What is a Bonus Issue?
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 give one bonus share for every five shares held. Companies issue bonus shares to attract further investment and reward shareholders.
- 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/or reflect a position of financial health.
- A downside of bonus issues is the opportunity cost of earnings utilized for other purposes.
Understanding Bonus Issues
Bonus issues increase a company’s outstanding shares but not its market capitalization. Companies usually fund a bonus issue through profits or existing share reserves. The issuance of bonus shares is not taxable; 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. Bonus 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 example, a three-for-one bonus issue entitles each shareholder 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).
A company’s share price proportionally adjusts to the number of bonus shares issued.
Why Do Companies Issue Bonus Shares?
Companies typically issue bonus shares for several key reasons. First, they encourage more retail investor participation in their stock by lowering the price per share and adding liquidity. Second, they provide an alternative to issuing a dividend payment for rewarding investors. And finally, they reflect that the company is in a financially sound position to keep growing and generating shareholder value. We will further discuss these reasons when looking at the advantages of issuing bonus shares.
Advantages of Issuing Bonus Shares
Encouraging retail participation: Increasing the number of outstanding shares adds liquidity and decreases a company’s stock price, making its shares more affordable and easier to trade for retail investors. Lower-priced shares allow investors to acquire more units, while 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 for smaller companies that want to attract more investors but don’t have earnings consistent enough to pay regular dividends.
Displaying financial health: A company that issues bonus shares demonstrates that it has sufficient share reserves and/or profits to reward prospective investors and current shareholders. Share issues also signal 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 from a taxation perspective, with the latter subject to a corporate tax rate of 10% to 37%. However, investors are still required to pay capital gains tax on bonus shares if selling them for a net gain.
Disadvantages of Issuing Bonus Shares
Opportunity cost: A company could use earnings set aside for a bonus issue for other purposes that may add more shareholder value. For example, retained earnings could be used for a strategic acquisition into a new growth market or to fund updated equipment and machinery. Lost opportunities also have the potential to create bad press for a company, which may negatively impact investor sentiment.
Negative impact on dividends: Issuing bonus shares does not generate cash for the company, which could result in a decline in future dividend payments, potentially upsetting shareholders. Additionally, some investors who receive bonus shares may think that the company may prioritize that form of reward over a cash dividend in the future.
No immediate financial benefit: Unlike a cash dividend payment, shareholders don’t immediately benefit financially because the company’s stock price drops proportionally to the additional bonus shares issued. For example, assume an investor buys 100 shares of XZY Ltd. stock for $10 each, and the company has a 1-for-1 bonus issue. After the bonus issue, the investor now holds 200 shares (100 original shares + 100 bonus shares). As a result of the additional bonus shares added to the outstanding supply, they are now worth $5 each ($10 ÷ 2), not providing the investor with any immediate financial gain.
Stock Splits vs. Bonus Shares
Stock splits and bonus shares have many similarities and differences. When a company declares a stock split, the number of shares increases, but the investment value remains the same. Companies typically declare a stock split as a method of infusing additional liquidity into shares, increasing the number of shares trading and making shares more affordable to retail investors.
When a stock is split, there is no increase or decrease in the company’s cash reserves. In contrast, when a company issues bonus shares, the shares are paid for out of the cash reserves, and the reserves deplete.
What are the main reasons why a company would issue bonus shares?
Companies issue bonus shares to make their stock more attractive for retail investors, provide an alternative to a cash dividend, and/or reflect a position of financial health. In a nutshell, a company issues bonus shares to boost investment and reward shareholders.
What are some drawbacks of issuing bonus shares?
A company could potentially better utilize earnings set aside for a bonus issue to fund other activities that may generate a greater return on investment for shareholders. Additionally, bonus shares could reduce dividend payments, as they don’t generate cash for a company.
Does a bonus issue affect a company’s share price?
Yes, the company’s share price proportionally adjusts to the number of bonus shares issued. For example, if a company’s stock price was at $10 and it had a 1-for-1 bonus issue, the stock price would readjust to $5 to reflect the additional bonus shares.
Do I still need to pay tax on my bonus shares?
No, and yes. Investors aren’t taxed on bonus shares when a company issues them; however, they must still pay capital gains tax if selling them for a net profit. Before filing a tax return, investors should inform their accountant if they have received bonus shares to ensure that they are managed correctly from a taxation standpoint.
The Bottom Line
Bonus issue of shares refers to a company allocating additional shares from earnings or existing reserves to stockholders. A bonus issue increases a company’s outstanding shares but not its market capitalization, as the stock price adjusts proportionally to the additional shares issued. Companies primarily have bonus issues to attract retail investors, provide an alternative to a dividend, and/or project a sound financial position.
On the flip side, earnings set aside for bonus issues could lead to lost opportunities that generate better shareholder value. Although investors aren’t directly taxed at the time that a company issues bonus shares, capital gains tax applies if they are sold for a net profit.