A stock dividend is the payment, to existing owners, of a dividend in the form of stock. Often firms pay stock dividends as a replacement for or a supplement to cash dividends. In a stock dividend, investors simply receive additional shares in proportion to the shares they already own. No cash is distributed, and no real value is transferred from the firm to investors. Instead, because the number of outstanding shares increases, the stock price declines roughly in line with the amount of the stock dividend.
The payment, to existing owners, of a dividend in the form of stock.
In an accounting sense, the payment of a stock dividend is a shifting of funds between stockholders’ equity accounts rather than an outflow of funds. When a firm declares a stock dividend, the procedures for announcement and distribution are the same as those described earlier for a cash dividend. The accounting entries associated with the payment of a stock dividend vary depending on its size. A small (ordinary) stock dividend is a stock dividend that represents less than 20 percent to 25 percent of the common stock outstanding when the dividend is declared. Small stock dividends are most common.
small (ordinary) stock dividend
A stock dividend representing less than 20 percent to 25 percent of the common stock outstanding when the dividend is declared.
The current stockholders’ equity on the balance sheet of Garrison Corporation, a distributor of prefabricated cabinets, is as shown in the following accounts.
|Preferred stock||$ 300,000|
|Common stock (100,000 shares at $4 par)||400,000|
|Paid-in capital in excess of par||600,000|
|Total stockholders’ equity||$2,000,000|
Garrison, which has 100,000 shares of common stock outstanding, declares a 10% stock dividend when the market price of its stock is $15 per share. Because 10,000 new shares (10% of 100,000) are issued at the prevailing market price of $15 per share, $150,000 ($15 per share × 10,000 shares) is shifted from retained earnings to the common stock and paid-in capital accounts. A total of $40,000 ($4 par × 10,000 shares) is added to common stock, and the remaining $110,000 [($15 − $4) × 10,000 shares] is added to the paid-in capital in excess of par. The resulting account balances are as follows:
|Preferred stock||$ 300,000|
|Common stock (110,000 shares at $4 par)||440,000|
|Paid-in capital in excess of par||710,000|
|Total stockholders’ equity||$2,000,000|
The firm’s total stockholders’ equity has not changed; funds have merely been shifted among stockholders’ equity accounts.
The shareholder receiving a stock dividend typically receives nothing of value. After the dividend is paid, the per-share value of the shareholder’s stock decreases in proportion to the dividend in such a way that the market value of his or her total holdings in the firm remains unchanged. Therefore, stock dividends are usually nontaxable. The shareholder’s proportion of ownership in the firm also remains the same, and as long as the firm’s earnings remain unchanged, so does his or her share of total earnings. (However, if the firm’s earnings and cash dividends increase when the stock dividend is issued, an increase in share value is likely to result.)
Ms. X owned 10,000 shares of Garrison Corporation’s stock. The company’s most recent earnings were $220,000, and earnings are not expected to change in the near future. Before the stock dividend, Ms. X owned 10% (10,000 shares ÷ 100,000 shares) of the firm’s stock, which was selling for $15 per share. Earnings per share were $2.20 ($220,000 ÷ 100,000 shares). Because Ms. X owned 10,000 shares, her earnings were $22,000 ($2.20 per share × 10,000 shares). After receiving the 10% stock dividend, Ms. X has 11,000 shares, which again is 10% of the ownership (11,000 shares ÷ 110,000 shares). The market price of the stock can be expected to drop to $13.64 per share [$15 × (1.00 ÷ 1.10)], which means that the market value of Ms. X’s holdings is $150,000 (11,000 shares × $13.64 per share). This is the same as the initial value of her holdings (10,000 shares × $15 per share). The future earnings per share drops to $2 ($220,000 ÷ 110,000 shares) because the same $220,000 in earnings must now be divided among 110,000 shares. Because Ms. X still owns 10% of the stock, her share of total earnings is still $22,000 ($2 per share × 11,000 shares).
In summary, if the firm’s earnings remain constant and total cash dividends do not increase, a stock dividend results in a lower per-share market value for the firm’s stock.
Stock dividends are more costly to issue than cash dividends, but certain advantages may outweigh these costs. Firms find the stock dividend to be a way to give owners something without having to use cash. Generally, when a firm needs to preserve cash to finance rapid growth, it uses a stock dividend. When the stockholders recognize that the firm is reinvesting the cash flow so as to maximize future earnings, the market value of the firm should at least remain unchanged. However, if the stock dividend is paid so as to retain cash to satisfy past-due bills, a decline in market value may result.
Although not a type of dividend, stock splits have an effect on a firm’s share price similar to that of stock dividends. A stock split is a method commonly used to lower the market price of a firm’s stock by increasing the number of shares belonging to each shareholder. In a 2-for-1 split, for example, two new shares are exchanged for each old share, with each new share being worth half the value of each old share. A stock split has no effect on the firm’s capital structure and is usually nontaxable.
A method commonly used to lower the market price of a firm’s stock by increasing the number of shares belonging to each shareholder.
Quite often, a firm believes that its stock is priced too high and that lowering the market price will enhance trading activity. Stock splits are often made prior to issuing additional stock to enhance that stock’s marketability and stimulate market activity. It is not unusual for a stock split to cause a slight increase in the market value of the stock, attributable to its informational content and because total dividends paid commonly increase slightly after a split.5
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Delphi Company, a forest products concern, had 200,000 shares of $2-par-value common stock and no preferred stock outstanding. Because the stock is selling at a high market price, the firm has declared a 2-for-1 stock split. The total before- and after-split stockholders’ equity is shown in the following table.
|Before split||After 2-for-1 split|
|Common stock||Common stock|
|(200,000 shares at $2 par)||$ 400,000||(400,000 shares at $1 par)||$ 400,000|
|Paid-in capital in excess of par||4,000,000||Paid-in-capital in excess of par||4,000,000|
|Retained earnings||2,000,000||Retained earnings||2,000,000|
|Total stockholders’ equity||$6,400,000||Total stockholders’ equity||$6,400,000|
The insignificant effect of the stock split on the firm’s books is obvious.
Stock can be split in any way desired. Sometimes a reverse stock split is made: The firm exchanges a certain number of outstanding shares for one new share. For example, in a 1-for-3 split, one new share is exchanged for three old shares. In a reverse stock split, the firm’s stock price rises due to the reduction in shares outstanding. Firms may conduct a reverse split if their stock price is getting so low that the exchange where the stock trades threatens to delist the stock. For example, the New York Stock Exchange requires that the average closing price of a listed security must be no less than $1 over any consecutive 30-day trading period. In June 2010, the video chain Blockbuster asked shareholders to approve a reverse stock split to prevent the NYSE from delisting Blockbuster’s stock. Shareholders didn’t approve the measure, and the NYSE delisted Blockbuster stock the following month.
reverse stock split
A method used to raise the market price of a firm’s stock by exchanging a certain number of outstanding shares for one new share.