CP

248 CHAPTER 6 The Cost of Capital

incorporate flotation costs? In the example above, application of the DCF methodol-

ogy gives a cost of equity of 13.4 percent if flotation costs are ignored and a cost of eq-

uity of 14.0 percent if flotation costs are included. Therefore, flotation costs add 0.6

percentage point to the cost of equity (14.0 
13.4 0.6). To incorporate flotation

costs into the CAPM estimate, you would add the 0.6 percentage point to the 13.8

percent CAPM estimate, resulting in a 14.4 percent estimated cost of external equity.

As an alternative, you could find the average of the CAPM, DCF, and bond-yield-

plus-risk-premium costs of equity ignoring flotation costs, and then add to it the 0.6

percentage point due to flotation costs.

How Much Does It Cost to Raise External Capital?

A recent study provides some insights into how much it costs U.S. corporations to

raise external capital. Using information from the Securities Data Company, they

found the average flotation cost for debt and equity issued in the 1990s as presented in

Table 6-2.

The common stock flotation costs are for non-IPOs. Costs associated with IPOs

are even higher—about 17 percent of gross proceeds for common equity if the

amount raised is less than $10 million and about 6 percent if more than $500 million

is raised. The data include both utility and nonutility companies. If utilities were ex-

cluded, flotation costs would be even higher.

What are flotation costs?

Are flotation costs higher for debt or equity?

Some Problem Areas in Cost of Capital

A number of difficult issues relating to the cost of capital either have not been men-

tioned or were glossed over in this chapter. These topics are beyond the scope of this

text, but they deserve some mention both to alert you to potential dangers and to pro-

vide you with a preview of some of the matters dealt with in advanced courses.

TABLE 6-2 Average Flotation Costs for Debt and Equity

Average Flotation Cost Average Flotation Cost

Amount of Capital Raised for Common Stock for New Debt

(Millions of Dollars) (% of Total Capital Raised) (% of Total Capital Raised)

2–9.99 13.28 4.39

10–19.99 8.72 2.76

20–39.99 6.93 2.42

40–59.99 5.87 2.32

60–79.99 5.18 2.34

80–99.99 4.73 2.16

100–199.99 4.22 2.31

200–499.99 3.47 2.19

500 and up 3.15 1.64

Source:Inmoo Lee, Scott Lochhead, Jay Ritter, and Quanshui Zhao, “The Costs of Raising Capital,” The Journal of

Financial Research, Vol. XIX, No. 1, Spring 1996, 59–74. Reprinted with permission.

The Cost of Capital 245