What are Bonus Shares? | Meaning, Working, Advantages and Disadvantages

Also known as capitalisation issues or scrip issues, Bonus shares refer to the offering of additional shares to a company’s extant shareholders based on the stocks they already own.

It differs from Rights shares insofar as the latter is provided at a discount rate. In contrast, Bonus shares are provided for free.

They are, in actuality, the accumulated incomes of a company which the company may decide to convert into free shares instead of raising the dividend payouts.

Why would a company issue Bonus shares?

A company may issue Bonus shares for a variety of purposes. Among them, the following are some of the most significant reasons behind a company offering Bonus shares.

  1. Shortage of cash: When companies face a depletion of cash reserves despite earning massive profits and are on the verge of failing to meet shareholders’ expectation for a regular income, they choose to offer Bonus shares. 
  2. Reorganise company reserves: Companies may provide Bonus issues to restructure their retained earnings. Consequently, the company’s share capital may increase while their other reserves may face a decrease. However, the net asset of the company remains the same.
  3. Promote retail participation: Sometimes, a company’s cost per share may turn out to be too high for interested investors. Bonus shares bring down the price per share to some extent and encourage investors to own more shares in the company.
  4. To reward extant shareholders: Bonus shares serve as an alternative form of reward for the loyal shareholders of a company.

How do Bonus Shares Work?

Bonus shares are offered according to the current holdings of each shareholder. As they are issued keeping in mind a constant ratio between the total number of shares and the number of shares owned, shareholders do not encounter an equity dilution.

For example, if a company offers 4:2 Bonus shares, it implies that the investors will get four additional shares for every two shares held. Accordingly, if a shareholder owns 1,000 shares in a company, he or she will gain 2,000 bonus shares (1000*4/2).

It is important to note that Bonus shares by themselves cannot be taxed. However, if the shareholders choose to sell their Bonus shares for a profit, a capital gain tax may be charged upon them.

From the point of internal accounting, issuance of Bonus shares entails reclassifying reserves with no net impact on the total equity except for its composition.

Advantages of Bonus shares

For the company

  1. Bonus shares as an alternative for dividend payouts help in retaining the shareholders’ trust in the concerned company.
  2. As issuance of Bonus shares is indicative of a company’s commitment to using cash for business development, a positive signal is sent to the market.
  3. Bonus shares increase the number of outstanding shares. Consequently, liquidity of the stock is enhanced.
  4. Issuance of Bonus shares leads to an increase in share capital which enhances the market perception of a company’s size.
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For the Shareholders

  1. No notable tax implications: Bonus shares unless sold for profit have no tax implications for the shareholders.
  2. Beneficial for long-term investments: Increased number of bonus shares raises the number of returns if the company chooses to reward in dividends in future.

Disadvantages of Bonus shares

Despite their varied benefits, Bonus shares do have some disadvantages.

  1. Shareholders’ discomfort: Not all investors may want bonus shares in place of dividends as they may have some liquidity issues. Selling bonus shares to resolve those liquidity issues may cost them their stakes in the company and therefore, their control over the company management.
  2. Costly affair: Issuance of Bonus shares entails more expenditure than offering dividends. 
  3. Reduces cost per share: Continuous offering of Bonus shares leads to accumulation of shares which in turn leads to a decline in price per share. Some investors may not favourably receive such conditions.
  4. Lengthy process: Issuing Bonus shares entails dealing with many legal and institutional matters. Consequently, it takes a lot of time to implement a decision related to offering Bonus shares.

References

  1. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=288743
  2. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=428122
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