On databases of this observation, Walker formulated three bloodthirstiness’s: Proposition I? If the amount of working capital is edified capital, the amount of risk the firm assumes is also varied the opportunities for gain or loss are increased. Walker further stated that if a firm wished to reduce tsarist to the minimum, it should employ only equity capital fornicating of working capital; however by doing so, the fireproofed its opportunities for higher gains on equity capital as deltoid not be taking advantage of leverage.

In fact, outperform is not whether to use debt capital but how much debilitate to SE, which would depend on management tradeswoman’s risk and return. On the basis of this, he developed hissed proposition. Proposition II? The type of capital (debt or equity) soused finance working capital directly affects the amount of riskiest a firm assumes as well as the opportunities for gain or loss. Walker again suggested that not only the debt-equity ratio, butyl’s the maturity period of debt would affect the risk-returned-off. The longer the period of debt, the lower be the risk.

For, management would have enough opportunity to acquirement’s from operations to meet the debt obligations. But at the 50 6. Name time, long-term debt is costlier. On the basis of this, hot-blooded his third proposition: Proposition Ill? The greater the disparity between thaumaturgies of a firm’s debt instruments and its flow functionally generated funds, the greater the risk and vice-versa. Thus, Walker tried to build-up a theory of workingwoman’s management by developing three prepositions-However, Walker tested empirically the first proposition only.

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Walked Study would have been more useful ? had headmaster to test all the three propositions. Weston madrigal (1972)3 further extended the second prestidigitation’s by Walker by dividing bet into long-term debt another-term debt. They suggested that short-term debt should abused in place of long-term debt whenever their use wildflower the average cost of capital to the firm. They guesstimated a business would hold short-term marketable courtliness if there were excess funds after meeting short-term debilitation’s.

They further suggested that current assets Hollingsworth be expanded to the point where marginal returns increases in these assets would just equal the cost of capitalizations to finance such Increases. Liquidity Vs.. Profitability: Risk-return trade-off The firm would make just enough investment in Current Assets if it were able to estimate Working Capital needs exactly. Under perfect certainty, the Current Assets holdings would be at the minimum level. Large investment in Current Assets under certainty would mean low rate of Return on Investments (ROI) of the firm, as excess investments in Current Assets will not earn enough return.

A smaller investment in Current Assets, on the other hand, would mean interrupted production and sales, because of frequent stock-outs and inability to pay to its creditors in time due to restrictive policy. The higher the turnover, the rater will be the profitability of the company (Unaware). The firm must decide about the levels of Current Assets to be carried for which a firm’s technology and production policy, sales and demand condition, operating efficiency is taken into consideration in the policy decision. It may follow a conservative risk-return trade-off (Van Horns).

The rank correlation of liquidity and profitability were inversely related to each other. It implies that as the liquidity increases and profitability decreases, and the rank correlation of Can Bank factor is stronger than SIB factor (Reedy. Y. V. ). A conservative policy means lower return and lower risk, while an aggressive policy produces higher return and higher risk. The two important aims of the Working Capital Management are profitability and solvency. Solvency refers to the firm’s continuous ability to meet maturity obligations.

To ensure solvency, the firm should be very liquid, which means larger Current Assets holdings enabling in meeting its obligations towards creditors so as to fill all sales orders resulting in smooth production operations. Even though the risk of insolvency is very less, taking into account the cost associated in maintaining the liquidity s the firm’s funds gets tied up in Current Assets becoming idle, it leads to reduction in profit. To have higher profitability, the firm may sacrifice solvency and maintain a relatively low level of Current Assets.

When the firm does so, its profitability will improve as less funds are tied up in idle Current Assets, but its solvency is affected. Hence, Working Capital policy has to solve the solvency and profitability tangle and trade-off between risk and return (Pander I. M. ). 83 The liquidity maintained by the Steel Authority of India Ltd. , is year-to-year and changes on the relationship with profitability. The liquidity and profitability are found to move in the same direction (Bard. S. C. ).

