Question

1. What are flotation costs and why they must be included in the initial cost of a project? Explain in detail.

2. Tell me the differences between the standard deviation and beta in the measurement of risk in the capital market.

Answer 1

1. What are flotation costs and why they must be included in the initial cost of a project? Explain in detail.

Flotation costs are the costs associated with the issue of securities [debt or equity] to the public. They include the following:

*Underwriting costs

*Registration fee

*Legal fees

*Other administrative costs related to the issue

There are two approaches with respect to treatment of the flotation costs.

The first approach is to include it in the cost of capital.

This approach has the following two disadvantages:

*It inflates the cost of capital which has impact for all the years, when cash flows are discounted. It has a compounding effect.

*Flotation costs are one time cash outflows and hence should be considered at the time it occurs.

The second approach is to include it along with the initial project cost.

This approach is more rational as it considers the cash outflow on account of flotation cost at the time it occurs.

Further, the cost of capital is not affected by the flotation costs.

For the above reasons, the flotation cost should be included in the initial cost of a project.

2. Tell me the differences between the standard deviation and beta in the measurement of risk in the capital market.

Standard deviation is a measure of the total risk of a security. It includes both systematic and non-systematic risk. It is a measure of the variation in the returns of the security with its average.

Beta is a measure of a security's systematic risk. It is a measure that relates the variation in a security's return in relation to the variation in the market's return. It does not include non-systematic