.

UNIT -TWO
DIVIDEND POLICY AND THEORIES
2.1. Meaning of Dividend
Dividend refers to the business concerns net profits distributed among the shareholders. It may
also be termed as the part of the profit after tax and interest of a business concern, which is
distributed among its shareholders. Proportion of earning distributed to share holder as…..
2.2. TYPES OF DIVIDEND/FORM OF DIVIDEND
Dividend may be distributed among the shareholders in the form of cash or stock. Hence,
Dividends are classified into:
A. Cash dividend C. Bond dividend
B. Stock dividend D. Property dividend
Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are
common and popular types followed by majority of the business concerns. Dividends come in
several different forms. The basic types of cash dividends are:
1. Regular cash dividends 3. Special dividends
2. Extra dividends 4. Liquidating dividends
The most common type of dividend is a cash dividend. Commonly, public companies pay
regular cash dividends four times a year. As the name suggests, these are cash payments made
directly to shareholders, and they are made in the regular course of business. In other words,
management sees nothing unusual about the dividend and no reason why it won’t be continued.
Sometimes firms will pay a regular cash dividend and an extra cash dividend. By calling part of
the payment “extra,” management is indicating that the “extra” part may or may not be repeated
in the future. A special dividend is similar, but the name usually indicates that this dividend is
viewed as a truly unusual or one-time event and won’t be repeated. Finally, the payment of a
liquidating dividend usually means that some or all of the business has been liquidated, that is,
sold off.

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Stock Dividend
Stock dividend is paid in the form of the company stock due to rising of more finance. Under this
type, cash is retained by the business concern. Stock dividend may be bonus issue. This issue is
given only to the existing shareholders of the business concern.
Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to
pay cash dividend, the company promises to pay the shareholder at a future specific date with the
help of issue of bond or notes.
Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distributed under
the exceptional circumstance. This dividend is one of tax escaping mechanism because there is
no tax on property dividend in many countries including Ethiopia.
2.3. Dividend payment chronology
Relevant dates associated with dividends are as follows:
1. Declaration date. This is the date on which the board of directors declares the dividend. On
this date, the payment of the dividend becomes a legal liability of the firm.
2. Ex-dividend date. The ex-dividend date is the date when the right to the dividend leaves the
shares. The right to a dividend stays with the stock until 2 days before the date of record. That is,
on the second day prior to the record date, the right to the dividend is no longer with the shares,
and the seller, not the buyer of that stock, is the one who will receive the dividend. The market
price of the stock reflects the fact that it has gone ex-dividend and will decrease by
approximately the amount of the dividend.
3. Date of record. This is the date upon which the believed stockholder is entitled to receive the
dividend.
4. Date of payment. This is the date when the company distributes its dividend checks to its
stockholders. Dividends are usually paid in cash. A cash dividend is typically expressed in Birrs
and cents per share. However, the dividend on preferred stock is sometimes expressed as a
percentage of par values.
2.4. Dividend policy

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A finance manager’s objective for the company’s dividend policy is to maximize owner wealth
while providing adequate financing for the company. When a company’s earnings increase,
management does not automatically raise the dividend. Generally, there is a time lag between
increased earnings and the payment of a higher dividend. Only when management is confident
that the increased earnings will be sustained will they increase the dividend. Once dividends are
increased, they should continue to be paid at the higher rate. The various types of dividend
policies are:
1. Stable dividend-per-share policy. Many companies use a stable dividend-per-share policy
since it is looked upon favorably by investors. Dividend stability implies a low-risk company.
Even in a year that the company shows a loss rather than profit the dividend should be
maintained to avoid negative connotations to current and prospective investors. By continuing to
pay the dividend, the shareholders are more apt to view the loss as temporary. Some stockholders
rely on the receipt of stable dividends for income. A stable dividend policy is also necessary for a
company to be placed on a list of securities in which financial institutions (pension funds,
insurance companies) invest. Being on such a list provides greater marketability for corporate
shares.
2. Constant dividend-payout-ratio policy. With this policy a constant percentage of earnings is
paid out in dividends. Because net income varies, dividend paid will also vary using this
approach. The problem this policy causes is that if company’s earnings drop drastically or there
is a loss, the dividends paid will be sharply curtailed or nonexistent. This policy will not
maximize market price per share since most stockholders do not want variability in their
dividend receipts.
3. Compromise dividend policy. A compromise between the policies of a stable dollar amount
and a percentage amount of dividends is for a company to pay a low dollar amount per share plus
a percentage increment in good years. While this policy affords flexibility, it also creates
uncertainty in the minds of investors as to the amount of dividends they are likely to receive.
Stockholders generally do not like such uncertainty. However, the policy may be appropriate
when earnings vary considerably over the years. The percentage, or extra, portion of the dividend
should not be paid regularly; otherwise it becomes meaningless.
4. Residual-dividend policy. When a company’s investment opportunities are not stable,
management may want to consider a fluctuating dividend policy. With this kind of policy the

