Question

Dividend Policy

a) Stock splits are said to be cosmetic events and yet investors react positively to stock split announcements. Explain why stock splits are considered as cosmetic events and briefly discuss why the market reacts positively to such events.

Mergers and Acquisition

b) Briefly discuss one reasons why takeovers occur.     

Answer 1

1. Stock splits are defined as issue of new shares to the existing shareholders in proportion to their current holdings with the company. Stock splits are considered to be cosmetic events because the cash flows of the company are unaffected, the shareholder retains his proportionate ownership & the claims of other classes of security holders also remain unaltered.

The stock split provides more liquidity to the market as a result of which it responds positively to the stock split. There can be increased volume of trading in the company because a company that was previously not drawing the investors interests can attract their interests now which can result in increased volume of trading in the market.

There has been no consensus on how markets and share prices generally react to stock splits. It is not possible to generalize market reaction elicit by stock splits around announcement and ex-day. It is quite captivating to find behaviour of share prices around stock splits though in theory splits have no effect on value creation.

2. Reason for takeover:

There can be many reasons for takeovers. But the major reason is gaining large market share & competitive advantage. One company can face difficulty in attaining high sales volume as there are many businesses offering similar services. Hence to face this issue the company may take over a competing firm that can help the business to gain large market share & also reduce the pressure of competition in the market.

It becomes possible that all the products and services offered by the acquired firm are controlled by the acquiring firm and all sales and profits are attributed to the acquiring firm. Once a business has been taken over by another business, the competition that previously existed between the two firms dies off as the two businesses become a single entity in the market competing against other businesses in the market.