Question

Define the term: Flotation Costs. Should we expect the flotation costs for debt to be significantly lower than those for equity? Why or why not? Please support your answer using supporting information from the chapters in this unit and the course. Do you agree with the positions taken by your classmates? Can you provide counterpoints or insight as to why they may want to reconsider their view of expected flotation costs?

Answer 1

Flotation cost refers to the cost of raising new Finance. Whenever a company raises more finance from any source it entails a cost such as cost of issuing prospectus, Commission paid, underwriting cost etc.such cost should be taken into account for computing the cost of capital.

Flotation cost of debt is lower than the cost of equity. This is because raising equity requires many legal formalities which result in higher cost of raising equity. There are various costs involved in raising equity such as legal fees, cost of issuing the prospectus, registration cost and underwriting cost. Moreover equity is sold in smaller amounts to various investors imposing higher transaction costs where is debt is issued in large amounts mostly to institutional investors.

I agree with the position taken by the others when they consider floatation cost for debt to be significantly lesser than that of equity. I do not agree with the position taken that the flotation cost for debt is higher than that of equity due to the reasons outlined above.

(If there is a specific student position that requires response, it may be posted in the comments and I will answer it)