Question

how do issue/flotation costs affect the cost of capital?

Answer 1

When the companies raise new capital, they pay certain amount to the investment bankers as a fee. This cost that the companies pay to investment bankers is referred to as floation cost.
Companies consider weighted average cost of capital (WACC) in capital budgeting. Weighted average cost of capital will have both equity and debt components.
When flotation cost is involved, the company that issues new equity gets a certain part of the investor's capital and the remaining goes to the investment bankers.
The formula to calculate cost of equity including flotation cost is given by:
Cost of equity from new stock including flotation cost=[D1/P0*(1-F)]+g

D1 refers to the stock dividend that is expected to be paid in one year.
D1=D0*(1+g) where D0 is the current dividend.
F= Flotation cost per share expressed in percentage
G is the growth rate

Let us take an example for better understanding,
Suppose current stock price P0=$100
Current dividend D0=$5 per share
Growth rate (g)=5%
Flotation cost=4%
Now, cost of equity from new stock including flotation cost=[$5*(1+5%)/100*(1-4%)]+5%=[$5*(1.05)/100*(1-.04)]+0.05
=[$5*(1.05)/$100*(0.96)]+0.05=$5.25/$96 +0.05=0.0546875+0.05=0.1046875 or 10.47% (rounded upto two decimal places)

Suppose that there is no flotation cost. So, F=0
Taking current stock price P0=$100
Current dividend D0=$5 per share
Growth rate (g)=5%
Flotation cost=0
The equation [D1/P0*(1-F)]+g becomes:
[$5*(1+5%)/100*(1-0%)]+5%=[$5*(1.05)/100*(1)]+5%=$5.25/$100+0.05=0.0525+0.05=0.1025 or 10.25%

With flotation cost, cost of equity=10.47%
Without flotation cost, cost of equity=10.25%

So, when we include the flotation costs, the cost of capital increases.