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CFA Level II Exam · Cost of Capital: Advanced Topics

Flotation Costs and Capital Budgeting Adjustments for CFA Level 2

Updated 7 October 2026 · Fact-checked

Flotation costs are the fees paid to raise external capital. For capital budgeting, treat them as an extra cash outflow at time zero, which lowers project NPV, instead of raising the cost of capital. Separately, discount a project at a rate that reflects its own risk, often found with a pure-play beta, not the company WACC.

Understand Flotation Costs and Capital Budgeting Adjustments

Flotation costs are the fees a company pays to issue securities: underwriting fees, legal costs, registration costs. If you raise 100 and pay 5 in fees, only 95 reaches the project. The cost is real, so it must show up in the analysis.

The question is where. One approach raises the cost of equity, for example k = D1 ÷ [P0 × (1 − F)] + g. The other approach is to keep the cost of capital clean and subtract the flotation cost from the project's cash flows at time zero. This is the approach usually favored for capital budgeting, and it is the one to use unless the vignette tells you otherwise. The reason is timing. The fee is paid once, at issuance. Building it into the discount rate spreads a one-time cost over every future year and misstates the project's value. Also, the cost of capital should reflect investors' required return, and flotation costs do not change what investors require.

To apply it, find the financing mix for the project. Weight each source's flotation cost by its share of financing. In the worked example below, the weighted percentage is applied directly to the investment amount (the $50 million), and that dollar amount is subtracted from the project NPV. Some vignettes instead say you must raise enough to net the full investment after fees. Only then use the gross-up, where the amount raised is I ÷ (1 − F). A project with a small positive NPV can turn negative once the fee is deducted, so the adjustment can change the decision.

The second idea is the discount rate. The company WACC suits projects with about the same risk as the firm's average business. A project with different risk needs a project-specific rate. You usually find a pure-play company in that line of business, take its equity beta, unlever it to an asset beta, relever at the project's target capital structure, then compute cost of equity with CAPM and a WACC. Using one company-wide rate for every project makes you accept risky projects that deserve a higher rate and reject safe ones that deserve a lower rate.

Key formulas to remember

Weighted average flotation cost
F = Σ (wi × fi)
wi is the share of financing from source i and fi is its flotation cost as a percentage of funds raised. Use the project's financing weights.
Flotation cost in currency
Flotation cost = F × investment amount
The default in this page's worked example: apply F directly to the investment amount (the $50 million). Only if the vignette says you must raise enough to net the investment I after fees, use the gross-up: amount raised = I ÷ (1 − F), and the cost is that amount minus I. Follow the vignette's wording.
Adjusted NPV
NPV (adjusted) = NPV (before flotation) − flotation cost
The cost is a time-zero outflow. Leave WACC unchanged. Assume fees are not tax-deductible unless the vignette says otherwise.
Unlevering beta (Hamada form)
βasset = βequity ÷ [1 + (1 − t) × D/E]
Assumes debt beta is zero. Use the pure-play firm's own D/E and tax rate.
Relevering beta
βequity = βasset × [1 + (1 − t) × D/E]
Use the project's target D/E and tax rate.
CAPM cost of equity
ke = Rf + β × (market risk premium)
Use the relevered project beta for a project-specific cost of equity.
WACC
WACC = (E/V) × ke + (D/V) × kd × (1 − t)
Convert D/E to weights: D/V = (D/E) ÷ (1 + D/E), E/V = 1 ÷ (1 + D/E).

How to solve Flotation Costs and Capital Budgeting Adjustments questions

Use this order for any item set question on flotation costs or project discount rates. Read the vignette first and mark what is given: financing mix, fee percentages, comparable-firm data.

  1. 1Decide what is asked: an adjusted NPV, a flotation cost, a project discount rate, or a judgment on method.
  2. 2Find the project's financing weights and each source's flotation percentage. Use the project's weights, not the company's, if both appear.
  3. 3Compute the weighted average flotation cost and multiply by the investment amount to get the currency cost. If the vignette says to raise enough to net the investment, use the gross-up I ÷ (1 − F) instead.
  4. 4Compute the project's NPV at the correct discount rate, with the flotation cost left out of the rate.
  5. 5Subtract the flotation cost from NPV. State the decision: accept if adjusted NPV is above zero.
  6. 6If project risk differs from the firm's, unlever the pure-play beta at its own D/E and tax rate, then relever at the project's target D/E.
  7. 7Compute cost of equity with CAPM, then the project WACC using the target weights and after-tax cost of debt.
  8. 8Check the units, and check that your answer matches the question: percent for rates, currency for NPV.

Quickest way: Fee as a time-zero outflow, then check the rate

When to use it: Use when the vignette gives financing weights, fee percentages and an NPV or present value of inflows, and you need the decision fast.

  1. Multiply each weight by its fee percentage and add them. This is F.
  2. Multiply F by the investment amount and subtract it from NPV. Use the gross-up I ÷ (1 − F) only if the vignette says the project must net the full investment.
  3. If the sign flips, the answer is reject. If NPV stays positive, accept.
  4. For discount-rate questions, run beta in three moves: divide by 1 + (1 − t)D/E, then multiply by 1 + (1 − t)D/E at the target. Then CAPM and WACC.
  5. Eliminate any option that raises WACC or ke to cover the fee.

