FIN 6160 California Miramar University Stock Repurchases Discussion

Description

Topic:
What kind of signal management of a company sends to investors by repurchasing its own shares?
PROFESSOR’S GUIDANCE FOR THIS WEEK’S LE:
In real life there is an information asymmetry between management and investors. Simply speaking management knows more about the company than investors. By repurchasing its own shares management can mitigate the information asymmetry. What kind of information such action conveys to market and investors?

by Ngoc Dinh
Learning Engagement # 6
What kind of signal does the management of a company send to investors by repurchasing its own shares?
When a company buys back shares, it’s generally a positive signal because it means that the company believes its stock is undervalued and is confident about its future earnings. A share repurchase is also known as a float shrink because it reduces the number of a company’s freely trading shares or floats.
When a publicly-traded corporation buys its own shares in the market, this is known as a share repurchase or buyback. Share repurchases, like dividends, are a mechanism for a corporation to repay cash to its shareholders. When a firm buys back shares, it’s usually a good indication since it indicates that it believes its stock is undervalued and is optimistic about its future profitability. Many of the best companies aim to reward their shareholders by increasing dividends and buying back stock on a regular basis. Because it reduces the amount of freely traded shares or float, a share repurchase is also known as a float shrink (Picardo, 2021).
A share repurchase refers to the management of a public company buying back company shares that were previously sold to the public. There are several reasons why a company may decide to repurchase its shares. For instance, a company may choose to repurchase shares to send a market signal that its stock price is likely to increase, to inflate financial metrics denominated by the number of shares outstanding (e.g., earnings per share or EPS), or to attempt to halt a declining stock price, or simply because it wants to increase its own equity stake in the company.
In real life, there is an information asymmetry between management and investors. Simply speaking management knows more about the company than investors. By repurchasing its own shares management can mitigate the information asymmetry. What kind of information does such action convey to the market and investors?
Asymmetric information, also known as “information failure,” occurs when one party to an economic transaction possesses greater material knowledge than the other party.
Financial markets convey asymmetric information in any transaction in which one of the two parties involved has more information than the other and thus has the ability to make a more informed decision. Economists say that asymmetric information leads to market failure. In any transaction in which one of the two parties involved has more information than the other and so has the potential to make a more informed decision, financial markets display asymmetric information (Tarver, 2021).
According to economists, unequal information causes market failure. That is, the rule of supply and demand, which governs how products and services are priced, is distorted. A situation of asymmetric information exists in any transaction when one party possesses information that the other does not. Market failure is thought to be the result of this. That is to say, the correct price cannot be determined by supply and demand.
References
Picardo, E. (2021). The Impact of Share Repurchases on Financial Accounting. Corporate Finance & Accounting. Accounting. Investopedia
Tarver, E. (2021). How Financial Markets Exhibit Asymmetric Information. Investing. Markets. Investopedia

by Jana Kmetova
According to Bank & Lawrenz (2005), the source of asymmetric information between managers and investors is because investors do not have a deep understanding of the company’s processes. Meanwhile, managers are assumed that they have a deep knowledge of the company that they are running, and how well it is doing and its growth potential. In addition, managers usually act in the best interest of already existing equity holders and current and future investors. Myers & Majluf (n/a) believe that managers give signal information of the company to the market. Moreover, if managers believe that a company is undervalued, they will not issue new equity because new equity leads to the weakening of existing shareholders. Managers will issue new equity only if the company is overvalued. Buying its shares by the company/managers is one of four ways a company can use its cash. Royal (2020) claims that rebuying its stock can create value in a few ways; Repurchases return cash to shareholders who want to exit the investment., They’re a more tax-efficient way to return the earnings of the business to shareholders, and repurchases by management show confidence in the business and support the stock price. There is more analysis, except buying its shares by management, that can help investors to control the management of the company. On the one hand, some analysis goes with the traditional organizational structure – equity holders, debt holders, tax authority, and bankruptcy costs. On the other hand, a claim supports management as an individual party, such as management claim to (Bank & Lawrenz, 2005).

