Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy(^570) 16. Raising Capital © The McGraw−Hill
Companies, 2002
- Issue costs. As we discuss next, there are substantial costs associated with selling
securities.
The drop in value of the existing stock following the announcement of a new issue is
an example of an indirect cost of selling securities. This drop might typically be on the
order of 3 percent for an industrial corporation (and somewhat smaller for a public util-
ity), so, for a large company, it can represent a substantial amount of money. We label
this drop the abnormal return in our discussion of the costs of new issues that follows.
To give a couple of recent examples, in July 2001, Charles River Laboratory
announced a seasoned equity issue of $232 million. Its stock fell 8.1 percent on the day.
Similarly, when Overseas Shipbuilding announced an offering in June of 2001, its stock
dropped by 9.9 percent. Note that, in both cases, the stock decline is larger than is
typical.
THE COSTS OF ISSUING SECURITIES
Issuing securities to the public isn’t free, and the costs of different methods are impor-
tant determinants of which is used. These costs associated with floating a new issue are
generically called flotation costs. In this section, we take a closer look at the flotation
costs associated with equity sales to the public.The Costs of Selling Stock to the Public
The costs of selling stock are classified in the following table and fall into six cate-
gories: (1) the gross spread, (2) other direct expenses, (3) indirect expenses, (4) abnor-
mal returns (discussed previously), (5) underpricing, and (6) the Green Shoe option.
The Costs of Issuing Securities- Gross spread The gross spread consists of direct fees paid by the
issuer to the underwriting syndicate—the difference
between the price the issuer receives and the offer price. - Other direct expenses These are direct costs, incurred by the issuer, that are
not part of the compensation to underwriters. These
costs include filing fees, legal fees, and taxes—all
reported on the prospectus. - Indirect expenses These costs are not reported on the prospectus and
include the costs of management time spent working
on the new issue. - Abnormal returns In a seasoned issue of stock, the price of the existing
stock drops on average by 3 percent upon the
announcement of the issue. This drop is called the
abnormal return.
CONCEPT QUESTIONS
16.6a What are some possible reasons why the price of stock drops on the an-
nouncement of a new equity issue?
16.6bExplain why we might expect a firm with a positive NPV investment to finance it
with debt instead of equity.542 PART SIX Cost of Capital and Long-Term Financial Policy