two business days. In the meantime, the bank will
show that United Carbon has an available balance of $1 million and an availability
float of $100,000:
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
Notice that the company gains as a result of the payment float and loses as a re-
sult of the availability float. The difference is often termed the net float. In our ex-
ample, the net float is $100,000. The company’s available balance is therefore
$100,000 greater than the balance shown in its ledger.
As financial manager you are concerned with the available balance, not with the
company’s ledger balance. If you know that it is going to be a week or two before
some of your checks are presented for payment, you may be able to get by on a
smaller cash balance. This game is often called playing the float.
You can increase your available cash balance by increasing your net float. This
means that you want to ensure that checks paid in by customers are cleared rap-
idly and those paid to suppliers are cleared slowly. Perhaps this may sound like
rather small beer, but think what it can mean to a company like Ford. Ford’s daily
sales average about $450 million. Therefore if it can speed up the collection process
by one day, it frees $450 million, which is available for investment or payment to
Ford’s stockholders.

Some financial managers have become overenthusiastic in managing the float.
In 1985, the brokerage firm E. F. Hutton pleaded guilty to 2,000 separate counts of
mail and wire fraud. Hutton admitted that it had created nearly $1 billion of float
by shuffling funds between its branches, and through various accounts at different
banks. These activities cost the company a $2 million fine and its agreement to re-
pay the banks any losses they may have incurred.
Managing Float
Float is the child of delay. Actually there are several kinds of delay, and so people in
the cash management business refer to several kinds of float. Figure 31.2 summarizes.
Of course the delays that help the payer hurt the recipient. Recipients try to
speed up collections. Payers try to slow down disbursements.
Speeding Up Collections
Many companies use concentration banking to speed up collections. In this case
customers in a particular area make payment to a local branch office rather than
to company headquarters. The local branch office then deposits the checks into a
CHAPTER 31
Cash Management 883
Company's ledger balance
$900,000
+
Bank's ledger balance
$1,100,000
equals
Payment float
$200,000
Available balance
$1,000,000
+
Availability float
$100,000

equals
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
local bank account. Surplus funds are transferred to a concentration account at one
of the company’s principal banks.
Concentration banking reduces float in two ways. First, because the branch office
is nearer to the customer, mailing time is reduced. Second, since the customer’s check
is likely to be drawn on a local bank, the time taken to clear the check is also reduced.
Concentration banking brings many small balances together in one large, central bal-
ance, which can then be invested in interest-paying assets through a single transaction.
For example, when Amoco streamlined its U.S. bank accounts in 1995, it was able to
reduce its daily bank balances in non-interest-bearing accounts by almost 80 percent.
3
Often concentration banking is combined with a lock-box system. In a lock-box
system, you pay the local bank to take on the administrative chores. The system
works as follows. The company rents a locked post office box in each principal re-
gion. All customers within a region are instructed to send their payments to the
post office box. The local bank, as agent for the company, empties the box at regu-
lar intervals and deposits the checks in the company’s local account. Surplus funds
are transferred periodically to one of the company’s principal banks.
884 PART IX
Financial Planning and Short-Term Management
Payer sees
same delays

as payment
float
Recipient
sees delays
as collection
float
Check received
Check deposited
Check
charged to
payer's account
Cash
available
to recipient
Check mailed
Processing float
Presentation
float
Availability
float
Mail float
FIGURE 31.2
Delays create float. Each heavy
arrow represents a source of
delay. Recipients try to reduce
delay to get available cash
sooner. Payers prefer delay
because they can use their
cash longer.
Note: The delays causing avail-

ability float and presentation float
are equal on average but can differ
from case to case.
3
“Amoco Streamlines Treasury Operations,” The Citibank Globe, November/December 1998.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
How many collection points do you need if you use a lock-box system or con-
centration banking? The answer depends on where your customers are and on the
speed of the U.S. mail. For example, suppose that you are thinking of opening a
lock box. The local bank shows you a map of mail delivery times. From that and
knowledge of your customers’ locations, you come up with the following data:
• Average number of daily payments to lock box: 150
• Average size of payment: $1,200
• Rate of interest per day: .02 percent
• Saving in mailing time: 1.2 days
• Saving in processing time: .8 day
On this basis, the lock box would increase your collected balance by
150 items per day ϫ $1,200 per item ϫ (1.2 ϩ .8) days saved ϭ $360,000
Invested at .02 percent per day, $360,000 gives a daily return of
.0002 ϫ $360,000 ϭ $72
The bank’s charge for operating the lock-box system depends on the number of
checks processed. Suppose that the bank charges $.26 per check. That works out to
150 ϫ .26 ϭ $39 per day. You are ahead by $72 Ϫ 39 ϭ $33 per day, plus whatever

your firm saves from not having to process the checks itself.
Our example assumes that the company has only two choices. It can do nothing,
or it can operate the lock box. But maybe there is some other lock-box location, or
some mixture of locations, that would be still more effective. Of course, you can al-
ways find this out by working through all possible combinations, but it may be
simpler to solve the problem by linear programming. Many banks offer linear pro-
gramming models to solve the problem of locating lock boxes.
4
Controlling Disbursements
Speeding up collections is not the only way to increase the net float. You can also
do so by slowing down disbursements. One tempting strategy is to increase mail
time. For example, United Carbon could pay its New York suppliers with checks
mailed from Nome, Alaska, and its Los Angeles suppliers with checks mailed from
Vienna, Maine.
But on second thought you will realize that such post office tricks are unlikely
to give more than a short-run payoff. Suppose you have promised to pay a New
York supplier on February 29. Does it matter whether you mail the check from
Alaska on the 26th or from New York on the 28th? Of course, you could use a re-
mote mailing address as an excuse for paying late, but that’s a trick easily seen
through. If you have to pay late, you may as well mail late.
5
There are effective ways of increasing presentation float, however. For example,
suppose that United Carbon pays its suppliers with checks written on a New York
City bank. From the time that the check has been deposited by the supplier, there
CHAPTER 31
Cash Management 885
4
See, for example, A. Kraus, C. Janssen, and A. McAdams, “The Lock-Box Location Problem,” Journal of
Bank Research 1 (Autumn 1970), pp. 50–58.
5

