Bonus shares are additional shares issued by a company to its existing shareholders for free, based on a ratio of the shares already owned by them. By issuing bonus shares, the number of shares outstanding increases; but while the distribution is made according to the ratio decided by the company, the individual shareholding stake does not change. Let’s suppose, company X issue bonus shares in the ratio of 2:1. This means that for each share that you own, the company gives you two for free.
Assuming you have 100 shares on the date of record, you will get 200 shares for free; so, your total holding will now be 300. Bonus shares are not really bonuses; they are a conversion of the company’s undistributed profits into capital through issue of additional shares. Note that the undistributed profit belongs to the existing shareholders.
Does the market price reduce after bonus issue?
After a bonus issue, the number of shares available in the market goes up. If company X had 10 million shares, with a bonus issue of 2:1, the total number of shares becomes 30 million. Owing to the increased number of shares, the earnings per share (EPS) of the company comes down. While the profit remains the same, the number of shares goes up.
Theoretically, when the EPS reduces, the price of the share also decreases proportionately. But practically, it may not be so for the following reasons: (a)As there are more number of shares in the market, the share is more liquid, making it easier to buy and sell; (b) liquidity will lead to price discovery, meaning which the true and fair value of the share can be identified when more number of people buy and sell the shares; (c) bonus issue is perceived as a good signal because the company is capable of serving a larger equity base; (d) as the net worth of the company remains intact, the price will not decline.
Bonus shares and Companies Act
Under the Companies Act, 1956, there was no specific Section dealing with bonus shares and, therefore, companies followed norms laid down by Sebi. But the Companies Act, 2013, introduced Section 63 to exclusively deal with bonus shares. This Section mentions the sources that can be utilised for issuance of bonus shares. Accordingly, a company can use only any one or all of the following reserves — free reserves, securities premium account and capital redemption reserve — for issue of bonus shares.
The Act also categorically states that the company cannot issues bonus shares in lieu of dividends. It documents a set of secretarial and legal procedure to be followed while issuing bonus shares.
Impact on company’s balance sheet
Once bonus shares are issued, the amount available to the company under reserves/surplus comes down to the extent of the bonus. At the same time, the share capital of the company goes up by the same amount. This is generally known as capitalisation of reserves. In short, the number of shares issued by the company goes up but its net worth remains the same. Further, by the issue of bonus shares, there will be no cash outflow for the company.
Home-made dividend through bonus shares
Shareholders who prefer dividend rather than capital appreciation also benefit from bonus shares via home-made dividend. Let’s recall the example cited earlier — where a shareholder who own 100 shares in company X gets a bonus shares of 200. If a shareholder prefers dividend to bonus shares, he could convert the bonus shares into home-made dividend. In this case, he sells some of his holdings, say 50 shares, after the bonus issue and treats the sales proceeds as dividend. But the brokerage and taxation aspects should be considered while going in for a home-made dividend.
who gets what?
After a bonus issue, the number of shares available in the market goes up
Assuming you have 100 shares on the date of record, you will get 200 shares for free if the bonus issue is in the ratio of 2:1; so, your total holding will be 300
Due to the increased number of shares, the earnings per share of the company comes down. While the profit remains the same, the number of shares goes up
Theoretically, when the EPS reduces, the price of the share also decreases proportionately
But practically, it may not be so for the following reasons: (a)As there are more number of shares in the market, the share is more liquid, making it easier to buy and sell; (b) liquidity will lead to price discovery, meaning which the true and fair value of the share can be identified when more number of people buy and sell the shares; (c) bonus issue is perceived as a good signal because the company is capable of serving a larger equity base; (d) as the net worth of the company remains intact, the price will not decline
Once bonus shares are issued, the amount available to the company under reserves/surplus comes down to the extent of the bonus. At the same time, the share capital of the company goes up by the same amount. This is generally known as capitalisation of reserve. In short, the number of shares issued by the company goes up but its net worth remains the same.
Further, by the issue of bonus shares, there will be no cash outflow for the company
The writer is an associate professor of finance and accounting
at IIM, Shillong
