Introduction to Corporate Finance

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^717

Companies, 2002

Planned or Possible Expenditures Firms frequently accumulate temporary invest-

ments in marketable securities to provide the cash for a plant construction program, divi-

dend payment, or other large expenditure. Thus, firms may issue bonds and stocks before

the cash is needed, investing the proceeds in short-term marketable securities and then

selling the securities to finance the expenditures. Also, firms may face the possibility of

having to make a large cash outlay. An obvious example would involve the possibility of

losing a large lawsuit. Firms may build up cash surpluses against such a contingency.

Characteristics of Short-Term Securities

Given that a firm has some temporarily idle cash, there are a variety of short-term secu-

rities available for investing. The most important characteristics of these short-term

marketable securities are their maturity, default risk, marketability, and taxability.

Maturity From Chapter 7, we know that for a given change in the level of interest

rates, the prices of longer-maturity securities will change more than those of shorter-

maturity securities. As a consequence, firms that invest in long-term securities are ac-

cepting greater risk than firms that invest in securities with short-term maturities.

We called this type of risk interest rate risk.Firms often limit their investments in

marketable securities to those maturing in less than 90 days to avoid the risk of losses in

value from changing interest rates. Of course, the expected return on securities with

short-term maturities is usually less than the expected return on securities with longer

maturities.

Default Risk Default riskrefers to the probability that interest and principal will not

be paid in the promised amounts on the due dates (or will not be paid at all). In Chap-

ter 7, we observed that various financial reporting agencies, such as Moody’s Investors

Service and Standard and Poor’s, compile and publish ratings of various corporate and

other publicly held securities. These ratings are connected to default risk. Of course,

some securities have negligible default risk, such as U.S. Treasury bills. Given the pur-

poses of investing idle corporate cash, firms typically avoid investing in marketable se-

curities with significant default risk.

Marketability Marketabilityrefers to how easy it is to convert an asset to cash; so

marketability and liquidity mean much the same thing. Some money market instruments

are much more marketable than others. At the top of the list are U.S. Treasury bills,

which can be bought and sold very cheaply and very quickly.

Taxes Interest earned on money market securities that are not some kind of govern-

ment obligation (either federal or state) is taxable at the local, state, and federal levels.

U.S. Treasury obligations such as T-bills are exempt from state taxation, but other gov-

ernment-backed debt is not. Municipal securities are exempt from federal taxes, but they

may be taxed at the state level.

Some Different Types of Money Market Securities

Money market securities are generally highly marketable and short-term. They usually

have low risk of default. They are issued by the U.S. government (for example, U.S.

Treasury bills), domestic and foreign banks (for example, certificates of deposit), and

business corporations (for example, commercial paper). There are many types in all, and

we only illustrate a few of the most common here.

690 PART SEVEN Short-Term Financial Planning and Management