Flotation Cost
What Is a Flotation Cost?
Flotation costs are incurred by a public corporation when it issues new securities and causes expenses, for example, underwriting fees, legal fees, and registration fees. Companies must consider the impact these fees will have on how much capital they can raise from another issue. Flotation costs, expected return on equity, dividend payments, and the percentage of earnings the business hopes to hold are all part of the equation to work out a company's cost of new equity.
The Formula for Float in New Equity Is
The equation for working out the flotation cost of new equity utilizing the dividend growth rate is:
Where:
- D1 = the dividend in the next period
- P = the issue price of one share of stock
- F = ratio of flotation cost-to-stock issue price
- g = the dividend growth rate
What Do Flotation Costs Tell You?
Companies raise capital in two ways: debt through bonds and loans or equity. A few companies lean toward giving bonds or getting a loan, particularly when interest rates are low and in light of the fact that the interest paid on numerous debts is charge deductible, while equity returns are not. Different companies favor equity since it needn't bother with to be paid back; notwithstanding, selling equity additionally involves surrendering an ownership stake in the company.
There are flotation costs associated with giving new equity, or recently issued common stock. These incorporate costs, for example, investment banking and legal fees, accounting and audit endlessly fees paid to a stock exchange to list the company's shares. The difference between the cost of existing equity and the cost of new equity is the flotation cost.
The flotation cost is communicated as a percentage of the issue price and is incorporated into the price of new shares as a reduction. A company will frequently utilize a weighted cost of capital (WACC) calculation to figure out which share of its funding ought to be raised from new equity and which portion from debt.
Illustration of a Flotation Cost Calculation
For instance, expect Company A necessities capital and chooses to bring $100 million up in common stock at $10 per share to meet its capital requirements. Investment bankers receive 7% of the funds raised. Company A delivers out $1 in dividends per share next year and is expected to increase dividends by 10% the following year.
Utilizing these factors, the cost of new equity is calculated with the following equation:
- ($1/($10 * (1-7%)) + 10%
The response is 20.7%. On the off chance that the analyst expects no flotation cost, the response is the cost of existing equity. The cost of existing equity is calculated with the following formula:
- ($1/($10 * (1-0%)) + 10%
The response is 20.0%. The difference between the cost of new equity and the cost of existing equity is the flotation cost, which is (20.7-20.0%) = 0.7%. As such, the flotation costs increased the cost of the new equity issuance by 0.7%.
Limitations of Using Flotation Costs
A few analysts contend that incorporating flotation costs in the company's cost of equity suggests that flotation costs are a continuous expense, and perpetually exaggerates the firm's cost of capital. In reality, a firm pays the flotation costs one time after giving new equity. To offset this, a few analysts change the company's cash flows for flotation costs.
Features
- Analysts contend that flotation costs are a one-time expense that ought to be adjusted out of future cash flows to not exaggerate the cost of capital for eternity.
- Flotation costs are costs a company causes when it issues new stock.
- Flotation costs make new equity cost more than existing equity.
