When a company makes a profit, it can distribute its net earnings among its shareholders in the form of dividends. However, it may instead choose to retain its earnings for further capital investment. In these cases, it can pay dividends to its shareholders in the form of additional stock. This transfers equity from retained earnings to capital stock accounts. Each investor then owns the same portion of the company as before, while holding more shares and a greater amount of equity.
1. Divide the company's retained earnings by its current stock price. For example, if a company plans to retain $6,000 in earnings, and its common stock currently sells at $15 then $6,000/15 = 400 shares.
2. Divide the number of new shares by the number of outstanding shares. For example, if investors currently own 10,000 of stock then 400/16,000 = 0.025.
3. Multiply the fraction that the new shares represent by 100: 0.025 × 100 = 2.5. Through capitalization of retained earnings, the company would therefore offer common shareholders a 2.5 percent stock dividend.
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