Treasury Management – BFI303

Tutorial 5 and 6
1) What is float? What are its four components?

Float refers to funds that have been sent by the payer but are not yet usable funds to the payee.
The four components of float are:

 Mail float- it results from the time that elapse from the mailing of cheque until it receipt
 Processing float- it is due to the processing time before the cheque is deposited into bank
 Availability float- it includes the time gap which is consumed in the clearance of cheque
 Collection float- it refers to the total time gap between the mailing of the payment by the
payer and the availability of cash in bank

2) What activities are involved in cash position management? How does the cash manager monitor
and take actions with regard to the end-of-day checking account balances?

Cash position management involves looking at, on a daily basis, the collection,
concentration and disbursement of funds for the company. The cash manager looks at the
amount of funds to be collected, moves balances to appropriate accounts and funds
projected disbursements. The cash position can be managed into the future when future cash
flows can be properly forecasted.

3) How do smaller firms that do not engage in cash position management typically set their target
cash balance? What is typically detailed in a bank account analysis statement?

Smaller firms that do not engage in active cash position management may set a target cash
balance for their checking accounts. Generally this is determined based on transactions
requirements or a minimum balance set by the bank. The transactions requirement is determined
by how much cash a firm needs for its day-to-day operations. A bank account analysis statement
determines the value of the balances a firm leaves on deposit and matches that to the value of the
services provided by the bank

4) What are the benefits of using a lockbox system? How does it work? How can the firm assess the
economics of a lockbox system?

A lockbox system affects all three components of float. Customers mail payments to a post office
box, which is emptied by the firm’s bank. The bank processes each payment and deposits the
payments in the firm’s account. The bank sends deposit slips to the firm so they can be credited
to the customers’ accounts. Because lockboxes are located near the firm’s customers, mail time
is reduced and often clearing time is also reduced. Processing time is reduced to almost zero
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because the bank deposits payments before the firm processes them. The firm assesses the
economics of a lockbox system by performing a cost-benefit analysis based on the float value
reduction in dollars, the firm’s cost of capital, the annual operating cost of the lockbox system
and the firm’s tax rate.

5) Consider the Reese Industries which has $5 billion in annual sales and eight days of customer
collection float in its cash conversion cycle. Reese wants to determine that if it should implement
a lockbox system that reduces customer collection float to five days. Reese has a cost of capital
of 13.5 percent per annum. Do you think it is feasible for the firm to employ a lockbox system
using a cost-benefit analysis.
5billion x (3 days/365) = 41.1 million.
Return = 41.1 * 0.135 = $5.55million.
If the cost of lockbox is less than the return that go for the lockbox system.

6) On January 1 the trade receivables balance for a business was RM149,620 and the balance at
31st March was RM136,280. The total sales for the 3 month period, shown in the income
statement was RM482,140. Cash sales accounted for 5% of sales on the income statement.
Calculate the total cash received in respect of credit sales in the period January 1 to 31 march.

Start with the total sales figure of £482140. 5% of these are cash sales so:

482140 x 0.95 = 458033

We then expect that the opening balance will have been paid so add that figure:

458033 + 149620 = 607653

And we're left with a closing balance which hasn't been paid yet so we deduct that:

607653 - 136280 = 471373.

7) Gale Supply estimates that its customers’ payments are in the mail for 3 days, and once received
they are processed in 2 days. After the payments are deposited in the firm’s bank, the funds are
made available to the firm by the bank in 2.5 days. The firm estimates its total annual
collections, received at a c onstant rate, from credit customers to be $87 million. Its annual
opportunity cost of funds is 9.5 percent. Assume a 365-day year.
a. How many days of collection float does Gale Supply have?
b. What is the current annual dollar cost of Gale Supply’s collection float?
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c. If the installation of an electronic invoice presentment and payment (EIPP) system would
result in a 4 day reduction in Gale’s collection float, how much could the firm earn
annually on this float reduction?
d. Based on your findings in part c, should Gale install the EIPP system if its annual cost is
$85,000? Explain your recommendation.

