Definition
Flotation cost refers to the cost incurred by a company when issuing new securities. These expenses may include underwriting fees, legal fees, and registration fees. Essentially, this term describes the cost of raising additional capital to facilitate the company’s growth or other business objectives.
Key Takeaways
- Flotation cost is the cost associated with the issue of new securities. It includes expenses like underwriting fees, legal fees, and registration fees. It is an essential aspect to consider during the installment of financial plans.
- The flotation cost is usually expressed as a percentage of the total issue cost. It can impact the cost of capital and is therefore an important element in calculations for project evaluations and decisions about funding options.
- Despite its importance, flotation cost is often neglected in the calculation of the cost of capital because it is a one-time expense and tends to be relatively small compared to the total cost. However, it may become significant when a company issues new securities frequently.
Importance
The finance term: Flotation Cost is important because it refers to the cost that a company incurs when it issues new securities to the public market.
This cost is significant as it directly impacts the pricing of new shares, and consequently, the amount of money that a company can raise from a security issuance.
Essentially, flotation costs encompass expenses related to underwriting, legal and accounting fees, and other components associated with the issuance, like printing and advertising.
Lower flotation costs means a company can create additional equity at a cheaper rate and it can incentivize them to issue more securities, possibly leading to expansion and growth.
Hence, a solid understanding of flotation costs can help a company to strategically plan its financing approach.
Explanation
Flotation cost is an essential term in corporate finance, playing a significant role in a company’s financial decision-making process. Primarily, flotation costs are the costs incurred by a company when issuing new securities, such as stocks or bonds, to raise capital.
These costs, which may include underwriting, legal, and registration fees, among other expenditures, influence the company’s choice of financing method for its projects or expansions. Essentially, the aim is to understand the total cost of financing and consequently, ascertain the feasibility and financial viability of taking on a new project or expanding operations.
Moreover, flotation costs are considered when a company estimates new capital’s net present value (NPV). This critical financial measure helps the company decide whether a particular project or expansion is likely to generate sufficient returns to cover its costs, including flotation costs. Therefore, the understanding and estimation of these costs are crucial for investors and financial managers to determine the true costs and potential returns of an investment, thereby guiding their investment and financing decisions.
Ignoring flotation costs may lead to an overestimation of a project’s potential returns. Therefore, these costs provide a more realistic picture of the financial outcomes of an investment decision, ensuring better risk management and fostering informed decision-making.
Examples of Flotation Cost
Initial Public Offering (IPO): When a private company decides to go public and list its shares on the stock exchange for the first time, the process involves various legal, accounting, and underwriting services. All these expenses constitute the flotation cost. For instance, in 2012 when Facebook went public, their flotation costs included fees for lawyers, accountants, and underwriters – reportedly costing them hundreds of millions of dollars.
Issuing Bonds: When corporations or governments need to raise funds, they may choose to issue bonds. The cost associated with this process is the flotation cost. For example, a corporation may have to pay for credit ratings for the bond, legal services, underwriting services, and registration – all contributing to the flotation cost.
Rights Issue: A company may want to raise additional equity capital without going to the public. In this case, they can provide existing shareholders with the right but not the obligation to buy more shares at a discount. The associated administrative and underwriting costs are again classified as flotation costs. An example of this could be when a company like British Airways decides to issue rights to their investors to raise capital for fleet expansion or other business growth plans.
FAQs on Flotation Cost
What is a Flotation Cost?
Flotation cost is the total cost that a company incurs while issuing new securities. It includes expenses such as underwriting fees, legal fees, and registration fees.
Why are Flotation Costs significant in finance?
Flotation costs are critical because they reduce the proceeds from the issuance of new securities, affecting the cost of new equity and/or the weighted average capital cost. These costs are important for companies to estimate before issuing new shares.
How are Flotation Costs calculated?
Flotation costs are generally calculated as a percentage of the total issue cost. For example, if a company plans to raise $5 million from an issue and the flotation costs are 4%, the actual cost to the company would be $200,000.
Does Flotation Cost affect the cost of equity?
Yes, Flotation Costs do affect the cost of equity. When new shares are issued, the Flotation costs increase the cost of the new equity after considering the expenses attached to the issuance of these new shares.
Is Flotation Cost a capital expenditure?
No, Flotation Costs are not a capital expenditure. These costs are associated with the process of raising additional capital and are considered as expense against the issue of securities. These costs are not used for generating future benefits.
Related Entrepreneurship Terms
- Capital Raising: This is the process of sourcing funds to finance a new project or investment. It is intrinsically connected to flotation cost as it’s a significant cost involved when a company raises new capital.
- Initial Public Offering (IPO): This refers to the first sale of stock by a company to the public. The flotation cost plays a major part in an IPO as it covers the cost of issuing these new shares.
- Underwriting: This refers to the process where investment banks raise investment capital from investors on behalf of corporations and governments that are issuing securities. The underwriting fees contribute to the total flotation cost.
- Cost of Capital: In finance, it’s the return a company needs in order to take on a capital project, such as purchasing new equipment or building a new factory. Flotation costs can affect the cost of capital by increasing the cost of issuing new securities.
- Secondary Market: This is the market where investors buy and sell securities they already own. Flotation costs are primarily associated with the primary market where new securities are issued.
Sources for More Information
- Investopedia – An extensive learning resource that provides definitions, examples, and analyses of financial concepts.
- Corporate Finance Institute – A professional certification organization providing financial modeling and valuation analyst certification programs.
- Khan Academy – Offers practice exercises, instructional videos, and a personalized learning dashboard for self-paced learning in finance and other fields.
- The Balance – Provides clear, practical advice to help you understand and navigate personal finance topics.
