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Q: Effect on the Number of Shares Outstanding and on the Stock Price ( Answered,   1 Comment )
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 Subject: Effect on the Number of Shares Outstanding and on the Stock Price Category: Business and Money > Finance Asked by: loman-ga List Price: \$25.00 Posted: 24 Jul 2005 20:22 PDT Expires: 23 Aug 2005 20:22 PDT Question ID: 547439
 ```Menomonie Publishing stock currently sells for \$40 per share. The company has 1,200,000 shares outstanding. What would be the effect on the number of shares outstanding and on the stock price of the following: 1. 15% Stock Dividend 2. 4-for-3 Stock Split 3. Reverse 3-for-1 Stock Split Last year both Hudson Homes and Baldwin Construction earned \$1 million in net income. Both companies have assets of \$10 million. Hudson generated a return on equity of 11.1%, whereas Baldwin produced a return on equity of 20.0%. What can explain the differences in return on equity between the two companies?```
 ```Loman ? I?ll answer the first 3 questions about stock valuation using strict financial theory -- but it?s important to note that the real world works a little differently. 1. Menomonie Publishing has a total valuation of \$48 million (1.2 million shares x \$40/per share), so increases in the number of shares should see a decrease in the stock price ? while lowering the number of outstanding shares should increase the per-share price: A 15% stock dividend will increase the number of shares to 1,380,000 and lower the price to \$34.78 = \$48,000,000 / 1,380,000 Thus, if you increase the number of shares by 15%, you lower the stock price by 1/1.15 or about 13%. 2. A 4-for-3 stock split is a 33.3% increase to 1,600,000 shares so the stock price should be \$48,000,000 / 1,600,000 shares = \$30 per share. A 33.3% increase in shares would reduce the stock price by 1/1.333 or about 25%. 3. A reverse split is designed to increase the stock price, often for regulatory reasons (see the next section, ?The Reality.?) A 3-for-1 split would take the company from 1.2 million shares to 400,000 shares and the value would be \$48,000,000 / 400,000 = \$120 THE REALITY ============= Companies like to keep their shares trading within certain ranges to allow a broader ownership. In the U.S. it?s often \$5 - \$100, though in the U.K. share prices are often in the 1 ? 10 pound range (and share prices there are shown in pence). Also, certain exchanges don?t allow low-priced stocks or so-called ?penny stocks,? so companies with declining share prices will often do a reverse split to stay publicly listed. A good example cited here is Agere Systems: USAToday ?Reverse Stock Split is Anything But Good News,? (Krantz, July 18, 2005) http://www.usatoday.com/money/perfi/columnist/krantz/2005-07-14-agere_x.htm When stocks split, theoretically only the number of shares change, as this Investopedia article indicates. But the reality is that the stock is more affordable in block trades to smaller investors ? and more importantly, it?s generally considered a signal from the board of directors that the company believes growth in sales and profits will continue: Investopedia ?Stock Splits,? (undated) http://www.investopedia.com/ask/answers/113.asp HUDSON - BALDWIN ================== There are a myriad of factors that can account for two companies having a different return on equity. These can include: ? Baldwin being in a growing market, where it?s overhead costs as a percentage of sales are shrinking ? while perhaps Hudson?s are increasing ? Better use of assets by the 2 companies. ? Better management of assets. ? Different risk factors, if they?re in different markets. Perhaps Baldwin is building casinos ? for which demand fluctuates highly in a recession ? and Hudson builds homes with a constant demand. I?ll treat one factor: a different weight-average cost-of-capital (WACC) ? and provide a detailed example. The WACC is simply a mix of debt and equity. Use of debt or leverage can increase the returns on equity. WEIGHTED-AVERAGE COST OF CAPITAL ================================= The full weighted-average cost-of-capital (WACC) for a firm is given by: WACC = Rc (E/VL) + rD(1-t)(D/VL) where, Rc: return on equity E/VL: proportion of equity in total firm value rD: debt or bond percentages t: tax rate (expressed as a decimal; 40% = 0.40) D/VL: proportion of debt in total firm value Just to simplify the Hudson-Baldwin example, we?ll ignore taxes here, so WACC simplifies to: WACC = Rc (E/VL) + rD (D/VL) HUDSON-BALDWIN WACC ====================== We know that the overall returns are \$1 million in net income on \$10M in assets ? but we don?t know what their debt/equity structures are. But we?ll eliminate debt costs (Rd), since it?s presumably equal for the two firms. If Hudson has \$10M in assets ? made up of \$9M in equity and \$1 million in debt, it?s returning 11.1%. HUDSON WACC: 10% = 11.1% * (0.9) + Rd (0.1) Baldwin can obtain higher returns by increasing its debt load: BALDWIN WACC: 10% = 20% (0.5) + Rd (0.5) So, by going from a 1/10 debt-to-equity ratio to a 5/10 debt-to-equity ratio, Baldwin is able to almost double its Rc or return on equity. Google search strategy: ?stock split? + ?stock price? Best regards, Omnivorous-GA```
 ```Hi There. You really should not ask homework/exam questions on Google Answers as the question is liable to be booted out.```