Question

Mammoth Corporation is considering a 3-for-2 stock split. It currently has the stockholder’s equity position shown. The current stock price is $120 per share. The most recent period’s earning available for common stock is included in retained earnings.

Preferred stock $1,000,000

Common stock (100,000 shares at $3 par) 300,000

Paid-in capital in excess of par 1,700,000

Retained earnings 10,000,000

Total stockholder equity $13,000,000

a. What effects on Mammoth would result in a stock split?

b. What change in stock price would you expect to result from the stock split?

c. What is the maximum cash dividend per share that the firm could pay on common stock before and after the stock split? (Assume that legal capital includes all paid-in capital)

d. Contrast your answer in parts a through c with the circumstances surrounding a 50% stock dividend

e. Explain the differences between stock splits and stock dividend.

Answer 1

a. What effects on Mammoth would result in a stock split?

Par value of common stock before stock-split is $3 per share

And number of outstanding shares before stock-split is 100,000 shares

After a 3-for-2 stock split -        

Par value of common stock will decrease to $2 per share (2*$3/3 = $2 per share)

And number of outstanding shares will increase to 150,000 shares (100,000* 3/2 = 150,000)

b. What change in stock price would you expect to result from the stock split?

Stock price before stock split stock price is $120 per shares

Stock price after a 3-for-2 stock split

= $120 * (2/3) = $80 per shares

Therefore the stock price will decrease after stock split to $80 per share

c. What is the maximum cash dividend per share that the firm could pay on common stock before and after the stock split? (Assume that legal capital includes all paid-in capital)

The maximum cash dividend per share that the firm could pay on common stock before the stock split

= Retained Earnings / number of outstanding shares before stock-split

= 10,000,000/ 100,000 = $100 per share

The maximum cash dividend per share that the firm could pay on common stock after the stock split

= Retained Earnings / number of outstanding shares after stock-split

= 10,000,000 /150,000 = $66.67 per share

d. Contrast your answer in parts a through c with the circumstances surrounding a 50% stock dividend

After a 50% stock dividend;

The number of outstanding shares = 100,000 * (1+ 50%) = 150,000

Stock price = ($120 * 100,000) /150,000 = $80

Retained earnings will decrease after stock dividend as funds from retained earnings will be transferred to common stock account and paid in capital excess of par account

Increase in Common stock account

= par value after stock dividend - par value before stock dividend

= $3 * 150,000 - $3 * 100,000 = $150,000

Increase in Paid in capital excess of par accounts

= incremental value of stock dividend - par value of stock dividend

= $120 * 50,000 - $150,000 = $5,850,000

Now,

Retained earnings after stock split = Retained earnings before stock dividend - Increase in common stock account - Increase in Paid in capital excess of par account

= $10,000,000 - $150,000 - $5,850,000 = $4,000,000

Therefore,

The maximum cash dividend per share that the firm could pay on common stock after the stock split

= Retained Earnings / number of outstanding shares after stock-split

= $4,000,000 / 150,000 = $26.67 per shares

e. Explain the differences between stock splits and stock dividend.

A stock dividend is the payment to shareholders of additional shares of equity rather than cash amount and par value of a share will remain the same while in stock split the par value of a share will reduce.

In case of stock dividend there will be a transfer of fund from retained earnings account to common stock account and Paid-in capital in excess of par account.

But the value of total equity will remain the same in the case of stock splits as well as stock dividend.