Cost of new equity with flotation costs

What are flotation costs ?

Flotation costs are a one-time cost incurred by company in the raising capital for a new business venture or project. They could be incurred in the issue of common stock, preferred stock, debenture stock or any other security being used to raise capital. Flotation costs include but are not limited to registration fees, legal fees, audit fees, stock market fee, underwriting commission, investment banking costs etc.,

Flotation costs increase the cost of equity and decrease the net amount raised in the issue.

 

What is the Cost of new equity with flotation costs ?

An issue of equity capital entails certain flotation costs. These flotation costs are sometimes included as a part of the cost of equity capital issued. Cost of new equity is the cost of new issue of common stock adjusted for flotation costs incurred. 

Cost of equity is usually arrived at using the dividend capitalization model. In this model, it is assumed that the company will pay dividend. The issue price of the common stock is adjusted for the flotation cost. The flotation cost is usually set as a percentage of amount of newly issued common stock.

 

What is the formula for calculating the cost of equity without flotation costs ?

As per the dividend capitalization model the cost of equity ( without floatation cost ) is

re = ( D1 /  P0 )  + g

where

re = Cost of equity  ;   D1 = Expected Dividend payable at end of the year 1  ;  

g = Constant growth rate   ;   P0  = Current price of the Common stock ; 

 

What is the formula for calculating the cost of new equity with flotation costs ?

Building on the above formula and incorporating flotation costs, the cost of new equity with flotation costs is calculated as follows :

re = [ ( D1 / ( P0 * ( 1 – f ) ) ] + g

where

re = Cost of new equity  ;   D1 = Expected Dividend payable at end of the year 1  ;  

g = Constant growth rate   ;   P0  = Current price of the Common stock ;  f = Flotation costs  ;

 

Example :

The common stock of Cash rich Co. is presently trading at $ 42.00 a share. It promises to pay an annual dividend of $ 4.00 a share at the end of the year D1 . The constant growth is expected to be 10 % a year. If the company issued new stock, it would incur a 18 % flotation cost. Calculate the cost of equity from new stock.

Solution :

The formula for calculating the cost of equity with flotation costs is

re = [ ( D1 / ( P0 * ( 1 – f ) ) ] + g

 

As per the information given in the question we have

D1 = $ 4.00  ;   g = 10 % = 0.10  ;   P0 = $ 42   ;   f = 18 % = 0.18  ;

 

Applying the above information in the formula we have cost of equity as

= [ $ 4.00 / ( $ 42 * ( 1 – 0.18 ) ) ] + 0.10

= [ $ 4.00 / ( $ 42 * 0.82 ) ] + 0.10

= [ $ 4.00 / $ 34.44 ] + 0.10

= 0.116144 + 0.10

= 0.216144

= 21.6144 %

= 21.61 %  ( when rounded off to two decimal places )

Thus the cost of equity with flotation costs when new common stock is issued = 21.61 %

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