Marketable Securities Management | Corporate Finance | Part 2 | Section B | Episode 20 | CMA USA

Welcome back to CMA USA exam coach, your dedicated learning partner on your CMA journey. In this episode, we are continuing our working capital management series, and the focus is on marketable securities management. Under marketable securities management, the key questions we'll explore are how much excess cash should a company invest in marketable securities? For how long should the funds be invested? In other words, what time period are we looking at before the cash might be needed again? The goal is to strike the right balance between earning a return on idle funds while keeping the investment safe and liquid, so the money is available when the business needs it. So, in this episode, we'll walk through how companies determine the amount and duration of investments in marketable securities, and how that helps them manage liquidity without compromising operational flexibility. Let's now understand what marketable securities actually are. As we discussed earlier, companies generally avoid holding too much liquid cash. Why? Because idle cash does not generate any return. It just sits in the bank, doing nothing for the business. So, to earn at least a small return on excess cash, companies choose to temporarily invest it in short-term, low-risk financial instruments. If these instruments have a maturity period of less than one year, they are called marketable securities. These are highly liquid, meaning the company can convert them back into cash quickly, whenever needed, without a major loss in value. Some common examples of marketable securities include treasury bills, commercial paper, certificates of deposit, or CDs, and other money market instruments. The key point to remember is that these investments are short-term, safe, and highly liquid, and they offer a return better than holding cash, even if small. So, instead of letting cash sit idle, the company parks it temporarily in marketable securities, and pulls it back when the funds are needed for operations. Now let's move on to understanding how companies actually manage their marketable securities. You see, it's not just about investing excess cash into marketable securities, it's also about knowing when to convert these investments back into cash, and how often it should be done. To help with this, financial experts have developed two very important models. These models guide companies in managing their marketable securities efficiently, balancing between liquidity needs and investment returns. These are 1. the Baumol model 2. the Miller-Orr model Let's first understand what each of these models is designed to do. The Baumol model is based on the same principles as the Economic Order Quantity EOQ model used in inventory management. It helps the company determine the optimal amount of cash it should withdraw or convert from marketable securities each time, and how often this should be done, in order to minimize the total cost of transactions and lost interest. The Miller-Orr model takes a more flexible approach. It recognizes that cash flows are unpredictable, so it works with upper and lower limits. Whenever cash drops below a certain minimum level, the company should convert securities into cash. And when cash exceeds an upper limit, excess funds should be invested back into marketable securities. Both models serve the same goal, to manage the trade-off between keeping too much idle cash and converting securities too frequently. In the next slides, we'll understand each model one by one with examples and logic. The Baumol model helps determine the optimum quantity of marketable securities Let's understand the logic behind this. Imagine if a company converts only a small amount of securities into cash each time. What happens? It will have to go through frequent conversions. And every time a conversion happens, there is a transaction cost. So frequent conversions mean higher total transaction costs. On the other hand, if the company converts a large quantity into cash all at once, it will have more cash on hand than it immediately needs. That excess cash just sits idle without earning any return. So this creates an opportunity cost. The company is losing out on potential interest it could earn if the funds stayed in securities. So what's the best approach? The optimum quantity is the balance point, where the total cost, which includes both transaction cost and opportunity cost, is minimized. This is what the Baumol model is all about. Finding that sweet spot to convert securities into cash in a cost-effective way. Now let's look at the formula used in the Baumol model. The formula is OC equals square root of 2 multiplied by B multiplied by T divided by I. Let me explain what these letters mean. OC stands for optimum conversion level. This is the ideal amount of securities the company should convert into cash each time. B is the transaction cost per conversion. Every time the company sells securities to get cash, there's a small cost involved. Maybe bank charges, brokerage fees, or administrative costs. T is the total cash requirement for the period. For example, if the company needs $1 million of cash over the next six months, then that's your T. I is the interest rate in the money