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UNCERTAIN CASH FLOWS

Baumol`s model stresses the essential similarity between the inventory problem and the cash management problem. It also demonstrates the relationship between the optimal cash balance on the one hand and the level of interest rates and the cost of transactions on the other. However, it is clearly too simple for practical use. For example, firms do not pay out cash at a steady rate day after day and week after week. Sometimes the firm may collect a large unpaid bill and therefore receive a net inflow of cash. On other occasions it may pay its suppliers and so incur a net outflow of cash.

Economists and management scientists have developed a variety of more elaborate and realistic models that allow for the possibility of both cash inflows and outflows. For example, Figure 2.8 illustrates how the firm should manage its cash balance if it cannot predict day-to-day cash inflows and outflows. You can see that the cash balance meanders unpredictably until it reaches an upper limit. At this point the firm buys enough securities to return the cash balance to a more normal level. Once again the cash balance is allowed to meander until this time it hits a lower limit. This may be zero, some minimum safety margin above zero, or a balance necessary to keep the bank happy. When the cash balance hits the lower limit, the firm sells enough securities to restore the balance to a normal level. Thus the rule is to allow the cash holding to wander freely until it hits an upper or lower limit. When this happens, the firm should buy or sell securities to regain the desired balance.

How far should the firm allow its cash balance to wander? The answer depends on three factors. If the day-to-day variability in cash flows is large or if the cost of buying and selling securities is high, then the firm should set the upper and lower limits far apart. The firm allows wider limits when cash-flow volatility is high to keep down the frequency of costly security sales and purchases. Similarly, the firm tolerates wider limits if the cost of security transactions is high. Conversely, if the rate of interest is high and the incentives to manage cash are correspondingly more important, the firm will set the limits close together.6

Have you noticed one odd feature about Figure 2.8? The cash balance does not return to a point halfway between the lower and upper limits. It always comes back to a point one-third of the distance from the lower to the upper limit. Always starting at this return point means the firm hits the lower limit more often than the upper limit. This does not minimize the number of transactions that would require always starting exactly at the middle of the spread. However, always starting at the middle would mean a larger average cash balance and larger interest costs. The lower return point minimizes the sum of transaction costs and interest costs.

Recognizing uncertainty in cash flows adds some extra realism, but few managers would concede that cash inflows and outflows are entirely unpredictable. The manager of Toys Us knows that there will be substantial cash inflows around Christmas. Financial managers know when dividends will be paid and when taxes will be due. Earlier we described how firms forecast cash inflows and outflows and how they arrange short-term investment and financing decisions to supply cash when needed and put cash to work earning interest when it is not needed.

This kind of short-term financial plan is usually designed to produce a cash balance that is stable at some lower limit. But there are always fluctuations that financial managers cannot plan for, certainly not on a day-to-day basis. You can think of the decision rule depicted in Figure 2.8 as a way to cope with the cash inflows and outflows which cannot be predicted, or which are not worth predicting. Trying to predict all cash lows would chew up enormous amounts of management time.

You should therefore think of these cash management rules as helping us understand the problem of cash management. But they are not generally used for day-to-day management and would probably not yield substantial savings compared with policies based on a manager`s judgment, providing of course that the manager understands the tradeoffs we have discussed.