Including Flotation Costs in NPV Project Evaluation

Imagine you are planning to open a new coffee shop. You have a fantastic location, a solid business plan, and you know your lattes will be legendary. To get started, you need to raise some money. Perhaps you decide to issue shares in your coffee shop to friends, family, or even the public, or maybe you decide to take out a loan by issuing bonds. The money you raise is crucial to get your dream off the ground. However, it’s not as simple as just receiving the full amount you aim to raise. There are costs associated with raising this capital, and these are what we call flotation costs.

Flotation costs are essentially the expenses a company incurs when it issues new securities, such as stocks or bonds, to raise funds. Think of it like this: when you sell your old car, you might need to pay for advertising, detailing, or perhaps a small fee to list it on a selling platform. These are your “flotation costs” for selling your car. For companies, these costs are much more structured and can include things like underwriting fees paid to investment banks who help sell the securities, legal fees for all the paperwork involved, accounting fees to ensure financial compliance, registration fees charged by regulatory bodies, and even printing and marketing expenses for prospectuses or offering documents. It’s all the behind-the-scenes work that goes into making a new stock or bond offering successful.

When a company is considering a new project, like our coffee shop expansion example, and they need to evaluate its profitability using Net Present Value, or NPV, flotation costs become a really important factor. NPV is essentially a way to calculate the present value of all the expected future cash flows from a project, minus the initial investment. It tells us if a project is expected to add value to the company. Now, if we ignore flotation costs when calculating NPV, we are painting an incomplete and potentially overly optimistic picture of the project’s true profitability.

Here’s why. Suppose your coffee shop expansion project requires an initial investment of one million dollars. You calculate the future cash flows and, without considering flotation costs, the NPV looks attractive. However, to raise that one million dollars, you issue new shares and incur flotation costs of, say, five percent of the total amount raised. This means that for every dollar you aim to raise, you actually receive only ninety-five cents after paying the flotation costs. To get the full one million dollars needed for your project, you actually need to raise more than one million dollars initially.

So, how do we account for these flotation costs in our NPV calculation? The most straightforward way is to treat them as an initial cash outflow, just like the initial investment in the project itself. Instead of simply subtracting the project’s initial investment from the present value of future cash flows, we also subtract the flotation costs. Let’s say the present value of future cash flows from your coffee shop expansion is one point two million dollars and the initial investment is one million dollars. Ignoring flotation costs, the NPV would be one point two million dollars minus one million dollars, which equals two hundred thousand dollars. This looks good!

But, if we have five percent flotation costs on the one million dollars needed, that’s fifty thousand dollars in flotation costs. Now, we need to adjust our NPV calculation. We still have the present value of future cash flows at one point two million dollars. However, our total initial cash outflow is now the one million dollar investment plus the fifty thousand dollars in flotation costs, totaling one million and fifty thousand dollars. The adjusted NPV is now one point two million dollars minus one million and fifty thousand dollars, resulting in one hundred and fifty thousand dollars. This is still positive, but it’s significantly lower than the two hundred thousand dollars we calculated when ignoring flotation costs.

Therefore, to accurately evaluate the NPV of a new project, it is crucial to include flotation costs. By treating them as an initial cash outflow, we get a more realistic picture of the project’s true profitability. Failing to account for these costs can lead to overestimating the NPV and potentially making poor investment decisions. Just like you wouldn’t forget to factor in the costs of ingredients when pricing your lattes, companies shouldn’t forget to factor in flotation costs when evaluating new projects. They are a real and significant expense of raising capital and must be considered for sound financial decision-making.