a. Flotation cost is the cost of raising the new capital. It includes costs such as underwriting fees, legal fees, registration fees, etc. There is also some fee charged by the investment bankers, which depends upon the size and type of issue.
b. The flotation cost for debt and preference shares is usually less than 1%, however, the cost of raising equity could be significant.
c. Flotation cost can be presented as a dollar-cost as well as a percentage cost.
d. The flotation cost, according to some text-books, should be included in the cost of capital. In a dividend discount model, it can be presented as (if the flotation cost is given in $ terms):
Re = [D1 / (P0 – F)] + g
However, if the cost is given in percentage terms, it can be presented as:
Re = [D1 / P0 (1– F)] + g
e. However, if we include the flotation cost to the cost of capital, the resulting discounting rate will not result in the correct value of discounted cash flows. Thus, the flotation cost should not be included in the cost of capital.
Alternatively, the flotation cost should be adjusted in the relevant cash flow. So, when there is a cash outflow in form of the flotation cost, the cash flow should be reduced by the same amount.