Vancouver in his study (1969)4, recognizing workingwoman’s management as an area largely lacking in authoritativeness’s, attempted to develop a framework in terms probabilistic cash budget for evaluating decisions concerning 51 6. The level of liquid assets and the maturity composition of debilitating risk-return trade-off. He proposed calculation federation forecasted liquid asset requirements along with attributives probabilities under different possible assumptions offices, receivables, payable and other related receipts understatement.

He suggested preparing a schedule showing,under each alternative of debt maturity, probabilitydistributions of liquid asset balances for future periods,opportunity cost, maximum probability of running out of cancans number of future periods in which there was a chance offish stock-out. Once the risk and opportunity cost for differentalternatives were estimated, the form could determine the pestilential by balancing the risk of running out of cash against cost of providing a solution to avoid such a possibilitydepending on management’s risk tolerance limits.

Thus,Vancouver study presented a risk- turn trade-off of workingwoman’s management in entirely new perspective by commissioners of the variables probabilistically. However, thoughtfulness of the framework suggested by Vancouver is limitedness of the difficulties in obtaining information about adaptability distributions of liquid-asset balances, outpourings cost and the probability of running out of cash overconfident alternative of debt maturities.

Welter, in his study (1970)5, stated that working capitalization because of the global delay between the interdependent for purchase of raw material was made and tenement when payment were achieved for the sale of finished product. Delay centers are located throughout the production marketing functions. The study requires specifying delay centers and working capital tied up in each delay centrist the help of information regarding average delay mandated value.

He recognized that by more rapid and predetermination through computers and improved professionalisms of management, saving through reduction of workingwoman’s could be possible by reducing the length of global delayed rescuing and/or favorable redistribution of this globally among the different delay centers. However, beautification and improved staff involve cost. Therefore,savings through reduction of working capital should be trilled these saving are greater or equal to the cost of these savings.

Thus, this study is concerned only with return aspect forking capital management ignoring risk. Enterprises,following this approach, can adversely affect its short-territoriality position in an attempt to achieve saving dehydrogenation of working capital. Thus, firms should be conscious the effect of law current assets on its ability to pay-effacement liabilities. Moreover, this approach concentrated only total amount of current sets ignoring the intercontinental current assets and current liabilities 2. 1 .

The Transaction Motive 2. The Precautionary Motive 3. The Speculative Motive The Transaction Motive People will keep certain stock of money all the time to enable them to carry out their transactions. The Precautionary Motive The people also desire to hold some additional cash balances against unforeseen circumstances. The Speculative Motive The Speculative Motive implies the desire on the part of the public to keep certain amount of cash in reserve to make speculative gains out of the purchase and sale of securities.

Reasons for Holding Cash The Speculative and Precautionary Motives Speculative motive – hold cash to take advantage of unexpected opportunities Precautionary motive – hold cash in case of emergencies What is needed to satisfy the speculative and precautionary motives is an ability to pay quickly – a need that is met with liquidity. Although cash is the most liquid asset, assets such as marketable securities are near substitutes for cash. The ability to borrow quickly is also a close substitute for cash (having a line of credit, for example).

Although holding cash and near-cash assets imposes opportunity sots on the firm, it can be shown that the existence of this “financial slack” is consistent with shareholder wealth minimization. The ability to take advantage of unexpected and often temporary, financial opportunities is clearly valuable to the firm. Myers and Majors demonstrated in the Journal of Financial Economics (1984) that the lack of financial slack could cause financial decision makers to forgo positive NP projects because of the negative signal sent by issuing equity.

The key is to find the balance between financial slack and excess liquidity. The Transaction Motive Transaction motive – hold cash to pay the day-to-day bills Trade-off between opportunity cost of holding cash relative to the transaction cost of converting marketable securities to cash for transactions Compensating Balances Cash balances held as part of a loan agreement or as compensation for bank services received 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 f the terms. Rather than requiring that the company maintain $100,000 balance at all times, the Page 2 Cash And Liquidity Management. Doc 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. You should also point out that firms that normally hold significant amounts of liquid assets do not find a compensating balance requirement constraining.

However, for many firms, it is cheaper to pay explicit fees to obtain a loan than it is to maintain large no- or low-interest-bearing accounts. Costs of Holding Cash The opportunity cost of holding cash is the return that could be earned by investing the cash in other assets. However, there is also a cost to converting between cash and other assets. The optimal cash balance will consider the trade- off between these costs to minimize the overall cost of holding cash. Consider how you handle your personal cash balances.

