Rather than let their cash reserves build up in excess of daily cash requirements, many firms invest in interest -bearing short -term marketable securities. Determining the level of liquid assets that should be invested in marketable securities depends on several factors, including:
Various quantitative models have been developed for determining the optimal division of a firm’s liquid asset balance between cash and marketable securities.8 These models vary in complexity, depending partly on the assumptions made about the firm’s cash flows. The simpler deterministic models assume that cash payments occur at a uniform certain rate over time. The more complex probabilistic or stochastic models assume that cash balances fluctuate from day to day in a random or unpredictable manner. Although these models provide the financial manager with useful insights into the cost trade -offs involved in effective cash management, they have not been widely implemented in actual decision-making situations.
Choosing Marketable Securities
A firm may choose among many different types of securities when deciding where to invest excess cash reserves. In determining which securities to include in its portfolio, the firm should consider a number of criteria, including the following:
Notice that the first three criteria deal with risk and the last one deals with return. Default Risk Most firms invest only in marketable securities that have little or no default risk (the risk that a borrower will fail to make interest and/or principal payments on a loan). U.S. Treasury securities have the lowest default risk, followed by securities of other U.S. government agencies and, finally, by corporate and municipal securities. Various financial reporting agencies, including Moody’s Investors service and Standard & Poor’s, compile and publish information concerning the safety ratings of the various corporate and municipal securities. Given the positive relationship between a security’s expected return and risk and the desire to select marketable securities having minimal default risk, a firm has to be willing to accept relatively low expected yields on its marketable securities investments.
Marketability A firm usually buys marketable securities that can be sold on short notice without a significant price concession. Thus, there are two dimensions to a security’s marketability: the time required to sell the security and the price realized from the sale relative to the last quoted price. If a long period of time, a high transaction cost, or a significant price concession is required to dispose of a security, the security has poor marketability and generally is not considered suitable for inclusion in a marketable securities portfolio. Naturally, a trade -off is involved here between risk and return. Generally, a highly marketable security has a small degree of risk that the investor will incur a loss, and consequently, it usually has a lower expected yield than one with limited marketability.
Maturity Date Firms usually limit their marketable securities purchases to issues that have relatively short maturities. Recall that prices of debt securities decrease when interest rates rise and increase when interest rates fall. For a given change in interest rates, prices of longterm securities fluctuate more widely than prices of short-term securities with equal default risk. Thus, an investor who holds long-term securities is exposed to a greater risk of loss if the securities have to be sold prior to maturity. This is known as interest rate risk. For this reason, most firms generally do not buy marketable securities that have more than 180 to 270 days remaining until maturity, and many firms restrict most of their temporary investments to those maturing in less than 90 days. Because the yields on securities with short maturities are often lower than the yields on securities with longer maturities, a firm has to be willing to sacrifice yield to avoid interest rate risk.
Rate of Return Although the rate of return, or yield, is also given consideration in selecting securities for inclusion in a firm’s portfolio, it is less important than the other three criteria just described. The desire to invest in securities that have minimum default and interest rate risk and that are readily marketable usually limits the selection to those having relatively low yields.
Types of Marketable Securities
Firms normally confine their marketable securities investments to “money market” instruments, that is, those high-grade (low default risk), short-term debt instruments having original maturities of 1 year or less.Money market instruments that are suitable for inclusion in a firm’s marketable securities portfolio include U.S. Treasury issues, other federal agency issues, municipal securities, negotiable certificates of deposit, commercial paper, repurchase agreements, bankers’ acceptances, Eurodollar deposits, auction rate preferred stocks, money market mutual funds, and bank money market accounts. (In some cases, firms will also use long-term bonds having 1 year or less remaining to maturity as “marketable” securities and treat them as money market instruments.)
Following efficient cash management policies is important for all firms, government agencies, and not-for profit enterprises. However, effective cash management is particularly important for entrepreneurial firms for several reasons. First, entrepreneurial businesses do not have the same extensive access to the capital markets as do larger firms.A major source of capital funds to small firms is commercial banks. However, bankers require borrowers to present detailed analyses of their anticipated cash needs.To do this, a firm must have efficient cash management procedures in place.
Second, because of an entrepreneurial firm’s limited access to capital, a cash shortage problem is both more difficult and more costly for an entrepreneurial firm to rectify than for a large firm. Third, because many entrepreneurial firms are growing rapidly, they have a tendency to run out of cash. Growing sales require increases in inventories and accounts receivable, thereby using up cash resources. Finally, entrepreneurial firms frequently operate with only a bare minimum of cash resources because of the high cost of, and limited access to, capital. As a result, it is imperative that financial managers of entrepreneurial firms use their firm’s scarce cash resources in the most efficient way possible.
on page 620 lists the characteristics and yields of various money market instruments. As can be seen in the last three columns of the table, yields on these securities vary considerably over time. Yields are a function of a number of factors, including the state of the economy, the rate of inflation, and government monetary and fiscal policies.
