Correct Treatment of Flotation Costs
Flotation costs are the fees charged by investment bankers when a company raises external equity capital and they can be often amount to between 2% and 7% of the total amount of equity capital raised, depending on the type of offering.
Many non-CFA people incorporate the flotation costs directly into the cost of capital by increasing the cost of external equity. For example if a company has a dividend of $1.50 per share, a current price of $30 per share and expected growth rate of 6%, the cost of equity without flotation costs would be:
Price = Expected Dividend for Next Year / Cost of Equity – Expected Growth Rate
$30 = $1.5* ( 1+ 0.06) / (Cost of Equity – 6%)
Cost of equity is 11.30%
and if we incorporate the flotation costs of 4.5% directly into the cost of equity computation, the cost of equity increases ;
$30 * (1- 0.045) = $1.5 * (1+ 0.06) / (Cost of Equity – 0.06)
Cost of equity is then, 11.55%
That is the wrong approach!
In the calculation above, we just saw that flotation costs effectively increase the WACC by a fixed percentage and will be a factor for the duration of the project because the future project cash flows are discounted at this higher WACC to determine the project NPV.
The problem with this approach is that flotation costs are not an ongoing expense for the firm.
Flotation costs are cash outflows that occurs at the initiation of a project and affect the project NPV by increasing the initial cash outflow. Therefore, the correct way to account for flotation costs is to adjust the initial project costs.
An analyst should calculate the dollar amount of the flotation cost attributable to the project and increase the initial cash outflow for the project.
Source: CFA Notes