Key Takeaways
- Costs incurred issuing new securities.
- Higher flotation costs for equity than debt.
- Reduces net proceeds from capital raised.
- Affects cost of capital and project valuation.
What is Flotation Cost?
Flotation cost refers to the expenses a company incurs when issuing new securities, including underwriting fees, legal fees, and registration charges. These costs reduce the net proceeds from the issuance and must be accounted for when calculating the cost of capital.
Understanding flotation costs helps you accurately evaluate the true cost of raising funds through equity or debt offerings.
Key Characteristics
Flotation costs have distinct features that impact financing decisions:
- Expressed as a percentage: Typically ranges from 5-10% for equity and 1-2% for debt issuance, reflecting different risk levels.
- Includes multiple fees: Underwriting, legal, printing, advertising, and regulatory costs all contribute to the total flotation cost.
- Affects net proceeds: The company receives less capital after these costs are deducted, influencing project funding.
- Varies by issuer size: Smaller firms usually face higher flotation costs due to less negotiating power and economies of scale.
- Impacts financial metrics: Must be considered in calculating weighted average cost of capital (WACC) and investment returns.
How It Works
Flotation costs are deducted from the gross proceeds of a new security issuance, reducing the effective funds available for investment. When calculating your project’s feasibility, you can either adjust the cost of equity or treat flotation costs as an upfront cash outflow.
Adjusting the fair value of new equity by incorporating flotation costs increases the required return, reflecting the higher expense of raising external funds. Alternatively, treating flotation costs as an initial expense avoids distorting ongoing discount rates, providing a more precise net present value (NPV) calculation.
Examples and Use Cases
Flotation costs appear in various industries and financing scenarios:
- Financial institutions: JPMorgan Chase issuing new shares must factor flotation costs into their capital raising strategies.
- Payment processors: When Visa raises funds, flotation costs impact the net capital raised and cost calculations.
- Exchange-traded funds: Funds like SPY may indirectly reflect flotation costs through underlying securities issuance.
Important Considerations
When evaluating flotation costs, ensure you incorporate them accurately in your financial models to avoid overestimating available funds. Ignoring these costs can lead to misleading project valuations and suboptimal capital structure decisions.
Additionally, flotation costs differ by security type and issuance size, so tailor your analysis accordingly. Understanding their impact on your earnings and investment returns is crucial to effective financial planning.
Final Words
Flotation costs directly reduce the funds a company nets from issuing new securities, impacting project evaluations and capital costs. To ensure accurate financial analysis, factor these costs into your cost of capital or treat them as an upfront project expense. Review your financing options carefully to minimize flotation expenses and improve overall funding efficiency.
Frequently Asked Questions
Flotation cost refers to the expenses a company incurs when issuing new securities, including underwriting fees, legal fees, SEC registration, printing, and advertising. These costs reduce the net proceeds from the issuance and vary depending on the security type.
Flotation costs are typically higher for equity, often between 5-10%, because issuing new stock involves greater risk, more regulatory requirements, and extensive marketing efforts compared to debt, which usually has flotation costs around 1-2%.
Flotation costs increase the effective cost of capital because they reduce the net funds raised. Companies often adjust their cost of equity or weighted average cost of capital (WACC) to account for these expenses when evaluating projects.
Two main approaches exist: adjusting the cost of capital by incorporating flotation costs into discount rates, or treating flotation costs as an initial cash outflow deducted directly from the project’s net present value (NPV), with the latter providing more precise results.
Flotation cost percentage is calculated by dividing the total flotation expenses by the total amount raised through the issuance and multiplying by 100%. For example, $50,000 in costs on a $1 million stock issue yields a 5% flotation cost.
Yes, ignoring flotation costs can overstate the net funds available for investment, leading to inaccurate project viability assessments. Including these costs ensures a realistic evaluation of expected returns and project profitability.
Flotation costs raise the cost of new equity by reducing the effective price received per share. The adjusted cost is calculated by dividing the expected dividend by the net price after flotation costs, then adding the growth rate, resulting in a higher required return.
For projects financed by both equity and debt, a weighted average flotation cost is calculated based on the proportion of each type of financing. This weighted flotation cost is then used to adjust the required investment or cost of capital for accurate analysis.
