Why Do Companies Announce Bonus Issues?
Corporate actions like dividend payments, stock splits, and bonus issues play a pivotal role in a company’s life cycle and significantly impact shareholders. Among these, the bonus issue is a noteworthy event, often viewed as a reward for shareholders and a signal of the company’s confidence in its financial health.
In this post, we will delve into the concept of bonus issues, why companies offer them, how they work, and their impact on investors and the market.
What Is a Bonus Issue?
A bonus issue, also known as a scrip issue or capitalization of reserves, occurs when a company issues additional shares to its existing shareholders free of charge. This corporate action increases the company’s outstanding share count while reducing the proportionate share price, keeping the overall market capitalization constant.
Bonus issues are often distributed in a specific ratio—for example, a 1:2 bonus issue means shareholders receive one additional share for every two shares they already own.
Why Do Companies Announce Bonus Issues?
Companies may initiate a bonus issue for several strategic reasons:
- Reward Existing Shareholders: Companies use bonus shares to reward their loyal shareholders without impacting cash reserves, unlike cash dividends.
- Increase Liquidity: By increasing the number of shares outstanding, bonus issues enhance the stock’s liquidity, making it easier to buy and sell shares in the market.
- Sign of Confidence: A bonus issue signals the company’s optimism about future growth, as it suggests the business has healthy reserves and strong earnings potential.
- Lower Share Price: The share price decreases proportionally after a bonus issue, making the stock more affordable for smaller investors without altering the company’s valuation.
How Does a Bonus Issue Work?
Here is a step-by-step explanation of how a bonus issue is typically executed:
- Board Approval: The company’s board of directors proposes the bonus issue, including the ratio of shares to be issued.
- Shareholder Approval: The proposal is put to a vote at a general meeting, where shareholders must approve the bonus issue.
- Record Date: A record date is set to determine which shareholders are eligible to receive the bonus shares. Only those holding shares as of this date qualify.
- Distribution: The new shares are credited to eligible shareholders’ accounts, and trading begins with the revised number of shares.
- Adjustment in Share Price: Post-issue, the share price adjusts in proportion to the bonus ratio, ensuring the market capitalization remains unchanged.
Example: Suppose a company announces a 1:1 bonus issue. If a shareholder owns 100 shares priced at $20 each, they will now own 200 shares priced at $10 each, maintaining their total holding value at $2,000.
Advantages of Bonus Issues
- Encourages Retail Participation: By lowering the stock’s trading price, bonus issues make the stock more accessible to retail investors.
- Improves Liquidity: With more shares in circulation, trading volume often increases, which can reduce price volatility.
- Tax Efficiency: In some jurisdictions, bonus shares are more tax-efficient than cash dividends because shareholders don’t pay taxes until they sell the shares.
- Positive Market Sentiment: Announcing a bonus issue can enhance investor confidence and boost the company’s reputation in the market.
Disadvantages of Bonus Issues
- No Immediate Monetary Benefit: Unlike dividends, bonus issues do not provide direct cash rewards to shareholders.
- Dilution of Earnings Per Share (EPS): As the number of shares increases, the EPS—a key profitability metric—declines unless the company achieves proportional earnings growth.
- Perceived as a Cosmetic Change: Critics argue that bonus issues merely repackage equity without adding tangible value.
Impact on Investors and the Market
- Existing Shareholders: They benefit from an increased shareholding while retaining their proportionate ownership in the company. However, the adjustment in the share price ensures no immediate monetary gain.
- New Investors: The reduced share price can make the stock more attractive, potentially broadening the investor base and increasing demand.
- Market Perception: Bonus issues are often viewed as a positive signal, reflecting the company’s growth potential and strong reserves. However, excessive reliance on bonus issues without meaningful earnings growth can erode market confidence over time.
Key Considerations for Investors
- Assess Company Fundamentals: Before reacting to a bonus issue announcement, evaluate the company’s financial health, earnings growth, and long-term prospects.
- Review Historical Performance: Check whether the company has a history of regular bonus issues and how its stock has performed post-issue.
- Understand Tax Implications: In some cases, bonus shares may have tax consequences upon sale. It’s wise to consult a tax advisor.
- Avoid Over-Optimism: Remember that while bonus issues increase shareholding, they do not directly impact the company’s intrinsic value or dividend payouts.
Conclusion
A bonus issue is a valuable corporate action that benefits shareholders in various ways, from rewarding loyalty to boosting stock liquidity. While it often signals a company’s strength and future potential, investors should analyse the company’s fundamentals to ensure the move aligns with long-term value creation.
Understanding the nuances of a bonus issue can help investors make informed decisions and optimize their portfolio strategies.
Note:- The information provided on this blog is for educational and informational purposes only, does not constitute a suggestion to invest, ask your financial advisor or do your own research before investing in any instrument. Because there is risk involved in the market.