(16 of 17) Ch.14 - Flotation costs: 2 examples - YouTube

Let's look at the following example.

A company wants to invest $15 million into a new project.

Eighty percent will be raised through new equity.

Twenty percent will be raised through new debt.

Flotation costs on equity are 10%.

Flotation costs on debt are 5%.

Two questions: what is the weighted average flotation cost and what is the true investment

needed for this new project?

To answer the first question, we need to use the weighted average flotation cost formula.

Because we are only raising money from two sources -- equity and debt -- there is no

preferred stock part in the weighted average flotation cost formula.

So, we just have the weight of equity times the flotation cost of equity plus the weight

of debt times the flotation cost of debt.

Plugging in the numbers, we have 0.8 times 0.10 plus 0.2 times 0.05 which gives 0.09

or a 9% overall flotation cost.

So whatever money we raise by selling common stock shares and bonds, 9% of that will be

gone.

It will be paid to some third party as a fee for helping us go through this process of

issuing the new financial securities.

Now let's answer the second question: what is the true investment that's needed?

Using the formula from one of the earlier slides, we need to take $15 million which

is what the investment requires us to spend upfront and divide it by one minus the weighted

average flotation cost, 0.09.

This gives $54.95 million.

What different step do proportions of money coming from new equity or new debt are not

80% and 20% but equal proportions, 50% and 50%?

Which part of our calculations for the two questions would be updated?

Well, the weights come up in the calculation of the weighted average flotation cost.

So, where we have 0.8 and 0.2, we will now have 0.5 and 0.5.

And that will change our weighted average flotation cost from 0.09 to 0.075.

So, because we will have less of the more expensive type of financing, the overall flotation

cost will drop.

And that's exactly what we see from our calculations.

And then the new flotation cost will affect the true initial investment for our investment

project.

We will now divide 15 million by one minus 0.075 which will give us 54.05.

So, it won't cost us as much to start the new project when the financing of the -- when

the flotation costs for the new financing for this project will become relatively cheaper.

Let's look at the following example.

A project requires $50 million in initial costs.

So, we are actually using the same numbers as on the previous slide.

Eighty percent will be raised from new equity and 20% will be raised from new bonds.

The flotation cost for equity is 10%.

The flotation cost for bonds is 5%, just like on the last slide.

What else do we know?

The investment project is expected to generate $32 million for two years.

So, it's a two-year project.

We also know that the pre-tax cost of debt to the firm is 8% per year and the cost of

equity for the firm is 14% per year.

We also know that the company faces a corporate income tax rate of 34%.

Is the project worth it?

Let's calculate the project's net present value.

Let's do it the wrong way and the correct way, the wrong way being ignoring flotation

costs completely.

Like, we don't know anything about them.

We don't know what those are.

And the right way will be with the flotation costs.

The first step to calculating the project's net present value is finding its discount

rate.

We are going to use the weighted average cost of capital formula for the discount rate.

Of course, this assumes -- by using the firm's WACC we are assuming that we are --

So plugging in the numbers, the weight of equity is 0.8.

The cost of equity is 0.14.

The weight of debt is 0.2.

The pretax cost of debt is 0.08.

And we then multiply the pretax cost of debt by one minus 0.34.

By the way, in some numerical problems, you are given the tax rate and you are given the

after-tax cost of debt.

This is a trick.

If you are given the after-tax cost of debt, then you are given RD times one minus TC.

So, you don't need to then multiply it again by one minus TC because that's already done

in the number you're given for the after-tax cost of debt.

So, keep that in mind.

Read the wording carefully.

The weighted average cost of capital gives 0.12256.

If you ignore the flotation costs, then we would then use the initial investment of $50

million for this project.

If you do not ignore the flotation costs, we would realize that $50 million is not going

to be the true cost of this project because it needs to be kind of adjusted up for the

flotation costs, the cost of raising money.

The overall flotation cost when the money comes from two sources -- new equity and new

bonds -- we will calculate it by taking the weight of equity, 0.8, just like the weight

we used in the WACC formula.

So, notice how we use it two times for two different things.

The weight of equity, 0.8, is then multiplied by the flotation cost of equity which is given,

10% or 0.1 in decimals.

Then we add the weight of debt, 0.2, multiplied by the flotation cost of debt, 5% or 0.05

in decimals which gives us 0.09.

So, 9% of the money that we raise will be paid to the third party helping us go through

this issuing process and what's left will be exactly $50 million that we need for the

project.

So how much extra do we need to raise to make up for the 9% flotation cost?

That's calculating the true initial investment.

Fifty million that we needed divided by one minus the overall flotation cost.

Fifty million divided by one minus 0.09 gives $54.95 million.

So, if you ignore the flotation costs, then the net present value would equal minus 50

million plus the first year's cashflow, $32 million, discounted using the WACC as the

discount rate, so divided by one plus 0.12256.

And then we add the second year's cashflow, another $32 million, discounted that by two

years using the WACC as the discount rate, so divided by one plus 0.12256 squared.

And that will give us $3.9 million.

And we would say that because the number is above zero, the project should be accepted.

It's worth it.

However, the mistake here is using -- Fifty million dollars for the initial investment.

That's too little.

The cost is actually higher when the flotation costs are considered.

The true year zero cashflow is negative $54.95 million.

And that will change the true net present value for our project to negative $1.05 million.

Because it's negative, the correct decision regarding this project should be rejecting

it.

The project is not worth it.

So, you see how ignoring or not ignoring flotation costs may make a difference between accepting

a project and rejecting it.

So, flotation costs are very important.

Too high flotation costs may result in a too high initial investment which will make the

net present value negative.

If we ignore flotation costs, we may mistakenly get a positive NPV.

So, we may mistakenly accept a project which, in fact, should be rejected.