U.S. Treasury Issues U.S. Treasury bills are the most popular marketable securities. They are sold at weekly auctions through Federal Reserve Banks and their branches and have standard maturities of 91 days, 182 days, and 1 year. Treasury bills are issued at a discount and then redeemed for the full face amount at maturity. Once they are issued, Treasury bills can be bought and sold in the secondary markets through approximately 40 government securities dealers. There is a large and active market for Treasury bills, which means that a firm can easily dispose of them when it needs cash. The smallest denomination of Treasury bills is $10,000 of maturity value.
The advantages of Treasury issues include short maturities, a virtually default-free status, and ready marketability. Their primary is advantage lies in the fact that their yields normally are the lowest of any marketable security.
The Treasury also issues notes that have original maturities from 2 to 10 years and bonds that have maturities over 10 years. As these securities approach their maturity dates, they become, in effect, short-term instruments that are then suitable for inclusion in a firm’s marketable securities portfolio. Treasury bonds and notes pay interest semiannually. Minimum Treasury bond denominations are $1,000.
Other Federal Agency Issues A number of federal government-sponsored agencies issue their own securities, including the “big five”: the Federal Home Loan Bank, the Federal Land Banks, the Federal Intermediate Credit Bank, the Bank for Cooperatives, and the Federal National Mortgage Association. Although each of these agencies guarantees its own securities, these securities do not constitute a legal obligation on the part of the U.S. government. Nevertheless, most investors consider them to be very low risk securities, and they sell at yields slightly above U.S. Treasury securities but below other money market instruments. Because these securities are traded in the secondary markets through the same dealers who handle U.S. Treasury securities, they are readily marketable should a firm need to dispose of them before maturity. Minimum denominations are generally $5,000.
Municipal Securities State and local governments and their agencies issue various types of interest-bearing securities. Short-term issues are suitable for inclusion in a firm’s marketable securities portfolio. The yields on these securities vary with the creditworthiness of the issuer. The pretax yields on these securities are generally lower than the yields on Treasury bills because the interest is exempt from federal (and some state) income taxes. The secondary market for municipal issues is not as strong as that for Treasury and other federal agency issues.Municipal (tax-exempt) money market mutual funds are also available.
Negotiable Certificates of Deposit Commercial banks are permitted to issue certificates of deposit (CDs), which entitle the holder to receive the amount deposited plus accrued interest on a specified date. At the time of issue, maturities on these instruments range from 7 days to 18 months or more. Once issued, CDs become negotiable, meaning they can be bought and sold in the secondary markets. Because CDs of the largest banks are handled by government securities dealers, they are readily marketable and thus are suitable for inclusion in a firm’s marketable securities portfolio. Yields on CDs are generally above the rates on federal agency issues having similar maturities.
Commercial Paper Commercial paper consists of short-term unsecured promissory notes issued by large, well-known corporations and finance companies with strong credit ratings.
Characteristics and Yields of Selected Money Market Instruments
Some finance companies, such as General Motors Acceptance Corporation (GMAC) and CIT Financial Corporation, which issue large amounts of commercial paper regularly, sell it directly to investors. Industrial, utility, and transportation firms and smaller finance companies, which issue commercial paper less frequently and in smaller amounts, sell their commercial paper through commercial paper dealers. Maturities on commercial paper at the time of issue range from 2 or 3 days to 270 days.
The secondary market for commercial paper is weak, although it is sometimes possible to make arrangements with the issuer or commercial paper dealer to repurchase the security prior to maturity. This weak secondary market combined with a somewhat higher default risk results in higher yields on commercial paper than on most other money market instruments.
Repurchase Agreements A repurchase agreement, or “repo,” is an arrangement with a bank or securities dealer in which the investor acquires certain short-term securities sub- ject to a commitment from the bank or dealer to repurchase the securities on a specified date. Securities used in this agreement can be government securities, CDs, or commercial paper. Their maturities tend to be relatively short, ranging from 1 day to several months, and are designed to meet the needs of the investor.
The yield on a repo is slightly less than the rate that can be obtained from outright purchase of the underlying security. The repo rate approximates the rate on federal funds, which is the rate used when banks borrow from other banks. Although repos generally are considered very safe investments, a number of investors did incur losses when several small government securities dealers (which were active in the repo market) failed.
The goals of cash management in a multinational company (MNC) parallel the cash management goals of purely domestic corporations. That is, MNCs attempt to speed up collections, slow disbursements, and make the most efficient use of the firm’s cash resources by minimizing excess balances and investing balances to earn the highest possible return, consistent with liquidity and safety constraints. However, there are some unique elements of cash management for an MNC. First, cash management is complicated by difficulties and costs associated with moving funds from one country (and currency) to another.
