Cost of capital is the cost of raising money for a business, while flotation costs are the fees a company pays when issuing new securities. Flotation costs are a factor in a company’s cost of capital.
Cost of capital refers to the expense incurred by a company to fund its operations and investments. It encompasses the interest paid on debt, dividends on preferred equity, and returns expected by shareholders on common equity. Accurately assessing the cost of capital is crucial for financial decision-making.
“Cost of capital is the rate of return a firm requires from an investment to increase its value in the marketplace.” Essentially, it is the minimum rate of return a company must earn to generate value. The cost of capital represents the cost of a company’s funds and the required rate of return for investors.
The accounting department calculates the cost of capital to determine the return on investment, financial risk, and whether an investment is justified.
Flotation Costs
Flotation costs are the fees a company incurs when issuing new securities, such as stocks. These costs include legal, underwriting, registration, and audit fees. Flotation costs reduce the amount of capital a company can raise and increase the company’s cost of capital when issuing common stock or raising debt.
Flotation costs include:
- Legal fees
- Underwriting fees
- Printing costs
- Registration fees
These costs are non-recurring expenses incurred only once when new securities are issued.
Flotation costs are a key consideration when determining how much capital to raise from investors. They are expressed as a percentage of the issue price and vary based on the type of security, market conditions, and the size of the offering.
Calculation of Flotation Cost
The flotation cost can be calculated using the following formula:
Example:
Flotation Cost= Total cost of New Securities ÷ Total Amount issued
If a company issues Rs.10 million worth of new stock and incurs Rs.600,000 in expenses, then the flotation cost would be:
Impact of Flotation Costs on the Cost of Capital
Once flotation costs are determined, they are incorporated into the final price of the issued securities. This incorporation reduces the final price and lowers the amount of capital a company can raise. Typically, the costs for issuing debt securities or preferred shares are lower than those for issuing common shares.
Example:
R(e)=-Cost of equity
D1=Dividends per share one year after
Po-Current Share Price
g=Growth rate of dividends
However, the issuance of new shares causes a company to incur flotation expenses. Thus, the current share price must be adjusted for the effect of such costs.
As a result, the cost of equity formula adjusted for the flotation costs will look:
R(e)=D1/Po(1-f) +g
Where, f – Flotation cost in percentage
However, this approach may overstate the cost of capital as it directly incorporates flotation expenses. An alternative method is to deduct flotation costs from the company’s cash flows when calculating the net present value (NPV), which provides a more accurate representation of the financial impact.
Flotation Costs and Cost of Capital Approaches
There are two main views regarding the impact of flotation costs on a company’s cost of capital:
- Direct Incorporation Approach:
- Flotation costs are added to the cost of capital, increasing it.
- Cash Flow Adjustment Approach:
- Flotation costs are deducted from cash flows used in NPV calculations, ensuring the cost of capital remains unaffected.
The second approach is considered more appropriate as it accounts for the one-time nature of flotation costs without overstating the company’s cost of capital.
Understanding flotation costs and their impact on the cost of capital is essential for businesses to make informed financial decisions and effectively manage fundraising strategies.
