Stock dividends, stock splits, donated capital for quasi-reoganisation and Total market value of the company

INTRODUCTION

              All the dividends, when declared, are debited to the retained earnings account except liquidating dividends. Liquidating dividends are debited to the additional paid in capital itself.

              Dividends cannot debited directly to the stocks out standing in any case. 

              A debit to the stock outstanding happens only when shares are donated , through treasury shares, as seen below.

DONATED CAPITAL

             Suppose 10% of 1000 shares 100 par outstanding with a market value of 160 per share are donated back to the company, then the journal entry is as below(for further clarification, see the blog on treasury stocks)

     treasury stock                           10000

     additional paid in capital             6000

     donated capital                                                              16000

     Common stock                         10000

     treasury stock                                                                10000

     Here the donated shares are bought at market value as treasury shares, and are retired (if not re issued )

      This donated capital can be used to clear the deficit in retained earnings during reorganisation, if there is no additional paid in capital in any other capital accounts.

      

STOCK DIVIDENDS

     Here, if the stock dividends declared is less than 25% of common stock outstanding, then the operation is as below.

      Suppose 10% stock dividend on 1000 shares, 100 par with an FMV of 160 are declared, then the journal entry is as follows.

      retained earnings                         16000

      stock dividend distributable                                  10000

      additional paid in capital                                        6000

      stock dividend distributable         10000

      common stock                                                     10000

   If it is more than 25%, then at par value is only used

     suppose it is 30% of common stock outstanding,

     retained earnings                          30000

     stock dividends distributable                                  30000

     stock dividends distributable          30000

     common stock                                                       30000

     A stock dividend is actually capital transferred from the retained earnings account to the common stock and paid in additional capital.

But in the market, when additional stock is created, all the stocks are distributed to the shareholders existing at the time of declaration. Though the EPS would have decreased, if the earnings had been the same the previous year, because of the increase in denominator, the per share value of the stock actually increases. This is because, stock dividends are declared, only when there is a considerable increase in the earnings over the previous year, which more than compensates for the increase in the denominator.

STOCK SPLITS

      Stock splits are done to decrease the market price in rupees, so that more shares can be bought with a small capital, to encourage small retail buyers and liquidity.

      

       Stock splits, though often described as bonus shares, are not stock dividends at all, as nothing additional is given to the existing shareholders from the retained earnings or any other capital account.

      Stock spits happen, when the par value of the common stock, is reduced by a certain ratio, so that the number of outstanding shares are increased proportionally, bringing down the market value proportionately.

This is caused, because the EPS decreases in the exact ratio of the split.

Stock dividend vs Stock split

Consider the following example:

The capital account of a company consists of

common stock                                                  100000

additional paid in capital                                     50000

The company has 1000 shares 100 par, with a premium of 50, and a FMV of 160

For a 2:1 split, no entry is done, because, the par value is halved and the number of stock is doubled. Therefore common stock outstanding remains the same. The split is mentioned in a memorandum note.

But if it is 100% stock dividend, then the following entry is made

retained earnings                     100000

stock dividend distributable                               100000

stock dividend distributable     100000

common stock                                                  100000

The capital account after the dividend is distributed, is as below

common stock                                                  200000
additional paid in capital                                     50000

Here also the common stock number doubled but the par value is not halved (FMV is ignored). The additional value of shares is created from the retained earnings of the company.

Both in 100% stock dividend, and 1:1 stock split, the number of shares is doubled. And since the EPS is halved in both cases, the market value, which depends on PE multiple, gets halved.

IN BOTH CASES, THE TOTAL SHARE HOLDER EQUITY WHICH INCLUDES THE RETAINED EARNINGS IS THE SAME, the number of shares outstanding also is the same. Only the par value is different.

TOTAL MARKET VALUE OF THE COMPANY

The total market value of the company is the market value of the stocks multiplied by the number of shares outstanding. Treasury shares are not counted for market value because

1. They are a decrease in the capital until reissued.
2. Therefore, they are not counted for when calculating the EPS, and for distributing dividends.

Stock splits and stock dividends do not affect the total market value of the company. This is because of the following reason

If the earnings do not change over the previous year, when stock dividend or a split is declared, the decrease in the market value of share of the shares caused by a reduced earnings per share(no of shares increases) is compensated exactly by the increase in the number of shares.

THEREFORE THE TOTAL MARKET VALUE OF THE COMPANY DEPENDS ONLY ON THE EARNINGS IN THAT YEAR. AND THE MARKET VALUE OF A SHARE DEPENDS ON THE EPS.