Cost of capital with flotation costs.

Introduction

An important role of corporations in the economy is finding and exploiting profitable long-term investment opportunities. Capital budgeting is the decision-making process that corporations use to evaluate potential investment opportunities. A key input to the process is

the opportunity cost of capital. For an investment to add value to a corporation, it must earn a return greater than the cost of capital. The weighted average cost of capital, based upon the theoretical work of Modigliani and Miller (1958, 1963), is the most common method for determining the cost of capital. Under this method the cost of capital is the weighted sum of the costs of the component sources of capital, with the weights chosen to maintain the same capital structure.

The original work by Modigliani and Miller does not consider the flotation costs associated with the sale of new debt or equity. Flotation costs can have a significant effect on the cost of capital, especially for small issues. Based upon information from Securities Data Company New Issue database, Lee et al. (1996) computed the average flotation cost as a percentage of issue size for equity and debt from 1990 to 1994. They determined the average equity flotation cost was 7.1 percent for seasoned issues and 11.0 percent for initial public offerings. For debt issues they determined the average flotation cost was 2.2 percent. The results depended upon the issue size and the credit rating of the issuer. If the issue size was between $2 million and $9.9 million, the flotation cost was 13.8 percent for seasoned equity and 4.5 percent for debt. For seasoned issues over $500 million, the flotation costs declined to 3.2 percent for equity and 1.53 percent for debt.

The two standard methods of adjusting the cost of new equity and debt for flotation costs are not consistent with the Modigliani and Miller framework and active capital structure management. The internal rate of return (IRR) method (see Brigham, 1998; Brigham and Gapenski, 1991; Clark, Hindelang, and Pritchard, 1989; Gitman, 2000; Keown, 1998) uses the same financing weights as weighted average cost of capital. The cost of each component source of capital is the IRR of the source of financing based upon the net proceeds after flotation.

The IRR approach understates the cost of new equity. For example, suppose the constant growth model applies with a dividend growth rate of 9 percent, and a cost of existing equity of 10 percent, and a flotation cost equal to 50 percent of the proceeds of the new issue. (1) If next year's dividend is $1, then the stock price that provides a cost of equity of 10 percent equals $100. The cost of new equity [k.sub.ns] is computed by equating the net proceeds per share, $50, to the present value of the dividend stream, 1/([k.sub.ns] - .09), and solving for the cost of new equity: [k.sub.ns] = 11 percent. The cost of new equity with a flotation cost of 50 percent must be greater than 11 percent.