Correct Treatment of Flotation Costs

Posted in CFA by qmarks on April 3, 2010

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

One Response

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  1. Melita Prati said, on November 9, 2013 at 8:23 pm

    I’m sorry to tell you, but given your boldface and strongly opinionated statement, I will reply in the same manner in telling you quite simply, that you are wrong. Although it is still commonly applied by many analysts (sadly) today, this is because it was taught in CFA circles for years. As a Finance Professor (i.e., Ph.D. in the subject), who instructs MBAs (yes, even some CFAs) on this topic, I can shed light on this method which comes from a paper published in JFQA nearly 40 years ago (1976).

    Let me first say that it’s not an entirely bad method, as WACC adjustments for flotation costs do skew cost of equity estimation. It has strengths and weaknesses like most approaches, but the weaknesses overshadow the strengths. Also, the Gordon growth model you employ in your reference is only one method of Ke estimation and should not be relied on exclusively. In addition, herein lies a related problem … WACC is the cost of capital for the entire firm, not just one project. When most public firms issue new securities, they do so NOT for an individual project, but rather because the CFO/Treasurer has generated a capital budget (with many projects) where additional funds are needed. With a marginal cost curve, WACC will vary depending on budget size, directly stemming from flotation costs incurred with increasing budgets. Moreover, including a financing cost in cash flows violates a fundamental precept in capital budgeting, namely the separation principle — this is the same reason marginal interest payments are excluded in the analysis — it would be double-counting otherwise.

    There’s more, but in any event, your post perpetuates bad information. Do a little research and you’ll find I’m correct. If anyone at the CFA institute is still pushing the old method you suggest, you might ingratiate yourself to remedy the situation.

    — Dr. P

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