In corporate finance, one significant concept is the issuance of bonus shares. A bonus share issue, or a stock dividend, is a strategy companies employ to distribute additional shares to their existing shareholders without any monetary cost. This practice underscores a company's financial health and brings many benefits that contribute to its growth and success.
In times of economic decline or when a company encounters challenges such as insufficient cash flow that result in its downturn, companies employ diverse strategies to maintain shareholder engagement and discourage their departure from the organization. The stock market's dynamics are significantly influenced by emotions. When unfavorable economic conditions or company-specific issues arise, there is an increased likelihood of market or company exits due to heightened apprehension.
When investor and trader sentiment is less favorable, companies may employ strategies such as issuing bonuses and repurchasing shares. Let's delve into the intricacies of bonus issues and grasp how they can benefit you as an investor.
The Understanding Bonus share offering
Bonus issues increase an organization's outstanding shares but not it's market capitalization. Organizations typically fund a bonus issue via existing or profits share reserves. The issuance of bonus shares isn't taxable; but, stakeholders must still pay cap gains tax if they sell them for a net profit.
An organization allocates bonus issues as per the shareholder's stake. Bonus shares do not dilute the equity of shareholders since they are issued in a consistent ratio that maintains the proportional equity of each shareholder at the same level as prior to the issuance. For instance, a three-for-one bonus issue entitles each shareholder to three shares for everyone that they hold before the problem.
Why Do Companies Issue Bonus Shares?
Organizations generally issue bonus shares for numerous key reasons:
To Encourage Retail Participation:
If a company's share price is high, fewer investors can afford to buy it. New investors often hesitate to enter the stock market when faced with higher per-unit costs. However, by issuing bonus shares, companies can augment the total number of shares available, leading to a decrease in the price per share. This, in turn, enhances affordability for retail investors. In addition, more stocks in the market enable liquidity, i.e., stock can be bought and sold more easily or quickly. Let us understand the same with an instance:
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Recently Nykaa announced a bonus issue of 5:1. Once the bonus was issued, you got five additional shares for every share you owned. Let's see how the price changed after the reward was given. On November 92022, the stock's closing price was INR 1,060. On the ex-bonus date (explained later in this article) of November 102022, the price of 1 stock of Nykaa decreased to INR 167 to match the original price, making it more affordable for retail investors. Thus, if you held ten shares worth INR 10,600 before the bonus issue, post bonus, you would have 50 shares at INR 167 per share, worth INR 8,350.
To reflects sound financial health:
The company issues bonus shares out of profits or where it has accumulated significant cash reserves that cannot be immediately utilized. When a company distributes bonus shares from its profits or reserves, it indicates its robust financial position to issue additional equity shares while also having generated profits.
Also, bonus shares are a great way to reward shareholders, especially when companies are short of cash and cannot pay cash dividends. Moreover, when a company issues bonus shares, it can quickly service the expanded capital in the future, thus indirectly indicating to investors that the future outlook is also good for the company.
Let's Walk Through Some of the Significant Benefits of Bonus Shares
Here are some key advantages that shareholders can employ:
Tax Efficiency: Shareholders are not subject to taxation when they receive bonus shares from a company. Moreover, bonus shares offer greater advantages compared to receiving dividends, as dividends could potentially incur a tax rate of up to 30%. Conversely, when bonus shares are issued, shareholders are liable for capital gains tax at rates of 15% for short-term sales or 10% for long-term sales (provided long-term capital gains surpass Rs. 1 lakh).
Additional advantage: Shareholders who wish to hold stocks for the long term can earn other benefits, like dividends on these shares, as and when the company declares. The income generated through dividends has the potential to significantly improve the overall performance of the stock.
Accessibility and Affordability: As mentioned before, this is a win-win for investors and companies. It is one of the primary reasons why companies issue bonus shares. Issuing bonus shares escalates the total number of outstanding shares in the company, thereby enhancing liquidity in the market. Moreover, a reduction in the share price after the bonus issue will make the share affordable and attractive, especially for new investors.
Note: Although bonus shares offer advantages, it's important to avoid assuming that companies not issuing them are unprofitable or financially weak.
Final Thoughts
In conclusion, bonus share issues are a strategic tool companies can use to reinforce their financial stability, enhance shareholder value, and attract new investors. The benefits of bonus shares span from conserving cash and rewarding loyal shareholders to signaling robust financial health to the market. Companies can strike a harmonious balance between satisfying their investors and pursuing growth initiatives by opting for bonus share issues.
As an integral part of corporate finance, bonus share issues showcase the dynamic nature of companies adapting to changing market conditions while prioritizing the interests of their stakeholders. If you want to know more about this, please book a demo with us at Vega Equity!