Chapter 13.6

Chapter 13.6 - 11/15/11 IEB Wireframe Page 389 13.6...

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11/15/11 IEB Wireframe 1/3 Page 389 13.6 Flotation Costs and the Weighted Average Cost of Capital 13.± Flotation Costs and the Weighted Average Cost of Capital So far, we have not included issue costs in our discussion of the weighted average cost of capital. When projects are funded by stocks and bonds, the firm will incur these costs, which are commonly called floWaWion coVWV . Sometimes it is suggested that the firm's WACC should be adjusted upward to reflect flotation costs. This is really not the best approach because the required return on an investment depends on the risk of the investment, not the source of the funds. This is not to say that flotation costs should be ignored. Since these costs arise as a consequence of the decision to undertake a project, they are relevant cash flows. We therefore briefly discuss how to include them in project analysis. The Basic Approach We start with a simple case. The Spatt Company, an all-equity firm, has a cost of equity of 20 percent. Because this firm is 100 percent equity, its WACC and its cost of equity are the same. Spatt is contemplating a large- scale $100 million expansion of its existing operations. The expansion would be funded by selling new stock. Based on conversations with its investment banker, Spatt believes its flotation costs will run 10 percent of the amount issued. This means that Spatt's proceeds from the equity sale will be only 90 percent of the amount sold. When flotation costs are considered, what is the cost of the expansion? Spatt needs to sell enough equity to raise $100 million afWeU covering the flotation costs. In other words Spatt's flotation costs are thus $11.11 million, and the true cost of the expansion is $111.11 million, including flotation costs.
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This note was uploaded on 01/04/2012 for the course ACTSC 372 taught by Professor Maryhardy during the Fall '09 term at Waterloo.

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Chapter 13.6 - 11/15/11 IEB Wireframe Page 389 13.6...

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