MODERN WORKING CAPITAL MANAGEMENT TEXT AND CASES FREDERICK C. SCHERR CHAPTER 3

1. Cash Forecasting
&
Models for the Management of Cash
and Temporary Investment
Working Capital Management

2. • Cash: Cash is the ready currency to
which all liquid assets can be reduced.
• Near Cash: It implies marketable
securities viewed the same way as
cash because of their high liquidity.
• Marketable Securities: Short-term
interest earning money market
instruments used by firms to obtain a
return on temporarily idle funds

3. Motives For Holding Cash
Cash management is one of the key areas of
working capital management. There are four
motives for holding cash:
1) Transaction motive,
2) Precautionary motive,
3) Speculative motive, and
4) Compensating motive.

4. 1. Transaction motive
The transaction motive refers to the holding of cash to meet
anticipated obligations whose time is not perfectly synchronized with
cash receipts.
2. Precautionary motive
Precautionary motive is a motive for holding cash/near-cash as a
cushion t meet unexpected contingencies/demand for cash. The
unexpected cash needs at short notice may be the result of:
Floods, strikes and failure of important customers;
Bills may be presented for settlement earlier than expected;
Unexpected slow down in collection of accounts receivable;
Cancellation of some order for goods as the customer is not
satisfied;
and
Sharp increase in cost of raw materials.

5. The cash balances held in reserve for such
random and unforeseen fluctuations in
cash flows are called as precautionary
balances. In other words, precautionary
motive of holding cash implies the need to
hold cash to meet unpredictable
obligations. Thus, precautionary cash
balance serves to provide a cushion to
meet unexpected contingencies.

6. 3. Speculative motive
Speculative motive is a motive for holding
cash/near-cash to quickly take advantage of
opportunities typically outside the normal
course of business.
4. Compensating motive
Compensating motive is a motive for holding
cash/near-cash to compensate banks for
providing certain services or loans.

7. The basic objectives of cash management are two-
fold:
(a) to meet the cash disbursement needs
(payment schedule)
(b) to minimize funds committed to cash
balances.

8. Meeting Payments Schedule
A basic objective of cash management is to meet the
payment schedule, that is, to have sufficient cash to meet the
cash disbursement needs of a firm.
The importance of sufficient cash to meet the payment
schedule can hardly be over emphasized. The advantages of
adequate cash are:
1)it prevents insolvency or bankruptcy arising out of the
inability of a firm to meet its obligations;
2)the relationship with the bank is not strained;
3)it helps in fostering good relations with trade creditors and
suppliers of raw materials
4)a cash discount can be availed of if payment is made
within the due date.

9. 5. it leads to a strong credit rating which enables
the firm to purchase goods on favorable terms
and to maintain its line of credit with banks and
other sources of credit;
6. to take advantage of favorable business
opportunities that may be available periodically;
and finally,
7. the firm can meet unanticipated cash
expenditure with a minimum of strain during
emergencies, such as strikes, fires or a new
marketing campaign by competitors.

10. • For example, a firm is entitled to a 2 per cent
discount for a payment made within 10 days
when the entire payment is to be made
within 30 days. Since the net amount is due
in 30 days, failure to take the discount
means paying an extra 2 per cent for using
the money for an additional 20 days. If a firm
were to pay 2 per cent for every 20-day
period over a year, there would be 18 such
periods (360 days ÷ 20 days). This represents
an annual interest rate of 36 per cent;

11. Minimizing Funds Committed to Cash Balances
The second objective of cash management is to minimize
cash balances. In minimizing the cash balances, two
conflicting aspects have to be reconciled. A high level of
cash balances will, as shown above, ensure prompt
payment together with all the advantages. But it also
implies that large funds will remain idle, as cash is a non-
earning asset and the firm will have to forego profits. A
low level of cash balances, on the other hand, may mean
failure to meet the payment schedule. The aim of cash
management, therefore, should be to have an optimal
amount of cash balances.

12. Factors Determining Cash Needs
The factors that determine the required cash balances are:
(1) Synchronization of cash flows
The need for maintaining cash balances arises from the non-
synchronization of the inflows and outflows of cash: if the
receipts and payments of cash perfectly coincide or balance each
other, there would be no need for cash balances. The first
consideration in determining the cash need is, therefore, the
extent of non-synchronization of cash receipts and
disbursements. For this purpose, the inflows and outflows have to
be forecast over a period of time, depending upon the planning
horizon which is typically a one-year period with each of the 12
months being a sub period. The technique adopted is a cash
budget.

