Q50568 What are Commercial Papers?

Question based on LPU Solved Assignment and other course

Answer:

Commercial Paper (CP) is an unsecured promissory note issued by a firm to raise funds for a short period, generally, varying from a few days to a few months. In India, the maturity period of Commercial Paper varies between 15 days to 1 year while in some other countries; the maturity period may go up to 270 days. It is a money market instrument and generally purchased by commercial banks, money market mutual funds and other financial institutions desirous to invest their funds for a short period. As the Commercial Paper is unsecured, the firms having good credit rating can only issue the commercial paper.

The firm or the dealers in Commercial Paper sell these to the short-term lenders who use it as interest earning investment of temporary surplus of operating funds. The nature of these surpluses and motives for buying the CP suggest that all the holders of the commercial paper expect to be paid in full at maturity. The maturity term of commercial paper is not extended. This expectation on the part of short term tenders requires that the borrowing firm must be (i) an established and profitable firm and (ii) consistently maintaining credit goodwill in the market and having good credit rating. The interest cost of the commercial paper depends upon the amount involved, maturity period and the prime lending rates of commercial banks. The main advantage of commercial paper is that cost involved is lower than the prime lending rates. In addition to this cost, the borrowing firm has to bear another cost in the form of placement fees payable to the dealer of Commercial Paper who arranges the sale.

The Commercial Paper market has ballooned from Rs. 44,000 crore in March, 2009 to Rs. 67,000 crore by June end and Rs. 80,000 crore by mid august 2009 as interest rates in the debt market have fallenbelow band rates at 4 to 5 percent.

Issue of Commercial Papers in India:

Commercial Paper was introduced as a money market instruments in India in January, 1990 with a view to enable the companies to borrow for short term. Since the commercial paper represents an unsecured borrowing in the money market, the regulation of CP comes under the purview of the Reserve Bank of India which has issued Guidelines in 2000 superseding all earlier Guidelines. These Guidelines are aimed at:

i) Enabling the highly rated corporate borrowers to diversify their sources of short term borrowings, and

ii) To provide an additional instrument to the short term investors.

These Guidelines have stipulated certain conditions meant primarily to ensure that only financiallystrong companies come forward to issue the CP. Commercial Paper should be in the form of usance promissory note negotiable by endorsement and delivery. It can be issued at such discount to the face value asmay be decided by the issuing company. Commercial Paper is subject to payment of stamp duty. In terms of the guidelines, the issuer company is not permitted to take recourse to the underwriters for underwriting the issue of Commercial Paper.

Updated Conditions of CP:

The updated conditions till 1^st July 2010 are as under,

1. Eligibility: A corporate would be eligible to issue Commercial Paper provided: i) the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crores; ii) company has been sanctioned working capital limit by bank/s or all India financial institution/s; and iii) the borrowal account of the company is classified as a Standard Assets by the financing banks/ institution.
2. Rating requirements: All eligible participants have to obtain the credit rating from CRISIL, ICRA or CARE or any other recognized credit rating agency. The minimum credit rating required for issue of commercial paper is P-2 of CRISIL or any other equivalent rating from other rating agencies.
3. Minimum Investment and Denomination: Amount that can be invested by a single investor cannot be less than Rs. 5 lakhs (face value). Commercial Paper can be issued in denomination of Rs. 5 lakhs or multiple there of.
4. Maximum Limit: Commercial Paper can be issued within the overall umbrella limit fixed by the RBI, i.e., issue of Commercial Paper together with other instruments, viz., term money borrowings, term deposits, certificate of deposit and inter-corporate deposits, all put together should not exceed 100 percent of its net owned funds, as per the latest audited balance sheet.
5. Aggregate Limit: The aggregate amount of CP from an issuer shall be within the limit as approved by its Board of Directors or the quantum indicated by the Credit Rating Agency for the specified rating, whichever is lower. Banks and financial institutions have the flexibility to fix working capital limits duly taking into account the resource pattern of companies’ financing including CPs. Earlier, Commercial Bank that sanctioned working capital limit was required to reduce the cash credit limit of the borrower to the extent of the issuance of commercial paper. Now, there is no need for the concerned commercial bank to reduce the sanctioned cash credit limit of the concerned company, automatically, after issuance of commercial paper. Commercial bank has the freedom to fix the working capital limits of the borrower.
6. Issuing and Paying Agent (IPA): Only a scheduled bank can act as an IPA for issuance of Commercial paper.
7. Period of Raising Subscription: Commercial Paper has to be raised within two weeks from the date of opening the issue for subscription. a) Maturity: Maturity runs between a minimum of 7 days and maximum of one year from the date of issue. No grace period is allowed for repayment and if the maturity date falls on a holiday then it should be paid on the previous working day. Each issue of Commercial Paper is treated as a fresh issue.
8. Interest: Commercial Paper is issued at a discount to its maturity value. The difference amount between the issue price and maturity amount is the return to the investor.
9. Credit Enhancement: Commercial Paper is a ‘stand alone’ product. However, banks have the flexibility to provide credit enhancement by way of stand- by assistance, based on their commercial judgement. In other words, in case of default in payment by the issuer, responsibility would be cast on the bank that has provided credit enhancement. This credit enhancement provides the necessary cushion to the investor’s confidence to invest. It may be made clear that the credit enhancement is not compulsory for the issue of commercial paper. The issuer normally seeks the credit enhancement when the credit rating for the commercial paper is not adequate, though enough to issue commercial paper to attract the investors’ response to raise finance at a cheaper interest rate. This credit enhancement strengthens the rating of the commercial paper.

