Dividend Policy and Theory

Dividend-Definition
The term dividend usually refers to payment made
out of a firm’s earnings to its owners, either in the
form of cash or stock.

If a payment is made from sources other than current

or accumulated retained earnings, the term
distribution rather than dividend is used.
Types of Dividend
Dividends can be
A. Cash dividend form
B. Stock dividend form
The basic types of cash dividends are:
1. Regular cash dividends
2. Extra dividends
3. Special dividends
4. Liquidating dividends
 1.Declaration date: is date on which the board of directors passes a resolution to pay a dividend.

The terminologies on dividend payments are illustrated with the following example:

Thursday Monday Friday Monday

January January January February
15 26 30 16
Declaration date Ex- dividend date Record date Payment date
1. Declaration date: is date on which the board of directors
passes a resolution to pay a dividend.
2. Ex- dividend date: is date four business days before the date of
record, establishing those individuals entitled to a dividend.
 If you buy the stock before this date, then you are entitled to
the dividend.
 If you buy on this date or after, then the previous owner will get
it.
 Example, Monday, January 26, is the ex-dividend date. Before
this date, the stock is said to trade “with dividend” or “cum
dividend.” Afterwards, the stock trades “ ex dividend.” The ex-
dividend date convention removes any ambiguity about who is
entitled to the dividend. Since the dividend is valuable, the
stock price will be affected when it goes “ex.”
3. Date of Record: is date on which holders of record
are designated to receive a dividend.
 Based on its records, the corporation prepares a list
on January 30 of all individuals believed to be
stockholders as of this date.
4. Date of Payment: is date that the dividend checks
are mailed to shareholders of record.
Example, the dividend checks are mailed on February
16.
 Ex-dividend and Stock Price
What happens to the stock price when it goes ex, meaning
the ex-dividend date arrive?
 Example, suppose there is a stock that sells for birr 10 per
share. The BOD declares a dividend of Br. 1 per share, and
the record date is Thursday, June 14. The ex-date will be
four businesses (not calendar) days earlier, on Friday, June
8.
If you buy the stock on Thursday, June 7, right as the market
closes, you will get the birr 1 dividend because the stock is
trading cum dividend. If you wait and buy the stock right as
the market opens on Friday, you will not get the birr 1
dividend. What will happen to the value of the stock
overnight?
 Establishing a Dividend Policy
1. Residual Dividend Approach
It is a dividend policy under which a firm pays dividends
only after meeting its investment needs while
maintaining a desired debt-equity ratio.
With a residual dividend policy, the firm’s objective is to
meet its investment needs and maintain its desired debt-
equity ratio before paying dividends.
2. Stable Dividend Policy / Cyclical dividend policy
Stable dividend policy is dividends are a constant
proportion of earnings over an earnings cycle.
 Cyclical dividend policy is dividends are a constant
proportion of earnings at each pay date.
3. A Compromise Dividend Policy
In practice, many firms appear to follow what
amounts to compromise dividend policy. Such a
policy is based on goals.
Under the compromise approach, the debt-equity
ratio is viewed as a long range goal.
One can minimize the problems of dividend
instability by creating two types of dividends: regular
and extra.
Dividend Theories
Different theories have been given by various people on
dividend policy.
1. Traditional theory
2. The modern theories can be grouped as
A.Theories that consider dividend decision as an active
variable in determining the value of the firm and
B. Theories that do not consider dividend decision as an
active variable in determining the value of the firm.
Optimal Dividend Policy is the dividend policy that
strikes a balance between current dividends and
future growth and maximizes the firm’s stock price.

