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Understanding The Reasons For Stock Splits

Aug 17, 2007
A stock split is a corporate action where the company divides the existing outstanding shares in order to boost the liquidity of shares. The prices of the shares adjust automatically in the stock market when the company implements the action. The equity capital of the company and its net assets remain the same. For instance, a board of directors for a company decides to do a 3:1 stock split. In this scenario, if the value per share stood at $90, the new value per share would become $30, while the net worth of the stock would remain the same. For every one share there would now be three.

The primary reason why companies decide for a stock spit is to increase the liquidity of the shares in stock the market. More liquidity makes the buying and selling of the shares easier for the consumer. The split is in the form of either a ratio or a percentage according to the convenience of shareholders. Liquidity is an important factor. It is the degree of flexibility with which investors can purchase or sell the shares or securities without making an impact on the prices of that share. It is done for the betterment of the investors.

Reverse Stock Split
Reverse stock split is an action that increases the par value of a share, while the total number of the company's outstanding shares decreases. In this kind of split there is no affect on the net equity capital either.

Reasons For Choosing A Stock Split
In past years, companies pursued stock splits in order to help brokerage firms, since brokerage firms charge commissions on the basis of the number of shares being traded. Also the market welcomed greater liquidity. However, the same does not hold true in today's market, as most of the brokers charge a flat rate, irrespective of the number of shares they trade.

Investors may be concerned whether they are capable of purchasing shares with a high value, but a greater number of shares at a reduced purchase rate per share, after a stock split, makes investors feel comfortable buying the stock. In this way, companies with a higher price may go for a stock split and decrease the rate per share, attracting prospective investors

Additional Help
The market is now equipped with software packages that enable people to handle necessary documents related to stock splits. These software packages help people to understand the accounting procedure involved in this process and are available in the market at affordable prices.
About the Author
David Gass is President of Business Credit Services, Inc. His company publishes a free weekly e-newsletter on Small Business Consulting at their web site http://www.smallbusinessconsulting.com
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