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Sunday, September 6, 2015

Reverse Stock Split - Concept and Rationale

A Reverse Stock Split, as the name indicates, is the opposite of a stock-split. It is the act of consolidating of two or more shares of a company whereby the number of shares outstanding is reduced. A reverse stock split brings about an increase in the Face Value of a share. 

Recommended Read: Concept of Stock Split

The concept of reverse stock split is better understood with the help of an example. 

The shares of ACE Ltd with a face value of Rs 5 per share are currently trading @Rs 20 per share. The total number of shares outstanding is 100,000. The management of ACE Ltd now decide to consolidate two such shares of Rs 5 each into one share of Rs. 10 each. Post such a reverse stock split the number of shares outstanding shall be reduced to 50000.

Note that the market price of the share (FV Rs. 10) post the reverse split will increase to Rs. 40 per share. A reverse stock split has no impact on the shareholder's wealth.
Why do companies go for a reverse stock split?

Companies go for a reverse stock split primarily for the following reasons:

1. To make shares more attractive to institutional investors: In case of a reverse stock split, the consolidation will result in the reduction of the number of shares outstanding while increasing the market price per share [see example above]. This might have the effect of making the stocks more attractive to high net worth and institutional investors [as these investors will often avoid investments in low-priced stocks.]

2. To Fulfill a listing requirement: Certain stock exchanges might prescribe a minimum bid price for shares to be listed on the said exchange. Companies in order to fulfill this requirement might go for a reverse stock split. 

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