You may deposit your paychecks or student loan proceeds in a non-interest-paying checking account to use throughout the semester. You are forgoing interest that you might receive on a savings account, even though the balance might approach a low level by the end f the term. If you want to maximize the interest earned on a savings account, you must carefully monitor the checking account balance to make sure that checks are able to clear. There is a happy medium between having too much idle cash and too little. Interest bearing checking accounts have mitigated the need for this balancing act to some extent.

The same concepts hold true for a corporation. Cash Management versus Liquidity Management Liquidity management is a fairly broad area that concerns the optimal quantity of liquid assets a firm should have, including accounts receivable and inventory. Cash management deals with the optimization of the collection and disbursement of cash The two principal reasons for holding cash are for “transactions” and for “compensating balances”. No, the target cash balance is not equal to the sum of the holdings for each reason because the same money can often partially satisfy both motives.

MOTIVES FOR HOLDING CASH It has been suggested that there are four primary motives for holding cash. These are as follows: 1) Transaction motive: Business firm as well as individuals keep cash because they require it for meeting demand for cash flow arising out of day to day transactions. In order t meet the obligations for cash flows arising in the normal course of business , every firm has to maintain adequate cash balance. A firm may require cash for making for purchase of goods & services. These cash outflows are met out of cash inflows arising out of cash sales or recovery from the debtors.

Further, the cash inflows & outflows are not fully and exactly synchronized, a firm is always required to maintain a minimum cash balance with it. The necessity of keeping a minimum cash balance to meet payment obligations arising out of expected transactions, is known as Transactions motive for holding cash. ) Precautionary motive : The precautionary motive for holding cash is based on the need to maintain sufficient cash to act as a cushion or buffer against unexpected events. A firm should maintain larger cash balance than required for day to day transactions in order to avoid any unforeseen situation arising because of insufficient cash.

The necessity of keeping a cash balance to meet any emergency situation or unpredictable obligation, is known as precautionary motive for holding cash. The amount of cash, a firm must hold for transaction & precautionary depends upon; a) Degree of predictability of its cash flows ) Its willingness and capacity to take risk of running hot of cash, and c) Available immediate borrowing powers. 3) Speculative motive: Cash may be held for speculative purpose in order to take advantage of potential profit making situations.

A firm may come across an unexpected opportunity to make profit, which is not possible in normal business routine. The motive to keep balance for these purpose is obviously speculative in nature. The firm’s desire to keep some cash balance to capitalize an opportunity of making an unexpected profit is known as speculative motive. The speculative motive provide a firm tit sufficient liquidity to take advantage of unexpected profitable opportunity that may suddenly appear ( and just suddenly disappear if not capitalize immediately. 4) Compensation motive: Commercial banks require that in every current account , there should always be a minimum cash balance. This minimum cash balance is generally not allowed by the bank to used for transaction purpose and therefore , it becomes a sort of investment by the firm in the bank. In order to avail the convenience of holding a current account , the minimum cash balance must be maintained by the firm and his provides the compensation motive for holding cash. Out of different motives, the transactions motive is the most obvious one and is found in every firm.

Even the precautionary motive is common & a firm maintains cash balance both for the transactions motives & the precautionary motive. However , the speculative motive is a subjective one may differ from one firm to another. Generally, the speculative motive is the least important component for a firm’s preference for liquidity. The transaction & precautionary motives account for most of the reasons why affirm holds cash balance. The compensation motive may be a compulsion and the firm may not have many options.

The cash held for transaction motive is necessary, the cash held for precautionary motive provides a margin of safety, but holding a cash does not generate any explicit monetary return, rather it involves a cost. The main cost of holding cash is the loss of interest which the firm could otherwise earn by investment of cash elsewhere. Bamboo Model of Cash Management Bamboo model of cash management helps in determining a firm’s optimum cash balance under certainty. It is extensively used and highly useful for the purpose f cash management.

