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What is a reverse stock split? Why might a company undergo such a split?

Eligibility in many indexes such as the S&P/TSE Composite index requires that a company’s stock price be above a certain level. Mutual funds often use the constituents of a particular index as the pool from which they select investments. A stock, which drops out of the index, therefore, drops out of sight of such institutional investors. As well, some pension funds and mutual funds adhere to guidelines that do not permit them to invest in stocks that trade below a certain floor level, perhaps $1, $5 or even $10. When company share prices dropped dramatically, they risk being dropped from indices and automatically overlooked by mutual funds

A reverse stock split is an inexpensive method of boosting the share price. The company issues one new share for a certain number of old shares. Once the process is complete the share price is higher and the number of shares in issue is lower. Without taking any negative market sentiment into account, the market value, also known as market capitalization, remains theoretically the same. Take for example, a fictional company ZZX Technologies. Let’s say that in August 2000 it traded at $50.00 and had 30 million shares outstanding. The market value then was $15 billion. It currently trades at $1.20 and market value is $36 million. The effect of a reverse share split is shown below.
Date Share price $ Shares Outstanding Market Value $
August 22, 2000 50.00 30,000,000 1.5 billion (1,500,000,000)
July 2, 2002 1.20 30,000,000 36,000,000
Reverse share split on the basis of 5 old for 1 new share, effective August 22, 2002
August 23, 2002 6 6,000,000 36,000,000
Reverse stock splits can reduce bloated pools of shares outstanding and avoid questions relating to potential delisting. In addition, there is the added bonus of avoiding the ignominy of a once proud stock becoming a penny stock. Some analysts and institutional investors have a negative view of reverse share splits, since such an action suggests that the company management does not believe that they can boost the share price through growth.

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