13. Another general factor to be considered in determining cash needs is the
cost associated with a shortfall in the cash needs. Included in the short
costs are the following:
(1) Transaction costs associated with raising cash to tide over the
shortage. This is usually the brokerage incurred in relation to the sale
of some short-term near-cash assets such as marketable securities.
(2) Borrowing costs associated with borrowing to cover the shortage.
These include items such as interest on loan, commitment charges and
other expenses relating to the loan.
(3) Loss of cash-discount, that is, a substantial loss because of a
temporary shortage of cash.
(4) Cost associated with deterioration of the credit rating which is
reflected in higher bank charges on loans, stoppage of supplies,
demands for cash payment, refusal to sell, loss of image and the
attendant decline in sales and profits.
(5) Penalty rates by banks to meet a shortfall in compensating balances.

14. Excess Cash Balance Costs
The cost of having excessively large cash balances is known
as the excess cash balance cost. If large funds are idle, the
implication is that the firm has missed opportunities to invest
those funds and has thereby lost interest which it would
otherwise have earned. This loss of interest is primarily the
excess cost.
Procurement and Management
These are the costs associated with establishing and
operating cash management staff and activities. They are
generally fixed and are mainly accounted for by salary,
storage, handling of securities, and so on.

15. Uncertainty and Cash Management
Finally, the impact of uncertainty on cash management
strategy is also relevant as cash flows cannot be
predicted with complete accuracy. The first
requirement is a precautionary cushion to cope with
irregularities in cash flows, unexpected delays in
collections and disbursements, defaults and
unexpected cash needs.
The impact of uncertainty on cash management can,
however, be mitigated through (i) improved
forecasting of tax payments, capital expenditure,
dividends, and so on; and (ii) increased ability to
borrow through overdraft facility.

16. Cash Forecasting
An estimation of the flows in and out of the
firm’s cash account over a particular period
of time
An estimation of the firm’s borrowing and
lending needs and the uncertainties
regarding these needs during various future
periods
It enables firms to anticipate periods of
surplus cash and periods where financing
will be needed

17. Why forecast cash flows?
If NO forecast:
 Unanticipated cash shortages may occur
 Slowdown cash out flows to suppliers
 Late delivery of critical materials
 Shareholders and creditors may react
negatively

18. If Unanticipated/unplanned surplus of cash:
 No investment for getting interest/profit
 Financial plan and cash control system will be
deteriorated
 Financial health will not be sound
 Wealth maximization objective will not be
achieved

19. Applications of cash forecasts
• Capital Budget
• Production Plan
• Sale forecasts

20. Types of Cash Forecasts
Types of cash forecasts can be differentiated
along two dimensions:
a. Length of the periods
b. Approach to cash flows

21. • Length/Time basis:
The length of the time can be daily, monthly,
weekly, yearly, etc. , sometimes for a longer
time.
Distribution and Scheduling are also necessary.
Distributions starts with data on relatively
longer periods and breaking it into smaller
periods.
Scheduling starts with data on relatively shorter
periods and aggregating into longer periods.

22. • Approach Basis:
a. Receipts and disbursement approach
b. Adjusted net income approach
The first one uses the amounts of cash expected
to be received and disbursed by the firm over
some periods chosen for the forecasts.
It is useful to control the firm’s cash system
accurately

23. Adjusted net income approach tells about the
sources and uses of funds.
Starts with projected net income on an accrual
basis and adjusts to cash basis.
It shows the changes in assets and liability
accounts.
But it cannot trace the individual cash inflows
and cash out flows.

24. Items to be forecast
• Some possible types of cash receipts:
Accounts receivable collections, notes
receivable, rental income, interest income,
principal on maturing investments, dividends
from subsidiaries, miscellaneous receipts

25. Items to be forecast
• Some possible types of cash disbursements:
Cash purchases of materials, payroll expenses,
Taxes, maturing accounts payable, mortgage
payments, maturing notes payable-interest and
principal, capital expenditures, utility payments,
dividend-preferred and common stock, sinking
fund payments-outstanding bonds, maturing
bonds payment, payment to pension fund,
market repurchase of outstanding stocks or
bonds, miscellaneous disbursements.

26. Methods of financial forecasting
Financial forecasting is the estimation of the
future level of a financial variable – cash flow,
asset level or liability level.
A linear relationship between the financial
variable and other variables.
nnt XaXaXaaY ++++= .......22110

27. Spot Method
Variable to be forecast is independent of all
other variables, or is predetermined. Such as
rental payment as a fixed expenses.

