When a company start making consistent profits or generating enough cash, it usually shares its profits with shareholders as a reward for providing it with the capital to run the business. In doing so, the company start paying dividends to shareholders. However, it is up to the board of directors whether to pay dividends or not. It is the board of directors that appointed by the shareholders to decide what percentage of earnings should company pay in dividend or use for other opportunities like investing in business growth, paying-off debt, buying back own shares, making acquisitions etc. But, sometimes companies decide to reward the shareholders with additional shares aka bonus shares.
Definition – “Bonus shares are additional shares issued by a company to its existing shareholders with no additional cost, based on the number of shares that the shareholder already owns.”
The interesting thing about the issuance of bonus shares is that when a company decides to issue bonus shares, the value of company remained constant meanwhile the issue of bonus shares increased the total number of shares issued.
It usually happens, when a company made profits, thus increase in employed capital. Technically, the issue of bonus shares is the alternative of dividends. But, due to a shortage of liquid funds or government restrictions on dividends payouts, the company decides to go with the option of bonus shares. Unlike the rights issue where there is a risk of dilution of investment, the bonus issue does not risk diluting your equity investment.
Generally, a company tends to reward their shareholders in form of dividends but when the company decides to avoid showing the distributable income on the balance sheet, ploughing back its profits into the capital which it has to distribute otherwise, it issue bonus shares. It benefits a company to avoid the investors demand dividends. When a company is making consistent profits and accumulating huge profits, it’s obvious for a company to increase dividend payments, investors entitled to.
Hence, to avoid converting its accumulated profits into heavy dividend payments, the company issue bonus shares instead.
Advantages: From the Investor’s Point of View
- There are no tax implications of receiving bonus shares for investors however when they are sold, they may be taxable – LTCG or SCTG tax, depending upon the holding period.
- Bonus Shares are free of cost to shareholders as they are issued by the company, which in turn increase the overall outstanding shares of an investor in the company, ultimately, enhances the liquidity of the stock.
- Bonus shares are advantageous for investors who are looking to make investments over the long-term to build a corpus for retirement saving plan or to achieve other long-term financial goals.
- Bonus shares help in building the trust of an investor in company’s business & operations as the faith under which investor invested in the company is intact and the company is putting that capital in good use and rewarding investor for it.
Advantages: From the Company’s Point of View
- Issue of Bonus shares benefits companies to get themselves out of the situation where they are not able to or simply not prefer to pay cash dividends to its shareholders. In such circumstances, the companies decide to pay extra shares to oblige their shareholders in place of dividend payouts.
- Issue of bonus shares may not increase the value of the company but it sure enhances its position and image in the market, gaining the trust of existing shareholders and attracting many small-investors to participate in the stock market and invest in the growth of those companies.
- With the issue of bonus shares, the companies have more free-floating shares in the market.
Disadvantages: From Investor’s Point of View
- There is not much of a disadvantage of owning the bonus share otherwise, it won’t be called by bonus share. However, one thing investors should know that the on receiving bonus shares, the profits will remain the same but as the number of shares increased, the Earning per Share (EPS) will decline.
Disadvantages: From Company’s Point of View
- In issuing bonus shares, the companies do not receive any cash. As a result, the ability to raise money by follow-on offerings is reduced.
- When a company keep issuing bonus shares instead of paying cash dividends, the cost of the bonus issue keeps adding up over the years.