If a company is sitting on huge cash reserves and wants to reward its shareholders for their faith and their support, it can do so through bonus shares. Bonus share are issued in a certain proportion to the existing holding. A 3:1 bonus would mean you get three additional shares at no cost for the one share you hold in the company.
Bonus shares are shares allotted to the existing shareholders (as on a certain date) at no cost to them. Since there is a nil purchase cost attached to bonus shares, you are able to reduce the cost of investment to that extent. Suppose you are holding 100 shares of Company ABC. The company issues a bonus of 1:2. This means that for every two shares that you hold, you are allotted one bonus share. This means that post bonus, your holding will rise to 150 shares (100 original shares + 50 bonus shares)…
Now, assume that your purchase cost was Rs 10,000 for the original 100 shares. Post the bonus your holding has risen to 150 shares. However, your purchase cost remains the same i.e. Rs 10,000. Therefore, your cost of purchase per share from the earlier Rs 100 (Rs 10,000 / 100 shares) stands reduced to Rs 67 (Rs 10,000 / 150 shares).
Bonus – increases the company’s capital base
A bonus issue adds to the total number of shares in the market. For instance, if a company had 10 million shares, with a bonus issue of 2:1, there will be 20 million bonus shares issued. Post bonus, there will be 30 million shares.
Bonus – impact on the company’s share price
Post issue, the earnings of the company will have to be divided by that many more shares. Earnings Per Share (EPS) = Net profit / number of shares
Since the profits remain the same but the number of shares has increased, the EPS will decline Theoretically speaking, the share price of the company should come down post the issue.
However, in reality, it may not happen. The reasons being:
a. The stock is now more liquid. Now that there are so many more shares, it is easier to buy and sell.
b. 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 were not confident of being able to increase its profits and distribute dividends on all these shares in the future.
c. A bonus issue is taken as a sign of the good health of the company.
Tax liability on bonus shares
Bonus shares are allotted free of cost to investors. Thus the cost of bonus shares is taken as Nil. The difference between sale proceeds and total cost of shares bought is taken as your capital gains. Long term capital gains (for shares held for more than 1 year) are exempted from tax and short term capital gains are taxed at a rate of 15%. Suppose you buy 100 shares of ABC Limited at a total cost of Rs. 20000 on April 01, 2007. On July 01, 2007, the company declares a bonus in the ratio of 1:1. Thus you are allotted additional 100 shares and your total holding increases to 200 shares. If you sell 200 shares on say December 31, 2007 at a price of Rs. 150 per share, your total sale proceeds will be Rs. 30000 (150*200). Your short term capital gains is Rs. 10000 (30000-20000) and you will have to pay tax of Rs. 1500 (10000*15/100).
