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(^368) Financial Management
dealer placements is roughly four to one in favour of direct placements. Dealers are
used primarily by industrial firms that make only infrequent use of the commercial
paper market or that, owing to their small size, would have difficulty placing the issue
without the help of a dealer.
Commercial Paper as a Source of Short-term Credit
A number of advantages accrue to the user of commercial paper:
Using commercial paper for short-term financing, however, involves a very important
risk. That is, the commercial paper market is highly impersonal and denies even the
most creditworthy borrower any flexibility in terms of repayment. When bank credit is
used, the borrower has someone with whom he can work out any temporary difficulties
he might encounter in meeting a loan deadline. This flexibility simply dose not exist for
the user of commercial paper.
Estimating the Cost of Commercial Paper
The cost of commercial paper can be estimated using the simple effective cost of
credit equation (RATE). The key points to remember are that commercial paper interest
is usually discounted and that if a dealer is used to place the issue a fee must be paid.
Even if a dealer is not used, the issuing firm will incur costs associated with preparing
and placing the issue, which also must be considered in estimating the cost of credit.
Example: The EPG Mfg. Company uses commercial paper regularly to support its
needs for short-term financing. The firm plans to sell Rs 100 crore in 270-day-maturity
paper on which it expects to have to pay discounted interest at an annual rate of 12 per
cent per annum. In addition, EPG expects to incur a cost of approximately dealer
placement fees and other expenses of issuing the paper. The effective cost of credit to
EPG can be calculated as follows:
.1320, or 13.20 per cent
270/360
1
Rs 100 crores- Rs 100,000 - Rs 9 crore
RATE = Rs^9 crores ¥ =
Where the interest cost is calculated as Rs 100 crore ◊ .12 ◊ 270/360 = Rs 9. Thus, the
effective cost of credit to EPG is 13.2 per cent.
CPs have to be credit rated in India. The highest credit rating holder corporates are
issuing CPs at around 8-12 % at this moment, which is much lower than the interest
rate they would have paid if they had gone through either the ICD market or the bank
finance route. Still CPs are not utilised to their maximum possible extent as the banks
do not like to fund through them because they lose on the interest they could have
charged if the corporates went through bank finance instead.