Flotation Costs and the Cost of Capital

To raise the necessary cash for a new project, the firm may need to issue stocks, bonds, or other securities. The costs of issuing these securities to the public can easily amount to 5 percent of funds raised. For example, a firm issuing $100 million in new equity may net only $95 million after incurring the costs of the issue.

Flotation costs involve real money. A new project is less attractive if the firm must spend large sums on issuing new securities. To illustrate, consider a project that will cost $900,000 to install and is expected to generate a level perpetual cash-flow stream of $90,000 a year. At a required rate of return of 10 percent, the project is just barely viable, with an NPV of zero: -$900,000 + $90,000/.10 = 0.

Now suppose that the firm needs to raise equity to pay for the project, and that flotation costs are 10 percent of funds raised. To raise $900,000, the firm actually must sell $1 million of equity. Since the installed project will be worth only $90,000/.10 = $900,000, NPV including flotation costs is actually -$1 million + $900,000 = -$100,000.

In our example, we recognized flotation costs as one of the incremental costs of undertaking the project. But instead of recognizing these costs explicitly, some companies attempt to cope with flotation costs by increasing the cost of capital used to discount project cash flows. By using a higher discount rate, project present value is reduced.

This procedure is flawed on practical as well as theoretical grounds. First, on a purely practical level, it is far easier to account for flotation costs as a negative cash flow than to search for an adjustment to the discount rate that will give the right NPV. Finding the necessary adjustment is easy only when cash flows are level or will grow indefinitely at a constant trend rate. This is almost never the case in practice, however. Of course, there always exists some discount rate that will give the right measure of the project's NPV but this rate could no longer be interpreted as the rate of return available in the capital market for investments with the same risk as the project.

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