 Flotation cost is very much critical for every listed company because the treatment of flotation cost may have an effect upon the overall cost of capital for the listed company. The treatment of flotation cost can also have a significant effect upon the value of a project. A project's future cash flows are discounted at the project's overall cost of capital. So, what is the flotation cost? By flotation cost, we mean the amount paid to investment bankers by a company upon its external public issue. This means whenever a company issues to the public some financial instruments like bonds, preferred stock or common stock, it gets some financial consultancy on this issue from investment banks or other financial analysts. Now, the consultancy fee paid to these investment bankers and financial analysts is termed as flotation cost for the company. The amount of this flotation cost is based on the size of the issue and the type of the offer whether it is bond or debt, whether it is a preferred stock or whether it is the common stock. The treatment of flotation cost can be ignored with reference to the debt issue or the preferred stock because the amount of flotation cost on these issues is very much insignificant in relation to the amount of the overall issue. But the treatment of flotation cost cannot be ignored with reference to the external issuance of the common equity because the amount of flotation cost is much significant in relation to the amount of the overall common issue. Now question arises should the flotation cost be incorporated into the cost of externally generated equity? There are two views on this question. The first view says yes it should be incorporated into the cost of externally generated equity. The second view is that there is no need to go for this treatment but the cost can be incorporated into the valuation analysis as the project's additional cost. Now flotation cost can be specified as an amount per share when we need to determine the return on equity or the cost of equity. You see in this model that the expected dividend, current price per share and the flotation cost all are the in terms of absolute value per share or this flotation cost can be incorporated into the cost of equity as the percentage of the share price in the model. You can see that here is the dividend per share, the current market price per share and this one is the overall proceed of the issue and the small f is the percentage of the flotation cost of the overall share price. Let's take an example, the growth rate of PLC is 5% with the current dividend and price of $2 and $40 per share respectively. Now how to calculate its cost of internally generated equity? We have a dividend discount model putting the value into this discount model. We have an expected dividend which will be grow at 5%. So we need to multiply the current dividend of 2 with 1.05. Then we need to divide this with the current market price of the share which is $40 per share. This ratio will give the dividend yield and we need to add this dividend yield to the growth rate of the company. Then solving this equation will give the cost of internally generated equity which is 10.25%. Now using this data, let's assume we have flotation cost of 4%, then how the externally generated equity would cost to the firm? Using these data, let's behave an expected dividend at the same value of 2 into 1.05. We need to divide this with the current price which is $40 and we will multiply this $40 with the remaining proceed. This means that we issue a share let's say for $1 incurring a flotation cost of 4%. This means we have net proceed of 96%. Now multiplying this net proceed of 96% with the $40 of the share price will give the adjusted dividend yield When we add this dividend yield to the growth rate of the company, the resulting cost of externally generated equity will be the 10.47%. So there is an increase of 0.2 from 10.25% to the 10.45% due to the inclusion of the flotation cost into the model in order to determine the cost of externally generated equity. Now we have certain problems with this methodology. At first, the flotation cost being the initial cash flow may affect the project's value by reducing the project's own initial cash flow as we have seen. In the second example where we reduced our proceed by the flotation cost. The second problem is that the adjusting the cost of capital for future cash for flotation cost means the adjusting present value of the future cash flows by a fixed percentage. This means that in the second example where we calculate 10.47% as the cost of equity in this cost there is an increment of 0.22 which is now a permanent part of this cost and through this cost the project's future cash flows will be discounted in order to determine the present value of the project cash flow whereas this is not the permanent part. In fact this has been added due to the inclusion of this flotation cost into the model. We have an alternative which is a recommended and preferred approach to treat the flotation cost and that is the adjustment to the project's initial cash flows at the valuation stage. There is an example to learn this approach. A project with initial cash outflow of 60,000 with yearly expected future cash flows of 10,000 for 10 years. So we have initial cash outflows of 60,000. We have a project life of 10 years and annual cash flows in annuity pattern which is 10,000. The company is in a tax back to 40% with the before tax cost of that of 5% with current stock price of 20. Next year's dividend is expected at 1 with an expected growth rate of 5%. Now using these values we can determine the cost of equity using the dividend discount model and the cost of equity comes to 10%. If we assume that the company will finance the project with a debt equity ratio of 40 and 60 the weighted average cost of capital comes to 7.2% which is calculated as in the table. In the debt we have 24,000 which is 40% of the project's overall cost of 60,000 and equity is 36,000 which is 60% of the project's cost of 60,000. So there is a proportion of debt equity in the ratio of 40-60. We know the cost of debt after tax which is 3% and the cost of equity is 10%. Now when we compute the project's VAC using this data this comes to 7.2%. Now discounting the project's cash flows over the VAC of 7.2% we have the project's net present value of 9.59%. But we have to see certain aspects. Let's if the project's NPV where the floatation cost is considered as part of the project's future cash flows or as part of the project's cost of equity. So we can treat the floatation cost into the project's cash flows and we can incorporate the floatation cost into the project's cost of equity. Now we have three options when we treat the floatation cost into the project's future cash flows. The first option is that we ignore the project's floatation cost in the cash flows. We have net present value of the project which is the difference between the present value of cash inflows and the present value of cash outflows which the result comes to 9,591. This is the net present value of the project without considering the floatation cost. Let's if we consider this net present value while taking into account the project's floatation cost which is 1,800. So our net present value will be down by further of 1,800 and it comes to 7,791. Now we have a third option where we can consider the inclusion of this floatation cost at the factor of after takes. So we have the net present value little improved at 8,511. So if we need to consider the floatation cost into the valuation stage as a cash flow, we have three options, we can ignore the floatation cost, we can consider the floatation cost without the tax effect or we can consider the floatation cost with the tax effect. We will have some improved valuation if we consider the floatation cost at the tax effect. At the second we have the option to consider floatation cost as the project's cost of equity which is 7.3578%. Then the project's net present value is 9,089. So we can see that where the net present value improves. Why to adjust floatation cost in the overall cost of capital? There are two reasons. The first reason is that it is often difficult for the financial analyst to identify specific financing associated with the project because he is unable to identify how much amount of a particular source of financing is linked with the project. The second reason is that the adjusting the cost of capital for the floatation cost makes it easier to demonstrate that how financing cost as a company change as it switches from the internally generated equity to the externally generated equity. This means that how much the cost of capital of a company changes if a company changes its policy from using of its retained earnings as internal equity towards the usage of external equity as the new issues of capital.