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amount of earnings retained depends upon the availability of investment opportunities in a

particular year. Dividends paid represent the residual amount from earnings after the
company’s investment needs are fulfilled.
Theoretical Position
Theoretically, a company should retain earnings rather than distribute them when the corporate
return exceeds the return investors can obtain on their money elsewhere. Further, if the company
obtains a return on its profits that exceeds the cost of capital, the market price of its stock will be
maximized. A capital gain arising from the appreciation of the market price of stock has a tax
advantage over dividends. On the other hand, a company should not, theoretically, keep funds
for investment if it earns less of a return than what the investors can earn elsewhere. If the
owners have better investment opportunities outside the firm, the company should pay a high
dividend. Although theoretical considerations from a financial point of view should be
considered when setting dividend policy, the practicality of the situation is that investors expect
to be paid dividends. Psychological factors come into play which may adversely affect the
market price of the stock of a company that does not pay dividends.
2.5. FACTORS DETERMINING DIVIDEND POLICY
Profitable Position of the Firm: Dividend decision depends on the profitable position of the
business concern. When the firm earns more profit, they can distribute more dividends to the
shareholders and the reverse is true
Income expectation: Future income is a very important factor, which affects the dividend policy.
When the shareholder needs regular income, the firm should maintain regular dividend policy.
Legal Constrains: The Companies Act and income tax Act has put several restrictions regarding
payments and declaration of dividends.
Liquidity Position: Liquidity position of the firms leads to easy payments of dividend. If the
firms have high liquidity, the firms can provide cash dividend otherwise, they have to pay stock
dividend.
Sources of Finance: If the firm has finance sources, it will be easy to mobilize large finance.
The firm shall not go for retained earnings.
Growth Rate of the Firm: A company that is rapidly growing, even if profitable, may have to
restrict its dividend payments in order to keep needed funds within the company for growth
opportunities.

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Restrictive covenants: Sometimes there is a restriction in a credit agreement that will limit the
amount of cash dividends that may be paid.
Earnings stability: A company with stable earnings is more likely to distribute a higher
percentage of its earnings than one with unstable earnings.
Maintenance of control: Management that is reluctant(unwilling) to issue additional common
stock because it does not wish to dilute its control of the firm will retain a greater percentage of
its earnings. Internal financing enables control to be kept within.
Degree of financial leverage: A company with a high debt-to-equity ratio is more likely to retain
earnings so that it will have the needed funds to meet interest payments and debts at maturity.
Ability to finance externally: A company that is capable of entering the capital markets easily
can afford to have a higher dividend payout ratio. When there is a limitation to external sources
of funds, more earnings will be retained for planned financial needs.
Uncertainty: Payment of dividends reduces the chance of uncertainty in stockholders’ minds
about the company’s financial health.
Age and size: The age and size of the company bear upon its ease of access to capital markets.
Tax Policy: Tax policy of the government also affects the dividend policy of the firm. When the
government gives tax incentives, the company pays more dividends.
Tax penalties: Possible tax penalties for excess accumulation of retained earnings may result in
high dividend payouts.
Capital Market Conditions: Due to the capital market conditions, dividend policy may be
affected. If the capital market is prefect, it leads to improve the higher dividend.
2.6. DIVIDEND DECISION THEORY
Dividend decision of the business concern is one of the crucial parts of the financial manager,
because it determines the amount of profit to be distributed among shareholders and amount of
profit to be treated as retained earnings for financing its long term growth. Hence, dividend
decision plays very important part in the financial management. Dividend decision consists of
two important concepts which are based on the relationship between dividend decision and
value of the firm.
There are two schools of thought on the relationship between dividend policy and the value of
the firm. These theories can be grouped in two categories:

