Definition
Flotation cost refers to the fee incurred by a company when they issue new securities in order to raise capital. These costs can include underwriting fees, legal fees, and registration fees. In simpler terms, it is the total expense a company has to bear in order to issue new stocks or bonds.
Phonetic
The phonetics of the keyword: Flotation Cost is /floʊˈteɪʃən koʊst/.
Key Takeaways
- Factor in Pricing New Securities: Flotation cost is a fee incurred by a company when it raises new capital. It is an essential consideration in the pricing of new securities since it can significantly impact the cost of the fresh capital acquired.
- Comprises Underwriting and Legal Fees: Flotation costs include underwriting fees paid to banks, legal fees paid for documenting the securities issue, administrative costs, and other associated expenses. These contribute to the overall cost of issuing new securities.
- Affects Net Proceeds: The flotation cost directly reduces the net proceeds from issuing new securities. As a result, the actual amount that a company raises in a new issue is less than the total value of the securities.
Importance
Flotation cost is a crucial concept in business and finance due to its direct impact on the amount of funds a company raises through issuing securities. It refers to the cost incurred by a company in the process of issuing new securities, including underwriting fees, legal fees, and registration fees. These costs reduce the net proceeds and can be substantial, especially in case of large public issues. Therefore, understanding and minimizing flotation costs help increase the net funds received, which can be invested in profitable ventures, ultimately affecting the overall financial health and growth of a company.
Explanation
Flotation cost refers to the cost associated with the issuance of new securities. Despite the specific term being somewhat abstract, it serves a critical operational function in the business world. Essentially, companies often need to raise capital for various endeavours, whether it’s for new projects, expansions, or debt repayments. The procedure of issuing new stocks or bonds is one of the accessible channels to raise this capital. Yet, the process is not executed for free – there are underwriting fees, legal fees, registration fees, and more. These costs collectively are referred to as flotation costs.The primary purpose of calculating flotation costs is to determine the feasibility and effectiveness of raising new capital. Financial advisors and strategists can use these costs to draw comparisons between the costs of issuance and the amount of capital required. It is an integral part of the decision-making process as it helps the executives identify the most efficient way to raise the necessary funds. Notably, if flotation costs are too high compared to other forms of financing, the company may decide against issuing new securities, opting for options like bank loans or internal funding instead. Thus, understanding flotation costs plays a crucial role in arriving at strategically beneficial and economically effective decisions.
Examples
1. Company ABC Issues New Stocks: Suppose Company ABC decides to issue new shares to raise capital for expansion. After consulting an investment bank, they learn that the total cost for legal advisory, underwriting, registration fees, and other costs associated with issuing new shares would account for 5% of the total amount raised. This 5% is the flotation cost, which the company needs to consider while determining how much capital they seek to raise.2. XYZ Corporation’s Bond Issuance: XYZ Corporation wants to issue bonds to investors in order to raise $10 million. After consulting with their financial advisors and underwriting institutions, they estimate that the fees associated with the bond issuance – including legal costs, commissions and printing costs for the bond certificates – will total $200,000. This $200,000 represents the flotation cost, which is a significant factor in XYZ Corporation’s decision-making for the bond issuance.3. Tech Startup’s IPO: A tech startup is planning to launch an Initial Public Offering (IPO) to raise capital for research and development of a new product. They estimate that the costs related to the IPO, including hiring an underwriter, accountant and lawyer fees, marketing, registration costs, and more would be about 7% of the total fund they aim to raise. This 7% is the flotation cost, which gives the startup an idea of the costs and the minimum they’d need to raise from investors to cover the fees and still meet their R&D funding goals.
Frequently Asked Questions(FAQ)
What is Flotation Cost?
Flotation Cost is the expenditure or the total fee involved in issuing new securities. It consists of the cost associated with creating and selling a new issue of common stock or bonds.
Why are Flotation Costs significant in business finance?
Flotation Costs are crucial in business finance as they can influence a company’s funding decisions. By understanding flotation costs, companies can make informed decisions about how and when to generate new securities.
How are Flotation Costs calculated?
Flotation Costs are generally calculated as a percentage of the total amount raised through the issue of new securities. They consist of underwriting and administrative costs, fees for legal, accounting, printing, and so on.
Can Flotation Costs be included in the calculation of cost of capital?
Yes, Flotation Costs can be included in the calculation of the cost of equity. However, it is more common to adjust the cost of capital for flotation costs in project analysis.
Are Flotation Costs tax-deductible?
No, Flotation Costs are not tax-deductible as they are considered capital expenses.
What are the components of Flotation Costs?
Flotation Costs primarily comprise underwriting fees, legal and accounting fees, taxes, promotional activities, such as roadshows and printing fees.
How does Flotation Cost impact the price of new securities?
Any increase in flotation costs results in a decrease in the net proceeds from the security sale, which may require a company to increase the price of new securities to meet its capital requirements.
What is the relationship between Flotation Costs and company size?
Generally, smaller companies face higher Flotation Costs compared to larger companies due to increased uncertainty and associated risks.
Related Finance Terms
- Equity Underwriting: The process of raising capital through the sale of shares, in which an underwriter secures the amount received after covering the flotation costs.
- Initial Public Offering (IPO): The first sale of stock by a private company to the public, often incurring substantial flotation costs.
- Cost of Capital: The cost of a company’s funds (both debt and equity), inclusive of flotation costs, used to finance new projects and investments.
- Optimal Capital Structure: The mix of debt and equity that minimizes the overall cost of capital, taking into consideration the impact of flotation costs.
- Capital Budgeting: The process in which an organization plans and manages its long-term investments, taking into account the implications of flotation costs.
