Concept Of Reverse Stock Splits

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The company may want to reduce the number of share outstanding if its share price falls substantially. Number of share is reduced by reverse stock split. The reduction of the number of outstanding share increases both the par value per share and market price per share. Reverse stock split also increases earning per share and dividend per share. It is just opposite of stock splits.

Example,

Suppose, total shareholder's account of a firm is as follows:

A. Common stock (10,000 Shares @ $ 10).........................= $ 100,000
B. Additional paid in capital...................................................= $ 100,000
C. Retained earnings..............................................................= $ 300000
Total shareholder's equity....................................................= $ 500,000

Now let us assume that the firm announced 2-for-5 reverse stock split, which results into decrease in number of outstanding shares from 10,000 shares to 4,000 shares (i.e. 10,000 shares x 2/5) and increase in the par value from $10 per share to $ 25 per share ( i.e. $10 x 5/2). This keeps the value of common stock constant at $ 100,000 ( i.e. 4,000 x $25). Thus, total shareholder's equity account of the firm after 2-for-5 reverse stock splits appear as:

A. Common stock (4,000 shares @ $25 each).......................= $ 100,000
B. Additional paid in capital .....................................................= $ 100,000
C. Retained earnings ................................................................= $ 300,000
Total shareholder's equity (A+B+C)......................................= $ 500,000.

Concept Of Stock Splits And Its Value To Shareholders

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A stock split is similar to a stock dividend in economic sense. When a company announces stock splits, it results into an increase in number of outstanding shares with a proportionate decrease in par value and market price of the stocks. Therefore, firms with exceptionally high market prices split their stocks in order to bring the market price within reasonable limits. As a result, small investors can purchase the company's share. With a stock split, total value of the shares of common stock outstanding remains unchanged along with no change in paid-in capital and retained earnings.

Example,
Suppose, a firm has the following total shareholder's equity account before stock split:

A. Common stock ( 4000 shares @ $10)...................=$ 40,000
B. Additional paid-in capital........................................= $ 20,000
C. Retained earnings ....................................................= $ 90,000
Total shareholder's equity (A+B+C)...........................= $ 150,000

If the firm announces 2-for-1 stock splits, it results into an increase in outstanding shares from 4,000 shares to 8,000 shares (i.e 4,000 shares x2) and reduction in the par value from $ 10 per share to $ 5 per share (i.e. $10 x 1/2). This keeps the value of common stock constant at $ 40,000 (i.e 8,000 shares x $ 5). Total shareholder's equity accounts of the firm after 2-for-1 stock splits announcement appears as:

A. Common stocks ( 8,000 shares @ $ 5 each)....................= $ 40,000
B. Additional paid in capital.....................................................= $ 20,000
C. Retained earnings................................................................= $ 90,000
Total shareholder's equity (A+B+C)......................................= $ 150.000

Unlike in stock dividend, stock split does not involve transfer of funds from retained earnings to paid-in capital and common stock accounts.
Stock splits do not change the proportionate ownership of the company. Therefore, stock splits has no economic value to the investors or shareholders. When the number of shares held by shareholders increases, because of stock splits, the market price of the stock should decrease proportionately to remain the total value of common stock unchanged.

Concept Of Stock Dividend And Its Value To Investors

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A stock dividend refers to the dividend paid to existing stockholders in the form of additional shares of common stock. Unlike cash dividends it does not result into the cash outflows. The purpose of stock dividend is to conserve cash in the firm, so that it can be used in new projects. It involves simple book keeping transfer from retained earnings to the capital stock account. The stock dividend does not affect the equity position of stockholders; rather it represents a recapitalization of a company which takes place in the form of transfer of certain amount from firm's retained earnings to capital stock account.

Example,
Suppose a firm has following total shareholder's equity account before a 20 percent stock dividend announcement:
A. Common stock (100,000 shares of $ 10 par) .........= $ 1,000,000
B. Additional paid in capital.............................................= $ 200,000
C. Retained earnings........................................................= $ 1,800,000
Total shareholder's equity(A+B+C)..............................= $ 3,000,000

If the firm announces 20% stock dividends, the firm has to issue additional 20,000 shares in common stock. To illustrate the effect of stock dividend on total shareholder's equity accounts, let us assume that current market price of the stock is $ 40. So, amount of stock dividend will be $ 800,000 (i.e. $40 x 20,000 shares). The total amount of dividend is transferred to common stock account and additional paid-in capital from retained earnings. Since par value of common stock is $ 10 a total of $ 200,000 (i.e. $10 x 20,000 shares) is transferred to common stock account and rest $ 600,000 (i.e $ 30 x 20,000 shares) is added to paid-in capital. Thus, the total amount of shareholder's equity remains the same. total shareholder's equity account after 20% stock dividend appears as follows:

A. Common stock( 120,000 Shares of $ 10 par)...............= $1,200,000
B. Additional paid-in capital.................................................= $ 800,000
C. Retained earnings.............................................................= $ 1,000,000
Total shareholder's equity (A+B+C)..................................= $ 3,000,000

Stock dividend generally has no economic significance as it only results into change in capitalization keeping total equity position constant. Stock dividend simply results into an increase in outstanding shares of common stock. In the above example, with a 20% stock dividend, there is an increase in outstanding shares of common stock from 100,000 shares to 120,000 shares.

Factors Affecting Dividend Policy Of A Firm

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A firm's dividend policy is influenced by the large numbers of factors. Some factors affect the amount of dividend and some factors affect types of dividend. The following are the some major factors which influence the dividend policy of the firm.

1. Legal requirements
There is no legal compulsion on the part of a company to distribute dividend. However, there certain conditions imposed by law regarding the way dividend is distributed. Basically there are three rules relating to dividend payments. They are the net profit rule, the capital impairment rule and insolvency rule.

2. Firm's liquidity position
Dividend payout is also affected by firm's liquidity position. In spite of sufficient retained earnings, the firm may not be able to pay cash dividend if the earnings are not held in cash.

3. Repayment need
A firm uses several forms of debt financing to meet its investment needs. These debt must be repaid at the maturity. If the firm has to retain its profits for the purpose of repaying debt, the dividend payment capacity reduces.

4. Expected rate of return
If a firm has relatively higher expected rate of return on the new investment, the firm prefers to retain the earnings for reinvestment rather than distributing cash dividend.

5. Stability of earning
If a firm has relatively stable earnings, it is more likely to pay relatively larger dividend than a firm with relatively fluctuating earnings.

6. Desire of control
When the needs for additional financing arise, the management of the firm may not prefer to issue additional common stock because of the fear of dilution in control on management. Therefore, a firm prefers to retain more earnings to satisfy additional financing need which reduces dividend payment capacity.

7. Access to the capital market
If a firm has easy access to capital markets in raising additional financing, it does not require more retained earnings. So a firm's dividend payment capacity becomes high.

8. Shareholder's individual tax situation
For a closely held company, stockholders prefer relatively lower cash dividend because of higher tax to be paid on dividend income. The stockholders in higher personal tax bracket prefer capital gain rather than dividend gains.