Bonus Issue of Shares Explained: How They Work

A bonus issue involves the issuance of additional shares to existing shareholders in proportion to their current holdings, free of charge. Unlike a cash dividend, which pays shareholders in money, a bonus issue rewards them with more equity in the company. For example, if a company declares a 1:1 bonus issue, shareholders receive one additional share for every share they already own. The total value of their investment remains unchanged immediately after the issue, as the share price adjusts to reflect the increased number of shares.

The primary source of funds for a bonus issue is the company’s accumulated profits or reserves, such as the retained earnings or general reserve. Instead of distributing these reserves as cash, the company capitalizes them by converting them into share capital. This distinguishes a bonus issue from a rights issue, where shareholders must pay to acquire additional shares, or a stock split, which increases the number of shares without altering the company’s reserves.

Why Do Companies Issue Bonus Shares?

Companies opt for bonus issues for a variety of strategic and financial reasons. Understanding these motivations provides insight into the broader implications of such corporate actions. Below are the primary reasons:

Rewarding Shareholders Without Cash Outflow
A bonus issue is a way to reward shareholders without depleting the company’s cash reserves. By issuing bonus shares, the company signals confidence in its future profitability while preserving liquidity for operational or investment purposes.
Enhancing Market Liquidity
By increasing the number of shares outstanding, a bonus issue can improve the stock’s liquidity in the market. More shares available for trading often attract a broader investor base, including retail investors who may find the stock more affordable after the price adjustment.
Adjusting Share Price to Attract Investors
High-priced stocks can deter small investors. A bonus issue reduces the per-share price by increasing the number of shares, making the stock appear more accessible, even though the overall value of the company remains unchanged.
Capitalizing Reserves
Companies with substantial accumulated reserves may choose to capitalize a portion of these funds by converting them into share capital. This strengthens the company’s equity base and aligns the capital structure with its growth trajectory.
Signaling Financial Strength
A bonus issue often signals that the company is financially robust and expects sustained earnings growth. It demonstrates that the company can afford to lock in reserves as permanent capital without needing them for immediate cash requirements.
Tax Advantages (in Some Jurisdictions)
In certain countries, bonus shares may be taxed more favorably than cash dividends, benefiting shareholders. However, tax implications vary widely, and shareholders should consult local regulations.

How Does a Bonus Issue Work?

The process of a bonus issue involves several steps, from the company’s decision-making to the distribution of shares to shareholders. Here’s a detailed breakdown:

Board Approval
The company’s board of directors proposes the bonus issue, determining the ratio (e.g., 2:1, meaning two bonus shares for every one share held) and the source of funds (typically reserves). The proposal is based on an assessment of the company’s financial health and strategic goals.
Shareholder Approval
In many jurisdictions, a bonus issue requires approval from shareholders at a general meeting. The company communicates the details, including the ratio, timeline, and impact on share capital, to ensure transparency.
Regulatory Compliance
The company must comply with regulations set by the stock exchange and securities authorities. This includes filing necessary documents and ensuring that the bonus issue adheres to corporate governance standards.
Record Date Announcement
The company announces a “record date” to determine which shareholders are eligible for the bonus shares. Only those holding shares on or before this date receive the additional shares.
Capitalization of Reserves
On the record date, the company transfers the required amount from its reserves to the share capital account. For example, if a company issues 1 million bonus shares with a nominal value of $10 each, it debits $10 million from reserves and credits the same to share capital.
Distribution of Shares
The bonus shares are credited to shareholders’ demat accounts (in electronic form) or issued as physical certificates (less common today). The distribution is proportional to the shareholders’ existing holdings.
Stock Price Adjustment
After the bonus issue, the stock price adjusts to reflect the increased number of shares. For instance, if a company’s share price is $100 and it issues a 1:1 bonus, the theoretical post-bonus price would be $50, as the total market capitalization remains unchanged.
Market Trading
Once the bonus shares are credited, they are fully tradable in the market, just like the original shares. The company’s market capitalization should theoretically remain the same, assuming no other market factors influence the stock price.

