A share split is a method to increase the number of outstanding shares through a proportional reduction in the par value of the share. A share split affects only the par value and the number of outstanding shares; the shareholders’ total fund remains unaltered.
Stock split is done to infuse liquidity and to make shares affordable for various investors who could not buy the shares of that company before due to high prices. People often confuse bonus shares with stock split. Distribution of bonus shares only changes its issued share capital whereas stock split splits the company’s authorized share capital.
Advantages of Share Split
- Price: Some investors are intimidated by high-priced stocks, especially those priced over $100 per share. These investors would rather buy 100 shares at $50 each than 50 shares each priced at $100, even though there is no economic difference between the two. Even the commissions are the same. Split stocks supposedly benefit from increased “liquidity,” the ability to sell stock without affecting its price. There is little evidence to support this conjecture.
- Signaling: There is some evidence that stock prices do temporarily increase right after a split, but the same studies show that the effect disappears quickly. Nonetheless, corporations may use stock splits to signal that their businesses are doing well. This benefit is more psychological than financial.
- It is Not a Reverse Split: While stock splits are probably neutral, reverse splits, where many old shares are consolidated into fewer new shares, is undoubtedly negative. It signals that a stock price has fallen to an “unrespectable” level, somewhere south of $10 a share. A reverse split calls attention to a stock price decline and raises a lot of questions as to why the price is so low. Below $5 per share, a stock is at risk of being delisted from the stock exchange, which would severely handicap the company’s ability to raise new equity funding.
- The Long Run: One of the most rewarding investments a person can make is to own shares that have a repeated pattern of growing and splitting.
Bonus Share Vs. Share Split
As with the bonus share the total net worth does not change and the number of outstanding shares increases with the share split. However, with the share split, the number of outstanding shares increases substantially. The bonus issue and the share split are similar except for the difference in their accounting treatment In case of the bonus shares, the balance of the reserves and surpluses account decreases due to a transfer to the equity capital and the share premium accounts. The par value per share remains unaffected. With a share split, the balance of the equity accounts does not change, but the par value per share changes. The earnings per share win be diluted and the market price per share will fall proportionately with a share split. But the total value of the holdings of a shareholder remains unaffected with a share split.
When a share is split, say, from Rs 10 denomination to Re 1 denomination, there would neither be an increase in the share capital nor a concomitant decrease in the reserves of the company. This is because while in a bonus issue a person having one share of Rs 10 face value would get another share of the same face value should the company go for a 1:1 bonus what would happen in a stock split is his one Rs 10 share would now be converted into ten Re 1 shares.
Reasons for Share Split
The following are reasons for splitting of a firm’s ordinary shares:
To make Shares Attractive – The main purpose of a stock split is to reduce the market price of the share in order to make it attractive to investors. With reduction in the market price of the share, the shares of the company are placed in a more popular trading range. For example, if the shares of a company are sold in the lots of 100 shares, it requires Rs 10,000 to buy 100 shares selling for Rs 100 per share. A five-for-one split would lower the price to Rs 20 per share and the total cost of 100 shares to Rs 2;000. The wealthy investor can still purchase shares of Rs 10,000 by acquiring a large number of shares (500 share at Rs 20). But a serious investor can also afford to buy 100 shares for Rs 2,000 for which he otherwise needed Rs 10,000 before the split Thus, the reduction in the market price, caused by the share split, motivates more investors, particularly those with small savings, to purchase the shares. This helps in increasing the marketability and liquidity of the company’s shares.
Indication of Higher Future Profit – The company man-agreement to communicate to investors’ uses the share splits that the company is expected to earn higher profits in future. The market price of high-growth firm’s shares increases very fast. If the shares are not split periodically, they fall outside the popular trading range. Therefore, the companies resort to share splits from time to time. The share split like bonus shares, thus, has an informational value that the firm is expected to perform efficiently and profitably and that the shares have been spited to avoid future high price per share.
Increased Dividend – When the share is split, seldom does a company reduce the cash dividend per share proportionately. Nor does it increase the cash dividend per share proportionately. However, the total dividends of a shareholder increase after a share split. For example, a company may be paying a cash dividend of Rs 3 per share· before the share spot. But after a spot of three-of-one, the company may pay a cash dividend of Rs 1.50 per share.
A shareholder holding 100 shares before the split will receive ‘a total cash dividend of Rs 300. The number of shares owned by the shareholder will increase to 300 after the split and his total cash dividend will be Rs 450. The increased dividends may favourably affect the after-split market price of the share. It should be noted that the share split per se has no effect on the market price of share.