Answer
a. Collection float = mail float + processing float + availability float = 3.0 days + 2.0 days + 2.5
days = 7.5 days

b. Average daily receipts = annual receipts ÷ 365 days = $87 million ÷ 365 days = $238,356
Collection float ($) = collection float (days) x average daily receipts = 7.5 days x $238,356 =
$1,787,670
Annual dollar cost = collection float ($) x opportunity cost = $1,787,670 x 9.5% =
$169,829

c. Annual earnings = float reduction (days) x average daily receipts x opportunity cost
= 4.0 days x $238,356 x 9.5% = $90,575

d. Gale should install the proposed EIPP system. The annual earnings of $90,575 exceed the
annual cost of $85,000, thereby resulting in an annual profit contribution of $5,575 ($90,575 -
$85,000)

8) It takes Cookie Cutter Modular Homes, Inc., about six days to receive and deposit checks
from customers. Cookie Cutter’s management is considering a lockbox system to reduce the
firm’s collection times. It is expected that the lockbox system will reduce receipt and deposit
times to three days total. Average daily collections are $127,000, and the required rate of
return is 6 percent per year. Assume 365 days per year.
a. What is the reduction in outstanding cash balances as a result of implementing the lockbox
system?
b. What is the daily dollar return that could be earned on these savings?
c. What is the maximum monthly charge Cookie Cutter should pay for this lockbox system if the
payment is due at the end of the month?
d. Is the maximum monthly charge Cookie Cutter should pay for this lockbox system if the
payment is due at the beginning of the month?

a. This one is pretty simple – 3 days x $127,000 = $381,000

b. First, figure the average daily rate: (1+r)^(1/365)-1 = 1.06^(1/365)-1 = .000159654

 Treasury Management – BFI303

Now multiply: $381,000 x .000159654 = $60.828, or $60.83 rounded

c. PV = c / r
381,000 = c / .0048676
381,000*.0048676 = c
1854.5368 = c

Or rounded, $1854.54

d. For c2, use the perpetuity due formula to solve:

c = (PV * r) / (1+r)
c = (381,000*.0048676) / 1.0048676 
c = 1845.5534

Or rounded, $1845.55

9) Using the following data find out the optimum cash balance using Baumol's Model.
Annual cash needed Rs.48,00,000
Transaction cost Rs.90 per conversion
Interest rate 9%

C = Cash required each time to restore balance to minimum cash

F= Total cash required during the year = Rs.48,00,000

T= Cost of each transaction between cash and marketable securities =Rs.90

r = Rate of interest on marketable securities = 9%

10) Given the following, calculate the optimum cash balance.

Fixed cost of a securities transaction = $5
Variance of daily net cash flows = $25
Per annum interest rate = 10%
Daily interest rate on securities = 0.0003 (10% per annum, so 10%/360 days = 0.0003
daily)

Optimal cash balance = 3√(3 x $5 x $25) / (4 x 0.0003) => $67.86

(or) $68 rounded off.

Upper limit, d = 3z = 3 x $68 = $204
Average cash balance = ($68 + $204)/3 => $90.67
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So, when the upper limit of $204 is reached, $136 ($204 - $68) will be purchased. When
the lower limit of zero dollars is reached, $68 of securities will be sold to again bring it to
the optimal balance of cash calculated as $68 approximately.

11) A Company estimates a cash requirement of $2,000,000 for a 1 month period. The
opportunity interest rate is 6% per annum, which works out to 0.5 percent per month. The
transaction cost for borrowing or withdrawing funds is $150. Estimate the optimum level of
cash and the number of transactions required.

Optimal level of cash = √(2 x $150 x $2,000,000) / 0.005 => $346,410.16

With the above optimal transaction size, we can now find the number of transactions
required.

Number of transactions required = $2,000,000 / $346,410.16 => 5.77 or 6 transactions

during the month.

12) Discuss the different types of cash collection and cash disbursement techniques.
Types of cash collection
Over the counter collection - Payment is received in face to face to meet the customers
- Since payments are not mailed, an over the counter
system does not contain mail float
- A local deposit bank serve as the entry point for the firms
banking system and an input into the firms central
information system

Mailed Payment Collection - System in which companies received payment through

System check mailed by customers
- A mailed payment system contains all three component
of collection float (Example, Mail float, processing float,
and availability float)
- Payments are mailed by customers to a designated
collection center operated by company or by an outside
agent
Pre Authorized Payment - Used when the payment amount and payment dates are
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specified in advance
- On the agreed date the payee initiates the value transfer
from the payer through the banking system
- It eliminates the mail float, reduce processing and
availability and improve both parties forecasting ability