Since the tax authorities look at the date of the postmark rather than the date of receipt, companies have
been tempted to use a remote mailing address to pay their tax bills. But the tax authorities have reacted
by demanding that large tax bills be paid by electronic transfer.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
will be an average lapse of little more than a day before it is presented to United
Carbon’s bank for payment. The alternative is that United Carbon pays its suppli-
ers with checks mailed to arrive on time but written on a bank in Helena, Montana;
Midland, Texas; or Wilmington, Delaware. In these cases, it may take three or four
days before each check is presented for payment. United Carbon, therefore, gains
several days of additional float.
6
Some firms even maintain disbursement accounts in different parts of the coun-
try. The computer looks up each supplier’s zip code and automatically produces a
check on the most distant bank.
The suppliers won’t object to these machinations because the Federal Reserve
guarantees a maximum clearing time of two days on all checks cleared through its
system. The Federal Reserve, however, does object and has been trying to prevent
remote disbursement.
A New York City bank receives several check deliveries each day from the Fed-
eral Reserve system as well as checks that come directly from other banks or
through the local clearinghouse. Thus, if United Carbon uses a New York City bank
for paying its suppliers, it will not know at the beginning of the day how many
checks will be presented for payment. It must either keep a large cash balance

to cover contingencies or be prepared to borrow. However, instead of having a
disbursement account with a bank in New York, United Carbon could open a zero-
balance account with a regional bank that receives almost all check deliveries in the
form of a single, early-morning delivery from the Federal Reserve. Therefore, it can
let the cash manager at United Carbon know early in the day exactly how much
money will be paid out that day. The cash manager then arranges for this sum to
be transferred from the company’s concentration account to the disbursement ac-
count. Thus by the end of the day (and at the start of the next day), United Carbon
has a zero balance in the disbursement account.
United Carbon’s regional bank account has two advantages. First, by choosing
a remote location, the company has gained several days of float. Second, because
the bank can forecast early in the day how much money will be paid out, United
Carbon does not need to keep extra cash in the account to cover contingencies.
The Finance in the News box describes how one Canadian company was able
to reduce its cash needs by concentrating its cash holdings and using zero-
balance accounts.
Electronic Funds Transfer
Throughout the world the use of checks is on the decline. For consumers they are
being replaced by credit or debit cards. In the case of companies, payments are in-
creasingly made electronically.
7
Electronic payments are relatively few in number
but they account for the majority of transactions by value. Electronic payment sys-
tems may be of two kinds—a gross settlement system or a net settlement system.
With gross settlement each payment is settled individually; with net settlement all
payment instructions are accumulated and then at the end of the day any imbal-
ances are settled.
886 PART IX
Financial Planning and Short-Term Management
6

Remote disbursement accounts are described in I. Ross, “The Race Is to the Slow Payer,” Fortune, April
18, 1983, pp. 75–80.
7
Consumers also may receive and pay bills electronically via their personal computer. Currently Elec-
tronic Bill Presentment and Payment (EBPP) accounts for only a small proportion of payments but it is
forecasted to grow rapidly.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
In the United States there are two systems for making large-value electronic
payments—Fedwire (a gross system) and CHIPS (a net system). Fedwire is op-
erated by the Federal Reserve system and connects over 10,000 financial institu-
tions in the United States to the Fed and thereby to each other. Suppose Bank A
instructs the Fed to transfer $1 million from its account with the Fed to the ac-
count of Bank B. Bank A’s account is debited immediately and Bank B’s account
is credited at the same time. Fedwire is therefore an example of a real-time gross
settlement (RTGS) system. Most developed countries now operate RTGS systems
for large-value payments.
Real-time gross settlement suffers from a potential problem. If Bank A needs to
pay Bank B, B needs to pay C, and C needs to pay A, there is a risk that the system
could gridlock unless each bank kept a large reserve with the Fed. (A might not be
able to pay B until it has been paid by C, C can’t pay A until paid by B, and B in
turn is awaiting payment by A.) To oil the wheels, therefore, the Fed takes on the
credit risk by paying the receiving bank even if there are insufficient funds in the
account of the payer. Since each payment is final and guaranteed by the Fed, each

receiving bank can be sure that it has the money and can give its customer imme-
diate access to the funds.
Cross-border high-value payments in dollars are handled by CHIPS, which is a
privately owned system connecting 115 large domestic and foreign banks. CHIPS
accumulates payment instructions throughout the day, and at the end of the day
each bank settles up the net payment using Fedwire. This means that, if the bank
receiving payments makes the funds available to its customers during the day, it
would be at risk if the paying bank goes belly up during the day. Banks control this
risk by imposing intraday credit limits on their exposure to each other.
887
FINANCE IN THE NEWS
HOW LAIDLAW RESTRUCTURED
ITS CASH MANAGEMENT
The Canadian company, Laidlaw Inc., has more
than 4,000 facilities throughout America, operating
school bus services, ambulance services, and Grey-
hound coaches. During the 1990s the company ex-
panded rapidly through acquisition, and its number
of banking relationships multiplied until it had
1,000 separate bank accounts with more than 200
different banks. The head office had no way of
knowing how much cash was stashed away in these
accounts until the end of each quarter, when it was
able to construct a consolidated balance sheet.
To economize on the use of cash, Laidlaw’s fi-
nancial manager sought to cut the company’s aver-
age float from five days to two. At the same time
management decided to consolidate cash manage-
ment at five key banks. This enabled cash to be
zero-balanced to a single account for each division

and swept daily to Laidlaw’s disbursement bank.
Because the head office could obtain daily reports
of the company’s cash position, cash forecasting
was improved and the company could reduce its
cash needs still further.
Source: Cash management at Laidlaw is described in G. Mann and
S. Hutchison, “Driving Down Working Capital: Laidlaw’s Story,”
Canadian Treasurer Magazine, August/September 1999.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
Fedwire and CHIPS provide same-day settlement and are used to make high-
value payments. Bulk payments such as wages, dividends, and payments to sup-
pliers generally travel through the Automated Clearinghouse (ACH) system and take
two to three days. In this case the company simply needs to provide a computer
file of instructions to its bank, which then debits the corporation’s account and for-
wards the payments to the ACH system. The ACH system is the largest payment
system in the United States and in 1999 handled 6.2 billion payments with a value
of $19 trillion.
For companies that are “wired” to their banks, customers, and suppliers, these
electronic payment systems have at least three advantages:
• Record keeping and routine transactions are easy to automate when money
moves electronically. Campbell Soup’s Treasury Management Department
discovered that it could handle cash management, short-term borrowing and
lending, and bank relationships with a total staff of seven. The company’s

domestic cash flow was about $5 billion.
8
• The marginal cost of transactions is very low. For example, it costs less than
$10 to transfer huge sums of money using Fedwire and only a few cents to
make an ACH transfer.
• Float is drastically reduced. Wire transfers generate no float at all. This can result
in substantial savings. For example, cash managers at Occidental Petroleum
found that one plant was paying out about $8 million per month three to five
days early to avoid any risk of late fees if checks were delayed in the mail. The
solution was obvious: The plant’s managers switched to paying large bills
electronically; that way they could ensure they arrived exactly on time.
9
International Cash Management
Cash management in domestic firms is child’s play compared with that in large
multinational corporations operating in dozens of countries, each with its own cur-
rency, banking system, and legal structure.
A single, centralized cash management system is an unattainable ideal for these
companies, although they are edging toward it. For example, suppose that you are
the treasurer of a large multinational company with operations throughout Eu-
rope. You could allow the separate businesses to manage their own cash but that
would be costly and would almost certainly result in each one accumulating little
hoards of cash. The solution is to set up a regional system. In this case the company
establishes a local concentration account with a bank in each country. Then any
surplus cash is swept daily into central multicurrency accounts in London or an-
other European banking center. This cash is then invested in marketable securities
or used to finance any subsidiaries that have a cash shortage.
Payments also can be made out of the regional center. For example, to pay wages
in each European country, the company just needs to send its principal bank a com-
puter file with details of the payments to be made. The bank then finds the least
costly way to transfer the cash from the company’s central accounts and arranges