References:
Bank M. & Lawrenz J. (2005, January). Jochen, Informational Asymmetry between Managers and Investors in the Optimal Capital Structure Decision , https://ssrn.com/abstract=673181 or http://dx.doi.org/10.2139/ssrn.673181
Myers & Majluf (n/a). Asymmetric Information Theory , https://www.cram.com/essay/Asymmetric-Information-…
Royal J. (2020, October). Stock buybacks: Why do companies repurchase their own shares and is it good for investors?,https://www.bankrate.com/investing/stock-buybacks/

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14
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Responding to Others’ Thoughts
Rich in Content, Full of Thoughts
Insightful Analyis, Substantial Info
Level 3
Pts Cnt
10
4
Level 4
Pts
Cnt
6
3
0
2
X
X
X
X
X
X
X
X
X
X
X
0
Word Counts, Minimum:
DBA:
500 – 700 Words
MBA:
300 – 400 Words
BSBA, ASBA: 100 – 200 Words
Rudimentary & Superficial
No Insightful Analysis
Less Than Minimum Words
X
X
X
Connecting to …
Previous Knowledge
Currently Discussed Knowledge
Class Related Topics
Referencing Real Life Scenario(s)
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All missing
4
Participation, Peer Responses (*) (**)
1st Responses Rich in Content
2nd Response Rich in Content
3rd Response Rich in Content
Active Participation in class
3
Severe
Severe
Severe
2
0
X
X
X
X
X
1
X
Severe
X
0
Later
Than
Friday
1
X
X
3
1
0
X
X
X
X
X
8
8
8
X
6
6
6
2
6
6
4
6
6
2

Severe
4
4
0
4
4
2

X
Later
Word Counts, Minimum:
DBA: 300 – 500 Words
MBA:
200 – 300 Words
BSBA, ASBA: 100 – 200 Words
Not as Rich in Content
Rudimentary and Superficial
Total Possible Points
(*)
X
X
X
X
X
X
X
X
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30
22
X
Than
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14
0
Points depending on submission on or before Sunday !!
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Matrix by Dr. Georg Schlueter, Corrected to match Faculty Handbook
V.5.0, July 23, 2020
1
CHAPTER 14
Distributions to Shareholders:
Dividends and Repurchases
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1
Topics in Chapter
?
?
?
?
?
?
Theories of investor preferences
Signaling effects
Residual model
Stock repurchases
Stock dividends and stock splits
Dividend reinvestment plans
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2
Sales revenues
?
Free Cash Flow: Distributions
to Shareholders
Operating costs and taxes
?
Required investments in operating capital
Free cash flow
(FCF)
=
Sources
Uses
Interest
payments
(after tax)
Principal
repayments
Dividends
Stock
repurchases
Purchase of
short-term
investments
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
What is “distribution policy”?
?
The distribution policy defines:
?
?
?
The level of cash distributions to
shareholders
The form of the distribution (dividend vs.
stock repurchase)
The stability of the distribution
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4
Distributions Patterns Over
Time
?
The percent of total payouts as a percentage of net
income has been stable at around 26%-28%.
?
?
?
?
Dividend payout rates have fallen, stock repurchases have
increased.
Repurchases now total more dollars in distributions than
dividends.
A smaller percentage of companies now pay
dividends. When young companies first begin making
distributions, it is usually in the form of repurchases.
Dividend payouts have become more concentrated in
a smaller number of large, mature firms.
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5
Dividend Yields for Selected
Industries
Industry
Div. Yield %
Leisure/Recreation
2.50
Forest Products
3.64
Software
1.36
Household Products
1.96
Food
1.72
Electric Utilities
4.17
Banks
1.81
Tobacco
3.66
Source: Reuters.com, February 2015
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6
Do investors prefer high or low
payouts?
?
There are three dividend theories:
?
?
?
Dividends are irrelevant: Investors don’t
care about payout.
Dividend preference, or bird-in-the-hand:
Investors prefer a high payout.
Tax effect: Investors prefer a low payout.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
7
Dividend Irrelevance Theory
?
?
?
?
