What Is a Flotation Cost?
Flotation costs are the fees and expenses a company pays when it issues new securities (usually shares or bonds). Typical items include underwriting fees, legal and accounting fees, printing and registration fees, listing fees, and marketing (roadshow) costs. Flotation costs are normally expressed as a percentage of the gross proceeds from the issue and reduce the net capital the company actually raises.
Key takeaways
– Flotation costs reduce the net proceeds from a security issue and effectively raise the company’s cost of new capital.
– They are usually expressed as a percentage (F) of gross issue proceeds.
– For equity, the cost of new equity (ke,new) is higher than the cost of existing equity (ke) because of flotation costs: ke,new = D1 / [P0(1 − F)] + g.
– Underwriting fees (especially for IPOs) are typically the largest single component; they often range from about 4% to 7% of gross proceeds. (PwC)
– Analysts differ on how to treat flotation costs: incorporate them into WACC, increase hurdle rates, or treat them as an up-front project cost.
What do flotation costs tell you?
– How much less cash the company will realize per dollar raised.
– How much the required return on new equity must increase to compensate for issuance expenses.
– Whether issuing new equity is a cost-effective source of capital compared with debt or alternative financing.
Flotation cost — the formal formula
For an equity issue where dividends grow at a constant rate (Gordon growth model), the cost of new equity including flotation costs is:
ke,new = D1 / [P0 (1 − F)] + g
Where:
– ke,new = required return on new equity (including flotation)
– D1 = expected dividend next period (or cash flow to equity)
– P0 = price per share received in the market (issue price)
– F = flotation cost as a fraction of gross proceeds (e.g., 0.07 for 7%)
– g = expected constant growth rate of dividends
Without flotation costs (existing equity), the standard Gordon model is:
ke = D1 / P0 + g
Example of a flotation cost calculation
Assumptions:
– Issue price P0 = $10 per share
– D1 = $1 dividend next year
– Expected dividend growth g = 10% (0.10)
– Underwriting/flotation fees F = 7% (0.07)
Cost of new equity:
ke,new = 1 / [10 × (1 − 0.07)] + 0.10 = 1 / 9.3 + 0.10 ≈ 0.1075 + 0.10 = 20.75% ≈ 20.7%
Cost of existing equity (no flotation):
ke = 1 / 10 + 0.10 = 0.10 + 0.10 = 20.0%
Flotation cost effect:
Difference = 20.7% − 20.0% = 0.7 percentage points. In other words, the flotation expenses raise the cost of the new equity by 0.7%.
Practical steps for companies considering issuing new equity (checklist)
1. Identify all likely flotation items and estimate amounts:
– Underwriting/placement fees
– Legal, accounting, and audit fees
– Registration and filing fees (SEC or local regulators)
– Listing fees and exchange charges
– Marketing/roadshow costs and printing/prospectus costs
2. Get competitive bids from investment banks and financial advisors:
– Compare structures (firm commitment vs best-efforts vs negotiated) and fee schedules.
– Ask about potential discounts, reduced fees for larger transactions, or staged fee schedules.
3. Consider alternatives and hybrid structures:
– Private placements, rights issues to existing shareholders, convertible debt, short-term bank debt, or staged equity raises may lower costs and dilution.
4. Model the impact on cost of capital:
– Compute ke,new with the flotation-adjusted formula.
– Recompute WACC if the firm’s financing mix will change: WACC = (E/(D+E)) × ke,new + (D/(D+E)) × kd × (1 − Tc), where kd is cost of debt and Tc is tax rate.
– Run sensitivity analysis on F, P0, and market conditions.
5. Adjust project appraisals:
– Treat flotation costs either by increasing the discount rate for projects funded by new equity (using ke,new) or by treating flotation costs as up-front project cash outflows (reduces NPV but avoids permanently inflating cost of capital).
6. Time the issuance:
– Market window matters. Issuing when valuations are high and investor demand is strong reduces relative flotation impact (F in percent terms can be lower or net proceeds higher).
7. Negotiate non-fee terms:
– Negotiate lockup durations, stabilization arrangements, and overallotment (greenshoe) options that can influence net proceeds and aftermarket performance.
8. Document assumptions and disclosure:
– Disclose estimated flotation costs and the basis for adjustments in internal analyses and public filings.
Limitations of using flotation costs
– One-time vs ongoing: Flotation costs are incurred once; treating them as permanently raising WACC overstates long-run cost of capital unless you expect repeated issuance.
– Allocation ambiguity: If a firm raises capital for multiple projects, allocating flotation costs to specific projects can be subjective.
– Market and timing risk: Estimates of F and P0 are uncertain and can change between planning and issuance.
– Hidden costs: Dilution, potential adverse market signaling, and time/management distraction are real but harder to quantify.
– Size and security type matters: Small issues and IPOs typically face higher relative flotation percentages than large seasoned offerings; debt issues often have lower flotation percentages than equity.
Explain flotation costs like I’m 5 years old
Imagine you want to sell lemonade to raise money to buy a new toy. To sell the lemonade at a big fair, you pay a booth fee, buy signs, and ask a helper to sell for you (they take a cut). After paying those costs, you have less money left to put toward the toy. Flotation costs are the fees a company must pay so it can “set up the booth” to sell part of the company (shares) and raise money.
What does “flotation” mean?
Flotation (or “going public” when it’s an IPO) is the act of offering a company’s securities (shares or bonds) to public investors. The process includes preparing filings, marketing the issue, and listing shares on an exchange.
What is the flotation price?
– Flotation price can mean: (a) the issue price at which securities are first sold to the public, or (b) the effective price net of flotation costs (i.e., P0 × (1 − F)). The latter is the price the issuing firm effectively receives per share after paying issuance expenses.
What is the main flotation cost?
– Underwriting fees charged by investment banks are typically the largest single component, especially in IPOs and public offerings. These fees compensate underwriters for underwriting risk, marketing, pricing, and distribution. They commonly range from about 4% to 7% of gross proceeds for many IPOs, though the rate depends on size, complexity, and market conditions. (PwC)
How flotation costs are treated in WACC and project appraisal
– If new equity will finance a project, use ke,new (flotation-adjusted) in your weighted-average cost of capital so the discount rate reflects the higher cost of that funding source.
– An alternative is to use the existing WACC (without flotation) and treat flotation costs as an up-front cash outlay against the project’s initial investment. Both approaches can be defensible — the key is consistency and clear disclosure.
– For firms that rarely issue new equity, many analysts prefer treating flotation costs as a one-time project cost instead of permanently inflating WACC.
The bottom line
Flotation costs are real, quantifiable expenses associated with raising capital. They reduce net proceeds and, for equity issues, increase the effective cost of capital. Companies should estimate all issuance costs up front, compare financing alternatives, and either adjust their cost of new equity/WACC or treat flotation costs as one-time project expenses when appraising investments. Negotiation, timing, and choice of issuance method (public vs private, rights issue vs general offering) can materially affect the percentage cost.
Sources
– Investopedia: “Flotation Cost.” (source URL provided)
– PwC: “Considering an IPO? First, Understand the Costs.” (PwC guidance on IPO costs and underwriting fees)
If you’d like, I can:
– Build a small spreadsheet template to compute ke,new, WACC with and without flotation costs, and project-level NPV comparisons.
– Show examples comparing rights issues, private placements, and bank debt in terms of flotation percentage and dilution.