What is the flotation cost, and why does it affect new equity issues

The money a business spends when it sells new stocks or bonds to the general public is known as the flotation cost.

Imagine Nitin wants to start a business and needs ₹10,00,000. Instead of taking a loan, he decides to sell shares to investors. But before he can do that, he has to pay different fees:

Below is a table that breaks down different expenses when a company issues new shares:
 

This table helps you see how different fees add up to the total flotation cost.

The money a business makes from selling shares gets reduced by flotation costs. To raise money, Nitin loses ₹95,000. This article explains the flotation cost and its impact on businesses.

Types of Flotation Costs

The fees a business incurs when it sells new bonds or shares to raise money are known as flotation costs. The actual amount of money the company receives from investors is decreased by these expenses.

Let’s understand this with an example:

Dev’s Tech Startup needs ₹5 crore to expand. Instead of taking a loan, he decides to issue new shares. However, before he receives the money, he must pay various fees, which are referred to as flotation costs.

Why Flotation Costs Matter:
 

• They eat into the money Dev’s company receives.
   
• Higher costs mean Dev must sell more shares to get the full ₹5 crore.
   
• Investors also care because these costs affect the actual profit the company earns.

Different Types of Flotation Costs:

Flotation costs can be split into direct costs (visible fees) and indirect costs (hidden expenses).

1. Direct Costs (Easy to See & Measure)

These are fees Dev must pay to banks, lawyers, and regulators.

• Underwriting Fees (Bank Charges): Investment banks assist in the sale of shares and receive a commission.
  • Example: Dev pays ₹25,00,000 to a bank for managing the share sale.

• Legal & Compliance Fees (Lawyer Charges): Lawyers ensure that rules are followed.
  • Example: Dev spends ₹8,00,000 on legal paperwork.

• Registration Fees (Government Charges): Paid to regulators like SEBI for approval.
  • Example: ₹3,00,000 for SEBI registration.

• Audit & Accounting Fees (Financial Check Costs): Auditors verify company's finances.
  • Example: ₹5,00,000 for audit reports.

• Printing & Marketing (Promotion Costs): Printing prospectuses and investor meetings.
  • Example: ₹4,00,000 on brochures and roadshows.

2. Indirect Costs (Hidden or Lost Opportunities)

These don’t appear on bills but still affect Dev’s company.

• Underpricing of Shares: Shares may be sold at a discount to attract buyers.
  • Example: Instead of ₹100/share, Dev sells at ₹95, losing ₹5 per share.

• Management Time & Effort: The Dev team spends months on IPO preparation instead of focusing on business growth.

• Market Reaction: The issuance of too many new shares can temporarily lower the stock price.

Flotation Costs Breakdown for Dev’s Startup:

Here’s a table showing how much Dev pays in flotation costs when raising ₹5 crore:
 

This table helps you see how different fees add up, leaving Dev with only ₹4.55 crore (₹5 crore - ₹45,00,000) for his business.

Flotation costs reduce the amount of money a company earns from selling shares. Fees cost Dev almost 10% of his ₹5 crore. Businesses can choose to issue shares or explore alternative funding sources, such as loans, by being aware of these expenses.

Why Do Flotation Costs Affect New Equity Issues?

When a company issues new shares, the actual amount of money it receives is decreased by flotation costs. Compared to other funding options, equity financing is more costly and less attractive due to these additional costs.

Let’s understand this with Devam’s Bakery, which wants to expand and needs ₹2 crore. Instead of borrowing, Devam decides to issue new shares. However, before receiving the money, he must pay flotation costs, which eat into his funding.

Key Reasons Flotation Costs Matter

Flotation costs reduce the amount of equity capital raised, making it more expensive than debt.
 

• They lower the net amount received from share sales
   
• Increase the effective cost of raising equity
   
• May force companies to issue more shares than planned
   
• Make debt financing (like loans) relatively cheaper

High flotation costs favour debt financing over equity for capital raising purposes.

How Flotation Costs Impact Devam’s Bakery:

Here’s a breakdown of costs when Devam raises ₹2 crore:
 

After paying these fees, Devam only gets ₹1.8 crore (₹2 crore - ₹20,00,000) for his bakery expansion, 10% less than he intended to raise.

Why This Hurts New Equity Issues:

Flotation costs increase capital hurdles, dilution risk, and make debt appealing.
 

1. Higher Effective Cost
   • Devam must generate higher returns to justify the reduced capital
      
2. Ownership Dilution
   • He might need to sell more shares to compensate for lost funds
      
3. Alternative Financing Becomes Attractive
   • A bank loan at 12% interest might now look more attractive than incurring a 10% loss due to flotation costs.

Costs push Devam towards debt to preserve ownership and returns.

This table shows how flotation costs carefully reduce a company's funding. Every ₹10 raised for Devam turns into ₹9 after fees. Knowing this enables investors to determine the actual share value and helps businesses make more informed funding decisions.

Conclusion

In simple terms, flotation costs significantly reduce the amount of money companies raise through new share issues. Similar to how Devam's Bakery lost 10% of its capital due to fees, every company must deal with this unmentioned expense when issuing stock. 

These expenses make share sales more costly than they appear, which often forces businesses to seek alternative options, such as loans. The company receives less funding for expansion, which could impact future earnings for investors. 

Businesses and investors can make better financial decisions by knowing flotation costs, whether they are deciding how to finance expansion or checking a company's actual capacity for fundraising.

FAQs

What exactly gets included in flotation costs?

Think of it like the extra charges when selling shares, bank fees for handling the sale, lawyer bills for paperwork, government registration costs, and even marketing expenses to attract investors.

Do companies always pay these costs?

Yes, every time a business issues new shares to the public, these fees come into play. The amount varies; big companies often pay a smaller percentage than smaller ones.

How does this affect me as an investor?

When companies incur flotation costs, they have less money left for actual business growth. This could result in slower expansion or lower profits in the future.

Are there ways to avoid these costs?

Companies can't altogether avoid them, but they can reduce costs by negotiating with banks, conducting private share sales to large investors, or utilising profits instead of issuing new shares.

Why don't we hear more about these costs?

They're often buried in financial reports as "issuance expenses." Most investors focus on the big numbers, like the total money raised, rather than what was subtracted along the way.

Do these costs make shares cheaper to buy?

Not directly, while companies get less money, your share price depends more on market demand. But heavy flotation costs might make the company slightly less valuable overall.

How much do these costs usually cost?

For a typical IPO, expect 5-10% of the total amount raised. So, for every ₹100 crore a company wants, ₹5-10 crore might vanish in fees.

Can these costs change over time?

When markets are hot and investors are eager, banks charge less. During slow periods, these fees often go up as banks take on more risk.

Who ultimately pays for these costs?

In the long run, it's the company and its shareholders, either through reduced growth funds or by needing to sell more shares than initially planned.

Are flotation costs tax-deductible?

Sometimes yes, but rules vary by country. Companies usually can't deduct the full amount immediately; they often have to spread it over several years.

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