Common mistakes in Flotation Costs and Capital Budgeting Adjustments

  • Adding the flotation cost to the cost of equity or WACC

    Textbooks on corporate finance show the adjusted ke formula, and it looks like a natural place for the fee.

    Fix: For capital budgeting, keep the rate unchanged and deduct the fee from NPV at time zero.

  • Using the company's financing weights when the project has its own

    The company capital structure appears first in the vignette.

    Fix: Use the weights the project is financed with. Read which mix the question links to the project.

  • Forgetting to weight fees by financing source

    Students apply the equity fee to the whole investment.

    Fix: Debt fees are usually much smaller. Compute Σ wi × fi.

  • Unlevering with the company's D/E instead of the pure-play firm's

    Both D/E ratios sit in the same exhibit.

    Fix: Unlever with the comparable firm's D/E and tax rate. Relever with the project's target D/E.

  • Using the company WACC for a project with different risk

    WACC is the familiar default.

    Fix: If the project's business risk differs, use a project-specific rate. The company WACC is right only for average-risk projects.

  • Leaving the sign wrong: adding the fee to NPV

    Rushing under time pressure.

    Fix: The fee is cash out. Adjusted NPV is always lower than unadjusted NPV.

Worked examples

Example 1

A company plans a $50 million project financed 60% with new equity and 40% with new debt. Flotation costs are 5% of equity raised and 1% of debt raised. Apply the weighted flotation cost directly to the $50 million investment. The present value of the project's cash inflows, discounted at the appropriate rate, is $53.0 million. (1) What is the weighted average flotation cost? (2) What is the flotation cost in dollars? (3) What is the adjusted NPV and should the project be accepted?

Show the solution
  1. (1) F = 0.60 × 5% + 0.40 × 1% = 3.0% + 0.4% = 3.4%.
  2. (2) Flotation cost = 3.4% × $50 million = $1.7 million.
  3. (3) NPV before flotation = $53.0 million − $50 million = $3.0 million.
  4. Adjusted NPV = $3.0 million − $1.7 million = $1.3 million.
  5. The discount rate is not changed. The adjusted NPV is positive, so accept.

Answer: (1) 3.4%. (2) $1.7 million. (3) Adjusted NPV is $1.3 million, so accept the project.

Example 2

A company with average-risk operations is evaluating a project in a different industry. A pure-play comparable has an equity beta of 1.40, D/E of 0.8 and a tax rate of 25%. The project will be financed at a target D/E of 0.5. The risk-free rate is 3%, the market risk premium is 5%, pre-tax cost of debt is 5% and the tax rate is 25%. Assume debt beta is zero. (1) Find the project's asset beta. (2) Find the project's cost of equity. (3) Find the project WACC.

Show the solution
  1. (1) Asset beta = 1.40 ÷ [1 + 0.75 × 0.8] = 1.40 ÷ 1.6 = 0.875.
  2. (2) Relever: equity beta = 0.875 × [1 + 0.75 × 0.5] = 0.875 × 1.375 = 1.2031.
  3. Cost of equity = 3% + 1.2031 × 5% = 3% + 6.0156% = 9.02%.
  4. (3) D/E of 0.5 gives D/V = 0.5 ÷ 1.5 = 1/3 and E/V = 2/3.
  5. After-tax cost of debt = 5% × 0.75 = 3.75%.
  6. WACC = (2/3) × 9.0156% + (1/3) × 3.75% = 6.01% + 1.25% = 7.26%.

Answer: (1) 0.875. (2) About 9.02%. (3) About 7.26%. Use this rate, not the company's own WACC, to discount the project's cash flows.

Exam tips

  • If an option says to raise the discount rate to cover flotation costs, treat it as the wrong method for capital budgeting.
  • Read whether the fee percentage applies to the investment amount or to the amount raised to net the investment. It decides whether you use the gross-up.
  • In beta questions, write the pure-play D/E and the project D/E beside each other before calculating, so you do not swap them.
  • Check whether a project needs a project-specific rate before computing anything else. Look for a change in industry or business line.
  • After adjusting NPV, always state the decision. A sign change is often what the question tests.

Flotation Costs and Capital Budgeting Adjustments: frequently asked questions

Should flotation costs adjust the cost of equity or the cash flows?

For capital budgeting, adjust the cash flows. Treat the fee as an outflow at time zero and subtract it from NPV. The fee is paid once and does not change investors' required return, so the discount rate should stay unchanged.

How do I calculate the flotation cost for a project financed with debt and equity?

Weight each source's flotation percentage by its share of financing and add the results. Multiply the weighted average by the investment amount. That gives the currency cost to subtract from NPV. Use the I ÷ (1 − F) gross-up only if the vignette says the project must net the full investment.

When should I use a project-specific discount rate instead of company WACC?

Use a project-specific rate when the project's risk differs from the company's average risk, such as entering a new industry. Company WACC is acceptable only for projects with similar risk and financing to the firm.

How do I find a project-specific beta?

Find a pure-play company in the same business. Unlever its equity beta using its own D/E and tax rate. Relever the asset beta at the project's target D/E and tax rate, then use it in CAPM.