market. This is also called the opportunity cost because this is what the company loses by holding cash instead of investing it. Now when we plug in these values into the formula, we get the optimum amount of cash that should be withdrawn each time. This balance will help minimize both the transaction costs and the opportunity costs. To summarize in simple words, the Baumol model is like an economic order quantity model. But instead of ordering inventory, here we are ordering or converting cash from marketable securities. Now let's go through a full example using the Baumol model to find out how much cash the company should convert from marketable securities each time and how many times to do this during the year. Let's say ABC Company estimates that it needs $750,000 in cash throughout the year. Every time the company converts marketable securities into cash, it incurs a transaction fee of $10. And the current money market interest rate, which represents the opportunity cost of holding idle cash, is 3% per year. Using the Baumol model, we apply the formula optimum cash conversion amount equals the square root of 2 multiplied by B multiplied by T divided by I. Where B is the transaction cost per conversion, which is $10. T is the total cash needed for the year, which is $750,000. And I is the money market interest rate, which is 0.03. Now let's plug the values into the formula. Optimum cash conversion amount equals square root of open parenthesis 2 multiplied by 10 multiplied by 750,000 divided by 0.03 close parenthesis. This equals the square root of 15 million divided by 0.03, which equals the square root of 500 million. So the optimum conversion amount is equal to 22,360.68. This means ABC Company should convert approximately $22,360 of marketable securities into cash each time. This is the optimum level of conversion that minimizes both the transaction costs from converting too frequently and the opportunity cost of holding too much idle cash. Now, let's find out how many times the company should convert during the year. To calculate the number of conversions, we divide the total annual cash need by the optimum conversion amount. Number of conversions equals 750,000 divided by 22,360.68. This gives us approximately 33.54 times per year. So ABC Company should ideally convert marketable securities into cash about 34 times per year. This balance ensures that the company is efficiently managing its short-term investments without incurring unnecessary costs. Now that we know ABC Company needs to convert about $22,360 each time, and they need to do this approximately 33.54 times per year, we can also calculate how often this conversion should happen in terms of days. We simply take the number of days in a year and divide it by the number of conversions. That is 365 divided by 33.54, which gives us approximately 10.88 days. So ABC Company should convert their marketable securities into cash roughly every 11 days. This means every 11 days, the company should sell about $22,360 worth of securities and use the cash for operations. This approach helps the company keep enough liquidity to meet day-to-day expenses without holding excess idle cash that earns no return. In short, by converting cash every 11 days in fixed amounts of $22,360, the company can minimize both the transaction cost of converting too often and the opportunity cost of holding too much cash. This is the practical benefit of applying the Baumol model in managing marketable securities efficiently. Now let's talk about the Miller-Orr model, which is another important approach used to manage marketable securities and cash levels in a company. Unlike the Baumol model, which assumes a fixed amount is converted each time, the Miller-Orr model works under uncertainty. It helps when cash flows are unpredictable or fluctuating daily. In this model, the company sets two important cash levels, a minimum level and a maximum level. Let's start with the maximum level. This is the upper limit of cash that the company wants to hold. If the actual cash balance goes above this maximum level, the company will take the excess cash and invest it into marketable securities or deposit it in the money market. Why? Because holding too much cash earns nothing, so they want to earn some return. Now let's come to the minimum level. This is the lowest amount of cash the company should have on hand. If the cash balance drops below this minimum level, the company needs to increase its cash immediately. To do that, it either sells some of its marketable securities or borrows from the money market to bring the cash back up. So in simple terms, the Miller-Orr model keeps the company's cash balance within a range, not too high, not too low. The system constantly adjusts. Excess cash goes into investments, and cash shortfalls are covered by liquidating investments. This model is especially useful when the company doesn't know exactly how much cash it will need each day, but still wants to control both liquidity and opportunity costs. Let's take a closer look at the three major types of money market securities that companies use to manage their excess cash. Treasury bills, commercial papers, and certificates of deposit. Understanding how each one is issued and what happens during their maturity will help us appreciate