Question

In at least 200 words, what are flotation Costs. how and why are they used, and why are they important?

Answer 1

Flotation costs are incurred by a publicly traded company/ Public company when it issues new securities, and includes expenses such as underwriting fees, legal fees, registration fees and other government fees etc. Flotation costs are also important in calculating a company's cost of new equity. Flotation costs make new equity cost more than existing equity.  Flotation costs depend on the size and riskiness of an issue as well as on the type of security to be sold.

It is incurred not just for stocks but also for other sources of raising capital like bonds and debentures. Usually, the cost of issuing equity stock is higher. In case of Debt and preferred stock, it is mostly less than 1%. It is an unavoidable cost incurred in an effort to raise capital for a new project or for business functioning. They are generally expressed as a percentage of an issue price.

Flotation costs are considered while evaluating 2 different projects and selecting one.  It is a cost that has to be incorporated into the project/projects of the company to arrive at the right profitability. Flotation cost can be seen in different ways, one is as a cost of raising capital and thus adjust it with cost of capital or other is to see it as a cash outlay.