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a) Theories that consider dividend decision of the firm is irrelevant or which cannot
influence firm value
b) Theories that consider dividend decision of the firm is one of active variable which can
influence the firm value
There are many dividend irrelevant and dividend relevant theorist but to discuss their stand it’s
better to see one approach from each perspective
2.6.1. Irrelevance of Dividend theories
According to professors Modigliani and Miller, dividend policy has no effect on the share price
of the company. There is no relation between the dividend rate and value of the firm. Dividend
decision is irrelevant of the value of the firm. Modigliani and Miller contributed a major
approach to prove the irrelevance dividend concept.
Modigliani and Miller’s Approach
According to MM, under a perfect market condition, the dividend policy of the company is
irrelevant and it does not affect the value of the firm. “Under conditions of perfect market,
rational investors, absence of tax discrimination between dividend income and capital
appreciation, given the firm’s investment policy, its dividend policy may have no influence on
the market price of shares”.
Assumptions of MM Approach
MM approach is based on the following important assumptions:
1. Perfect capital market.
2. Investors are rational.
3. There is no tax.
4. The firm has fixed investment policy.
5. No risk or uncertainty.
Proof for MM approach
When the over mentioned assumptions were true, value of the firm is equal to:
nPo = ( N+S )P1 – ( I- NI )
1 + Ke
Where,
nPo= value of the firm.
N = outstanding shares.

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S= number of new shares to be issued to fill the remaining to investment.

P1= price of the share at the end of the period.
I= Amount of investment required.
Ni= net profit of the firm.
Ke= Cost of equity capital.
Value of the firm (nPo) can be proved with the help of the following formula:
Po = D1 +P1
(1 + Ke)
Where,
Po = Prevailing market price of a share.
Ke = Cost of equity capital.
D1 = Dividend to be received at the end of period one.
P1 = Market price of the share at the end of period one
P1 can be calculated with the help of the following formula.
P1 = Po (1+Ke) – D1
When earning of the firm is not sufficient to address dividend payment and new investment
proposal, additional new shares to be issued to fill this gap at market price (P1).
The number of new shares to be issued can be determined by the following formula:
S= I - (X – nD1)
P1
Where,
S = Number of new share to be issued.
P1 = Price at which new issue is to be made.
I = Amount of investment required.
X= Total net profit of the firm during the period.
nD1= Total dividend paid during the period.
Exercise
Z Ltd., has risk allying firm for which capitalization rate is 12%. It currently has outstanding
8,000 shares selling at Rs. 100 each. The dividend for the current financial year is Rs. 7 per
share. The company expects to have a net income of Rs. 69,000 and has a proposal formatting

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new investments of Rs. 160,000. Show that under the MM hypothesis the payment of dividend
does not affect the value of the firm?
(a) Price of the shares at the end of the current financial year?
(b) Number of shares to be issued?
(c) Value of the firm?
Then, the value of the firm is not changed. At the beginning the value of the firm is also
800,000(i.e value of the firm = number shares outstanding x market price of the share). So
paying dividend not increases the value of the firm as per MM approach.
Criticism of MM approach:- MM approach consists of certain criticisms also.
MM approach assumes that tax does not exist. It is not applicable in the practical life of the firm.
MM approach assumes that, there is no risk and uncertain of the investment. It is also not
applicable in present day business life.
MM approach does not consider floatation cost and transaction cost. It leads to affect the value
of the firm.
MM approach considers only single decrement rate, it does not exist in real practice.
MM approach assumes that, investor behaves rationally. But we cannot give assurance that all
the investors will behave rationally.
2.6.2. DIVIDEND RELEVANCE THEORY
A. Walter model
Walter argues that the choice of dividend policies almost always affect the value of the firm.
His model shows the importance of the relationship between the firm’s rate of return, r, and it
cost of capital, k, in determining the dividend police that will maximize the wealth of
shareholder
Walter model is based on the following assumptions:
 Internal financing
 Constant return and cost of capital
 100% payout or retention
 Constant EPS
 Infinite time
When the above assumptions were kept, Walter says price of the share is equal to:
P= Div + (r/k) (EPS - Div)

