Commercial paper is a money-market security issued (sold) by large corporations to obtain funds to meet short-term debt obligations (for example, payroll), and is backed only by an issuing bank or corporation’s promise to pay the face amount on the maturity date specified on the note.
Commercial paper is a lower-cost alternative to a line of credit with a bank. Once a business becomes established, and builds a high credit rating, it is often cheaper to draw on a commercial paper than on a bank line of credit. Nevertheless, many companies still maintain bank lines of credit as a “backup”. Banks often charge fees for the amount of the line of the credit that does not have a balance. While these fees may seem like pure profit for banks, in some cases companies in serious trouble may not be able to repay the loan resulting in a loss for the banks.
The advantage of commercial paper:
- High credit ratings fetch a lower cost of capital.
- A wide range of maturity provides more flexibility.
- It does not create any lien on asset of the company.
- Tradability of Commercial Paper provides investors with exit options
Disadvantages of commercial paper:
- Its usage is limited to only blue-chip companies.
- Issuances of commercial paper bring down. the bank credit limits.
- A high degree of control is exercised on the issue of Commercial Paper.
- Stand-by credit may become necessary