Commercial Paper Homework Help & Commercial Paper Tutoring
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Commercial Paper
Commercial paper is a short-term unsecured obligation with a maturity ranging from
2 to 270 days, issued by companies to investors with temporarily idle cash. It is
generally issued by companies as a means of raising short-term debt and by a process
of securitization, intermediation of the bank is eliminated. It can be issued only
if the company possesses a very high credit rating. Commercial paper is usually
sold at a discount with the interest immediately deducted from the face of the note
by the creditor and the company pays the full face value upon maturity. But it can
also be issued in interest-bearing form. The issuer promises the buyer a fixed amount
at a future date but pledges no assets. It may be issued through a dealer or directly
placed to an institutional investor. When the company directly deals with the investor,
rather than use a securities dealer as an intermediary, the commercial paper is
called a direct paper. Such companies announce the current rates of CPs
of various maturities and investors can then choose accordingly. When commercial
papers are issued by security dealers on behalf of their corporate customers, they
are called dealer papers.
Pros & Cons of Commercial Paper:
Benefits:
Commercial Paper Interest Calculation:
- No security is required.
- Interest rate is typically less than that required by banks or finance companies.
- Commercial paper dealer often offers financial advice.
- It is a simple instrument.
- Very less documentation between the issuer and the investor.
- It is flexible in terms of maturities of the underlying promissory note.
- It can be tailored to match the cash flow of the issuer.
- A good credit rated company can diversify its sources of finance from banks to the short-term money market at a cheaper cost.
- For the investors, higher returns obtained than if they invest their funds in any bank.
- For the companies, they are better known to the financial world and hence placed in a better position to borrow long-term funds in future.
- There is no limitation on the end-use of funds raised through commercial papers.
- They are highly liquid.
- It can only be issued by large financially sound companies.
- The dealings of commercial paper are impersonal.
The effective pre-tax interest yield of commercial paper is calculated by the following
formula:
Where:
Net amount realized = Face value – discount – issuing & paying agent charges like stamp duty, rating charges, dealing bank fee and fee for stand by facility.
|
Face Value - Net Amount Realized
Net Amount Realized |
X |
360
Maturity Period |
Where:
Net amount realized = Face value – discount – issuing & paying agent charges like stamp duty, rating charges, dealing bank fee and fee for stand by facility.
Example:
Let us calculate the pre-tax effective cost of the following commercial paper.
Discount = $600,000 x 2% = $12,000.
Let us calculate the pre-tax effective cost of the following commercial paper.
| Face value | = | $600,000 | |||||
| Maturity period | = | 90 days | |||||
| Net amount realized | = | $595,000 | |||||
| Discount & other charges | = | 2% | |||||
| Effective cost/Interest yield | = |
|
|||||
| = | 11.66% | ||||||
Discount = $600,000 x 2% = $12,000.
Commercial paper Net Cost calculation:
Example:
A company issues $300,000 worth of 18%, 90 day commercial paper. However, the funds are required only for 70 days. The excess funds can be invested in securities earning 17%. The brokerage fee associated with the commercial paper transaction is 1.5%.
The dollar cost to the company in issuing the commercial paper is: Interest expense:
A company issues $300,000 worth of 18%, 90 day commercial paper. However, the funds are required only for 70 days. The excess funds can be invested in securities earning 17%. The brokerage fee associated with the commercial paper transaction is 1.5%.
The dollar cost to the company in issuing the commercial paper is: Interest expense:
| ($300,000 x 18% x 90/360) | = | $13,500 | |
| Add: Brokerage fees ($300,000 x 1.5%) | = | $4,500 | |
| Total cost | = | $18,000 | |
| Less: Return on marketable securities | |||
| ($300,000 x 17% x 20/360) | = | $2,833 | |
| Net cost | = | $15,167 |
Example:
Let us calculate the percentage cost of issuing commercial paper, for every two months period in a year.
Solution:
Therefore, percentage cost of commercial paper = $78,000 / $600,000 x 100 = 13%.
Let us calculate the percentage cost of issuing commercial paper, for every two months period in a year.
| Face value | = | $600,000 | |
| Rate of CP | = | 12% | |
| Maturity period | = | 2 months or 60 days for each CP. | |
Solution:
| Interest ($600,000 x 12%) | = | $72,000 | |
| Add: Brokerage cost($1,000 x 6) | = | $6,000 | |
| Total cost per annum | = | $78,000 |
Therefore, percentage cost of commercial paper = $78,000 / $600,000 x 100 = 13%.
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