## Value of Stock Splits and Stock Dividends

The laws of logic tell us that stock splits and stock dividends can (1) leave the value of the firm unaffected, (2) increase its value, or (3) decrease its value. Unfortunately, the issues are complex enough that one cannot easily determine which of the three relationships holds.

The Benchmark Case A strong case can be made that stock dividends and splits do not change either the wealth of any shareholder or the wealth of the firm as a whole. In our preceding example, the equity had a total market value of \$660,000. With the small stock dividend, the number of shares increased to 11,000, so it seems that each would be worth \$660,000/11,000 = \$60.

For example, a shareholder who had 100 shares worth \$66 each before the dividend would have 110 shares worth \$60 each afterwards. The total value of the stock is \$6,600 either way; so the stock dividend doesn't really have any economic effect.

After the stock split, there are 20,000 shares outstanding, so each should be worth \$660,000/20,000 = \$33. In other words, the number of shares doubles and the price halves. From these calculations, it appears that stock dividends and splits are just paper transactions.

Although these results are relatively obvious, there are reasons that are often given to suggest that there may be some benefits to these actions. The typical financial manager is aware of many real-world complexities, and, for that reason, the stock split or stock dividend decision is not treated lightly in practice.

Popular Trading Range Proponents of stock dividends and stock splits frequently argue that a security has a proper trading range. When the security is priced above this level, many investors do not have the funds to buy the common trading unit of 100 shares, called a round lot. Although securities can be purchased in odd-lot form (fewer than 100 shares), the commissions are greater. Thus, firms will split the stock to keep the price in this trading range.

For example, in early 1999, Microsoft announced a two-for-one split. This was the eighth split for Microsoft since it went public in 1986. The company said that "Microsoft works to make our technologies broadly accessible to customers. Similarly, we aim to make our stock broadly accessible to individuals and this stock split should help achieve that objective." Similarly, since 1984, Wal-Mart has split its stock two-for-one four times, and Dell Computer has split three-for-two once and two-for-one six times since going public in 1988.

Although this argument is a popular one, its validity is questionable for a number of reasons. Mutual funds, pension funds, and other institutions have steadily increased their trading activity since World War II and now handle a sizable percentage of total trading volume (on the order of 80 percent of NYSE trading volume, for example). Be trading range

The price range between the highest and lowest prices at which a stock is traded.

Ross et al.: Fundamentals I VI. Cost of Capital and I 18. Dividends and Dividend I I © The McGraw-Hill of Corporate Finance, Sixth Long-Term Financial Policy Companies, 2002

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cause these institutions buy and sell in huge amounts, the individual share price is of little concern.

Furthermore, we sometimes observe share prices that are quite large that do not appear to cause problems. To take a well-known case, Berkshire-Hathaway, a widely respected company headed by legendary investor Warren Buffet, sold for as much as \$84,000 per share in 1998.

Finally, there is evidence that stock splits may actually decrease the liquidity of the company's shares. Following a two-for-one split, the number of shares traded should more than double if liquidity is increased by the split. This doesn't appear to happen, and the reverse is sometimes observed.

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