All of the preceding arguments are pieces of the puzzle but none seems very

All of the preceding arguments are pieces of the

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All of the preceding arguments are pieces of the puzzle, but none seems very convincing. Booth and Smith have identified a function of the underwriter that had not been taken into account in previous cost studies. 14 They argue that the underwriter that the offering price is consistent with the true value of the issue. This certification is implied in the underwriting relationship and is provided when the underwriting firm gets access to inside information and puts its reputation for correct pricing on the line. 20.9 Dilution A subject that comes up quite a bit in discussions involving the selling of securities is dilution. Dilution refers to a loss in existing shareholders’ value. There are several kinds: 1. Dilution of percentage ownership. 2. Dilution of market value. 3. 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.
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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. 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 20.12 , USM currently has 1 million shares outstanding and no debt. Each share is selling for $5, and the company has a $5 million market value. USM’s book value is $10 million total, or $10 per share. Table 20.12 New Issues and Dilution: The Case of Upper States Manufacturing USM has experienced a variety of difficulties in the past, including cost overruns, regulatory delays in building a nuclear-powered electricity-generating plant, and below-normal profits. These difficulties are reflected in the fact that USM’s market-to-book ratio is $5/10 = .50 (successful firms rarely have market prices below book values).
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