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Commercial Papers

Commercial paper is a short-term unsecured promissory note issued by large, creditworthy corporations to raise funds. It typically matures in under 270 days. Investors can purchase commercial paper directly from brokers or through money market funds. While it provides lower-cost funding than other options, commercial paper is only available to investment-grade issuers.

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68 views3 pages

Commercial Papers

Commercial paper is a short-term unsecured promissory note issued by large, creditworthy corporations to raise funds. It typically matures in under 270 days. Investors can purchase commercial paper directly from brokers or through money market funds. While it provides lower-cost funding than other options, commercial paper is only available to investment-grade issuers.

Uploaded by

Sandia Espejo
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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PRESENTATION OF CONTENT

COMMERCIAL PAPERS

 What is Commercial Paper?


 It is a promissory note issued by a large, strong firm – most often a financial
institution – that wants to borrow on a short-term basis.
 It is a commonly used type of unsecured, short-term debt instrument issued by
corporations, typically used for the financing of payroll, accounts payable and
inventories, and meeting other short-term liabilities.
 Maturities on commercial paper typically last several days, and rarely range longer
than 270 days. Commercial paper is usually issued at a discount from face value and
reflects prevailing market interest rates.

 Types of Commercial Paper (Uniform Commercial Code)


1. Drafts - is an unconditional written order by one person (the drawer) directing
another person (the drawee) to pay a certain sum of money on demand or at a
definite time to a named third person (the payee) or to bearer.
2. Checks - defines a check as “a draft drawn on a bank and payable on demand
(Section 3-104(2)(b) of the UCC)
3. Notes - often called a promissory note—is a written promise to pay a specified sum
of money on demand or at a definite time. There are two parties to a note:
the maker (promisor), and the payee (promisee).
4. Certificates of Deposit - commonly called a CD; is a written acknowledgment by a
bank that it has received money and agrees to repay it at a time specified in the
certificate.

 How do you buy commercial paper?


 Commercial paper is usually traded among large institutions, but individual
investors can participate in two ways:
a. Individuals can buy commercial paper from a broker.
b. Retail investors can put money in funds or money market accounts that invest
in commercial paper.

 Example of Commercial Paper


 An example of commercial paper is when a retail firm is looking for short-term
funding to finance some new inventory for an upcoming holiday season. The firm
needs $10 million and it offers investors $10.1 million in face value of commercial
paper in exchange for $10 million in cash, according to prevailing interest rates. In
effect, there would be a $0.1 million interest payment upon maturity of the
commercial paper in exchange for the $10 million in cash, equating to an interest
rate of 1%. This interest rate can be adjusted for time, contingent on the number of
days the commercial paper is outstanding.
 Advantages and Disadvantages of Commercial Paper
 A major benefit of commercial paper is that it does not need to be registered with
the Securities and Exchange Commission as long as it matures before nine months,
or 270 days, making it a very cost-effective means of financing. Although maturities
can go as long as 270 days before coming under the purview of the SEC, maturities
for commercial paper average about 30 days, rarely reaching that threshold. The
proceeds from this type of financing can only be used on current assets, or
inventories, and are not allowed to be used on fixed assets, such as a new plant,
without SEC involvement.
 Advantages of Commercial Paper
1. No collateral is needed.
2. Lower cost of funding.
3. Lesser documentation and compliance.
4. Highly liquid.
5. It allows the diversification of funds in short-term instruments.
6. High-rated instruments, hence fewer chances of default.
7. For investors, returns are higher as compared to bank deposits.
8. No restriction on the end-use of funds.
 Disadvantages
1. Commercial paper can be issued by investment-grade banks and large
corporations only. Hence it is not a source of fund which is available to all.
2. Small investors cannot directly invest in commercial paper.
3. The secondary market for commercial papers is less liquid.

 Calculation of Yield of Commercial Paper


 Formula for Yield Commercial Paper:
Yield = (Face Value – Sale Price/ Sale Price) * (360/Maturity Period) * 100
 Example: Calculate the interest yield of the following commercial paper:
 Face Value: $500,000
 Sale Price: $490,000
 Maturity period: 100
 Brokerage and Other charges: 3%
Solution:
 Brokerage = 3% of $500,000 = $15,000
 Net Sale Price = $490,000 – $15,000 = $475,000
 The calculation for Yield is as follows –

Yield = [(Face Value – Sale Price)/Sale Price] * (360/Maturity Period) * 100


= (500,000 – 475,000)/475,000 * (360/100) * 100
= 18.95%
 Calculation of Pricing of Commercial Paper
 Formula for Pricing Commercial Paper:
Price = Face Value / [1+(Yield/100 * Maturity Period/360)]
 Example: Calculate the market price of the following example of commercial paper:
 Face Value: $600,000
 Yield (after brokerage): 20%
 Maturity period: 100
 Solution:
The calculation for Pricing is as follows –
Price = Face Value / [1+{(Yield/100)*(Maturity Period/360)}]
= 600,000 / [1+{(20/100)*(100/360)}]
= $568,421

 Long – Term Commercial Papers - carrying value as of the balance sheet date of long-
term unsecured obligations issued by corporations and other borrowers to investors
(with maturities initially due after one year or beyond the operating cycle if longer),
excluding current portion.

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