Flotation costs are the service charges that an investment banker or a book runner charges when new security is issued to the public.
Companies can raise capital by two means, equity issues and bond issue. The finance committee of the firm decides and what proportion capital should be raised. Weighted average cost of capital is used to determine the proportion of capital and the cost of capital of each form of issue. In issuing equity, the obligation of paying back is obsolete, but the cost of new common stock is high and provides no tax benefits. Issuing fixed securities are of lower cost but, huge part of the operating cash flow is taken away for interest payments after the tax deduction.
Flotation costs include legal fees, auditing and accounting fees and the fee charged by the stock exchange for the new share to be traded. The flotation cost of the firm is computed as a percentage of the total capital raised from the round and are used in absolute terms while calculating present value of the project being financed.
In the old days of investment banking flotation costs in terms of percentage has been added to the discount rate of the issue, the project. This has been a misconception since the origin of external capital raised and the present value of the project is flawed by using flotation cost in terms of percentage.
How to calculate flotation cost:
In the method of calculating NPV of a project which is externally financed,
Capital raised Equity- $100,000, Cost of new common stock – 10%, Bond- $200,000, Cost of new debt – 6%, Tax rate – 30%
Weighted average cost of capital (Cost of new capital, assuming no prior external financing) – 6.1%
Flotation cost- $5,000 (1.66%)
Discounted rate – 6.1 + 1.66 = 7.76% NPV= $198,633.
This way of computing Present value or the Internal Rate of Return of the project gives a false image of the value, because floatation cost is a one time expense which is to be deducted from the capital raised, that is, in absolute terms. $295,000 is the initial outlay and ($300,000-$5000 = $295,000) and the discount rate should be 6.1%. This gives a true value of the project as $196,107.