What is Bonus Issue of Shares - Example, Advantage, Procedure, & Meaning
During the time of downfall in the economy or when a company is facing a lack of cash inflow or some issues that lead the company a downfall, companies follow various tricks to keep their shareholders motivated enough to avoid their exit from the company. The stock market majorly works on sentiments. If the economy or a company faces unfavorable conditions, the probability of exiting the market or the company is high due to fear.
When things don't look great among investors or traders, bonus issues and buying back of shares are the techniques that companies might carry out. Let's dive deep into the concept of bonus issues and understand how it will help you if you are an investor.
What is the bonus issue?
As the name suggests, bonus, which indicates "for free". The bonus issue means when a company gives shares to their existing shareholders for free, without any cost. It is distributed in a specific ratio, such as 2:1.
If a company has announced its bonus issue in the ratio of 1:2, it typically means for every one share; you will get two additional shares for free. This means that you will have three shares.
Why do companies issue bonus shares?
Companies distribute bonus shares to promote retail involvement and broaden their investor base. In some cases, the company's stock price becomes unaffordable for many retail investors.
During a bonus issue, the price per share decreases as the number of shares increases. But the total capital stays the same even if bonus shares are declared.
By issuing bonus shares, shareholders can help themselves in meeting the liquidity requirements in their respective lives. Investors expect some liquidity from the stocks they hold. They can sell their equity shares received as bonus issues and stay invested at the same time.
When the company shares are highly-priced, retail investors might not be able to invest heavily in the company. The issue of bonus shares helps the company bring down the stock prices and lets other investors participate in the company.
Impact on the company's valuation
Investors might look at selling their bonus shares for two reasons:
- To meet their liquidity requirements
- Out of fear that the company will not be able to give returns in the future as they might not be able to generate profits.
However, this might not be the reason in every case. Everything has an exception of its own.
In the first case, if investors start selling their shares in huge numbers, the company's valuation will go down because of a massive exit from the market. The share prices will fall, and eventually, the valuation too.
On the contrary, if the economy is going great, there is a high possibility of an increase in valuation as investors might show a willingness to buy shares of the company after the announcement of the bonus issue to accumulate more shares of a fundamentally strong company.
Impact on existing shareholders
When a company issue fresh equity shares, the shareholding of the existing investors gets diluted, by dilution, we mean that it reduces the shareholding percentage of one investor due to the entrance of new shareholders.
Let's understand with an example-
Suppose a company has 100 shareholders. Each investor has 1% of voting right in the company. Now, the board of directors of the company decided to issue additional 100 shares by way of fresh equity.
The voting right of shareholders reduced to 0.50% each.
However, in the case of bonus shares, there is no entrance of new investors, i.e. free shares will be issued to existing shareholders only, in a particular proportion. Taking the above example, BOD has issued 100 bonus shares to the existing shareholders. Now, there are 100 individuals invested in the company holding two shares of each, keeping their total voting rights the same, i.e., 1%.
There are various tax provisions levied on the companies and shareholders when a company announces anything that has to be credited to the account of investors. To escape the liquidity crisis within the company while keeping shareholders happy, the company announces bonus shares. It will not only help investors to gain confidence in the company but help the company to save their cost of paying dividend distribution tax.
However, according to the recent provisions, tax on dividends has to be paid by the investors only.
Since there is no cash inflow in the hands of shareholders or outflow of cash from the company's account, no one has to pay tax at the time of crediting shares to the investor's Demat account.
But, when selling bonus shares, investors must pay tax according to the time horizon of holding the shares.
The tax levied on the sale of bonus shares will be calculated based on the First In First Out method, which means if your bonus shares are credited to your Demat account before 31st Jan 2018, the cost of acquisition will be taken as the closing price of the stock at the same date. But, if bonus shares are credited to your Demat account after 31st Jan 2018, the cost of acquisition will be zero.
For applying such a case in a practical scenario, the FIFO method will be used for calculating the holding period of the shares, according to which you have to pay tax on the sale of shares.
Long-term capital gain tax
When the holding period of shares is more than one year, you have to pay long-term capital gain at 10% of the profit above ₹1 lakh. It also includes cess and surcharge if the investor exceeds the eligibility criteria.
Short-term capital gain tax
If you sell your bonus shares before the acquisition of one year, which means your holding period of less than a year, you have to pay short term capital tax under section 111A at the flat rate of 15%.
Getting more company shares should not be the sole reason to buy the shares. Always understand the intention behind the issue of bonus shares. It helps you decode the company's future operations and money management.