Intro to Finance: Cost of Capital - Flotation Costs and Their, Impact on WACC

What This Is

Flotation costs are expenses incurred when a company issues new securities to raise capital. These costs can significantly impact a company's weighted average cost of capital (WACC). For example, assume Apple Inc. issues $1 billion in new debt with a 5% coupon rate and incurs a flotation cost of 2% of the issue price. The effective cost of debt for Apple would be 7% (5% coupon rate + 2% flotation cost).

Key Formulas & Symbols

• WACC = (E/V x Re) + (D/V x Rd x (1 - T)) where WACC = weighted average cost of capital, E = market value of equity, V = total market value of the firm, Re = cost of equity, D = market value of debt, Rd = cost of debt, T = corporate tax rate.
• Cost of Equity = Rf +-× (Rm - Rf) where Cost of Equity = cost of equity, Rf = risk-free rate,-= beta of the stock, Rm = expected market return.
• Cost of Debt = (Coupon Rate + Flotation Cost) / (1 - (1 + Flotation Cost)^(-Years to Maturity)) where Cost of Debt = cost of debt, Coupon Rate = coupon rate of the bond, Flotation Cost = flotation cost of the bond, Years to Maturity = years to maturity of the bond.
• Market Value of Debt = Face Value of Debt x (1 + Coupon Rate)^Years to Maturity / (1 + Flotation Cost)^Years to Maturity where Market Value of Debt = market value of debt, Face Value of Debt = face value of debt, Coupon Rate = coupon rate of the bond, Years to Maturity = years to maturity of the bond.
• Market Value of Equity = Market Capitalization where Market Value of Equity = market value of equity, Market Capitalization = market capitalization of the company.
• Flotation Cost = (Issue Price - Face Value) / Issue Price where Flotation Cost = flotation cost, Issue Price = issue price of the security, Face Value = face value of the security.

Step-by-Step Calculation

1. Determine the market value of debt and equity.
2. Calculate the cost of debt using the formula Cost of Debt = (Coupon Rate + Flotation Cost) / (1 - (1 + Flotation Cost)^(-Years to Maturity)).
3. Calculate the cost of equity using the formula Cost of Equity = Rf +-× (Rm - Rf).
4. Calculate the WACC using the formula WACC = (E/V x Re) + (D/V x Rd x (1 - T)).

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market value instead of book value because market value reflects the current market price of the security.
• Mistake: Confusing IRR and NPV ranking.
• Correction: IRR is the rate at which the NPV of a project is zero, while NPV ranking is the ranking of projects based on their NPV.
• Mistake: Not considering flotation costs when calculating WACC.
• Correction: Flotation costs can significantly impact the cost of debt and, therefore, the WACC.

Exam / CFA Tips

• Tip: Be careful with the formula for WACC, as it can be easily misremembered.
• Tip: Make sure to consider flotation costs when calculating WACC.
• Tip: Be able to calculate the cost of debt and equity using the given formulas.

Quick Practice Problem

Apple Inc. issues $1 billion in new debt with a 5% coupon rate and incurs a flotation cost of 2% of the issue price. What is the effective cost of debt for Apple?

Answer: 7% (5% coupon rate + 2% flotation cost) Explanation: The effective cost of debt is the sum of the coupon rate and the flotation cost.

Last-Minute Cram Sheet

• The flotation cost is a one-time expense and should not be confused with the ongoing interest expense.
• The WACC is a weighted average of the cost of debt and equity.
• The cost of debt is affected by the flotation cost, which can be significant.
• The cost of equity is affected by the beta of the stock.
• The market value of debt is affected by the flotation cost.
• The market value of equity is equal to the market capitalization of the company.
• The WACC is used to discount future cash flows in a discounted cash flow (DCF) analysis.
• The cost of debt is used to calculate the WACC.
• The flotation cost is a sunk cost and should not be confused with the ongoing interest expense.
• The WACC is a critical component of a company's capital structure.