Flotation Cost

Flotation cost refers to the expenses incurred by a company when it issues new securities. This cost includes both direct expenses like underwriting fees, legal fees, and registration fees, as well as indirect expenses like shifts in share price. Flotation costs are most commonly associated with issuing new equity but can also apply when issuing debt.

Components of Flotation Cost

1. Underwriting Fees:

These fees are paid to investment banks or underwriters who manage the issuance process. Underwriters buy the issued securities from the company and resell them to the public or institutional investors. The underwriting fee is typically a percentage of the total amount raised.

Legal fees cover the cost of regulatory compliance and contract creation. Firms need legal advice to ensure that their issues follow all rules and regulations of the securities market.

3. Registration Fees:

These fees are paid to the Securities and Exchange Commission (SEC) or equivalent regulatory bodies to register the new securities.

4. Marketing and Administrative Costs:

The company may also incur marketing and administrative costs to promote the new issuance and manage the process internally. These costs can include roadshows, marketing materials, and internal labor.

5. Price Impact:

Issuing new equity can result in a temporary decrease in the company’s existing share price. This phenomenon is often referred to as “market impact” or “price dilution.”

Importance in Financial Decisions

Flotation costs are crucial when corporations make financing decisions. Here’s how:

A. Cost of Capital:

The inclusion of flotation costs affects the cost of capital. For example, a higher flotation cost would increase the cost of new equity, thereby making debt financing relatively cheaper. This could also influence the company’s capital structure.

B. Break-even Analysis:

Companies often conduct a break-even analysis incorporating flotation costs to determine how many securities need to be sold to cover these expenses and still meet the fundraising goals.

C. Net Raise Calculation:

The actual amount raised post the issuance is typically less than the gross amount due to flotation costs. Therefore, flotation costs need to be subtracted from the total raise to understand net proceeds accurately.

Formula

The flotation cost ( F ) as a percentage of the amount raised ( A ) can be formulated as:

[ F = \frac{\text{Total Flotation Costs}}{A} ]

For practical purposes when calculating cost of equity or cost of debt, the flotation cost is often included as an adjustment in the denominator.

Example Calculation

Suppose a company plans to issue $1,000,000 in new equity. The various flotation costs are estimated as follows:

Total flotation costs = $85,000

[ F = \frac{85,000}{1,000,000} = 8.5\% ]

Therefore, the flotation cost percentage for this issuance is 8.5%.

Application in Equity and Debt Issues

Equity

Equity issuance often involves higher flotation costs compared to debt. When evaluating a new equity issuance, companies must consider:

Debt

Debt issuance usually has lower flotation costs but involves other considerations like interest rates and debt covenants. When issuing new debt:

Minimizing Flotation Costs

1. Negotiation with Underwriters:

Companies can minimize flotation costs by effectively negotiating terms and fees with underwriters.

Opting for more cost-effective yet compliant legal services can reduce legal expenses.

3. Pre-planning and Efficiency:

Proper planning and efficient execution of the issuance process can minimize administrative and marketing costs.

Real-world Examples

1. Tesla’s Capital Raise:

Tesla Inc. issued approximately $2 billion in new equity in February 2020. Considering the flotation costs, the underlying expenses included underwriting, legal, and marketing fees, significantly impacting the net proceeds.

2. Apple’s Debt Issuance:

Apple Inc. frequently issues bonds to finance its operations. In one of its significant debt offerings, Apple raised $7 billion in 2019. Flotation costs were minimal compared to the equity issuance costs, making debt a more attractive option for the tech giant Apple Inc..

Conclusion

Flotation costs are a fundamental consideration for any company looking to raise new capital. They can significantly affect the net proceeds of the issue, the company’s cost of capital, and ultimately influence strategic financial decisions. Effective management of these costs through careful planning and negotiation can optimize the capital-raising process, allowing companies to achieve their financial goals more efficiently.