Flotation Costs

Flotation Costs

The฀process฀of฀selling฀new฀issues฀of฀securities฀(e.g.,฀bonds,฀preferred฀stock,฀and฀common฀stock)฀to฀raise฀ capital is commonly referred to as floating a new issue, and its costs are referred to as flotation costs.

Selling securities is a complicated process that generally involves a great deal of the time of corpo- rate฀officers฀and฀the฀services฀of฀an฀outside฀investment฀banker.฀Investment฀bankers฀serve฀as฀intermediaries฀ between฀firms฀issuing฀securities฀and฀the฀public฀and฀other฀buyers,฀and฀they฀are฀paid฀handsome฀fees฀for฀ their services. Their services generally include:

•฀ Forming฀the฀underwriting฀syndicate฀to฀sell฀the฀securities •฀ Preparing฀the฀registration฀statement฀for฀the฀Securities฀and฀Exchange฀Commission฀(SEC) •฀ Acting฀as฀a฀consultant฀to฀the฀issuing฀firm,฀with฀advice฀on฀the฀pricing฀of฀the฀issue฀and฀its฀timing.

Flotation฀costs฀must฀be฀added฀to฀the฀component฀cost฀of฀capital฀to฀give฀a฀correct฀value฀for฀the฀cost฀ of capital. The most common method for adding flotation costs is termed the cost of capital adjustment technique. This method calculates the net amount the company receives from the sale of the securities by฀decreasing฀the฀market฀price฀for฀the฀new฀securities฀by฀their฀floatation฀costs.

When฀flotation฀costs฀are฀included,฀equations฀9.2,฀9.4,฀and฀9.6฀are฀revised฀to฀the฀following,฀where฀f is฀the฀flotation฀cost฀and฀the฀other฀variables฀are฀as฀defined฀before: For฀the฀pre-tax฀cost฀of฀new฀debt฀with฀the฀flotation฀cost฀f included,

FV

V f Pmt  −= (

Cost of Capital ❧ 307 For฀the฀cost฀of฀new฀preferred฀equity฀with฀the฀flotation฀cost฀f included,

For฀the฀cost฀of฀new฀common฀equity฀with฀the฀flotation฀cost฀f included,

Example 9.8:฀ The฀Holdberg฀Corporation฀must฀raise฀$1฀million฀to฀finance฀the฀remodeling฀of฀its฀corporate฀ headquarters.฀It฀plans฀to฀do฀this฀by฀increasing฀the฀number฀of฀shares฀of฀preferred฀and฀common฀stock฀and฀by฀issu- ing฀15-year฀corporate฀bonds฀with฀a฀face฀value฀of฀$1000฀and฀annual฀payments฀at฀a฀coupon฀rate฀of฀9.0฀percent.

The฀ corporation’s฀ long-term฀ debt฀ currently฀ amounts฀ to฀ 20,000฀ corporate฀ bonds฀ with฀ a฀ current฀ market฀ value฀of฀$910.00/bond.฀The฀corporation฀has฀50,000฀shares฀of฀preferred฀stock฀outstanding฀with฀a฀market฀value฀of฀ $125.00/share. The corporation also has 1,500,000 outstanding shares of common stock with a current market value of $45.00/share.

Holders of preferred stock receive annual dividends of $10/share, and holders of common stock receive annual dividends of $4.00/share. The annual growth rate of common stock is 5 percent.

Flotation฀costs฀are฀1฀percent฀for฀bonds,฀2฀percent฀for฀preferred฀stock,฀and฀4.5฀percent฀for฀common฀stock. Holdberg’s฀tax฀rate฀is฀40฀percent. What฀is฀the฀weighted฀average฀cost฀of฀capital?

Solution:฀ Figure฀9-12฀is฀a฀spreadsheet฀solution.฀Total฀market฀value฀is฀calculated฀as฀before—that฀is,฀by฀multi- plying฀the฀number฀of฀bonds฀or฀shares฀by฀their฀current฀market฀values.฀The฀percentage฀of฀the฀total฀market฀value฀ for฀each฀component฀and฀the฀amount฀of฀capital฀to฀be฀raised฀by฀each฀component฀are฀also฀calculated฀as฀before.

Figure฀9-12

WACC with Flotation Costs

Example 9.8: HOLDBERG CORPORATION, COST OF CAPITAL BASED ON MARKET VALUE WITH

1 FLOTATION COSTS ADDED

Number of

Current Market

Percentage of

Amount of

Capital to be 2 Source of Funds

Bonds or

Value, per Bond

Total Market

Total Market

Raised After-Tax Cost 3 Bonds (i.e., Borrowing)

Shares

or Share

Value

Value

197,934 6.20% 4 Preferred Stock

67,972 8.16% 5 Common Equity

12.63% 7 Additional Bond Data

8 Tax Rate

WACC

9 Coupon Rate

10 Face Value

Key Cell Entries

11 Years to Maturity 15 D3: =B3*C3, copy to D4:D5 12 Flotation Cost

D6: =SUM(D3:D5)

E3: =D3/$D$6, copy to E4:E5 14 Dividend, $/share

13 Additional Preferred Stock Data

E6: =SUM(E3:E5)

15 Flotation Cost

F3: =$F$6*E3, copy to F4:F5

G3: =RATE(B11,B9*B10,–C3*(1–B12),B10)*(1–B8) 17 Dividend, $/share

16 Additional Common Equity Data

G4: =B14/(C4*(1–B15))

18 Annual Growth Rate

G5: =(B17*(1+B18))/(C5*(1–B19))+B18 19 Flotation Cost

G6: =SUMPRODUCT(E3:E5,G3:G5)

308 ❧ Corporate Financial Analysis with Microsoft Excel ®

The฀after-tax฀cost฀of฀the฀bonds฀is฀calculated฀by฀using฀Excel’s฀RATE฀function฀to฀calculate฀the฀pre-tax฀cost฀ and฀then฀multiplying฀the฀pre-tax฀cost฀by฀1฀minus฀the฀tax฀rate.฀This฀is฀done฀by฀the฀following฀entry฀in฀Cell฀G3:฀ =RATE(B11,B9*B10,-C3*(1-B12),B10)*(1-B8).

The฀after-tax฀cost฀of฀preferred฀and฀common฀equity฀is฀closely฀approximated฀by฀their฀pre-tax฀values.฀These฀ are฀calculated฀by฀the฀entry฀=B14/(C4*(1-B15))฀in฀Cell฀G4฀for฀the฀cost฀of฀preferred฀equity฀and฀by฀the฀entry฀ (B17*(1+B18))/(C5*(1-B19))+B18฀in฀Cell฀G5฀for฀the฀cost฀of฀common฀equity.

The฀WACC฀is฀calculated฀in฀Cell฀G6฀by฀the฀entry฀=SUMPRODUCT(E3:E5,G3:G5).฀The฀result฀is฀the฀ value 12.63 percent.