The function of shareholders is critical in the realm of finance and investing. They are the business’s proprietors, and their financial contributions help it develop and flourish. Companies frequently use a variety of tactics, including the issuance of bonus shares, to reward shareholders and increase their value. This article will provide a basic concept of bonus shares, their significance for shareholders, and the overall impact on a company’s share capital along with its disadvantages.
Understanding Bonus Shares:
Bonus shares, also known as scrip dividends or capitalization issues, are additional shares given to existing shareholders at no cost. Unlike regular dividends paid in cash, bonus shares are distributed by a company using its retained earnings or capital reserves. By issuing bonus shares, companies effectively convert a portion of their accumulated profits into share capital, which is then distributed among their shareholders.
Such bonus shares may be distributed to its participants from:
- Capital Redemption Reserve Account
- Free Reserves ( P/L Account, Preference Share Redemption Reserve, General Reserve, Securities Premium, and Capital Redemption Reserve)
But, revaluation of Assets-created capitalizing reserves should not be used by the Company to issue bonus shares.
Different types of Bonus Shares
There are two distinct categories of bonus shares that can be identified:
- Fully paid bonus shares
- Partly-paid up bonus shares
1. Fully Paid Bonus Shares
Fully paid bonus shares refer to shares that are distributed to investors without any additional cost, in proportion to their existing holdings within the company.
These types of bonus shares can be issued from various sources including:
- Profit and loss account
- Capital reserves
- Capital redemption reserves
- Security premium account
2. Partly-Paid Up Bonus Shares
To comprehend partly-paid up bonus shares, it is imperative to understand the concept of partly paid shares first.
Partly paid shares in a company are shares that have only been partially paid in comparison to their full issue price. This implies that investors can purchase partly paid shares without having to pay the entire issue price upfront.
The remaining amount for these partly paid shares can be paid in instalments as and when the company makes calls for payment. Partly-paid up bonus shares are obtained by applying the bonus to shares that have already been partially paid for, resulting in their conversion into fully paid shares without the need to utilize profit capitalization to cover the remaining uncalled amount.
However, it should be noted that unlike fully-paid up bonus shares, the issuance of partly paid-up bonus shares is not permitted through the utilization of a capital redemption reserve account or security account.
Why does a Company issue Bonus Shares?
Companies frequently offer bonus shares for a number of important factors.
- By decreasing the price per share and increasing liquidity, they promote greater involvement in their stock by regular investors.
- The company gives investors an alternative to receiving dividend payments as a kind of compensation.
- The company shows that the business is in a strong financial position to continue expanding and creating value for shareholders. When looking at the benefits of bonus issue, we will go into more detail about these causes.
Benefits for Shareholders:
- Increased Ownership: When a company issues bonus shares, existing shareholders receive additional shares without any direct cost. This boosts their overall ownership in the company and provides an opportunity to accumulate more wealth over time.
- Enhanced Liquidity: Bonus shares improve the liquidity of a company’s stock. With more shares in circulation, trading volume typically increases, creating a more active market for investors. This increased liquidity gives shareholders greater flexibility and enhances their capacity to react to market situations by making it easier for them to acquire or sell their shares.
- Greater Market Value: The issuance of bonus shares may result in a greater market value for a corporation. The total market value of the company rises as additional shares are allocated to owners. The higher stock prices that frequently follow this rise in market value might translate into large returns for current shareholders.
- Tax Benefits: In certain jurisdictions, bonus issue may offer tax advantages. Since they are not distributed as cash dividends, shareholders may be exempt from immediate taxation. However, it is essential to consult with a tax advisor or expert to understand the specific tax implications based on your jurisdiction.
Impact on Share Capital:
- Capitalization of Profits: By issuing bonus shares, a company converts its accumulated profits or capital reserves into additional share capital. This helps in maintaining an optimal capital structure and utilizing surplus funds effectively. The increase in share capital can enhance the financial strength and stability of the company, positioning it for future growth and expansion.
- Dilution of Ownership: While bonus shares increase the number of outstanding shares, they do not affect the proportional ownership of existing shareholders. However, if new investors enter the market and purchase shares, the existing shareholders’ ownership percentage may dilute over time. This dilution is a natural consequence of expanding the share base to accommodate new investors and potential capital inflows.
- Impact on Earnings per Share (EPS): Bonus shares do not impact the overall financial position of a company since they do not involve any cash outflow. However, the number of outstanding shares increases, leading to a higher denominator in the EPS calculation. Consequently, the EPS may decrease, but the intrinsic value of each share remains the same.
What are the disadvantages of issuing bonus shares?
- Opportunities cost: The earnings set aside for incentive issue may be used by a firm for other goals that could boost shareholder value. For example, retained earnings could be used to finance new machinery and equipment purchases or a smart entry into a new market with high growth potential. Additionally, lost opportunities could lead to negative press for a company, which might be bad for investor sentiment.
- Impact on dividends: Since bonus share issuance does not increase the company’s cash flow, it may cause dividend payments to decline in the future, upsetting shareholders. Additionally, some shareholders who get bonus shares might believe that the business will eventually favour bonus shares over cash dividends.
- No monetary measurement: The company’s stock price decreases proportionately to the additional bonus shares distributed, thus stockholders do not instantly profit financially, unlike with a cash dividend payout.
Bonus shares vs stock splits
There are many similarities and distinctions between stock splits and bonus shares. The number of shares grows but the investment value stays the same when a corporation announces a stock split.
A stock split is typically announced by companies to increase share liquidity, increase trading volume, and cut the price of shares for individual investors.
The impact of a stock split on the company’s cash reserves is unaffected. The reserves, however, are reduced when a corporation grants bonus shares because the cost of the shares are offset by the cash reserves.
In summary, bonus shares offer a range of advantages for shareholders and companies alike. Shareholders benefit from increased ownership, enhanced liquidity, potentially higher market value, and certain tax advantages. Meanwhile, companies can utilize bonus shares to strengthen their share capital, optimize their capital structure, and foster long-term growth.
While bonus shares can dilute ownership and impact EPS, their overall positive impact on shareholder value cannot be ignored. Companies that carefully consider and strategically implement bonus share issues can effectively reward their shareholders while positioning themselves for future success.