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

Definition of floating rate:-when publically traded companies needs to raise funds/ capital from markets then this process cost them in expenses like legal expenses, underwriting charges. It is called floating rate because it’s always variable and related with current interest rates.

And we should expect the flotation costs for debt to be significantly lower than those for equity-yes

Because when companies raise funds through debt, they just need to pay a specific rate interest / tax / commission. It’s always limited and can be calculated before the event.

But in case of equities floating cost is higher because it cannot be predetermined before issue.

May be the underwriting expense may go higher.

Maybe company could not get minimum subscription for issued shares. There is many of uncertain expenses.so we can say debt is cheaper than equity in terms of floating cost.

example:- cost of debt:- tax rate 40%

before tax interest rates:- 5 %

cost of debt:- .05 X (1-.40)=.03=3%

Cost of equity:- increase in share price+ next yr dividend + growth rate of dividend

   current market price of share