question_answer 22)

What is a commercial paper? What are its advantages and limitations?

Answer:

Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. It is issued by one firm to other business firms, insurance companies, pension funds and banks. The amount raised by CP is generally very large. The CP can be issued only by firms having good credit rating as this debt is totally unsecured. Issue of CP is regulated by the Reserve Bank of India. Merits of Commercial Paper (i) A commercial paper does not contain any restrictive conditions as it is sold on an unsecured basis. (ii) It has high liquidity as it is a freely transferable instrument. (iii) It provides more funds compared to other source. (iv) The cost of CP to the issuing firm is generally lower than the cost of commercial bank loans. (v) A commercial paper provides a continuous source of fund because their maturity can be tailored to suit the requirements of the issuing firm. (vi) Companies can invest their excess funds in commercial paper and can earn good return on them. Limitations of Commercial Paper (i) Only firms which are financially sound and have high credit ratings can raise money through commercial papers. New and moderately rated firms are not in a position to raise funds by this method as these are unsecured. (ii) The amount of money that can be raised through commercial paper is limited. (iii) Commercial paper is an impersonal method of financing and if a firm is not in a position to redeem its paper due to financial difficulties, extending the maturity of a CP is not possible.