Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy- Dividends and Dividend
Policy
(^654) © The McGraw−Hill
Companies, 2002
A seemingly arbitrary accounting procedure is used to adjust the balance sheet after
a small stock dividend. Because 1,000 new shares are issued, the common stock account
is increased by $1,000 (1,000 shares at $1 par value each), for a total of $11,000. The
market price of $66 is $65 greater than the par value, so the “excess” of $65 1,000
shares $65,000 is added to the capital surplus account (capital in excess of par value),
producing a total of $265,000.
Total owners’ equity is unaffected by the stock dividend because no cash has come in
or out, so retained earnings is reduced by the entire $66,000, leaving $224,000. The net
effect of these machinations is that Peterson’s equity accounts now look like this:
Example of a Stock Split A stock split is conceptually similar to a stock dividend,
but it is commonly expressed as a ratio. For example, in a three-for-two split, each
shareholder receives one additional share of stock for each two held originally, so a
three-for-two split amounts to a 50 percent stock dividend. Again, no cash is paid out,
and the percentage of the entire firm that each shareholder owns is unaffected.
The accounting treatment of a stock split is a little different from (and simpler than)
that of a stock dividend. Suppose Peterson decides to declare a two-for-one stock split.
The number of shares outstanding will double to 20,000, and the par value will be
halved to $.50per share. The owners’ equity after the split is represented as:
Note that, for all three of the categories, the figures on the right are completely unaf-
fected by the split. The only changes are in the par value per share and the number of
shares outstanding. Because the number of shares has doubled, the par value of each is
cut in half.
Example of a Large Stock Dividend In our example, if a 100 percent stock dividend
were declared, 10,000 new shares would be distributed, so 20,000shares would be out-
standing. At a $1par value per share, the common stock account would rise by $10,000,
for a total of $20,000. The retained earnings account would be reduced by $10,000,
leaving $280,000. The result would be the following:
CHAPTER 18 Dividends and Dividend Policy 627
Common stock ($1 par, 10,000 shares outstanding) $ 10,000
Capital in excess of par value 200,000
Retained earnings 290,000
Total owners’ equity $500,000
Common stock ($1 par, 11,000 shares outstanding) $ 11,000
Capital in excess of par value 265,000
Retained earnings 224,000
Total owners’ equity $500,000
Common stock ($.50par, 20,000shares outstanding) $ 10,000
Capital in excess of par value 200,000
Retained earnings 290,000
Total owners’ equity $500,000