How should flotation costs affect project NPV?

Question

AcadiFi · Accepted Answer

Flotation costs are one-time expenses of issuing new securities: underwriting fees, legal costs, registration, roadshow expenses. For equity issuance, fees typically run 5-7% of proceeds; debt issuance costs run 1-2%.

There are two approaches to incorporating flotation costs in capital budgeting, and only one is correct:

WRONG approach (common but flawed): Adjust the cost of equity upward by flotation factor, so Ke_adj = Ke / (1 - f). This inflates WACC and discounts all future cash flows at the higher rate. The flaw: future cash flows have nothing to do with issuance costs; only the initial financing event does. Compounding a one-time cost across all years overstates its impact.

CORRECT approach (subtract as cash outflow): Treat flotation costs as an additional upfront cash outflow when raising the capital. Discount future cash flows at the unadjusted WACC.

For Pinnacle's $500M equity raise for a pipeline at 6% flotation: upfront flotation cost = 500M * 6% = $30M. Project NPV = -Investment - Flotation + PV(future cash flows at unadjusted WACC). If project NPV before flotation was $80M, adjusted NPV = 80 - 30 = $50M.

Additional nuances: (1) only incremental flotation counts—if the firm would have issued equity anyway, incremental is zero; (2) if financing mix is 60% equity / 40% debt for Pinnacle's $500M, blended flotation = 0.6*6% + 0.4*1.5% = 4.2%, applied only to the incremental external financing; (3) retained earnings have zero flotation; issuing new equity has full 6%—this is why Modigliani-Miller tax benefits prefer debt all else equal.

Flotation costs are one reason firms prefer internal financing (pecking order theory). The CFA curriculum has historically tested both approaches, but the subtraction method is theoretically correct and should be the preferred answer on Level II Corporate Finance questions.

How should flotation costs affect project NPV?

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