Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy- Raising Capital © The McGraw−Hill^583
Companies, 2002 - Dilution of percentage ownership
- Dilution of market value
- Dilution of book value and earnings per share
The differences between these three types can be a little confusing, and there are some
common misconceptions about dilution, so we discuss it in this section.
Dilution of Proportionate Ownership
The first type of dilution can arise whenever a firm sells shares to the general public. For
example, Joe Smith owns 5,000 shares of Merit Shoe Company. Merit Shoe currently
has 50,000 shares of stock outstanding; each share gets one vote. Joe thus controls 10
percent (5,000/50,000) of the votes and gets 10 percent of the dividends.
If Merit Shoe issues 50,000 new shares of common stock to the public via a general
cash offer, Joe’s ownership in Merit Shoe may be diluted. If Joe does not participate in
the new issue, his ownership will drop to 5 percent (5,000/100,000). Notice that the
value of Joe’s shares is unaffected; he just owns a smaller percentage of the firm.
Because a rights offering would ensure Joe Smith an opportunity to maintain his pro-
portionate 10 percent share, dilution of the ownership of existing shareholders can be
avoided by using a rights offering.
Dilution of Value: Book versus Market Values
We now examine dilution of value by looking at some accounting numbers. We do this
to illustrate a fallacy concerning dilution; we do not mean to suggest that accounting
value dilution is more important than market value dilution. As we illustrate, quite the
reverse is true.
Suppose Upper States Manufacturing (USM) wants to build a new electricity-
generating plant to meet future anticipated demands. As shown in Table 16.11, USM
currently has one millionshares outstanding and no debt. Each share is selling for $5,
and the company has a $5 millionmarket value. USM’s book value is $10 milliontotal,
or $10 per share.
CHAPTER 16 Raising Capital 555TABLE 16.11
New Issues and
Dilution: The Case of
Upper States
ManufacturingAfter Taking on New Project
Initial With Dilution With No Dilution
Number of shares 1,000,000 1,400,000 1,400,000
Book value $10,000,000 $12,000,000 $12,000,000
Book value per share (B) $10 $8.57 $8.57
Market value $5,000,000 $6,000,000 $8,000,000
Market price (P) $5 $4.29 $5.71
Net income $1,000,000 $1,200,000 $1,600,000
Return on equity (ROE) .10 .10 .13
Earnings per share (EPS) $1 $.86 $1.14
EPS/P .20 .20 .20
P/EPS 5 55
P/B .5 .5 .67
Project cost $2,000,000 NPV $1,000,000 NPV $1,000,000