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## A STUDY ON CORRECT USE OF FLOTATION COST IN

CAPITAL BUDGETING
MR. VINAYAK ASHOK GUNDA**

**M.COM.(PART 1) Student
400604,
Maharashtra.India.

ABSTRACT
The use of flotation cost while making a financial management decision has
been the same around many years and numerous education literatures extensively
discuss the usage of it while making a capital budgeting decision. These literatures
allows the use of flotation cost to be included in the discount rate of the firm. This
traditional approach towards the use of flotation cost leads to a higher weighted average
cost of capital, thereby making significant errors while calculating the net present value
of a project. I am presenting an approach which can be an alternative to the existing
treatment of flotation cost and will be comparing with the traditional approach to find out
the cost of equity of BSE SENSEX 30 companies. The research paper will show if there
is difference in the cost of equity by using either approach and how significant is the
difference.

## KEYWORDS: Financial management, corporate finance, weighted average cost of

capital, cost of equity, flotation cost.

INTRODUCTION
The topic Corporate Finance of Financial Management quite often discusses the
various methods by which companies make their capital budgeting decisions. The Net
Present Value (NPV) approach is the most common approach used by managers all
around the world for the evaluation and selection of capital projects.
Graham and Harvey (2001) find that 75% of the firms that they surveyed use this
NPV approach as their investment criterion. The number of large firms using this
approach was even higher.

## The NPV is calculated as:

Where:
NPV = net present value of the project today (time 0),
-C0 = cash-flow in project today (the project investment),
Ci = cash-flow from project at future time i,
T = period in which last cash-flow occurs.
r = Weighted average cost of capital (WACC) is obtained as:

## WACC = wdrd (1 t) + wprp + were

where
wd = is the proportion of debt that the company uses when it raises new funds
rd = is the before-tax marginal cost of debt
t = is the companys marginal tax rate
wp = is the proportion of preferred stock the company uses when it raises new funds

## rp = is the marginal cost of preferred stock

we = is the proportion of equity that the company uses when it raises new funds
re = is the marginal cost of equity
To interpret the marginal cost of equity (re ) we use the Dividend discount model (DDM )
which assumes that the value of stock today is the present value of all future dividends,
discounted at the rate of return and a constant growth rate (g) :

Cost of Equity =

+ Growth Rate

OR

Cost of Equity =

+ Growth Rate

## Current Market Price

Flotation cost: When a company raises new capital it generally seeks the help of
investment banks that charge the company with a fee according to the size and type of
offering. It is typically in percentage of the total issue of new capital.
The traditional approach of treatment of flotation cost:

Cost of Equity =

## Current Year Dividend (1 + Growth Rate)

Current Market Price (1- Flotation Cost )

+ Growth Rate

LITERATURE REVIEW:
Various literature use traditional approach of incorporating the flotation cost while
calculating the cost of equity.
Brealey, Myers and Marcus (2007), Brigham and Ehrhardt (2005), Ross, Westerfield,
and Jaffe (2002) ,H. Kent Baker, J. Clay Singleton, E. Theodore Veit(2010 ) are the
types of literature where the author agrees to the fact that incorporating the flotation
cost which is a onetime cost for the firm raises the cost of equity which in turn affects
the WACC and NPV of a project.

## NEED FOR THE STUDY:

CFOs of the top publicly traded companies in India mostly use the dividend discount
model for their approach in making a capital budgeting decision. If the approach used
by the CFO is traditional in finding the cost of equity where the floatation cost in
incorporated in the Dividend Discount Model (DDM), he may have a different value as
compared to this alternate method that simply use the flotation costs as a negative cash
flow when performing a project analysis.

ALTERNATE APPROACH:

Where:
NPV = net present value of the project today (time 0),
C0 = cash-flow in project today (the project investment),
Ci = cash-flow from project at future time i,
T = period in which last cash-flow occurs.
r = Weighted average cost of capital (WACC)

FC = Flotation Costs.

The problem with the traditional approach of treatment of flotation costs is that, the
costs are not an ongoing expense for the firm. Flotation costs are the expense occurring
at the initiation of a project and affect the project NPV by increasing the initial cash
outflow. Therefore, the correct way to account for flotation costs is to adjust the initial
project cost.

