Unveiling the Mystery behind Flotation Costs
Flotation costs are expenses incurred by a publicly-traded company when it issues new securities, including underwriting fees, legal fees, and registration fees. These costs affect the amount of capital that can be raised from the new issue. Companies must factor in flotation costs, expected return on equity, dividend payments, and the percentage of retained earnings to determine the cost of new equity.
Key Takeaways
- Flotation costs are incurred when a company issues new stock.
- These costs include underwriting, legal, registration, and audit fees.
- Expressed as a percentage of the issue price, flotation costs reduce the capital raised.
- Companies use a weighted average cost of capital (WACC) to decide funding shares from new equity and debt.
- Analysts argue that flotation costs should be adjusted out of future cash flows to avoid overstating the cost of capital.
What Do Flotation Costs Tell You?
Companies have two principal ways to raise capital: through debt instruments such as bonds and loans, or through equity. Some prefer debt, particularly when interest rates are low since the interest on loans can often be tax-deductible, whereas equity returns are not.
Equity does not require repayment, which is its biggest advantage. However, it involves giving up ownership stakes and can be a costly venture due to associated flotation costs, such as investment banking fees, legal charges, and fees for listing on a stock exchange.
The flotation cost of new equity, usually lower in price than existing equity, is incorporated into the share value, ultimately reducing the total capital raised.
Flotation Cost Formula
To calculate the flotation cost of new equity using the dividend growth rate formula:
- D1 = Dividend in the next period
- P = Issue price per share
- F = Ratio of flotation cost to stock issue price
- g = Dividend growth rate
Example of a Flotation Cost Calculation
Assume Company A needs to raise $100 million by issuing common stock at $10 per share. Investment bankers receive 7% of the capital raised. The expected dividend next year is $1 per share, anticipated to grow by 10% the following year.
Using these values, the cost of new equity is calculated as follows:
Limitations of Using Flotation Costs
Some debate that including flotation costs in the company’s cost of equity implies perpetual expenses, overstating the cost of capital. To manage this, some analysts adjust the company’s cash flows for flotation costs.
What Does Flotation Mean?
In financial terms, flotation means publicly selling company shares for the first time. This is a widespread method for companies to generate funds for expansion.
What Is the Flotation Price?
The flotation price is the initial price that the public can purchase shares for, also inclusive of the costs the company incurs issuing these securities.
What Is the Main Flotation Cost?
Underwriting fees, charged by investment banks during initial public offerings (IPOs), typically constitute the largest flotation cost. These fees range between 4%-7% of gross proceeds and cover preparation, marketing, pricing, and the risks undertaken by the underwriters.
The Bottom Line
- Raising capital through new securities includes considerable costs via underwriting, legal, and other transactional fees, known as flotation costs.
- Expressed as a percentage of the issue price, these costs vary by security type, issue size, and transaction risks. Companies should estimate these costs beforehand to ensure this method is cost-effective for raising funds.
Related Terms: Underwriting Fees, Return on Equity, Weighted Average Cost of Capital.
References
- PricewaterhouseCoopers. “Considering an IPO? First, Understand the Costs”.
