Reducing Float Costs, Loans, Credit, Inventory Management
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8. Briefly explain how each of the following can be used to reduce a firm's float costs:
(a) wire transfers;
(b) zero balance accounts (ZBAs);
(c) controlled disbursing;
(d) centralized processing of payables;
(e) lockboxes.
9. What causes the differences between available balances and book balances?
10. Why do investors require firms issuing commercial paper to be of high creditworthiness?
11. Why are interest rates on short-term loans not necessarily comparable to each other? Give three possible reasons.
12. Explain how agency costs, created by market imperfections, can lead to the use of trade credit.
15. Explain how a firm's inventory and accounts receivable management problems are like a capital budgeting problem.
19. What benefits and costs should be analyzed when deciding the proper safety stock level?
20. How does a just-in-time inventory system benefit a firm? What conditions are needed for its successful use?
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Solution Summary
The question asks for conceptual explanations of several methods of reducing a firm's float costs. It expands on this to inquire about the source of differences between bank balances and book balance. The question also moves onto credit, by asking about commercial paper, interest rates, agency costs and the use of trade credit. The question also asks about another area of management - inventory management, more specifically safety stock and the use of a just-in-time inventory system.
Solution Preview
The techniques below reduce float (as stated in the question), however it's important to distinguish between disbursement and receivables float. For example, it is ideal to maximize disbursement float sometimes because that is money that is leaving the organization however it is optimal to minimize receivables float because that is money the organization is receiving and can be used for organizational activities.
Wire Transfer
- This is the electronic transfer of money from 1 bank account to another
- This reduces float because the money is transferred instantaneously and is immediately available for use by the recipient
Zero-Balance Accounts
- An account that keeps a zero balance
- Another account is used to transfer just enough money into the zero balance account to satisfy checks drawn on it
- This manages disbursement float
Controlled Disbursing
- Used to manage disbursement float
- The bank communicates with the company and lets them know which checks are going to be drawn from their account on any given day
Centralized Processing of Payables
- If processing is centralized, all processing occurs in the same facility (either for a company or for each business unit if the company is large and/or multinational)
- This central unit will operate under the guidance of company procedures
- Checks can be issued from this centralized unit
- Can manage float to take advantage of early payment discounts, as the company feels are appropriate
Lockboxes
- These are used to manage receivables float
- Payments are received by a PO box which is managed by the bank. The bank regularly collects the funds received and deposits them in the company's account
- All payments are received in a central location rather than having checks being sent to various branches or offices of the same entity
- The company benefits because cash is available for use faster
Available Versus Book Balances
- Float explains much of the difference between the balance recorded in a company's records and the actual amount of money available to be spent at any given time
- For example, you receive a check. You deposit the check and record an increase in your ...
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