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What Is a Flotation Cost?
Let me explain flotation costs directly: these are the expenses a publicly traded company faces when issuing new securities, including underwriting fees, legal fees, and registration fees. You need to consider how these fees affect the capital raised from a new issue. They tie into the expected return on equity, dividend payments, and the percentage of earnings retained, all part of calculating a company’s cost of new equity.
Key Takeaways
- Flotation costs are what a company pays when issuing new stock.
- These include underwriting, legal, registration, and audit fees.
- Expressed as a percentage of the issue price, they reduce the capital raised.
- Companies use weighted average cost of capital (WACC) to decide on equity versus debt funding.
- Some analysts view flotation costs as one-time and adjust them out of future cash flows to avoid overstating capital costs.
What Do Flotation Costs Tell You?
Companies raise capital through debt like bonds and loans or through equity. Some prefer debt when interest rates are low, since interest is tax-deductible, unlike equity returns. Equity's main advantage is no repayment required, but it means giving up ownership, and the process is costly.
Flotation costs come with issuing new equity, covering investment banking, legal, accounting, audit, and stock exchange listing fees. The flotation cost is the difference between existing and new equity costs, expressed as a percentage of the issue price, reducing the final price and capital raised.
Remember, flotation costs are a percentage of the issue price. Companies often calculate weighted average cost of capital (WACC) to balance equity and debt funding.
Flotation Cost Formula
Here's the formula for flotation cost of new equity using dividend growth rate: Dividend growth rate = D1 / (P * (1 - F)) + g, where D1 is next period's dividend, P is the stock issue price, F is the flotation cost ratio to issue price, and g is the dividend growth rate.
Example of a Flotation Cost Calculation
Take Company A raising $100 million in common stock at $10 per share. Investment bankers take 7% of funds. It pays $1 dividend per share next year, expected to grow 10% the following year.
Cost of new equity: ($1 / ($10 * (1-7%))) + 10% = 20.7%. Without flotation cost: ($1 / ($10 * (1-0%))) + 10% = 20.0%. The difference is 0.7%, showing flotation costs increased new equity cost by 0.7%.
Limitations of Using Flotation Costs
Some analysts argue including flotation costs in equity cost implies they're ongoing, overstating capital costs forever. Actually, they're one-time upon issuance, so adjust cash flows accordingly.
Explain Flotation Costs Like I’m 5 Years Old
Flotation costs are fees a company pays to get money for growth, incurred when issuing new stock and facing related expenses.
What Does Flotation Mean?
In finance, flotation means selling shares to the public for the first time. Floating shares lets the public buy ownership units, a way to raise expansion money.
What Is the Flotation Price?
The flotation price is where shares first sell to the public, or it can mean costs to issue securities publicly.
What Is the Main Flotation Cost?
Underwriting fees from investment banks are usually the biggest for IPOs. They handle the process, prepare documents, market, set prices, and buy shares to sell, getting 4% to 7% of proceeds.
The Bottom Line
Issuing new securities costs money, with expenses like underwriting, legal, registration, and audit fees known as flotation costs, reducing raised capital. These are a percentage of issue price, varying by security type, issue size, and risks. Companies predict costs to check if it's the best funding way.
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