Question

a) What’s the difference between a stock dividend and a stock split?

    b)     How do stock dividends and splits affect stock prices?

    c)     In what situation should a firm pay a stock dividend?

    d)     In what situation should a firm split its stock?

    e)    Consider the following case: You have 100 common shares of Comm Suppliers Inc. (CSI) The EPS is $4.00, the DPS is $2.00; and the stock sells for $60 per share. If CSI does a two-for-one stock split how many shares will you have; what will be the new EPS and DPS; and what would you expect the stock price to be?

Answer 1

a) The difference between a stock dividend and a stock split may be illustrated as follows:

Stock Dividend:

When a firm distributes a portion of its profits to equity shareholders, the same is called a dividend. It may be a cash dividend or a stock dividend.

Dividend payouts in the form of equity or shares are known as Stock Dividend.

Stock dividends have benefits in that they help to increase the liquidity of the company, and tax benefits can be passed on to the investors.

Stock Split:

A stock split takes place when a company divides or splits its existing shares into multiple shares. This is done in a bid to  lower the trading price of their stock, so that additional investors can be attracted to the company, and the liquidity of the shares can be increased.

Let's take an example of an investor who currently holds 1000 shares of a company X Limited having a face value of Rs. 100 and market value Rs. 150.

If Company X Ltd, decided to go in for a stock split in the ratio of 2 for 1, then the investor will get an additional 1 share, for every 1 share that he holds. which means that for every 1 share, a shareholder will get 1 more share.

In this example, Mr. A is holding 1000 Shares, after the stock split his shareholding will increase to 2000 shares. Also, the price of the share will be halved and the number. of shares will increase.

Stock splits that increase the number of shares are called as forwarding Stock Split and stock splits which decrease the number of shares is called Reverse stock splits.

b) Companies with regular dividend payouts, are generally perceived to be financially stable. Stock dividends may not provide an actual increase in value, however, it has generally been observed that the stock prices register an increase after a declaration of dividend.

However, a stock dividend has the effect of increasing the number of shares outstanding, and the enterprise value remains stable. However, the book value per common share, and the stock price reduces.

In case of a stock-split, the number of shares held increases, but the investment value/market capitalization remains intact.

Stock splits are done with reference to the face value. Suppose the stock’s face value is Rs.10, and there is a 2:1 stock split then the face value will change to Rs.5. If you owned 1 share before split you would now own 2 shares after the split.

An illustration follows.

Ratio	Original FV	No of shares you own before split	Share Price before split	Investment Value before split	New FV	No of shares you own after the split	Share Price after the split	Investment value after the split
1:2	10	100	1000	100000	5	200	500	100000
1:5	10	100	1000	100000	2	500	200	100000

c) Companies usually pay cash dividends to investors. However, there may be several forms of dividend payments, including property dividends and stock dividends.

A company may pay a stock dividend in the following situations:

- Lack of  adequate cash to pay a cash dividend.

- The company wants to increase the number of shares.

- To pass on tax benefits to the investor. In case of cash dividends, the proceeds are taxable as income, but stock dividends are liable for tax only when an investor sells them.

d) Usually, a stock split happens to adjust trading prices so that the company can attract additional investors. For examples, for an investor, a 100 shares of $10 stock is easier to purchase, as opposed to 10 shares of $100 stock.

Hence, if trading or share prices go up, a company will consider a stock-split. When a stock split is implemented, share prices are adjusted accordingly. For example, a 2-for-1 stock split means that for every one share held by an investor, there will now be two.

e) If the company goes in for a two-for-one stock split, the number of shares will be doubled.

For every 100 common shares held by the investor, there will be additional 100 shares. Hence, the total number of shares would be 200.

Earnings per share or EPS =  Net Profits or earnings/Number of shares outstanding.

A stock split results in an increase in the number of shares, with profits remaining constant, hence; a split will result in a lower EPS.

A 2-for-1 stock split will result in an EPS of half the amount of the pre-split earnings or what the earnings would have been had the split not occurred.

Hence, post the stock split, the EPS will be $2.00

In case of a stock split, the total amount of dividends paid remains the same, but due to the increase in the number of shares, DPS will be reduced.

Therefore, in case of two-for-one stock split, the new DPS will be $1.00.

Similarly, the stock price will be reduced by half, $60/2 = $30.