What is a 'Flotation Cost'
Flotation costs are incurred by a publicly traded company when it issues new securities, and includes expenses such as underwriting fees, legal fees and registration fees. Companies must consider the impact these fees will have on how much capital they can raise from a new issue. Flotation costs, expected return on equity, dividend payments and the percentage of earnings the company expects to retain are all part of the equation to calculate a company's cost of new equity.
BREAKING DOWN 'Flotation Cost'Companies raise capital in two ways: bonds and loans or equity. Some companies prefer issuing bonds or obtaining a loan, especially when interest rates are low. Other companies prefer equity because it does not need to be paid back. That said, there is a significant cost of equity, especially new equity. The cost of new equity, or newly issued common stock, includes the costs associated with raising new equity, such as investment banking and legal fees. The difference between the cost of equity and the cost of new equity is the flotation cost. The flotation cost is a percentage of the issue price and is incorporated into the price with a reduction.
Calculating the Cost of Float in New Equity
The equation for calculating the cost of new equity using the dividend growth rate is:
(Dividend / (Price * (1-Flotation Cost) ) + Growth Rate
Dividend = the dividend in the next period
Price = the issue price of one share of stock
Flotation Cost = the ratio of flotation cost to the price
Growth Rate = the dividend growth rate.
As an example, assume company A needs capital and decides to raise $100 million in common stock at $10 per share to meet its capital requirements. Investment bankers receive 7% of the funds raised. Company A pays out $1 in dividends per share next year and is expected to increase dividends by 10% the following year.
Using these variables, the cost of new equity is calculated with the following equation: ($1 / ($10 * (1-7%)) + 10%. The answer is 20.7%.
If the analyst assumes no flotation cost, the answer is the cost of existing equity.
The cost of existing equity is calculated with the following formula: ($1 / ($10 * (1-0%)) + 10%. The answer is 20%.
The difference between the cost of new equity and the cost of existing equity is the flotation cost, which is 0.7%. In other words, the flotation costs increased the cost of the new equity issuance by 0.7%.