In an effort to find out the optimal dividend policy

different theories and models have been suggested by
various scholars.
1. Traditional Approach
This approach is given by B. Graham and D. L. Dodd.
They clearly emphasize the relationship between the
dividends and the stock market(Firm Value).
According to them, the stock value responds
positively to high dividends and negatively to low
dividends, that is, the share values of those
companies rises considerably which pay high
dividends and the prices fall in the event of low
dividends paid.
Drawbacks of the Traditional
Approach
As per this approach, there is a direct
relationship between P/E ratios and dividend pay­out
ratio.
High dividend pay­out ratio will increase the P/E ratio
and low dividend pay­out ratio will decrease the P/E
ratio.
This may not always be true. A company’s share prices
may rise in spite of low dividends due to other Factors.
 Modern Dividend Theories
Dividend Relevance Model
A. Walter Model
Prof. James E. Walter considers dividend pay­outs are relevant
and have a bearing on the share prices of the firm.
The choice of an appropriate dividend policy affects the value of
the firm.
His model clearly establishes a relationship between the firm’s
rates of return r, its cost of capital k, to give a dividend policy
that maximizes shareholders’ wealth.
The firm would have the optimum dividend policy that will
enhance the value of the firm.
This can be studied with the relationship between r
and k.
1. If r>k,the firm’s earnings can be retained as the
firm has better and profitable investment
opportunities and the firm can earn more than what
the shareholders could by re­investing, if earnings are
distributed.
Firms which have r>k are called ‘growth firms’
and such firms should have a zero pay­out ratio.
2. If return on investment r <k, the firm should have a
100% pay­out ratio as the investors have better
investment opportunities than the firm.
 Such a policy will maximize the firm value.
3. If a firm has r=k, the firm’s dividend policy will have
no impact on the firm’s value. The dividend pay­outs
can range between zero and 100% and the firm value
will remain constant in all cases. Such firms are called
‘normal firms’.
Assumptions of Walter’s Model
Walter’s Model is based on certain assumptions:
a. Financing: All financing is done through retained
earnings. Retained earnings is the only source of finance
available and the firm does not use any external source of
funds like debt or new equity.
b. Constant rate of return and cost of capital: The firm’s r
and k remain constant and it follows that any additional
investment made by the firm will not change the risk and
return profile.
c. 100% pay­out or retention: All earnings are either
completely distributed or reinvested entirely immediately.
d. Constant EPS and DPS: The earnings and dividends do
not change and are assumed to be constant forever.
e. Life: The firm has a perpetual life.
Walter’s formula to determine the market price
is as follows:
Example:
The following information relates to Alpha Ltd.
Show the effect of the dividend policy on the
market price of its shares using the Walter’ s Model.
Equity capitalization rate Ke 11%
Earnings per share $ 10
ROI (r) may be assumed as follows: 15%, 11% and
8%
Show the effect of the dividend policies on the share
value of the firm for three different levels of r, taking
the DP ratios as zero(0%), 25%, 50%, 75% and 100%
Interpretation: The above workings can be summarized
as follows:
1. When r>k, that is, in growth firms, the value of shares is
inversely related to DP ratio, as the DP increases, market
value of shares decline.
 Market value of share is highest when DP is zero and
least when DP is 100%.
2. When r=k, the market value of share is constant
irrespective of the DP ratio. It is not affected whether
the firm retains the profits or distributes them.
3. In the third situation, when r<k, in declining firms, the
market price of a share increases as the DP increases.
There is a positive correlation between the two.
Limitations of the Model
1. Walter has assumed that investments are exclusively
financed by retained earnings and no external
financing is used. This model is applicable only to all
equity firms.
2. Secondly r is assumed to be constant which again is
not a realistic assumption.
3. Finally, Ke is also assumed to be constant and this
ignores the business risk of the firm which has a
direct impact on the firm value.
Gordon’s Dividend Capitalization Model
Gordon also contends that dividends are relevant to the
share prices of a firm.
Assumptions
All equity firm: The firm is an all equity firm with no
debt.
No external financing is used and only retained
earnings are used to finance any expansion schemes.
Constant return r
 Constant cost of capital Ke
The life of the firm is indefinite.
Constant retention ratio: The retention ratio g=br is
constant forever.
Cost of capital greater than br, that is Ke>br
Gordon’ s model assumes investors are rational and
risk averse.
They prefer certain returns to uncertain returns and
therefore give a premium to the constant returns and
discount uncertain returns.
 The shareholders therefore prefer current dividends
to avoid risk. In other words, they discount future
dividends.
 Retained earnings are evaluated by the shareholders
as risky and therefore the market price of the shares
would be adversely affected.
Gordon explains his theory with preference for current
income. Investors prefer to pay higher price for stocks
which fetch them current dividend income
Example
Given Ke as 11%, E is $ 10, calculate the stock value of
Mahindra Tech. for (a) r=12%, (b) r=11% and (c) r=10%
for various levels of DP ratios given under:
 Interpretation
Gordon is of the opinion that dividend decision does
have a bearing on the market price of the share.
1. When r>k, the firm’ s value decreases with an increase in
pay­out ratio. Market value of share is highest when DP is
least and retention highest.
2. When r=k, the market value of share is constant
irrespective of the DP ratio. It is not affected whether the
firm retains the profits or distributes them.
3. When r<k, market value of share increases with an
increase in DP ratio.
Summary of factors influencing
dividend policy
Factors that affect the dividend policy may be grouped
into four categories :
1. Constraints on dividends payments,
2. Investment opportunities,
3. Availability and cost of alternative sources of capital,
and
4. Effects of dividend policy on the cost of capital.
Bond indentures (agreements): debt contracts often
limit dividends payment to earnings generated after the
loan was granted.

