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Bonus Shares Its Advantages and Disadvantages

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  • Category: Stock

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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).

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