These conditions change from time to time and the conditions existing at the time of issue govern the issue of commercial paper.

Any company proposing to issue commercial paper has to submit an application to the bank which provides working capital limit to it, along with the credit rating of the firm. The issue has to be privatelyplaced within two weeks by the company or through a merchant banker. The initial investor pays the discounted value of the commercial paper to the firm. Thus, Commercial Paper is issued only through the bank that has sanctioned the working capital limit and it does not increase the working capital resources of the firm.

Recent Importance:

With the recent reduction in interest rates, importance of commercial paper has diminished, of late. However, corporate sector still finds issue of commercial paper cheap and has again regained its erstwhile importance to raise finances at a lower interest rate compared to the rates of interest charged on loans by banking sector. The Indian economy has started witnessing the unprecedented increasing trends on inflation from the middle of the year 2006. In consequences, bank interest rates have been hardening more significantlyfrom the year 2007. Increase in interest rates, offered by banks, is also in consequences of different stringent initiatives taken by RBI. The different measures are increase of credit reserve ratio and statutory liquidity ratio to contain or control the galloping inflation trends, prevailing more than 6% during the year 2010. So, commercial paper has regained its importance to work as a potent weapon to raise short-term finances by highly rated companies to improve their bottom line. In other words, commercial paper has become attractive way to finance short-term requirements, instead of borrowing from banks.

Annual financing cost of Commercial Paper:

The annual financing cost of Commercial Paper depends upon the discount on issue and the maturity period. The annualized pre tax cost of commercial paper can be computed as below:

Benefits and limitations of Commercial Paper as a Source of Financing

From the point of the issuing company, Commercial Paper provides the following benefits:

1. Commercial Paper is sold on an unsecured basis and does not contain any restrictive conditions.
2. Maturing commercial paper can be repaid by selling new commercial paper and thus can provide a continuous source of funds.
3. Maturity of Commercial Paper can be tailored to suit the requirement of the issuing firm.
4. Commercial Paper can be issued as a source of fund even when money market is tight.
5. Generally, the cost of Commercial Paper to the issuing firm is lower than the cost of commercial bank loans.

However, Commercial Paper as a source of financing has its own limitations.

1. Only highly credit rated firms can use it. New and moderately rated firms generally are not in a position to issue Commercial Paper.
2. Commercial Paper can neither be redeemed before maturity nor can be extended beyond maturity.

So, Commercial Paper is advantageous both to the issuer as well as to the investor. The issuer can raise short-term funds at lower costs and the investor as a short term outlet of funds. Commercial Paper provides liquidity as they can be transferred. However, the issuer must adhere to the RBI guidelines.