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Questions about Splitting Common Stock on the Series 7 Exam

You may ask yourself, “Why would a company split its stock?” The Series 7 may also ask you about this choice. The obvious answer is that the company wants to make the market price of the security more attractive. The normal unit of trading is 100 shares of stock and if the price of a security gets too high, the number of investors who can purchase it becomes limited.

If Microsoft had never split its stock (which it has already done nine times), a round lot would cost investors about $750,000 at the time of this writing. Know a lot of investors who could afford that?

Companies may alternatively use a reverse split, consolidating shares so they can raise the price of the stock and perhaps boost investor confidence.

Stockholders can vote on stock splits. Be aware that after a stock split, investors may have more or fewer votes, but they still hold the same percentage of votes. When a company splits its stock, the number of authorized shares needs to be changed on the corporate charter.

Forward splits of common stock

During a forward stock split, the number of shares increases and the price decreases without affecting the total market value of outstanding shares. After a company forward splits its stock, investors receive additional shares, but the market price (and par value) per share drops. A forward split may be a 2-for-1, a 3-for-1, a 3-for-2, and so on, where A represents the first number and B represents the second number.

Use the following calculations to figure out an investor’s position after an A-for-B split:

image0.jpg image1.jpg

The following question tests your ability to answer a stock split question.

Bob Billingham owns 1,200 shares of DEF common stock at a current market price of $90 per share. If DEF splits its stock 3-for-1, what would Bob’s position be after the split?

(A)    400 shares at $270 per share
(B)    400 shares at $90 per share
(C)    3,600 shares at $33.33 per share
(D)    3,600 shares at $30 per share

The answer you’re looking for is Choice (D). A forward stock split, like a 3-for-1, increases the number of shares and decreases the price of the stock, so you can immediately cross off Choices (A) and (B). Now check your work:

image2.jpg image3.jpg

A good way to double check your work is to make sure that the overall value of the investment doesn’t change after the split. Using the example, Bob had $108,000 worth of DEF (1,200 shares × $90) before the split, and after the split he has $108,000 worth of DEF (3,600 shares × $30).

Reverse common stock splits

A reverse stock split has the opposite effect on a security than a forward split does; with a reverse split, the market price of the security increases and the number of shares decreases. As with forward stock splits, the overall market value of the securities doesn’t change. A company may reverse split its stock if the market price gets low, whereby potential investors may think the company has a problem.

In the event of a reverse split, investors usually have to send in their old shares to the transfer agent to receive the new shares. If a company were executing a 1-for-3 reverse split, investors would receive one new share for every three they sent in.

You can use the same formula to determine an investor’s position after a reverse split that you use for forward splits.

The following question tests your ability to answer a reverse stock split question.

Betty Billings owns 3,600 shares of GHI common stock at a current market price of $2 per share. If GHI reverse splits its stock 1-for-5, what would Betty’s position be after the split?

(A)    600 shares at $10 per share
(B)    720 shares at $10 per share
(C)    18,000 shares at $0.40 per share
(D)    18,000 shares at $10 per share

The correct answer is Choice (B). With a reverse split, the number of shares has to decrease and the price has to increase, so you can immediately eliminate Choices (C) and (D). Check your work:

image4.jpg image5.jpg
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