RESEARCH OBJECTIVES:
While making an informed decision of capital budgeting the CFO or the management
team of expertise evaluate various methods to arrive at cost of equity. The objectives of
this research are:
1) To measure the cost of equity of public companies by both the traditional as well
as the alternate method.
2) To identify if there is a difference in cost of equity arrived due to the use of two
different methods.
3) To identify if this difference is adequate enough to change the methods of
treating the flotation costs.

HYPOTHESIS:
Based on the literature reviewed and the conceptual model following hypotheses
were generated to be verified:
H01: The flotation costs should be incorporated in the Dividend Discount Model
(DDM) while calculating the cost of equity.
H02: The flotation cost should treated as negative cash outlay while calculating the
NPV.

## METHODOLOGY AND MEASUREMENT:

The treatment of flotation cost by using the traditional approach(old) and the
alternate method(new) of Dividend discount Model on BSE SENSEX 30 companies
to find their cost of equity(COE). Flotation cost is assumed to be 1% as a standard
fee for all the following companies.
NAME OF THE COMPANY

(%g)

%COE(old

%COE(ne

method)

w method)

AXIS BANK

11.11

15.08

15.12

BAJAJ AUTO

11.11

13.42

13.44

BHEL

47.69

48.76

48.77

BHARTI AIRTEL

80

80.58

80.59

CIPLA

0.421

0.425

COAL INDIA

107.14

111.0158

111.055

## DR. REDDYS LAB

20

20.64

20.64

GAIL(INDIA)

8.33

10.64

10.67

HDFC

24.55

25.42

25.43

HERO MOTOCORP

8.33

10.74

10.76

HINDALCO INDUSTRIES

28.57

29.32

29.33

HINDUSTAN UNILEVER

23.81

25.66

25.68

12

13.409

13.42

15

16.512

16.52

INFOSYS LTD.

50

51.89

51.91

ITC LTD.

14.29

16.32

16.34

15.45

16.42

16.43

9.18

9.19

50

50.56

50.57

NTPC LTD.

27.78

31.29

31.32

## OIL AND NATURAL GAS LTD.

10

13.25

13.29

RELIANCE INDUSTRIES

5.56

6.73

6.74

18

19.42

19.44

## STATE BANK OF INDIA

27.71

28.89

28.90

SUN PHARMACEUTICAL

30.5

30.97

30.97

45.45

47.95

47.98

7.56

8.07

8.07

16.72

18.28

18.30

8.66

11.09

11.11

14.29

16.02

16.04

WIPRO LTD.
st

## FINDINGS AND ANALYSIS:

As seen in the table above, cost of equity calculated by both the methods yield
different cost of equity which will be used to discount the future cash flows while
evaluating a project. The difference seen in these costs of equity might not seem so
significant but when these large cap companies raise a Rs 100cr. Or more worth of
equity, even the slightest difference in the cost of equity will have a significant impact
while calculating a projects NPV.

## LIMITATIONS OF THE STUDY:

Although the flotation cost assumed here is 1% which is the most prevalent fee
charged by investment bankers in India considering their Market cap, it may vary for
different companies and the size of issuance of new equity. Some CFOs might not
even use the Dividend Discount Model (DDM) to find the cost of equity but might resort
to the alternate approach of Capital Asset Pricing Model (CAPM).

## SUGGESTION AND CONCLUSION:

The cost of equity which is one of the discounting factors while evaluating a project
using Net Present Value (NPV) is higher if flotation cost is treated by traditional
approach. And since the flotation cost is not an ongoing expense but a onetime
expense, it should be adjusted as a negative cash flow at the initiation of the project.

REFERENCES:
Graham, J. R., and C. R. Harvey (2001), The Theory and Practice of
Corporate Finance: Evidence from the Field, Journal of Financial Economics, 187243.
Eugene Brigham, Michael Ehrhardt, Financial Management: Theory & Practice.
Cengage Learning, 2005.
H. Kent Baker, J. Clay Singleton, E. Theodore Veit, Survey Research in Corporate
Finance: Bridging the Gap between Theory and Practice. Oxford University Press,
2010.
Ross, Stephen A., Randolph W. Westerfield, and Jeffrey F. Jaffe (2002),
Corporate Finance, New York, New York: Irwin/McGraw-Hill.
Brealey, Richard A., Stewart C. Myers, and Alan J. Marcus (2007), Fundamentals of
Corporate Finance, New York, New York: Irwin/McGraw-Hill.
Institute, CFA. 2015 CFA Level I Volume 4 Corporate Finance and Portfolio
Management. Wiley Global Finance, 2014-07-14.