for the funds to be credited on the correct day to the employees in each country.
888 PART IX
Financial Planning and Short-Term Management
8
J. D. Moss, “Campbell Soup’s Cutting-Edge Cash Management,” Financial Executive 8 (September/
October 1992), pp. 39–42.
9
R. J. Pisapia, “The Cash Manager’s Expanding Role: Working Capital,” Journal of Cash Management 10
(November/December 1990), pp. 11–14.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
Companies that maintain separate balances in each country are liable to find
that they have a cash surplus in one country and a shortage in another. In this case
the company could lend the surplus and borrow the deficit. However, that is likely
to be costly, since banks need to charge a higher rate to borrowers than they pay to
lenders. One alternative is to convert the surplus cash pool into the currency which
is in short supply, but the simpler solution is to arrange for the bank to pool all your
cash surpluses and shortages. In this case no money is transferred between ac-
counts. Instead, the bank just adds together the credit and debit balances and pays
you interest at its lending rate on the net surplus.
Most large multinationals have several banks in each country, but the more
banks they use, the less control they have over their cash balances. So development
of regional cash management systems favors banks that can offer a worldwide
branch network. These banks also can afford to invest the several billion dollars

that are needed to set up computer systems for handling cash payments and re-
ceipts in many different countries.
Paying for Bank Services
Much of the work of cash management—processing checks, transferring funds,
running lock boxes, helping keep track of the company’s accounts—is done by
banks. And banks provide many other services not so directly linked to cash man-
agement, such as handling payments and receipts in foreign currency or acting as
custodian for securities.
10
All these services have to be paid for. Usually payment is in the form of a
monthly fee, but banks may agree to waive the fee as long as the firm maintains a
minimum average balance in an interest-free deposit. Banks are prepared to do
this, because, after setting aside a portion of the money in a reserve account with
the Fed, they can relend the money to earn interest. Demand deposits earmarked
to pay for bank services are termed compensating balances. They used to be a very
common way to pay for bank services, but there has been a steady trend away from
using compensating balances and toward direct fees.
CHAPTER 31
Cash Management 889
10
Of course, banks also lend money or give firms the option to borrow under a line of credit. See Section 30.6.
31.2 HOW MUCH CASH SHOULD THE FIRM HOLD?
Cash pays no interest. So why do individuals and corporations hold billions of dol-
lars in cash and demand deposits? Why, for example, don’t you take all your cash
and invest it in interest-bearing securities? The answer of course is that cash gives
you more liquidity than securities. You can use it to buy things. It is hard enough
getting New York cab drivers to give you change for a $20 bill, but try asking them
to split a Treasury bill.
In equilibrium all assets in the same risk class are priced to give the same expected
marginal benefit. The benefit from holding Treasury bills is the interest that you re-

ceive; the benefit from holding cash is that it gives you a convenient store of liquid-
ity. In equilibrium the marginal value of this liquidity is equal to the marginal value
of the interest on Treasury bills. This is just another way of saying that Treasury bills
are investments with zero net present value; they are fair value relative to cash.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
Does this mean that it does not matter how much cash you hold? Of course not.
The marginal value of liquidity declines as you hold increasing amounts of cash.
When you have only a small proportion of your assets in cash, a little extra can be
extremely useful; when you have a substantial holding, any additional liquidity is
not worth much. Therefore, as financial manager you want to hold cash balances
up to the point where the marginal value of the liquidity is equal to the value of the
interest forgone.
If that seems more easily said than done, you may be comforted to know that
production managers must make a similar trade-off. Ask yourself why firms carry
inventories of raw materials. They are not obliged to do so; they could simply buy
materials day by day, as needed. But then they would pay higher prices for order-
ing in small lots, and they would risk production delays if the materials were not
delivered on time. That is why they order more than the firm’s immediate needs.
11
But there is a cost to holding inventories. Interest is lost on the money that is tied
up in inventories, storage must be paid for, and often there is spoilage and deteri-
oration. Therefore production managers try to strike a sensible balance between
the costs of holding too little inventory and those of holding too much.

It is exactly the same with cash. Cash is just another material that you require to
carry on production. If you keep too small a proportion of your funds in the bank, you
will need to make repeated sales of securities every time you want to pay your bills.
On the other hand, if you keep excessive cash in the bank, you are losing interest.
The Inventory Decision
Let us look at what economists have had to say about managing inventories and
then see whether some of these ideas may also help us to manage cash balances.
Here is a simple inventory problem.
Everyman’s Bookstore experiences a steady demand for Principles of Corporate
Finance from customers who find that it makes a serviceable doorstop. There are
two costs to holding an inventory of the book. First there is the carrying cost. This
includes the cost of the capital that is tied up in the inventory, the cost of the shelf
space, and so on. The second type of cost is the order cost. Each order involves a
fixed handling expense and delivery charge.
These two costs are the kernel of the inventory problem. An increase in order
size increases the average number of books in inventory, and therefore the carry-
ing cost rises. However, as the store increases its order size, the number of orders
falls, so that the order costs decline. The trick is to strike a sensible balance between
these two costs. When carrying costs are high, you should hold a smaller inventory
and replenish it more often. When order costs are high, you should hold a larger
inventory and place orders less frequently.
Some numbers may help to illustrate. Suppose that the bookstore sells 100
copies of the book a year. Suppose also that the carrying cost of inventory works
out at $4 per book and that each order placed with the publisher involves a fixed
order cost of $2. The upward sloping line in Figure 31.3 shows that carrying costs
increase in proportion to order size. The effect of order size on order costs is de-
890 PART IX
Financial Planning and Short-Term Management
11
Not much more in many manufacturing operations. “Just-in-time” assembly systems provide for a

continuous stream of parts deliveries, with no more than two or three hours’ worth of parts inventory
on hand. Financial managers likewise strive for just-in-time cash management systems, in which no
cash lies idle anywhere in the company’s business. This ideal is never quite reached because of the costs
and delays discussed in this chapter. Large corporations get close, however.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
picted by the downward sloping line. Order costs halve when the bookstore orders
two books at a time rather than one, but thereafter the savings from increases in or-
der size steadily diminish.
The upper curve in Figure 31.3 shows the sum of the carrying and order costs.
You can see that total costs are minimized when the store orders 10 books at a time.
Thus, 10 times a year the bookstore should place an order for 10 books and it
should work off this inventory over the following five weeks.
12
The Extension to Cash Balances
William Baumol was the first to point out that this simple inventory model can tell
us something about the management of cash balances.
13
Suppose that you keep a
reservoir of cash that is steadily drawn down to pay bills. When it runs out, you re-
plenish the cash balance by selling Treasury bills. The order cost is the fixed ad-
ministrative expense of each sale of Treasury bills. The main carrying cost of hold-
ing this cash is the interest that the firm is losing.
Deciding on the firm’s cash holding is exactly analogous to the problem of op-

timum order size faced by Everyman’s Bookstore. You just have to redefine the
variables. For example, instead of referring to the number of books per order, or-
der size becomes the amount of Treasury bills sold each time the cash balance is re-
plenished. Order cost becomes cost per sale of Treasury bills, while carrying cost is
just the interest lost from holding cash rather than bills.
If high interest rates increase the cost of carrying cash, you should hold a smaller
inventory of cash and therefore make smaller and more frequent sales of Treasury
CHAPTER 31
Cash Management 891
1 4 7 10 13 16 19
Order size (number of books)
Total cost
Order cost
Carrying cost
22 25 28 31 34
0
10
20
30
40
50
60
70
Inventory costs ($)
FIGURE 31.3
Optimal order size involves a trade-off between order costs and carrying costs.
12
See the Principles of Corporate Finance Web page (www.mhhe.com/bm7e) for an explanation of how to
calculate the optimal order size.
13

