Flotation Costs

Refers to the cost that is paid by the company that issues new securities

A publicly-traded company incurs flotation costs when it issues new securities and includes expenses such as underwriting fees, legal fees, and registration fees. Therefore, companies must consider how these fees will affect the capital they raise from a new issue. 

Flotation costs, expected return on equity, dividend payments, and the percentage of earnings retained are all factors in calculating a company's cost of new equity. When a publicly-traded company issues new securities or bonds, it incurs costs. 

The company that issues the new securities pays the costs, including underwriting, legal, and registration fees. Companies must consider how these fees will affect the capital they raise from a new issue.

As new issues are intended to raise capital for the company, it must ensure that it will at least recoup its investment. Flotation costs, expected return on equity, dividend payments, and the percentage of earnings retained are all factors in calculating a company's cost of new equity.

Interpretation

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 the cost of existing and new equity 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 is to deduct the cost from the company's cash flow, which is then used to calculate the Net present value.

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.

It is adjusted with the cost of capital to raise capital. It is also the company's cash outlay for the project. The discounted rate (denominators) or the cash inflow or outflow are used to calculate the net present value.

Formula 

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

Re = D1 / P0(1 - f) + g

Where,

Re = Cost of Equity

D1 = Dividends per share after one year

P0 = Current share price

f = flotation cost

g = dividend growth rate

Calculations

Flotation Costs and Cost of Capital

The cost of a 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.

Cost of capital can be calculated in two different ways:

A. 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 capital 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:

Re = D1 / P0 (1 - f) + g

Where,

Re = Cost of Equity

D1 = Dividends per share after one year

P0 = Current share price

f = flotation cost

g = dividend growth rate

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

The second strategy is to adjust the company's cash flows to account for the flotation costs. The adjustment method, unlike the first, does not change the actual cost of capital. Instead, a company subtracts the costs from the cash flows used to calculate the net present value (NPV).

Cash Flow

The method's main idea 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.

Advantages & 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 quoted shares creates a significant opportunity for businesses to acquire.
  4. It raises the company's profile and fosters trust among suppliers and customers.

The proper utilization of this cost can save the company from financial mismanagement. 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. In running a company, you must consider shareholder interests to gain a return on their capital; however, companies may sometimes diverge from their own goals.
  4. Managers may become distracted from running the business during the flotation process because they will have to deal with investors afterward.
  5. Because of ongoing flotation cost expenses, some analysts believe the firm's cost of capital will always be overstated. 

Example 

Consider a company, ABC ltd looking to raise $500 million from the public markets at $20/per share. The costs of the company 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:

Re = 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%

Conclusion 

  1. It is a one-time payment made to third parties to facilitate the issuance of new securities in the market.
  2. Depending on the security issue, the average flotation cost ranges from 2% to 8%.
  3. It will reduce the amount the organization hopes to raise by issuing new securities in the market.
  4. The best way to record this cost is to subtract them from the cash flows used to calculate the net present value.
  5. It is a cash outlay because the organization never received the funds.
  6. Because there is a cost associated with issuing new stocks in the market, these stocks will cost the organization more than those already traded in the market.
  7. These cause new equity to be more expensive than existing equity.
  8. These reduce the net proceeds of bonds because they are paid from the money available with bonds.
DCF Modeling Course

Everything You Need To Master DCF Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Researched and authored by Kavya Sharma | LinkedIn

Free Resources

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