Preferred stock restrictions: typically, common

dividends cannot be paid if the company has omitted its
preferred dividend.

Impairment of capital rule: Dividend payments cannot

exceed the balance sheet item “retained earnings”.
Availability of cash: cash dividends can be paid only
with cash. Thus, a shortage of cash in the bank can
restrict dividend payments; however, the availability to
borrow can offset this factor.

Possibility of accelerating or delaying projects: the

ability to accelerate or to postpone projects will permit a
firm to adhere more closely to a stable dividend policy.

Cost of selling new stock: If a firm needs to finance a

given level of investment, it can obtain equity by
retaining earnings or by issuing new common stock
Ability to substitute debt for equity: A firm can
finance a given level of investment with either debt or
equity. If the firm can adjust its debt ratio without
raising costs sharply, it can pay the expected dividend,
even if earnings fluctuate, by using a variable debt ratio.

Control: If management is concerned about

maintaining control, it may be reluctant to sell new
stock; hence the company may retain more earnings
than it otherwise would.
 Repurchases of Shares
When a firm wants to pay cash to its shareholders, it
normally pays a cash dividend.

Another way is to repurchase its own stock i.e. a firm

can pay cash to its shareholders by a repurchase of its
own stock from the shareholders as an alternative to
paying cash dividend.
Advantages of Stock Repurchases
Repurchase announcements are viewed as positive
signals by investors.
Stockholders have a choice when a firm repurchases
stocks: They can sell or not sell.
Dividends are sticky in the short-run because
reducing them may negatively affect the stock price.
Extra cash may then be distributed through stock
repurchases.
The target payout ratio may be achieved with the
help of repurchases.
Disadvantages of Stock Repurchases
Stockholders may not be indifferent
between dividends and capital gains.

The selling stockholders may not be fully

aware of all the implications of a repurchase.

The corporation may pay too much for the

repurchased stocks.
 Stock Split and Reverse Stock Split
A stock split is a method to increase the number of
outstanding shares by proportionately reducing the face
value of a share.

A stock split affects only the par value and does not have
any effect on the total amount outstanding in share
capital.
The reasons for splitting shares are:
To make shares attractive: The prime reason for effecting
a stock split is to reduce the market price of a share to
make it more attractive to investors.
Shares of some companies enter into higher trading zone
making it out of reach to small investors.

Indication of higher future profits: Share split is

generally considered a method of management
communication to investors that the company is expecting
high profits in future.
Higher dividend to shareholders: When shares are split,
the company does not resort to reducing the cash
dividends. If the company follows a system of stable
dividend per share, the investors would surely get higher
dividends with stock split
Working capital
management
Introduction
Working Capital Management: Defined
Working capital management is the administration
and control of current assets, current liabilities and
the relationship between them.
Specifically it involves the determination of:
The level of investment in each type of current assets
and consequently the level of total current asset
investment.
The specific sources of financing of working capital
and their proportions
Working capital management has the following objectives.

1. It helps to maximize the value of a firm by focusing

on maximizing the returns from the working capital
investment in relation to its cost.
2. It helps to minimize, in the long run the cost of
working capital employed by identifying least cost
sources of finance.
3. It helps to control the flow of funds within the
organization so that the firm can meet its financial
obligation and run its operation smoothly
 Working capital management is important for a
number of reasons
 First through a proper working capital management a
firm can avoid liquidity crisis that results in financial
embarrassment to its creditors.

Second, in many manufacturing and merchandising firms

current assets constitute relatively large proportion of
total assets. This by itself justifies the close attention and
management of working' capital.

