Question

Explain the stock price before- and after stock split, and show how the increasing number of stocks affects the market value of share and shareholders' wealth.

Answer 1

A company might opt to split its number of shares, for instance 2-for-1 stock split would mean that the equity shareholders would have two shares for each share owned previousl. This is called stock split.

Let's say, if the stock split is 4-for-1, equity shareholders will have 4 shares instead of 1 share post the split.

Companies generally choose to split their shares if the market price has significantly increased over a period of time. A higher price per share compared to market peers could cause decline in liquiditiy and volume traded in the markets as small investors participation would get limited.

It must be noted that the share price would decrease in proportion to the split. For instance, if the market price of a stock is $100 and the shares are split based on 2-for-1, the price will become half i.e. $50.However, the market capitalization will largely remain same (because no of shares are higher). Hence, shareholder's wealth is not impacted immediately as such.

However, a lower price encourages higher trading of volumes which boosts liquidity, since this would attract more participation from investors, traders and speculators. All things being equal, this would contribute towards increase in prices and thus shareholder's wealth over a given period of time (generally, short to medium term)