Commercial Paper - Financial Management

Commercial paper consists of short -term unsecured promissory notes issued by major corporations. Only companies with good credit ratings are able to borrow funds through the sale of commercial paper. Purchasers of commercial paper include corporations with excess funds to invest, banks, insurance companies, pension funds, money market mutual funds, and other types of financial institutions. Over $1.2 trillion in commercial paper was outstanding at the end of 2003.

Large finance companies, such as General Motors Acceptance Corporation (GMAC) and CIT Financial Corporation, issue sizable amounts of commercial paper on a regular basis, selling it directly to investors like those just mentioned. Large industrial, utility, and transportation firms, as well as smaller finance companies, issue commercial paper less frequently and in smaller amounts; they sell it to dealers who, in turn, sell the commercial paper to investors. Maturities on commercial paper at the time of issue range from several days to a maximum of nine months. Companies usually do not issue commercial paper with maturities beyond nine months, because these issues must be registered with the Securities and Exchange Commission.

The size of an issue of commercial paper can range up to several hundred million dollars. It is usually sold to investors in multiples of $100,000 or more. Large issuers of commercial paper normally attempt to tailor the maturity and amounts of an issue to the needs of investors. Commercial paper represents an attractive financing source for large, financially sound firms, because interest rates on commercial paper issues tend to be below the prime lending rate. To successfully market commercial paper (and get an acceptable rating from Moody’s, Standard & Poor’s, or both), however, the company normally must have unused bank lines of credit equal to the amount of the issue. The primary disadvantage of this type of financing is that it is not always a reliable source of funds.

The commercial paper market is impersonal. A firm that is suddenly faced with temporary financial difficulties may find that investors are unwilling to purchase new issues of commercial paper to replace maturing issues. In addition, the amount of loanable funds available in the commercial paper market is limited to the amount of excess liquidity of the various purchasers of commercial paper. During tight money periods, enough funds may not be available to meet the aggregate needs of corporate issuers of commercial paper at reasonable rates. As a result, a company should maintain adequate lines of bank credit and recognize the risks of relying too heavily on commercial paper. Finally, a commercial paper issue usually cannot be paid off until maturity. Even if a company no longer needs the funds from a commercial paper issue, it must still pay the interest costs.

Commercial paper is sold on a discount basis; this means that the firm receives less than the stated amount of the note at issue and then pays the investor the full face amount at maturity. The annual financing cost of commercial paper depends on the maturity date of the issue and the prevailing short -term interest rates. In addition to the interest costs, borrowers also must pay a placement fee to the commercial paper dealer for arranging the sale of the issue. The annual financing cost can be computed as follows, based on

AFC=(Interest costs+fees)/Usable funds*365/maturity(days)

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Financial Management Topics