When we invest the share capital in a business, we do so with the expectation of getting back not only our invested capital, but also a proportionate share of the surplus generated from operations, after all the other stakeholders have been paid their dues. Thus, collectively the business owes its shareholders, their invested capital as well as the surplus generated from operations. But in reality, while the business may pay us annual dividends, seldom is this surplus fully distributed away as dividends. Thus, the surplus which is retained in the business is still owed to us. This retained surplus is also reflected as retained earnings or reserves in the Balance sheet of a company. Together, share capital and reserves are known as equity or the net worth of a company.
Over a period of time, the retained earnings of a firm can become quite large: often several times the original share capital. And when this happens, the management of the firm may decide to transfer some amount from the reserves account to the share capital account by a mere book entry. This has the effect of decreasing or debiting the reserves in the balance sheet of the firm and increasing or crediting the share capital (and hence the number of shares outstanding). In such a case, the firm is said to have made a bonus issue.
THE BENEFIT OF A BONUS ISSUE TO A SHAREHOLDER:
Let us assume that a company makes a 1: 2 bonus issue. In other words, for every two shares held, the shareholders receive one additional share. For example, if this company’s original share capital was Rs.10 crore(with one crore shares of par value Rs.10 outstanding), the bonus issue has the effect of increasing the share capital to Rs.15 crore(implying 1.5 crore shares or Rs.10 each), so that the reserves go down accordingly by Rs.5 crore. Thus, the shareholder of the firm who previously held two shares is now in possession of three shares, i.e., one extra share. Henceforth, the shareholders would begin to receive dividends on three shares held by them earlier. The same effect could have been achieved by the company by increasing its dividend payments by 50% on the earlier two shares, without making the bonus issue.
Since a bonus issue implies no real change in the fortunes of the business, the ex-bonus price (the market price after the bonus issue) of the three shares including the bonus share, will be equal to the cum-bonus price (the price before the bonus issue) of the original two shares. Hence, following this bonus issue, the market price per share must fall by 33.33% (assuming that everything else remains unchanged). In other words, now the market price of the ex-bonus share will be only two thirds of the price of the cum-bonus share.
The bonus issue enthusiasts may argue that this fall in market price is likely to be much less than 33.33%, so that the ex-bonus value of the three shares would be greater than the cum-bonus value of the two shares, implying an increase in the wealth position of the shareholder as a consequence of the bonus issue. If this were indeed so, it would imply creation of wealth through book entry, for a bonus issue is nothing but just that. In a logical world, there is no reason to believe that the shareholders would not have achieved the same increase in wealth if the company had decided to merely enhance the dividend by 50%, rather than issue a bonus of 1:2 (assuming that the company maintained its DPS following the bonus issue). Thus, strictly speaking, bonus issue implies absolutely no change in the fortunes of either the issuing company or its shareholders.
IF THE BONUS ISSUE IS MERELY A BOOK ENTRY, THEN WHY DO COMPANIES ISSUE BONUS SHARES AT ALL:
Perhaps the only rational reason for a firm to do so is that by not issuing bonus shares, the market price of a firm may increase to extremely high levels over a period of time (remember that regular bonus issues have the effect of keeping the market price per share low on account of the enlarged share capital base). Such high share prices may make it difficult for the shareholders to trade in the shares. For example, over the 1982-1992 period Colgate-Palmolive India Ltd made four bonus issues of 1:1 and one of 3:5. This means, that a shareholder who held one share prior to 1982, held about twenty-five shares in 1992. The average market price of a Colgate share was around 400 in 1992 (par value being Rs.10). This means that if Colgate had made no bonus issues between 1982 and 1992, the market price of its share would have been about Rs.10000 (Rs.400 x 25) by 1992. Small and medium investors may find it difficult to trade a share at such a price. Thus when a bonus issue is made, the share may become relatively more liquid. The resulting increase in the liquidity of the ex-bonus shares may, to some extent, explain why following a bonus issue of, say, 1:1, the price of the share falls less than 50%. However, there is no strong empirical evidence to support this hypothesis.
There may possibly be other reasons why firms may choose to make bonus issues periodically. It may be that when the retained earnings of a firm grow very large in relation to its share capital, the firm feels exposed to the charge of making enormous profits at the cost of the consumer, and may be apprehensive about attracting close public scrutiny. For the same reason they may be reluctant to announce very high rates of dividends and hence choose to make bonus issues instead. However, such a reason hardly appears to be elegant.
It is also argued that, by issuing bonus shares, a firm indirectly discloses to the market its continued ability to pay dividends on the enlarged capital base in future, so that the investors expect a stable increase in the company’s profits in future and the share price goes up. There is some empirical evidence to support this view. But the catch is that there is no reason why the same information cannot be imparted to the market through an appropriate increase in dividends or through a straight and simple announcement by the management to that effect. Thus, as we said earlier, it is in fact difficult to see how by making an accounting entry in the books of accounts can create any wealth through increase in share prices.