A bonus issue, also called an equity dividend, is when companies issue additional shares to their shareholders without any consideration (money). Shareholders get these bonus shares at no extra cost depending on their shareholding in the company. Bonus shares are announced in a specific ratio.
Suppose a company notifies a 1:2 bonus issue. You are entitled to one additional share of the company for every two existing shares you hold. However, the value of your investment remains the same.
Companies make bonus issues out of their free reserves from genuine profits. Companies that default on principal and interest payments on debt securities cannot make a bonus issue.
Let’s say you hold 100 shares of a company whose current share price is Rs 10, and this company declares a 1:1 bonus. This means you will receive one additional share free for every share you hold in the company.
Your total shareholdings in the company are 200 after the bonus issued by the company. However, the investment value remains the same.
The value of your investment before the bonus issue = 100 * Rs 10 = Rs 1,000.
The value of your investment after the bonus issue = 200 * Rs 5 = Rs 1,000.
After the company’s 1:1 bonus issue, the fair price of the share will fall to Rs 5 from Rs 10.
Stock splits are corporate actions where the face value of a company’s existing shares is split in a defined ratio. When a firm declares a stock split, the number of shares of the firm increases; however, its market capitalisation remains the same.
A stock split of 1:5 means the shares of the face value of Rs 10 may be reduced to a face value of Rs 2. It means the share’s face value goes down to one-fifth of its original face value.
Let’s say you own a share of a company that opts for a 1:10 stock split. Its current share price is Rs 3,000, and each share has a face value of Rs 10.
If you held one share of the company with a face value Rs 10 before the stock split, you would hold ten shares with a face value of Re 1 each after the stock split. However, the stock that was trading at Rs 3,000 before the stock split may now trade at Rs 300.
If the company had 1 lakh shares outstanding prior to the stock split, it would now have 10 lakh shares outstanding after the stock split. However, the company’s market capitalisation remains unchanged.
Stock splits help companies increase the liquidity of their shares. For instance, a company’s share price may be high, and many investors are unwilling to pay a higher amount for its shares. Stock splits make the share affordable, thereby increasing the liquidity of the company’s shares.