Commercial Paper

Definition

Commercial paper is an unsecured, short-term debt instrument issued by corporations to finance their immediate cash flow needs. It typically has maturities ranging from a few days to up to 270 days and is usually issued at a discount from face value. This instrument is important for businesses as it provides a means to obtain short-term financing without the need for collateral, thus offering flexibility in managing operational expenses.

5 Must Know Facts For Your Next Test

1. Commercial paper is generally issued in denominations of $100,000 or more, making it primarily accessible to institutional investors.
2. It is often used by companies with high credit ratings, as they can issue commercial paper at lower interest rates compared to other forms of borrowing.
3. Unlike bonds, commercial paper is not registered with the SEC and is sold directly to investors, which allows for quicker access to capital.
4. Many companies use commercial paper as a means of financing their working capital needs, such as inventory purchases or payroll.
5. If a company cannot repay its commercial paper at maturity, it may need to rely on bank lines of credit or issue new commercial paper to refinance.

Review Questions

• How does commercial paper differ from traditional bank loans in terms of accessibility and cost for corporations?
  • Commercial paper offers corporations a more flexible and often cheaper alternative to traditional bank loans. Companies with strong credit ratings can access short-term financing through commercial paper at lower interest rates compared to bank loans. Additionally, issuing commercial paper allows companies to quickly raise funds without the extensive paperwork and approval processes associated with bank loans, making it an attractive option for managing immediate cash flow needs.
• Discuss the implications of using commercial paper for a company's cash flow management strategy and its potential risks.
  • Using commercial paper can significantly enhance a company's cash flow management strategy by providing quick access to capital for short-term operational expenses. However, this strategy also comes with risks; if market conditions change or if the company faces financial difficulties, it may struggle to roll over maturing commercial paper. This reliance on short-term borrowing can expose the company to liquidity risk, especially during economic downturns when refinancing may become difficult.
• Evaluate how changes in interest rates can impact the market for commercial paper and corporate financing strategies.
  • Changes in interest rates can have a profound impact on the market for commercial paper. When interest rates rise, the cost of issuing new commercial paper increases, potentially leading companies to seek alternative financing methods such as bank loans or equity financing. Conversely, when interest rates are low, issuing commercial paper becomes more attractive as companies can benefit from lower borrowing costs. This dynamic can influence corporate financing strategies by encouraging businesses to rely more heavily on commercial paper during periods of low interest rates while diversifying their funding sources when rates increase.

Related terms

Promissory Note: A written promise by one party to pay a specified sum of money to another party at a predetermined time or on demand.

Letter of Credit: A document issued by a financial institution that guarantees payment to a seller, ensuring that the buyer's payment will be received on time and for the correct amount.

Negotiable Instrument: A signed document that promises a sum of payment to a specified person or the bearer, allowing it to be transferred from one party to another.