Flotation Costs Explained

Flotation costs are expenses that a company incurs during the process of raising additional capital. The value of these flotation costs is related to the amount and type of capital being raised.

When a company raises debt and preferred stock, flotation costs are not usually incorporated into the estimated cost of capital. This is attributable to the negligibility of the costs in these instances, often less than 1%. However, whenever a company raises equity, the value of flotation costs can be quite material and hence should be included when estimating the cost of equity.

Incorporation of Flotation Costs into Cost of Capital

Two approaches may be used in response to the question of whether or not a company should incorporate flotation costs into the cost of capital.

First Approach: Flotation Incorporated into the Cost of Capital

The first approach posits that a company should incorporate flotation costs into the cost of capital. According to this viewpoint, in monetary terms, a company can specify flotation costs as an amount per share or as a percentage of the share price.

When flotation costs are specified on a per share basis, F, the equation below represents the cost of external equity:

$$ { r }_{ e }=\left( \frac { { D }_{ 1 } }{ { P }_{ 0 }-F } \right) +g $$

When a company specifies flotation costs as a percentage applied against the price per share, the equation below represents the cost of external equity:

$$ { r }_{ e }=\left( \frac { { D }_{ 1 } }{ { P }_{ 0 }\left( 1-f \right) } \right) +g $$

where f is the flotation cost as a percentage of the issue price.

This approach has the effect of having flotation costs behave like a cash outflow at the initiation of a project. This negatively impacts the value of the project by reducing its initial cash flow. Adjusting the cost of capital for flotation costs using this approach is incorrect since it adjusts the present value of the future cash flows of a project by a fixed percentage, which is not necessarily equal to the present value of the flotation costs.

Second Approach: Adjustment to Cash Flows

The second approach is the recommended approach which adjusts cash flows in the valuation computation.  In other words, instead of including flotation costs in the cost of capital, a company should incorporate them into any valuation analysis as additional project costs.

Despite this being the recommended approach, the approach of adjusting flotation costs in the cost of capital appears to be the more popular approach. The main reason is that by adjusting the cost of capital for flotation costs, it is easier to demonstrate how financing costs change as a company exhausts its internally generated equity and switches to externally generated equity.

An example will make understanding the difference between the two approaches easier.

Example: Net Present Value Using the Two Approaches

Assume that a company undertakes a project which requires an initial cash outlay of $50,000 and is expected to produce cash flows of $22,000 for 3 years. Further, assume that the company finances the project with 100% equity, has a current stock price of $15, intends to pay dividends of $1.50 next year, and the expected sustainable growth rate is 6%. The company’s marginal tax rate is 35%. If flotation costs are 5% of the new equity capital raised, what is the project’s Net Present Value (NPV), using the two methods for accounting for flotation costs?

Solution

Approach 1:
Using the equation,
$$ { r }_{ e }=\left( \frac { { D }_{ 1 } }{ { P }_{ 0 }\left( 1-f \right) } \right) +g $$
$$ \text { cost of equity } = \frac { $1.50 }{ $15\left( 1-0.05 \right) }+0.06 =0.165263=16.53\% $$
Therefore,
NPV = $$ \frac { $22,000 }{ \left( 1.1653 \right) } +\frac { $22,000 }{ { \left( 1.1653 \right) }^{ 2 } } \frac { $22,000 }{ { \left( 1.1653 \right) }^{ 3 } } -$50,000=-$1,016.51 $$
Approach 2:
Using the dividend discount model and not factoring in flotation costs, cost of equity,
$$ { r }_{ e }=\left( \frac { { D }_{ 1 } }{ { P }_{ 0 } } \right) +g=\frac { $1.50 }{ $15 } +0.06=0.16=16\% $$
Flotation costs in monetary term = 5% x $50,000 = $2,500
Therefore,
$$ NPV = \frac { $22,000 }{ { \left( 1.16 \right) }^{ 1 } } +\frac { $22,000 }{ { \left( 1.16 \right) }^{ 2 } } +\frac { $22,000 }{ { \left( 1.16 \right) }^{ 3 } } -$50,000-$2,500=-$3,090.43$$

It is evident that both approaches result in different NPVs.

Question

Which of the following statements is the most accurate?

1. When flotation costs are incorporated into the cost of capital, the adjusted cost of capital  would be less than if flotation costs were not included.
2. The preferred method for including flotation costs in the analysis is as an initial cash flow in valuation analysis.
3. Whenever debt and preferred stock are raised, flotation costs are usually incorporated into the estimated cost of capital.

Solution

The correct answer is B.

Approach 2 is the recommended approach, although it is not as popular as the approach of adjusting the cost of capital for flotation costs.

A is incorrect. Adjusting the cost of capital to incorporate flotation costs results in a larger denominator in the cost of equity formula. This leads to an overall increase in the cost of equity value.

C is incorrect. Flotation costs are not usually incorporated in the estimated cost of capital for debt and preferred stock issues.