It is costly to convert cash from one currency to another. Second, there is a general lack of integrated international cash transfer facilities, such as exist in the United States and most other Western nations.The absence of this capability makes it difficult to move funds quickly from one country to another. Third, investment opportunities for temporary excess cash balances are much broader for an MNC than for a domestic firm. MNCs must consider short-term investment options in many different countries—a process further complicated by exchange rate risk. Fourth, the host government may place restrictions on the movement of cash out of the country.
Practicing MNC cash managers have developed a number of techniques designed to optimize the process of international cash management in the face of these difficulties. First, there is general agreement that the cash management function for an MNC should be centralized with respect to the information-gathering and decision-making process.The parent normally maintains an international cash manager who has the expertise and responsibility to keep track of the firm’s cash balances around the world and to identify the best sources for short-term borrowing and lending. Second,many MNCs have instituted a process called multilateral netting.
Multilateral netting is designed to minimize the cost associated with misdirected funds. Misdirected funds are funds that cross an international border unnecessarily. It is costly to convert funds from one currency to another, hence it is desirable to minimize unnecessary transactions. For example, consider an MNC that has subsidiaries operating in Spain, England, and Switzerland. Each subsidiary purchases supplies from the other subsidiaries. If the English unit purchases $10 million from the unit in Spain, and the Spanish unit purchases $8 million from the English unit, the transaction cost associated with transferring funds from the English unit to the Spanish unit can be reduced if these payments are netted out against each other. Thus, instead of the English unit converting $10 million in funds to send to the Spanish unit, it will net out the Spanish unit’s purchases from the English unit and simply send a $2 million payment. The greater the number of subsidiaries an MNC has, the more complex is the process of managing a multilateral netting system. At the same time, the potential cost savings are greatly increased.
Bankers’ Acceptances A bankers’ acceptance is a short-term debt instrument issued by a firm as part of a commercial transaction. Payment is guaranteed by a commercial bank. Bankers’ acceptances are commonly used financial instruments in international trade, as well as in certain lines of domestic trade.
These instruments vary in amount, depending on the size of the commercial transactions. A secondary market exists in which these acceptances can be traded should a bank or investor choose not to hold them until maturity, which usually ranges between 30 and 180 days at the time of issue. Bankers’ acceptances are relatively safe investments because both the bank and the borrower are liable for the amount due at maturity. Their yields are comparable to the rates available on CDs.
Eurodollar Deposits Eurodollar deposits are dollar-denominated deposits in banks or bank branches located outside the United States. These deposits usually have slightly higher yields than on corresponding deposits in domestic banks because of the additional risks. Eurodollar CDs issued by London banks are negotiable, and a secondary market is developing for them.
Auction Rate Preferred Stocks A number of large investment banks issue, on behalf of their client companies, a type of preferred stock known as auction rate preferred stock, which is a suitable short-term investment for excess corporate funds. The dividend yield on this type of security is adjusted every 49 days through an auction process, where investors can exchange their stock for cash. As a result, the price of the stock stays near par. Because 70 percent of the dividends received are exempt from corporate income taxes, the after-tax yields are often above the yields on other marketable securities such as CDs or commercial paper. The stock is sold in minimum denominations of $100,000 to $500,000, depending on the issue.
Money Market Mutual Funds Many of the higher-yielding marketable securities described earlier are available only in relatively large denominations. For example, negotiable CDs usually come in amounts of $100,000 or more. As a result, a smaller firm that has limited funds to invest at any given time is often unable to obtain the higher yields offered on these securities.An alternative is a money market mutual fund that pools the investments of many other small investors and invests in large-denomination money market instruments. By purchasing shares in a money market fund, such as Dreyfus Liquid Assets or Merrill Lynch Ready Assets, a smaller firm can approach the higher yields offered on large-denomination securities. In addition, most of these funds offer check-writing privileges, which provide liquidity and enable firms to earn interest on invested funds until their checks clear.
Bank Money Market Accounts Banks are permitted to offer checking accounts with yields comparable to those on money market mutual accounts with limited check-writing privileges. These accounts provide yields that are comparable to those on money market mutual funds.
Financial Management Related Interview Questions
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Financial Management Tutorial
The Role And Objective Of Financial Management
The Domestic And International Financial Marketplace
Evaluation Of Financial Performance
Financial Planning And Forecasting
The Time Value Of Money
Risk And Return On At&t Common Stock
Fixed-income Securities: Characteristics And Valuation
Common Stock: Characteristics,valuation, And Issuance
Capital Budgeting And Cash Flow Analysis
Capital Budgeting: Decision Criteria And Real Option Considerations
Capital Budgeting And Risk
The Cost Of Capital
Capital Structure Concepts
Capital Structure Management In Practice
Working Capital Management
The Management Of Cash And Marketable Securities
Management Of Accounts Receivable And Inventories
Lease And Intermediate-term Financing
Financing With Derivatives
Internationan Financial Management
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