Floatation Costs and Investment Banking

Whenever companies need to raise money by accessing the public markets, they have to use the services of investment banks. This is because investment bankers have a readymade network which they use to sell securities to the general public.

Investment banks are the central character for a company if it needs to go public. It has to use many other intermediaries, such as lawyers and accountants as well. However, investment bankers play the biggest role.

Now, all these intermediaries charge a cost to the firm to help them raise money from the public markets. These costs as called floatation costs.

In this article, we will have a closer look at what floatation costs are and how they impact the capital-raising process.

What are Floatation Costs?

As mentioned above, floatation costs are the cost of floating a public issue. In simple words, it includes all the fees, commissions, and brokerages that are paid to intermediaries such as investment bankers, lawyers, accountants, and anyone else who helps take the company public.

The principles of accounting dictate that when an asset is purchased, the cost of acquiring and installing the asset should also be capitalized. Similarly, when a company undertakes a long term liability, the cost for undertaking the same is also often added to the liability itself.

Let’s understand this with the help of an example.

Let’s say that a company wants to raise $100 million from a public issue. However, in order to do so, they will have to incur an overall cost of 5% of the net issue. This means that in order to receive $100 million of the proceeds, they will have to raise a total of $105 million.

In this example, $105 million is called the gross receipts, $5 million is called the floatation cost, and $100 million is the net proceed to the company.

The net proceeds form a huge portion of the net worth of the company. Hence, in a way, private companies have to pay a percentage of their post-money valuation to the investment banker.

Why do Floatation Costs Vary so Much?

There is no fixed fee for floatation costs. It can vary from as little as 2% of the gross receipts of the issue to as much as 8% of the gross receipts.

Now, as already mentioned above, the gross receipts are huge sums of money. Hence, the difference between 2% and 8% can be millions of dollars. This brings up the question about why floatation costs vary so much amongst different issues.

The floatation costs are a reflection of the assumed difficulty in selling the securities. For instance, if the selling company is well known and already has a positive image, then the floatation costs are low.

On the other hand, if the company is relatively new and investors have no knowledge about the business of the firm, then the floatation costs are high. Hence, floatation costs vary based on several factors such as market timing, the financial performance of the company, the industry to which the company belongs, etc.

Some people believe that the floatation costs of debt are lower as compared to the floatation costs of equity. However, that may not always be the case.

Floatation Costs and Cost of Capital

Floatation costs involve significant amounts of money. Also, the benefit of the money raised accrues for many years. Hence, it would be wrong to expense the costs in the same year. Instead, the costs have to be amortized over a number of years.

However, floatation costs also affect the return on investment. For example, if the company generates $10.5 million from the utilization of $100 million funds, it cannot claim a 10.5% return. This is because the gross amount raised is $105 million. The floatation costs also need to be taken into account, and this reduces the return on equity to 10%.

Companies also have to take floatation costs into account while doing capital budgeting. They do it in one of the two ways:

One of the ways is to include the floatation cost while calculating the weighted average cost of capital. This approach assumes that the floatation costs are affecting the different components of capital in the same proportion as they form part of the total capital.

Also, this calculation does not take into account the fact that floatation costs are a one time expense. They end up unnecessarily inflating the cost of capital in the long run. Viable projects are likely to be rejected if an artificially inflated cost of capital is used in the capital budgeting process.

The other way is to calculate the dollar value of the floatation cost and then reduce it from the net present value, which is calculated as a result of the capital budgeting exercise. This approach is more accurate since it assumes that floatation costs are being paid upfront, which they actually are.

The bottom line is that floatation costs are an important expense for the company raising capital. They are an important source of income for the investment bank. Floatation costs might be the single largest source of income for investment banks all around the world.