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 proportionate 10 percent share, dilution of the ownership of existing shareholders can be avoided by using a rights offering.

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