Definition
Flotation (Floatation) Cost represents the total expenses that a company incurs when it issues new securities, whether stocks or bonds. These costs are necessary for the company to legally and effectively issue public offerings or raise capital through debt instruments. Flotation costs are usually expressed as a percentage of the total issue size and can vary based on the type of security being issued and the conditions of the market.
Examples
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Stock Issuance:
- A technology company decides to raise $100 million by issuing new shares. The underwriting and legal fees amount to $5 million. Thus, the flotation cost is 5% of the fundraising amount.
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Bond Issuance:
- A utilities company issues $200 million worth of bonds. The associated fees, including underwriting and registration, total $4 million. Hence, the flotation cost is 2% of the bond issue.
Frequently Asked Questions
What constitutes flotation costs?
Flotation costs include underwriting fees, legal fees, registration fees, audit fees, and general expenses related to issuing new securities.
Why are flotation costs important?
They affect the net proceeds from the issuance of securities and can significantly influence a company’s cost of capital.
How are flotation costs accounted for in financial statements?
Typically, flotation costs are deducted from the proceeds of the issue rather than being expensed directly.
Can flotation costs be avoided?
While they cannot be entirely avoided, companies can minimize flotation costs by negotiating better terms with underwriters and other service providers.
Do flotation costs vary between different types of securities?
Yes, flotation costs can vary significantly between issuing stocks and bonds due to different regulatory requirements and underwriting complexities.
Underwriting Fees
The compensation received by underwriters for managing the public issuance and distribution of securities.
Registration Fees
Fees paid to regulatory bodies for the legal authorization to issue new securities.
Cost of Capital
The cost of funds used for financing a business, including debt and equity.
Public Offering
The process of selling new securities to the public in order to raise capital.
Equity Financing
Raising capital through the sale of shares in a company.
Online References
- Investopedia: What are Flotation Costs?
- Corporate Finance Institute: Flotation Costs
Suggested Books for Further Studies
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, Franklin Allen, and Alex Edmans
- “Corporate Finance: The Core” by Jonathan Berk and Peter DeMarzo
- “Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions” by Joshua Rosenbaum and Joshua Pearl
Fundamentals of Flotation (Floatation) Cost: Corporate Finance Basics Quiz
### Why do companies incur flotation costs?
- [ ] To pay dividends to shareholders.
- [x] To issue new stocks or bonds.
- [ ] To settle outstanding debts.
- [ ] To fund internal projects.
> **Explanation:** Companies incur flotation costs as expenses related to issuing new stocks or bonds to raise capital, including underwriting, legal, and registration fees.
### What percentage range typically represents flotation costs for stock issuances?
- [ ] 0.5% - 1%
- [ ] 1% - 2%
- [x] 3% - 5%
- [ ] 10% - 15%
> **Explanation:** Flotation costs for stock issuances typically range from 3% to 5% of the total funds raised due to associated underwriting and legal expenses.
### Are flotation costs considered when calculating a company’s cost of capital?
- [x] Yes
- [ ] No
> **Explanation:** Flotation costs are considered in calculating a company’s cost of capital as they reduce the actual proceeds received from the issuance of securities.
### How can companies minimize flotation costs?
- [x] By negotiating better terms with underwriters and service providers.
- [ ] By avoiding issuing securities altogether.
- [ ] By paying flotation costs after issuance.
- [ ] By issuing securities in a private placement.
> **Explanation:** Companies can minimize flotation costs by negotiating better terms with underwriters and service providers, thereby reducing overall expenses.
### What is underwriting in the context of flotation costs?
- [ ] Auditing of financial records.
- [ ] Legal authorization for issuing securities.
- [ ] Distribution of profits among shareholders.
- [x] Management of public issuance of securities.
> **Explanation:** Underwriting refers to the management of the public issuance and distribution of securities, for which underwriters charge a fee.
### Which type of flotation cost involves fees to regulatory bodies?
- [ ] Underwriting fees
- [x] Registration fees
- [ ] Audit fees
- [ ] Selling commissions
> **Explanation:** Registration fees are paid to regulatory bodies for the legal authorization to issue new securities.
### How do flotation costs affect the proceeds from a securities issuance?
- [x] They reduce the net proceeds received from the issuance.
- [ ] They increase the total funds raised.
- [ ] They have no effect on the proceeds.
- [ ] They are reimbursed by the shareholders.
> **Explanation:** Flotation costs are deducted from the proceeds of a securities issuance, thus reducing the net amount received by the company.
### What is typically higher, flotation costs for stocks or bonds?
- [x] Stocks
- [ ] Bonds
- [ ] They are equal.
- [ ] Depends on the issuing company.
> **Explanation:** Flotation costs for stocks are typically higher due to greater regulatory requirements and underwriting complexities compared to bonds.
### Can flotation costs be recorded as an expense in financial statements?
- [ ] Yes, always recorded as an expense.
- [ ] No, not recorded in financial statements.
- [x] Typically deducted from proceeds.
- [ ] Included in the balance sheet.
> **Explanation:** Flotation costs are usually deducted from the proceeds of the issuance rather than being directly expensed in financial statements.
### What directly affects the size of the flotation cost percentage?
- [ ] The company’s market capitalization.
- [x] The total amount of the securities issuance.
- [ ] The age of the company.
- [ ] The geographic location of the company.
> **Explanation:** The total amount of the securities issuance directly affects the percentage of flotation costs, as larger issues might incur different fee structures.
Thank you for learning about flotation costs and testing your knowledge with our comprehensive quiz. Keep striving to master the essentials of corporate finance!
