Aided by strong economic upturn across economies over the last couple of years, corporates have managed to dole out impressive financial performances. Corporates, across the globe, had undertaken a cost cutting and productivity enhancement exercise in order to emerge from the economic troughs of 2001.

This coupled with better sales have helped their coffers grow to a substantial size on the back of robust growth in profitability. And it is during such times that investor friendly announcements like high dividends, stock-splits and bonus issues come to the fore.

In this article, we shall try to throw some light on the aspect of bonus issue and how an investor/company is affected by such an action.

Bonus issue

Bonus issue basically implies the issue of additional shares by the company to its shareholders. Unlike a stock-split, where an existing share is divided into the agreed upon ratio, in the case of a bonus issue, additional shares are issued to shareholders in proportion to their holdings.

Thus, for example, if the ratio decided upon were 1:1, it would imply that the shareholder would get one additional share for every one share held. Similarly, if the ratio were 2:1, the investor would get 2 additional shares for every 1 share held. Here, unlike a stock split, where the equity base remains unaltered, in the case of bonus issue, the equity base would stand augmented to the extent of the bonus announcement.

The additional shares are issued from the accumulated reserves of the company and as such, the company's book value stands reduced to that extent. Let us see with an example how are the two parties in this process affected.

An investor:  Mr. A had 100 shares of company X at a face value of Rs 10 per share and a total investment of Rs 10,000, assuming a share price of Rs 100. Post the 1:1 bonus issue, Mr. A will have 200 shares of face value Rs 10 each, while the market price of the shares would halve to Rs 50, thus keeping his total investment at Rs 10,000.

It must be noted that here the stock price is halved owing to the fact that the equity shares of the company have doubled and with the profits of the company remaining at the same level, the earnings per share would stand reduced by half, which is consequently reflected in the halved stock price.

The company:  Company X had 10 crore (100 mn) outstanding shares of face value Rs 10 each. The share price currently being quoted on the stock exchanges is Rs 100 thus making the market capitalisation of the stock at Rs 1000 crore {Rs 10 bn (outstanding shares x share price)}.

Post the bonus issue; the company's outstanding shares would increase to 200 m with shares retaining the face value of Rs 10. However, owing to the share price reducing by half to Rs 50, the market capitalisation would continue to remain at Rs 1000 crore. However, the company's equity capital could stand expanded from Rs 100 crore {Rs 1 bn (100 m shares x Rs 10 face value)} to Rs 200 crore {Rs 2 bn (200 m shares x Rs 10 face value)}.

Why the process of bonus issue?

The basic premises of giving a bonus issue are:

• Rewarding shareholders:  This is the basic premise of announcing a bonus issue as an investor gets additional shares in proportion to his/her current holdings. Unlike a rights issue, a shareholder does not have to part with any money to acquire the additional shares. However, while there are no immediate gains to the shareholder, as the total value of its shares in the company would remain unchanged owing to the price adjustment, it is the additional liquidity and affordability, which augurs well for the stock over the long-term.
  

• Management confidence:  The issue of bonus shares is often considered as a reflection of management confidence of its company's growth prospects. This is because, with additional outstanding shares i.e. higher equity base, the management would have a greater responsibility in terms of servicing the expanded equity base.
  

• Better leverage opportunities:  A higher equity capital would assist the company to raise higher debt. This is because a company's debt-to-equity ratio would stand reduced, putting the company in a comfortable position to raise further debt from the market. While some may argue here that the company's return on equity would get adversely affected and it would be wise to raise debt from the markets at competitive costs without leveraging on additional equity raised from shareholders, the former argument (debt-equity) cannot be discarded.

Conclusion

Similar to stock-split, a bonus issue has no fundamental effect on a company or its valuations and thus an investor must not base his investment decision on the basis of this. It is status quo for the company on the basis of fundamentals and valuation in the post-bonus era. Thus, the general factors like the growth prospects of the company, management capability, business model, etc. should continue to remain the deciding factors while making an investment decision. The only additional points that can be added in the case of bonus issue (over that of a stock-split) are that on the one hand, while a bonus announcement reflects the management's confidence in its growth prospects going forward, investors must remember that if the company fails to meet its growth targets, the EPS could get hit much harder than otherwise owing to reduced profits and higher equity base.