28. Proportion to Another Account
Used to project financial variables that are
expected to vary directly with the level of
another variable. For example: percent of
sales as cost of sales
11 XaYt =

29. Compound Growth
Used when a particular financial variable is
expected to grow at a steady growth rate over
time. For example: Dividend growth rate.
1)1( −+= tt YgY

30. Multiple Dependencies
The variable is thought to depend on more than
one factor; not just sales or some other
variable but a combination of several
variables. For example: Inventory level; firms
keep a minimum portion as safety stock level
and the rest is stored with the proportionate
of demand.
110 XaaYt +=

31. Forecasting collections from
Accounts Receivable
Two major ways to make decisions here:
a. Forecasting Methodology: on either turnover
basis or payment approach basis
b. Degree of Aggregation: different lines/ sectors

32. • Assume that last month’s sales were $ 20,000,
that this month’s sales are expected to be $
30,000 and the next month’s sales would
increase by 5 percent than this month’s sales
volume. Also assume that 30 percent of the
customers purchased products for cash, 40
percent pays in 30 days, the remaining pays in
60 days. Forecast cash receipts for next
month by the turnover and payment
proportions methods.

33. Sources of Uncertainty in Cash
Forecasting
• Sales Uncertainty
• Collection rate
• Production cost
• Capital Outflow: regarding future amount of
capital outflow which indicates the timing of
cash disbursements and construction process.

34. Hedging Cash Balances Uncertainties
If there is no hedging system, the solution to the
problem will be very costly occurred by deficit
fund, it may deteriorate the relationship with the
stakeholders.
The cash balances uncertainties can be hedged by:
a. holding a stock of extra cash
b. holding a stock of near cash assets:
treasury bills, repurchase agreements, etc.
c. Extra borrowing capacity from banks and
financial institutions

35. Features of some hedging Strategies
for Risks in Cash
• Hedge – Keep stock of extra cash
• When Applicable – Hedges any shortages
• Costs – Opportunity loss on investment in
amount of the firm’s costs of capital

36. Features of some hedging Strategies
for Risks in Cash
• Hedge – Keep stock of near-cash assets
• When Applicable – Hedges any shortages
• Costs – Opportunity loss on investment in
amount of the difference between the after-
tax return on the near-cash investments and
the firm’s cost of capital

37. Features of some hedging Strategies
for Risks in Cash
• Hedge – Invest temporary surplus in near-cash
assets rather than longer-term assets
• When Applicable – During surpluses only
• Costs – If yield curve is Upslopping difference
in yield between near-cash and longer-term
assets; Transaction costs of purchase,
reinvestment and sale of costs

38. Features of some hedging Strategies
for Risks in Cash
• Hedge – Arrange for extra borrowing capacity
• When Applicable – Hedges any shortages
• Costs – Out-of-pocket expenses of applying
for and drawing down extra borrowing;
Commitment fees on extra borrowing capacity
for maximum needed hedge

39. Features of some hedging Strategies
for Risks in Cash
• Hedge – Invest temporary surplus in longer-
term investments and hedge interest rate risk
with options on financial futures
• When Applicable – During surpluses only
• Costs – If yield curve is Upslopping difference
in yield between near-cash and longer-term
assets; Transaction costs of purchase,
reinvestment and sale of costs

40. Selection Criteria
• The choice of cash and investment mix is based
on trade off between opportunity to earn a
return on idle fund during holding period and
brokerage cost associated with purchase and
sale of securities, considering the following
facts:
– Financial/default risk
– Interest rate risk
– Taxability
– Liquidity
– Maturity
– Yield available

41. Determining Cash Need
There are two approaches to derive an optimal cash
balance, namely,
a) minimizing cost cash models and
b) cash budget
Cash Management/Conversion Models:
1) Baumol Model
2) Beranek Model
3) Miller-Orr Model
4) Stone Model

42. Determination of Optimum Level of
Cash Balance
• In order to invest the excess funds, the
financial manager must know the minimum
amount of cyclical requirement
• Also required to determine the optimal
amount of cash and bank balances, and in
what quantity the securities should be
purchased or sold
• Certainty approach theory and uncertainty
approach theory

43. Certainty Model- Baumol
• This model considers that the firm is assumed to
receive cash periodically but pay out cash
continuously at a steady rate.
• Has a portfolio of cash and marketable
securities which earn a particular rate of return
(i) per period regardless of the amount to be
invested.
• Also assumes that marketable securities are
uniformly and infinitely divisible
• For any transaction into or out of the portfolio,
there is a fixed charge (b) per transaction
independent of the amount of investment

44. • Total demand for cash (T) of the firm at a
periodic interval is known
• The firm sells securities at a periodic intervals
to replenish cash
• A firm begins with an amount (C) of cash
balance. When this amount is spent, it
replenishes the cash by selling (C) the same
amount of securities
• When a firm receives cash inflows, it puts
enough cash in its disbursement account to
cover cash out flow until the next inflow is
received