W. J. Baumol, “The Transactions Demand for Cash: An Inventory Theoretic Approach,” Quarterly Jour-
nal of Economics 66 (November 1952), pp. 545–556.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
bills. On the other hand, if the firm incurs high costs in selling securities, you
should hold larger cash balances.
The Cash Management Trade-off
Baumol’s model of cash balances is unrealistic in one important respect: It assumes
that the firm is steadily using up its cash inventory. But that is not what usually
happens. In some weeks the firm may collect some large unpaid bills and therefore
receive a net inflow of cash. In other weeks it may pay its suppliers and so incur a
net outflow of cash. Some of these cash flows can be forecasted with confidence; in
other cases the amount of the flow or its timing is uncertain.
Economists and management scientists have developed a variety of more elab-
orate and realistic models that allow for the possibility of both cash inflows and
outflows.
14
But no model will ever succeed in capturing all the intricacies of the
firm’s cash requirements or provide a substitute for the judgment of the cash man-
ager. The importance of Baumol’s model and its many offspring is that they all
highlight the basic trade-off that the cash manager needs to make between the
fixed costs of selling securities and the carrying costs of holding cash balances.
Since there are economies of scale in buying or selling securities, the firm should
wait and place a sufficiently large order rather than place a series of smaller orders.

Baumol’s model helps us understand why small and medium-sized firms hold
significant cash balances. But for very large firms, the transaction costs of buying
and selling securities become trivial compared with the opportunity cost of hold-
ing idle cash balances.
Suppose that the interest rate is 8 percent per year, or roughly 8/365 ϭ .022 per-
cent per day. Then the daily interest earned by $1 million is .00022 ϫ 1,000,000 ϭ
$220. Even at a cost of $50 per transaction, which is generously high, it pays to buy
Treasury bills today and sell them tomorrow rather than to leave $1 million idle
overnight.
A corporation with $1 billion of annual sales has an average daily cash flow of
$1,000,000,000/365, about $2.7 million. Firms of this size end up buying or selling
securities once a day, every day, unless by chance they have only a small positive
cash balance at the end of the day.
Why do such firms hold any significant amounts of cash? There are basically
two reasons. First, cash may be left in non-interest-bearing accounts to compensate
banks for the services they provide. Second, large corporations may have literally
hundreds of accounts with dozens of different banks. It is often better to leave idle
cash in some of these accounts than to monitor each account daily and make daily
transfers between them.
One major reason for the proliferation of bank accounts is decentralized man-
agement. You cannot give a subsidiary operating autonomy without giving its
managers the right to spend and receive cash.
Good cash management nevertheless implies some degree of centralization. You
cannot maintain your desired inventory of cash if all the subsidiaries in the group
are responsible for their own private pools of cash. And you certainly want to
avoid situations in which one subsidiary is investing its spare cash at 8 percent
892 PART IX
Financial Planning and Short-Term Management
14
For example, the problem of cash management when inflows and outflows are unpredictable is ana-

lyzed in M. H. Miller and D. Orr, “A Model of the Demand for Money by Firms,” Quarterly Journal of
Economics 80 (August 1966), pp. 413–435. The Miller–Orr model is described in the Principles of Corpo-
rate Finance Web page.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
while another is borrowing at 10 percent. It is not surprising, therefore, that even
in highly decentralized companies there is generally central control over cash bal-
ances and bank relations.
CHAPTER 31
Cash Management 893
31.3 INVESTING IDLE CASH
The Money Market
Temporary cash surpluses are generally invested in short-term securities. The mar-
ket for these short-term investments is known as the money market. The money
market has no physical marketplace. It consists of a loose agglomeration of banks
and dealers linked together by telex, telephones, and computers. But a huge volume
of securities is regularly traded on the money market, and competition is vigorous.
Most large corporations manage their own money-market investments, buy-
ing and selling through banks and dealers or over the Web. Small companies
sometimes find it more convenient to hire a professional investment manage-
ment firm or to put their cash into a money-market fund. This is a mutual fund
that invests only in low-risk, short-term securities. We discussed money-market
funds in Section 17.3.
Valuing Money-Market Investments

When we value long-term debt, it is important to take default risk into account. Al-
most anything may happen in 30 years, and even today’s most respectable com-
pany may get into trouble eventually. This is the basic reason that corporate bonds
offer higher yields than Treasury bonds.
Short-term debt is not risk-free either. When Penn Central failed, it had $82 mil-
lion of short-term commercial paper outstanding.
15
After that shock, investors be-
came much more discriminating in their purchases of commercial paper.
Such examples of failure are exceptions; in general, the danger of default is less
for money-market securities issued by corporations than for corporate bonds.
There are two reasons for this. First, the range of possible outcomes is smaller for
short-term investments. Even though the distant future may be clouded, you can
usually be confident that a particular company will survive for at least the next
month. Second, for the most part only well-established companies can borrow in
the money market. If you are going to lend money for only one day, you can’t af-
ford to spend too much time in evaluating the loan. Thus you will consider only
blue-chip borrowers.
Despite the high quality of money-market investments, there are often signifi-
cant differences in yield between corporate and U.S. government securities. Why
is this? One answer is the risk of default. Another is that the investments have dif-
ferent degrees of liquidity or “moneyness.” Investors like Treasury bills because
they are easier to turn into cash on short notice. Securities that cannot be converted
quickly and cheaply into cash need to offer relatively high yields.
During times of market turmoil investors often place a high value on having
ready access to cash. On such occasions the yield on illiquid securities can increase
dramatically. This happened in the fall of 1998 when a large hedge fund, Long
15
Commercial paper is short-term debt issued by corporations. We described it in Section 30.6.
Brealey−Meyers:

Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
Term Capital Management (LTCM), came close to collapse.
16
Fearful that LTCM
would be forced to liquidate its huge positions, investors shrank from securities
that could not be converted easily into cash. The spread between the yield on com-
mercial paper and Treasury bills rose to about 120 basis points (1.20 percent), al-
most four times its level at the beginning of the year.
Calculating the Yield on Money-Market Investments
Many money-market investments are pure discount securities. This means that
they don’t pay interest. The return consists of the difference between the amount
you pay and the amount you receive at maturity. Unfortunately, it is no good try-
ing to persuade the Internal Revenue Service that this difference represents capital
gain. The IRS is wise to that one and will tax your return as ordinary income.
Interest rates on money-market investments are often quoted on a discount ba-
sis. For example, suppose that six-month bills are issued at a discount of 5 percent.
This is rather a complicated way of saying that the price of a six-month bill is 100 Ϫ
(6/12) ϫ 5 ϭ $97.50. Therefore, for every $97.5 that you invest today, you receive
$100 at the end of six months. The return over six months is 2.5/97.5 ϭ .0256, or 2.56
percent. This is equivalent to an annual yield of 5.12 percent simple interest or 5.19
percent if interest is compounded annually. Note that the return is always higher
than the discount. When you read that an investment is selling at a discount of 5
percent, it is very easy to slip into the mistake of thinking that this is its return.
17

