How to Calculate Flotation Costs

When a publicly traded company issues new securities, such as stock, it hopes to profit from the investors who purchase these securities. But the company incurs certain fees just by issuing securities. These fees are collectively called flotation costs, which are mathematically expressed as a percentage of the security's issue price. Although the actual flotation costs vary among different companies, calculating these costs follows the same path.

No two companies have the same flotation cost totals when they issue new securities because these fees represent various expenses that are company-specific. Common fee categories, however, include legal fees, registration fees, audit fees and underwriting fees. A company must also pay a fee to a stock exchange to list its new shares.

Because these fees can drive up the cost of new shares, which directly impacts how much capital a company can raise when it issues the shares, flotation costs are an essential part of the equation that determines the total cost a company fronts to issue new shares. Generally, flotation costs represent the difference between the cost of a company's existing equity and the cost of its new equity.

Because of the variance in specific flotation cost fees from company to company, there's no across-the-board fixed amount for this monetary outlay. Flotation costs depend on numerous factors, which include a company's size, the investment risks and the specific type of securities that will be issued. Common stock typically carries higher issuing costs than those for preferred stock or debt securities. Flotation costs for issuing common shares typically fall in the range of 2 percent to 8 percent of the final price of the newly issued securities.

A company's total cost of capital represents the smallest rate of return a company must make before generating a profit. Flotation costs impact a company's total capital costs because the total of these fees increases the total capital costs and impacts the price of new securities. Companies recoup their flotation costs either by including the costs in the security's issuing price or by absorbing these costs into their future cash flows.

If a company decides to incorporate flotation costs into its calculation of capital costs, it first uses a cost of equity calculator to determine the amount of its equity before adjusting the issuing price of its new securities. Its current share price, represented by P₀ in the following equation, is adjusted by the flotation costs, represented by "f."

The cost of equity calculation before adjusting for flotation costs is:

r_e = (D₁ / P₀) + g, where "r_e " represents the cost of equity, "D₁" represents dividends per share after 1 year, "P₀" represents the current share price and "g" represents the growth rate of dividends.

The cost of equity calculation after adjusting for flotation costs is:

r_e = D₁ / [P₀(1 - f)] + g

In the above equation, the only different factor from the previous equation is "f," which represents flotation costs, expressed as a percentage.

Because flotation costs are one-time, nonrecurring fees, using the flotation costs calculator to determine a company's price for new securities typically casts a skewed view of the company's long-term capital cost. Many financial analysts agree that flotation costs should be absorbed into future cash flows instead of considered as a factor for newly issued securities costs. This way, a company's capital costs are not overstated by nonrecurring flotation costs fees.