Third, working capital involves firm's day-to-day

transactions and occupies most of the time of finance
personnel.
• Working capital: firm’s investments in current
assets.
• Net working capital: current assets minus current
liabilities.
Components of Working Capital
1. current asset: cash, marketable securities,
accounts receivable and inventory.
2. Current liabilities: accounts payable,
banks loans and notes payable; and portion of long
term debt (due in one year).
 Working Capital policy
1. Permanent Working Capital
 There is always a minimum level of current assets,
which is continuously required by the enterprise
to carry out its normal business operations.
 For example, every manufacturing firm has to
maintain a minimum level of raw materials, work-
in-process, finished goods and cash balance.
 This minimum level of current assets is called
permanent working capital or permanent current
assets as this part of working capital is
permanently blocked in current assets.
 2. Variable /Temporary working capital
Temporary working capital or temporary current
assets, on the other hand, are the investment in
current assets that varies with seasonal
requirements.
It is the amount of working capital, which is required
to meet the seasonal demands and some special
unforeseen events.
Temporary working capital differs from permanent
working capital in the sense that it is required for
short periods and cannot be permanently employed
in the business.
 Working Capital Investment policy
Investment in current assets has a lower return than in
fixed assets. Current assets have lower risks (dangers)
too.

Therefore, although large investment in current assets

signifies low risk the profitability of this investment is
low as compared to profitability of investment in fixed
assets at the same time.
A business has to strike the right balance between its
investment in current assets and that in fixed assets.
 Cont’d….
Under these assumptions, the actual level of current
assets within the firm will depend upon the firm’s
evaluation of the risk-profitability tradeoffs. Because of
the following reasons:
 increasing the proportion of current assets to fixed assets
lowers the profitability of assets (rate of return on assets)
but decreases risk (or increase the liquidity position of a
firm to meet unexpected future funds requirement)
 decreasing the proportion of current assets to fixed assets
increases profitability of assets but it increases the risk
(or reduces the liquidity position of a firm to meet
unexpected future funds requirement).
There are three alternative working
capital investment policies. These
include conservative, Maturity Matching
Financing Policy/Strategy and aggressive
working capital investment polices.
1. Maturity Matching Financing
Policy/Strategy

A strategy (policy) to match asset and liability maturities

Short term sources are used to finance the temporary

current assets.
The permanent current asset and fixed assets are
financed with long term sources
The strategy is to match expected funds inflows with
expected fund out flows.
Purchase terms = 2/10, n/30
Sales terms = 2/10, n/30
 2. Conservative strategy (policy)
 Suggest that estimated working capital is financed by long
term funds and if there is an emergency you can use short
term funds
 Much of the assets requirement is financed with long term
sources
 Excess of funds during off-peak season are invested in short
term securities or will be applied for the repayment of short
term obligations.
 Under conservative working capital investment policy the
company holds a relatively large proportion of its total
assets in the form of current assets.
 3. Aggressive strategy (policy)
o Financing the temporary and part of the permanent
current assets with short term sources (borrowing).

o The remaining assets are financed with long term sources

o Under this policy, the company holds a relatively small
proportion of its total assets in the form of current assets.
o This policy yields a higher expected profitability and a
higher risk in contrast to conservative policy.
o The firm may be unable to meet its short-term
obligations when due from its current assets.
Factors Affecting Working Capital
Requirements (Determinants of Working
Capital)
There are no set rules or formulae to determine the
working capital requirements of firms.
Therefore, an analysis of relevant factors should be
made in order to determine total investment in
working capital. These factors affect different firm
differently.
Factors that determine working capital requirement
of the firm include:

