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610 CHAPTER 16 Working Capital Management

daily as conditions change. Recently, commercial paper rates have ranged from 1^1 ⁄ 2

to 3^1 ⁄ 2 percentage points below the stated prime rate, and up to^1 ⁄ 2 of a percentage

point above the T-bill rate. For example, in December 2001, the average rate on

three-month commercial paper was 1.75 percent, the stated prime rate was 5.0 per-

cent, and the three-month T-bill rate was 1.68 percent.

Use of Commercial Paper

The use of commercial paper is restricted to a comparatively small number of very

large concerns that are exceptionally good credit risks. Dealers prefer to handle the

paper of firms whose net worth is $100 million or more and whose annual borrowing

exceeds $10 million. One potential problem with commercial paper is that a debtor

who is in temporary financial difficulty may receive little help because commercial pa-

per dealings are generally less personal than are bank relationships. Thus, banks are

generally more able and willing to help a good customer weather a temporary storm

than is a commercial paper dealer. On the other hand, using commercial paper per-

mits a corporation to tap a wide range of credit sources, including financial institu-

tions outside its own area and industrial corporations across the country, and this can

reduce interest costs.

What is commercial paper?

What types of companies can use commercial paper to meet their short-term fi-

nancing needs?

How does the cost of commercial paper compare with the cost of short-term

bank loans? With the cost of Treasury bills?

Use of Security in Short-Term Financing

Thus far, we have not addressed the question of whether or not short-term loans

should be secured. Commercial paper is never secured, but other types of loans can be

secured if this is deemed necessary or desirable. Other things held constant, it is bet-

ter to borrow on an unsecured basis, since the bookkeeping costs of secured loans are

often high. However, firms often find that they can borrow only if they put up some

type of collateral to protect the lender, or that by using security they can borrow at a

much lower rate.

Several different kinds of collateral can be employed, including marketable

stocks or bonds, land or buildings, equipment, inventory, and accounts receivable.

Marketable securities make excellent collateral, but few firms that need loans also

hold portfolios of stocks and bonds. Similarly, real property (land and buildings) and

equipment are good forms of collateral, but they are generally used as security for

long-term loans rather than for working capital loans. Therefore, most secured

short-term business borrowing involves the use of accounts receivable and invento-

ries as collateral.

To understand the use of security, consider the case of a Chicago hardware dealer

who wanted to modernize and expand his store. He requested a $200,000 bank loan.

After examining his business’s financial statements, the bank indicated that it would

lend him a maximum of $100,000 and that the effective interest rate would be 12.1 per-

cent. The owner had a substantial personal portfolio of stocks, and he offered to put up

$300,000 of high-quality stocks to support the $200,000 loan. The bank then granted

the full $200,000 loan, and at the prime rate of 9.5 percent. The store owner might also

For current rates, seehttp://
http://www.federalreserve.
gov/releases,and look at
the Daily Releases for
Selected Interest Rates.

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