Understanding what are bonus shares

What are Bonus Shares? And How They Help Investors?

Understanding what are bonus shares: Everyone loves a bonus. This may be at work or also on simple shopping purchases. These bonuses also exist in the stock market under Bonus Shares. But does a bonus share issue in the stock resembles the same ones we experience in our day do day lives?

Today we take a closer look at understanding a Bonus Shares issue. Here, we’ll look into what are bonus shares, why are they issued, their pros, cons, and more. Let’s get started.

What are Bonus Shares?

bonus shares

Bonus shares, also known as scrip dividends are additional shares given to shareholders without any extra cost. These shares are issued to the shareholders based on a constant ratio that decides how many shares a shareholder is to receive based on the number of shares already held by him.

These shares, however, are issued from the company’s accumulated earnings. Hence these bonus shares are issued only by companies that have accumulated retained earnings or large free reserves. As bonus shares are issued from the profits (retained earnings or reserves) it is also called capitalization of profits.

Here are a few of the recent bonus shares offered by different public companies in India:

Recent bonus shares in India

(Source: Moneycontrol)

Why are bonus shares issued?

Here are some of the reasons why a company may opt to issue shares.

  • Bonus shares are issued by the company when the company has performed well but has not generated enough cash that they pay out dividends. This ensures that investors who depend on dividends for income will still be able to earn from the sale of the bonus shares in the market. On the other hand, it also pleases investors who are not looking for dividend payouts.
  • Bonus shares also issued to encourage retail participation. At times the price per share of the company becomes so high that it becomes difficult for investors to easily sell them or to buy them in the market. By issuing bonus shares take care of this as the total worth of the shares remains the same but the price per share reduces allowing them to be easily traded on an exchange. 
  • Another reason why a bonus share may be issued is when a company is looking to restructure its reserves.

How are bonus shares calculated?

Let us take the example of company ‘A’. Say the company announces a bonus in the ratio of 2:3. Here for every three shares held by the shareholder he receives two additional shares. 

The price in the above case also gets adjusted. If the shares are at a book value of Rs. 50 per share. Post the bonus issue the value would drop to Rs. 30. This would not change the total book value of the shares held by the shareholder if he held 3 shares valued at Rs. 150 prior to the issue he would be left with 5 shares post the bonus with a book value of Rs.150.

Similarly, the stock price too is adjusted on a proportionate basis. This also answers the question that “Does a Bonus share issue increase the net worth of your holdings?”. The answer is “No”.

What is the record and Ex-date in a bonus issue?

Shares are traded on a regular basis, this would make it hard for the company to decide which investor is eligible to receive the shares.

This is also because the delivery after the purchase of the shares into the Demat account happens on a T+2 days basis( 2 days after the shares are purchased). In order to avoid confusion, an Exdate and record date is used. An Ex-date is used to decide who receives the shares.

The record date is the cut-off date set by the company. The Ex-date is always one day before the record date. You are eligible for the bonus shares if you purchase the shares one day prior to the Ex-date. If you want to sell the shares but are holding onto them you need to hang onto the shares until the ex-date.

What are the advantages and disadvantages of a Bonus Issue?

Advantages of Bonus Shares

– Bonus shares increase the liquidity of the shares which makes it easier for the shareholders to sell and buy.

– The issue of Bonus shares creates the perception that its size has increased. This due to the increase in share capital due to the transfer from reserves and due to increase in shares outstanding after the bonus issue in accordance with the ratio set.

Disadvantages of Bonus Shares

– Investors who depend on dividends from the company may have to sell their shares to ensure liquidity. This, in turn, may reduce their stake in the company in comparison to those who hold onto their shares. This reduction in stake may be viewed unfavorably. 

– Bonus shares require the transfer of reserves to share capital. This may upset some shareholders as these reserves could have been paid as a dividend in later years resulting in increased dividends.

Are there any tax implications for the bonus issue?

One may be under the impression that as the bonus shares are issued out of reserves that are used to pay dividends they too may be subject to taxes. This is not the case on receipt of bonus shares.

The shareholder is not required to pay any dividend if he receives bonus shares. However, he is subject to capital gain tax if and when he chooses to sell the bonus shares received.