Discussion Topic: Bonus Issue
Today, we are going to discuss a very interesting topic, i.e. – bonus issue of shares. This article will help to remove all the misconception about bonus issue. After reading this article you will learn what is bonus issue of shares? When and why company issues bonus shares? How to calculate the number of bonus shares? Effect of bonus shares on the stock price, the advantages and disadvantages of bonus issue, and should you invest in a company issuing bonus shares?
What is Bonus Issue of Shares?
A bonus issue of shares, also popularly known as a capitalization issue or a scrip issue, is an offer of free additional shares to existing shareholders based on the number of shares they currently hold. For example, a company may give two bonus shares for every five shares an investor holds.
The primary reason behind the decision of distributing bonus share is to restrict the increasing the dividend payout.
The fundamental behind bonus shares is that the total number of shares increases with a ratio of "number of shares held to the number of shares outstanding". For instance, if Investor A holds 200 shares of a company and a company declares 2:1 bonus, that is for every one share, he will get 2 additional shares for free. That is total 400 shares for free and his total holding will increase to 600 shares.
Though this looks very similar to a stock split, it’s not the same. See our guide on the difference between stock split and bonus issue.
Companies usually issue bonus shares to encourage retail participation and increase their equity base. If the share price of a company becomes much higher, issuing bonus shares reduces the price per share while retaining the company's capital structure. Thus it gets attention from small investors who otherwise would face difficulty in buying shares of that particular company.
Important Dates to Remember:
Record Date: This is the cut-off date specified by a company to determine who is eligible to get bonus shares. You will receive bonus shares only if you hold shares of that company in your demat account on this date.
Ex-Bonus Date: It is a pre-determined date after the record date on which the share price is adjusted on stock exchanges according to the bonus ratio.
How to Calculate the Number of Bonus Shares?
Suppose you own a total of 200 shares of Company X at a current market price of $150 per share. Now the company decides to issue bonus in a 3:2 ratio (i.e. - issuing 3 additional shares for every 2 shares you hold).
So, after bonus issue:
The number of bonus shares you will get: (200*3)/2 = 300 shares
Total share count on your account will be: 300+200 = 500 shares
The Market value of the share will be: ($150*2)/5 = $60 per share.
Face value will remain same as bonus issue does not impact the face value of company shares.
Effect of Bonus Issue on Stock Price:
As we have already discussed that bonus issue decreases the share price in a proportion with the declared bonus. But the magical fact is that the bonus issue usually sends a positive signal to the investors. Hence, investors start to invest more money in that company and eventually the share price rises.
After analyzing the records of past 10 years, we have found that the on 85% of cases share price of large capital companies increases 60% on an average within a year of issuing bonus shares.
But, one thing to remember that all of those companies were having strong fundamental positions. We have not seen much growth in companies having weak fundamentals. Some of those even lost their market position after bonus issue. Hence, consider the fundamentals of a company before investing.
To learn more, check out our guides on fundamental analysis.
When and Why a Company Issues Bonus Shares?
The decision to issue bonus shares depends on many factors. Some of them are as follows:
- When the company doesn't want to declare a higher rate of dividend on its capital, it can take a decision to issue bonus shares.
- When the company cannot announce a cash bonus either because of an unsatisfactory cash position or estimating its adverse effects on the operating capital of the company, they issue bonus shares.
- When there is a substantial difference in the nominal value and market value of the shares of the company.
Advantages of Bonus Issue of Shares:
We can look into the advantages of bonus issue from the point of view of both the company and shareholder. Let's first start with Company’s viewpoint.
Advantages from the viewpoint of the company:
- It retains the capital to carry on a larger and more profitable business.
- When a company distributes bonus to its shareholders in form of shares and not as cash, the operating capital of the company is not affected.
- Issuance of Bonus share can somewhat satisfy its investors if the company is not able to pay dividends.
- It enables a company to capitalize on its profits on a permanent basis and increases creditworthiness of the company.
- Paying abnormally high rate of dividend can be replaced by issuing bonus shares.
- The balance sheet of the company will bring out a more truthful picture of the capital structure and the capacity of the company.
Advantages from the shareholder’s viewpoint:
- The bonus shares are considered as a permanent source of income for the investors.
- Even though the rate of dividend falls, the total amount of dividend may increase because the investor will get the dividend on a larger number of shares.
- The investors can easily sell these additional shares and receive immediate cash, if they desire to do so.
- Shareholders don’t have any liability to pay taxes on bonus shares.
Disadvantages of Bonus Issue of Shares:
There are some disadvantages as well for the issue of bonus shares. Some of them are listed below:
- The issue of bonus shares leads to a noticeable reduction in the future dividend rates as the earnings do not usually increase with the bonus issue of shares.
- If the rate of profit does not increase over time, the rate of the dividend may be decreased substantially.
- The dip in the future dividend rate may result in the fall of the market price of shares. This may also spread unhappiness among the shareholders.
- Bonus issue may encourage speculation which is not much desirable for a financially stable company.
Should I Buy Shares of a Company that May Announce Bonus Shares?
If you are planning to buy shares of a company which is going to announce bonus issue, holds on. You should never buy shares solely on the basis of expected bonus announcement unless you are satisfied with the fundamentals of the company.
A bonus issue is a signal that the company is trying to expand equity and increase liquidity, but it can not be considered as a performance indicator. In fact, bonus issue leads to fall in the share price in the immediate term. The share price then further increases or decreases depending on the fundamentals and growth prospects of the company.
So, you should take a decision only after carefully studying the fundamentals and growth prospect of the company.
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