Commercial paper is a type of short-term debt that is issued by corporations and financial institutions to finance their working capital needs, such as payroll, accounts payable, and inventory. Commercial paper is unsecured, meaning it does not have any collateral backing it up. Therefore, only companies with high credit ratings can issue commercial paper.
Commercial paper has a maturity of one to 270 days, but most issues mature in one to six months. Commercial paper is usually sold at a discount from its face value, which means that the investors who buy it pay less than the amount they will receive at maturity. The difference between the purchase price and the face value is the interest earned by the investors.
Commercial paper is an attractive source of funding for companies because it is cheaper and more flexible than other forms of short-term borrowing, such as bank loans or lines of credit. Commercial paper is also exempt from the registration requirements of the Securities and Exchange Commission (SEC), which reduces the time and cost of issuing it. However, commercial paper also has some risks, such as the possibility of default by the issuer or the lack of liquidity in the secondary market.
Commercial paper is a common component of money market funds, which are mutual funds that invest in short-term securities. Money market funds offer investors a safe and liquid way to earn a higher return than guaranteed instruments, such as bank deposits or treasury bills. However, money market funds are not insured by the Federal Deposit Insurance Corporation (FDIC) and may lose value if the commercial paper they hold defaults or declines in value.
Basic Theory:
Commercial paper represents a promissory note issued by a company to meet short-term obligations. These obligations typically include payroll, accounts payable, and other immediate financial needs. Commercial paper is an attractive financing option due to its lower interest rates compared to traditional bank loans.
The formula for calculating the cost of commercial paper is:
![\[ CP\_Cost = \frac{(Face Value \times (1 + \frac{Interest Rate \times Days}{360})) - Face Value}{Days} \]](https://excelcalculations.refrigeratordiagrams.com/wp-content/ql-cache/quicklatex.com-b5928c5ac6732432457e8da317f40789_l3.svg "Rendered by QuickLaTeX.com")
Where:
- CP_Cost: the cost of commercial paper.
- Face Value: the face value of the commercial paper.
- Interest Rate: the annual interest rate.
- Days: the number of days to maturity.
Procedures:
- Gather Information: Collect data such as face value, interest rate, and days to maturity.
- Enter Data in Excel: Create an Excel table with columns for face value, interest rate, days to maturity, and the calculated cost.
- Use the Formula: Apply the commercial paper formula to calculate the cost for each instrument.
- Scenario: Let’s consider a scenario where a company issues commercial paper with a face value of $500,000, an annual interest rate of 4%, and a maturity period of 60 days.
Excel Table:
| Face Value | Interest Rate | Days to Maturity | CP Cost |
|---|---|---|---|
| $500,000 | 4% | 60 | Formula |
Calculation in Excel:
In the “CP Cost” column, use the formula mentioned above to calculate the cost for each instrument:
![\[ CP\_Cost = \frac{(500,000 \times (1 + \frac{0.04 \times 60}{360})) - 500,000}{60} \]](https://excelcalculations.refrigeratordiagrams.com/wp-content/ql-cache/quicklatex.com-7a087c6bcf970bab42365247bb528e30_l3.svg "Rendered by QuickLaTeX.com")
Result: 
Other Approaches:
- Excel Functions: Utilize built-in Excel functions such as
PV(Present Value) andRATEto streamline calculations. - Data Validation: Implement data validation in Excel to ensure accurate input, reducing the risk of errors in calculations.
- Sensitivity Analysis: Perform sensitivity analysis by changing input values to understand how variations in face value, interest rate, or days to maturity impact the cost of commercial paper.
