Explain how to adjust component cost of debt, preferred stock, common stock for flotation costs?

Expert Solution

Flotation cost is the cost incurred when new capital is to be raised. This comprises of underwriting, legal and other costs associated with raising capital. The adjustments are made as follows:
1). Debt - The flotation cost adjustment is made in the issue price of the bond. For example, if the issue price is 100 and flotation cost is 10 then for calculating the YTM (or cost of debt), the price is taken to be 100 - 10 = 90.

2). Preferred stock - Flotation cost adjustment is done in the price of the preferred stock. For example, if preferred stock price is 50 and flotation cost is 10% then for calculating the cost of preferred stock (or dividend yield), price will be taken as 50*(1-10%) = 45.

3). Common stock - Here also, flotation cost is adjusted in the issue price of new equity. For calculating cost of equity, price will be taken as issue price*(1-flotation cost) if flotation cost is given as a percentage of price.

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Explain how to adjust component cost of debt, preferred stock, common stock for flotation costs?

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