Flotation costs refer to the costs associated with issuing new securities, particularly the costs to issue new stocks or bonds. These costs are incurred by a company when it raises new capital and can include fees such as underwriting fees, legal fees, registration fees, and more.
The underwriting fees are usually paid to banks or other financial institutions for managing the issuance of new securities. Legal fees are necessary to ensure the new issuance complies with all relevant laws and regulations. Registration fees are paid to securities regulators for listing the new shares or bonds.
Other flotation costs might include auditing fees, consultancy fees, or the costs of producing, marketing, and distributing prospectuses to potential investors. The total flotation costs are usually a small percentage of the total amount of capital being raised.
Flotation costs can be substantial and are an important consideration when a company decides between issuing debt, issuing equity, or using internal financing. They can also impact the pricing and potential success of a new security issuance.
Example of Flotation Costs
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.