Cash Management Paper 3

Answer (B) is correct. The additional annual income (loss) from using the lockbox service is the excess (deficit) of interest earned on the accelerated deposits over (under) the cost of the service. If the plan is adopted, the company’s average cash balance will increase by $600,000 ($150,000 × 4 days). Benefit (loss) = Interest earned – Cost = ($600,000 × 4%) – ($2,500 × 12 months) = $24,000 – $30,000 = $(6,000

Answer (D) is correct. Compensating balances are either (1) an absolute minimum balance or (2) a minimum average balance that bank customers must keep at the bank. These are generally required by the bank to compensate for the cost of services rendered. Maintaining compensating balances will not accelerate a company’s cash inflows because less cash will be available even though the amount of cash coming in remains unchanged.

Answer (C) is correct. Various methods of accelerating cash collections include decentralized collection outposts (normally one in each Federal Reserve District), electronic funds transfers, centralized banking for all company branches to avoid having to maintain minimum balances in several locations, and lockbox systems. A compensating balance is a minimum average or absolute amount that must be maintained in a bank account. Hence, it is not a means of accelerating cash collections. This requirement means that less cash is available to the depositor.

Answer (A) is correct. An ACH electronic funds transfer (EFT is an electronic payment to a company’s account at a concentration bank. A concentration bank is a large bank to which a company transfers funds from local depository banks. These local banks operate the company’s lockboxes and thus serve as collection points. The transfer of funds to the concentration bank allows the company to take advantage of economies of scale in cash management. The use of ACHs facilitates concentration banking. ACHs are electronic networks operated by the Federal Reserve (except for the New York regional ACH association) that guarantee 1-day clearing.

Answer (D) is correct. Kemple can compare the costs of the two alternatives as follows: Standard account = Variable cost + Fixed cost = [(80 checks × $.10) + $10] × 12 months = $18 × 12 months = $216 per year Premium account = Variable cost + Fixed cost = [$0 + ($2,500 reqd. – $500 projected)] × 10% = $2,000 × 10% = $200 per year Thus, the premium account should be selected because it is cheaper by $16 per year.

Answer (A) is correct. A compensating balance is a minimum amount that the bank requires the firm to keep in its demand account. Compensating balances are noninterest-bearing and are meant to compensate the bank for various services rendered, such as unlimited check writing. These funds are obviously unavailable for short-term investment and thus incur an opportunity cost.

Answer (B) is correct. A draft is a three-party instrument in which one person (the drawer) orders a second person (the drawee) to pay money to a third person (the payee). A check is the most common form of draft. It is an instrument payable on demand in which the drawee is a bank. Consequently, a draft can be used to delay the outflow of cash. A draft can be dated on the due date of an invoice and will not be processed by the drawee until that date, thereby eliminating the necessity of writing a check earlier than the due date or using an EFT. Thus, the outflow is delayed until the check clears the drawee bank.

Answer (B) is correct. A draft is a three-party instrument in which one person (the drawer) orders a second person (the drawee) to pay money to a third person (the payee). A check is the most common form of draft. It is an instrument payable on demand in which the drawee is a bank. Consequently, a draft can be used to delay the outflow of cash. A draft can be dated on the due date of an invoice and will not be processed by the drawee until that date, thereby eliminating the necessity of writing a check earlier than the due date or using an EFT. Thus, the outflow is delayed until the check clears the drawee bank.

Answer (A) is correct. The float period is the time between when a check is written and when it clears the payor’s checking account. Check float results in an interest-free loan to the payor because of the delay between payment by check and its deduction from the bank account. If checks written require 1 more day to clear than checks received, the net float equals 1 day’s receipts. The company will have free use of the money for 1 day. In this case, the amount is $10,000.

Answer (A) is correct. The difference between collections and payables is $5,000 daily. Five days’ worth amounts to $25,000 of float.