Bonus Stocks

Companies do not generally distribute their entire profits to the stockholders as dividends. A fairly large part of the profit is retained and added on to what is commonly called the reserves of the company. As the name indicates, reserves are back up funds which a company keeps for meeting unforeseen increases in expenditure, and for financing its future expansion or diversification programmes. Over the years, most profit making companies build up large reserves. There is also a sizeable increase in their assets, sales and volume of business. When such growth takes place, companies often find that their equity capital is too small compared to the expanded size of their business operations. It is not advantageous for companies to operate a continuously expanding business on a narrow capital base. Therefore, in order to expand their equity capital they capitalize a part of their reserves by issuing bonus stocks to their stockholders. Bonus stocks, as the name suggests, are issued free to existing stockholders in proportion to the number of stocks held by them. It is essentially a book transfer by which a sum of money equal to the value of the bonus stocks is transferred from the reserves to the equity capital in the company's books of accounts. The issue of bonus stocks enlarges a stockholder's stockholding without any dilution in his proportionate ownership of the company.

The issue of bonus stocks almost always leads to a fall in the market price of a stock. This does not, however, adversely affect the stockholder because such a fall in the market price is more than offset by the increase in the size of his stockholding.

To illustrate how this happens, let us assume that you own 100 stocks in XYZ Ltd. when it issues bonus stocks in the ratio of 1: 1. Let us also assume the market price to be $1 per stock prior to the bonus issue. With the issue of bonus stocks, your stockholding doubles to 200 stocks. At the same time, the market price of the stocks would probably fall to $0.5 per stock, Even though the price has fallen, you do not lose because the value of your stockholding remains at $100. The fall in price from $1 to $0.5 per stock is fully compensated by the increase in your stockholding from 100 to 200 stocks. Actually, stock prices generally do not fall in the same proportion in which bonus stocks, are issued. In this case, the ex bonus price of XYZ stocks would probably fall to around $0.53 per stock.

Companies usually continue to pay the same rate of dividend after the issue of bonus stocks as they were paying prior to the issue. This benefits the stockholder because he gets the same rate of dividend on a larger stockholding. A company will not normally issue bonus stocks unless it is confident that its future growth prospects justify an expansion in its equity capital Therefore, the expectation of a bonus issue by any company normally creates a climate of optimism and cheer in the stock markets and usually results in a rise in the price of a company's stocks just before or upon the announcement by it of a bonus issue.