Bonus Shares

An issue of bonus share represents a distribution of shares in addition to the cash dividend (known as stock dividend in the U.S.A.) to the existing shareholders. This has the effect of increasing the number of outstanding shares of the company. The shares are distributed proportionately. Thus, a shareholder retains his proportionate ownership of the company. For example, if a shareholder owns 100 shares at the time when a 10 per cent (i.e., I: 10) bonus issue is made, be will receive 10 additional shares. The declaration of the bonus shares will increase the paid-up share capital and reduce the reserves and surplus of the company. The total net worth is not affected by the bonus issue. In fact, a bonus issue represents a recapitalization of the owners’ equity portion, i.e., the reserves and surplus. It is merely an accounting transfer from reserves and surplus to paid-up capital.

The basic principle behind bonus shares is that the total number of shares increases with a constant 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 4:1 bonus, that is for every one share, he gets 4 shares for free. That is total 800 shares for free and his total holding will increase to 1000 shares.

Companies issue bonus shares to encourage retail participation and increase their equity base. When price per share of a company is high, it becomes difficult for new investors to buy shares of that particular company. Increase in the number of shares reduces the price per share. But the overall capital remains the same even if bonus shares are declared.

Advantages of Bonus Shares

Prima facie the bonus shares do not affect the wealth of the shareholders. In practice, however, it carries certain advantages both to shareholders and the company.

Shareholders – The following are advantages of the bonus shares to Share-holders:

Tax Benefit – One of the advantages to shareholders in the receipt of bonus shares is the beneficial treatment of such dividends with regard to income taxes. When a shareholder receives cash dividend from company, this is included in his ordinary income and taxed at ordinary income tax rate. But the receipt of bonus shares by the shareholder is not taxable as income. Further, the shareholder can sell the new shares received by way of the bonus issue to satisfy his desire for income and pay capital gain taxes, which are usually less than the income taxes on the cash dividends. The shareholder could sell a few shares of his original holding to derive capital gains. But selling the original shares are considered as a sale of principal by some shareholders. They do not mind selling the shares received by way of the bonus shares as they consider it a windfall gain and not a part of the principal.

Indication of Higher Future Profits – Shareholders normally interpret the issue of bonus shares as an indication of higher profitability. When the profits of a company do not rise, and it declares a bonus issue, the company will experience a dilution of earnings as a result of the additional shares outstanding. Since a dilution of earnings is not desirable, directors usually declare bonus shares only when they expect rise in earnings to offset the additional outstanding shares. The bonus shares, thus, may convey some information, which may have a favorable impact on value of the shares. But it should be noticed that the impact on value is that of the growth expectation and not the bonus shares, which simply conveys the information.

Future Divided may Increase – If a company has been following a policy of paying a fixed amount of dividend per share and continues it after the declaration of the bonus issue, the total cash dividends of the shareholders will increase in future. For example, a company may be paying a Re I per share dividend and pays 1 : 10 bonus shares with the announcement that the cash dividend per share win remain unchanged. If a shareholder originally held 100 shares, he will receive additional 10 shares. His total cash dividend in future will be Rs 110 (Rs I x 110) instead of Rs 100 (Re 1 x 100) received in the past The increase in the shareholders’ cash dividend may have a favorable effect on the value of the share. It should be, however, realized that the bonus issue per se has no effect on the value of the share.

Psychological Value – The declaration of the bonus issue may have a favorable psychological effect on shareholders. The receipt of bonus shares gives them a chance to sell the shares to make capital gains without impairing their principal investment. They also associate it with the prosperity of the company. Because of these positive aspects of the bonus issue, it is usually received positively by the market. The sale of the shares, received by way of the bonus shares, by some shareholders widens the distribution of the company’s shares. This tends to increase the market interest in the company’s shares; thus supporting or raising its market price.

Company – The bonus share is also advantageous to the company. The advantages are:

Conservation of Cash – The declaration of a bonus issue allows the company to declare a dividend without using up cash that may be needed to finance the profitable investment opportunities within the company. The company is, thus, able to retain earnings and at the same time satisfy the desires of shareholders to receive dividend. We have stated earlier that directors of a company must consider the financial needs of the company and the desires of share- holders while making the dividend decision. These two objectives are often in conflict. The use of bonus issue represents a compromise, which enables directors to achieve both these objectives of a dividend policy. The company could retain earnings without declaring bonus shares issue. But the receipt of bonus shares satisfies shareholders psychologically. Also their total cash dividend can increase in future, when cash dividend per share remains the same.

Only means to pay dividend under financial difficulty and contractual restrictions

In some situations, even if the company’s intention is not to retain earnings, the bonus issue is the only means to pay dividends and satisfy the desires of shareholders. When a company is facing a stringent cash situation, the only way to replace the, cash dividend is the issue of bonus shares. The declaration of the bonus issue under such a situation should not convey a message of the company’s profitability, but financial difficulty. The declaration of the bonus issue is also necessitated when the restrictions to pay the cash dividend are put under loan agreements. Thus. under the situations of financial stringency or contractual constraining the bonus issue is meant to maintain the confidence of shareholders in the company.

More Attractive Share Price – Sometimes the intention of a company in issuing bonus shares is to reduce the market price of the share and make it more attractive to investors. If the market price of a company’s share is very high, it may not appeal to small investors. If the price could be brought down to a desired range, the trading activity would increase. Therefore, the bonus issue is used as a means to keep the market price of the share within a desired trading range.

Limitations of Bonus Shares – Bonus shares are considered valuable by most shareholders. But they fail to realize that the bonus shares do not affect their wealth and therefore, in itself it has no value for them. The declaration of bonus shares is a method of capitalizing the past earnings of the shareholders. Thus, it is a formal way of recognizing something (earnings), which the shareholders already own. It merely divides the ownership of the company into a large Humber of share certificates. Bonus shares represent simply a division of corporate pie into a large number of pieces In fact, the bonus issue does not give any extra or special benefit to a shareholder. His proportionate ownership in the company does not change. As discussed in the preceding section, the chief advantage of the bonus share issue is that it has a favorable psychological impact on shareholders. The issue of bonus shares gives an indication of the company’s growth to shareholders. Therefore, they welcome the distribution of bonus shares. The disadvantage of bonus issues from the company’s point of view is that they are more costly to administer than cash dividend? The bonus issue can be disadvantageous if the company declares periodic small bonus shares. The investment analysts do not adjust the earnings per share for small issues of bonus shares. Only the significant issues of bonus shares are adjusted by them. When the earnings per share are not adjusted, the measured growth in the ea.ri1ings per share will be less than the true growth based on the adjusted earnings per share. As a result, the price-earnings ratio would be distorted downwards.

Limitations of Bonus Shares

• To the company – as issue of this may lead to increase in capital of the company.
• Shareholder expect existing rate dividend per share to continue.
• It also prevents the new investors from becoming the shareholders of the company.
• Shareholder preferring cash to stock dividend may be disappointed.