Expectancy Balance Model for Cash Flow †MyAssignmenthelp.com

Question: Discuss about the Expectancy Balance Model for Cash Flow. Answer: Introduction: The complete calculative procedure involving Eli Lillys nursery and Plant Company has been provided below. It involves two separate scenarios, each one showcasing the cash balance of Eli at the end of the year. The first scenario shows us the cash at the end of the year where there was an increase in the sales and the other scenario, which shows no change in the sales. Scenario 1: Amount Particulars Sales in year 1 A $6,00,000 Sales in Year 2 B $12,00,000 Increase in sales C $6,00,000 Asset build-up D= (50% of C) $3,00,000 Net Assets E=(50% of B) $6,00,000 Return on Sales F $1,20,000 Cash at the beginning of the year G $1,20,000 Less: Asset Build-up D $3,00,000 Add: Profit/Return on sales F $6,00,000 Cash balance at the end of the year H=(G-D+F) $4,20,000 Scenario 2: Cash at the beginning of the year G $1,20,000 Add: Profit/Return on sales F $6,00,000 Cash balance at the end of the year I= G+F $7,20,000 The above calculation presents us with two different scenarios, the first one showing an increase in the sales and the second one showing a constant amount of sale in the subsequent year. In the first case, after the increase in the sales, an asset build-up takes place amounting to $3, 00,000 which is deducted from the cash as it may have led to purchase of asset. The profit or the return on sales has been added which takes the amount of cash at the end of the year at $4, 20,000. Subsequently, in the second case, there has been no increase in sales, as a result of which only the profit has been added. This has caused the cash at the end of the year balance to increase by $3, 00,000 and it stood at $7, 20,000. It can be deduced that a subsequent increase in sales does not guarantee an increase in the cash balance at the end of the year. Whereas, when the sales remain constant at $6, 00,000, the cash balance at the end of the year increases and stands at $7, 20,000. Thus, if the sales remains constant, Eli might have a reason to be optimistic about her cash position at the end of the year. Treasury bills are one of the shortest securities which mature within a year of their issuance. They are actually discount instruments of money and are traded in the money market because of their short term nature. They are issued at a discount and they usually mature at their face value. They are usually issued by the Central Bank of the country to mitigate the temporary liquidity shortfalls prevalent in the economy at a certain point of time (Kacperczyk Schnabl, 2013). They are issued by the government to raise short term finance and are primarily issued to full fill the gap which exists between the receipts and expenditure. They remain one of the most favoured sources of earning short term revenue till date. The popularity of treasury bills has led to a wide range of users to use it in a regular fashion. Individuals, financial and other institutions, estates, trusts and various corporations regularly use Treasury bills and securities for various purposes. In many cases, even investment funds use Treasury bills in order to meet their objectives relating to their fiduciary requirements, and even individual investors often purchase treasury bills because it provides them the guarantee as well as security that they would receive their principal and interest under a fixed period of time. Treasury bills remain the most favourite place for financial managers to invest excess cash till now because of the following reasons: They are operated and traded in the largest active financial market, which adds to their popularity among finance managers. This leads to their increase usage. The wide market provides the finance managers ample opportunities to invest the funds of their companies. As a result of which, they favour treasury bills as the best monetary instrument in order to invest the excess cash, which provides them best returns from their largest market. The usage of treasury bills provides a sure guaranteed rate of return for the users. This allows the finance mangers to opt for them amongst the other financial instruments available in the financial market (Treasury Bills, 2018). Moreover, it is one of the fewest monetary instruments which offers a complete risk free rate of return to its investors in a very short span of time There is no loss in value in the usage of treasury bills. These bills are backed by the government and as a result of which the safety granted by these instruments is very high. The principle amount as well as the interest remains safe and sound (Treasury Bills, 2018). This causes the finance mangers to invest the excess cash in them as it is safe from the periodic market fluctuations. Their short term nature is another factor which compels finance managers to use them when funds are necessary. They put the excess cash on these treasury bills because the returns from these monetary instruments can be expected at a very short period of time. Thus as a result of which, they can expect extra return on the excess cash at a relatively short span of time. For example, if a firms finance manager sees that he can deposit an excess cash of $10,000 can invest it as a treasury bill of the same face value with a maturity period of 91 days. Another company, Drawnzer Ltd. purchases this bill for a discount at a price of $9,833(after deducting discount). Thus it can be seen that the finance manager can expect a quick yield after just a period of 3 months, which is beneficial for the company. There exists an inverse relationship between bonds and interest rates. At the time of issuing of new bonds, they carry coupon rates at the current market rates or very close to the present market rate, which is prevalent in the market. They exercise an inverse relationship between the two; when the price of one goes up, the other one goes down (Melo Bilich, 2013). The prevailing interest rate affects the value of a bond and this could be explained with the help of the concept of opportunity cost. Investors always want a better return on their investments. As a result of which, they always tend to compare the returns which they expect from their current investment with the returns they could get from any other places in the market (Neely et al., 2014). As the rate of interest which is prevalent in the market tends to change, the coupon rate of the bonds, which usually remains constant, becomes more attractive to the investors in this case. This leads to investors paying even less for the bond itself (Forbes Welcome, 2018). The behaviour has been explained with the help of an example below. Laninster Ltd offers a 7% interest rate on the coupon. It means the company would offer a $70 interest in the year. After analysing the bond, it is purchased for $1000 at par. This could lead to two cases: When the rate goes up: In this case, when the rate goes up from 7% to 8%, the company now would be reluctant to pay the same $1000 because now it would like to pay $875 as it follows an inverse relationship. When the rate declines: When the rate declines, it would lead to an increase in the prices of the bonds leading to a premium. The rate when increases to 7%, the company would be paying $1166 (Kaufman Hopewell, 2017). As it would be carrying a higher interest rate, therefore it would be available at a premium. References: Bekaert, G., Harvey, C. (2017). Emerging equity markets in a globalizing world. Forbes Welcome. (2018). Forbes.com. Retrieved 10 April 2018, from https://www.forbes.com/sites/mikepatton/2013/08/30/why-rising-interest-rates-are-bad-for-bonds-and-what-you-can-do-about-it/#4728ff2e6308 Kacperczyk, M., Schnabl, P. (2013). How safe are money market funds?. The Quarterly Journal of Economics, 128(3), 1073-1122. Kaufman, G. G., Hopewell, M. H. (2017). Bond price volatility and term to maturity: A generalized respecification. In Bond Duration and Immunization (pp. 64-68). Routledge. Melo, M. A., Bilich, F. (2013). Expectancy balance model for cash flow. Journal of Economics and Finance, 37(2), 240-252. Neely, C. J., Rapach, D. E., Tu, J., Zhou, G. (2014). Forecasting the equity risk premium: the role of technical indicators. Management Science, 60(7), 1772-1791. Treasury Bills. (2018). Treasury.gov.mt. Retrieved 10 April 2018, from https://treasury.gov.mt/en/Pages/Debt_Management_Directorate/Treasury_Bills.aspx