###### Beta and Cost of Capital of a Project

When estimating the cost of equity using the Capital Asset Pricing Model (CAPM),... **Read More**

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

Whenever debt and preferred stock are being raised, flotation costs are not usually incorporated in the estimated cost of capital. This is attributable to the negiligibility of the costs in these instances; often less than 1%. However, whenever equity is being raised, the value of flotation costs can be quite material, and hence should be included when estimating the cost of equity.

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

The first approach posits that flotation costs should be incorporated into the cost of capital. According to this viewpoint, in monetary terms, flotation costs can be specified 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 cost of external equity is represented by the following equation:

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

When flotation costs are specified as a percentage applied against the price per share, the cost of external equity is represented by the following equation:

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

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 from the standpoint that 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.

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, they should be incorporated into any valuation analysis as additional costs of a project.

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 lies in the fact that by adjusting the cost of capital for flotation costs, it is easier to demonstrate how the costs of financing a company change as a company exhausts its internally generated equity and switches to externally generated equity.

An example will make it easier to understand the difference between the two approaches.

Suppose 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. 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 Net Present Value (NPV) of the project, 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.

QuestionWhich of the following statements is

the mostaccurate?A. When flotation costs are incorporated into the cost of capital, the adjusted cost of capital is less than if flotation costs were not included.

B. The preferred method for including flotation costs in the analysis is as an initial cash flow in valuation analysis.

C. Whenever debt and preferred stock are raised, flotation costs are usually incorporated in the estimated cost of capital.

SolutionThe 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.

Option A is incorrect. The effect of adjusting the cost of capital to incorporate flotation costs results in a larger denominator in the cost of equity formula which leads to an overall increase in the cost of equity value.

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

*Reading 33 LOS 33l:*

*Explain and demonstrate the correct treatment of flotation costs*