Hi everyone,
I have a question regarding the effect of stock splits or stock dividends on the composition of equity (total equity is not affected of course). In the CFA curriculum it says in Reading 38 of Corporate Finance that:
”Stock dividends, on the other hand, do not affect assets or shareholders’ equity. Although retained earnings are reduced by the value of the stock dividends paid (i.e., by the number of shares issued × price per share), contributed capital increases by the same amount (i.e., the value of the shares issued). As a result, total shareholders’ equity does not change. Neither stock dividends nor stock splits (which are discussed in the next section) should affect liquidity ratios or financial leverage ratios.”
It is not quite clear to me, why retained earnings are reduced and contributed capital is increased. After all, what is happening here is that we have more shares (say 10%) and after the increase in the amount of shares, all shares decrease in value (10% decrease in value). So the total market vale of shares does not change, neithes does the ownership share of someone who held say 1% of the shares (that shareholder would still have 1% after the split). There is also no cash distributed from the net income of that period, so I do not see why retained earnings would increase.
Does this have something to do with the fact that for ‘Contributed Capital’ the current market price of the common shares is irrelevant (i.e. the value of the common shares is equal to the par value)? Thus, if there is a decrease in the stock price through the dividend (or split), we have adjust retained earnings in order to balance out this effect?
I appreciate your help.
Tartaglia
I have a question regarding the effect of stock splits or stock dividends on the composition of equity (total equity is not affected of course). In the CFA curriculum it says in Reading 38 of Corporate Finance that:
”Stock dividends, on the other hand, do not affect assets or shareholders’ equity. Although retained earnings are reduced by the value of the stock dividends paid (i.e., by the number of shares issued × price per share), contributed capital increases by the same amount (i.e., the value of the shares issued). As a result, total shareholders’ equity does not change. Neither stock dividends nor stock splits (which are discussed in the next section) should affect liquidity ratios or financial leverage ratios.”
It is not quite clear to me, why retained earnings are reduced and contributed capital is increased. After all, what is happening here is that we have more shares (say 10%) and after the increase in the amount of shares, all shares decrease in value (10% decrease in value). So the total market vale of shares does not change, neithes does the ownership share of someone who held say 1% of the shares (that shareholder would still have 1% after the split). There is also no cash distributed from the net income of that period, so I do not see why retained earnings would increase.
Does this have something to do with the fact that for ‘Contributed Capital’ the current market price of the common shares is irrelevant (i.e. the value of the common shares is equal to the par value)? Thus, if there is a decrease in the stock price through the dividend (or split), we have adjust retained earnings in order to balance out this effect?
I appreciate your help.
Tartaglia