262 B.E. Eckbo et al.
conveys negative information about the issuing firm that managers alway knew, which
would become public at some future date anyway, so why should it represent an issue
cost? In contrast, other researchers view this announcement effect as capitalizing the
direct and indirect effects of raising new equity capital, including empire building. At
this point, we don’t have resolution on this question. However, what we do know is
that the typical negative announcement effect represents an expected permanent drop
in the issue price. Furthermore, we view the early revelation of negative information
about the issuer as an expected issue cost as well, as would any shareholder selling in
the secondary market thereafter and as would any blockholder selling shares in a sec-
ondary offering. Evidence about security offering announcement effects is discussed
extensively in Section4, below.
While expected flotation costs tend not to change much over short time periods,
market conditions and the firm’s financial condition as well as the quality of publicly
available information about the firm are all likely to vary substantially over longer pe-
riods of time (several years). For example, there are distinct differences in the level of
underpricing needed to float a security issue and sizable differences in the likelihood of
offer cancellation, both of which depend on current market conditions. Furthermore, our
sample period has witnessed significant changes in securities regulations (such as shelf
registration) and the competitive structure of the underwriting market—with the entry of
commercial banks, investment banking industry consolidation and the increased inter-
nationalization of the security offering process—which can alter the level of underwriter
competition and the pricing of their services.
Expected flotation costs also vary across firms at any point in time, depending of
the characteristics of the issuers and the security offering. Thus, knowing these char-
acteristics allows us to better forecast the expected flotation costs an issuer will bear
from making a particular security offering. In the discussion to follow, we examine the
existing evidence on the determinants of several of the flotation cost components.
3.1. Total flotation costs
Flotation costs are made up of direct costs and indirect cost of selling a security through
a public offering, where the direct costs include underwriter compensation, registration
and listing fees, legal, accounting and printing expenses, etc. Underwriter compensation
is made up of several components, the most important being the underwriter’s gross
spread or the difference between the public offering price and the underwriter purchase
price. The other components of underwriter compensation include: an over-allotment
option (typically this is a one month warrant to purchase an additional 15 percent of
shares at the same price as the offering itself), plus long term warrants exercisable at the
offer price, and extra reimbursements of underwriter expenses by the issuer.
Security sales also involve indirect flotation costs. The most important indirect cost
is the typical underpricing costs associated with selling a security at a discount relative
to both its prior trading day’s closing price and its closing market price immediately
following the public offering. Since an underwriter can allocate the issue, it is possible