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Ke
Where,
P= market price per share
Div= dividend per share
EPS= earning per share
r= firm’s rate of return
Ke= cost of equity capital
Walter model shows the optimum dividend policy depend on the relationship between the firm’s
rate of return, r , and its cost of equity capital, k. its model also state that different dividend
policy has different impact on the value of the firm respectively from the perspective of growth
firm, normal firm and declining firm.

Growth firm, normal firm declining firm

r>k r=k r <k

r= 0.15 r=0.1 r= 0.08

k= 0.1 k=0.1 k= 0.1
EPS= 10 EPS= 10 EPS= 10

Payout ratio 0 % Div= 0

P= 0 + (0.15/0.10)(10 - 0 ) =$150 =$100 =$80
0.1
Payout ratio 40% =$130 =$100 =$88
Payout ratio 80% =$110 =$100 =$96
Payout ratio 100% =$100 =$100 =$100
Based on the result of the model Walter conclude that the effect of dividend policy differ from
company to company i.e. the same payment policy has different impact on the value the firm on
growth, normal and declining firms. Let see what he conclude based on the model result
Growth firm
Are those firms which expand rapidly because of ample investment opportunities yielding return
higher than the opportunity cost of capital? This firms can reinvest earning at rate (r) which is

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higher than the rate expected by shareholders (k). they will maximize the value per share if they
follow a policy of retaining all earning for internal investment .as shown on the above table the
market value per share for the growth firm is max ($150) when it retain 100% earning and the
minimum is $100 when if they distributes all earning, thus the optimum payout ratio for growth
firm is zero. The market value per share P, increases as payout ratio is declines
Normal firm
Most of the firm do not have unlimited surplus- generating investment opportunities, yielding
return higher than the opportunity cost of capital. After exhausting super profitable opportunities,
this firms earn on their investment rate of return equal to the cost of capital, r=k. for normal firms
with r=k, the dividend policy has not effect on the market value per share in Walter model. As
shown on the table above the market value per share for normal firms is same ($100) for
different dividend payout ratio. Thus, there is no unique optimum payout ratio for normal firm
because one dividend policy is as good as the other.
Declining firms
Declining firms do not have profitable investment opportunity to invest their earning their rate
of return from their few opportunities is less than the minimum rate required by investors.
Investors of this firms would like earning to be distribute to them so that they may either spend it
or invest somewhere to get rate higher than declining firm. The market value per share of
declining firm with r<k will be maximized when it does not retain nothing. As observed on the
table the market value of the share increase when this firm payout ratio is increase. Thus the
optimum dividend payout ratio is 100% payout or retains nothing
Criticism of Walter’s Model
The following are some of the important criticisms against Walter model:
 Walter model assumes that there is no extracted finance used by the firm. It is not
practically applicable.
 There is no possibility of constant return. Return may increase or decrease, depending
upon the business situation.
 According to Walter model, it is based on constant cost of capital. But it is not applicable
in uncertain world rather it is associated with risk. When risk is increase also required
rate by investor (r) is increase to compensate the uncertainty of their investment.

