Flotation Cost: Meaning, Example, And Why is Relevant for the Firms?

Finance

Introduction

In financial transitions, flotation cost plays a vital role to stabilize the business. Mostly a firm raises capital via debt bonds or loans. In a process of raising capital, a company incurs the capital. The investment bankers charge a fee. The amount of fee varies according to the type and size of the offering.

What Is Meant By Flotation Cost?

When a company offers new securities to the public in this process the total cost incurred by the corporation is called flotation cost. This cost can be a registration fee, underwriting fee, accounting fee, legal fee, and audit fee, etc.

A flotation expense is indicated as a percentage of issue rates as the money is raised after the selling of new stock after the subtraction of flotation value. The final rate of new stock is decreased because of the cost that is incurred in the allocation of new capital, eventually, a low capital is raised.

The debt securities or preferred stock cost is generally smaller than the issuing of common stock. On average the range of flotation cost lies between 2% to 8% in the issuance process of common stock.  The main approach is to deduct the cost from the company cash flow which is used to determine the Net present value.

Relation of Flotation Cost and Cost of Capital

The cost of a capital concept is significantly correlated with flotation costs. It involves the cost of equity and debt. Thus, raising finance through the issuance of new stock or debt would influence the cost of capital.

Calculation of Flotation Cost

The flotation cost of new equity by use of dividend growth rate is calculated as;

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Dividend Growth Rate Equation = D1/P*(1-F) + g

D1: Next Period Dividend

F: Ratio of Flotation Cost to Stock Issue Price

P: One Share Stock Issue Price

G: Dividend Growth Rate

Flotation Cost Example

Consider a company XYZ that issued common stock to raise $700 million in the market. Currently, the rate of stock in the market is $30. 6% of raised capital would be the investment banker’s fee. XYZ company a premium of 3$ per share in the year 2020, and a 15% increase is expected in the year 2021.

Hence, the flotation value is calculated with the help of the above formula. The cost of existing equity is subtracted from the cost of new equity to find out the final flotation cost.

Why Flotation Cost is Relevant for the Firms?

At the time of issuance of equity share, the floatation cost is paid in cash form. These costs are incorporated into the projects of firms that receive at right profitability.

To raise the capital it is adjusted with the cost of capital. It is also the cash outlay of the company project. In the calculation of net present value, it is adjusted with the discounted rate (denominators) or with the cash inflow or outflow.

Advantages of Flotation Cost

 The public corporation gets a range of benefits with the help of flotation cost;

  1. Allows companies to provide employees with additional incentives by offering share options. These incentives boost the motivation and work engagement of workers.
  2. To develop business it grants access to the new capital.
  3. By the use of quoted shares, it provides a significant opportunity for businesses to do an acquisition.  
  4. It enhances the company profile and builds trust amongst the suppliers and customers. 
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Limitations of Using Flotation Cost

Correct use of flotation costs can save the company from financial mismanagement. However, the cons of flotation cost are as below;

  1. The public company is required to fulfill additional regulations and policies and is required to maintain the corporate standard such as transparency & announcement regarding new financial development.
  2. As there is uncertainty in the economy, stock market situation and due to market fluctuation the business may become vulnerable.
  3. In the process of running a company you need to take care of shareholder interest, to gain a return from their capital, sometimes companies may differ from their own goals.
  4. There is a possibility that during the flotation process the managers get distracted from running the business as they are required to deal with investors afterward.
  5. Some analysts believe the firm cost of capital is forever overrated due to ongoing flotation cost expenses.

Conclusion

Floatation cost brings significant outcomes for public businesses when they issue new stock in the market. The financial analysts consider flotation cost investment effective for the companies’ stability and success.

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