When a company raises new capital, it generally seeks the assistance of investment bankers. Investment bankers charge the company a fee based on the size and type of offering. This fee is referred to as the flotation cost. In the case of debt and preferred stock, we do not usually incorporate flotation costs in the estimated cost of capital because the amount of these costs is quite small, often less than 1 percent.39
However, with equity issuance, the flotation costs may be substantial, so we should consider these when estimating the cost of external equity capital. For example, Inmoo Lee, Scott Lochhead, Jay Ritter, and Quanshui Zhao observe average flotation costs for new equity in the United States of 7.11 percent.40 The flotation costs in other countries differ from the U.S. experience: Thomas Buhner and Christoph Kaserer observe flotation costs around 1.65 percent in Germany, Seth Armitage estimates an average issuance cost of 5.78 percent in the United Kingdom, and Christoph Kaserer and Fabian Steiner observe an average cost of 4.53 for Swiss capital offerings.41 A large part of the differences in costs among these studies is likely attributed to the type of offering; cash underwritten offers, typical in the United States, are generally more expensive than rights offerings, which are common in Europe.
Should we incorporate flotation costs into the cost of capital? There are two views on this topic. One view, which you can find often in textbooks, is to incorporate the flotation costs into the cost of capital. The other view is that flotation costs should not be included in the cost of capital but, rather, incorporated into any valuation analysis as an additional cost of the project.
Consistent with the first view, we can specify flotation costs in monetary terms, as an amount per share or as a percentage of the share price. With flotation costs in monetary terms on a per share basis, F, the cost of external equity is
As a percentage applied against the price per share, the cost of external equity is r. =
where /is the flotation cost as a percentage of the issue price.
Suppose a company has a current dividend of $2 per share, a current price of $40 per share, and an expected growth rate of 5 percent. The cost of internally generated equity would be 10.25 percent:
re = f --I + 0.05 = 0.0525 + 0.05 = 0.1025, or 10.25 percent
39 We can incorporate them for these sources by simply treating the flotation costs as an outlay, hence reducing proceeds from the source.
40 Inmoo Lee, Scott Lochhead, Jay R. Ritter, and Quanshui Zhao, "The Costs of Raising Capital," Journal of Financial Research, Vol. 19 (Spring, 1996), pp. 59-71.
41 Thomas Bühner and Christoph Kaserer, "External Financing Costs and Economies of Scale in Investment Banking: The Case of Seasoned Equity Offerings in Germany," European Financial Management, Vol. 9 (June 2002), pp. 249; Seth Armitage, "The Direct Costs of UK Rights Issues and Open Offers," European Financial Management, Vol. 6 (2000), pp. 57-68; Christoph Kaserer and Fabian Steiner, "The Cost of Raising Capital—New Evidence from Seasoned Equity Offerings in Switzerland," Technische Universität München working paper (February 2004).
If the flotation costs are 4 percent of the issuance, the cost of externally generated equity would be slightly higher at 10.469 percent:
The problem with this approach is that the flotation costs are a cash flow at the initiation of the project and affect the value of any project by reducing the initial cash flow. Adjusting the cost of capital for flotation costs is incorrect because by doing so, we are adjusting the present value of the future cash flows by a fixed percentage—in the above example, a difference of 22 basis points, which does not necessarily equate to the present value of the flotation costs.42
The alternative and recommended approach is to make the adjustment to the cash flows in the valuation computation. For example, consider a project that requires a €60,000 initial cash outlay and is expected to produce cash flows of €10,000 each year for 10 years. Suppose the company's marginal tax rate is 40 percent and that the before-tax cost of debt is 5 percent. Furthermore, suppose that the company's dividend next period is €1, the current price of the stock is €20, and the expected growth rate is 5 percent so that the cost of equity using the dividend discount model is (€l/€20) + 0.05 = 0.10 or 10 percent. Assume the company will finance the project with 40 percent debt and 60 percent equity. Table 6 summarizes the information on the component costs of capital.
TABLE 6 After-Tax Costs of Debt and Equity
Source of Capital
Proportion Marginal After-Tax Cost
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