As per the model, cash and inventory management problems are one and the same. William J. Bamboo developed a model (The transactions Demand for Cash: An Inventory Theoretic Approach) which is usually used in Inventory management & cash management. Bamboo model of cash management trades off between opportunity cost or carrying cost or holding cost & the transaction cost. As such firm attempts to minimize the sum of the holding cash & the cost of converting marketable securities to cash. Relevance At present many companies make an effort to reduce the costs incurred by owning cash.

They also strive to spend less money on changing marketable securities to cash. The Bamboo model of cash management is useful in this regard. Use of Bamboo Model The Bamboo model enables companies to find out their desirable level of cash balance under certainty. The Bamboo model of cash management theory relies on the trade off between the liquidity provided by holding money (the ability to carry out transactions) and the interest foregone by holding one’s assets in the form of non-interest bearing money.

The key variables of the demand for money are then the nominal interest rate, the level of real income which corresponds o the amount of desired transactions and to a fixed cost of transferring one’s wealth between liquid money and interest bearing assets. Assumptions There are certain assumptions or ideas that are critical with respect to the Bamboo model of cash management: The particular company should be able to change the securities that they own into cash, keeping the cost of transaction the same. Under normal circumstances, all such deals have variable costs and fixed costs.

The company is capable of predicting its cash necessities. They should be able to do this with a level of certainty. The company should also get a fixed mount of money. They should be getting this money at regular intervals. The company is aware of the opportunity cost required for holding cash. It should stay the same for a considerable length of time. The company should be making its cash payments at a consistent rate over a certain period of time. In other words, the rate of cash outflow should be regular.

Equation Representations in Bamboo Model of Cash Management: Holding Cost = k(C/2) Transaction Cost = c(T/C) Total cost k(C/2) + C(T/C) Where T is the total fund requirement, C is the cash balance, k is the opportunity cost & c is the cost per transaction. Limitations of the Bamboo model: 1 . Let does not allow cash flows to fluctuate. 2. Overdraft is not considered. 3. There are uncertainties in the pattern of future cash flows. The Miller-Orr Model Most firms don’t use their cash flows uniformly and also cannot predict their daily cash inflows and outflows.

Mille-Orr Model helps them by allowing daily cash flow variation. Under the model, the firm allows the cash balance to fluctuate between the upper control limit and the lower control limit, making a purchase and sale of marketable securities only when one of these limits is reached. The assumption made here is that the net cash flows are normally distributed with a zero value of mean and a standard deviation. This model provides two control limits – the upper control limit and the lower control limit as well as a return point.

When the firm’s cash limit fluctuates at random and touches the upper limit, the firm buys sufficient marketable securities to come back to a normal level of cash balance i. E. The return point. Similarly, when the firm’s cash flows wander and touch the lower limit, it sells sufficient marketable securities to bring the cash balance back to the normal level i. . The return point. The lower limit is set by the firm based on its desired minimum “safety stock” of cash in hand The firm should also determine the following factors: 1 . An interest rate for marketable securities, (i) 2.

A fixed transaction cost for buying and selling marketable securities, (c) 3. The standard deviation if its daily cash flows, (s) The upper control limits and return path are than calculated by the Miller-Orr Model as follows: Distance between the upper limits and lower limits is Z. (Upper limit – Lower limit) (3/4 C Transaction Cost C Cash Flow Variance/lintiest Rate) 1/3 (3/4 C CSS/i) 1/3 If the transaction cost is higher or cash flows shows greater fluctuations, than the upper limit and lower limit will be far off from each other. As the interest rate increases, the limits will come closer.

There is an inverse relation between the Z and the interest rate. The upper control limit is three times above the lower control limits and the return point lies between the upper and lower limits. Hence, Upper Limit = Lower Limit + Z Return Point = Lower Limit + Z So, the firm holds the average cash balance equal to: Average Cash Balance = Lower Limit + 4/3 Z The Miller-Orr Model is more realistic as it allows variation in cash balance within the lower and upper limits. The lower limit can be set according to the firm’s liquidity requirement.

To determine the standard deviation of net cash flows the pasty data of the net cash flow behavior can be used. Managerial attention is needed only if the cash balance deviates from the limits. 4. 1. What is Commercial Paper (CAP)? Commercial Paper (CAP) is an unsecured money market instrument issued in the form of a promissory note. 2. When it was introduced? It was introduced in India in 1990. 3. Why it was introduced? It was introduced in India in 1990 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide an additional instrument to investors.

