While raising new capital, a company incurs cost, which is paid as a fee to the investment bankers.
This fee is referred to as the flotation cost. The amount of fee depends on the size and type of offering.
Flotation cost is generally less for debt and preferred issues, and most analysts ignore it while calculating the cost of capital. However, the flotation cost can be substantial for issue of common stock, and can go as high as 6-8%.
In the investment industry, there are different views about whether flotation costs should be incorporated in the calculation of cost of capital or not.
Including Flotation Cost in Calculating Cost of Capital
If we decide to include the flotation costs in our calculation, then the formula for the cost of equity will be modified as follows:
Where f is the flotation costs expressed as a percentage.
The following details about a company are available with us:
|Current Stock price||$105|
|Current dividend (D0)||$5 per share|
The cost of equity will be calculated as follows:
Many analysts consider this approach inappropriate because flotation cost is actually a cash out flow at the beginning of the project. The project is actually affected as the initial cash flow reduces. What we are doing instead is adjusting the PV of future cash flows by a fixed percentage.
The alternative method is to adjust the cash flows while valuing the project. So, we first calculate the NPV of the project and then deduct the flotation costs from it. This is a preferred method used by most analysts.
This approach was suggested by john R. Ezzell and R. Burr Porter in their paper “Flotation Costs and the Weighted Average Cost of Capital” In this paper they argue that the correct way of treating flotation costs is to deduct it as a part of the valuation.