How is a bonus issue different from a stock split?

by J Victor on October 27th, 2011

Hi there ,

Most readers seem to have some confusion about whether bonus issue and stock splits are the same or not.   They may appear to be the same especially in the eyes of a person not well-versed in finance. But they are, in fact, two different things. This article will help you to get a clear picture of the difference between the two.

WHAT’S THE DIFFERENCE?

Simply put- A bonus is a free additional share. A stock split is the same share split into two.

Usually companies accumulate it’s earnings in reserve funds instead of paying it to share-holders in form of dividend. This accumulated reserve fund is then converted into share-capital and allotted to share-holders as bonus shares in proportion to their existing holding. So, Share-capital of the company increases with a concomitantdecrease in its Reserve profits. Share-holders get bonus shares in compensation of dividend.

But when a share is split, say, from Rs 10 denomination to Re 1 denomination, there would neither be an increase in the share capital nor a concomitant decrease in the reserves of the company. This is because while in a bonus issue a person having one share of Rs 10 face value would get another share of the same face value should the company go for a 1:1 bonus what would happen in a stock split is his one Rs 10 share would now be converted into ten Re 1 shares.

WHY DOES A COMPANY ISSUE BONUS SHARES?

One of the major reasons why companies declare bonus issues is that a higher number of shares improves float and liquidity and thereby traded volumes of the stock. A lower price also makes the stock seem more affordable to small retail investors, who might otherwise give it a miss at high price levels. Another aspect of a bonus issue is that it reflects the confidence of the company in its ability to service a larger equity base. Thus, bonus issues are said to be a good signaling mechanism on the company’s capacity to deliver future benefits to shareholders in terms of increased dividend.

Not all is positive with a bonus issue. In some cases, a bonus share ploy is used by companies to mask flagging performance and to perk up sentiment.

• For example, a company has an authorized share capital of Rs. 1,00,000. It has issued 10,000 shares with a face value of Rs. 10 each. Thus, its issued share capital is also Rs. 1,00,000.It has an accumulated reserve of Rs. 10,00,000. It decides to issue bonus shares in the ratio of 1:1 or “1 for 1” – that is, 1 bonus share for each share held. In this case, it transfers Rs. 1,00,000 from its reserves to its authorized share capital. Thus, its reserves come down to Rs. 9,00,000, and its authorized share capital increases to Rs. 2,00,000.Using this new share capital of Rs. 1,00,000, the company issues 10,000 new shares, each having a face value of Rs. 10, and gives a new share – the bonus share – for each share held. Its issued share capital also goes up to Rs. 2,00,000.

HOW DOES BONUS SHARE AFFECT INVESTORS?

Immediately, It doesn’t affect your investments anyway. Post the bonus, the share price should fall in proportion to the bonus issue, thereby making no difference to the personal wealth of the share holder. However, more often than not, a bonus is perceived to be a strong signal given out by the company and the consequent demand push for the shares causes the price to move up.So, when stock prices move up in the long run, there will be dramatic increase in the wealth you’re holding.

WHY DOES A COMPANY SPLIT IT’S STOCK?

The primary reason is to infuse additional liquidity into the shares by making them more affordable. It needs to be reiterated here that the shares only appear to be cheaper, though it makes no difference whether you buy one share for Rs 3,000 or two for Rs1,500 each.

HOW DOES IT AFFECT YOU?

It is like cutting an eight-inch pizza into 12 slices from four slices before. But if you want to buy the shares of a company which are frightfully expensive, you can now buy them for less. Except for that , in a stock split,  fundamentals about the company does not change, the issued share capital remains the same, the revenue remains the same, and the profit remain the same too! But, since the number of shares issued increases, the profit per share (or the Earnings Per Share – EPS) decreases by the same factor.

• So, if EPS is Rs. 15 per share for a share having a face value of Rs. 10, after a 10:1 stock split, the EPS would come down to Rs. 1.5. But since you would be holding 10 shares now, your share of EPS remains the same: Rs. 1.5 * 10 shares = Rs. 15, which is as before!

So, if the PE of the stock is 20 in our example, the price would go down from Rs. 300 (EPS of Rs. 15 * PE 20 = Rs. 300 per share) to Rs. 30 (EPS of Rs. 1.5 * PE 20 = Rs. 30 per share). But again, since you would be holding 10 shares now, your actual holding remains the same: Rs. 30 * 10 shares = Rs. 300, which is as before!

So, there is absolutely no change anywhere, except for the number of shares traded!

WHY DOES MARKET CHEER STOCK SPLITS?

Stock market interprets a stock split as a statement of confidence by the company – it interprets a split as a signal from the company that it is confident about its future growth. Also, a stock split increases the number of shares traded in the market, which increases liquidity.These factors are considered positive, and therefore the market reacts positively!

TAX IMPLICATIONS

Bonus shares- As far as tax is concerned, since no money is paid to acquire bonus shares, these have to be valued at nil cost while calculating capital gains. The originally acquired shares will continue to be valued at the price paid at the time of acquisition. An incidental tax planning benefit is that since the market price of the original shares falls on account of the bonus, there may arise an opportunity to book a notional loss on the original shares. This is known as bonus stripping. The Indian Income-Tax Act has introduced measures to curb bonus stripping.

Stock splits – As far as the tax implications for stock splits are concerned, well, there aren’t any. A stock split, like a bonus issue, is tax neutral. However, when the shares are sold, the capital gains tax implications are different that what is applicable for bonus issues. Here, the original cost of the shares also has to be reduced. For instance, if the cost of the 100 shares at Rs 1,500 per share was Rs 1, 50,000, after the split the cost of 500 shares would be reduced to Rs 300 per share, thereby keeping the total cost constant at Rs 1, 50,000.

CONCLUSION

So, if you are an investor in the company, you have reason to celebrate when you get a bonus. But don’t celebrate when your company splits stock. It’s is just a technical change in the face value of the stock. But if you want to buy more shares, it is good news because now, you will be able to afford them or at least get them cheaper!

Bye for now. Have a nice day !

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