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How are Issue Costs handled in calculating the APV of a project?
What are Issue Costs?
When companies raise money from the market, it needs to distribute securities in the market which requires the company to incur some cost. These one-time costs are called issue costs that have to be considered while the project begins. It is a preliminary cost all companies must spend to raise money from the investors in the market.
How to Handle Issue Costs?
Issue costs are handled at the outset of a project. The best way to manage the issue cost is to use the APV model to evaluate an investment project. In APV approach, the issue cost is discounted in the beginning of the project. That is, the issue cost must be subtracted from the added sum of "all-equity NPV" and Present Value of interest tax shields to get the APV.
We can write,
$$\mathrm{APV} = \mathrm{\mbox{All-equity NPV}} + \mathrm{PV\:of\:Interest\:Tax\:Shields} − \mathrm{Issue\:Costs}$$
It is notable that in the APV method of evaluating a project, the "all-equity NPV" is an important factor. The all-equity NPV is the NPV in equity terms and we do not have to consider the value of debt while considering this factor. The consideration of all-equity and no debt is one of the basic considerations in evaluation of a project.
Floatation Cost
Issue costs are also known as floatation cost and they are part of the calculation of APV. These costs expand the cost of new equity more than the existing equity, as more securities are usually distributed incurring issue costs. The issue costs need to be included in the future cash flows of a company in order to avoid overstating capital forever.
Some companies prefer to raise money from the market via equity because they don’t have to repay the money raised. However, when money is raised via equity, a stake of the company has to be offered to the investors which involves money in the process. In such a transaction, the companies need to incur various costs such as legal fees, market fees, government fees and costs for printing and advertisement, etc. These costs are accounted as one-time costs for the company that are also known as issue cost.
Flotation costs are the difference in costs incurred from existing to issuance of new equities. Such a process may also involve investment banking expenses, registration fees in the markets, and accounting and audit fees. Depending on the amount needed for issue costs, a company can always determine what portion of capital should be invested in equity and how much should be raised via debt.
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