The International Money Market
In Chapter 24 we pointed out that there are two main markets for dollar bonds.
There is the domestic market in the United States and there is an international mar-
ket. Similarly, in this chapter we shall see that in addition to the domestic money
market, there is also an international market for short-term dollar investments.
Since this market is based largely in Europe, it has traditionally been known as the
eurodollar market. However, now that the European single currency has been called
the euro, the term “eurodollar” is potentially confusing and we will just refer to
“international dollars.”
An international dollar is not some strange bank note; it is simply a dollar de-
posit in a bank outside the United States. For example, suppose that an American
oil company buys crude oil from an Arab sheik and pays for it with a $1 million
check drawn on Chase Manhattan Bank. The sheik then deposits the check into his
account at Barclays Bank in London. As a result, Barclays has an asset in the form
of a $1 million credit in its account with Chase Manhattan. It also has an offsetting
liability in the form of a dollar deposit. That dollar deposit is placed in Europe; it
is, therefore, an international dollar deposit.
18
894 PART IX Financial Planning and Short-Term Management
16
Hedge funds specialize in making positive investments in securities that are believed to be underval-
ued, while selling short those that appear overvalued. The story of LTCM is told in R. Lowenstein, When
Genius Failed: The Rise and Fall of Long Term Capital Management, Random House, New York, 2000; and
N. Dunbar, Inventing Money: The Story of Long Term Capital Management and the Legends behind It, John
Wiley, New York, 2000.
17
To confuse things even more, dealers in the money market often quote rates as if there were only 360
days in a year. So a discount of 5 percent on a bill maturing in 182 days translates into a price of 100 Ϫ
5 ϫ (182/360) ϭ 97.47 percent.
18

The sheik could equally well deposit the check with the London branch of a U.S. bank or a Japanese
bank. He would still have made an international dollar deposit.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
We will describe the principal domestic and international dollar investments
shortly, but bear in mind that there is also an international market for investments
in other currencies. For example, if a U.S. corporation wishes to make a short-term
investment in yen, it can do so in the Tokyo money market or it can make an in-
ternational yen deposit in London.
If we lived in a world without regulation and taxes, the interest rate on an in-
ternational dollar loan would have to be the same as the rate on an equivalent do-
mestic dollar loan, the rate on an international yen loan would have to be the same
as that on a domestic yen loan, and so on. However, the international loan markets
thrive because individual governments attempt to regulate domestic bank lending.
For example, between 1963 and 1974 the U.S. government controlled the export of
funds for corporate investment. Therefore, companies that wished to expand
abroad were forced to borrow dollars outside the United States. This demand
tended to push the interest rate on these loans above the domestic rate. At the same
time the government limited the rate of interest that banks in the United States
could pay on domestic deposits; this also tended to keep the rate of interest that
you could earn on dollar deposits in Europe above the rate on domestic dollar de-
posits. By early 1974 the restrictions on the export of funds had been removed, and
for large deposits the interest rate ceiling had also been abolished. In consequence,
the difference between the interest rate on international dollar deposits and do-

mestic deposits narrowed, but it did not disappear: Banks are not subject to Fed-
eral Reserve requirements on international dollar deposits and are not obliged to
insure these deposits with the Federal Deposit Insurance Corporation. On the
other hand, depositors are exposed to the (very low) risk that a foreign government
could prohibit banks from repaying international dollar deposits. For these reasons
international dollar investments continue to offer slightly higher rates of interest
than domestic dollar deposits.
The U.S. government has become increasingly concerned that its regulations are
driving banking business overseas to foreign banks and the overseas branches of
American banks. To attract some of this business back to the States, the government
in 1981 allowed U.S. and foreign banks to establish so-called international banking
facilities (IBFs). An IBF is the financial equivalent of a free-trade zone; it is physi-
cally situated in the United States, but it is not required to maintain reserves with
the Federal Reserve and depositors are not subject to any U.S. tax.
19
However,
there are tight restrictions on what business an IBF can conduct. In particular, it
cannot accept deposits from domestic United States corporations or make loans
to them.
Banks in London lend dollars to one another at the London interbank offered rate
(LIBOR). LIBOR is a benchmark for pricing many types of short-term loans in the
United States and overseas. For example, a corporation in the United States may
issue a floating-rate note with interest payments tied to LIBOR.
CHAPTER 31
Cash Management 895
19
For these reasons dollars held on deposit in an IBF are also classed as international dollars.
31.4 MONEY-MARKET INVESTMENTS
Table 31.1 summarizes the principal money-market investments. We will describe
each in turn.

Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
896 PART IX Financial Planning and Short-Term Management
Basis for
Maturities Calculating
Investment Borrower When Issued Marketability Interest Comments
Treasury bills U.S. 4 weeks, Excellent Discount Auctioned weekly
government 3 months, secondary
or 6 months market
Federal FHLB, “Fannie Typically 3 to Very good Discount for Sold through
agency Mae,” “Sallie 6 months secondary securities dealers
discount Mae,” “Freddie market of 6 months
notes Mac,” etc. or less
Tax-exempt Municipalities, 3 months to Good secondary Usually Tax anticipation
municipal states, school 1 year market interest- notes (TANs),
notes districts, etc. bearing; revenue antici-
interest pation notes
at maturity (RANs), bond
anticipation
notes (BANs),
etc.
Tax-exempt Municipalities, 20 to 40 years Good secondary Variable interest Long-term bonds
variable-rate states, state market rate but with put
demand bonds universities, etc. options to

(VRDBs) demand
repayment
Non-negotiable Commercial banks, Usually 1 to 3 Poor secondary Interest-bearing Receipt for time
time deposits savings and months; also market for with interest deposit
and negotiable loans longer-maturity CDs at maturity
certificates of variable-rate
deposit (CDs) CDs
Commercial Industrial firms, Maximum 270 Dealers or issuer Usually Unsecured
paper (CP) finance companies, days; usually 60 will repurchase discount promissory
and bank holding days or less paper note; may be
companies; also placed through
municipalities dealer or
directly with
investor
Medium-term Largely finance Minimum 270 Dealers will Interest-bearing; Unsecured
notes (MTNs) companies and days; usually repurchase usually fixed promissory
banks; also less than notes rate note; placed
industrial firms 10 years through dealer
Bankers’ Major commercial 1 to 6 months Fair secondary Discount Demands to pay
acceptances banks market that have been
(BAs) accepted by a
bank
Repurchase Dealers in U.S. Overnight to No secondary Repurchase price Sales of
agreements government about 3 market set higher than government
(repos) securities months; also selling price; securities by
open repos difference dealer with
(continuing quoted as repo simultaneous
contracts) interest rate agreement to
repurchase
TABLE 31.1

Money-market investments in the United States.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
U.S. Treasury Bills
The first item in Table 31.1 is U.S. Treasury bills. These are usually issued weekly
and mature in four weeks, three months, or six months.
20
Sales are by auction. You
can enter a competitive bid and take your chance of receiving an allotment at your
bid price. Alternatively, if you want to be sure of getting your bills, you can enter
a noncompetitive bid. Noncompetitive bids are filled at the average price of the suc-
cessful competitive bids. You don’t have to participate in the auction to invest in
Treasury bills. There is also an excellent secondary market in which billions of dol-
lars of bills are bought and sold every day.
Federal Agency Securities
Agencies of the federal government such as the Federal Home Loan Bank (FHLB)
and the Federal National Mortgage Association (“Fannie Mae”) borrow both short
and long term. The short-term debt consists of discount notes, which are similar to
Treasury bills. They are very actively traded and are often held by corporations.
Their yields are slightly above those on comparable Treasury securities. One rea-
son for the slightly higher yields is that agency debt is not quite as marketable as
Treasury issues.
Another is that most agency debt is backed not by the “full faith and credit” of
the U.S. government but only by the agency itself.

