Bonus Issue WHAT ARE THEY? Bonus shares are issued in a certain proportion to the existing holders. A 2 for 1 bonus would mean you get two additional shares — free of cost — for the one share you hold in the company.If you hold 100 shares of a company and a 2:1 bonus offer is declared, you get 200 shares free. That means your total holding of shares in that company will now be 300 instead of 100 at no cost to you. WHO BEARS THE COST IF IT’S FREE FOR ME? You are right. There is no free lunch.Bonus shares are issued by cashing in on the free reserves (accumulated profits) of the company.A company builds up its reserves by retaining part of its profit over the years (the part that is not paid out as dividend). After a while, these free reserves increase, and the company wanting to issue bonus shares converts part of the reserves into capital.So you do not pay; and the company’s profits are not impacted. WHAT ARE THE EFFECTS OF A BONUS ISSUE? Bonus shares do not directly affect a company’s performance. Bonus issue has following major effects. 1. Share capital gets increased according to the bonus issue ratio. 2. Liquidity in the stock increases. 3. Effective Earnings per share, Book Value and other per share values stand reduced. 4. Markets take the action usually as a favorable act. 5. Accumulated profits get reduced. 6. A bonus issue is taken as a sign of the good health of the company. WILL THE SHARE PRICE CHANGE AFTER BONUS ISSUE? A bonus issue adds to the total number of shares in the market.Say a company had 10 million shares. Now, with a bonus issue of 2:1, there will be 20 million shares issues. So now, there will be 30 million shares.This is referred to as a dilution in equity.Now the earnings of the company will have to be divided by that many more shares.(Earnings Per Share = Net Profit/ Number of Shares)Since the profits remain the same but the number of shares has increased, the EPS will decline.Theoretically,When EPS declines, the stock price should also decrease proportionately. But, in reality, it may not happen. That’s because: i. The stock is now more liquid. Now that there are so many more shares, it is easier to buy and sell. ii. A bonus issue is a signal that the company is in a position to service its larger equity. What it means is that the management would not have given these shares if it was not confident of being able to increase its profits and distribute dividends on all these shares in the future. #1: What is Rights Issue? Let us start of with ‘Rights’. The ‘Rights’ refer to the existing shareholders of the company. They have already bought shares of the company. In this case, the ‘Rights’ are directed to shareholders of Moosa Butt Co.. Now, we talked about ‘Issue’. This refers to issuance of new shares. If you put the two words together, it simply means the issuance of new shares to existing shareholders of the company. Rights Issue = Issuance of New Shares to Existing Shareholders at Discounted Prices Often, the shares are issued at a discount to its current market price. Hence, the discount is only applicable to existing shareholders, hence, the word ‘Rights’. It is an opportunity for existing shareholders to buy new shares of the company at a discount. This would allow them to maintain the proportion of shareholdings within the company. #2: Why Stocks Undertake Rights Issue? In general, there are 3 reasons why stocks may undertake rights issue. They include: 1 - Fund Expansions This refers to stocks that have identified specific expansion plans to grow but lack the resources to finance them. To name a few, these expansion plans may include: Within the Business Construct New Factories Buy Advanced Machineries Open New Outlets Expand Overseas Other Working Capital Beyond the Business Buy Investment Properties Subsidiaries & Associates Co. Form Joint Ventures New Property Development Project Buy Oil Palm Plantation Estates 2 - Capital Restructuring This refers to stocks that may be highly-geared. In other words, they have high levels of debt in proportion to their shareholders’ equity. Hence, they would undertake rights issue to pay off and lower the company’s debt-to-equity ratio. This would strengthen the company’s balance sheet and also reduces its finance cost in the future. Often, stocks that are unable to borrow money may employ Rights Issue as an alternative method of financing. This may be due to having poor credit as a result of shaky financial standings by the company. 3 - Higher Chance of Take-Up Rights issue is often used as a faster method to raise cash. This is because the shares are issued at a discount to its current market price. Hence, this could attract higher take-up for new shares by existing shareholders as compared to selling shares to new potential investors at current market prices. #3: The Impact to Existing Shareholders This involves some calculation. 1 - Before Rights Issue Let us assume that you are a shareholder of Moosa Butt Co. Before Rights Issue, you own 1,000 Moosa Butt Co. shares which are worth RS. 5.50 each. Hence, your current investment in ABC Co. is worth RS. 5,500. 2 - The Deal Then, Moosa Butt Co. announced that it is undertaking Rights Issue exercise. It is issued on the basis of 3 Rights Shares for every 10 Existing Shares held by existing shareholders. The offer price is RS. 3.00 per share. 3 - What Can You Buy? With the announcement, you are entitled to buy 300 shares at RS. 3.00 per share. This is calculated: You Can Buy = Current Shareholdings x 3 Rights Shares / 10 Existing Shares = 1,000 x 3 / 10 = 300 Shares 4 - Let’s Assume You Did How many would you have now? New Shareholdings = 1,000 + 300 = 1,300 Shares What’s the theoretical value of your investment in Moosa Butt Co.? New Value = RS. 5,500 + (RS. 3.00 x 300 Shares) = RS. 5,500 + RS. 900 = RS. 6,400 Why is it called ‘Theoretical’ value? This is because share price of Moosa Butt Co. may fluctuate and change after the Rights Issue. Hence, the results of this calculation would be ‘in-theory’ and be treated as a guide. What’s the theoretical value of one share of Moosa Butt Co.? New Value of One Share = RS. 6,400 / 1,300 shares = RS. 4.923 / share Why the Theoretical Value is lower than RS. 5.50 (current market price before Rights Issue)? This is because Moosa Butt Co. would have increased its number of shares issued by 30%. Hence, this would dilute the existing value of each shares of Moosa Butt Co. Does it mean that you’ve incurred a loss? Not necessary. This is because the loss incurred from the value diluted of your existing shareholdings is compensated by the gain from purchasing new shares at a discount. Allow me to illustrate: Value Loss from Dilution = (New Theoretical Value - Market Price Before Rights Issue) x No. of Existing Shares = (RS. 4.923 - RS. 5.50) x 1,000 shares = - RS. 577 Gain from New Discount Shares = (New Theoretical Value - Offer Price of Rights Shares) x No. of New Shares Bought = (RS. 4.923 - RS. 3.00) X 300 shares = RS. 577 Hence, you did not lose a single cent by acquiring new shares. Your Total Loss = Value Loss from Dilution + Gain from New Discount Shares = - RS. 577 + RS. 577 = RS. 0 5 - What If You Did Not Subscribed Then, the value of your investment in Moosa Butt Co. would shrink by RS. 577, down from RS. 5,500 to RS. 4,923. Therefore, in most cases, it is more advisable to take-up the Rights Issue. However, once again, it depends whether you are willing to invest an additional RS. 900 into Moosa Butt Co. New Value if You Did Not Subscribed = New Theoretical Value x Existing No. of Shares = RS. 4.923 x 1,000 shares = RS. 4,923