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A. Gordon’s Model
Myron Gordon suggest one of the popular model which assume that dividend policy of a firm
affects its value, and it is based on the following important assumptions:
1. The firm is an all equity firm.
2. The firm has no external finance.
3. Cost of capital and return are constant.
4. The firm has perpetual life.
5. There are no taxes.
6. Constant retention ratio (b) and constant growth rate (g=br).
7. Cost of capital is greater than growth rate (Ke>br).
When the above assumptions were kept the value of the share can be proved with the help of the
following formula:
P= EPS (1 - b)
Ke – br
Where,
P = Price of a share
E = Earnings per share
1 – b = D/p ratio (i.e., percentage of earnings distributed as dividends)
Ke = Capitalization rate
br = Growth rate = rate of return on investment of an all equity firm.
Like Walter model, Gordon model shows the optimum dividend policy depend on the
relationship between the firm’s rate of return, r , and its cost of equity capital, k. its model also
state that different dividend policy has different impact on the value of the firm respectively from
the perspective of growth firm, normal firm and declining firm.
The result and the conclusion of Walter and Gordon model is almost the same, this similarity is
become because of their assumption similarity. The criticism is also the same.
The Bird-In-The-Hand Argument
According to Gordon’s model, dividend policy is irrelevant where r=k, when all other
assumptions are held valid. But when the simplifying assumption are modified to conform more
closely to reality, Gordon concludes that dividend policy does affect the value of the share even

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when r=k. This view is based on the assumption that under condition of uncertainty, investors
tend to discount distant dividends (capital gain) at higher rate than they discount near dividends.
Investors behaving rationally are risk-averse and, therefore, have a preference for near dividends
to future dividends. The logic underlying the dividend effect on the value of the share can be
described as the Bird-In-The-Hand argument.
Kirshman first of all, put forward the bird in hand argument in the following words: of two stock
with identical earning and prospects but the one pay a large dividend than the other, the former
will undoubtedly command higher price merely because stock holder prefer present to future
values. Myopic vision plays apart in price making process. Stockholders often act upon the
principle that a bird in the hand is more worth than two in the bush and for this reason
stockholders willing to pay premium for stock with higher dividend rate the typical investor
would most certain prefer to have his dividend today and let tomorrow take care of itself.
The Clientele Effect
In our earlier discussion, we saw that some groups (wealthy individuals, for example) have an
incentive to pursue low-payout (or zero payout) stocks. Other groups (corporations, for example)
have an incentive to pursue high-payout stocks. Companies with high payouts will thus attract
one group, and low-payout companies will attract another. These different groups are called
clienteles, and what we have described is a clientele effect. The clientele effect argument states
that different groups of investors desire different levels of dividends. When a firm chooses a
particular dividend policy, the only effect is to attract a particular clientele. If a firm changes its
dividend policy, then it just attracts a different clientele.
What we are left with is a simple supply and demand argument. Suppose 40 percent of all
investors prefer high dividends, but only 20 percent of the firms pay high dividends. Here the
high-dividend firms will be in short supply; thus, their stock prices will rise. Consequently, low-
dividend firms will find it advantageous to switch policies until 40 percent of all firms have high
payouts. At this point, the dividend market is in equilibrium. Further changes in dividend policy
are pointless because all of the clienteles are satisfied. The dividend policy for any individual
firm is now irrelevant. To see if you understand the clientele effect, consider the following
statement: In spite of the theoretical argument that dividend policy is irrelevant or that firms
should not pay dividends, many investors like high dividends; because of this fact, a firm can

