The thought was that distribution of shares in lieu of a cash...

The thought was that distribution of shares in lieu of a cash dividend might still allow the franking credits to be distributed. But if you're correct that cash dividends are needed for franking credits to be of any use, then we can presumably forget about this scheme happening.

I don't follow your line of thought about the issue of extra shares (dilution) necessarily leading to a decrease in the share price though. If it were a bonus issue, then yes, 100% pro rata. But this scheme would see the dividends reinvested in the company. The reinvested funds would presumably generate a return. If the rate of return was similar to the return on existing funds deployed, then I don't see there would be any effect on the share price. In theory, the funds could generate a higher rate of return, eg. via economies of scale - and have a positive effect on the share price.