4 ADVISROS | July 2010

By Dr. Vinod Kumar

Mithilesh Kumar

PERSPECTIVE

?Do Bonus Shares reward

Investors

The typical news that finds a prominent place in the financial newspapers is the declaration of

bonus shares by a company and is often referred to as reward to the investors for their loyalty to the company. Often, it brings smile on the face of a tired and harried investor that free shares are offered to the shareholders. Several companies regularly reward their shareholders with free shares for example, during 2009 about 44 companies declared bonus shares.

as retained earnings. If the reserves and surplus amount becomes too large, the company may transfer some amount from the reserves to the share capital account by an accounting entry. This is done by increasing the number of shares outstanding by transferring the reserves and every shareholder is given bonus shares in a ratio called the bonus ratio and such an issue is called the bonus issue. If the bonus ratio is 1:2, it means that for every two shares held, the shareholder is entitled to one extra share. Thus a shareholder holding two shares, post bonus, holds three shares of the company. This whole process, in accounting terminology, is known as the capitalization of reserves.

1. Bonus shares can be issued by a company only if the Articles of Association of the company authorize a bonus issue. Where there is no provision in this regard in the articles, then Articles of Association must be amended by passing a special resolution at the general meeting of the company.

2. It must be sanctioned by shareholders in the general meeting on recommendations of the Board of Directors of the company.

3. Guidelines issued by SEBI must be

IS THE COMPANY BOUND TO

DECLARE A BONUS? WHY DO

ONLY SOME COMPANIES AND

NOT ALL ISSUE BONUS SHARES?

DO SHAREHOLDERS REALLY

BENEFIT FROM A BONUS ISSUE

MADE BY THE COMPANY OR

ARE THE GAINS ILLUSORY?

DOES THE COMPANY STAND

TO BENEFIT IF IT ISSUES BONUS

SHARES? WHY AND HOW

DO MARKETS REACT TO THE

NEWS OF A BONUS ISSUE BY A

COMPANY? THESE ARE SOME

OF THE QUESTIONS THAT ARISE

IN THE MINDS OF INVESTORS

HOLDING EQUITY SHARES IN A

COMPANY. THERE EXIST A LOT

OF MISCONCEPTIONS ABOUT

THE IMPLICATIONS OF THE

BONUS ISSUE .THIS ARTICLE

IS AN ATTEMPTS TO RESOLVE

THESE MISCONCEPTIONS.

While investing in shares the motive of an investor is not only capital gains but also proportionate share of surplus generated from the operations once all other stakeholders have been paid. The reserves of a company, built up thus over a period of time, belong to the investors. But the distribution of this surplus to shareholders rarely happens. Instead, this is transferred to the reserves and surplus account known

5July 2010 | ADVISROS

complied with. Care must be taken that issue of bonus shares does not lead to total share capital in excess of the authorized share capital. Otherwise, the authorized capital must be increased by amending the capital clause of the Memorandum of Association. If the company has availed of any loan from financial institutions, prior permission for the issue of bonus shares has to be obtained from these lending institutions. If the company is listed on the stock exchange, the stock exchange must be informed of the decision of the board to issue bonus shares immediately after the board meeting. Where the bonus shares are to be issued to the non-resident members, prior consent of the Reserve Bank should be obtained.

Only fully paid up bonus shares can be issued. Partly paid up bonus shares cannot be issued since the shareholders become liable to pay the uncalled amount on those shares.

The number of shares held by a shareholder would proportionately increase to the extent of bonus received from a company. So if “A” is holding 100 equity shares and his company announces 1:1 bonus, he will receive additional 100 equity shares, thereby his holding would double to 200, and all this without shelling out a single rupee. The issue of bonus shares increases the floating stock of the company in the market which increases the liquidity in the scrip. This would also provide an opportunity to those investors who intend to enter such a company by buying its shares.

Several blue-chip companies such as Infosys, Reliance and TCS have come out regularly with bonus offerings

Infosys Tech. 1994 1:1 85.7 24.1

Infosys Tech. 1997 1:1 155.43 50.94

Infosys Tech. 1999 1:1 107.97 37.24

Infosys Tech. 2006 1:1 249.89 81.41

Infosys Tech. 2004 3:1 488.21 170.01

Reliance Inds. 1997 1:1 184.77 28.85

Reliance Inds. 2009 1:1 727.78 95.24

Reliance Inds. 1980 3:5 30.95 10.85

Reliance Inds. 1983 3:5 45.43 15.77

TCS 2006 1:1 114.64 53.63

TCS 2009 1:1 136.38 45.53

Source – Capitaline

If you moved money from your right pocket to the left, would you become any richer? Similarly, bonus issues declared by companies do not really result in wealth-addition for shareholders.

