Flotation Costs

What are flotation Costs?

Flotation costs, which include underwriting fees, legal fees, and registration fees, are expenses that a company incurs when issuing new securities.

These costs impact the capital raised from the new issue, and it's essential for companies to consider how these fees will affect the capital they raise.

These costs are a factor in calculating a company's cost of new equity. When a publicly traded company issues new securities or bonds, it incurs costs. 

Flotation costs are a factor in calculating a company's cost of new equity. Therefore, understanding and accounting for these expenses is crucial for companies engaging in such financial activities.

Understanding Flotation Costs

Companies can raise capital in two ways: through debt (bonds and loans) or equity. Some businesses prefer to issue bonds or obtain a loan, especially when interest rates are low, and interest on many debts is tax-deductible, whereas equity returns are not. 

Other businesses prefer equity because it does not have to be repaid; however, selling equity also means giving up a stake in the company. Issuing new equity or newly issued common stock incurs these costs. 

These expenses include investment banking and legal fees, accounting and audit fees, and fees paid to a stock exchange to have the company's shares listed. The difference between existing and new equity costs is known as the flotation costs.

It is a percentage of the issue price and is deducted from the price of new shares. A company will frequently use a weighted cost of capital (WACC) calculation to determine how much of its funding should be raised through new equity and how much through debt.

The cost of debt securities or preferred stock is generally lower than the cost of issuing common stock.

For example, in issuing common stock, average costs range between 2% and 8%. 

The primary method involves discounting cash flows to calculate the Net Present Value (NPV). This cost is paid in cash at the time of equity share issuance. These expenses are incorporated into the projects of firms that are profitable.

The cost of capital determines the financing mix for raising capital. It is also the company's cash outlay for the project. The discounted rate is applied to future cash flows to calculate the net present value.

Flotation Cost Formula

The following equation can be used to calculate the flotation cost of new equity using the dividend growth rate:

R_e= [D₁/ (P₀ * (1 - f))] + g

Where,

• R_e= Cost of Equity
• D₁ = Dividends per share after one year
• P₀= Current share price
• f = Flotation cost
• g = Dividend growth rate

Example of a Flotation Cost Calculation

Let us take an example to understand the concept better.

Consider a company, ABC Ltd, looking to raise $500 million from the public markets at $20/per share. The company's costs are estimated to be 5.5%. 

The company plans to distribute dividends of $4/per share in the next year, estimated to grow at a rate of 10%. Given the above information, the cost of equity of the company will be:

We know the cost of equity, considering the flotation costs, is represented as:

R_e= [D₁/ (P₀ * (1 - f))] + g

So,

Re = {4 / 20 (1 - 0.055)} + 0.1 = 0.311 = 31.1%

Therefore, the cost of equity of the company will be 31.1%

Flotation Costs and Cost of Capital

The cost of capital concept is highly correlated with the cost of flotation. This is because it includes the costs of both equity and debt. Thus, raising capital through issuing new stock or debt would impact the cost of capital.

The cost of capital can be calculated in two different ways:

1. By including flotation costs in the cost of capital

According to the first approach, flotation expenses must be factored into a company's cost of equity calculation.

It says that this cost raises a company's cost of capital. Remember that a company's cost of capital is made up of the cost of debt and the cost of equity. Depending on the securities issued, expenses affect the cost of capital by influencing the cost of debt or equity.

The issuance of new equity in a company leads to this cost. Therefore, the expression for the cost of equity, including flotation costs, becomes:

R_e= D₁ / P₀ (1 - f) + g

Where,

• R_e= Cost of Equity
• D₁= Dividends per share after one year
• P₀= Current share price
• f = flotation cost
• g = dividend growth rate

2. By making changes to the company's cash flows

The second strategy is to adjust the cash flows used in NPV calculations to account for the impact of flotation costs.

Unlike the first, the adjustment method does not change the actual cost of capital. Instead, a company subtracts the flotation costs from the cash flows before calculating the net present value (NPV).

The main idea behind this method is that the costs are only one-time payments to third parties. Because of the one-time nature of the expenses, deducting the flotation expenses from the company's cash flows is preferable to directly incorporating the costs into a cost of capital. 

At the same time, a company's cost of capital is not affected by the flotation expenses and is not overstated.

Flotation Costs Advantages and Limitations

It provides numerous benefits to the public corporation.

1. Allows businesses to provide additional incentives to employees by offering stock options. These incentives increase worker motivation and engagement.
2. It provides access to new capital for business development.
3. The use of publicly traded shares provides businesses with opportunities for acquisitions.
4. It raises the company's profile and fosters trust among suppliers and customers.

Properly managing the flotation process can streamline capital-raising activities for the company. However, the disadvantages are as follows:

1. The public company must comply with additional regulations and policies and uphold corporate standards such as transparency and announcing new financial developments.
2. As the economy, stock market situation, and market fluctuation are uncertain. As a result, the business may become vulnerable.
3. While considering shareholder interests is important for companies to generate returns on capital, diverging from their goals can pose challenges, regardless of flotation costs.
4. Managers may become distracted from running the business during the flotation process because they will have to deal with investors afterward.
5. Ongoing flotation cost expenses may lead some analysts to believe that the firm's initial cost of capital is overstated. 

Researched and Authored by Kavya Sharma | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Capital Structure
• Cost of Capital
• Cost of Equity
• Debt vs Equity Financing
• Return on Equity (ROE)