Custom Search

Flotation Costs and the Cost of Capital

To raise the necessary cash for a new project, the firm may need to issue stocks, bonds, or other securities. The costs of issuing these securities to the public can easily amount to 5 percent of funds raised. For example, a firm issuing $100 million in new equity may net only $95 million after incurring the costs of the issue.

Flotation costs involve real money. A new project is less attractive if the firm must spend large sums on issuing new securities. To illustrate, consider a project that will cost $900,000 to install and is expected to generate a level perpetual cash-flow stream of $90,000 a year. At a required rate of return of 10 percent, the project is just barely viable, with an NPV of zero: Ј$900,000 + $90,000/.10 = 0.

Now suppose that the firm needs to raise equity to pay for the project, and that flotation costs are 10 percent of funds raised. To raise $900,000, the firm actually must sell $1 million of equity. Since the installed project will be worth only $90,000/.10 = $900,000, NPV including flotation costs is actually Ј$1 million + $900,000 = Ј$100,000.

In our example, we recognized flotation costs as one of the incremental costs of undertaking the project. But instead of recognizing these costs explicitly, some companies attempt to cope with flotation costs by increasing the cost of capital used to discount project cash flows. By using a higher discount rate, project present value is reduced.

This procedure is flawed on practical as well as theoretical grounds. First, on a purely practical level, it is far easier to account for flotation costs as a negative cash flow than to search for an adjustment to the discount rate that will give the right NPV. Finding the necessary adjustment is easy only when cash flows are level or will grow indefinitely at a constant trend rate. This is almost never the case in practice, however. Of course, there always exists some discount rate that will give the right measure of the project`s NPV, but this rate could no longer be interpreted as the rate of return available in the capital market for investments with the same risk as the project.

The cost of capital depends only on interest rates, taxes, and the risk of the project. Flotation costs should be treated as incremental (negative) cash flows; they do not increase the required rate of return.

Summary

Why do firms compute weighted-average costs of capital?

They need a standard discount rate for average-risk projects. An ¬average-risk ­ project is one that has the same risk as the firm`s existing assets and operations.

What about projects that are not average?

The weighted-average cost of capital can still be used as a benchmark. The benchmark is adjusted up for unusually risky projects and down for unusually safe ones.

How do firms compute weighted-average costs of capital?

Here`s the WACC formula one more time:

WACC = rdebt ГЧ (1 Ј Tc) ГЧ D/V + requity ГЧ E/V

The WACC is the expected rate of return on the portfolio of debt and equity securities issued by the firm. The required rate of return on each security is weighted by its proportion of the firm`s total market value (not book value). Since interest payments reduce the firm`s income tax bill, the required rate of return on debt is measured after tax, as rdebt ГЧ (1 Ј Tc). This WACC formula is usually written assuming the firm`s capital structure includes just two classes of securities, debt and equity. If there is another class, say preferred stock, the formula expands to include it. In other words, we would estimate rpreferred, the rate of return demanded by preferred stockholders, determine P/V, the fraction of market value accounted for by preferred, and add rpreferred ГЧ P/V to the equation. Of course the weights in the WACC formula always add up to 1.0. In this case D/V + P/V + E/V = 1.0.

How are the costs of debt and equity calculated?

The cost of debt (rdebt) is the market interest rate demanded by bondholders. In other words, it is the rate that the company would pay on new debt issued to finance its investment projects. The cost of preferred (rpreferred) is just the preferred dividend divided by the market price of a preferred share.

The tricky part is estimating the cost of equity (requity), the expected rate of return on the firm`s shares. Financial managers use the capital asset pricing model to estimate expected return. But for mature, steady-growth companies, it can also make sense to use the constantgrowth dividend discount model. Remember, estimates of expected return are less reliable for a single firm`s stock than for a sample of comparable-risk firms. Therefore, some managers also consider WACCs calculated for industries.

What happens when capital structure changes?

The rates of return on debt and equity will change. For example, increasing the debt ratio will increase the risk borne by both debt and equity investors and cause them to demand higher returns. However, this does not necessarily mean that the overall WACC will increase, because more weight is put on the cost of debt, which is less than the cost of equity. In fact, if we ignore taxes, the overall cost of capital will stay constant as the fractions of debt and equity change.

Should WACC be adjusted for the costs of issuing securities to finance a project?

No. If acceptance of a project would require the firm to issue securities, the flotation costs of the issue should be added to the investment required for the project. This reduces project NPV dollar for dollar. There is no need to adjust WACC.