Investors are indifferent between dividends
and retention-generated capital gains. If
they want cash, they can sell stock. If they
don’t want cash, they can use dividends to
buy stock.
Modigliani-Miller support irrelevance.
Implies payout policy has no effect on stock
value or the required return on stock.
Theory is based on unrealistic assumptions
(no taxes or brokerage costs).
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
8
Dividend Preference (Bird-inthe-Hand) Theory
?
?
?
Investors might think dividends (i.e., thebird-in-the-hand) are less risky than potential
future capital gains.
Also, high payouts help reduce agency costs
by depriving managers of cash to waste and
causing managers to have more scrutiny by
going to the external capital markets more
often.
Therefore, investors would value high payout
firms more highly and would require a lower
return to induce them to buy its stock.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
9
Tax Effect Theory
?
?
Low payouts mean higher capital gains.
Capital gains taxes are deferred until
they are realized, so they are taxed at a
lower effective rate than dividends.
This could cause investors to require a
higher pre-tax return to induce them to
buy a high payout stock, which would
result in a lower stock price.
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10
Empirical Tests: Dividends and
Required Returns
?
?
?
Research shows that investors require higher
pre-tax returns on stock in high payout
companies.
But taxes alone can’t explain the difference in
required returns between high-payout
companies and low-payout companies.
These finding support the tax effect
hypothesis, but are not conclusive.
See Naranjo, Nimalendran, and Ryngaert; cited in textbook.
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11
Empirical Tests: International
Evidence on Taxes and Payouts
?
?
?
Different countries have different tax laws, with some
countries taxing dividends more heavily than capital gains.
This “dividend tax penalty” can be measured for different
countries.
Research shows that in countries with relatively low
dividend tax penalties:
?
?
?
In countries with relatively high dividend tax penalties:
?
?
More companies pay dividends
Dividend payments are larger
More companies repurchase stock
This evidence doesn’t directly support the tax effect
hypothesis, but it does show that taxes affect payout
policies.
See Jacob and Jacob, cited in textbook.
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12
Empirical Tests: Changes in
Tax Codes
?
In 2005, Congress reduced the tax rate on dividends to be equal
to the tax rate on capital gains.
?
?
In mid-December 2010, Congress extended the tax treatment
temporarily for two more years.
?
?
?
But law was temporary and was set to expire at end of 2010
Set to expire at end of 2012.
January 2013, Congress enacted law to “permanently” tax
dividends and capital gains at 20% for high-income investors.*
Lots of uncertainty in late 2010 and 2012, making them
excellent periods to study dividend changes. See next slide for
more.
*This is the essence of the tax law, but the actual tax law is a bit more complicated.
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13
Empirical Tests: Uncertainty about tax
laws leads to changes in dividends.
?
?
2010 and 2012: Fear of tax increases on dividends.
Comparing late 2010 and 2012 (great uncertainty)
with late 2009 and 2011:
?
?
Additional special dividends of over $7 billion.
176 companies moved up payment dates from beginning of
next year to late in 2010 and 2012 before rates changed.
?
?
?
Over $12 billion in sooner-than-normal regular dividend payments.
Companies with higher insider ownership were more likely to
pay special dividends or accelerate payment dates.
This evidence doesn’t directly support the tax effect
hypothesis, but it does show that taxes affect payout
policies.
See Hanlon and Hoopes, cited in textbook.
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14
Empirical Tests: Tax Effects
versus Agency Costs
?
Some countries have legal system with poor
investor protection.
?
?
?
Agency costs, such as perquisite consumption and
wasteful acquisitions, are harder for investors to to
prevent.
Low dividend payouts make more cash available for
these activities.
Research shows that in countries with poor
investor protection (where agency costs are most
severe), high payout companies are valued more
highly than low payout companies.
See Pinkowitz, Stulz, and Williamson; cited in textbook.
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15
Summary of Empirical Tests
?
?
?
Taxes certainly affect dividend policies chosen
by companies.
Evidence that investors prefer to avoid
taxation.
Some evidence that investors require higher
pre-tax returns on stocks with big dividend
payouts.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
16
What’s the “clientele effect”?
