Effects of Stock Split

EFFECTS OF STOCK SPLIT

Introduction

The purpose of this research paper is information retrieval regarding stock split practice in a modern stock market, its major reasons and valuation effects on the company's financial position.

According to the definition stock split is a method commonly used to lower the market price of a firm's stock by increasing the number of shares belonging to each shareholder. Companies are able to split their stocks in any number of ways. The most common stock splits are, 2-for-1, 3-for-2 and 3-for-1. For example, if you own 100 shares of a company that trades at $100 a share and it declares a 2-for-1 stock split, you will own a total of 200 shares at $50 a share after the split. It is also possible to have a reverse stock split: a 1-for-10 means that for every ten shares you own, you get one share.

In spite of the fact that theoretically stock split has insignificant effect on the firm's capital structure and value of what shareholders own, many companies consider carrying out this corporate action. Let's take a look at the real world examples and find out the actual motivations of this tendency.

Regular Stock Split

Macy's, Inc

On May 19, 2006, the Macy's, Inc. board of directors approved a two-for-one stock split of Macy's, Inc. common stock. June 12, 2006 Macy's, Inc. common shares traded on NYSE at the new split-adjusted price, reflecting the doubling of the number of outstanding shares. It was the first stock split since Macy's, Inc. was listed in its current form on the New York Stock Exchange in February 1992.

The split is structured in the form of a 100% stock dividend, payable June 9, 2006 to shareholders of record on May 26, 2006. As a result of the stock split, each shareholder received one additional share of common stock for each share of common stock owned as of the close of business on the record date, at half the market price per share. For example, if an investor owns 100 shares of FD as of the record date and the market price is $74.00/share, that investor's total value is $7,400.00. After the split, the investor will have a total of 200 shares of stock, but the market price will be $37.00/share. The investor's total investment value in FD remains the same at $7,400.00 until the stock price moves up or down.

After the stock split the proportionate vote and interest a stockholder maintains in Macy's Inc. remained the same relative to other shareholders. The par value didn't change and stayed at $0.01 per share while quarterly dividend was 12.75 cents per outstanding common share. There was no cost to stockholders in connection with the stock split and they did not have to pay taxes on their receipt of new shares.

In order to analyze influence on the company's financial position on the market let's take a look at the numbers. The table 1 provides information for 2006.

Table 1

As we can see, in the second quarter of 2006 close price adjusted for dividends and splits had a tendency to go down (from 42.69 to 34.51), but after the 2:1 stock split it became to increase (from 35.98 to 38.12). However, at the end of the year the close price went down to 32.37.

In order to analyze this situation lets take a look at the theoretical and practical sides of stock split situation, its economic reasons and possible results.

As we know from Law of Demand, there is a negative or inverse relationship between price and quantity demand. After stock split in the second quarter 2006 the price of each stock decreased of half market price and become more affordable for the larger amount of investors. As a result, the number of Macy's Inc common share buyers increases, which moved the curve of the demand of Macy's Inc common share up (table 2).

The increase in demand leaded the price of the stock to move up and we can see the results of it in the previous table 1.

Table 2. Supply and Demand of Macy's Inc common share

P Ð'- price per share

Q - quantity of share

S - supply

D - demand

Theoretically, a stock split is commonly done by companies that feel its per-share price has risen beyond what an individual investor is willing to pay. They believe that lowering the market price will make their stocks more affordable for these investors and thereby stimulate and increase trading activity.

However, the low price is not the guaranty of success. For instance, there are many cheep stocks at the market, which nobody wants to buy because there is no potential of these companies.

Another economic reason why company might do a stock split is its optimism about the future. Eventually the stock split causes an increase in the numbers of shares on the market, which lead to decreasing of Earning Per Share (EPS). It is normal for EPS to decline after stock split because EPS = Net Income/ Total of shares outstanding. Since Net Income will not be impacted by the stock split, EPS has to go down due to increase in amount of shares outstanding. However, if the company has good expectations about their financial future, it might not be too concern about decline in EPS.

In the practice we can see that the theory works and summation of increasing numbers of investors willing to buy the stocks and underline company's signal of its optimistic view at the future lead to increasing of Macy's common share's price.

However, we can assume that Macy's positive prognoses about the future are not completely proved in reality and price eventually went down. Again, it provides evidence that price is not the key point of buying decision. The main factor, which stimulates investors to purchase the stocks, is their expectation of increasing company's future profitability.

In order to prove this point, let's take a look at the history of Berkshire Hathaway Inc, which has an extremely high price per share. For example, one year ago a single share of Berkshire Hathaway cost around $101,000 per share and was the first stock to ever hit a six-digit share price. Berkshire Hathaway is not going to split their stocks and not interesting to make the price more affordable for small investors because these stocks are not for common people. These stocks are designed for very wealthy investors.

As we can see from Figure 1, through one year the price of Berkshire Hathaway's