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Boost its share price by having a higher dividend payout ratio. True or false? The answer is
“false” if clienteles exist. As long as enough high-dividend firms satisfy the dividend-loving
investors, a firm won’t be able to boost its share price by paying high dividends. An unsatisfied
clientele must exist for this to happen, and there be no evidence that this is the case.
Dividend signaling hypothesis
It suggests that dividends have an impact on share price because they communicate information,
or signals, about the firm’s profitability. Presumably, firms with good news about their future
profitability will want to tell investors. Rather than make a simple announcement, dividends may
be increased to add conviction to the statement. When a firm has a target dividend-payout ratio
that has been stable over time, and the firm increases this ratio, investors may believe that
management is announcing a positive change in the expected future profitability of the firm. The
signal to investors is that management and the board of directors truly believes that things are
better than the stock price reflects. Accordingly, the price of the stock may react favorably to this
increase in dividends. The idea here is that the reported accounting earnings of a company may
not be a proper reflection of the company’s economic earnings. To the extent that dividends
provide information on economic earnings not provided by reported earnings, share price will
respond. Put another way, cash dividends speak louder than words. Thus dividends are said to be
used by investors as predictors of the firm’s future performance. Dividends convey
management’s expectations of the future.
STOCK DIVIDEND AND STOCK SPLIT
Stock Dividend: A payment of additional or bonus shares of stock to existing shareholders.
Often used in place of or in addition to a cash dividend. Stock dividend declare in percent of
outstanding shares e.g , A 5% stock dividend means five percent of outstanding shares are issued
as bonus share, if there is 100,000 outstanding shares, new additional 5,000 shares are to be print
out to cover the declared dividend. These additional shares are print out from unissued portion of
their authorized share or from treasury stock (share which is already issued but hold by the
company itself).
Why firms pay stock dividend?
There are many reasons that makes the firms to pay dividend instead of cash these includes:
 To avoid double taxation (corporate tax 30% and dividend income tax 10%) if
dividend is paid in stock there is no dividend income tax.

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 Stock dividend is great means to pay dividend under financial difficulty, when the
company facing stringent cash situation the best way to replace cash dividend is the
issuing of bonus shares.
 Conservation cash even if there is shortage of cash firms pay stock dividend if they
need it for other profitable investment
 To increase future dividend, if the company pay fixed amount per share and if that
amount is not decrease for the next dividend period then dividend of share holder will
increase b/c their share is increased.
 Is bell or indication of higher future profit, as we said above the next dividend of share
holder will increase if dividend per share will not change, so the next dividend amount
to be paid for the share holder become more to cover this amount there should be high
profit.
 To make the share price more attractive, when the stock is divided instead of cash
share holder may sold out this new additional shares to secure their current cash at less
price in this time small investor can acquire the share b/c the price attractive for those
kind of investor. 📉 Stock Splits or Stock Dividends and Share Price Attractiveness
 🔄 What is a Stock Split or Stock Dividend?
 A stock split or stock dividend is when a company gives additional shares to existing
shareholders instead of paying cash.
 For example: In a 2-for-1 stock split, a shareholder who owns 1 share at $100 will now
have 2 shares at $50 each. The total value remains the same, but the price per share is
lower.

What is the effect of stock dividend? ON

 EPS (earning per share) is decrease why?
 Outstanding share is increase why?
 Equity of share holder is not affected, about this we have more detail below
Classification of stock dividend
As indicated above stock dividend is declare in percent of outstanding share, thus based on the
percent that declare stock dividend is classified as
 Small scale/percentage stock dividend: when it is less than or 25% of outstanding shares

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 Large scale/percentage stock dividend: when it is greater than equals to 25% of

outstanding share.
Both have no effect on the equity of the share holder but accounting treatment for the two kind
of stock dividend is not the same, let’s look how it is:
Small-percentage stock dividends
Typically less than 25% of previously outstanding common stock.
Assume a company with 400,000 shares of $5 par common stock outstanding pays a 5% stock
dividend. The pre-dividend market value is $40. How does this impact the shareholders’ equity
accounts?
 $800,000 ($40 x 20,000 new shares) transferred (on paper) “out of” retained earnings.
 $100,000 transferred “into” common stock account @ par.
 $700,000 ($800,000 - $100,000) transferred “into” additional paid-in-capital in excess of
par.
“Total shareholders’ equity” remains unchanged at $10 million.
Before 5% Stock Dividend
Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
After 5% Stock Dividend
Common stock
($5 par; 420,000 shares) $ 2,100,000
Additional paid-in capital 1,700,000
Retained earnings 6,200,000
Total shareholders’ equity $10,000,000
After a small-percentage stock dividend, what happens to EPS and total earnings of individual
investors?
Assume that investor SP owns 10,000 shares and the firm earned $2.50 per share.
Total earnings = $2.50 x 10,000 = $25,000.

