Ch. 6: Security Offerings 263
for an underwriter to capture much of the value associated with security offer underpric-
ing. The effect of a security issue announcement on its offering price and the expected
cost of a security issue delay or withdrawal are also potentially important indirect costs,
which are discussed below. Finally, management time and energy devoted to the offer-
ing process is yet another significant, but hard to quantify indirect cost.
To summarize, expected flotation costs can be separated into direct and indirect cost
components. Direct flotation costs are composed of:
- Fees to underwriters (including warrants and over-allotment options).
- Other out of pocket expenses, which include fees to accountants, law firms, listing
fees, registration fees, printing, advertising as well asroad showexpenses and the
cost of management time.
Indirect flotation costs include - Issue underpricing, which can potentially be captured by underwriters through their
power to allocate the issue to preferred customers and affiliates. - Stock price reactions to initial offering announcements, which on average are neg-
ative, and any follow up announcements concerning changes in offer size and other
characteristics. - Costs of offering delays/cancellations.
Most of the extant literature focuses on the size and determinants of underwriting dis-
counts (or fees) and security offering underpricing of equity offerings.
Early research on SEO flotation costs was conducted by the SEC staff in a series of
studies and later bySmith (1977), who examined mean underwriter fees and other ex-
penses. These two direct flotation cost components were examined across issue size
categories and three major flotation methods. Flotation costs as a percent of gross
proceeds were observed to fall with a rise in issue size. In addition, these costs were
found to vary with flotation method for comparable size offers; more specifically, un-
derwriter fees and other expenses were largest for firm commitments and cheapest for
rights offers. Smith raised the question of why most U.S. firms appear to choose the
highest cost flotation method and explored a number of possible added costs and ben-
efits associated with each of these flotation methods. He was unable to explain away
the puzzle. The question of whether there is a comparative advantage for alternative
flotation methods was first raised byHansen and Pinkerton (1982). A complication in
undertaking this analysis is that the flotation method is an endogenous issuer decision,
which could produce selection biases across the samples. These issues were more ex-
tensively studied byEckbo and Masulis (1992)who re-examine the question of whether
issuing firms fail to choose the flotation method that maximizes the net proceeds from
their security sales. They uncover evidence consistent with the hypothesis that firms’
choices do maximize net proceeds (further details on this issue are given in Section 4
below).
The issuer type and the flotation method choice generally affect both direct and in-
direct flotation costs of a particular security offering. As summarized inTable 6,in
their sample of 1,249 SEOs over the period 1963–1981,Eckbo and Masulis (1992)
report that the average direct cost of uninsured rights as a percent of total issue