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CASH MANAGEMENT IN THE LARGEST CORPORATIONS

For very large firms, the transaction costs of buying and selling securities become trivial compared with the opportunity cost of holding idle cash balances. Suppose that the 6 See M. H. Miller and D. Orr, ¬A Model of the Demand for Money by Firms, ­ Quarterly Journal of Economics

80 (August 1966), pp. 413 Ј435.

interest rate is 4 percent per year, or roughly 4/365 = .011 percent per day. Then the daily interest earned on $1 million is .00011 $1,000,000 = $110. Even at a cost of $50 per transaction, which is generous, 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? For two reasons. First, cash may be left in non Јinterest-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 less expensive 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 management. You cannot give a subsidiary operating freedom to manage its own affairs without giving it 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 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 balances and bank relations.

INVESTING IDLE CASH: THE MONEY MARKET

We have seen that when firms have excess funds, they can invest the surplus in interestbearing securities. Treasury bills are only one of many securities that might be appropriate for such short-term investments. More generally, firms may invest in a variety of securities in the money market, the market for short-term financial assets.

Only fixed-income securities with maturities less than 1 year are considered to be part of the money market. In fact, however, most instruments in the money market have considerably shorter maturity. Limiting maturity has two advantages for the cash manager. First, short-term securities entail little interest-rate risk. Recall that price risk due to interest-rate fluctuations increases with maturity. Very-short-term securities, therefore, have almost no interest-rate risk. Second, it is far easier to gauge financial stability over very short horizons. One need not worry as much about deterioration in financial strength over a 90-day horizon as over the 30-year life of a bond. These considerations imply that high-quality money- market securities are a safe ¬parking spot ­ to keep idle balances until they are converted back to cash.

Most money-market securities are also highly marketable or liquid, meaning that it is easy and cheap to sell the asset for cash. This property, too, is an attractive feature of securities used as temporary investments until cash is needed. Treasury bills are the most liquid asset. Treasury bills are issued by the United States government with original maturities ranging from 90 days to 1 year. Some of the other important instruments of the money market are

Commercial paper. This is the short-term, usually unsecured, debt of large and well-known companies. While maturities can range up to 270 ays, commercial paper usually is issued with maturities of less than 2 months. Because there is no active trading in commercial paper, it has low marketability. Therefore, it would not be an appropriate investment for a firm that could not hold it until maturity. Both Moody`s and

Standard & Poor`s rate commercial paper in terms of the default risk of the issuer. Certificates of deposit. CDs are time deposits at banks, usually in denominations greater than $100,000. Unlike demand deposits (checking accounts), time deposits cannot be withdrawn from the bank on demand: the bank pays interest and principal only at the maturity of the deposit. However, short-term CDs (with maturities less than 3 months) are actively traded, so a firm can easily sell the security if it needs cash.

Repurchase agreements. Also known as repos, repurchase agreements are in effect collateralized loans. A government bond dealer sells Treasury bills to an investor, with an agreement to repurchase them at a later date at a higher price. The increase in price serves as implicit interest, so the investor in effect is lending money to the dealer, first giving money to the dealer and later getting it back with interest. The bills serve as collateral for the loan: if the dealer fails, and cannot buy back the bill, the investor can keep it. Repurchase agreements are usually very short term, with maturities of only a few days.