Stock Split
Stock Split

Stock Split – Understanding

What is a Stock Split?

A stock split is an action taken or technique used by a firm (company, corporate) to increase the number of shares outstanding by reducing the par value and market price of the stock. Even, the number of outstanding shares increases the cash value of the company does not increase, rather than remains the same as pre-split amounts because it does not affect the balance sheet amount of the company. The purpose of it is to enhance the marketability of shares bringing it within optimal price range.

When a company announces stock splits, it results in an increase in the 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 other to bring the market price within reasonable limits. The opposite of stock splits is the reverse stock splits which reduce the firm’s number of outstanding shares and proportionately increases the stock price.

Understanding the Stock Split Ratio’s

Most of the stock split ratio’s are announces as: 2-for-1, 3-for-1, 5-for-1, 10-for-1, 15-for-1, 100-for-1, and so on. Let us take a 2-for-1 stock split, which means that the existing number of outstanding shares will be double and the existing price of shares will be halved. In other words, one share held by the investor after it there will be two numbers of share, and one share held price now it will be the price of two shares. Here, under the 2-for-1 stock split, to calculate the number of outstanding shares the existing number of outstanding shares is multiplied by 2 and for price per stock, the existing par value or market price of stocks is divided by 2.

For a practical example of the 2-for-1 stock split, suppose ABC company has 1,000 shares outstanding and has a par value of Rs. 100 a share. Then, after assumed stock splits the total outstanding shares increased from 1,000 shares to 2,000 shares (i.e. 1,000 shares × 2) and the par value of a share decreased from Rs. 100 to Rs. 50 a share (i.e. Rs. 100 × 1/2).

Understanding 2-for-1 Stock Split through the image

2-for-1 Stock Split

On the above image or picture, a company announced a 2-for-1 stock split, before the announcement the price of one stock was Rs. 100 a stock and after it, the price of two stocks equals the previous one stock (i.e. a stock = Rs. 50 and another stock = Rs. 50). Similarly, before it, there was one stock and after it, there are two stocks but the price is decreased halved.

Similarly, 3-for-1 Stock Split

3-for-1_stock_split

Reasons for stock splits (How and Why?)

Stock splits as an action or technique used by the various corporation helps to reduce the price of stocks and an increase in the number of outstanding shares. When a company’s board of directors decide to announce the stock splits the board of director prices the stocks as comfortable to the investors. For the comforting of investors, the price of stocks is reducing to increase in the liquidity of the shares. The stock split changes the viewing point of the investors in a way by reducing the price. Most investors are willing to be the common stockholders of the company to enjoy the rights of common stock when they see the price low and think comfortably to purchase it they will buy. Hence, the manager or board of directors has to make a decision by analyzing the behavior of the investors around the business firm. As a lower stock price, it increases the demand in the market.

Most of the business firms are using this stock split technique but it is not necessary to use by the firm. Mostly, when the firm’s stock price reaches up to Rs. 100 or Rs. 200 or more then the firm uses stock splits to attract the investors. But some firms are never taking action of the stock splits either their stock price too much high. Therefore, it is not compulsory but when desired it can be used by the firms.

Let’s clarify with the example

Let us consider, a firm has the following total shareholder’s equity account before the stock split.

Common stock (4,000 shares @ Rs. 100)
Additional paid-in capital
Retained earnings
Rs. 400,000
200,000
900,000
Total shareholder’s equityRs. 1,500,000

If the firm announces 2-for-1 stock splits, it results in an increase in the number of outstanding shares from 4,000 shares to 8,000 shares (i.e 4,000 shares × 2). And, a reduction in the par value from Rs. 100 per share to Rs.50 per share (i.e. Rs. 100 × 1/2). This keeps the value of common stock constant at Rs. 400,000 (i.e. 8,000 shares × Rs. 50).

The total shareholder’s equity accounts of the firm after the 2-for-1 stock split announcement appears as:

Common Stock (8000 shares @ Rs. 50 each)
Additional paid-in capital
Retained earnings
Rs. 400,000
200,000
900,000
Total shareholder’s equityRs. 1,500,000

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