Cost of new debt includes flotation cost
A great point!
When a company issues new debt, such as bonds, it incurs not only the face value of the debt (also known as the principal) but also additional costs, including flotation costs. Flotation costs are fees and expenses associated with the issuance of debt, such as:
- Underwriting fees: Paid to the investment banks or financial institutions that help the company issue the debt.
- Legal fees: Paid to lawyers who review and draft the debt documents.
- Accounting and auditing fees: Paid to accountants and auditors who verify the company's financial statements and ensure compliance with regulatory requirements.
- Printing and mailing costs: Paid for printing and mailing the debt documents to investors.
- Registration fees: Paid to regulatory bodies, such as the Securities and Exchange Commission (SEC) in the United States.
These flotation costs can be significant, typically ranging from 1% to 5% of the face value of the debt. For example, if a company issues a $100 million bond with a 4% flotation cost, the total cost of the debt would be $104 million ($100 million face value + $4 million flotation cost).
To calculate the effective cost of new debt, you need to add the flotation costs to the face value of the debt. This is often referred to as the "all-in" cost of debt. The all-in cost of debt is the total cost of borrowing, including both the interest rate and the flotation costs.
For example, if a company issues a bond with a 6% interest rate and a 4% flotation cost, the all-in cost of debt would be:
6% (interest rate) + 4% (flotation cost) = 10%
In this example, the company would need to earn a return of at least 10% on the debt to justify the cost of borrowing.