Question

Sarah Corporation, which manufactures biotech drugs, has been experiencing a tremendous growth in the price of its common stock. The stock price increased from $4.50 on January 1, 20X1 to $18.00 per share on December 31, 20X5. Its current net worth statement is as follows:

Common stock (2.0 million shares) $37,000,000
Retained earnings $33,000,000
Total : $70,000,000
a) What changes would occur in the above statement of net worth after a 2 for 1 stock split?
b) Earnings for 20X5 were $1,575,000, what would EPS be before and after the stock split?

Answer 1

After a 2 for 1 stock split for Sarah Corporation, the number of shares will double, and the price per share will halve, but the total equity stays the same. The net worth remains at $70,000,000. EPS before the split is $0.7875, and after the split, it is $0.39375.

Step-by-step explanation:

Understanding Stock Splits and Earnings Per Share (EPS)

When Sarah Corporation performs a 2 for 1 stock split, the number of shares will double, and the price per share will halve. However, the overall equity value of the company remains the same. Each shareholder will hold twice as many shares at half the price each.

a) After the 2 for 1 stock split, Sarah Corporation's net worth statement will show:

• Common stock (4.0 million shares at $9.25 per share) $37,000,000
• Retained earnings $33,000,000
• Total net worth: $70,000,000

The value of the common stock is calculated by taking the new share price post-split, here hypothetically assumed to be $9.25 (since the original price was not provided post-split), multiplied by the new number of shares: 4 million.

b) Before the stock split, the EPS for 20X5 can be calculated as:

Earnings / Number of shares = $1,575,000 / 2,000,000 shares = $0.7875 per share

After the stock split, the EPS would be:

Earnings / Number of shares = $1,575,000 / 4,000,000 shares = $0.39375 per share

The EPS is halved, just like the share price, but the total earnings and net worth of the company do not change.