A bonus issue, also known as a scrip issue or a capitalization issue, is an offer of free additional shares to existing shareholders. For example, a company may offer one bonus share for every five shares held. Companies issue bonus shares to attract further investment and reward shareholders.
Key Takeaways
- A bonus issue of shares is the allocation of additional shares to stockholders.
- Bonus shares increase a company’s share capital but not its market capitalization.
- A bonus issue of shares is funded by a company’s earnings or share reserves.
- Bonus issues don’t dilute shareholders’ equity because they are issued in a constant ratio that keeps the relative equity of each shareholder the same as before the issue.
- Companies issue bonus shares to make their stock more attractive for retail investors, provide an alternative to a cash dividend, and reflect a position of financial health.
- The downside includes opportunity costs and potential negative impacts on future dividend payments.
Understanding Bonus Issues
Bonus issues increase a company’s outstanding shares but not its market capitalization. Companies typically fund a bonus issue through profits or existing share reserves. The issuance of bonus shares is not taxable at the time of issue; however, shareholders must still pay capital gains tax if they sell them for a net gain.
A company allocates bonus issues according to each shareholder’s stake. These shares do not dilute shareholders’ equity because they are issued in a constant ratio that keeps the relative equity of each shareholder the same as before the issue. For instance, a three-for-one bonus issue entitles each shareholder to three shares for every one that they hold before the issue. A shareholder with 1,000 shares receives 3,000 bonus shares (1,000 × 3 ÷ 1 = 3,000). The share price adjusts proportionally to the number of bonus shares issued.
Why Do Companies Issue Bonus Shares?
Companies typically issue bonus shares for several key reasons.
Encouraging retail participation: Increasing the number of outstanding shares adds liquidity and decreases the stock price, making shares more affordable and easier to trade for retail investors. Lower-priced shares allow investors to acquire more units and increased liquidity reduces slippage costs.
Alternative to paying dividends: Companies generating irregular profits may issue bonus shares rather than cash dividends to build shareholder confidence. Bonus issues may be particularly appealing to smaller companies wanting to attract more investors but lacking consistent earnings to pay regular dividends.
Displaying financial health: A company issuing bonus shares demonstrates sufficient share reserves and/or profits to reward prospective investors and current shareholders. This issuance also signals that a company is in a financially sound position to keep growing and adding shareholder value.
Favorable tax treatment: Bonus shares aren’t taxed when issued, making them more favorable than a cash dividend. However, investors are required to pay capital gains tax on bonus shares if sold for a net gain.
Disadvantages of Issuing Bonus Shares
Opportunity cost: The earnings set aside for a bonus issue could be used for other purposes yielding more shareholder value, such as funding a strategic acquisition or upgrading equipment and technology.
Negative impact on dividends: Issuing bonus shares does not generate cash for the company, which might decrease future dividend payments, potentially upsetting shareholders. Some investors may perceive that the company may prioritize bonus shares over cash dividends in the future.
No immediate financial benefit: Unlike cash dividends, shareholders don’t immediately benefit financially from bonus shares because the stock price drops proportionally to the additional shares issued.
Stock Splits vs. Bonus Shares
Stock splits and bonus shares share similarities but also have key differences. In a stock split, the number of shares increases without changing investment value. Companies typically use stock splits to infuse additional liquidity and make shares more affordable to retail investors. Unlike stock splits, bonus shares are funded from a company’s reserves, causing a depletion in those reserves.
The Bottom Line
Bonus issues refer to a company allocating additional shares from earnings or reserves to stockholders, increasing outstanding shares but not market capitalization, as the stock price adjusts proportionally. Companies primarily issue bonus shares to attract retail investors, provide an alternative to cash dividends, or project a sound financial position. However, this could lead to lost opportunities for more effective earnings utilization and may reduce future dividend payments. Although bonus shares are not taxed immediately, capital gains tax applies if they are sold for a profit.
Related Terms: stock split, dividends, shareholder equity, capitalization.
References
- RuleZero. “Bonus Shares Issue—Exploring Concept, Purpose, and Implications”.
- eFinanceManagement. “Advantages and Disadvantages of Bonus Shares”.
