Flotation Cost

Flotation cost is the cost incurred by the company when they issue new stocks in the market as the process involves various stages and participants. It includes audit fees, legal fees, accounting fees, investment bank’s share out of the issuance, and the fees for listing the stock exchange stocks that need to be paid to the exchange.

It is expressed as a percentage of the issue price since the capital raised after the sale of the new stocks will be after the deduction of the flotation cost. The cost of issuing debt securities or preferred stocks is often less than common stocks.

Key Takeaways                                                               

• Flotation cost refers to a company's price if they issue new stocks in the market since the method has different stages and participants. It involves audit fees, legal fees, accounting fees, investment bank's share out of the issuance, and the fees for listing the stock exchange stocks that must be paid to the exchange.
• The flotation costs average range for issuing common stocks is between a minimum of 2% and a maximum of 8%.
• It is unavoidable while raising capital for a new project or business.

Flotation cost is a one-time expense paid to third parties to facilitate the issuance of new securities in the market. The average flotation cost ranges from 2% to 8%, which may vary depending on the security issued. It will decrease the amount the organization aims to raise by issuing new securities in the market.

The ideal approach to record flotation costs is to deduct the cost from the cash flows used to calculate the net present value. This cost is a cash outlay since the organization never received the amount. Since a cost is involved in issuing new stocks in the market, these stocks will cost more for the organization than those traded in the market.

As this cost is involved in the issuance of the new stocks, the final price is reduced, resulting in a lowered amount of capital that one can raise. The average range of flotation costs for issuing common stocks falls anywhere between a minimum of 2% to a maximum of 8%.

Flotation costs are unavoidable in raising capital for a new project or business. The cost includes legal, investment banking, audit, and stock market fees, to name a few. Due to this cost, new stocks cost the organization more than those already traded in the market. It is incurred not just for stocks but also for other sources of raising capital like bonds and debentures. However, the cost of issuing stock is on the higher side.

It can consider in either of the two ways: the first approach includes flotation costs into the cost of capital, whereas the second approach adjusts the organization’s cash flows. This cost can eat up a good portion of the capital raised.at is raised.

Along with flotation costs, the organization must adhere to the regulators’ stringent rules and regulations and the stock exchanges. It incurs when issued new stocks in the market. It will eventually result in the dilution of the ownership stake. Since it is high, organizations may look for alternate sources of raising capital to reduce the cost. An increased flotation cost may result in an inflated stock price, which may or may not be accepted positively in the market.

There are two types of formulas that help compute flotation costs effectively. Let us look at them in detail:

#1 - Inclusion of Flotation Costs into 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. Hence, raising money via debt or issuance of new stocks would affect the cost of capital.

We can use the below formula to find the cost of equity of the organization: -

Cost of Equity = (D1/P0) + g

Where,

• D1 is the dividend per share after a year
• P0 is the current price of the shares traded in the market
• g is the growth rate of dividends over the years
• The issuance of new stocks will increase the cost of equity. The share's current price will need to be adjusted to accommodate the flotation cost. The below formula can represent it: -

Cost of Equity = (D1/ P0 ) + g

Where,

• D1 is the dividend per share after a year
• P0 is the current price of the shares traded in the market
• g is the growth rate of dividends over the years
• F is the percentage of flotation cost

#2 - Adjustment in the Cashflow

This approach deducts from the cash flows used to calculate Net Present Value (NPV) instead of including the flotation cost in the cost of equity. This approach of removing it from the cash flows is more appropriate and effective than directly having the expenses in the price of capital since this is a one-time expense. Moreover, the cost of capital is not inflated and remains unaffected.

The approach of adjusting it from the cash flow is arguably apt. It results in a correct representation of the one-time cost of issuing new securities in the market.

Let us consider the following instances to understand the concept better and also explore how to calculate flotation cost:

Example 1

In 2018, ABC Inc. issued common stock in the market to raise $500 million. The current price of a stock in the market is $20. The investment banker’s fees would be 6% of the raised capital. ABC Inc. paid a dividend of $2 per share in 2019 and expected an increase of 12% in 2020.

The calculation for the cost of new equity is: -

The calculation for the cost of existing equity is: -

Hence, the flotation cost will be: -

Cost of New Equity – Cost of Existing Equity

= 22.64-22.0%

= 0.64%.

It results in an increase in the cost of new equity by 0.64%.

This approach is inaccurate and does not depict the actual picture since it includes the flotation costs in the equity cost. The issuance of new stocks in the market involves a one-time expense, and this approach only inflates the cost of capital.

Example 2

XYZ Inc. requires $10,000,000 for a new project and expects this project to generate cash flows of $4,500,000 for three years. Accordingly, it issues common stock in the market at $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 7%.

NPV = – ($10,000,000) = $909,300.

NPV after Flotation Cost

• = $909,300 – (9% x $10,000,000)
• = $909,300 – $900,000
• = $9,300.