The cake must grow bigger

Every company needs capital for its inception. This is provided by the promoter. Say,if a promoter invests Rs 10,000 to start a company,this amount,which is called equity share capital,can be divided into shares of,say,Rs 10. So at inception the owner owns 1,000 shares or 100 per cent of the company. When the company starts earning profits,the retained earning,which is part of the post-tax net profits that the promoter does not take as dividends and reinvests in the company,is added to the companys equity capital. This raises its net worth. At some stage the companys promoter decide to sell some stake through an initial public offer IPO to investors who might be willing to pay a premium over the face value in this case Rs 10. When an investor buys a stake in a company he becomes a shareholder.

WHAT IS A BONUS SHARE ISSUE?

With time as retained earnings increase if the company is profitable,the companys net worth rises and its share price moves upwards. At some point,the company may decide to convert a part of its net worth into paid-up equity and hence issue a proportionate number of shares to its shareholders. This is called a bonus issue. So in a bonus issue there is a change in the structure of a companys net worth. Its paid-up capital rises and there is an equivalent fall in retained earning. However,there is no change in the value or net worth of a company.

WHY DO COMPANIES ISSUE BONUS SHARES?

Some companies issue bonus shares to lower the price of their shares and increase liquidity. A 1:1 issue would bring down the share price to half of the existing market price while a 1:2 bonus issue would bring down the price to almost 33 per cent of the prevailing market price. The issue increases the equity base and brings in more investors into the company who would not have been able to buy the companys stock at its earlier higher price.

The negative of a bonus issue is that too much supply of shares can be detrimental for its share price if demand for these shares is not strong.

IS IT BENEFICIAL FOR INVESTORS?

Though the term bonus sounds like a free gift from the company,in the real sense it is just a change in the structure of the equity base rather than any value addition to the share price. The share price of a company is determined by a combination of net worth,future growth prospects and its dividend-paying record. Shareholders can reward themselves by cashing on the price rise that accompanies the bonus issue announcement and come back later when the prices have fallen after the issue, says the chief executive officer of a mid-cap company requesting anonymity,who is planning a bonus issue. However,experts say that a bonus issue is nothing more than a book entry. Bonus issues generate a feel-good factor around the company as investors see it as a good signal. Prices generally go up in the short run as market men perceive the company as having a bright future and being capable of servicing an expanded equity base, says Mumbai-based financial planner Amar Pandit. But for any real benefits to accrue to shareholders,the net profits of the company must rise.

swarup.chakraborty expressindia.com