Question

In: Accounting

Can you explain how and why the value of shares are diluted when firms allow their...

Can you explain how and why the value of shares are diluted when firms allow their employees to buy the firm's stock at a discount?

Solutions

Expert Solution

When the firms allow their employees to buy firm's stock option at a discount the share value becomes diliuted.Now how this dilution takes place can be explained with the help of following example:

Suppose the outstanding shares in a company is 100000 shares and the value of share is $ 100 per share.Now if the company issues 10000 shares more but not to the employees of company rather to outsiders without giving any discount at a rate of $100.So the number of shares outstanding will increase to 110,000 shares and the value of the whole company will be $11,000,000 i.e $100*110,000 shares which works out to $100 per share.But if the company issues 10000 share to the employees at a discounted price,suppose at $90 per share.Then the value of the company will increase from $10,000,000 to $10,900,000..But the shares outstanding will increase by the same number i.e 10000 shares.Now there would be 110000 shares outstanding.That works out to be $99.09 per share or a reduction in value of $0.91 i.e $100 - $99.09.

This shares value dilution take place when employees are allowed to buy stock at a discount and they excercise their options.When the shares are issued,firstly the number of outstanding shares increases.Secondly each employee stock holder owns a smaller,or diluted percentage of the company,making each share less valuable.


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