Browse Series 7

Understanding Stock Splits and Reverse Stock Splits: A Guide

Explore stock splits and reverse stock splits with FINRA Series 7 sample exam questions and quizzes to enhance your understanding.

Introduction

In this section of Chapter 9, we delve into the intriguing world of stock splits and reverse stock splits. Both processes are strategic decisions made by companies to adjust their stock price and market perception, while the overall value to shareholders remains unchanged. Understanding these concepts is crucial for any financial professional, especially those preparing for the FINRA Series 7 exam.

Purpose of Stock Splits

Stock splits are a financial tool used by companies to adjust the price of their shares without impacting the total value held by shareholders. The primary aim is to make shares more affordable and increase market liquidity. By lowering the price per share through a split, more investors may find the stock attractive, potentially increasing trading activity and market capitalization.

How Stock Splits Work

A stock split increases the number of shares outstanding by issuing additional shares to shareholders while reducing the share price proportionally. For example, in a 2-for-1 stock split, every shareholder receives an additional share for each share they own, while the stock price is halved. This means that if you owned 100 shares priced at $50 each, after the split, you would own 200 shares priced at $25 each.

    graph LR
	    A(Pre-Split: 100 shares @ $50 each) --> B(Post-Split: 200 shares @ $25 each)
	    C([Total Value: $5000]) --> D([Total Value: $5000])

Reverse Stock Splits

Reverse stock splits, on the other hand, reduce the number of shares outstanding and increase the price per share. This is often done to meet exchange listing requirements, such as a minimum share price, or to improve the perception of a company’s stock. In a 1-for-2 reverse stock split, a shareholder with 200 shares priced at $10 would end up with 100 shares priced at $20.

Why Reverse Splits Occur

The primary reasons companies undergo reverse stock splits include adhering to listing standards of major stock exchanges, improving the company’s image by having a higher share price, and reducing the number of shares to make the stock seem more desirable.

Conclusion

Stock splits and reverse stock splits are significant financial events that impact the trading strategy of a company. Understanding these actions is vital for those involved in trading and financial analysis, as they influence investor perception and market activity.


Glossary:

  • Stock Split: A corporate action that increases the number of a company’s outstanding shares by issuing more shares to current shareholders, without changing the shareholder’s equity.
  • Reverse Stock Split: A corporate action to reduce the number of outstanding shares and proportionally increase the share price.
  • Liquidity: The ease with which an asset can be bought or sold in the market without affecting its price.

Additional Resources:


### What is the primary purpose of a stock split? - [x] To make shares more affordable and increase liquidity - [ ] To decrease the overall market value of the company - [ ] To convert shares into bonds - [ ] To prepare the company for a merger > **Explanation:** Stock splits are designed to make shares more accessible to a wider range of investors by lowering the price per share, which can increase market liquidity. ### What happens in a 2-for-1 stock split? - [x] The number of shares is doubled, and the share price is halved. - [ ] The number of shares remains the same, but the share price is doubled. - [x] The share price is reduced by 50%. - [ ] The total value of shares doubles. > **Explanation:** In a 2-for-1 stock split, each share is split into two, increasing the number of shares but halving the price, keeping the total investment value constant. ### What effect does a stock split have on a shareholder's equity? - [x] No change - [ ] Increases significantly - [ ] Decreases significantly - [ ] Converts to debt > **Explanation:** A stock split does not affect the total equity of a shareholder; it merely adjusts the share price and number of shares. ### How does a reverse stock split affect the number of outstanding shares? - [x] Decreases the number of outstanding shares - [ ] Increases the number of outstanding shares - [ ] No effect on the number of outstanding shares - [ ] Converts shares to preferred stock > **Explanation:** A reverse stock split consolidates shares, thus decreasing the total number of shares but increasing the price per share proportionally. ### Why might a company perform a reverse stock split? - [x] To increase the share price - [ ] To decrease share price - [x] To meet exchange listing requirements - [ ] To raise capital immediately > **Explanation:** Companies might initiate a reverse stock split to meet minimum share price requirements for listing on stock exchanges and to improve stock market perception. ### If a company executes a 1-for-4 reverse stock split, how many shares will an investor own if they previously had 800 shares? - [x] 200 shares - [ ] 400 shares - [ ] 1600 shares - [ ] 800 shares > **Explanation:** In a 1-for-4 reverse stock split, every four shares held by an investor are combined into one share. ### What happens to the price of shares after a 1-for-3 reverse stock split? - [x] The share price triples - [ ] The share price halves - [x] The share price increases significantly - [ ] The share price stays the same > **Explanation:** In a 1-for-3 reverse split, each shareholder receives one share for every three shares held, tripling the share price if the market value remains constant. ### What is a common reason companies might perform a stock split? - [x] To increase stock liquidity - [ ] To decrease the number of shares - [ ] To change business structure - [ ] To reduce dividend payouts > **Explanation:** Stock splits are often performed to enhance market liquidity by reducing the per-share price. ### Is it true that stock splits change the fundamental value of a company? - [x] False - [ ] True > **Explanation:** Stock splits do not alter the fundamental market value of the company; they merely adjust the structure of the shares. ### Which corporate action is most likely intended to address a low share price issue? - [x] Reverse stock split - [ ] Stock split - [ ] Issuance of bonds - [ ] Merger and acquisition > **Explanation:** Reverse stock splits are typically used to increase the share price and address issues arising from a low market value per share.

Stock splits and reverse stock splits are tactical moves that signify more than just changes in numbers—they indicate a company’s strategic direction and can have significant impacts on market perception. Engaging with these concepts through quizzes can help deepen your understanding and prepare you for scenarios presented in the FINRA Series 7 exam.

Sunday, October 13, 2024