Cost of issuing new stocks or bonds. It varies with the amount of underwriting risk and the job of physical distribution. It comprises two elements: (1) the compensation earned by the investment bankers (the underwriters) in the form of the spread between the price paid to the issuer (the corporation or government agency) and the offering price to the public, and (2) the expenses of the issuer (legal, accounting, printing, and other out-of-pocket expenses). Securities and Exchange Commission studies reveal that flotation costs are higher for stocks than for bonds, reflecting the generally wider distribution and greater volatility of common stock as opposed to bonds, which are usually sold in large blocks to relatively few investors. The SEC also found that flotation costs as a percentage of gross proceeds are greater for smaller issues than for larger ones. This occurs because the issuer's legal and other expenses tend to be relatively large and fixed; also, smaller issues tend to originate with less established issuers, requiring more information development and marketing expense. An issue involving a Rights Offering can involve negligible underwriting risk and selling effort and therefore minimal flotation cost, especially if the underpricing is substantial.
The Underwriting Spread is the key variable in flotation cost, historically ranging from 23.7% of the size of a small issue of common stock to as low as 1.25% of the par value of high-grade bonds. Spreads are determined by both negotiation and competitive bidding.
