Wednesday, January 21, 2009

dilution of shareholder equity

A Series 7 candidate just emailed me a question he had seen somewhere among his large stack of materials. The question is good and, like many on the exam, a little bit tough.

Current common shareholders' interest would be diluted by:
I. A 3 for 1 split of the common stock
II. A sale of 500,000 shares of previously unissued stock by the company
III. 20,000 debentures converted by their holders into common stock
IV. A 25% stock dividend on common
(A) I and IV only
(B) II and III only
(C) II, III and IV only
(D) I, II, III and IV

RESPONSE: stock splits don't dilute anything. We used to have 1,000 shares worth $30 each. After a 3-for-1 split, we'd have 3,000 shares worth $10 each. So, eliminate anything with a "I" in it. And then eliminate choice "IV" because stock dividends and stock splits don't change any value, actually. They just manipulate the per-share price that a stock is quoted on the exchange. It "sounds cheaper" to hear about a stock trading for $10 than for $30, maybe, but it's all an illusion. If the company sells convertible debentures, those bondholders will eventually receive shares of stock without bringing anything to the party. The same profits at the company will suddenly be divided into more shares because of these freeloading former bondholders. That's dilution. So is selling more shares of stock.

Dilution just means that there is a total profit at the company, and common stock is worth a share of those profits. If they keep cutting the profits into more and more shares, it's just like a pie being cut into more and more slices--pretty soon it gets too thin to enjoy.

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