Question

Contrast the differences between a stock dividend and a stock split. Imagine that you are a stockholder in a company. Determine whether you would prefer to see the company that you researched declare a 100% stock dividend or declare a two-for-one split. Provide support for your answer with one real-world example of your preference.

Answer 1

Stock Dividend vs Stock Split

Stock Dividend Definition

This Involves issuing existing stockholders additional shares in the company that may replace or even supplement a cash dividend from its retained earnings.

Example. Say a company issues a stock dividend of 10%. A stockholder holding 100 shares will receive 10 additional shares of the company. All existing shareholders will be issued additional shares in proportion to their original shares held.

This will also INCREASE the number of outstanding shares of the company post issuance. Usually a Stock Dividend is considered if the issuance is 20% or less of outstanding shares

Stock Split Definition

This works in the same way of a Stock Dividend but by a much larger factor and it increases the outstanding shares.

Example: If a firm issues a “two-for-one” stock split the shareholder an additional share is given for each share held by a shareholder.

Impact on Value:

Both Stock splits and Stock Dividends have no effect on the cash flows of the firm but change the outstanding shares post issuance. Since Stock Dividends are issues from Retained Earnings it will only record this as financing activity.

This will not increase the value of the equity of the firm.

Example:

Assume a firm with $110 million in Equity Value with outstanding shares of 100 million. Price of share (110/100) = 11

If the firm issues a 10% stock dividend, the total equity value will remain the same, but the outstanding shares will increase to 100 million. Then, the share prices will drop to ($110mm equity value/110 outstanding shares)- $10 per share.

Similarly of a stock of a firm is trading at $50 and issues a two-for-one stock split, post issuance the price of the stock will halve to $25 as the aggregated equity value of the equity stays the same only the outstanding shares doubles.

As the equity value of the Equity stays the same the Price of the Stock post Stock Dividends or Stock Splits can change.

Impact on Price Movements and Shareholder Wealth

If a current shareholder is researching the company that he/she holds share is a 100% stock dividend or a two-for-one split preferable?.

This depends on the (i) prospects of the company from research and (ii) purpose of the issuance.

Rationale

Option for stock Dividend

Scenario A: A company may wish to issue the Stock Dividend because it wishes to keep its retained Earnings instead of to grow the company. Then this should be seen as positive as it mitigates the need for external borrowing to grow.

If a Stock Dividend is not taxed, then I would prefer to have the 100% stock dividend as my shareholding will double and I will be only taxed on Share Capital Gains. In some instances, no capital gains after some period of holding

Briefly, one would prefer stock dividend if and only if,

• Increase the Liquidity of Cash, allowing a growth and expansion
• Increases the Liquidity of Shares in the market, driving up share price
• Increases the investor interest in the company by Tax Benefits.

Scenario B: Suppose the company has been historically providing Cash Dividends and decides to give a Stock Dividend of 100% instead of cash.

This can be considered a dubious replacement of cash and the research indicates it is in a low position to generate cash and its prospects are bleak then the shareholder wealth can come to zero. If poor prospects of the company, retention of the stock is not advised for such a declaration.

Opting for Stock Spit:

The purported reason for raising(doubling) outstanding shares is to increase shareholder subscription by lowering the purchase price of the stock. As in the example, it will half the price of the stock, allowing better access for retail or institutional investors to buy. This is the increase of liquidity rationale.

This is acceptable if the prospects are good as the price or the share will increase,