?
?
?
Different groups of investors, or clienteles,
prefer different dividend policies.
Firm’s past dividend policy determines its
current clientele of investors.
Clientele effects impede changing dividend
policy. Taxes & brokerage costs hurt
investors who have to switch companies due
to a change in payout policy.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
17
The Signaling Hypothesis
(also called the information content hypothesis)
?
?
Investors view dividend changes as
signals of management’s view of the
future. Managers hate to cut dividends,
so won’t raise dividends unless they
think raise is sustainable.
Therefore, a stock price increase at
time of a dividend increase could reflect
higher expectations for future EPS, not
a desire for dividends.
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18
What’s the “residual
distribution model”?
?
?
?
Find the reinvested earnings needed for
the capital budget.
Pay out any leftover earnings (the
residual) as either dividends or stock
repurchases.
This policy minimizes flotation and
equity signaling costs, hence minimizes
the WACC.
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19
Using the Residual Model to
Calculate Distributions Paid
Net
Distr. = income –
Target
equity
ratio
Total
capital
budget
Net
Distr. =
– Required equity
income
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20
Application of the Residual
Distribution Approach: Data for IWT
?
?
?
?
Capital budget: $112.5 million.
Target capital structure: 20% debt,
80% equity. Want to maintain.
Forecasted net income: $140 million.
Number of shares: 100 million.
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21
Application of the Residual
Distribution Approach
Number of shares
100
100
100
80%
80%
80%
Capital budget
$112.5 $112.5
$112.5
Net income
$140.0
$90.0
$160.0
Req. equ.: (ws X Cap. Bgt.)
$90.0
$90.0
$90.0
Dist. paid: (NI – Req. equity)
$50.0
$0.0
$70.0
35.7%
0.0%
43.8%
$0.50
$0.00
$0.70
Equity ratio (ws)
Payout ratio (Dividend/NI)
Dividend per share
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22
Investment Opportunities and
Residual Dividends
?
?
Fewer good investments would lead to
smaller capital budget, hence to a
higher dividend payout.
More good investments would lead to a
lower dividend payout.
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23
Advantages and Disadvantages of
the Residual Dividend Policy
?
?
?
Advantages: Minimizes new stock issues
and flotation costs.
Disadvantages: Results in variable
dividends, sends conflicting signals,
increases risk, and doesn’t appeal to any
specific clientele.
Conclusion: Consider residual policy when
setting target payout, but don’t follow it
rigidly.
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24
The Procedures of a Dividend
Payment: An Example
?
November 16: Board declares a quarterly
dividend of $0.50 per share to holders of record
as of December 15, payable on January 5.
November 16, 2016:
Declaration date
December 12, 2016:
Dividend goes with stock (owner on this day
will get dividend)
December 13, 2016:
Ex-dividend date (purchaser on or after this
date doesn’t get dividend)
December 14, 2016:
December 15, 2016:
Holder-of-record date
January 5, 2017:
Payment date
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25
Stock Repurchases
?
?
Repurchases: Buying own stock back from
stockholders.
Reasons for repurchases:
?
?
?
?
As an alternative to distributing cash as dividends.
To dispose of one-time cash from an asset sale.
To make a large capital structure change.
To use when employees exercise stock options.
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26
The Procedures of a
Repurchase
?
?
Firm announces intent to repurchase stock.
Three ways to purchase:
?
?
?
?
Have broker/trustee purchase on open market
over period of time.
Make a tender offer to shareholders.
Make a block (targeted) repurchase.
Firm doesn’t have to complete its announced
intent to repurchase.
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27
IWT Before a Distribution:
Inputs (Millions)
Value of operations
Short-term investments
Debt
Number of shares
$1,937.50
$50.00
$387.50
100.00
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28
Intrinsic Value Before
Distribution
Vop
$1,937.50
+ ST Inv.
50.00
VTotal
$1,987.50
? Debt
387.50
S
$1,600.00
÷n
100.00
P
$16.00
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29
Intrinsic Value After a $50
Million Dividend Distribution
Before
After Dividend
Vop
$1,937.50
$1,937.50
+ ST Inv.
