the float is this extra $3,000 that comes in immediately. No other cash flows are affected, so Lambo is $3,000 richer.

In other words, the PV of eliminating the float is simply equal to the total float. Lambo could pay this amount out as a dividend, invest it in interest-bearing assets, or do anything else with it. If it costs $2,000 to eliminate the float, then the NPV is $3,000 -2,000 = $1,000; so Lambo should do it.

EXAMPLE 202 ■ Reducing the Float: Part I

-:—' Instead of eliminating the float, suppose Lambo can reduce it to one day. What is the maximum Lambo should be willing to pay for this?

If Lambo can reduce the float from three days to one day, then the amount of the float will fall from $3,000 to $1,000. From our discussion immediately preceding, we see right away that the PV of doing this is just equal to the $2,000 float reduction. Lambo should thus be willing to pay up to $2,000.

EXAMPLE 203 ■ Reducing the Float: Part II

-:—' Look back at Example 20.2. A large bank is willing to provide the float reduction service for

$175 per year, payable at the end of each year. The relevant discount rate is 8 percent. Should Lambo hire the bank? What is the NPV of the investment? How do you interpret this discount rate? What is the most per year that Lambo should be willing to pay?

The PV to Lambo is still $2,000. The $175 would have to be paid out every year forever to maintain the float reduction; so the cost is perpetual, and its PV is $175/.08 = $2,187.50. The NPV is $2,000 - 2,187.50 = -$187.50; therefore, the service is not a good deal.

Ignoring the possibility of bounced checks, the discount rate here corresponds most closely to the cost of short-term borrowing. The reason is that Lambo could borrow $1,000 from the bank every time a check was deposited and pay it back three days later. The cost would be the interest that Lambo would have to pay.

The most Lambo would be willing to pay is whatever charge results in an NPV of zero. This zero NPV occurs when the $2,000 benefit exactly equals the PV of the costs, that is, when $2,000 = C/.08, where C is the annual cost. Solving for C, we find that C = .08 x $2,000 = $160 per year.

Ethical and Legal Questions The cash manager must work with collected bank cash balances and not the firm's book balance (which reflects checks that have been deposited but not collected). If this is not done, a cash manager could be drawing on un-

© The McGraw-Hill Companies, 2002

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CHAPTER 20 Cash and Liquidity Management 681

collected cash as a source of funds for short-term investing. Most banks charge a penalty rate for the use of uncollected funds. However, banks may not have good enough accounting and control procedures to be fully aware of the use of uncollected funds. This raises some ethical and legal questions for the firm.

For example, in May 1985, Robert Fomon, chairman of E. F. Hutton (a large investment bank), pleaded guilty to 2,000 charges of mail and wire fraud in connection with a scheme the firm had operated from 1980 to 1982. E. F. Hutton employees had written checks totaling hundreds of millions of dollars against uncollected cash. The proceeds had then been invested in short-term money market assets. This type of systematic overdraft-ing of accounts (or check kiting, as it is sometimes called) is neither legal nor ethical and is apparently not a widespread practice among corporations. Also, the particular inefficiencies in the banking system that Hutton was exploiting have been largely eliminated.

For its part, E. F. Hutton paid a $2 million fine, reimbursed the government (the U.S. Department of Justice) $750,000, and reserved an additional $8 million for restitution to defrauded banks. We should note that the key issue in the case against Hutton was not its float management per se, but, rather, its practice of writing checks for no economic reason other than to exploit float.

Despite the stiff penalties for check kiting, the practice apparently continues to go on. For example, in April 2001, a contractor near Chicago was sentenced to more than three years in prison and ordered to pay restitution of $1.1 million for engaging in a 15-month check-kiting scheme that cost two Chicago-area banks more than $2.4 million.

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