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Definition of Dilution:
occurs when there is a reduction in ownership interest resulting from issuing additional shares of stock.
The effect of dilution is illustrated using supply and demand. On the graph below, the supply of shares is increased, and the price drops.
The number of shares is increased when management elects to secure additional capital through the sale of stock, or when an employee (or anyone else) chooses to exercise stock options. (Employees are frequently compensated in stock options, which enables the employee to acquire stock at a predetermined price if exercised.) Shareholder ownership interest is reduced or diluted. For example, assume a company has 100,000 shares outstanding. Initially there are 10 shareholders. Each shareholder owns 10,000 shares or one-tenth of the company. Management chooses to issue an additional 100,000 shares, so there are now 200,000 shares outstanding. If the initial shareholders choose not to purchase any additional shares then each of their ownership interest would be “diluted” and drop to five percent.
Management may also choose to sell shares to raise capital rather than borrowing the money from a bank or issuing a bond. In either case, the increase in the number of shares “dilutes” the value of the remaining shares. Conversely, management may purchase some of its shares to reduce the dilution of shares.
A stock split does not cause dilution. The number of shares is increased, and the price per share is adjusted, while the ownership interest remains unchanged. In our example above, assume there was a two-for-one stock split. Following the split each shareholder would own 20,000 shares, but their ownership interest would remain 10 percent. In this case, their ownership interest has not been diluted.
Normally shareholders do not like seeing their interest diluted. The graph above illustrates why. However, one should not conclude that shareholders are hurt by a falling share price every time there is dilution. Dilution can benefit shareholders when the capital secured from issuing stock is invested profitably because the added profits normally increase the demand for the shares of a company. For example, assume that prior to issuing the additional 100,000 shares the company’s income equaled $200,000, or $2 per share. The company invests wisely, and income increases to $500,000 after issuing the new shares, yielding a new earnings per share of $2.50 ($500,000 / 200,000) and benefiting the initial shareholders.
Company XYZ may purchase Company ABC and pay for ABC by “trading” shares. This causes a dilution of ownership interest, however, like the scenario above, if the acquired company is a wise investment, all of the shareholders will benefit.
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