COMMERCIAL PAPERS (CPs)

Short-term, unsecured money market instrument, issued as a promissory

note by big corporations having excellent credit ratings.
As the instrument is not backed by collateral, only large firms with
considerable financial strength are authorized to issue the instrument.
Features of Commercial Paper
The maturity period of commercial paper lies between 30 to 270 days.
It is sold at a discount but redeemed at its par value.
There is no well-developed secondary market for commercial paper; rather
they are placed with existing investors who intend to hold it till it gets
matured.
The primary purpose of issuing commercial paper is to raise short-term
funds so as to meet working capital requirements of the firm. Working
capital is the money used to cover all of a company's short-term expenses,
including inventory, payments on short-term debt, and day-to-day expenses
called operating expenses. However, firms also raise money through CP’s to
fill the gap between fund required currently and long term funds raised from
the market.
Since, the instrument is unsecured, if the company fails to pay the amount
due, the buyers of the instrument, have no claim on the company’s assets.
And due to this, only companies with high credit ratings are eligible to sell
their commercial paper at reasonable prices. Further, due to the shorter
maturity period, the rate of return is relatively low.
Credit Rating
A credit rating is an opinion of a particular credit agency regarding the
ability and willingness an entity (government, business, or individual) to
fulfill its financial obligations in completeness and within the established
due dates. A credit rating also signifies the likelihood a debtor will default.
A credit agency evaluates the credit rating of a debtor by analyzing the
qualitative and quantitative attributes of the entity in question. The
information may be sourced from internal information provided by the
entity, such as audited financial statements, annual reports, as well as
external information such as analyst reports, published news articles,
overall industry analysis, and projections.
There are three prominent credit agencies that control 85% of the overall
ratings market:
Moody’s Investor Services
Standard and Poor’s (S&P)
Fitch Group
Each agency uses unique, but strikingly similar, rating styles to indicate
credit ratings.
APPLICATIONS:
1. Super Acme Corporation purchases a P625,000.00 CPs due in 60days
at 5.4%. What is the discount (D) and what is the cost (C)?
Solution:
T = total future value
DR = discount rate
N = number of days to maturity
FV = future value
D = T (DR / 100) (N / 360)
D = 625,000.00 (0.054 / 100) (60 / 360)
D = 625,000.00 (.00054) (0.16667)
D = P56.25   This is the discount
 
C=T–D
  = 625,000.00 – 56.25
  = P624,943.75  This is the cost of the CP
 
2. Polo, Inc. purchases CPs worth P21,750,000.00 in 180 days at 4.25%.
What is the discount and what is the cost?
D = (21,750,000.00) (0.0425 / 100) (180 /360)
  = (21,750,000.00) (0.000425) (0.5)
  = P4,621.88
C = T –D
  = 21,750,000.00 – 4,621.88
  = P21,745,378.12
 
3. Calculating the Yield of CP
Formula: Yield = (FV – SP) / (SP) * (360 / M) * (100)
Where: FV – Face Value, SP – Sale Price, M – maturity
Calculate the yield of the following CP:
FV = P500,000.00
SP = P490,000.00
M = 100
Brokerage Fee = 3%
Solution:
Brokerage Fee = (FV) (Brokerage Fee)
                = (P500,000.00) (0.03)
                = P15,000.00
Net SP = SP – Brokerage Fee
        = P490,000.00 – P15,000.00
        = P475,000.00
Yield = (500,000.00 – 475,000.00 / 475,000.00) * (360 /100) * (100)
      = (25,000.00 / 475,000.00) * (3.6) * (100)
      = (0.05263) (3.6) (100)
      = 18.9468
      = 18.95%
Indication: 18.95% expressed as an annual percentage rate based on
the CP’s cost and is the income returned on the investment of a CP.
The yield for commercial paper holders is the annualized
percentage difference between the price paid for the paper and the
face value using a 360-day year.