Stock Dividends and Stock Splits - Financial Management

A stock dividend is the payment of additional shares of stock to common stockholders. It involves making a transfer from the retained earnings account to the other stockholders’ equity accounts.For example, the Colonial Copies Company has the following common stockholders’ equity:

Stock Dividends and Stock Splits

INTERNATIONAL ISSUES

Dividend Policies for Multinational Firms

Dividend payments from foreign subsidiaries represent the primary means of transferring funds to the parent company. Many factors determine the dividend
payments that are made back to the parent, including tax effects, exchange risk, political risk, the availability of funds, the financing requirements of the foreign subsidiary, and the existence of exchange controls. Taxes in the host country play a significant role in determining a multinational firm subsidiary’s dividend policy.

For example, in Germany, the tax rate on earnings paid out as dividends is much lower than the tax rate on retained earnings. When the parent is located in a country with a strong currency and the subsidiary is located in a country with a weak currency, there will be a tendency to rapidly transfer a greater portion of the subsidiary’s earnings to the parent to minimize the exchange rate risk. In the face of high political risk, the parent may require the subsidiary to transfer all locally generated funds to the parent except for those funds necessary to meet the working capital and planned capital expenditure needs of the subsidiary.

As is true for domestic enterprises, large and more mature foreign subsidiaries tend to remit a greater proportion of their earnings to the parent, reflecting the reduced growth opportunities and needs for funds that exist in larger firms.Also, when the foreign subsidiary has good access to capital within th host country, it tends to pay larger dividends to the parent because funds needed for future expansion can be obtained locally.

Finally, some countries with balance -of-payments problems often restrict the payment of dividends from the subsidiary back to the parent. Many firms require that the payout ratio for foreign subsidiaries be set equal to the payout ratio of the parent.The argument in favor of this strategy is that it requires each subsidiary to bear an equal proportionate burden of the parent’s dividend policy. However, even when this strategy is adopted, it often is modified on a country -by-country basis to reflect the considerations

Suppose the firm declares a 10 percent stock dividend and existing shareholders receive 10,000 (10% *100,000) new shares. Because stock dividend accounting is usually based on the predividend market price, a total of $200,000 (10,000 shares*an assumed market price of $20 per share) is transferred from the firm’s retained earnings account to the other stockholders’ equity accounts. Of this $200,000, $50,000 ($5 par *10,000 shares) is added to the common stock account and the remaining $150,000 is added to the contributed capital in excess of par account. Following the stock dividend, Colonial has the following common stockholders’ equity:

post stock dividend common stockholders equity

The net effect of this transaction is to increase the number of outstanding shares and to redistribute funds among the firm’s capital accounts. The firm’s total stockholders’ equity remains unchanged, and each shareholder’s proportionate claim to the firm’s earnings remains constant. For example, if Colonial Copies Company has 100,000 shares outstanding prior to a 10 percent stock dividend and its total earnings are $200,000 ($2 per share), a stockholder who owns 100 shares has a claim on $200 of the firm’s earnings. Following the 10 percent stock dividend, earnings per share decline to $1.82 ($200,000/110,000 shares).

The stockholder who originally owned 100 shares now has 110 shares but continues to have a claim on only $200 (110 shares*$1.82 per share) of the firm’s earnings. Because each shareholder’s proportionate claim on a firm’s net worth and earnings remains unchanged in a stock dividend, the market price of each share of stock should decline in proportion to the number of new shares issued. This relationship can be expressed as follows:

Post–stock dividend price = Pre–stock dividend price/1 + Percentage stock dividend rate

In the Colonial Copies example, a $20 pre–stock dividend price should result in a poststock dividend price of

Post–stock dividend price = $20/1 + 0.10 = $18.18

If a stockholder’s wealth prior to the dividend is $2,000 (100 shares*$20 per share), postdividend wealth should also remain at $2,000 (110 shares*$18.18 per share). In essence, all a stock dividend does is increase the number of pieces of paper in the stockholders’ hands.Nevertheless, there are a number of reasons why firms declare stock dividends. First, a stock dividend may have the effect of broadening the ownership of a firm’s shares because existing shareholders often sell their stock dividends.Second, in the case of a firm that already pays a cash dividend, a stock dividend results in an effective increase in cash dividends, providing that the per -share dividend rate is not reduced.

(It is rare for a firm to declare a stock dividend and reduce its cash dividend rate at the same time.) And, finally, the declaration of stock dividends effectively lowers the per-share price of a stock, thereby possibly broadening its investment appeal. Investors seem to prefer stocks selling in approximately the $15 to $70 price range because more investors will be financially able to purchase 100 -share round lots. Round lots of 100 shares are more desirable for investors to own because lower transactions costs are associated with their purchase and sale.Stock splits are similar to stock dividends in that they have the effect of increasing the number of shares of stock outstanding and reducing the price of each outstanding share.

From an accounting standpoint, stock splits are accomplished by reducing the par value of existing shares of stock and increasing the number of shares outstanding. For example, in a two -for-one stock split, the number of shares would be doubled. Although stock splits have an impact similar to stock dividends, they normally are not considered an element of a firm’s dividend policy.


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