1. Nature of Business
Working capital requirements of a firm are basically
influenced by the nature of its business.
 Public utilities have a very limited need for working capital
and have to invest abundantly in fixed assets. This is because
they may have only cash sales and supply services, not
products.
 Thus, no funds will be tied up in debtors and stock
(inventories)
 Trading and financial firms have a very small investment in
fixed assets, but require a large sum of money to be invested
in working capital.
 WC is high because they have to stock a variety of goods.
 Manufacturing -WC requirement fall between the two
extreme requirements of trading firms and public utilities.
 2. Production (manufacturing) cycle (and
technology)
The manufacturing cycle (or the inventory conversion
cycle) comprises of the purchase and use of raw
materials and the production of finished goods.
It covers the time span from procurement till the time
it becomes finished goods.
Longer the manufacturing cycles, larger will be the
firm’s working capital requirements.
E.g. Sugar Factory Vs Beer Factory
 3. Production policy
A strategy of constant production may be maintained
in order to resolve the working capital problems
arising due to seasonal changes in the demand for the
firm’s product.
A steady production policy will cause inventories to
accumulate during the off-season periods and the firm will
be exposed to greater inventory costs and risks.
Thus, if costs and risks of maintaining a constant
production schedule are high, the firm may adopt a
variable production policy, varying its production
schedules in accordance with changing demand.
4. Credit Policy
The credit policy of a firm in its dealings with debtors
and creditors influences considerably the requirements
of working capital investment.
A firm that purchases on credit and sells its
products/services on cash requires lesser amount of
working capital investment.
On the other hand, a firm buying its requirements for
cash and allowing credit to its customers shall need
larger amount of working capital investment as very
huge amount of funds are bound to be tied up in
accounts receivable.
 5. Business cycle
During the period of boom, production is more
and WC is high.
During a period of recession, production decline,
the requirement of WC is low.
6. Marketing policy of the firm (Market and
demand conditions)
 Skimming the cream-pricing strategy that a firm should
adopt, i.e., taking the most important thing from the
market.
 It is possible when there is no close substitute
(Competition) to the market.
 The production is less, you sell less then you will get
higher amount of profit by using a small amount of WC
Market penetration: - By making the price , sale ,
profit , you will have to produce more so working capital
will be more.
 7. Growth and expansion
More fixed assets and more working capital
Product diversification
Expanding existing product line
New business line.
 8.Availability of Credit from
suppliers
The working capital requirements of a firm are also
affected by credit terms granted by it suppliers.

 A firm will needless working capital if liberal credit

terms are available to it from suppliers.

In the absence of suppliers credit, the firm either

has to hold cash or borrow from bank (which is
interest bearing).
 9. Profit level
The net profit is the source of working capital to
the extent that it has been earned in cash.

 Higher profit margins would improve the

prospects of generating more internal funds there
by contributing to the working capital needs.
 10. Level of taxes
The first appropriation of profit is tax.
Taxes may be payable in advance depending on
previous profit.
If tax liability is increased, working capital requirement
will be high.
Tax evasion: cheating income tax amount.
Concealment of income is tax evasion illegal action
Tax avoidance: making use of income tax provision for
reducing tax liability.
11. Dividend policy
Dividend policy
 Cash dividend
 Stock dividend

 No dividend

12. Deprecation policy

There is no payment for depreciation, so no cash is
needed for this purpose
 It has an indirect effect
 12. Price level changes
During period of inflation to maintain the same level
of requirement additional investment is needed.
The situation has an effect only at initial position
because the company also sells the product at high
amount. In this case WC increase drastically

13. Operating Efficiency

The operating efficiency of the firm related to the
optimum utilization of resources at minimum costs.
The firm will be effectively contributing in keeping the
working capital investment at a lower level if it is
efficient in controlling operation costs and utilizing
current assets.
Working capital policy: refers to the firm’s basic policies
regarding
1) Target levels for each category of current assets and
2) How current assets will be financed.
Working capital management: involves the
administration of current assets and current liabilities.
The three tasks of working capital management
– speeding up receipts of cash
– delaying payments of cash, and
– investing excess cash
• These three tasks should be done in a manner to
maximize shareholders wealth ,considering time value
of money in to account.
• Current asset Investment
Policies
• Relaxed current asset investment( fat cat) policy
– large amounts of cash, marketable securities, and
inventories are carried and where sales are stimulated by the
use of a credit policy that provides liberal financing to
customers and a corresponding high level of receivables.
• Restricted current asset investment (lean and mean)
Policy
– Holdings of cash, securities, inventories, and receivables are
minimized.
•  Moderate current asset investment policy.
– Between the two extremes.
Relaxed

Moderate

Restricted
 Chapter three

Cash and Marketable Security

Management
Cash and marketable security management

• Cash is the ready currency to which all liquid

assets can be reduced
• Marketable securities are short term, interest-
earning, money market instruments that are used
by the firm to obtain a return on temporarily idle
funds.
• Cash and marketable securities are held by firms
to reduce the risk of technical in solvency by
providing a pool of liquid resources for use in
making planned as well as unexpected outlays.
 CASH MANAGEMENT
The basic objective in cash management is to keep
the investment in cash as low as possible while still
keeping the firm operating efficiently and
effectively (i.e., is reducing the idle cash amount).

