Introductory Corporate Finance: Cost of Capital - Flotation Costs, Adjustment in WACC for New Issues

What This Is

Flotation costs, also known as issuance costs, are expenses incurred when a company issues new securities to raise capital. These costs can include underwriting fees, legal fees, and other expenses associated with the issuance process. For example, let's consider a company like Tesla, which issued $5 billion in new debt in 2020. The flotation costs associated with this issuance might be 2% of the total amount, or $100 million. To accurately calculate Tesla's weighted average cost of capital (WACC), we need to adjust for these flotation costs.

Key Formulas & Models

• WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
  • wd: weight of debt
  • rd: cost of debt
  • T: tax rate
  • wps: weight of preferred stock
  • rps: cost of preferred stock
  • we: weight of equity
  • re: cost of equity
• FC = (Issue Price - Par Value) + Underwriting Fees + Other Issuance Costs – flotation costs; expenses associated with issuing new securities.
  • Issue Price: price at which the new securities are issued
  • Par Value: face value of the new securities
  • Underwriting Fees: fees paid to underwriters for their services
  • Other Issuance Costs: other expenses associated with the issuance process
• Adjusted WACC = WACC + FC / (Issue Price - FC) – adjusted weighted average cost of capital; takes into account flotation costs.
  • Issue Price: price at which the new securities are issued
  • FC: flotation costs
• FC / Issue Price – flotation cost ratio; measures the percentage of the issue price that is spent on flotation costs.
  • Issue Price: price at which the new securities are issued
  • FC: flotation costs
• WACC = wd × rd + wps × rps + we × (re + FC / Issue Price) – adjusted weighted average cost of capital; includes flotation costs in the cost of equity.
  • wd: weight of debt
  • rd: cost of debt
  • wps: weight of preferred stock
  • rps: cost of preferred stock
  • we: weight of equity
  • re: cost of equity
  • FC: flotation costs
  • Issue Price: price at which the new securities are issued
• FC / (Issue Price - FC) – flotation cost adjustment factor; used to adjust the WACC for flotation costs.
  • Issue Price: price at which the new securities are issued
  • FC: flotation costs
• WACC = wd × rd(1?T) + wps × rps + we × (re + FC / Issue Price) × (1 - FC / Issue Price) – adjusted weighted average cost of capital; includes flotation costs in the cost of equity and adjusts for the impact on the cost of equity.
  • wd: weight of debt
  • rd: cost of debt
  • T: tax rate
  • wps: weight of preferred stock
  • rps: cost of preferred stock
  • we: weight of equity
  • re: cost of equity
  • FC: flotation costs
  • Issue Price: price at which the new securities are issued

Step-by-Step Calculation

1. Calculate the flotation costs (FC) associated with the new issuance.
2. Determine the issue price of the new securities.
3. Calculate the adjusted WACC by adding the flotation costs to the WACC and dividing by the issue price minus the flotation costs.
4. Calculate the flotation cost ratio by dividing the flotation costs by the issue price.
5. Adjust the WACC for the flotation costs by adding the flotation costs to the cost of equity and multiplying by the flotation cost adjustment factor.
6. Calculate the adjusted WACC using the adjusted cost of equity.

Common Mistakes

• Mistake: Ignoring flotation costs when calculating WACC.
  • Correction: Include flotation costs in the WACC calculation to accurately reflect the cost of capital.
• Mistake: Using book value instead of market value for WACC.
  • Correction: Use market value instead of book value to reflect the true cost of capital.
• Mistake: Confusing sunk cost with opportunity cost.
  • Correction: Distinguish between sunk costs (already incurred) and opportunity costs (potential future costs).
• Mistake: Not adjusting WACC for flotation costs.
  • Correction: Adjust WACC for flotation costs to accurately reflect the cost of capital.

Exam / CFA Tips

• Tip: Be prepared to calculate WACC with and without flotation costs.
• Tip: Understand the impact of flotation costs on the cost of equity.
• Tip: Be able to distinguish between sunk costs and opportunity costs.
• Tip: Review the formulas and models for calculating WACC and flotation costs.

Quick Practice Problem

A company has EBIT of $10M, interest $2M, tax 25% – compute DFL (debt flotation).

Answer: $0.5M

Explanation: DFL = (Interest x Tax Rate) / (1 - Tax Rate) = ($2M x 0.25) / (1 - 0.25) = $0.5M

Last-Minute Cram Sheet

• WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital.
• FC = (Issue Price - Par Value) + Underwriting Fees + Other Issuance Costs – flotation costs.
• Adjusted WACC = WACC + FC / (Issue Price - FC) – adjusted weighted average cost of capital.
• FC / Issue Price – flotation cost ratio.
• WACC = wd × rd + wps × rps + we × (re + FC / Issue Price) – adjusted weighted average cost of capital.
• FC / (Issue Price - FC) – flotation cost adjustment factor.
• WACC = wd × rd(1?T) + wps × rps + we × (re + FC / Issue Price) × (1 - FC / Issue Price) – adjusted weighted average cost of capital.
• DFL = (Interest x Tax Rate) / (1 - Tax Rate) – debt flotation.
• FC / Issue Price – flotation cost ratio.
• In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.