Foundations of Financial Management: An Analysis (part 24)

 “An investment in knowledge pays the best interest.” 

– Benjamin Franklin 

Sources of Short-Term Financing (part C)

by

Charles Lamson

Financing through Commercial Paper

For large and prestigious firms, commercial paper may provide an outlet for raising funds. Commercial paper represents a short-term, unsecured promissory note issued to the public in minimum units of $25,000.

Commercial paper falls into two categories. First, there are finance companies that issue paper primarily to institutional investors such as pension funds, insurance companies, and money market mutual funds. It is probably the growth of money market mutual funds that has had such a great impact on the ability of companies to sell such an increased amount of commercial paper in the market. Paper sold by financial firms is referred to as finance paper, and since it is usually sold directly to the lender by the finance company, it is also referred to as direct paper. The second type of commercial paper is sold by industrial companies, utility firms, or financial companies too small to have their own selling network. These firms use an immediate dealer network to distribute their paper, and so this type of paper is referred to as dealer paper.

Traditionally commercial paper is just that. A paper certificate is issued to the lender to signify the lender's claim to be repaid. This certificate could be lost, stolen, misplaced, or damaged and, and in rare cases, someone could fail to cash it in at maturity. There is a growing trend among companies that sell commercial paper directly to computerize the handling of commercial paper with what is called book-entry transactions, in which no actual certificate is created. All transactions simply occur on the books. The use of computer-based electronic issuing methods lowers cost and simplifies administration, as well as linking the lender and the issuing company. As the market becomes more accustomed to this electronic method, large users ($500 million or more) will likely find it profitable to switch from physical paper to the book entry system, where all transfers of money are done by wiring cash between lenders and commercial paper issuers.

Advantages of Commercial Paper

The growing popularity of commercial paper can be attributed to other factors besides the rapid growth of money market mutual funds and their need to find short-term securities for investment. For example, commercial paper may be issued at below the prime interest rate. This rate differential is normally 2 to 3 percent.

A second advantage of commercial paper is that no compensating balance (a minimum bank account balance that a borrower agrees to maintain with a lender) requirements are associated with its issuance, though the firm is generally required to maintain commercial bank lines of approved credit equal to the amount of the paper outstanding (a procedure somewhat less costly than compensating balances). Finally, a number of firms enjoy the prestige associated with being able to float their commercial paper and what is considered a "snobbish market" for funds.

Limitations on the Issuance of Commercial Paper

Although the funds provided through the issuance of commercial paper are cheaper than bank loans, they are also less predictable. While a firm may pay a higher rate for a bank loan, it is also buying a degree of loyalty and commitment that is unavailable in the commercial paper market.

Foreign Borrowing

An increasing source of funds for you U.S. firms has been overseas banks. This trend started several decades ago with the Eurodollar market centered in London. A Eurodollar loan is a loan denominated in dollars and made by a foreign bank holding dollar deposits. Such loans are usually short-term to intermediate-term in maturity. London Interbank Offer Rate (LIBOR) is the base interest rate paid on such loans for companies of the highest quality. As Figure 1 shows, Eurodollar loans at LIBOR rather than the prime interest rate can be cheaper than U.S. domestic loans. International companies are always looking in foreign markets for cheaper ways of borrowing.

Figure 1 The prime rate versus the London Interbank Offered Rate on U.S. dollar deposits

One approach to borrowing has been to borrow from international banks in foreign currencies either directly or through foreign subsidiaries. In using a subsidiary to borrow, the companies may convert the borrowed currencies to dollars, which are then sent to the United States to be used by the parent company. While international borrowing can often be done at lower interest rates than domestic loans, the borrowing firm may suffer a currency risk. That is, the value of the foreign funds borrowed may rise against the dollar and the loan will take more dollars to repay. Companies generating foreign revenue streams may borrow in those same currencies and thereby reduce or avoid any currency risk. Currency risk will be given greater coverage in the next post.

Use of Collateral in Short-Term Financing

Almost any firm would prefer to borrow on an unsecured (no-collateral) basis; but if the borrower's credit rating is too low or its need for funds too great, the lending institution will require that certain assets be pledged. A second credit arrangement might help the borrower obtain funds that would otherwise be unavailable.

In any loan the lenders primary concern, however, is whether the borrowers capacity to generate cash flow is sufficient to liquidate the loan as it comes due. Few lenders would make a loan strictly on the basis of collateral. Collateral is merely a stopgap device to protect the lender when all else fails. The bank or finance company is in business to collect interest, not to repossess and resell assets.

Though a number of different types of assets may be pledged, our attention will be directed to accounts receivable and inventory. All states have now adopted the Uniform Commercial Code, which standardizes and simplifies the procedures for establishing security on a loan. It is to accounts receivable financing that we turn to in the next post. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 219-222*

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