45. • Appropriate strategy for investing funds until
they are needed next:
– Two-transaction strategy
– Three-transaction strategy
According to the two-transaction strategy, when the
cash inflows is received, invest one-half of the
total inflow, put the remaining one-half in the
disbursement account. During the first half of the
period, pay expenses from the disbursement
account.
Investment Income = ¼ (iY)
Profit = ¼(iY)-2a

46. According to the three-transaction strategy, initially
invest two-third of it, place the remaining one-
third into disbursement account, when this one-
third is exhausted, disinvest one-half the
investment account, put the amount of 1/3(Y) in
the disbursement account and the remaining
1/3(Y) in the disbursement account through the
remainder of the period.
Interest income = (2/3)(1/3)iY+(1/3)(1/3)iY=(1/3)iY
Profit = (1/3)iY-3a

47. • In general, the optimal strategy should be a
general expression for the optimal number of
transactions
• Interest income = [(n-1)/2n]iY
• Profit = [(n-1)/2n]iY-na
• Number of transaction, n =
• In Baumol model, the firm will always make one
deposit and (n-1) withdrawals from the
investment account
• The amount of withdrawals will be (1/n)Y
a
iY
2

50. • Limitations of the Baumol Model are:
– Specification of costs associated with security
transactions
– Return in all the market is not always fixed
– Steady usage of cash may not be always possible
– It will not work if the uncertainty of cash flows is
very high
– Does not deal with risk of cash flows

51. • A firm runs an apartment complex, cash comes
in at the beginning of the month (from rental
payments) and is disbursed uniformly through
out the following month. For the upcoming
month, the firm expects to have cash expenses
of $250,000 which can be invested at 0.5
percent per month where transaction costs are
$50 per transaction. What is the firm’s best
investment strategy and how much will this
earn?

52. Certainty Model- Beranek Model
• Beranek hypothesized that cash inflows are
steady, but cash outflows are periodic
• Cash flow pattern are the mirror images of the
Baumol model cash flow pattern
• Cash would be collected continuously at a
uniform rate, but would be disbursed over a short
time as a group of firm’s chesks reached its bank
and were paid
• The challenge is to profitably invest the funds
between the time of their receipts and the time
when checks are presented to the bank for
payment

53. • The optimal number of transactions, n =
• The amount of final withdrawal =
• Profit = [(n-1)/2n]iY-na
• All cash flows are certain
• Cash out flows are periodic and instantaneous
• Cash inflows occur at a constant rate
aiY 2/
Ynn ]/)1[( −

54. • A firm receives $100000 per day which it will
eventually need to make disbursements, and
follows a policy of writing checks every two
weeks. Over a two-week period, it accumulates
$1400000. it can invest at an interest rate of
6.825 percent per year. The transaction cost of
invest or disinvest is $ 37.50. what investment
strategy should the firm follow and how much
will it earn?

55. Uncertainty Model- Miller-Orr Model
• Applicable when uncertainty of cash outflows is
so high, results random fluctuation in cash
balances
• Investment or disinvestment cost is fixed
irrespective of the amount of securities.
• There is a lower limit below which the amount
cash balance cant go, if reached, transferred
from market securities take places, by selling
securities
• When cash balance goes above the upper limit,
transfer of cash to market securities take places
by purchasing securities

56. • When cash balance stays within these bounds,
no transactions take place in spite of some
amount of fluctuations in cash flows.
• Assumed that cash flows are normally
distributed, the standard deviation of cash flows
is not changed for a long time.
• Upper control limit (h), return point (Z),
opportunity cost of holding cash (i) and security
transaction cost (b)
• Here h= 3Z
• Z =
i
bs
4
3
3
2

57. • A company projects, the daily net cash flows for
the next seen days as follows:
• The policy of the company is to maintain a
minimum cash balance of $10,000 at all times
• Fixed cost of transaction $1600, return on
securities 10% p.a
• Determine the return point and the upper limit of
cash holding for the firm
Day 1 2 3 4 5 6 7
Cash
flow
forecast
+24 +13 -16 -12 +36 +4 -28

58. Uncertainty Model- Stone Model
• Applicable when management’s estimation of
future cash flow is required
• There is inner control limits (UCL1, LCL1) and the
outer control limits (UCL2, LCL2)
• Under this Stone model, strategy proceeds as
follows, the firm performs no evaluation until its
cash balance falls outside the outer control
limits, the firm adds the expected cash flows for
the next few days to the current balances

59. • If the sum of the current balance and these
expected future cash flows falls outside the
inner control limits, a transaction is made
• If the forecasted cash flow is expected to move
within the inner limits, the balance is closer to
the target balance, no transaction is made,
thus save the costs of transaction.
• If the forecasted cash balance is outside the
inner limits, the closing balance is far away
from the target balance, the manager orders
buying and selling of securities so that closing
balance becomes equal to the target balance.

60. Thank You