 This goal usually reduces to the dictum (motto)

“collect early and pay late”.
Motives for holding cash and near cash balances
• There are three motives for holding cash and near cash
(marketable securities) balances :
• Transaction motive: A firm maintains cash balances to satisfy
the transaction motive, which is to make planned payments for
items such as materials and wages.

• Safety motive: Balances held to satisfy the safety motive are

invested in highly liquid marketable securities that can be
immediately transferred from securities to cash.
• Such securities protect the firm against being unable to satisfy
unexpected demands for cash.

• Speculative motive: This is a motive of holding cash or near to

be able to quickly take advantage of unexpected opportunities
that may arise.
• Speculative motive is the least common of the three motives.
 OBJECTIVES OF CASH MANAGEMENT
The basic objectives of cash management are two,
these are:
To meet the cash disbursement need (payment
schedule)

To minimize funds committed to cash balance

(Minimization of Idle cash).
These two objectives are conflicting and mutually
contradictory and it is the task of cash management to
reconcile them.
1. Meeting the payment schedule
 In the normal course firms have to make payment of cash
on a continuous and regular basis to supplier of goods,
employees and so on. At the same time there is a constant
inflows of cash through collection from debtors and cash
sales.
 Cash is “oil to lubricate the ever turning wheals of
business, without it the process of grinds to stop”.
 A basic objective of cash management is to meet the
payment schedule i.e., to have sufficient cash to meet the
cash disbursement needs of the firm. Keeping large cash
balances however implies a high cost. Sufficient and not
excessive cash can well realize the advantages of prompt
payment of cash.
 2. Minimizing funds committed to cash balance

 High level of cash balance has the advantages of prompt

payment but has high costs.

 A low level of cash may result in not keeping up

payment schedule but has low cost.

 Excessive cash balance reduces profitability as well as

lower cash leads to insolvency. As excess cash or shortage
has its own costs, an optimal cash balance would have to
be arrived.
 CASH MANAGEMENT STRATEGIES
The broad cash management strategies are essentially
related to the cash turnover process i.e., the cash cycle
together with the cash turnover. 
 
 
 
 
 
 
Cash cycle – refers to the time taken from the time cash
is paid to purchase raw materials till the time it is
received from customers.
Keeping the cash cycle so short is utmost important

Cash turnover – means the number of times firm’s cash

is used during each year
Minimum operating cash- the higher cash turnover, the
less cash the firm requires.

Cash turn over = Number of days in a year

Cash cycle
High turnover is desirable since it reduces firm’s
average cash balance and holding costs.
Minimum cash balance = Total annual outlay
Cash turn over
The operational implication of the minimum cash
requirement is that if the firm has an operating
minimum cash balance it would be able to meet its
obligation when they become due.

 But the minimum operating cash involves cost in terms

of the earning forgone from investing it temporarily
(i.e., opportunity cost). Also the firm will have to pay a
cost for this amount.
Cash cycle= ACP + Manufacturing time – creditors pmt period
 The cash management strategies are intended to minimize the
operating cash balance requirements.
Example:
Over the past year, X company’s accounts receivable have averaged 80
day sales and inventories have averaged 60 days. The company has
paid its creditors, on average, 25 days after receiving the bill.
Production is evenly spread over the year and the company expects
to spend birr 18 million during the year for materials and supplies
1. Compute the following
Cash cycle
Cash turnover
Minimum cash balance
2. What is the birr cost of tying up the fund if the company’s
opportunity cost is 20%?
MANAGING CASH COLLECTION AND DISBURSEMENT

Float: Difference between bank cash balance and

book cash balance
Float= Firm’s bank balance- firm’s book balance
Float: Difference between bank cash balance and book
cash balance
Float= Firm’s bank balance- firm’s book balance

Disbursement float Collection float

Checks written by firm Checks received by the
Decreased in book cash firm
but no immediate Increase in book cash
change in bank balance but no immediate
change in bank balance
Net float= disbursement float + collection float

