Rationale & ramifications of bonus shares
Rakesh Khanna, a student of Sentinel Centre for Human Resources Development (SCHMRD), one of the premier business schools in the country, had just come back to his hostel room, after a hard day in college.
The accounting professor had just started with the topic of bonus shares before ending the session for the day. Khanna, could not figure out, as to why did a company issue bonus shares. To him it appeared to be just an accounting entry, which moved money from one heading to another. What was the deeper reason for a company to issue bonus shares? Before the professor started the discussion again in the next class, he wanted to figure it out himself.
Bonus shares are free additional shares that a company may decide to issue to its existing shareholders in a certain proportion to the current holding. So if a company comes out with a 1:1 bonus issue, an investor gets 1 additional share for every existing share that he holds in the company.
A company has a certain amount of reserves, which it has built up over the years, by retaining a proportion of the profit and not giving it out as a dividend. While issuing bonus shares the company converts a part of these reserves into shares. So in the strictest sense, bonus shares are really not free.
But it still did not make sense to Khanna. If a company did a 1:1 bonus, the number of shares in the stockmarket would double and accordingly the stock price should half. So why do so many companies issue bonus shares? In the calendar 2005, 90 companies had made announcement of issuing bonus shares, the accounting professor had told the class.
Khanna did not have the answer to this and so decided to go out for a smoke, hoping to run into someone who would clear his doubt. As luck would have it, he ran into his batchmate, Ratan Jain, the acknowledged stud at SCHMRD, as far as stock markets were concerned.
And Jain had the answer: "One way of looking at it is that when a company issues bonus shares the market takes it as a signal that in the days to come the present good run of the company will continue. The management of the company would not have distributed these shares if it was not confident of distributing dividends on all the shares in the days to come."
"Take the case of Wipro. It announced a 1:1 bonus on April 22, 2005. The closing price of the stock on that day was Rs 643.95. After that the price of the stock started going up. It closed on Rs 720.05 , on August 19, 2005. On August 22, 2005, a Monday, the stock, went ex bonus i.e., the bonus shares became available in the market. So theoretically the stock should have opened at around Rs 360 (Rs 720/2). But it opened at Rs 368.50. Since then the price of the stock has gone up and the closing price as on January 16, 2006 was Rs 460," said Jain.
"So, that's one reason. Also with the market price of the stock falling and with more shares in the market, it becomes much easier to buy and sell the stock. But, one needs to be careful. The promoters of penny stocks can resort to issuing bonus shares to create a buzz around the company," he added.
"That's the logic behind issuing bonus shares," thought Khanna. But he still did not understand the tax implications of bonus shares, which he thought he needed to know, as he had plans to invest in the stock markets in the days to come. So he asked Jain.
"Well, let's do it one at a time. Ye thi ghatnayein aaj tak, intezaar keejiye kal tak," added Jain, and walked off, blowing cigarette smoke rings into the air.
The example is hypothetical
