Commercial Paper: Commercial can be define as
“commercial paper is short term unsecured promissory notes which is issued by
large scale, well established and financially strong organizations in money market
as a source of short term financing”. L.J Gilman define it as form of financing
consisting of short term, unsecured promissory notes issued by firms with a
high credit standing.
Features Of Commercial: Following are the some main and
important features of commercial paper;
1) Short Term Source: It is a short term and unsecured source of financing.
2) Money Market Instrument: Commercial paper is a money market instrument, because it is
short term source of fund. Commercial paper market is “blue chip” market.
3) Large Scale Organization: Only large scale, well established and financially sound
organization are able to issue to commercial paper.
4) Issuing Source:
Commercial papers are issued through dealer market or through direct placement.
5) Maturity:
Usually maturities of commercial papers ranges for 1 to 27 days.
6) Sale: It is
sold at discount from its par and face value.
7) Purchase:
These are purchased by the other firm like small business, insurance companies
and other financial institutions.
8) Cost Of Commercial Paper: Cost of commercial paper is always lower than bank but it
include discount (e.g. 8.16%) and commission fee to the dealer.
9) Interest Rate On Commercial Paper: The interest paid by the issue of commercial paper is
determining by the size of discount and maturity time. The interest rate is
calculated the following formula;
Ø Interest rate = face value – sales price multiply by 360
Sales price maturity
Ø e.g. = 50,000 – 49,000 multiply by 360 multiply 100 = 8.00
49,000 90
Sales Of Commercial Paper: Commercial paper market is composed
of two parts;
1)
The Dealer Market
2)
The Direct Placement Market
So, through
these two markets firm issue the commercial papers.
The Dealer Market: In simple words we can say that a
market where dealer act as a intermediate party between buyer and issuer or
commercial paper is called dealer market. Dealer perform this duty on the basis
of commission, it can be easily understood with the help of following ;
|
Seller |
Dealer |
Buyer |
In this case
the paper is sold for one third of face value. the dealer receives their
commission fees equal to 1 to 1/8% of total amount. The maturity of dealer
paper is (1 to 90) days.
The Direct Placement Market: In this market commercial paper is
directly sold to the buyer. In simple words we can say that a market where
commercial paper is directly issued to buyer is called direct placement market.
The paper sold through this method is known as financial paper.
|
Seller |
Buyer |
The interest
rate is low as compared to dealer sold paper. While the maturity of direct
paper is (1 to 270) days.
Cost Of Commercial Paper:
Cost of commercial paper is always lower then bank loan. But it includes
discount and commission fees to the dealer. Cost of commercial paper depends on
discount and maturity period.
Maturity Of Commercial Paper: In case of dealer paper minimum
maturity is 3 to 10 days. But in case of finally paper minimum maturity will be
to 1 to 27 days.
Denomination: There is no set denomination but it
is issued with a minimum denomination. Dealer market minimum denomination will
be 10,000 and finance paper minimum denomination will be 25,000. Following are
the main costs commercial paper;
1) Dealer commission
2) Discount rate
3) Commitment fee on unused cost of credit
4) Commission on rating companies
Formula: Cost of commercial paper = face
value – sales price multiply 360
Sales
price maturity
·
E.g.
face value = $100,000
·
sales
price = $96,000
·
maturity
= 60 days
·
Discount
= $100,000 - $96,000 = $4,000
· Interest yield on commercial paper = discount multiply 360 multiply 100
Sales price M
o
=
$4,000 multiply 360 multiply 100 = 2.5%
o 96,000 60
ADVANTAGES AND DISADVANTAGES OF
COMMERCIAL PAPER
Advantages: Following are the main advantage of
commercial paper.
1)
Low Cast
2)
No Compensating Balance
3)
Enjoyment Of Prestige
4)
Quick Source
5)
No Legal Limitation
6)
Desirable Source
7)
Dealer Supervision/Advice
8)
Fund From Broad Spectrum
9)
Short Period
Now we can
explain all the above main types of advantages of commercial paper.
1) Low Cost: It
is a principle advantage to seller as a source of short term financing because
the cost of commercial paper is even less than prime rate of bank.
2) No Compensating Balance: To issue commercial paper there is no need to maintain
compensating balance. While in case of bank loan, bank require compensating
balance.
3) Enjoyment Of Prestige: Issue of commercial paper adds to the prestige if issuing firm.
It issuance signifies that the firm is large scale and financially sound.
4) Quick Source: Commercial
paper is a quick source of arranging short term funds.
5) No Legal Limitation: There is no legal restriction to obtain any amount of fund through
commercial paper as compared to the size of bank loan.
6) Desirable Source: It is very suitable because through it, company would born
heavily/maximum amount when the bank interest rate is high as vice versa.
7) Dealer Supervision/Advice: Dealer’s provides valuable advice to issuing firm about
floatation of commercial paper and other money market instruction.
8) Fund From Broad Spectrum: It provides opportunity to issuing firm to obtain fund from
very broad spectrum of potential leader, include other small and large scale
companies.
9) Short Period: It
provides funds shorter period without any security. So, these are the some
advantages of commercial paper.
Disadvantages: These are only two weak points of
commercial paper.
1) Commercial paper market is highly impersonal
market.
2) When commercial paper market dries up
the firm will be difficult to issue commercial paper.
Types Of Commercial Paper: Mainly commercial paper’s are of
three types;
1)
Euro Commercial Paper
2)
Universal Commercial Paper
3)
Bank Supported Commercial Paper
Now we can
explain all the above types of commercial paper one by one as under;
1) Euro Commercial Paper: These commercial paper are denominated in dollar but issued
by outsider firms in USA market. These commercial paper are used by European
countries, but they are not valid in USA even they denominated in US dollar.
2) Universal Commercial Paper: Those commercial paper are denominated in foreign currency
but issued by US firms out side the US. Maturity of EURO commercial paper is
higher than universal commercial paper.
3) Bank Supported Commercial Paper: These commercial papers are supported by bank to issue such
commercial paper, bank provides a line of credit which provides a guarantee to
the investor that company’s obligation’s will be paid.