Example:
Disbursement float
XYZ co. currently has birr 1,000,000 on deposit with its bank.
The book balance also shows birr 1,000,000. Assume that
XYZ co. Purchased materials and make payments by
writing a check for birr 100,000
The book balance is immediately adjusted to $ 900,000 when
the check is issued.
The bank balance will not decrease until the check is
presented to XYZ’s bank by the supplier or his bank.
Disbursement float = Bank balance – book balance
= 1,000,000 – 900,000 = 100,000
Collection float
Consider the same example above, but instead of
payment, the firm receives a check from a customer for
$ 200,000 and deposits the check at its bank.
Book balance is adjusted immediately to $ 1,200,000
Bank balance will not increase immediately until XYZ’s
bank present the check to the customer’s bank and
received the amount
Collection float = Bank balance - book balance
= 1,000,000 – 1,200,000 = -200,000
Net float = 100,000- 200,000 =- 100,000
Cash management techniques
1. Cash flow synchronization
It is arranging of events that cash receipts coincide
with required cash outflows. It reduces the
transaction balances to a minimum, decrease its bank
loans, lower interest expenses, and boost profits.
2. Float
 In the broadest sense, float refers to funds that
have been dispatched by a payer ( the firm or
individual making payment) but are not yet in a form
that can be spent by the payee( the firm or individual
receiving payment).
 Float also exists when a payee has received funds in a
spendable form but these funds have not been
withdrawn form the account of the payer.
Types of floats
Collection float: results from the delay between the
times when a payer or customer deducts a payment
form its checking account ledger and the time when
the payee or vendor actually receives these funds in a
spendable form.
Thus collection float is experienced by the payee and
is a delay in the receipt of funds.
Disbursement float: results from the lapse between
the time when a firm deducts a payment form its
checking account ledger (disburse it) and the time
when funds are actually withdrawn from its account.
Disbursement float is experienced by the payer and is
a delay in the actual withdrawal of funds.
Components of float.
Both collection float and disbursement float have the
same three basic components:
Mail float: the delay between the time when a payer
places payment in the mail and the time when it is
received by the payee.
Processing float: the delay between the receipt of a
check by the payee and the deposit of it in the firm’s
account.
Clearing float: the delay between the deposit of a check
by the payee and the actual availability of the funds.
This component of float is attributable to the time
required for a check to clear the banking system
There are a specific techniques and process for speedy
collection of receivable and slowing disbursements.

A. Speeding up collections
Concentration banking: a collection procedure in which
payments are made to regionally dispersed collection
centers, then deposited in local banks for quick clearing.
 Reduces collection float by shortening mail and clearing
float.
Lockboxes: a collection procedure in which payers send their
payments to a nearby post office box that is emptied by the
firm’s bank several times daily; the bank deposits the
payment checks in the firm’s account. Reduces collection
float by shortening processing float as well as mail and
clearing float.
Direct send: a collection procedure in which the payee presents
payment checks directly to the banks on which they are
drawn, thus reducing clearing float.
Preauthorized checks
Wire transfer.
B. S-L-O-W-I-N-G D-O-W-N DISBURSMENTS

Form the firm’s point of view, disbursement float is

desirable, so the goal in managing disbursement float is
to slow down disbursements as much as possible.

To do this, the firm may develop strategies to increase

mail float, processing float and availability float on the
checks it writes.

Beyond this, firms have developed procedures for

minimizing cash held for payment purposes.
Increasing disbursement float

Disbursement float can be increased by writing a

check on a geographically distant bank.
Controlling disbursements
I) Zero-balance accounts
II) Controlled disbursement accounts
With a controlled disbursement account system almost
all payments that must be made in a given day are known
in the morning.
The bank informs the firm of the total and the firm
transfers (usually by wire) the amount needed.
DETERMINING THE TARGET CASH BALANCE
 The target cash balance involves a trade-off between the
opportunity costs of holding too much cash (the carrying
costs) and the costs of holding too little (the shortage
costs, also called adjustment costs).
 The nature of these costs depends on the firm’s working
capital policy.
Cash holding
Benefit- liquidity
Cost- interest for gone
Estimating cash balances
• If levels of cash are too high, the profitability of the
firm will be lower than if more optimal balance were
maintained.
• Firms can use either subjective approaches or
quantitative models to determine appropriate
transactional cash balances.

