Bonus issue of shares is when the company issues free additional shares to its existing shareholders in propotion to the number of shares held by them. This is done by capitalizing on the company’s retained earnings or reserves, thereby increasing the number of outstanding shares without compromising the equity and ownership proportion of the shareholders.
1. What is Bonus Issue of Shares?
Definition: A bonus issue, also known as a stock dividend is the act of issuing excess shares to its shareholders at no cost usually in a given ratio- e.g. 1:1that is one bonus share to every one held.
How it works: The company would use its retained earnings or reserves to make the bonus issue instead of payment in cash.
Bonus Issue of Shares Advantageous
Reward to Shareholders Without Cash Outflow
Bonus shares allow the company to reward the shareholders without spending cash so that cash outflows for any future investments or operational purposes can be kept intact.
Signal of Confidence
Bonus shares are issued by companies when they are sure about their growth and their sound financial position. Bonus shares alert the shareholders that the company has enough retained profits to finance future growth.
Increases Liquidity
A bonus issue can make the shares relatively cheaper and more affordable in the market, thereby boosting trading volume and liquidity.
Tax Advantage to Shareholders
Generally, tax advantages accrue to shareholders from bonus issues since they are not taxed initially. Since bonus shares do not possess the characteristics of revenue, which may be taxable as income, they generally are not subject to taxation prior to sale.
Higher Perceived Value for Shareholders
Bonus shares increase the number of shares that each shareholder owns, which could enhance shareholder sentiment even though the actual value per share adjusts accordingly.
Drawbacks of Bonus Issue of Shares
No Instant Cash Benefit to Shareholders
Bonus shares are not an instant source of cash like dividends; in the case of bonus shares, the shareholder only benefits in case of an appreciation in the stock price by selling the respective shares.
Administrative and Regulatory Costs
Bonus issues are administratively complex and, unless the issues are large, their costs of regulatory compliance may outweigh benefits.
Perception of Scarce Investment Opportunities
At times, the bonus issue suggests a scarcity of investment opportunities for the issuing company and it is distributing surplus reserves without any logical purpose.
EPS Dilution
Higher shares outstanding without the earning increasing will see a corresponding reduction of the EPS thus making the stock appear less worthwhile due to lower profitability per equity share.
Impact to the Share Price
Adjustment to Market Price per Share
Subsequently, the share price also changes with the addition in the number of shares. For instance, if there has been a 1:1 bonus issue, then the share price declines approximately by half despite the fact that total market capitalization has not altered.
This process makes the stock cheaper, and therefore, it draws in more small investors and increases the liquidity of the market.
No Short-Term Change in Market Capitalization
Increased outstanding shares does not initially affect the market capitalization of a firm because the price per share adjusts proportionally when bonus issues occur.
Appreciation over Long time
Bonus issues can improve appreciation over a long-term, where it enhances demand because liquidity increases and attracts the crowd. It is also unlikely. It depends on the way companies function.
Conclusion
Bonus issues give existing shareholders additional shares. While bonus issues do not give shareholders direct cash flows, they contribute to liquidity and eventually enhance shareholder value. Generally, the general stock price tends to factor in the bonus issue, but when the company does well, shareholders can enjoy a gain in share price and reap the fruits of capital appreciation in the long term.