Page 312 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes The firm declares a 2–for–1 stock split. After the split, the outstanding share will go up to
40,00,000 and will sell for approximately 10 per share. A shareholder with 100 shares worth
2000 before the split will hold 200 shares worth 2000.

Notes Why firms go for stock splits?
1. Reduction of market price of stock: The major objective behind most stock split is to
reduce the per share price of a firm’s common shares. A lower price per share makes
the stock more affordable in marketable lots (usually 100 shares) to more investors.
2. Indication of future growth: The announcement of the stock split is perceived as a
favourable news by the investors in that with growing earnings, the company has
bright prospects and the investors can reasonably look for increase in future
dividends.
3. Reverse split: An indication of trouble. In case of reverse split, the firm reduces the
number of outstanding shares. The declaration of reverse split is an indication that
the firm does not have good prospects.

14.4.3 Stock Repurchase

This occurs when a firm brings back outstanding shares of its own common shares. Firms
repurchase stock for three major reasons:

1. For stock option: A stock option is the right to purchase a specified number of shares of
common shares during a stated time period and a stipulated price. Stock options are
frequently given to senior officers of a company as an incentive to work to raise the value
of the firm. As for example, a firm’s stock is currently selling for 20 per share when the
president is given the option to buy 1000 shares for 22 at anytime in the next three years.
If the stock value rises to 40 the president can exercise the option, purchase the stock for
22,000 (1000 shares @ 22) and sell it for 40,000 immediately. The capital gain arising on
the sale will be a profit for the president as a direct result of the success of the firm.

2. To have shares for acquisition: When a firm is seeking control of another firm, it may be
willing to offer its own common shares for the shares of the other firm. In this exchange of
shares, the firm can repurchase stock to make the acquisition. This allows take over without
increasing the number of outstanding shares and avoids a dilution of earnings.
3. To retire the stock, thus increasing earnings per share: When a firm retires a portion of its
shares or buys back its own shares (as per procedure laid down by statute), the repurchase
increases the firm’s earnings per share.

Stock Repurchase Viewed as Cash Dividend

When common shares are repurchased for cancellation, the motive is to distribute excess cash to
the owners. Generally, as long as earnings remain constant, the repurchase reduces the number
of outstanding shares raising the earnings per share and therefore the market price per share.
Besides, the advantage of an increase in per share earnings, certain tax benefits to owner also
result. In case of cash dividend, the owner is required to pay income taxes on it, whereas, the
increase in market value of the shares, that resulted from repurchase would not be taxed till the
owner sells the shares. Of course, when the stock is sold, the capital gain is taxed at a favourable
rate than one applied to ordinary income.

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