Bonus shares are issued by companies in lieu of paying a cash dividend. As with any form of wealth transfer, these also have their own advantages and disadvantages. There are two parties involved, the issuing company and the shareholder or investor, and we discuss the advantages and disadvantages from the point of view of both.
Investor’s Point of View:
Why does an investor buy equity shares of a company? It can be for two reasons –
1) investing for the long term, and
2) generating an annual income by means of dividends.
The first goal is fulfilled when the company is managed properly and adds economic value. The second goal depends on the payout policies of the company. A growth stage company may refrain from paying any cash dividend and reinvesting everything back into the business while a mature company may have to pay a regular annual cash dividend. But both types of companies can pay a stock dividend through a bonus issue.
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- The investor doesn’t need to pay any tax upon receiving the bonus shares.
- It is specifically beneficial for the investors who believe in the long-term story of the company and want to increase their investment in the same.
- Issuing additional shares and using cash for the business growth of the company increases the investor’s belief in operations of the company.
- If the company starts paying the cash dividend in the future, the investor receives more because he holds a number of shares in the company due to past policy of paying a stock dividend.
- Not all investors may be interested in receiving the shares as a dividend; some may want liquidity for fulfilling other objectives. When such investors sell their bonus shares for generating liquidity, their stake in the company is reduced.
- The stock dividend doesn’t give any extra wealth to the shareholders because share price drops by a proportionate amount to keep the market capital of the company same as before.
Company’s Point of View:
Over the course of a company’s lifetime, the capital needs of the company keep on changing. In the initial growth phase, preserving cash is of utmost importance while satisfying the return desires of its shareholders takes precedence when the company is mature. A company has various means at its disposal to satisfy its objectives and one of these is the type of dividend pay-out. A company can either choose or is forced to (because of cash constraints) to pay a cash or stock-based dividend. Each carries its own advantages and disadvantages which are discussed below.
- Bonus issue allows the company to conserve cash for reinvesting back into the business.
- It has a signaling effect and gives a positive sign to the market that company believes in its long-term growth story.
- Sometimes, the company may not be in a position to pay any cash, so bonus issue is the only means to satisfy the shareholders’ desire for a dividend.
- Increasing the number of outstanding shares through a bonus issue increases the participation of smaller investors in the company’s shares and hence enhances the liquidity of the stock.
- The Increase in the issued share capital increases the perception of company’s size.
- Bonus issue increases the number of outstanding shares of the company and this will decrease the future EPS and cash dividend yield. This can have a negative impact on the market’s perceived value of the company.
- The company doesn’t receive any cash upon issuing bonus shares. So, the company’s ability to raise money by follow-on offerings is reduced.
- The cost of administering a Bonus Share Plan is more than that of paying a cash dividend. This cost can add up over the years if the company keeps on issuing bonus shares.