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Chapter 27 and Chapter 28 notes

Chapter 27 and Chapter 28 notes - Conference#10 covers...

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Conference #10 covers chapters 27 and 28 – Cash and Credit Management. There are four reasons to hold cash : 1. for transactions 2. compensating balance with the bank a. A compensating balance requirement serves both as a term of a loan imposed by the lender and as compensation for services rendered by the bank. As such, it is sometimes negotiable. For example, the borrower can attempt to have the size of the required balance reduced or negotiate the nature of the terms. Rather than requiring that the company maintain $100,000 balance at all times, the lender may agree to allow the firm to maintain an average balance of $100,000 over a specified period. The latter case gives the borrower more flexibility. 3. speculative – to take advantage of investment opportunities. 4. precautionary – to meet immediate liquidity requirements. You may noticed that companies hold cash for the same reasons we do Target cash balance – the desired cash balance as determined by the trade-off between carrying costs and storage costs. Determining the Target Cash Balance: 1. The Baumol Model 2. The Miller-Orr Model 3. Other Factors Influencing the Target Cash Balance Baumol Model : Define: C = optimal cash transfer amount (amount of marketable securities to sell to raise cash) F = fixed cost of selling securities T = cash needed for transactions over entire planning period R = opportunity cost of cash (interest rate on marketable securities) Assume that cash is paid out at a constant rate through time. Opportunity cost = average cash balance * interest rate = [(C+0)/2]*R Trading cost = # of transactions*cost per transfer = (T/C)*F Total cost = opportunity cost + trading cost = (C/2)R + (T/C)F To find the optimal transfer amount, take a first derivative of the cost function relative to C and set it equal to zero. You can also find it by setting opportunity cost = trading cost and solving for C. Method 1: Method 2: Example: Hermes Co. has cash outflows of $500 per day, the interest rate is 10%, and the fixed transfer cost is $25. T = 365*500 = 182,500 F = 25 R = .1 The Miller-Orr model offers a general approach to handling uncertain cash flows.
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The basic idea: U * = upper limit on cash balance L = lower limit on cash balance C * = target cash balance When cash reaches U * , the firm transfers cash (buys securities) in the amount of U * - C * . If cash falls below L, the firm sells C * - L worth of securities to add to cash. Given the variance (
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