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What is a Flotation Cost?

John Lister
John Lister

A flotation cost is one of the costs of raising capital which a business might incur. It is most commonly associated with issuing equity securities such as stocks. In some cases it can also apply with debt securities.

One key flotation cost when issuing stock is the underwriting spread. This involves underwriters who, in this context, guarantee that the company issuing stock will receive a certain amount per share, and thus a certain overall total. In the event that the investing public does not buy all the issued stock at launch, the underwriters will buy and hold any unsold stock.

Man climbing a rope
Man climbing a rope

To compensate underwriters for this risk, the amount the company receives for each share will be lower than the price any public investors pay for the new stock. This is known as the underwriting spread and is effectively the profit margin for the underwriters. It is usually express as a percentage of the total price per share. The underwriting spread can vary significantly from case to case and is largely determined by the total amount being underwritten and an assessment of the likelihood of the public buying the stock at the chosen issue price.

There are several other expenditures which can be classed as a flotation cost when issuing stock. Some of these costs are directly spent, such as any listing fees with the stock market through which the stock is being offered for sale. Others are in the form of internal costs such as the administration involved in the process. Exactly how this type of flotation cost is accounted for can vary. For example, there may be no direct increase in staffing costs during the flotation process, but there may be an opportunity cost in the sense that staff are diverted from other duties.

In most cases, the proportional effects of the flotation cost are smaller when the total value of stock being issued is higher. This is mainly because administration and legal fees tend to be either fixed or have a minimum cost. Another reason for this is that companies offering larger stock issues tend to be more established and thus seen as less risky for investors. In turn, this lowers the risk that the stock will not find buyers, and thus lowers the underwriting spread.

The flotation cost will usually be accounted for when a company looks at the costs of raising capital. This can affect which option makes the most economic sense. For example, in some cases it may appear that issuing stock and having discretion over dividends is a "cheaper" way to raise cash than borrowing from a financial institution and paying interest. After factoring in the flotation cost, the balance between the two options may change.

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