Flotation cost, also spelled as “floatation cost,” is the set of expenses that a company must incur to issue new stocks or bonds. These costs can significantly impact a company’s decision on how to raise funds.
Components of Flotation Cost
Flotation costs typically include the following components:
- Underwriting Fees: These are fees paid to investment banks or underwriters who oversee the issuance process.
- Legal Fees: The costs for legal services to ensure that all regulatory and compliance issues are properly addressed.
- Registration Fees: Fees paid to regulatory bodies to register the new securities.
- Printing Expenses: Costs associated with printing prospectuses and other necessary documents.
- Miscellaneous Expenses: Additional costs such as marketing, advisory fees, and communication-related expenses.
Calculating Flotation Costs
Flotation costs are often expressed as a percentage of the total amount to be raised. The formula is given by:
1\text{Flotation Cost} = \left( \frac{\text{Total Costs Incurred}}{\text{Total Amount Raised}} \right) \times 100
For example, if a company incurs $5 million in flotation costs to raise $100 million, the flotation cost percentage is:
1\text{Flotation Cost} = \left( \frac{5,000,000}{100,000,000} \right) \times 100 = 5\%
Types of Securities and Flotation Costs
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Equity Securities (Stocks): Issuing new equity tends to incur higher flotation costs due to underwriting fees, more intensive legal scrutiny, and extensive marketing efforts.
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Debt Securities (Bonds): Generally have lower flotation costs compared to equity due to less marketing and underwriting risk.
Historical Context and Considerations
Historically, flotation costs were considered a significant barrier for smaller firms needing to raise capital. Technological advancements and regulatory changes have made the process less cumbersome, reducing the impact of flotation costs over time. However, it remains a critical factor for financial planning.
Applicability in Financial Decision-Making
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Impact on Net Proceeds: High flotation costs reduce the net proceeds from the issuance, thereby impacting the capital available for use in operations or investment.
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Cost of Capital: Flotation costs need to be factored into the calculation of a company’s weighted average cost of capital (WACC). Ignoring them can lead to underestimation of the true cost of capital.
Example Calculation
Consider a company planning to raise $50 million. They estimate flotation costs to be approximately 6%. The calculation would be:
- Total Flotation Cost: 0.06 $\times$ 50,000,000 = $3,000,000
- Net Proceeds: 50,000,000 - 3,000,000 = $47,000,000
Comparisons and Related Terms
- Issuance Cost: A broader term that includes all costs associated with issuing new securities, including flotation costs.
- Underwriting Spread: Part of the underwriting fees that represent the difference between what the underwriters pay the issuing company and what they receive from selling to the public.
FAQs
What are typical flotation costs?
Can flotation costs be avoided?
Do flotation costs only apply to public companies?
How are flotation costs accounted for?
References
- Gitman, L. J., & Zutter, C. J. (2012). Principles of Managerial Finance. Pearson Education.
- Brealey, R. A., Myers, S. C., & Marcus, A. J. (2014). Fundamentals of Corporate Finance. McGraw-Hill Education.
Summary
Flotation costs are the expenses incurred by a company when issuing new stocks or bonds. These costs, including underwriting, legal, and registration fees, can have a significant impact on the net proceeds and the overall cost of capital. Proper understanding and management of flotation costs are crucial for effective financial planning and capital raising.