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After the 5% dividend, investor SP owns 10,500 shares and the same proportionate
earnings of $25,000.
EPS is then reduced to $2.38 per share because of the stock dividend ($25,000 / 10,500
shares = $2.38 EPS).
Large-percentage stock dividends
Typically 25% or greater of previously outstanding common stock.
The material effect on the market price per share causes the transaction to be accounted for
differently. Reclassification is limited to the par value of additional shares rather than pre-
stock-dividend value of additional shares.
Assume a company with 400,000 shares of $5 par common stock outstanding pays a
100% stock dividend. The pre-stock-dividend market value per share is $40. How does
this impact the shareholders’ equity accounts?
 $2 million ($5 x 400,000 new shares) transferred (on paper) “out of” retained earnings.
 $2 million transferred “into” common stock account.
Before 100% Stock Dividend
Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
After 100% Stock Dividend
Common stock
($5 par; 800,000 shares) $ 4,000,000
Additional paid-in capital 1,000,000
Retained earnings 5,000,000
Total shareholders’ equity $10,000,000
Stock Split
Is dividing old outstanding share in to small new shares, this increase the number of shares
outstanding by reducing the par value of the stock. Unlike that of stock dividend it expressed in
terms of ratio. Stock split has similar economic consequences as a 100% stock dividend. Stock

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split primarily used to move the stock into a more popular trading range and increase share
demand. Also stock split has no effect on equity of shareholder let’s look.
Assume a company with 400,000 shares of $5 par common stock splits 1-to-2. How does this
impact the shareholders’ equity accounts?
Before 1-for-2 Stock split
Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
After 1-for-2 Stock split
Common stock
($2.50 par; 800,000 shares) $ 4,000,000
Additional paid-in capital 1,000,000
Retained earnings 5,000,000
Total shareholders’ equity $10,000,000

In a 2-for-1 stock split, each shareholder gets 2 shares for every 1 share they own. This:

 Doubles the number of shares

 Halves the par value per share
 Does not change total shareholders’ equity
 Does not affect retained earnings or additional paid-in capital

Reverse split
When the share is over split it becomes undervalue. When the share become under value it loss
respect from many investors. Undervalued shares are not as such traded in the market because
their price in the market is below the popular trading range so many investors not willing on this
kind of share. Increasing the value of the share in to popular trading range is the aim of reverse
split. Like stock split reverse split also not affect the equity of share holders.
Assume a company with 400,000 shares of $5 par common stock splits 4-to-1. How does this
impact the shareholders’ equity accounts?

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Before 4-to-1 Stock Split

Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
After 4-to-1 Stock Split
Common stock
($20 par; 100,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000

Stock Repurchase/buy back

When the firm itself repurchases (buyback) its own stock from the share holders, either in the
open (secondary) market or by self-tender offer, we called it Stock Repurchase.
Reasons for stock repurchase:
 If there is no best investment option like investing on its own stock.
 If there is excess free cash out of current investment opportunity and dividend.
 To defend hostile takeover by other company.
 “Go private” by repurchasing all shares from outside stockholders
 To permanently retire the shares.
 As an alternative to distributing cash as dividends.
 To make a large capital structure change.
Methods of Repurchase
1. Open-market repurchase
A company repurchases its stock through a brokerage on the secondary market. In this
repurchase style the companies not announce that it is going to repurchase. There is no specified
time period to repurchase and the firm can repurchase repetitively within short period of time
2. Fixed-price self-tender offer

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An offer by a firm to repurchase some of its own shares, typically at a set price and at specified
period of time.
3. Dutch auction self-tender offer
A buyer (seller) seeks bids within a specified price range, usually for a large block of stock or
bonds. After evaluating the range of bid prices received, the buyer (seller) accepts the lowest
price that will allow it to acquire (dispose of) the entire block.
4. Direct negotiation
In this method of repurchase the firm directly discuss with some shareholders to repurchase their
share. Especially from those who have hostile takeover ambition and those who have very few
share.

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