CP

Adjusting the Cost of Capital for Flotation Costs 247

after-tax cost of debt adjusted for flotation. With a financial calculator, enter N 30,

PV 
990, PMT 60, and FV 1000. Solving for I, we find I rd(1 
T) 

6.07%, which is the after-tax component cost of debt. Note that the 6.07 percent the-

oretically correct after-tax cost of debt is quite close to the original 6.00 percent after-

tax cost, so in this instance adjusting for flotation doesn’t make much difference.

However, the flotation adjustment would be higher if F were larger or if the bond’s

life were shorter. For example, if F were 10 percent rather than 1 percent, then the

flotation-adjusted rd(1 
T) would have been 6.79 percent. With N at 1 year rather

than 30 years, and F still equal to 1 percent, then rd(1 
T) 7.07%. Finally, if

F 10% and N 1, then rd(1 
T) 17.78%. In all of these cases the differential

would be too high to ignore.^14

Cost of Newly Issued Common Stock, or External Equity, re

The cost of new common equity, re, or external equity, is higher than the cost of eq-

uity raised internally by reinvesting earnings, rs, because of flotation costs involved in

issuing new common stock. What rate of return must be earned on funds raised by

selling new stock to make issuing stock worthwhile? To put it another way, what is the

cost of new common stock?

The answer for a constant growth stock is found by applying this formula:

(6-9)

Here F is the percentage flotation cost incurred in selling the new stock, so P 0 (1 
F)

is the net price per share received by the company.

Assuming that Axis has a flotation cost of 10 percent, its cost of new outside equity

is computed as follows:

Investors require a return of rs13.4% on the stock.^15 However, because of flotation

costs the company must earn more than 13.4 percent on the net funds obtained by sell-

ing stock if investors are to receive a 13.4 percent return on the money they put up.

Specifically, if the firm earns 14 percent on funds obtained by issuing new stock, then

earnings per share will remain at the previously expected level, the firm’s expected div-

idend can be maintained, and, as a result, the price per share will not decline. If the

firm earns less than 14 percent, then earnings, dividends, and growth will fall below

expectations, causing the stock price to decline. If the firm earns more than 14 per-

cent, the stock price will rise.

As we noted earlier, most analysts use the CAPM to estimate the cost of equity.

Suppose the CAPM cost of equity for Axis is 13.8 percent. How could the analyst

6.0%8.0%14.0%.



$1.24

$20.70

8.0%

re

$1.24

$23(1
0.10)

8.0%

re

D 1

P 0 (1
F)

g.

(^14) Strictly speaking, the after-tax cost of debt should reflect the expectedcost of debt. While Axis’ bonds have
a promised return of 10 percent, there is some chance of default, so its bondholders’ expected return (and
consequently Axis’ cost) is a bit less than 10 percent. However, for a relatively strong company such as Axis,
this difference is quite small.
(^15) If there were no flotation costs, rs=$1.24+ 8.0% = 13.4%.
$23

244 The Cost of Capital