Equity Dilution - Effects on the share price of firm

Many of us believe that if a company offers additional stock, then after issuing shares, there will be more shares in the market. This means that equity will be diluted and share price should go down.

But this is certainly not true as the popular conception is. Let us take an ideal world example. Assume that company A is worth 100 Rs and it has a total of 10 shares trading in the market. So the price of each share would be 100/10 = Rs. 10.

Now assume, that A wants to issue 10 more shares at the current market price, which is Rs. 10 in our ideal case. Most investors argue that since there are 20 shares in the market, so price should now be 100/20 = Rs. 5 per share. But BEWARE!! you are overlooking the fact that company has not donated its shares in charity. It stands to receive some money against these shares. In our case, A has received 10*10 = Rs. 100. Original firm value was Rs. 100 and after the offer, firm value has increased to Rs. 200.

The effect on price? There is no effect because the share price should be 200/20 = Rs. 10. However note that our case is not a real world case where actual market prices may not reflect the company's true worth. As a company then, how would you make share pricing decisions?

Let's assume a real world company B which has a firm value of Rs. 100 and has 10 shares trading in the market. You should remember that outsiders may not know the true value of company but the insiders (the management and promoter group) always know what their own company is worth.

Case 1: Assume that the current market price of B's shares is Rs. 5. Would the company issue more shares now? Absolutely NOT!!! The managers of B know that they will be in a loss if they issue shares below the fair value of Rs. 10. Let's still assume that B offers 10 more shares at Rs. 5.

What is the new firm value? Rs.100 + Rs. 50 = Rs. 150
What is the total number of shares? 10+10 = 20 shares
What should be the new share price? 150/20 = Rs. 7.5 per share.
Why this situation is bad for managers and promoters? BAD, because they just had a loss in the new shares transaction. The value of shares that they already owned has shrunk suddenly by 25%.
Would company B ever do such a deal? NO!!!

Case 2 is easy to assume now. If the shares are traded at more than the fair value, company B will make profit if it issues more shares because the reasons are obvious.

The takeaway is that the news of issuing additional shares will be bad for existing shareholders because it will immediately tell you that shares are overvalued. But if additional shares are successfully issued at a higher price, then company value goes up, though the extent of increase depends on how much overvalued the shares were.