What is Flotation Cost?
Flotation cost is defined as 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 to list the stocks on the stock exchange that needs to be paid to the exchange.
- It is expressed as a percentage of the issue price since the capital that is raised after the sale of the new stocks will be after the deduction of the flotation cost.
- It is evident that due to this cost that is involved in the issuance of the new stocks, the final price of the new stocks is reduced and ultimately results in a lowered amount of capital that can be raised.
- The cost involved in the issuance of debt securities or preferred stocks is often less than issuing common stocks.
- The average range of flotation costs for issuing common stocks falls anywhere between a minimum of 2% to a maximum of 8%.
Cost of Capital and Flotation Cost Formulas
#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 capital via debt or issuance of new stocks would affect the cost of capital.
The below formula can be used to find the Cost of Equity of the organization:
[When this cost is given as per-share basis]
- D1 is the dividend per share Per ShareDividends per share are calculated by dividing the total amount of dividends paid out by the company over a year by the total number of average shares held. after a year
- P0 is the current price of the shares being traded in the market
- g is the Growth rate of dividendGrowth Rate Of DividendDividend Growth Rate is the rate of growth of a stock's dividend on a year-to-year basis (in percent). It varies according to business cycles and can be addressed monthly or quarterly. over the years
- The issuance of new stocks will increase the cost of equity. The current price of the share will need to be adjusted to accommodate the flotation cost. The below formula can represent it:
[When it is given as a percentage]
- D1 is the dividend per share after a year
- P0 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 percentage of flotation cost
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 an increase of 12% is expected in 2020.
The calculation for the Cost of New Equity are:
The calculation for the Cost of Existing Equity are:
Hence the flotation cost will be:
Cost of New Equity – Cost of Existing Equity
It results in an increase in the cost of new equity by 0.64%.
This approach is not accurate and does not depict the actual picture since it includes the flotation costs into the cost of equity Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.. The issuance of new stocks in the market involves a one-time expense, and this approach only inflates the cost of capital.
#2 – Adjustment in the Cashflow
In this approach, it is deducted from the cash flows, which are used for the calculation of Net Present ValueCalculation Of Net Present ValueNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not. (NPV) instead of including the flotation cost in the cost of equity. This approach of deducting it from the cash flows is appropriate and effective than directly including the costs in the cost 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 and results in a correct representation of the one-time cost involved in the issuance of 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
- 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 lookout for alternate sources of raising capital would reduce the cost.
- An increased flotation cost may result in an inflated stock price, which in turn may or may not be accepted positively in the market.
Important Points to Note
- Flotation cost is an unavoidable cost incurred in an effort to raise capital for a new project or business functioning.
- The cost includes legal fees, investment bankingInvestment BankingInvestment banking is a specialized banking stream that facilitates the business entities, government and other organizations in generating capital through debts and equity, reorganization, mergers and acquisition, etc. fees, audit fees, and stock market fees, to name a few.
- Due to this cost, new stocks cost more to the organization than the stocks already being 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 is mainly considered 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.
- It is a one-time expense that is paid to third parties to facilitate the issuance of new securities in the market.
- The average flotation cost ranges from 2% – 8%, which may vary depending on the security that is being issued.
- It will decrease the amount that the organization is aiming to raise through the issuance of new securities in the market.
- The ideal approach to record flotation costs is to deduct the cost from the cash flows that are used to calculate the Net present value.
- This cost is a cash outlay since the organization never received the amount.
- Since there is a cost involved in the issuance of new stocks in the market, these stocks will cost more for the organization than the stocks already being traded in the market.
This article has been a guide to what is Flotation Cost and its meaning. Here we discuss how flotation cost impacts the cost of capital calculations along with examples and limitations. You can learn more about financing from the following articles –