Potentiality of Commercial Paper as a Source of Corporate Finance
Commercial paper is a very useful instrument for meeting working capital needs of firms. However, only large and well-established business enterprises with a track record of high creditworthiness can make use of CP as a means of financing their short-term needs because CP is an unsecured promissory note and does not carry any tangible security. The basic reason for the popularity of CP as a means of financing is that it is usually less expensive than short-term bank credit by about 1 to 2 percent and cost differential increases in periods of easy money.
Since no compensating balance requirements are associated with the issuing of CP, cost of its issue would further be lower than that of the bank credit. Another reason for the usefulness of CP as a source of financing is that by means of this instrument firms can raise large amount of funds which they cannot take from a single bank. CP provides sufficient flexibility in business financing in as much as issuing firm may decide the quantum of CP and its maturity on the basis of its future cash flows. Financially, use of CP adds to the prestige of the issuing company, it seems more likely that the prestige was there before the paper was sold.
A significant drawback of this source of financing is that it is less reliable source of credit than bank loans. Because of the impersonal nature of the market, a buyer of commercial paper feels no obligation “to see the borrower through” a period of hard times or tight money. Buyers of CP simply look for the best yield possible for a shortterm investment at a minimum risk. Thus, alacrity with which buyers of CP will switch to more attractive investments leaves firms high and dry in hard days when money market condition becomes tight forcing the management to seek funds from banks. It is generally noted that banks do not look favourably on credit requests only in periods of tight money.
A firm relying too heavily on CP may, therefore, find itself shut off from an important source of capital in future periods of need. Therefore, a finance manager must be careful not to impair relations with its bank. He must maintain lines of credit of commercial banks in order to tide over money market conditions. Another limitation is that CP must be paid when due. There is no extension of maturity, as in the case of a short-term bank loan.