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Welcome back as we wrap up this topic on cost of capital with a discussion on floatation costs.
When a company raises new capital, it generally seeks the assistance of investment bankers.
The investment bankers typically charge flotation fees of between two and seven percent on the amount
of equity capital raised.
Such fees are substantial and should be factored in when a company is evaluating a capital project.
The fees for preferred stock and debt, however, are usually not considered as they are usually quite
insignificant.
So let's say a company is evaluating a $1 million project, which is expected to produce cash receipts
of $400000 per year for the next three years.
The project is to be funded 100 percent through equity issuance and the flotation cost is four and a
half per cent of the equity amount raised.
Recall that the NPV of the project is the present value of all the cash flows discounted by the way
CC of the project.
Since the project is 100 per cent funded by equity, the WCC is therefore just the cost of equity of
the project.
And one of the methods to estimate the cost of equity is the dividend discount approach.
So at which stage of the capital budgeting process should we take care of this floatation cost?
You may want to pause for a while to figure out how you would factor in the floatation cost.
OK, some of you may figure that the solution is to incorporate the flotation costs into the cost of
equity.
So if we specify the flotation cost as a percentage of the share price, this raises the cost of equity
of the project.
In this case, if the company's shares are trading at $129, have an expected dividend of $3 and 21
cents per share next year, and the expected growth rate is seven per.
The cost of equity would be 9.4 nine percent if flotation costs are not considered.
However, if flotation costs are considered, the cost of equity would be 9.6 one percent.
Before we proceed further, let me first state that according to the CFA curriculum, this is an incorrect
approach to incorporate floatation cost into the analysis.
This is because the flotation costs are a cash flow only at the initiation of a project.
Adjusting the cost of equity is incorrect, as it affects the present value of all the future cash flows,
flotation costs are not an ongoing cost to the project.
So I must emphasize, please do not use this method.
Rather, the correct way to account for flotation costs is to adjust the initial project cost when calculating
the NPV.
So if we add the $45000 flotation cost to the NPV equation, we get an NPV of minus 40 $1300.
It's interesting to note that for this project, if we did not factor in the flotation cost, the NPV
would be positive.
And now's your turn to practice.
Kuga Corp has a target capital structure of 70 per cent equity, 30 per cent debt and the after tax
cost of debt of the company is 7.8 per cent..
The company just paid a dividend of two dollars, and its stock is currently priced at $33.
The expected growth rate of the company is six per cent..
Kuga is currently evaluating a $500000 project, which will return $850000 five years later.
Calculate the NPV of the project accounting for the flotation cost of five percent on the amount of
equity raised.
Pause the video now and work out your answer.
And we're back.
Let us start by estimating the cost of equity of the firm using the dividend discount model approach.
We get a cost of equity of twelve point four per cent..
As pointed out earlier, do not incorporate the flotation cost at this stage.
Next, we estimate the ICC of the firm.
Plug in the weights and the respective component costs, and we get a CC of 11 per cent.
Note that the cost of debt is already after tax.
So we do not multiply the marginal tax rate again.
The next step would be to calculate the amount of flotation cost.
The project cost is $500000, but only 70 percent of it is to be funded through equity.
This is why we multiply the target weight of 0.7 here.
Multiply the amount by the five per cent flotation fee, and we get a cost of $7500.
And to calculate the NPV, we subtract this amount from the initial cash flow.
Using the discount rate of 11 percent, we calculated earlier the NPV of the project is minus thirteen
thousand and sixty six dollars.
And that concludes this lesson on floatation cost.
See you at our next topic.