21
Most investors do not believe
that the U.S. government would allow one of its agencies to default, but in 2000
their faith and the price of agency debt both took a knock when a senior Treasury
official reminded Congress that the government did not guarantee the debt. Sooth-
ing noises from the Treasury subsequently helped to reassure investors.
Short-Term Tax-Exempts
Short-term notes are also issued by municipalities, states, and agencies such as
state universities and school districts.
22
These are slightly more risky than Treasury
bills and not as easy to buy or sell.
23
Nevertheless they have one particular attrac-
tion—the interest is not subject to federal income tax.
24
Pretax yields on tax-exempts are substantially lower than those on comparable
taxed securities. But if your company pays tax at the standard 35 percent corporate
rate, the lower gross yield of the municipals may be more than offset by the sav-
ings in tax.
Tax-exempt issues also include variable-rate demand bonds (VRDBs). These are
long-term securities, whose interest payments are linked to the level of short-term
interest rates. Whenever the interest rate is reset, investors have the right to sell the
bonds back to the issuer for their face value. This ensures that on these reset dates
the price of the bonds cannot be less than their face value. Therefore, although
CHAPTER 31
Cash Management 897
20
So-called three-month bills actually mature 91 days after issue, and six-month bills mature 182 days
after issue.

21
The exception is Ginnie Mae, whose debt is guaranteed by the U.S. government.
22
Some of these notes are general obligations of the issuer; others are revenue securities, and in these cases
payments are made from rent receipts or other user charges.
23
Defaults on tax-exempts are rare but not unknown. For example, in 1983 the municipal utility Wash-
ington Public Power Supply System (unfortunately known as WPPSS) defaulted on $2.25 billion of
bonds. The 1994 default of Orange County is described in Section 13.4.
24
This advantage is partly offset by the fact that Treasury securities are free of state and local taxes.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
VRDBs are long-term bonds, their prices are very stable and they compete with
short-term tax-exempt notes as a home for spare cash.
Bank Time Deposits and Certificates of Deposit
If you make a time deposit with a bank, you are lending money to the bank for a fixed
period. If you need the money before maturity, the bank will usually allow you to
withdraw it but will exact a penalty in the form of a reduced rate of interest.
In the 1960s banks introduced the negotiable certificate of deposit (CD) for
time deposits of $1 million or more. In this case, when the bank borrows, it issues
a certificate of deposit, which is simply evidence of a time deposit with that bank.
If a lender needs the money before maturity, it can sell the CD to another investor.
When the loan matures, the new owner of the CD presents it to the bank and re-

ceives payment.
In recent years doubts about the creditworthiness of some banks have caused
the secondary market in CDs to become less active, so that CDs are now much
more like large non-negotiable time deposits.
25
Instead of depositing dollars with a bank in the United States, a corporation can
deposit them overseas with a foreign bank or the foreign branch of a U.S. bank. These
deposits pay a fixed rate of interest, and either they are for a fixed term that may vary
from one day to several years or they are for an undefined term but may be called at
one or more days’ notice. Since a time deposit is an illiquid investment, the London
branches of the major banks also issue negotiable international dollar CDs.
Commercial Paper
We described commercial paper in the last chapter so we will not discuss it here
beyond reminding you that it is short-term debt that is issued on a regular basis by
both financial and nonfinancial companies. Commercial paper is popular with
both industrial companies and money-market mutual funds as a parking place for
short-term cash.
Bankers’ Acceptances
In the next chapter we will explain how bankers’ acceptances (BAs) may be used
to finance exports or imports. An acceptance begins life as a written demand for
the bank to pay a given sum at a future date. The bank then agrees to this demand
by writing “accepted” on it. Once accepted, the draft becomes the bank’s IOU and
is a negotiable security that can be bought or sold through money-market dealers.
Acceptances by the large U.S. banks generally mature in one to six months and in-
volve very low credit risk.
Repurchase Agreements
Repurchase agreements, or repos, are effectively secured loans to a government se-
curity dealer. They work as follows: The investor buys part of the dealer’s holding
of Treasury securities and simultaneously arranges to sell them back again at a
later date at a specified higher price. The borrower (the dealer) is said to have en-

tered into a repo; the lender (who buys the securities) is said to have a reverse repo.
898 PART IX
Financial Planning and Short-Term Management
25
Some CDs are not negotiable at all and are therefore identical to time deposits. For example, banks may
sell low-value non-negotiable CDs to individuals.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
Repos sometimes run for several months, but more frequently they are just
overnight (24-hour) agreements. No other domestic money-market investment of-
fers such liquidity. Corporations can treat overnight repos almost as if they were
interest-bearing demand deposits.
Suppose that you decide to invest cash in repos for several days or weeks.
You don’t want to keep renegotiating agreements every day. One solution is to
enter into an open repo with a security dealer. In this case there is no fixed ma-
turity to the agreement; either side is free to withdraw at one day’s notice. Al-
ternatively, you may arrange with your bank to transfer any excess cash auto-
matically into repos.
For many years repos appeared to be not only very liquid instruments but also
very safe.
26
This reputation took a knock in 1982 when two money-market dealers
went bankrupt. Each case involved heavy use of repos. One dealer, Drysdale Se-
curities, had been in existence for only three months and had total capital of $20

million. However, it went bankrupt, owing Chase Bank $250 million. It’s not easy
to run up debts that fast, but Drysdale did it.
CHAPTER 31
Cash Management 899
26
To reduce the risk of repos, it is common to value the security at less than its market value. This dif-
ference is known as a haircut.
27
Preferred shares are usually better short-term investments for a corporation than common shares. The
preferred shares’ expected return is virtually all dividends; most common shares are expected to gen-
erate capital gains, too. The corporate tax on capital gains is usually 35 percent. Corporations therefore
have a strong incentive to like dividends and dislike capital gains.
31.5 FLOATING-RATE PREFERRED STOCK—AN
ALTERNATIVE TO MONEY-MARKET INVESTMENTS
There is no law preventing firms from making short-term investments in long-term
securities. If a firm has $1 million set aside for an income tax payment, it could buy
a long-term bond on January 1 and sell it on April 15, when the taxes must be paid.
However, the danger in this strategy is obvious. What happens if bond prices fall
by 10 percent between January and April? There you are, with a $1 million liabil-
ity to the Internal Revenue Service, bonds worth only $900,000, and a very red face.
Of course, bond prices could also go up, but why take the chance? Corporate treas-
urers entrusted with excess funds for short-term investment are naturally averse
to the price volatility of long-term bonds.
We saw earlier how municipalities devised variable-rate demand bonds, which
investors could periodically sell back to the issuer. The prices of these bonds are
nearly immune to fluctuations in interest rates. In addition, the interest on munic-
ipal loans has the attraction of being tax-exempt. So a municipal variable-rate de-
mand bond offers a safe, tax-free, short-term haven for your $1 million of cash.
Common stock and preferred stock also have an interesting tax advantage for cor-
porations, since firms pay tax on only 30 percent of dividends received from other