how businesses manage short-term liquidity. Let's start with treasury bills, also known as T-bills. These are issued by the U.S., federal government, and are considered the safest form of short-term investment in the financial markets. Treasury bills are sold at a discount to their face value. This means if the face value of the bill is $10,000, an investor might buy it for $9,700. The government does not pay any interest during the holding period. Instead, the investor earns the difference between the purchase price and the face value. At maturity, let's say in three months or six months, the government pays the full $10,000 to the investor. So the earning or return for the investor is the discount amount, which in this case is $300. Treasury bills are very liquid, very safe, and often used by companies and financial institutions that want to park their money securely for short durations. Now let's move on to the commercial paper, which is quite different. Commercial paper is a short-term unsecured debt instrument issued by large, credit-worthy private companies. Since it is unsecured, there's no collateral behind it. Only companies with a strong reputation and solid credit rating are able to issue commercial paper. It works similarly to treasury bills. Commercial papers are also issued at a discount, and the company repays the full face value at maturity. Let's say a company issues a commercial paper with a face value of $1 million, and an investor buys it for $980,000. When the paper matures, which could be anywhere from one week to 270 days, the company pays back the full $1 million to the investor. The difference, which is $20,000 in this case, is the return for the investor. Companies use commercial papers for short-term funding needs, like paying salaries, purchasing raw materials, or managing cash flow gaps. And they are a cheaper alternative to short-term bank loans for large firms. Now let's talk about the third one, the certificate of deposit, also called a CD. This is issued by a commercial bank and represents a fixed deposit made by an investor. When an investor deposits money with the bank for a fixed term, say three months or six months, the bank issues a certificate acknowledging that deposit. The CD specifies the deposit amount, the interest rate, and the maturity date. Unlike treasury bills and commercial papers, CDs usually pay periodic interest or lump-sum interest at maturity. For example, if an investor puts $100,000 into a six-month CD at 5% interest, they will receive $2,500 in interest at maturity, and the full principal of $100,000 is also returned. In the money market, large-denomination certificates of deposit can be traded in the secondary market. So if the investor wants to exit before maturity, they can sell the CD to another investor. CDs are considered safe and stable because they are backed by banks, and in some cases, even insured. So in summary, treasury bills are issued by the government, sold at a discount, and repaid at face value. Commercial papers are issued by large companies, also at a discount, and paid back in full at maturity. Certificates of deposit are issued by banks, earn fixed interest, and can be traded in the market. All three instruments help businesses earn returns on idle cash and allow quick access to funds when needed, a key part of efficient working capital management. Before we wind up, let's take a quick look at what we learned in today's episode. We started by understanding what marketable securities are. These are short-term, highly liquid investments that can easily be converted into cash with minimal risk. Companies use them to manage idle cash efficiently while still earning returns. Then we explored the Baumol model. This model helps businesses determine the optimal amount of cash to withdraw from marketable securities. It's like the Economic Order Quantity, EOQ model, but for cash management. It balances transaction costs with the opportunity cost of holding cash. Next, we covered the Miller-Orr model. This model adds flexibility by setting upper and lower control limits. It's perfect for businesses with unpredictable cash flows. When cash hits the upper limit, the excess is invested. When it drops to the lower limit, funds are transferred back in. It's a dynamic, real-world model for managing cash uncertainty. Finally, we took a detailed look at money market securities. We studied treasury bills, commercial paper, and certificates of deposit. Treasury bills are issued by the government, sold at a discount, and repaid at full face value. Safe and highly liquid. Commercial papers are issued by reputable private companies and also sold at a discount. They are unsecured and used for short-term funding. Certificates of deposit are issued by banks. They pay fixed interest and can be traded if in large denominations. A stable option backed by the banking system. Each of these instruments helps businesses manage their short-term liquidity needs smartly and securely. Thank you for joining today's session. Make sure to review these models and instruments carefully. They're important for both your CMA exam and your real-world understanding of corporate finance. Study well, stay consistent, and always keep learning. All the best for your CMA journey. See you in the next episode.