Question

When a company issues new security, how do flotation costs affect the cost of raising that capital?

Answer 1

Flotation costs are incurred by a publicly-traded company when it issues new securities and incurs expenses, such as underwriting fees, legal fees, and registration fees.

When a company issues new security, Flotation costs increases the cost of capital.

We can understand this by following example:-

As an example, assume Company A needs capital and decides to raise $1000 million in common stock at $100 per share to meet its capital requirements. Investment bankers receive 7% of the funds raised. Company A pays out $10 in dividends per share next year and is expected to increase dividends by 10% the following year.

Using these variables, the cost of new equity is calculated with the following equation:

• ($10 / ($100 * (1-7%)) + 10%

The answer is 20.75%. If the analyst assumes no flotation cost, the answer is the cost of existing equity. The cost of existing equity is calculated with the following formula:

• ($10 / ($100 * (1-0%)) + 10%

The answer is 20.0%. The difference between the cost of new equity and the cost of existing equity is the flotation cost, In other words, the flotation costs increased the cost of the new equity issuance by 0.75%.