Flotation costs are the costs incurred by a company in issuing new securities. These costs can be quite substantial depending on the type of security being issued. The term “flotation” comes from the phrase “putting on the market” – just as a boat floats on water, securities are put onto the financial market.
Flotation costs include:
- Underwriting fees: These are fees paid to financial intermediaries, such as investment banks, who help the company issue the securities. They ensure the securities are correctly priced, help with marketing efforts, and often guarantee that all the securities will be sold by purchasing any that aren’t bought by investors.
- Legal fees: Companies must pay legal fees to ensure the issuance complies with all relevant laws and regulations.
- Registration fees: When issuing securities, companies often have to pay fees to regulatory bodies like the Securities and Exchange Commission in the United States.
- Other costs: These might include fees for auditors, consultants, or the costs of printing and distributing prospectuses to potential investors.
Flotation costs are typically expressed as a percentage of the total amount raised in the securities issuance. They can be an important consideration for a company deciding how to raise capital, as they reduce the total amount of funds the company will receive. These costs are often overlooked but can impact the cost of new capital and the decision of capital budgeting.
Example of Floatation Cost
Let’s consider a company that is planning to issue new shares to raise capital for expansion.
The company wants to raise $10 million by issuing new shares. To do this, it hires an investment bank to underwrite the issue. The investment bank charges a fee of 5% of the total amount raised for its services, which includes pricing the shares, marketing them to investors, and guaranteeing the sale of all the shares.
So, the underwriting fees would be $500,000 (5% of $10 million).
In addition to the underwriting fees, the company also incurs legal fees of $100,000 to ensure the share issuance complies with all laws and regulations, registration fees of $50,000 to register the issuance with the relevant regulatory bodies, and other costs of $50,000 for auditing, consulting, printing, and distribution.
The total flotation costs would therefore be $700,000 ($500,000 + $100,000 + $50,000 + $50,000), which is 7% of the total amount the company wanted to raise.
So, the company will only effectively get $9.3 million from the share issuance for its expansion after accounting for the flotation costs. It’s important for the company to factor these costs into its capital-raising decisions, as they can significantly impact the net proceeds from the issuance.