Flotation costs are costs incurred by a company in issuing its securities to public. When a company’s securities are listed on a public exchange, we say the securities are floated on the exchange and hence the name. Flotation costs are also referred to as issuance costs.
The process of listing or issuing securities on a public exchange involves hiring an investment banker to manage the whole issue and find buyers for the company’s securities. Lawyers advise the company on the legal requirements of registration with the relevant regulator such as the SEC and the exchange. They also help in drafting the prospectus and memorandum keeping in view the disclosures required by relevant laws. The company also hires public accountants such as CPAs to vet the company’s historical financial statements and other data and prepare disclosures required to the investors.
Flotation costs include charges paid to the investment bankers, lawyers, accountants, and any other ancillary charges such as registration fees of the securities regulator and the exchange on which the issue is to be listed.
Flotation costs vary based on several factors, such as company’s size, issue size, issue type (debt vs equity), company’s relationships with investment bankers, etc. In general, they are higher for smaller issues of less known companies and lower for bigger issues of well-established companies. Further, flotation costs of debt issues are significantly lower than those for equity issues of the same company.
Calculation of Amount Raised
In many cases, flotation costs are quite significant, and the amount of a company’s total issue depends on the flotation costs. If a company needs at least $200 million to fund a project and the flotation costs are estimated to be 6% of the total amount raised, the amount the company must raise so that it is left with $200 million net is worked out as follows:
|Amount Raised =||FN|
|1 - F|
Where FN is the amount of funding needed and F is the percentage of flotation costs to the amount raised.
In the above example, the company must raise $212.77 million. The excess $12.77 million represents the flotation cost.
Flotation Costs in WACC and Capital Budgeting
The flotation costs must be treated as part of the initial investment outlay at the start of a project to correctly calculate the net present value (NPV) and internal rate of return (IRR) of the project for which funding is needed.
Under this approach, the cost of equity (cost of common stock) using the Gordon Growth Model is estimated as per the following formula:
|Cost of Equity =||D1||+ g|
|P0 × (1 - F)|
Where D1 is the dividend per share in the first year after the issuance of stock, P0 is the price per stock, F is the flotation cost percentage (i.e. total flotation costs divided by total value of stock issued) and g is the expected growth rate of dividends i.e. the sustainable growth rate.
Cost of preferred stock with flotation costs can be worked out using the following formula:
|Cost of Preferred Stock =||D|
|P0 × (1 - F)|
Where P0 is the current price of a share of preferred stock, F is the flotation cost as percentage of issue price P0 and D is the annual preferred dividend.
Flotation cost-adjusted yield on debt can also be calculated by using the after-flotation cost price of a debt instrument in the bond pricing formula.