Question

Question #4: 1. What are flotation costs? 2. How do they affect the Cost of Capital for Stock and Bonds? 3. What source of Capital are not affected by Flotation Costs?

Answer 1

1) Flotation costs are costs a company incurs when it issues new stock. The costs can be various expenses including, but not limited to, underwriting, legal, registration, and audit fees. Flotation expenses are expressed as a percentage of the issue price.

2) All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation. A firm's WACC increases as the beta and rate of return on equity increase because an increase in WACC denotes a decrease in valuation and an increase in risk

3) Flotation Costs and WACC. While raising new capital, a company incurs cost, which is paid as a fee to the investment bankers. Flotation cost is generally less for debt and preferred issues, and most analysts ignore it while calculating the cost of capital. Flotation costs are the cost a company incurs to issue new stock. Flotation costs make new equity cost more than existing equity. Analysts argue that flotation costs are a one-time expense that should be adjusted out of future cash flows in order to not overstate the cost of capital forever. It is the cost incurred by company to issue bond to investor. These cost are cost of prospectus, merchant banker fees, Credit rating agency fees etc. Flotation cost affects the net proceeds from Bond. For example Company issued 1000 Bonds at the face value of 100 each.