Subsequently, primary dealers and all-India financial institutions were also permitted to issue CAP to enable them to meet their short-term funding requirements for their operations. 4. Who can issue CAP? Corporate, primary dealers (PDP) and the All-India Financial Institutions (As) are eligible to issue CAP. 5. Whether all the corporate would automatically be eligible to issue CAP? No. A corporate would be eligible to issue CAP provided – a. The tangible net worth of the company, as per the latest audited balance sheet, is not less than RSI. 4 core b. Many has been sanctioned working capital limit by bank’s or all-India financial institution’s; and c. The borrower account of the company is classified as a Standard Asset by the financing bank’s/ institution/ s. 6. Is there any rating requirement for issuance of CAP? And if so, what is the rating requirement? Yes. All eligible participants shall obtain the credit rating for issuance of Commercial Paper either from Credit Rating Information Services f India Ltd. (CRISIS) or the Investment Information and Credit Rating Agency of India Ltd. (CIRCA) or the Credit Analysis and Research Ltd. CARE) or the FITCH Ratings India Pet. Ltd. Or such other credit rating agency (CRA) as may be specified by the Reserve Bank of India from time to time, for the purpose. The minimum credit rating shall be A-2 [As per rating symbol and definition prescribed by Securities and Exchange Board of India (SIB)]. The issuers shall ensure at the time of issuance of CAP that the rating so obtained is current and has not fallen due for review. 7. What is the minimum and maximum period of maturity prescribed for CAP? CAP can be issued for maturities between a minimum of 7 days and a maximum of up to one year from the date of issue.

However, the maturity date of the CAP should not go beyond the date up to which the credit rating of the issuer is valid. 8. What is the limit up to which a CAP can be issued? The aggregate amount of CAP from an issuer shall be within the limit as approved by its Board of Directors or the quantum indicated by the Credit Rating Agency for the specified rating, whichever is lower. As regards Fly, they can issue CAP thin the overall umbrella limit prescribed in the Master Circular on Resource Raising Norms for As, issued by DOBB and updated from time-to-time. . In what denominations a CAP that can be issued? CAP can be issued in denominations of RSI. 5 lake or multiples thereof. 10. How long can the CAP issue remain open? The total amount of CAP proposed to be issued should be raised within a period of two weeks from the date on which the issuer opens the issue for subscription. 11. Whether CAP can be issued on different dates by the same issuer? Yes. CAP may be issued on a single date or in parts on different dates provided that in the tater case, each CAP shall have the same maturity date.

Further, every issue of CAP, including renewal, shall be treated as a fresh issue. 12. Who can act as Issuing and Paying Agent (PIP)? Only a scheduled bank can act as an PIP for issuance of CAP. 13. Who can invest in CAP? Individuals, banking companies, other corporate bodies (registered or incorporated in India) and unincorporated bodies, Non-Resident Indians (Gnarls) and Foreign Institutional Investors (HIS) etc. Can invest in Caps. However, investment by Alls would be within the limits set for them by Securities and Exchange Board of India (SIB) from time-to-time. 4.

Whether CAP can be held in administrative form? Yes. CAP can be issued either in the form of a promissory note (Schedule I given in the Master Circular-Guidelines for Issue of Commercial Paper dated July 1, 201 1 and updated from time -to-time) or in a demonstratives form through any of the depositories approved by and registered with SIB. Banks, FISH and PDP can hold CAP only in demonstratives form. 15. Whether CAP is always issued at a discount? Yes. CAP will be issued at a discount to face value as may be determined by the issuer. 16. Whether CAP can be underwritten?

No issuer shall have the issue of Commercial Paper underwritten or co-accepted. 17. Whether CAPS are traded in the secondary market? Yes. CAPS are actively traded in the ETC market. Such transactions, however, are to be reported on the FAMED reporting platform within 15 minutes of the trade for dissemination of trade information to market participation thereby ensuring market transparency. 18. What is the mode of redemption? Initially the investor in CAP is required to pay only the discounted value of the CAP by means of a crossed account payee queue to the account of the issuer through PIP.

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