When it comes to issuing new securities, flotation costs play a major role. It’s important to understand how much capital they will be able to raise from those new securities and how much it will cost them to do so.
It’s an important factor that helps businesses determine if issuing new securities is a viable option for them. By understanding how it works, businesses can make informed decisions and plan accordingly for the future.
What are Flotation Costs?
Flotation costs are the expenses businesses face when they decide to issue new shares to raise money – these costs include fees for legal advice, paperwork (like registration and audit fees), and paying the financial experts who help sell the shares, known as underwriters.
These costs are taken from the price at which the shares are sold, meaning the business ends up with less money than initially expected.
To balance how much money should come from selling shares versus borrowing, businesses often work out their average cost of getting capital through a method called weighted average cost of capital (WACC).
Some experts believe flotation costs shouldn’t keep being counted in future costs because they’re only paid once. Leaving them out helps avoid making it look like it costs more for the business to get money in the long run.
How Flotation Costs Work
When a company issues new stock, it incurs costs such as underwriting, legal, registration, and audit fees, known as flotation costs – these expenses, expressed as a percentage of the issue price, reduce the total capital raised.
For example, if a company aims to raise $1 million but faces 5% flotation costs, it will actually receive $950,000 ($1,000,000 – 5% of $1,000,000).
This reduced capital can influence the company’s financial decisions. Moreover, analysts argue that these one-time expenses should be adjusted out of future cash flows to avoid overestimating the cost of capital in the long term.
Formula For Calculating Flotation Costs
Here is the formula for calculating the flotation costs using dividend growth rate
D1 / {P x (1 – F)} + G
Where,
D1 = Next year’s dividend
P = Current stock price
F = Flotation cost percentage
G = Constant growth rate of dividends
Example of Calculating Flotation Costs
Let’s say a company expects to issue new stock at $20 per share with flotation costs of 5%. The expected dividend next year is $1. If the constant growth rate of dividends is 3%, we can calculate the flotation costs as:
$1 / {$20 x (1 – 0.05)} + 0.03 = $1.05 / {$19} + 0.03 = 0.0553 or 5.53%
So, the company’s flotation costs for issuing new stock at $20 per share would be 5.53%.
Conclusion
It’s important for businesses to understand how flotation costs work because it can affect their long-term financial decisions. By factoring in these expenses, companies can make more informed decisions regarding issuing new stock and accurately calculate their cost of capital. This can result in better financial management for the business in the long run.
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