Stock Splits, Trading Continuity, and the Cost of Equity Capital

Based on the premise that non-trading reflects illiquidity, we hypothesize that managers use stock splits to attract more uninformed trading so that market makers can provide liquidity services at lower costs, which increases investors’ trading propensity and improves liquidity. The improvement allows investors to face reduced liquidity risk and require a lower liquidity premium, which in turn leads to a lower cost of equity capital for the firm. We examine a large sample of stock splits and find that, consistent with our hypothesis, incidence of no trading decreases, implying a decline in the latent trading costs, liquidity risk is lower, and the cost of equity capital is reduced following the splits. Further, the split announcement returns are correlated with the improvements in both the liquidity level and liquidity risk. Our analysis suggests that the economic benefits of the liquidity improvements are nontrivial, with less liquid firms benefiting more from stock splits. Stock Splits, Trading Continuity, and the Cost of Equity Capital