What Are Flotation Costs in Finance?
Flotation costs are non-recurring expenses that are paid to third parties to facilitate the issuance of new securities in the market.
Flotation costs are incurred by publicly-traded companies when they issue new stock. They incur expenses, such as underwriting fees, legal fees, and registration fees. Companies must consider the impact these fees will have on how much capital they can raise from a new issue. Flotation costs are a necessary part of the equation to calculate a company’s cost of new equity. They must be considered along with expected return on equity, dividend payments, and the percentage of earnings the business expects to retain.
These added expenses make new equity cost more than existing equity. Analysts argue that flotation costs are a one-time expense that should be adjusted out of future cash flows. This is in order to not overstate the cost of capital forever.
Flotation Costs – A Closer Look
Companies raise capital in two ways – either debt via bonds and loans, or equity.
- Debt – Some companies prefer issuing bonds or debt, especially when interest rates are low. Primarily because the interest paid on many debts is tax-deductible while equity returns are not.
- Equity – Other companies prefer equity because it does not need to be paid back. However, selling equity also entails giving up an ownership stake in the company.
There are flotation costs associated with issuing new equity, or newly issued common stock. These include costs such as investment banking and legal fees, accounting and audit fees, and fees paid to a stock exchange to list the company’s shares. The difference between the cost of existing equity and the cost of new equity is the flotation cost.
Flotation costs are expressed as a percentage of the issue price of the stock. These costs are incorporated into the price of new shares as a reduction. A company will often use a weighted cost of capital (WACC) calculation to determine what share of its funding should be raised from new equity and what portion from debt. (Source: investopedia.com)
Flotation Costs – Breakdown
Flotation costs include charges paid to the investment bankers, lawyers, accountants, and any other ancillary charges. For example, registration fees of the securities regulator and the exchange on which the issue is to be listed.
- Investment banker – The process of listing or issuing securities on a public exchange involves hiring an investment banker. Their services are required to manage the whole issue and find buyers for the company’s securities.
- Lawyers – Legal advice to meet the requirements of registration with the relevant regulator such as the SEC and the exchange. Lawyers also help in drafting the prospectus and memorandum keeping in view the disclosures required by relevant laws.
- Accountants – The company also hires public accountants such as CPAs. They vet the company’s historical financial statements and other data and prepare disclosures required to the investors.
Flotation costs vary based on several factors. Company size, issue size, issue type (debt vs equity), the company’s relationships with investment bankers, among others. In general, they are higher for smaller issues of less known companies. On the other hand, they are lower for bigger issues of well-established companies. Further, flotation costs of debt issues are significantly lower than those for equity issues of the same company.
Calculating Flotation Costs
#1 – Flotation Costs Included in the Cost of Capital
This approach includes flotation costs into the cost of capital. Cost of capital consists of the cost of debt and equity. Therefore, raising capital via debt or issuing new stocks affects the cost of capital. The formula below is used to find the Cost of Equity for the organization:
Cost of Equity = (D/ P [1-f]) + g
- D is the dividend per share after a year
- P is the current price of the shares being traded in the market
- g is the Growth rate of dividend over the years
- f is the flotation cost as a percentage
Company XYZ needs capital and decides to raise $100 million in common stock to meet its capital requirements. The current stock price for the company is $10 per share. Investment bankers receive 7% of the funds raised. Company XYZ pays out $1 in dividends per share next year. They expect to increase dividends by 10% the following year.
- Current Stock Price – $10
- Dividend per share – $1
- Flotation cost (f) – 7%
- Growth rate (g) – 10%
Using these variables, the cost of existing equity, as well as new equity, is calculated as follows:
- Cost of new equity = ($1 / ($10 * (1-7%)) + 10% = 20.7% The answer is 20.7%.
- The cost of existing equity is calculated using no flotation costs:
- Cost of existing equity (using no flotation costs) = ($1 / ($10 * (1-0%)) + 10% The answer is 20.0%.
- The difference between the cost of new equity vs existing equity = (20.7-20.0%) = 0.7%.
- The flotation costs increased the cost of the new equity issuance by 0.7%.
Many analysts consider this approach inappropriate. This is because flotation costs are actually a cash outflow at the beginning of the project. Instead, this method adjusts the PV of future cash flows by a fixed percentage. So, the later stages of the project are affected as the initial cash flow reduces. As a result, this approach does not depict the actual picture by including the flotation costs into the cost of equity. The issuance of new stocks in the market involves a one-time expense. Therefore, using this approach only inflates the cost of capital.
#2 – Adjustment in the Cashflow
In this approach, flotation costs are not included in the cost of equity. Instead, they are deducted from the cash flows. These are then used for the calculation of Net Present Value (NPV). This approach is appropriate and more effective than directly including the costs in the cost of capital. This method properly recognizes flotation costs as a one-time expense. As a result, the cost of capital is not inflated and remains unaffected.
The approach of adjusting costs from the cash flow is arguably sound from an accounting perspective. Moreover, it results in a correct representation of the one-time nature of costs when issuing new securities in the market.
XYZ Inc requires $10,000,000 for a new project, and it expects this project to generate cash flows of $4,500,000 for 3 years. It issues common stock in the market with a price of $30 per share and decides to pay a dividend of $1.25 per share next year. The flotation cost incurred is 9% of the capital raised, and the growth rate is expected to be 7%.
NPV = [($4,500,000 / 1.1146) + ($4,500,000 / 1.11462) + ($4,500,000 / 1.11463)] – ($10,000,000) = $909,300
NPV after Flotation Cost
- = $909,300 – (9% x $10,000,000)
- = $909,300 – $900,000 = $9,300
Limitations of Flotation Costs
As stated above, some analysts argue that including flotation costs in the company’s cost of equity implies that flotation costs are an ongoing expense. As a result, it forever overstates the firm’s cost of capital. In reality, a firm pays the flotation costs one time upon issuing new equity. To offset this, some analysts adjust the company’s cash flows for flotation costs.
- This cost can eat up a good portion of the actual capital that is raised.
- Along with flotation cost, the organization needs to adhere to the stringent rules and regulations set up by the regulators and the exchanges in which the stock will be listed.
- It is incurred when new stocks are issued in the market; this will eventually result in dilution of ownership stake.
- Since it is high, organizations may look for alternate sources of raising capital that would reduce the cost.
- An increased flotation cost may result in an inflated stock price. This in turn may or may not be accepted positively in the market.
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