Through the bonus mechanism, companies simply transfer funds belonging to the company’s owners, that is, equity shareholders, from one accounting head (reserves and surplus) in the balance-sheet to another (share capital). Sure, there is an increase in the issued equity share capital when bonus shares are issued. However, the reserves and surplus (comprising mostly accumulated profits over the years), which also belongs to the shareholders, declines to the same extent i.e. commensurately.“A bonus cannot create wealth. All that happens is that reserves are transferred to equity account. If wealth can be created by an accounting entry then companies do not have to produce goods and sell them. They just have to engage accountants to keep capitalizing Reserves!” The only difference in the balance sheet after bonus is that the reserves take the name of equity capital.

When a bonus issue is announced, the company also announces a record date for the issue. The record date is the date

Equity Capital 100 Cr. -

Reserves 400 Cr. -

Net Worth 500 Cr . -

6 ADVISROS | July 2010

Crompton Greaves 2010 3:4 05/03/2010 442.35 09/03/2010 246.10 08/03/2010 249.85Hind.Dorr-Oliver 2010 1:1 12/03/2010 221.55 17/03/2010 104.85 15/3/2010 105.85Castrol India 2010 1:1 06/04/2010 730.10 12/04/2010 369.90 15/04/2010 379.45VST Till. Tract. 2010 1:2 04/02/2010 490.70 09/02/2010 301.25 8/02/2010 307.30Pidilite Inds. 2010 1:1 12/03/2010 240.80 16/03/2010 113.85 15/03/2010 113.80Chromatic India 2010 5:2 17/03/2010 90.20 23/3/2010 28.25 22/03/2010 26.95Indo Asian Finan 2010 2:1 16/03/2010 50.45 19/03/2010 16.30 18/03/2010 16.70IVRCL Infra. 2010 1:1 17/03/2010 339.00 19/03/2010 168.75 18/03/2010 172.95Chembond Chem. 2010 1:1 09/03/2010 308.55 11/03/2010 159.85 10/03/2010 156.45Poly Medicure 2010 1:1 25/03/2010 199.95 29/03/2010 94.35 26/03/2010 96.85Cadila Health. 2010 1:2 01/04/2010 828.65 6/04/2010 559.25 05/04/2010 554.40FCS Software 2010 1:1 25/02/2010 12.15 2/03/2010 7.55 26/02/2010 7.29Sterlite Tech. 2010 1:1 08/03/2010 437.25 10/03/2010 87.85 09/03/2010 89.20Sh.Renuka Sugar 2010 1:1 12/03/2010 154.05 17/03/2010 76.00 15/03/2010 76.50

Source – Capitaline

on which the bonus takes effect, and shareholders on that date are entitled to the bonus. After the announcement of the bonus but before the record date, the shares are referred to as cum-bonus. After the record date the price of the share is known EX- bonus price. If the ex bonus price is equivalently reduced by the size of the bonus issue, then there is no benefit to the investor.

Bonus issue increases the number of shares floating in the market which brings down the price of the share. A lower price makes the stock more affordable to small retail investors, who might otherwise give it a miss at high price levels. For instance, after its 1:1 bonus issue in November 2009, one share of Reliance Industries traded at around Rs. 1100. This may appear more affordable to a small retail investor compared with the pre-bonus price of around Rs. 2,200.

Theoretically, the share price, post-bonus, should adjust in exact (reciprocal) proportion to the increased capital base. For example, a 1:1 bonus, which doubles equity capital, should ideally

reduce the share price by half.However, this may not necessarily happen, given that market price is influenced by several other factors too, important among which is also the increased equity capital base due to the bonus issue. Greater investor interest in the scrip improves price discovery and accentuates price movements. This, combined with the general positive sentiment associated with bonus shares, at times, results in the share price trading higher than the theoretical post-bonus price.

Companies which plan to raise equity capital for expansion or diversification also sometime resort to bonus issues to make the offer seem affordable to retail investors. For instance, Engineers India, which intends to go for an initial public offering later this year, plans a 2:1 bonus issue in addition to a stock split, prior to the public issue. This Pre-IPO bonus issue also attempts to increase the promoters ‘holding in the company.In some cases though, a bonus share ploy is used by companies to mask poor performance and to perk up sentiment of the investors. This however is the practice adopted most sparingly by the corporate.

It is important to note here that Issue of bonus shares does not require the release of company’s assets. When bonus shares are issued as fully paid up out of capitalized accumulated profits, there is distribution of capitalized accumulated profits but such distribution does not entail release of assets of the company. The company doesn’t lose out anything when the bonus shares are given to the shareholders.

The SEBI has issued guidelines for Bonus issue which are contained in Chapter XV of SEBI (Disclosure & Investor Protection) Guidelines, 2000. A company issuing Bonus Shares should ensure that the issue is in conformity with the guidelines for bonus issue laid down by SEBI (Disclosure & Investor Protection) Guidelines, 2000. It is a detailed guideline which enumerates that the bonus issue has to be made out of free reserves; the reserves from revaluation should not be capitalized. Bonus issue should not be made in lieu of dividend. There should be no default in respect to fixed deposits. Bonus issue should be made within 6 months from date of approval. Dr Vinod Kumar is Associate Professor with

Sri Guru Nanak Dev Khalsa College and

Mithilesh Kumar is a lecturer with ICOFP.