corporations. For each $1 of dividends received, the firm gets to keep 1 Ϫ .30 ϫ
.35 ϭ $.895. Thus the effective tax rate is only 10.5 percent. This is higher than the zero
tax rate on the interest from municipal debt but much lower than the rate that the
company pays on other debt interest.
Suppose you consider putting that $1 million in some other corporation’s pre-
ferred shares.
27
The 10.5 percent tax rate is very tempting. On the other hand,
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
since preferred dividends are fixed, the prices of preferred shares change when
long-term interest rates change. A $1 million investment in preferred shares
could be worth only $900,000 on April 15, when taxes are due. Wouldn’t it be
nice if someone invented a preferred share that was insulated from fluctuating
interest rates?
Well, there are such securities, and you can probably guess how they work: Spec-
ify a dividend payment which goes up and down with the general level of interest
rates.
28
The prices of these securities are less volatile than those of fixed-dividend
preferreds.
Varying the dividend payment on preferred stock doesn’t quite do the trick.
For example, if investors become more concerned about the risk of preferred
stock, they might demand a higher relative return and the price of the stock

could fall. So companies sometimes add another wrinkle to floating-rate pre-
ferred. Instead of being tied rigidly to interest rates, the dividend can be reset
periodically by means of an auction which is open to all investors. Existing
shareholders can enter the auction by stating the minimum dividend they are
prepared to accept; if this turns out to be higher than the rate that is needed to
sell the issue, the shareholders sell the stock to the new investors at its face
value. Alternatively, shareholders can simply enter a noncompetitive bid, keep-
ing their shares and receiving whatever dividend is set by the other bidders. The
result is similar to the variable-rate demand note: Because auction-rate pre-
ferred stock can be resold at regular intervals for its face value, its price cannot
wander far in the interim.
29
Why would any firm want to issue floating-rate preferreds? Dividends must be
paid out of after-tax income, whereas interest comes out of before-tax income. Thus,
if a taxpaying firm wants to issue a floating-rate security, it would normally choose
to issue floating-rate debt to generate interest tax shields.
However, there are plenty of firms that are not paying taxes. These firms cannot
make use of the interest tax shield. Moreover, they have been able to issue floating-
rate preferreds at yields lower than what they would have to pay on a floating-rate
debt issue. (The corporations buying the preferreds are happy with these lower
yields because 70 percent of the dividends they receive escape tax.)
Floating-rate preferreds were invented in Canada in the mid-1970s, when sev-
eral billion dollars’ worth were issued before the Canadian tax authorities cooled
off the market by limiting the dividend tax exclusion on some types of floating-rate
issues. They were reinvented in the United States in May 1982, when Chemical
New York Corporation, the holding company for Chemical Bank, raised $200 mil-
lion. The securities proved so popular that over $4 billion of floating-rate pre-
ferreds were issued by the following spring. Then the novelty wore off, and the fre-
quency of new issues slowed down. It was back to business as usual, with one
important exception: There was one more item on the menu of investment oppor-

tunities open to corporate money managers.
28
Usually there are limits on the maximum and minimum dividends that can be paid. Thus if interest
rates leap to 100 percent, the preferred dividend would hit a ceiling of, say, 15 percent. If interest rates
fall to 1 percent, the preferred dividend would hit a floor at say, 5 percent.
29
See M. J. Alderson, K. C. Brown, and S. L. Lummer, “Dutch Auction Rate Preferred Stock,” Financial
Management 16 (Summer 1987), pp. 68–73.
900 PART IX Financial Planning and Short-Term Management
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
In the United States a high proportion of small purchases are paid for by check. To
make the best use of their cash, companies need to understand how a company’s
cash changes when it writes or deposits a check. The cash shown in the company’s
ledger is not the same as the available balance in your bank account. The difference
is the net float. When you have written a large number of checks awaiting clear-
ance, the available balance will be larger than the ledger balance. When you have
just deposited a large number of checks that have not yet been cleared by the bank,
the available balance will be smaller. If you can predict how long it will take checks
to clear, you may be able to play the float and get by on a smaller cash balance.
You can also manage the float by speeding up collections and slowing down pay-
ments. One way to speed collections is to use concentration banking. Customers
make payments to a regional office which then pays the checks into a local bank
account. Surplus funds are transferred from the local account to a concentration

bank. An alternative technique is lock-box banking. In this case customers send
their payments to a local post office box. A local bank empties the box at regular in-
tervals and clears the checks. Concentration banking and lock-box banking reduce
mailing time and the time required to clear checks.
Large-value payments are almost always made electronically. In the United
States there are two large-value systems—Fedwire (for dollar payments within the
country) and CHIPS (for cross-border payments). Bulk payments, such as wages
and dividends, are usually made by means of the Automated Clearinghouse
(ACH) system.
Banks provide many services. They handle checks, manage lock boxes, provide
advice, obtain references, and so on. Firms either pay cash for these services or pay
by maintaining sufficient cash balances with the bank.
In many cases you will want to keep somewhat larger balances than are needed
to pay for the tangible services. One reason is that the bank may be a valuable
source of ideas and business connections. Another reason is that you may use the
bank as a source of short-term funds. Leaving idle cash at your bank may be im-
plicit compensation for the willingness of the bank to stand ready to advance credit
when needed. A large cash balance may, therefore, be good insurance against a
rainy day.
Cash provides liquidity, but it doesn’t pay interest. Securities pay interest, but
you can’t use them to buy things. As financial manager you want to hold cash up
to the point where the marginal value of liquidity is equal to the interest that you
could earn on securities.
Cash is just one of the raw materials that you need to do business. It is expen-
sive keeping your capital tied up in large inventories of raw materials when it
could be earning interest. So why do you hold inventories at all? Why not order
materials as and when you need them? The answer is that it is also expensive to
keep placing many small orders. You need to strike a balance between holding too
large an inventory of cash (and losing interest on the money) and making too many
small adjustments to your stock of cash (and incurring additional administrative

and transaction costs). If interest rates are high, you want to hold relatively small
inventories of cash. If your cash needs are variable and your costs are high, you
want to hold relatively large inventories.
If you have more cash than is currently needed, you can invest it in the money
market. There is a wide choice of money-market investments, with different
SUMMARY
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Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
902 PART IX Financial Planning and Short-Term Management
degrees of liquidity and risk. Remember that the interest rate on these invest-
ments is often quoted as a discount. The compound return is always higher than
the rate of discount.
The principal money-market investments in the United States are
• U.S. Treasury bills
• Federal agency notes
• Short-term tax-exempts
• Time deposits and certificates of deposit
• Repurchase agreements
• Commercial paper
• Bankers’ acceptances
Figure 31.4 should give you some feel for which of these investments are the most
popular homes for surplus cash.
FURTHER

