FNCE30011 · Essentials Of Corporate Valuation
Where Value Comes From and Dilution
Two questions sit together here. First, where does value come from? Firms earn value above book from three sources: a sustainable competitive advantage (earning returns above the cost of capital), growth options (the right but not the obligation to expand), and financing effects including dilution. Second, how does a share issue split value? The key distinction is between pure percentage dilution and a wealth transfer. Issuing at fair value dilutes each old holder's percentage of the firm but transfers no wealth — the new cash exactly funds the new claim. Issuing below fair value (the two-price raising, the Social-Network-style case) does both: it dilutes the percentage and moves dollars from existing, non-participating owners to the new investor, because the new shares are sold for less than they are worth. The exam skill is conceptual and quick: read a raising, decide whether it is fair or value-transferring, separate equity-percentage dilution from value dilution, and compute the cum-issue and ex-issue value per share and the dollars that move. Formulas are provided, so the marks are in the judgement.
What this chapter covers
- 019.1 The three sources of value: competitive advantage, growth options, dilution
- 029.2 Returns above the cost of capital and the value of growth
- 039.3 Share-issue pricing: cum-issue vs ex-issue value per share
- 049.4 Issuing at fair value — percentage dilution but no wealth transfer
- 059.5 The two-price raising — issuing below fair value transfers wealth
- 069.6 Separating percentage dilution from value dilution; who gains, who loses
Worked example: an under-priced raising
- +1Identify. Issue price ($6.00) is below fair value ($8.00) — a two-price raising: expect both percentage dilution and a wealth transfer.
- +1Post-issue equity. Old equity + new cash = 1,600 + 300 = $1,900m.
- +1Ex-issue value per share. Total shares = 200 + 50 = 250m, so value/share = 1,900 / 250 = $7.60 (down from $8.00).
- +1New investor's stake. 50m × $7.60 = $380m, paid for $300m — a gain of $80m.
- +1Old owners' loss. Their stake fell from $1,600m to 200m × $7.60 = $1,520m — a loss of $80m, exactly the new investor's gain. The under-pricing moved $80m.
Key terms
- Competitive advantage
- The ability to earn returns above the cost of capital sustainably — the primary source of value above book. Without it, growth merely reinvests at the cost of capital and adds no value.
- Growth options
- The right, but not the obligation, to expand — a source of value beyond the assets in place, akin to a call option on future investment that is exercised only if conditions are favourable.
- Percentage dilution
- The fall in each existing holder's fraction of the firm when new shares are issued. It happens in every issue, even a fair one, and does not by itself destroy value.
- Value dilution / wealth transfer
- The loss of dollar value to existing, non-participating owners when shares are issued below fair value — dollars moving to the new investor on top of pure percentage dilution. A fair-value issue has none.
- Two-price (under-priced) raising
- A capital raising priced below the shares' fair value, so new shares are sold cheap. It both dilutes the percentage and transfers wealth from old to new owners — the signature exam case.
Where Value Comes From and Dilution FAQ
Does issuing new shares always destroy value for existing owners?
No. Issuing at fair value dilutes each old holder's percentage of the firm but transfers no wealth — the cash raised exactly equals the value of the new claim, so value per share is unchanged. Value is only transferred when shares are issued below fair value: then the new investor pays less than the shares are worth, and the difference comes out of existing, non-participating owners' pockets. Percentage dilution and value dilution are different things.
How do I separate percentage dilution from value dilution?
Percentage dilution is the drop in your fraction of the company (your shares ÷ the larger total). Value dilution is the drop in the dollar value of your holding. In a fair-value raising your percentage falls but your dollar value does not — you own a smaller slice of a bigger pie worth the same per share. In an under-priced raising both fall, and the dollar loss equals the new investor's gain. Compute the ex-issue value per share to see which is happening.
Why does an under-priced issue transfer wealth even though the firm gets the cash?
The firm does receive the cash, but it sells claims worth more than the cash for less than they are worth. After the issue, total equity is spread over more shares, so the value per share falls toward a blended figure. The new investor, having bought cheap, ends up holding shares worth more than they paid — that surplus is funded by the dilution of existing owners who did not participate. The dollars are conserved: the old owners' loss equals the new investor's gain.
Is this a heavy-calculation question type?
Not usually. It is largely conceptual and quick: the exam tends to ask you to recognise whether a raising is fair or value-transferring and to separate percentage from value dilution, with a short numerical illustration of the ex-issue price and the dollars moved. The decision — fair or under-priced, who gains, who loses — carries the marks, so practise the reasoning, not long arithmetic.
Exam move
Lead with the decision: is the raising at fair value (percentage dilution only, no wealth transfer) or below fair value (a two-price raising that also moves dollars)? Practise the quick computation — post-issue equity = old equity + new cash, ex-issue value per share = that divided by the new total shares — and then the conservation check that the old owners' dollar loss equals the new investor's gain. Keep the three sources of value (competitive advantage, growth options, dilution) and the fair-vs-under-priced test on your A4. Because this is a conceptual short-answer type with provided formulas, the marks are in naming the effect correctly, not in long arithmetic.