Impact on Shareholders

While a bonus issue is often perceived as a positive event, its impact on shareholders is more complex than it appears. Here’s how it affects them:

No Immediate Increase in Wealth
A bonus issue does not increase the shareholder’s wealth immediately. Although they own more shares, the per-share price decreases proportionally, leaving the total value of their investment unchanged. For example, if a shareholder owns 100 shares at $50 each (total value $5,000) and receives a 1:1 bonus, they now own 200 shares at $25 each (still $5,000).
Potential for Future Gains
Over time, bonus shares can enhance returns if the company performs well. More shares mean a larger claim on future profits and dividends, assuming the company’s earnings grow.
Improved Liquidity
The lower share price post-bonus can make the stock more attractive to new investors, potentially increasing trading volume and price stability.
Tax Implications
In many jurisdictions, bonus shares are not taxed when issued, as they are considered a capitalization of reserves rather than income. However, capital gains tax may apply when the shares are sold, based on the adjusted cost basis.
Psychological Appeal
Receiving “free” shares can boost investor confidence and create a positive perception of the company, even if the economic impact is neutral in the short term.

Impact on the Company

A bonus issue also has significant implications for the company’s financial structure and market perception:

Strengthened Equity Base
By converting reserves into share capital, the company increases its permanent capital, which can support long-term growth initiatives.
Reduced Cash Outflow
Unlike cash dividends, a bonus issue preserves liquidity, allowing the company to retain funds for reinvestment, debt repayment, or other priorities.
Lower Dividend Per Share
With more shares outstanding, the company’s future dividends per share may decrease unless earnings grow significantly. For example, a $1 dividend on 1 million shares costs $1 million; the same dividend on 2 million shares (post-bonus) costs $2 million.
Market Perception
A bonus issue can enhance the company’s reputation as a shareholder-friendly entity, potentially attracting more investors and boosting stock demand.
Administrative Costs
Issuing bonus shares involves regulatory filings, communication with shareholders, and updates to share registries, which incur administrative expenses.

Advantages of a Bonus Issue

Shareholder Benefit: Rewards investors without requiring them to invest additional capital.
Liquidity Boost: Increases the number of shares in circulation, improving marketability.
Preserves Cash: Allows the company to retain cash for growth or operational needs.
Positive Signal: Demonstrates confidence in future profitability.
Affordable Stock Price: Makes shares more accessible to retail investors.

Disadvantages of a Bonus Issue

No Immediate Value Creation: Does not increase shareholders’ wealth in the short term.
Dilution of Metrics: Reduces per-share metrics like earnings per share (EPS) and dividends per share unless earnings grow.
Administrative Burden: Involves costs and regulatory compliance.
Market Misinterpretation: Some investors may misjudge the bonus issue as a sign of limited cash flow.
Tax Complexity: Adjusting the cost basis for tax purposes can be cumbersome in some jurisdictions.

Bonus Issue vs. Stock Split

A bonus issue is often confused with a stock split, but they differ in key ways:

Source of Shares: A bonus issue uses reserves to create new shares, increasing share capital. A stock split simply divides existing shares without altering reserves or capital.
Accounting Impact: A bonus issue reduces reserves and increases share capital. A stock split has no impact on the balance sheet.
Shareholder Perception: A bonus issue is seen as a reward, while a stock split is primarily a price adjustment.

For example, in a 2:1 bonus issue, a shareholder with 100 shares gets 200 additional shares, funded by reserves. In a 2:1 stock split, the same shareholder’s 100 shares become 200 shares, with no change to reserves.

Real-World Examples

Reliance Industries (India, 2017)
Reliance Industries, a conglomerate, announced a 1:1 bonus issue in 2017, doubling its outstanding shares. The move was aimed at rewarding shareholders and enhancing liquidity for its high-priced stock.
Apple Inc. (USA, 2014)
While technically a 7:1 stock split, Apple’s action had similar effects to a bonus issue, reducing the share price to make it more accessible to investors, boosting trading volumes.

These cases illustrate how companies use bonus issues or similar actions to align their capital structure with market expectations and investor needs.

Key Considerations for Investors

Investors should evaluate a bonus issue in the context of the company’s overall performance and strategy:

Financial Health: A bonus issue from a company with strong fundamentals is more likely to create long-term value.
Dividend Policy: Consider whether the company can sustain dividends per share post-bonus.
Market Conditions: A bonus issue may not yield benefits in a bearish market or if the stock is overvalued.
Tax Implications: Understand the tax treatment of bonus shares in your jurisdiction.
Long-Term Perspective: Focus on the company’s growth potential rather than the immediate impact of the bonus.

Conclusion

A bonus issue of shares is a strategic tool that benefits both companies and shareholders when executed thoughtfully. For companies, it offers a way to reward investors, enhance liquidity, and strengthen the capital base without sacrificing cash. For shareholders, it increases their stake in the company and holds the potential for future gains, even if it doesn’t boost wealth immediately. However, investors must look beyond the allure of “free shares” and assess the company’s fundamentals, market conditions, and long-term prospects.