READING
The next three articles analyze the design of lock-box and concentration banking systems:
A. Kraus, C. Janssen, and A. McAdams: “The Lock-Box Location Problem,” Journal of Bank
Research, 1:50–58 (Autumn 1970).
G. Cornuejols, M. L. Fisher, and G. L. Nemhauser: “Location of Bank Accounts to Optimize
Float: An Analytic Study of Exact and Approximate Algorithms,” Management Science,
23:789–810 (April 1977).
S. F. Maier and J. H. Vander Weide: “What Lock-Box and Disbursement Models Really Do,”
Journal of Finance, 37:361–371 (May 1983).
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CDs & time
deposits
$ billions
Commercial
paper &
BAs
Repos
Treasury
securities
Agency
securities
Tax-
exempts
0
5
10
15
20
25
30

35
40
FIGURE 31.4
Short-term assets held by U.S.
nonfinancial corporations, 4th
quarter, 2000.
Source: Federal Reserve System,
Division of Research and Statistics,
Flow of Funds Accounts (www.federal
reserve.gov/releases/Z1/current/data.
htm).
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
CHAPTER 31 Cash Management 903
Baumol was the pioneer in applying inventory models to cash management. Miller and Orr extend
the Baumol model to handling uncertain cash flows, and Mullins and Homonoff review tests of in-
ventory models for cash management.
W. J. Baumol: “The Transactions Demand for Cash: An Inventory Theoretic Approach,”
Quarterly Journal of Economics, 66:545–556 (November 1952).
M. H. Miller and D. Orr: “A Model of the Demand for Money by Firms,” Quarterly Journal
of Economics, 80:413–435 (August 1966).
D. Mullins and R. Homonoff: “Applications of Inventory Cash Management Models,” in
S. C. Myers (ed.), Modern Developments in Financial Management, Frederick A. Praeger, Inc.,
New York, 1976.

The following article provides a useful description of electronic payments systems in the United
States:
G. R. Junker, B. J. Summers, and F. M. Young: “A Primer on the Settlement of Payments in
the United States,” Federal Reserve Bulletin, 77:847–858 (November 1991).
Specialized “how-to” texts on cash management include:
J. E. Finnerty: How to Manage Corporate Cash Effectively, American Management Association,
New York, 1991.
J. G. Kallberg and K. L. Parkinson: Corporate Liquidity: Management and Measurement, Richard
D. Irwin, Homewood, IL, 1993.
C. R. Malburg: The Cash Management Handbook, Prentice-Hall, Englewood Cliffs, NJ, 1992.
For a detailed description of the money market and short-term lending opportunities, see:
L. Epstein: Corporate Investing: A Treasurer’s Reference, John Wiley, New York, 2001.
F. J. Fabozzi, The Handbook of Fixed Income Securities, 6th ed., McGraw-Hill Companies, Inc.,
New York, 2000.
M. Stigum: The Money Market, 3rd ed., McGraw-Hill Professional Publishing, New York, 1990.
Chapter 4 of U.S. Monetary Policy and Financial Markets, which is available on the New York
Federal Reserve website, www
.newyorkfed.org.
QUIZ
1. A company has the following cash balances:
Company’s ledger balance $600,000
Bank’s ledger balance $625,000
Available balance $550,000
a. Calculate the payment float and availability float.
b. Why does the company gain from the payment float?
c. Suppose the company adopts a policy of writing checks on a remote bank. How is
this likely to affect the three measures of cash balance?
2. Anne Teak, the financial manager of a furniture manufacturer, is considering operating
a lock-box system. She forecasts that 300 payments a day will be made to lock boxes,
with an average payment size of $1,500. The bank’s charge for operating the lock boxes

is either $.40 a check or compensating balances of $800,000.
a. If the interest rate is 9 percent, which method of payment is cheaper?
b. What reduction in the time to collect and process each check is needed to justify
use of the lock-box system?
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Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
31. Cash Management
© The McGraw−Hill
Companies, 2003
904 PART IX Financial Planning and Short-Term Management
3. Complete the passage that follows by choosing the appropriate terms from the follow-
ing list: lock-box banking, Fedwire, CHIPS, payment float, concentration banking, availability
float, net float.
The firm’s available balance is equal to its ledger balance plus the _______ and
minus the _______. The difference between the available balance and the ledger bal-
ance is often called the _______. Firms can increase their cash resources by speeding
up collections. One way to do this is to arrange for payments to be made to regional
offices which pay the checks into local banks. This is known as _______. Surplus
funds are then transferred from the local bank to one of the company’s main banks.
Transfers can be made electronically by the _______ or _______ systems. Another
technique is to arrange for a local bank to collect the checks directly from a post office
box. This is known as _______.
4. Everyman’s Bookstore has experienced an increased demand for Principles of Corpo-
rate Finance. It now expects to sell 216 books a year. Unfortunately, inventory carry-
ing costs have increased to $6 per book per year, whereas order costs have remained
steady at $2 per order. How many orders should the store place per year and what is

its average inventory? You can answer the question either by plotting store costs as in
Figure 31.1 or using the formula shown on the Principles of Corporate Finance Web page
(www
.mhhe.com/bm7e
)
5. Now assume that Everyman’s Bookstore uses up cash at a steady rate of $20,000 a year.
The interest rate is 2 percent, and each sale of securities costs $2. How many times a year
should the store sell securities and what is its average cash balance? Either plot the costs
as in Figure 31.1 or use the formula shown on the Principles of Corporate Finance Web
page (www
.mhhe.com/bm7e
)
6. Suppose that you can hold cash that pays no interest or invest in securities that pay in-
terest at 8 percent. The securities are not easily sold on short notice; therefore, you must
make up any cash deficiency by drawing on a bank line of credit which charges inter-
est at 10 percent. Should you invest more or less in securities under each of the follow-
ing circumstances?
a. You are unusually uncertain about future cash flows.
b. The interest rate on bank loans rises to 11 percent.
c. The interest rates on securities and on bank loans both rise by the same proportion.
d. You revise downward your forecast of future cash needs.
7. In January 2002 six-month (182-day) Treasury bills were issued at a discount of 1.75 per-
cent. What is the annual yield?
8. For each item below, choose the investment that best fits the accompanying description:
a. Maturity often overnight (repurchase agreements/bankers’ acceptances).
b. Maturity never more than 270 days (tax-exempts/commercial paper).
c. Often directly placed with investors (finance company commercial
paper/industrial commercial paper).
d. Registered with the SEC (commercial paper/medium-term notes).
e. Issued by the U.S. Treasury (tax-exempts/3-month bills).

f. Quoted on a discount basis (certificates of deposit/Treasury bills).
g. Sold by auction (tax-exempts/Treasury bills).
9. Consider three securities:
a. A floating-rate bond.
b. A preferred share paying a fixed dividend.
c. A floating-rate preferred.
A financial manager responsible for short-term investment of excess cash would
probably choose the floating-rate preferred over either of the other two securities. Why?
Explain briefly.
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