Suppose your boss comes to you and asks you to reevaluate a capital budgeting project. The first...

Question:

Suppose your boss comes to you and asks you to reevaluate a capital budgeting project. The first evaluation was in error, he explains, because it ignored flotation costs. To correct for this, he asks you to evaluate the project using higher cost of capital which incorporates these costs.

Is your boss approach correct? Why or why not?

Flotation Cost:

The flotation cost appears as the commission fees, legal fees and other fees associated with a new issue of security. For instance, a firm will need to pay a commission fee for the investment bank in the IPO.

Answer and Explanation:

The appearance of the flotation cost will increase the cost of equity. Since the flotation cost will reduce the actual money received from new issue of shares, the cost of equity will increase consequently as mentioned. Thus, the cost of capital will go up accordingly as well. With that being said, the boss is right about the higher cost of capital. However, there is a concern that if the flotation cost is included in the cost of capital, it is ongoing cost, which is not appropriated since the flotation cost does appear on time.


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Required Return vs. Cost of Capital

from Finance 101: Principles of Finance

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