Introduction to Finance

commercial 
paper
,
 
which is a short-term promissory note. This means the notes are backed by the 
issuer’s credit quality; there is no security or collateral behind them. Commercial paper may 
be sold directly by the issuer to fi nancial institutions or other investors. Alternatively, it can 
be sold to commercial paper houses or dealers who purchase the promissory notes to resell 
them to individuals or businesses. A fee based on the amount of notes purchased, charged to 
the issuer of the notes, provides the basic income of commercial paper dealers. With about 
$1.1 trillion outstanding in early 2010, trading in this short maturity form of debt is at about 
one-half of the level that it was before the fi nancial crisis began in late 2007. Fears of fi nan-
cial uncertainty can send shockwaves through the commercial paper market, as we saw in 
2007–2009. The commercial paper market all but dried up as investors fl ed to the safety of 
U.S. Treasury securities in the fear of possible fi nancial system meltdown. Many fi rms could 
access commercial paper fi nancing only after the Fed stepped in to provide liquidity and 
backing to the market.
12
A fi rm that wishes to obtain funds from a commercial paper house must have an unques-
tioned reputation for sound operation. First the commercial paper house makes a thorough 
investigation of the fi rm’s fi nancial position. If the fi rm’s notes can be sold easily, an agree-
ment is made for the outright sale of a block of the fi rm’s promissory notes to the commercial 
paper house. The house will resell these notes as quickly as possible to banks, pension fund 
managers, business corporations with surplus funds, or other investors. The notes are usually 
prepared in denominations of $100,000 or more, with maturities ranging from a few days to 
commercial paper 
short-term 
promissory note sold by high-
credit-quality corporations; notes 
are backed by the issuer’s credit 
quality
11
R. S. Carmichael & Co. Inc. and Commercial Finance Association, 
Annual Asset-Based Lending and Factoring 
Surveys, 2014
, issued March 31, 2015, accessed July 2, 2016, at https://www.cfa.com/eweb/DynamicPage.aspx?
Site=cfa&WebKey=2f388eee-12cc-441b-9584-986d6261fc51.
12
The Commercial Paper Funding Facility is described at http://www.federalreserve.gov/monetarypolicy/cpff .htm.

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16.4 Nonbank Short-Term Financing Sources
507
270 days.
13
The size of the notes and the maturities can be adjusted to suit individual investor 
requirements.
Commercial paper is sold on a discount basis. Dealers will pay the borrower the face amount 
of the notes minus the interest charge and a fee, usually between 0.02 and 0.05 percent. The 
interest charge is determined by the general level of prevailing rates in the money market and the 
strength of the borrowing company. When these notes are resold to banks and other lenders, the 
prevailing interest charge is deducted from the face value of the notes. Hence, the commercial 
paper dealer receives the fee as compensation for the negotiation and intermediation.
Commercial paper is no longer sold only through dealers or brokers. Investors can buy 
commercial paper online through an electronic trading system. The fi rst fi rm to off er its paper 
online was Ford Motor Company on a commercial paper trading system designed by CS First 
Boston. Since then, others have developed online commercial paper systems to facilitate 
the direct issue of paper to investors. In recent years, the most successful of them has been 
SunGard’s Transaction Network. Online issuance of paper allows issuers to cut in half the fees 
usually collected by dealers.
Commercial paper is issued by large, well-known, and fi nancially stable fi rms; they have 
the ability to raise large sums of short-term fi nancing quickly and with a bank’s backing.
14
Many of the borrowers of commercial paper are fi nancial fi rms, such as commercial fi nance 
companies; they seek to fi nance their own lending and leasing operations by raising short-term 
funds through commercial paper. They will borrow at the commercial paper rate and lend the 
funds to others at higher interest rates.
Suppose Eastnorth Manufacturing wants to issue $100,000 of commercial paper that will 
mature in nine months (270 days). The placement fee is 0.10 percent and the interest charge 
will be 7.5 percent over the nine-month period. To compute Eastnorth’s eff ective fi nancing 
cost, we must determine the net proceeds, or usable funds, Eastnorth will obtain from the sale 
as well as the total interest charges it will pay. The net proceeds will be the $100,000 raised, 
minus the interest, less the placement fee:
Net proceeds = $100,000 – [(0.075)($100,000)] – [(0.0010)($100,000)]
= $100,000 – $7,500 – $100
= 
$92,400
The interest charge is 0.075 × $100,000, or $7,500, and the placement fee is $100, for total 
expenses of $7,600. The nine-month fi nancing cost for the commercial paper issue is the 
following:
9-month cost = $7,600∕$92,400 = 0.0823, or 8.23 percent
The annualized cost of the commercial paper issue will be the following:
(1 + 0.0823)
12∕9
– 1 = 0.1111 or 11.11 percent
The most important reason to a fi rm for issuing commercial paper is that the cost of borrowing 
is generally less than regular bank rates. The reason for the lower rates is that only the largest, 
most fi nancially stable fi rms can issue commercial paper. Unlike banks, which typically service 
a geographic region, commercial paper is sold by dealers to investors worldwide, so interna-
tional short-term rates rather than bank loan committees help determine commercial paper 
rates. The need for compensating bank balances that increase interest costs on short-term bank 
loans is avoided. Loan restrictions on the amount that can be borrowed from a single bank may 
favor the issuance of commercial paper by large corporations.
Like bonds, commercial paper is rated. The rating is important to the issuer because the 
higher the rating, the lower the interest expense. Industrial fi rms and other nonbank lenders 
often purchase commercial paper as a more profi table alternative to Treasury bills (T-bills) for 
investing excess cash.
13
Commercial paper has a maximum maturity of 270 days, as Securities and Exchange Commission (SEC) regula-
tions require that securities with maturities exceeding 270 days must go though the costly and time-consuming SEC 
registration process.
14
Banks are a major player in the commercial paper market as they off er issuers a line of credit equal to their amount of 
paper outstanding. Up until 1999, Standard & Poor’s (S&P) required this to award its top A-1 rating to a fi rm issuing 
paper. S&P now considers all sources of liquidity that can be used to redeem the paper.

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508
C H A PT E R 1 6 Short-Term Business Financing
Commercial paper provides a yield slightly above that of short-term government secur-
ities, as we saw in Figure 15.6 (in Chapter 15). Although commercial banks were historically 
the main purchasers of commercial paper, it is held by industrial corporations, money market 
mutual funds, and other lenders.
Many top-rated U.S. commercial paper issuers can issue paper overseas. The European 
commercial paper (Euro CP) market off ers advantages to commercial paper issuers just as the 
Eurodollar bond market off ers advantages over the U.S. bond market. There is no SEC regu-
lation of the Euro CP market, so commercial paper maturities are generally a little longer and 
interest costs lower. In addition, Euro CP is available only to the “cream” of the commercial 
paper issuers, so no ratings are needed. Investors know the safest issuers. So, not having to pay 
for a rating makes the Euro CP market attractive to those fi rms able to use it.