XYZ Corporation has 400,000 shares of common stock outstanding, a P/E ratio of 8, and $500,000 available for common stockholders. The board of directors has just voted a 3-2 stock split
a. If you had 100 shares of stock before the split, how many shares will you have after the split?
b. What was the total value of your investment in XYZ stock before the split?
c. What should be the total value of your investment in XYZ stock after the split?
d. In view of your answers to (b) and (c) above, why would a firm's management want to have a stock split?
Answer:
a. Number of shares after split = 3/2 × 100 = 150
b. EPS before split = ($500,000/400,000) = $1.25
Price per share before split = 8 × $1.25 = $10
Total value of investment = $10 × 100 = $1,000
c. Total number of shares after split = 3(400,000/2) = 600,000
EPS after split = ($500,000/600,000) = $.8333
Price per share after split = 8 × $.833 = $6.67
Total value of investment after split = $6.67 × 150 = $1,000
d. (1) Stock splits are believed to have favorable information content. Splits are often associated with growth companies.
(2) Splits can conserve corporate cash if the firm has cash flow problems or needs additional funds for attractive investment opportunities.
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