A stock split is similar to a stock dividend in economic sense. When a company announces stock splits, it results into an increase in number of outstanding shares with a proportionate decrease in par value and market price of the stocks. Therefore, firms with exceptionally high market prices split their stocks in order to bring the market price within reasonable limits. As a result, small investors can purchase the company's share. With a stock split, total value of the shares of common stock outstanding remains unchanged along with no change in paid-in capital and retained earnings.
Example,
Suppose, a firm has the following total shareholder's equity account before stock split:
A. Common stock ( 4000 shares @ $10)...................=$ 40,000
B. Additional paid-in capital........................................= $ 20,000
C. Retained earnings ....................................................= $ 90,000
Total shareholder's equity (A+B+C)...........................= $ 150,000
If the firm announces 2-for-1 stock splits, it results into an increase in outstanding shares from 4,000 shares to 8,000 shares (i.e 4,000 shares x2) and reduction in the par value from $ 10 per share to $ 5 per share (i.e. $10 x 1/2). This keeps the value of common stock constant at $ 40,000 (i.e 8,000 shares x $ 5). Total shareholder's equity accounts of the firm after 2-for-1 stock splits announcement appears as:
A. Common stocks ( 8,000 shares @ $ 5 each)....................= $ 40,000
B. Additional paid in capital.....................................................= $ 20,000
C. Retained earnings................................................................= $ 90,000
Total shareholder's equity (A+B+C)......................................= $ 150.000
Unlike in stock dividend, stock split does not involve transfer of funds from retained earnings to paid-in capital and common stock accounts.
Stock splits do not change the proportionate ownership of the company. Therefore, stock splits has no economic value to the investors or shareholders. When the number of shares held by shareholders increases, because of stock splits, the market price of the stock should decrease proportionately to remain the total value of common stock unchanged.
