OPTIMIZATION MODELS

Many firms have small surpluses available for short periods of time; we need, therefore, to address the problem of trade-off between investment income and transaction costs of investing and disinvesting. In this regard, we may mention about four models that provide optimum strategies for investment and disinvestment when transaction costs play an important part. These models are the Baumol model, the Beranek model, the Miller-Orr model, and the Stone model. Each of these models provides optimum strategies for a given time pattern of cash flows.

The miller-Orr and Stone models explicitly address the risk in the net cash flows, while the Baumol and Beranek models assume certainty. To choose among these models, the first step is to match the time pattern of the firm’s cash flows to the time patterns assumed in the models. This match should be based on the specific of the firm’s business policies that affect cash flows (how often payments are made to suppliers, the firm’s terms of sale, and so forth) and on empirical investigations of the time pattern of cash flow. The latter investigations might include time plots of net cash flow and statistical comparisons of net cash flows with known probability distributions.

OPTIMIZATION MODELS FOR SHORT TERM INVESTMENTS-1

In addition, cash managers are responsible for keeping the firm in a liquid position. If an unexpected need for cash should arise, the cash manager may need to investments before maturity. Thus, an important criterion for a short-term investment strategy is instrument’s marketability.

 

Firms take a variety of approaches to investment policies. Some firms give the cash manager a loose reign on short-term investment decision. Others carefully spell out what types on investments can be made at certain maturities and at what risk. Policies often relate how a firm’s top management views the role of short-term investments. Is short-term investing seen as liquidity management or portfolio management? A company that takes a liquidity management approach to its short-term investments focuses on the recording, control, and prediction of daily receipts and disbursements. Any excess cash is places in very short period (may be even overnight) investments.

 

On the other hand, a company with a true portfolio management approach to investing considers the explicit income to be gained from sophisticated strategies. To some, sophisticated means having a model-based decision support system. At either end of the spectrum, investment guidelines define the cash manager’s investment task. Typically, guidelines are formulated based on the firm’s definition of allowable risk, given sensitively to investment-instrument’s safety, marketability and yield.

Market Update

Weekly Recap – Week ending 26-Dec-08

From an investor’s standpoint, Wall Street didn’t bring any Christmas cheer this week.  Amid light trading conditions, the market dropped 1.7%, bringing its year-to-date decline to 41%.

It was a typical week in that we received another batch of dour economic news, saw oil prices continue to decline, and heard the Fed invoke its emergency powers again to lend stability to the financial system.  

In a front-end loaded week for economic data, it was reported that November existing home sales declined 8.6% from October and that new home sales of 407,000 units on an annualized basis hit their lowest level in 17 years.

Initial jobless claims surged to a 26-year high of 586,000, durable orders declined 1.0% in November, and personal income and personal spending fell 0.2% and 0.6%, respectively, in November.

Separately, MasterCard Spending Pulse said Friday that holiday sales from Nov. 1 to Dec. 24 declined as much as 4%, excluding autos and gasoline. 

Amazon.com (AMZN) for its part said 2008 was its best holiday season ever.  What that means for its income statement remains a mystery, but at least Amazon saw record order activity of its own.

Unfortunately, Amazon will be the exception and not the norm this holiday season.  Consumers have clearly become guarded with their spending activity in the face of concerns about rising unemployment, falling home prices, and much lower stock prices.

The final Q3 GDP report released this week indicated as much.  Real personal consumption expenditures declined 3.8% in the third quarter and knocked 2.8% off real GDP growth, which was negative 0.5% for the quarter. more… 

OPTIMIZATION MODELS FOR SHORT TERM INVESTMENTS

A cash management imperative is that idle excess balances represent an opportunity cost to the firm. To ignore investment possibilities, even for one day, is inconsistent with the objective of managing cash as an asset that must return value to the company. Our next logical focus is, therefore, on short-term investment strategies.

 

In most firms, the cash management staff is responsible for short-term investing. One reason for this is that the cash manager has ‘hands-on’ knowledge of the money market and its players. Besides, cash manager is equipped, and psychologically geared, to react to fast-breaking investment opportunities. He and his staff are used to thinking in terms of very short time frames, days and hours. In the investment world, that us when profits are made, and fortunes lost.

 

There are several outlets for short-term investments like inter corporate advances; inter corporate bills financing, stock market operations, treasury bills, commercial papers, etc. The return on such investments is different and depends on money market conditions, amounts to be invested, period of investment, and transaction cost. The risks associated with a certain investment determines its safely, marketability and, hence, its yield. For the most part, the cash manager is primarily concerned with preserving principal. Although he hopes for the best returns on short-term investments, he looks for instruments that are, above all, safe.

SIMULATION APPROACH

Still today we have discussed on cash management and credit analysis. Today we are going to discuss on Simulation Approach. Simulation analysis permits the financial manager to incorporate in his forecasting both likely value of ending cash balances (surplus/deficits) for each of the forecast periods (say, for each month over the next quarter) and the margin of error associated with this estimate. It involves the following steps: First, probability distributions for each of the major uncertain variables are developed. The variables would generally include sales, selling price, proportion of cash and credit sales, collection rates, production costs, and capital expenditures. Some of these variables have the greatest influence upon cash balances.

 

Clearly, more time and effort should be spent in obtaining probability distribution of these variables. Second, values are drawn at random for the variables from their respective probability distributions and using these values each balances are estimated. Third, the process is repeated several times (say, 1000times). Needless to say, such tedious and cumbersome computations are done on computer.

 

In practice, the array of possible hedging strategies is quite a bit more complicated. One is required to consider various alternatives and the associated costs and risks in hedging strategies.

Collection Rate Uncertainty

The firm is also faced with collection rate uncertainty. The firm may historically have collected an average of a certain per cent of its outstanding receivables from a particular period in another particular period, but this average contains considerable variability. Further, changing market and economic conditions may make extrapolation of past historic data into future periods a futile exercise.  

 

There is still another source of uncertainty – production cost uncertainty. The price of materials may change; production problems may arise that lead to increased labor costs; and errors in the sales estimates themselves would necessarily lead to forecasting errors in purchases – hence the volume of payables.  

 

Capital outflow uncertainty is one of the biggest sources of surprises in cash flow forecasting. This is the uncertainty regarding the timing of cash disbursement related to the firm’s major capital expenditure and constructions programmes. For instance, construction firms are notorious for filing late progress reports and then expecting immediate payment. While only a small per cent of the firm’s total bills are from capital construction programmes, the amounts involved are usually very large. One unexpected item of this sort can impair a carefully drawn cash flow forecast.  

 

An efficient way to deal with above uncertainties is to apply simulation analysis of the cash forecast. We will now briefly outline this method.