Commercial Paper: Definition, Advantages & Disadvantages

Lesson Transcript
Instructor: LeRoy Rands

Bill has taught college undergraduate and MBA classes in finance, economics & management, 40 years of finance experience and has a MBA degree.

A great way for companies with high credit ratings to raise short term cash for operating purposes is through commercial paper. Most large public companies issue commercial paper. Updated: 09/02/2021

What Is Commercial Paper?

What is unique about commercial paper? Why do many large Fortune 500 companies use commercial paper to raise money to fund short-term assets?

Commercial paper is short-term, unsecured promissory notes issued to raise cash based on the credit worthiness of the company issuing the paper. The paper is usually issued in notes of $100,000. There is presently over one trillion dollars of commercial paper in the market.

Commercial paper has slightly higher interest rates than bank loans, but the company has no registration requirements and the paper is sold to large institutional buyers, like large financial institutions, hedge funds, and multinational corporations. Since the paper is unsecured, the companies do not have to pledge accounts receivables and inventories as collateral, which they would have to do with a line of credit. It's also not insured by the FDIC.

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  • 0:04 What Is Commercial Paper?
  • 0:59 Credit Ratings
  • 2:23 Refinancing
  • 3:12 Advantages
  • 4:08 Disadvantages
  • 5:30 Lesson Summary
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Credit Ratings

To be able to issue commercial paper, a company has to have the highest credit rating, either AAA or Aaa. Moody's, Standard & Poor's, and other rating agencies determine the credit rating of companies. Institutional investors buy the commercial paper solely on the credit worthiness of the company, with the understanding that the company will buy back the paper with interest at the maturity date.

Say ABC Corp is a large public company with a credit rating of AAA. It funds its cash needs through commercial paper and decides to issue paper for $200 million with a 4% interest rate and a 30-day maturity:

  • $200 million × (4% / 12) = $666,666.67
  • $200 million + $666,666.67 = $200.67 million

Investors will buy the paper because of ABC's credit rating, but ABC will have to pay $200.67 million to redeem the paper after the 30 days.

Access to the commercial paper market and the investors willing to buy the paper is solely dependent on maintaining the company's credit rating. If its credit rating is downgraded, the cost and interest rate for its paper will increase, and the company could be excluded from selling commercial paper.

Refinancing

Commercial paper usually is issued with maturity dates between 30 days and 270 days. That means that the company has to pay back the money borrowed within a very short period of time. However, most companies who are using commercial paper regularly will just issue new commercial paper to raise the money to retire maturing paper. It can do this as long as its credit rating stays good.

XYZ Corp has $450 million of commercial paper that is maturing in three months. XYZ doesn't want to use any of its cash to retire that maturing issue, so they prepare another batch of commercial paper and start contacting buyers. They issue new commercial paper for $600 million to cover the $450 million due plus interest and to raise additional cash.

Advantages of Commercial Paper

Commercial paper does not require any registration or approvals, which a company needs to issue new stocks and bonds. Commercial paper also does not require any collateral backing up the issuance. Therefore, commercial paper can be easily and cheaply issued. It provides access to institutional lenders for ready cash for those companies that have the necessary high credit ratings.

Commercial paper usually has slightly higher interest rates than lines of credit or short-term loans from banks. For most companies, the higher interest rate is more than offset by the flexibility of using the commercial paper market and not having to pledge collateral for the borrowings.

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