Hi I am kinda confused as to which is the correct method for floating costs on raising new equity. The CFA text mentions both methods can be used, but which is preferred? Subtracting the cost of new equity from NPV or Taking out the floatatin cost while computing WACC? Thanks for your help
According to Schweser it should be simply deducted from NPV calcualtion. It makes sense! Flotation cost is a one0off cost and it would be inappropariate to increase WACC for the whole lif eof the project just because such a cost is incured once at the moment when equity is issued. Increasing WACC would impact the whole CF of the project and could result in refusing possibly good project. Schweser says it sometimes happenflotation is included in WACC calculation but even without reading it was clear to me that it is not the most appropriate way…
From the CFAI text : “Adjusting the cost of capital for floatiation costs is incorrect because by doing so, we are adusting the present value of the future cash flows by a fixed percentage.” They toy with you in the prior page by asking “Should we incorporate floatation costs into the cost of capital?”, and finally answer “no” in that roundabout way above. However, they do list both methods, so like many of the other readings it is important to know how to do both (ie. just as PB, DPB, IRR, NPV, and AAR are taught, but NPV is superior). So: Subtracting the cost of new equity from NPV Preferred. “Recommended approach is tho make adjustment to the cash flows in the valuation computation” or Taking out the floatatin cost while computing WACC? Not preferred.