Determining The Target Cash Balance

Based on our general discussion of current assets in the previous chapter, 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

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VII. Short-Term Financial Planning and Management

20. Cash and Liquidity Management

© The McGraw-Hill Companies, 2002

CHAPTER 20 Cash and Liquidity Management called adjustment costs). The nature of these costs depends on the firm's working capital policy.

If the firm has a flexible working capital policy, then it will probably maintain a marketable securities portfolio. In this case, the adjustment, or shortage, costs will be the trading costs associated with buying and selling securities. If the firm has a restrictive working capital policy, it will probably borrow in the short term to meet cash shortages. The costs in this case will be the interest and other expenses associated with arranging a loan.

In our discussion that follows, we will assume that the firm has a flexible policy. Its cash management, then, consists of moving money in and out of marketable securities. This is a very traditional approach to the subject, and it is a nice way of illustrating the costs and benefits of holding cash. Keep in mind, however, that the distinction between cash and money market investments is becoming increasingly blurred.

For example, how do we classify a money market fund with check-writing privileges? Such near-cash arrangements are becoming more and more common. It may be that the prime reason they are not universal is regulation limiting their usage. We will return to this subject of such arrangements at various points in the following discussion.

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