Definition: Commercial Paper or CP is defined as a 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 authorised 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. However, firms also raise money through CP’s to fill the gap between fund required currently and long term funds raised from the market.
CP’s are sold at a discount but redeemed at face value. Thus, the effective pre-tax cost will be calculated as:
Regulations in India
In India, commercial paper can be issued by large corporates, primary dealers and all-India financial institutions. Since it is an unsecured source of finance, it is regulated by the apex bank of the country.
Based on the recommendations of Vaghul Working Group, guidelines have been issued by the Reserve Bank of India (RBI), in the year 1990. These conditions are meant to ensure that only firms with a good financial record can issue CP. As per the guidelines, a firm is authorised to issue commercial paper provided:
- The maturity period of the instrument ranges between 7 days to one year from the date of the issue.
- The tangible net worth of the issuing company is minimum 50 million, as per their audited balance sheet.
- The issue of CP can be in denomination 5 lakh rupees or multiples thereof.
- The company should obtain credit ratings from a recognised credit rating agency such as CRISIL or ICRA. Further, the ratings should not be older than two months, at the time of applying to the RBI.
- These are no listing requirements for public sector companies but for other companies the equity of the company should be quoted on one or more stock exchanges.
- The fund base working capital limit of the company sanctioned by the financing bank or institution is not less than 5 crores.
- By classification of current assets and liabilities the minimum current ratio should be 1.33:1
- The issuing company itself will bear the expenses in connection with the issue.
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.
Very nice theory