What it means
When a company sells new shares or bonds to the public, it cannot do so alone. Investment banks, lawyers, auditors, registrars and the exchange itself all take a cut, and the total of those charges is the flotation cost.
This matters because the charge quietly raises the true cost of the money being raised. If a business pays 6% of gross proceeds to intermediaries, it still owes investors a return on 100% of the capital they handed over while only having 94% of it available to invest in the business.
Finance teams handle the number in one of two ways. Some simply subtract it from the proceeds and record the smaller net figure on the balance sheet, while others adjust the cost of capital upward so that project appraisals reflect the real price of the funding.
The size of the charge varies with the type of security and the size of the deal. Debt issues are usually cheapest, seasoned share issues sit in the middle, and a first-time public offering by a small company is the most expensive because underwriters are taking on more risk and more work.
One nuance is often missed: flotation cost applies only to newly issued securities, never to retained earnings. Profits the company keeps carry no issuance fee at all, which is a big part of why internal funding is usually cheaper than going back to the market.
Investors should also recognise that flotation cost is a one-off, not an ongoing charge. It hits the year of issue, so comparing that year's return on capital with a normal year without adjusting for the fee will make management look worse than it deserves.
In practice
Real-world examples
Example 1
A regional brewery lists on a smaller exchange and raises $25,000,000 gross. After underwriting, legal and listing fees of $2,000,000, only $23,000,000 reaches the company account, and the finance director has to trim the planned bottling line budget to fit.
Example 2
A software firm issues $50,000,000 of bonds and pays $500,000 in issuance costs, or 1%. The treasurer amortises that cost over the eight-year life of the bond rather than expensing it all at once, which spreads the hit across the same years that carry the interest.
Example 3
A family-owned logistics company compares two funding routes for a $6,000,000 depot. Retained profits carry no issuance fee, while a share issue would cost roughly $360,000 in flotation charges, so the board decides to fund the depot internally and delay a dividend increase.
Think of it
Think of selling a house through an estate agent. You might sell the property for 300,000 pounds, but after paying agent fees and legal costs, you do not keep the full amount. Flotation costs are simply the estate agent fees of the corporate finance world.
Formula
Calculation
Net proceeds = Gross proceeds x (1 - Flotation cost rate)
Adjusted cost of new equity = (Next year's dividend / (Share price x (1 - Flotation cost rate))) + Growth rate
A manufacturer raises $10,000,000 by issuing new shares. The underwriting syndicate, lawyers and auditors charge a combined 6% of the gross amount.
Flotation cost = $10,000,000 x 6% = $600,000
Net proceeds = $10,000,000 - $600,000 = $9,400,000
Now the cost of that equity. The shares trade at $40, the company expects to pay a dividend of $2.00 next year, and dividends are growing at 5% a year.
Cost of retained earnings = ($2.00 / $40) + 5% = 5% + 5% = 10%
Effective issue price after fees = $40 x (1 - 0.06) = $37.60
Cost of new equity = ($2.00 / $37.60) + 5% = 5.32% + 5% = 10.32%
The flotation cost adds 0.32 percentage points to the cost of the funding. Any project financed with this issue must clear 10.32%, not 10%, to be worth doing.Case study
Seen in the real world
Northgate Ceramics is a fictional mid-sized tableware maker used here to illustrate how flotation cost changes a funding decision. The board approved a $12,000,000 expansion and assumed a share issue would deliver exactly that amount. When the bankers quoted an all-in fee of 7%, the finance director recalculated: a $12,000,000 gross issue would net only $11,160,000, leaving an $840,000 hole.
The team had two choices, both illustrative of real practice. They could gross up the issue to about $12,900,000 so the net landed near the target, accepting more dilution, or they could shrink the project. They chose to gross up modestly and fund the remaining gap from cash reserves.
The more useful outcome was a change to the appraisal process. Northgate's investment committee now applies a flotation-adjusted cost of capital to any project funded by a new issue, which pushed two marginal proposals below the hurdle rate and out of the plan entirely.
Watch out
Common mistakes
- Treating the headline raise as the cash received. A $10,000,000 issue with 6% costs delivers $9,400,000, and budgets built on the gross figure will fall short.
- Applying flotation cost to retained earnings. Money the company already holds costs nothing to issue, so adding a fee to internally funded projects overstates their hurdle rate.
- Assuming the fee is a fixed percentage regardless of deal size. Underwriting economics mean small issues typically carry a much higher percentage charge than large ones.
Questions
People also ask
Is flotation cost tax deductible?
Treatment varies by jurisdiction, but share issuance costs are commonly charged against equity rather than deducted as an expense, while debt issuance costs are usually amortised against taxable profit over the life of the loan.
Does flotation cost change every year?
No, it is a one-off charge incurred at the moment of issue, although the accounting effect can be spread over several years when the costs relate to a bond.
How large is a typical flotation cost?
For share issues it commonly ranges from about 3% to 10% of gross proceeds depending on deal size and market conditions, with debt issues usually well below that.