CTP practice question 9 of 10

XYZ Company is considering different methods of concentrating cash from its subsidiary accounts to its main operating account. It uses short-term…

Choose your answer, then check it against the explanation.

XYZ Company is considering different methods of concentrating cash from its subsidiary accounts to its main operating account. It uses short-term borrowings with a rate of 7% to fund daily operations, and the reserve adjusted earnings credit rate on its subsidiary accounts is 1%. A review of its bank fees shows that wires (same day transfer) cost the XYZ Co. $7.00 each while ACH debits (next day transfer) cost $1.25 each. If the primary objective is to minimize costs, what must the transfer amount be (rounded to the nearest whole $) to justify the use of a wire transfer instead of an ACH to concentrate the funds?

Answer options

Correct Answer:

Explanation

The decision to use a wire transfer over an ACH is justified when the financial benefit of receiving the funds one day earlier equals or exceeds the wire's higher cost. This break-even amount is calculated by dividing the incremental cost of the wire by the net daily opportunity cost.

Incremental Cost: $7.00 (Wire) - $1.25 (ACH) = $5.75

Net Opportunity Cost: 7% (Borrowing Rate) - 1% (ECR) = 6%

Calculation: $5.75 / ((0.06) / 365) = $34,979.17

Therefore, a transfer of at least $34,979 is required to justify the additional cost of the wire.

Why Incorrect

A. $17,490: This is the result of a miscalculation and does not correctly apply the break-even formula with the given financial rates and costs.

B. $29,982: This answer is derived by incorrectly ignoring the 1% earnings credit rate (ECR) and using only the 7% borrowing rate as the opportunity cost.

D. $42,583: This is the result of a miscalculation, possibly by adding the interest rates instead of finding the net differential.

References

1. Association for Financial Professionals (AFP). (2020). Essentials of Treasury Management

6th Edition. Chapter 5: Cash Management and Forecasting. The section on "Cash Concentration Systems" details the cost-benefit analysis for different fund transfer mechanisms. It specifies that the break-even analysis must account for both explicit transaction costs and the opportunity cost

which is the net interest differential for the acceleration period (in this case

one day). The formula used is: Break-even Amount = Incremental Cost / (Opportunity Cost Rate × Time).

2. Gallagher

T. J.

& Andrew

J. D. (2018). Financial Management: Principles and Practice

8th Edition. Pearson. Chapter 16

"Cash and Working Capital Management

" discusses the objective of cash concentration

which is to minimize costs

including both transaction fees and the opportunity cost of idle cash. The calculation for comparing transfer methods explicitly uses the net interest benefit against the incremental transaction fee.

3. Brigham

E. F.

& Ehrhardt

M. C. (2016). Financial Management: Theory and Practice

15th Edition. Cengage Learning. Chapter 27

"Working Capital Management

" explains that the choice between payment systems (like wire vs. ACH) involves a trade-off between cost and speed. The value of faster availability is determined by the firm's opportunity cost of funds

which should be a net rate reflecting both borrowing costs and forgone interest on balances.

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