Question

What are flotation costs and how do companies make financial decisions based on it?

Answer 1

Floatation costs are costs that a company incurs in offering securities to the public that is when they try to issue new capital. It is less in case of debt and preference capital and more in the case of common equity. These fees are paid to the investment bankers, lawyers and other legal practitioners who advice the firm on legal matters registering shares on exchange. The flotation cost can be substantial for issue of common stock . It is also incorporated in the calculation of the cost of capital.The company decides weather how much capital to raise based on these costs. These costs are higher for larger issues and small for small issues of shares.

Re = D1/ PO(1-F) + G,

in case of preference shares, floatation costs can be incorporated as:

Rp = dp/ p0(1 -f)

where, the price of the preference shares is reduced by the amount of floatation costs.

Financial decisions based on floatation costs:

In the traditional method :

The floatation costs are adjusted in the components of debt, equity and preference capital while calculating WACC. A company can determine the effect of debt and equity on their capital structure by using WACC and adjusting for flotation costs.

but the correct approach to deal with the floatation costs is:

These costs are not incurred during the running of a project, but these costs are the initial cash outflow, and should be added to the cash outflow that happens in year 0.

NPV = - (C0 + FLOATATION COSTS ) + CF1(1+R)^1 +CF2/(1+ R)^2 +...CFN/ (1+R)^N

So, with the correct treatment of floatation costs, we can find put the NPV of a project and take decisions weather to accept or reject it.