50.00
0.00
VTotal
$1,987.50
$1,937.50
? Debt
387.50
387.50
S
$1,600.00
$1,550.00
÷n
100.00
100.00
P
$16.00
$15.50
DPS
$0.50
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30
Drop in Price with Dividend
Distribution
?
Note that stock price drops by dividend
per share in model.
?
?
If it didn’t there would be arbitrage
opportunity (assuming no taxes).
In real world, stock price drops on
average by about 90% of dividend.
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31
A repurchase has no effect on
stock price!
?
The announcement of an intended repurchase might
send a signal that affects stock price, and the
previous events that led to cash available for a
distribution affect stock price, but the actual
repurchase has no impact on stock price because:
?
?
If investors thought that the repurchase would increase the
stock price, they would all purchase stock the day before,
which would drive up its price.
If investors thought that the repurchase would decrease the
stock price, they would all sell short the stock the day
before, which would drive down the stock price.
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32
Remaining Number of Shares
After Repurchase
?
?
?
?
# shares repurchased = nPrior ? nPost
# shares repurchased =CashRep/PPrior
nPrior ? nPost = CashRep/PPrior
nPost = nPrior ? (CashRep/PPrior)
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33
Remaining Number of Shares
After Repurchase
?
?
?
nPost = nPrior ? (CashRep/PPrior)
nPost = 100 ? ($50/$16)
nPost = 100 ? 3.125 = 96.875
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34
Intrinsic Value After a $50
Million Repurchase
Before After Repurchase
Vop
$1,937.50
$1,937.50
+ ST Inv.
50.00
0.00
VTotal
$1,987.50
$1,937.50
? Debt
387.50
387.50
S
$1,600.00
$1,550.00
÷n
100.00
96.875
P
$16.00
$16.00
Shares rep.
3.125
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35
Key Points
?
?
?
?
ST investments fall because they are used to
repurchase stock.
Stock price is unchanged by actual
repurchase.
Value of equity falls from $1,600 to $1,550
because firm no longer owns the ST
investments.
Wealth of shareholders remains at $1,600
because shareholders now directly own the
$50 that was previously held by firm in ST
investments.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
36
Repurchase vs. Dividends
?
Repurchase
?
?
?
Stock price doesn’t fall at time of
repurchase
Number of shares falls
Dividend distribution
?
?
Stock price falls by amount of dividend at
time of payment
Number of shares doesn’t change
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
37
Repurchase vs. Dividends
Over Time
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
38
Advantages of Repurchases
?
?
?
?
Stockholders can choose to sell or not.
Helps avoid setting a high dividend that
cannot be maintained.
Income received is capital gains rather
than higher-taxed dividends.
Stockholders may take as a positive
signal–management thinks stock is
undervalued.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
39
Disadvantages of Repurchases
?
?
May be viewed as a negative signal
(firm has poor investment
opportunities).
IRS could impose penalties if
repurchases were primarily to avoid
taxes on dividends.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
40
Setting Dividend Policy
?
?
?
?
?
Forecast capital needs over a planning
horizon, often 5 years.
Set a target capital structure.
Estimate annual equity needs.
Set target payout based on the residual
model.
Generally, some dividend growth rate
emerges. Maintain target growth rate if
possible, varying capital structure somewhat
if necessary.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
41
Stock Dividends vs. Stock
Splits
?
?
Stock dividend: Firm issues new shares
in lieu of paying a cash dividend. If
10%, get 10 shares for each 100 shares
owned.
Stock split: Firm increases the number
of shares outstanding, say 2:1. Sends
shareholders more shares.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
42
Stock Dividends vs. Stock
Splits (continued)
?
?
?
Both stock dividends and stock splits increase
the number of shares outstanding, so “the pie
is divided into smaller pieces.”
Unless the stock dividend or split conveys
information, or is accompanied by another
event like higher dividends, the stock price
falls so as to keep each investor’s wealth
unchanged.
But splits/stock dividends may get us to an
“optimal price range.”
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
43
When sh