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22-39
Miller-Orr model example
M-O Ltd. has a lower control limit, L = $2,000, F =
$200, k = 0.09 per year, and the standard deviation, ,
of the daily cash flows is $3,000.
The daily compound opportunity cost is
The variance of the net daily cash flows is
Determining the Daily Cash Balance
Models for Determining the Target Cash Balance
(continued)
( ) 0.000236 1 (1.09) k 0.09 1 k 1
1/365
365
daily
= = = +
$9,000,000 ($3,000)
2 2
= =
o
22-40
The target cash balance is
The upper control limit is
H = 3($19,884.38) - 2($2,000) = $55,653.14
The average cash balance is
[4($19,884.38) - $2,000]/3 = $25,845.84
Determining the Daily Cash Balance
Models for Determining the Target Cash Balance
(continued)
$19,884.38
000 , 2 $
) 4(0.000236
00,000 3(200)$9,0
Z
3 / 1
=
+
(
=
22-41
Assumptions for the Miller-Orr model
Daily cash flows are random and cannot be predicted
Transfers to and from marketable securities are
instantaneous
Seasonal and/or cyclical trends are not considered
The cost of buying or selling securities is fixed
regardless of the size of the transaction
The term structure of interest rates is flat and the level of
interest rates does not change
Determining the Daily Cash Balance
Models for Determining the Target Cash Balance
(continued)
22-42
Miller-Orr model works reasonably well if
The distribution of net daily cash flows is approximately
normal
The cash flows are random from day-to-day
Only one source of investment is available
Stone look ahead model
Similar to the Miller-Orr model, except it focuses on
managing cash balances instead of determining the
optimal transaction size
Uses upper and lower control limits, but "looks ahead"
a few days at the anticipated cash balances
Determining the Daily Cash Balance
Models for Determining the Target Cash Balance
(concluded)
22-43
Funds which represent very temporary excess cash
are invested in marketable securities
Funds that are not likely to be needed for a long
period of time will be invested in long-term
instruments
Long-term bonds or common stock generally are
not part of the marketable securities portfolio
Management of the Marketable
Securities Portfolio
22-44
Short-term investment alternatives include
Treasury bills
Short-term obligation of the federal government
Bankers' acceptances
Promissory note for payment by a corporation and
guaranteed by a bank
Commercial paper
Short-term promissory note issued by a corporation
Sales finance paper
Short-term paper issued by finance companies
Management of the Marketable
Securities Portfolio
Investment Alternatives
22-45
Repurchase agreements
Dealer sells government securities and agrees to
repurchase on a set date
Bank certificates of deposit
Promissory note from a bank or trust to repay a deposit
Negotiable certificates of deposit
Promissory note from a bank or trust company to repay a
deposit
Eurodollar
Dollar-denominated time deposits at foreign banks
Money market mutual funds
Pool of money market instruments
Management of the Marketable
Securities Portfolio
Investment Alternatives
(concluded)
22-46
The firm's risk-return posture determines the
specific composition of the marketable securities
portfolio after taking into consideration the
interaction of
Risk
Liquidity
Because firms use their marketable securities portfolio as
a source of ready cash, the liquidity aspect of the
investment also requires careful consideration
Management of the Marketable
Securities Portfolio
Selection Criteria
22-47
Maturity
Most large firms keep some cash invested overnight in
repurchase agreements and other shorter-maturity
securities
Then they follow a layered approach of matching longer
cash availability with investments in longer term
marketable securities
Yield
Treasury bills, are the least risky of the securities and
consequently always have the lowest yield
Other securities have higher returns, depending on their
risk and liquidity
Management of the Marketable
Securities Portfolio
Selection Criteria
(continued)
22-48
Yields on three-months money market instruments
Management of the Marketable
Securities Portfolio
Selection Criteria
(continued)
Year
Instrument 1995 1996 1997 1998 1999
Treasury bills 7.05 4.21 3.20 4.72 4.69
Bankers' acceptances 7.15 4.34 3.60 5.04 4.91
Commercial paper 7.19 4.50 3.61 5.15 5.02
Source: CANSIM series B14060, B14057 and B114010.
22-49
T-Bill pricing example
Suppose you purchase a 182-day treasury bill with a
face value of $10,000 at a price of $9,400. What is your
bond equivalent yield?
Answer:
Management of the Marketable
Securities Portfolio
Selection Criteria
(continued)
12.03%
182
365
$10,000
$9,400 - $10,000
k
maturity until days of Number n
price Discounted P
bill Treasury the of alue Maturity v P
yield equivalent Bond k
where
n
365
P
P P
k
BE
0
M
BE
0
0 M
BE
=
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22-50
If you are told that the bond equivalent yield on a 182-
day $10,000 T-Bill was 9.8%. How much should you
pay?
Answer:
If you buy the 182-day T-Bill for $9,534.11 and hold it
until maturity your bond equivalent yield is 9.8%.
Management of the Marketable
Securities Portfolio
Selection Criteria
(continued)
$9,534.11
365
182
0.098 1
$10,000
365
n
k 1
P
P
BE
M
0
=
|
.
|
\
|
+
=
|
.
|
\
|
+
=
22-51
What happens if you are forced to sell after 60 days,
when the bond equivalent yield at that time is 10%.
What will be the actual bond equivalent yield received?
Answer:
Using Equation 22.5 you must first determine the price
of the treasury bill with 122 (i.e., 182 - 60) days to
maturity as follows
Management of the Marketable
Securities Portfolio
Selection Criteria
(continued)
56 . 676 , 9 $
365
122
10 . 0 1
000 , 10 $
P
0
=
|
.
|
\
|
+
=
22-52
Then the actual bond equivalent yield over the 60 days
the treasury bill was owned can be determined
Management of the Marketable
Securities Portfolio
Selection Criteria
(concluded)
( )( )
( )( )
( )( )
( )( )
% 09 . 9
60 $9,534.11
365 $9,534.11 - $9,676.56
owned Days price Purchase
365 price Purchase - price Selling
k
BE
=
=
=
22-53
Management of the Marketable
Securities Portfolio
The Marketable securities Portfolio
The interaction of risk, liquidity, and maturity
determines the returns
The firm's risk-return posture then determines the
specific composition of the marketable securities
portfolio
Very risk-averse firms might have a marketable
securities portfolio composed almost entirely of
treasury bills
More aggressive firms will opt for a large portion in
higher-yielding Eurodollars or certificates of deposit
issued by overseas branches of Canadian-based banks