Bonus Shares

Bonus Share
When the additional shares are allotted to the existing shareholders without
receiving any additional payment from them, it is known as issue of bonus
shares.

Bonus shares are allotted by capitalizing the reserves and surplus.

Issue of bonus shares results in the conversion of the company's profits into
share capital. Therefore it is termed as capitalization of company's profits.

Since such shares are issued to the equity shareholders in proportion to their
holdings of equity share capital of the company, a shareholder continues to retain
his / her proportionate ownership of the company.

Issue of bonus shares does not affect the total capital structure of the company. It
is simply a capitalization of that portion of shareholders' equity which is
represented by reserves and surpluses.

It also does not affect the total earnings of the shareholders.

Issue of Bonus Shares is more or less a financial gimmick without any real
impact on the wealth of the shareholders. Still firms issue bonus shares and
shareholders look forward to issue of bonus shares.

Reasons for issuing Bonus Shares

1. The bonus issue tends to bring the market price per share within a more
reasonable range.
2. It increases the number of outstanding shares. This promotes more active
trading.
3. The nominal rate of dividend tends to decline. This may dispel the impression
of profiteering.
4. Share capital base increases and the company may achieve a more
spectacular size in the eyes of the investing company.
5. Shareholders regard a bonus issue as a strong indication that the prospects of
the company have brightened and they can reasonably look for an increase in
total dividend.
6. It improves the prospects of raising additional funds.

Regulation of Bonus Issues

Important regulatory provisions governing issue of bonus shares are:
1. The bonus issue is made out of free reserves built out of the profits or share
premium collected in cash only.
2. The residual reserves after the proposed capitalization shall be at least 40% of
the increased paid up capital.

Stock Splits
In a stock split the face value per share is reduced and the number of shares is
increased proportionately.
A stock split is similar to a bonus issue from economic point of view. But there are
some differences from the accounting point of view.

Difference between Bonus Issue and Stock Split

Bonus Issue Stock Split

1. The par value of share is unchanged. 1. The par value of share is reduced.
2. A part of the reserves is capitalized. 2. There is no capitalization of reserves.

Advantages of issue of bonus shares to the company

1. Conservation of Cash:
Issue of bonus shares does not involve cash outflow. The company can retain
earnings as well as satisfy the desire of the shareholders to receive dividend.

2. Keeps the EPS at a reasonable level:

A company having high EPS may face problems both from employees and
consumers.
Employees may feel that they are underpaid.
Consumers may feel that they are being charged too high for the company's
products.
Issue of bonus shares increases the number of shares and reduces the earning
per share.

3. Increases the marketability of company's shares:

Issue of bonus shares reduces the market price per share. The price of the share
may come within the reach of ordinary investors. This increases the marketability
of shares.

4. Enhances prestige of the company:

By issuing bonus shares, the company increases its credit standing and its
borrowing capacity. It reflects financial strength of the company.

5. It helps in financing its projects:

By issuing bonus shares, the expansion and modernization programmes of a
company can be easily financed. The company need not depend on outside
agencies for finances.
6. Retention of managerial control:
Any new issue of shares has a danger of dilution of managerial control over the
company.
Since bonus shares are issued to the existing shareholders in proportion to their
current holdings, there is no threat of dilution of managerial control over the
company.

Advantages to the shareholders

1. Tax benefits:
When a shareholder receives dividend in cash, it adds to his total income and is
taxed at usual income tax rates.
From this point of view the bonus shares increase the wealth of shareholders. In
case the shareholder requires cash he can sell his additional shares.

2. Indication of higher future profits:

Issue of bonus shares is generally an indication of higher future profits.
This is because a company declares a bonus issue only when its earnings are
expected to increase.

3. Increase in future dividend:

The shareholder will get more dividends in the future even it the company
continues to offer existing cash dividend per share.

4. High psychological value:

Issue of bonus shares is usually perceived positively by the market. This tends to
create greater demand for the company's shares. In fact, always the share prices
rise at the declaration of bonus shares.

Limitations of Bonus Issues

Disadvantages for the company:
1. Issue of bonus shares leads to an increase in the capitalization of the
company. The increased capitalization can be justified only if there is increase in
the earning capacity of the company.
2. After the issue of the bonus shares the shareholders expect the existing rate of
dividend per share to continue. It is really a challenging task for the company to
retain the existing rate of dividend per share.
3. Issue of bonus shares prevents new investors from becoming the
shareholders of the company (no doubt they can buy the shares in the secondary
market).

Disadvantages to the shareholders:

1. Some shareholders may prefer cash dividend to stock dividend, such
shareholders may feel disappointed (no doubt they can very well sell their bonus
shares and get their money).