A less frequently encountered financial maneuver is the reverse split. In 1999, for example, 79 Nasdaq firms executed reverse splits. In 2000, only 36 did. Reverse splits generally range from 1 for 2 to 1 for 10. In a one for three reverse split, each investor exchanges three old shares for one new share. The par value is tripled in the process.
As with stock splits and stock dividends, a case can be made that a reverse split has no real effect. Given real world imperfections, three related reasons are cited for reverse splits. First, transaction costs to shareholders may be less after the reverse split. Second, the liquidity and marketability of a company’s stock might be improved when its price is raised to the popular trading range. Third, stocks selling at prices below a certain level are not considered respectable, meaning that investors underestimate these firms’ earnings, cash flow, growth, and stability. Some financial analysts argue that a reverse split can achieve instant respectability. As was the case with stock splits, none of these reasons is particularly compelling, especially not the third one.
There are two other reasons for reverse splits. First, stock exchanges have minimum price per share requirements. A reverse split may bring the stock price up to such a minimum. In 2001, this motive became an increasingly important one. By July of 2001, 86 companies had asked their shareholders to approve reverse splits. The most common reason is that Nasdaq delists companies whose stock price drops below $1 per share for 30 days. A large number of companies, particularly Internet related technology companies, found themselves in danger of being delisted and used reverse splits to boost their stock prices. Second, companies sometimes perform reverse splits and, at the same time, buy out any stockholders who end up with less than a certain number of shares. For example, after it was spun off from AT&T, NCR had 600,000 stockholders (out of 1 million total) with fewer than 10 shares. In early 1999, NCR planned a 1 for 10 reverse split, followed by a cash purchase of all holdings of less than one share, to buy out these small stockholders and save millions in mailing and other costs. What made the proposal especially imaginative was that exactly 1 minute after the reverse split, NCR proposed to do a 10 for 1 split to restore the stock to its original cost!
a What is the effect of a stock split on stockholder wealth?
b How does the accounting treatment of a stock split differ from that used with a small stock dividend?