Chapter 15 Working Capital Management 499SELF^ TEST What is a promissory note, and what terms are normally included in a
promissory note?
What is a line of credit? a revolving credit agreement?
What’s the di! erence between simple interest and add-on interest as
bankers use these terms?
If a " rm borrowed $500,000 at a rate of 10% simple interest with monthly
interest payments and a 365-day year, what would be the required interest
payment for a 30-day month? If interest must be paid monthly, what would
be the e! ective annual rate? ($4,109.59; 10.47%)
If this loan had been made on a 10% add-on basis payable in 12 end-of-month
installments, what would be the monthly payments? What is the annual per-
centage rate? the e! ective annual rate? ($45,833.33; 17.97% 19.53%)
How does the cost of costly trade credit generally compare with the cost of
short-term bank loans?15-11 COMMERCIAL PAPER
Commercial paper is a promissory note issued by a large, strong! rm—most often
a! nancial institution—that wants to borrow on a short-term basis. Commercial
paper is sold primarily to other business! rms, insurance companies, pension
funds, money market mutual funds, and banks in denominations of at least
$100,000. It is generally unsecured; but “asset-backed paper” secured by credit
card debt and other small, short-term loans has also been issued. Also (and with
very bad consequences) in 2007, subsidiaries of! nancial institutions such as
Merrill Lynch and Citigroup sold a great deal of commercial paper and used it to
buy bonds backed by subprime mortgages. This created a situation where short-
term commercial paper was backed by long-term debt—and very poor quality
debt at that. When the real situation was learned, holders of commercial paper
refused to roll it over when it matured and the! nancial institutions that had sold
it were forced to sell the mortgages that backed the paper, often at huge losses.
That forced Citi, Merrill, and other institutions to bail out their subsidiaries and to
take losses in the tens of billions of dollars.
A large majority of the commercial paper outstanding has been issued by
! nancial institutions. Non! nancial companies also issue a great deal of paper, but
they generally rely more heavily on bank loans for short-term funding. For exam-
ple, in March 2008, the Federal Reserve reported that commercial paper issued by
non! nancial! rms totaled slightly more than $177 billion—that same month the
total amount of commercial and industrial loans held by commercial banks was
nearly 1.5 trillion dollars.
Commercial Paper
Unsecured, short-term
promissory notes of large
firms, usually issued in
denominations of
$100,000 or more with an
interest rate somewhat
below the prime rate.Commercial Paper
Unsecured, short-term
promissory notes of large
firms, usually issued in
denominations of
$100,000 or more with an
interest rate somewhat
below the prime rate.SELF^ TEST What is commercial paper?
What types of companies use commercial paper to meet their short-term
" nancing needs?