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(15 of 17) Ch.14 - Flotation costs & effect on Net Present Value (NPV): explained - YouTube
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And now let's look at the last slide -- ah,
sorry, at the last topic in chapter 14.
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We've been talking about a firm that raises
money and it costs the firm some percentage
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of that money every year.
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So that's what we call the cost of equity.
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We call it the cost of preferred stock, cost
of debt, which combine what are called weighted
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average cost of capital.
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What we've been ignoring so far is that it
costs money to raise money.
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So, when a firm sells shares of stock or sells
bonds, it's not free to the firm.
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The cost of issuing new equity and new debt
is called flotation costs.
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How should we adjust -- so should we adjust
the weighted average cost of capital upward
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to reflect these additional costs to the firm?
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No.
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That's not the best approach because the required
return on an investment depends one of the
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risks of the investment, not the source of
the funds, not how much it costs.
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Instead where we are going to be making the
adjustments to the flotation costs is the
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initial investment into the project.
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We are going to adjust the initial cost of
the project upwards.
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As a result, because the initial investment
will be higher, the project's net present
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value will go down.
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Let's look at the following example.
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We want to invest $50 million funded by selling
new shares of stock.
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Flotation costs associated with selling these
new stock shares will equal 10%.
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What will be the true cost of our investment
into this new project?
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Solution.
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So, we need to pay -- so it will cost 10%
of the money that we need to pay for, you
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know, some sort of third party that's between
investors who are providing us their money
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and our firm.
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So, there is a third party in between that
will collect 10% of the money that we are
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raising from investors.
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So, we kind of need to add 10% to what we
need, right?
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So, we need 50 million.
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We add 10% of 50 million which is five million.
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And that would give us 55 million.
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Unfortunately, while the D is correct, the
calculations are wrong because think about,
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like, going backwards.
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We raised $55 million worth of money by sharing
additional shares of stock, right?
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And flotation costs of 10% means that 10%
of 55 million will be gone, paid to this third
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party that's helping us go through this issuing
process.
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What's 10% of 55 million?
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It's 5.5 million.
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If you subtract 5.5 million from 55 million
we will be left with 49.5 million.
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But that's not enough for the project.
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We need 50 million.
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So, 55 million worth of new stock shares is
not enough.
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What is enough?
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How do we do the calculations correctly?
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The correct calculations are to follow this
sort of backward approach that I now used
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to show how what we did was wrong.
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So, we sell, you know, some million dollars’
worth of new shares of stock.
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Ten percent of that will be gone.
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So, we multiply that dollar amount by one
minus 0.1 and that should equal exactly $50
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million that we need for our project.
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Let's rearrange it to solve for the unknown.
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The unknown dollar amount that we need to
raise from stock share issues should equal
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$50 million that we actually need for our
project divided by one minus the flotation
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cost of 0.1 in decimals.
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This gives 55.6 million.
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So, 55.6 million is actually just right.
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When we subtract 10% of that we will be left
with exactly 50 million that we need for our
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project.
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To summarize, to calculate the amount that
needs to be raised, we take the initial investment
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that's required for our project and divide
it by one minus the flotation cost where flotation
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costs are either in percent or in decimals.
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So, they are -- this is not a dollar amount.
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This is actually a percentage.
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What if you want to raise money from two or
maybe three different sources?
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So maybe stocks and bonds.
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Or stocks, common stocks and preferred stocks,
and bonds.
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And the flotation cost on the two may be very
different.
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Typically, the flotation cost for stocks is
higher than the flotation cost for bonds.
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It's a lot more complicated process to sell
new shares of stock rather than to sell new
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bonds.
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This is something which is actually covered
in the textbook but the chapter on that is
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not part of this course coverage.
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To figure out the overall flotation cost that
sort of covers several different sources of
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financing, of raising funds, we need to calculate
the so-called weighted average flotation cost
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which we denote by lowercase f and subscript
capital A. So, A basically stands for assets.
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So, fA equals the weight of equity, just like
before where we take the market value of equity
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and divide by the market value of the firm
overall, multiplied by equity's flotation
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cost, f subscript capital E. Then we add the
same thing for preferred stock, weight of
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preferred stock times flotation cost for preferred
stock.
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And then we add the last term for debt, the
weight of debt multiplied by debt's flotation
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cost, f subscript D.
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