1. Subjective approaches
2. Quantitative models
Two quantitative models:
• Baumol(BAT) model and
• The Miller-Orr model.
Baumol(BAT) model
A model that provides for cost efficient transactional
cash balances.
Assumes that the demand for cash can be predicted
with certainty and determines the economic
conversion quantity (ECQ/C*).
 It treats cash as inventory item whose future demand
for settling transactions can be predicted with
certainty.
helps in determining a firm’s optimum cash balance
under certainty.
A portfolio of marketable securities acts as a reservoir
for replenishing transactional cash balances.
The firm manages this cash inventory on the basis of
the cost of converting marketable securities into cash
(the conversion cost) and the cost of holding cash
rather than marketable securities (opportunity cost).
The economic conversion quantity (ECQ), the cost
minimizing quantity in which to convert marketable
securities to cash is
 
ECQ = 2 x Cost per Conversion x demand for cash
Opportunity cost (in decimal form)
  
 
Conversion cost: includes the fixed cost of placing and
receiving an order for cash in the amount ECQ.
It includes the cost of communicating the necessary
information to transfer funds to the cash account,
associated paper work costs, and the cost of any follow
up action.
The conversion cost is stated as birr per conversion.
Opportunity cost: is the interest earnings per birr
given up during a specified time period as a result of
holding funds in a non-interest earning cash account
rather than having them invested in interest earning
marketable securities.
Total cost: is the sum of the total conversion and total
opportunity costs.
Total conversion =cost per conversion *number of
conversions per period.
The number of conversions per period
= the period’s cash demand
economic conversion quantity (ECQ).
The total birr opportunity cost
opportunity cost (in decimal form) *average cash
balance.
The average cash balance is found by dividing ECQ by
2.
The total cost equation is
Total cost = Transaction cost + Holding cost
=(Cost per conversion x number of conversions)+ [Opportunity
cost (in decimal form) x average cash balance]
Example:- The management of Alem Sport, a small distributor of
sporting goods, anticipates birr 1,500,000 in cash outlays
(demand) during the coming year. A recent study indicates
that it costs birr 30 to convert marketable securities to cash.
The marketable securities portfolio currently earns an 8
percent annual rate or return,
Compute
1. Economic conversion quantity (ECQ)
2. Number of conversions
3. Average cash balance
4. Total cost
Assumptions that are made in the model
1. The firm is able to forecast its cash requirements with
certainty and receive a specific amount at regular intervals.
2. The firm’s cash payments occur uniformly over a period of
time i.e. a steady rate of cash outflows.
3. The opportunity cost of holding cash is known and does
not change over time. Cash holdings incur an opportunity
cost in the form of opportunity foregone.
4. The firm will incur the same transaction cost whenever it
converts securities to cash.
Limitations of the Baumol model:
1. It does not allow cash flows to fluctuate.
2. Overdraft is not considered.
3. There are uncertainties in the pattern of future cash
flows.
2. MILLER- ORR MODEL
• A model that provides for cost efficient transactional
cash balances
• assumes uncertain cash flows and determines an upper
limit (i.e. the maximum amount) and return point for
cash balances.
• The return point represents the level at which the cash
balance is set, either when cash is converted to
marketable securities or vice versa.
• Cash balances are allowed to fluctuate between the upper
limit and a zero balance.
• Return point: the value for the return point depends on:
•
Conversion costs
• The daily opportunity cost of funds, and
• The variance of daily net cash flows.
 The formula for determining the return point is

 Return point= 3 x Conversion cost x Variance of daily net cash flows

3 4 x daily opportunity cost (in decimal form)

 Upper limit: the upper limit for the cash balance is three times the
return point.
 Cash balance reaches the upper limit: when the cash balance reaches the
upper limit, an amount equal to the upper limit minus the return point
is converted to marketable securities.
Cash converted to marketable securities = upper limit – return point
Marketable securities converted to cash = return point – zero balance
 Cash Balance falls to zero: when the cash balance falls to zero, the
amount converted from marketable securities to cash is the amount
represented by the return point.  
Example, continuing with the prior example, it
costs Alem sport birr 30 to convert marketable
securities to cash, or vice versa; the firm’s
marketable securities portfolio earns an 8 percent
annual return, which is 0.0222 percent daily(
8%/360 days). The variance of Alem sport’s daily net
cash flows is estimated to be birr 27,000.