Publication: Capital Market Magazine, February 2011
Article Summary: This article explains the economic logic behind two widely discussed corporate actions—bonus issues and stock splits—and clarifies several misconceptions surrounding them. Bonus shares are issued by capitalising a company’s reserves, converting a portion of accumulated profits into equity share capital. While shareholders receive additional shares free of cost, the company’s net worth remains unchanged because reserves decline by the same amount by which equity capital increases. Consequently, although the number of shares held by investors rises, their proportional ownership in the company and the overall value of their investment remain broadly the same.
The article also explains how market prices adjust after a bonus issue or stock split. Once the shares begin trading ex-bonus or post-split, the market price typically falls in proportion to the increase in the number of shares so that the total market value of an investor’s holdings remains largely unaffected. It further discusses the taxation aspects of bonus shares and stock splits, including the treatment of cost of acquisition and holding period for capital gains. The article highlights how certain investors have historically used bonus announcements to manage tax liabilities through strategies such as bonus stripping, a regulatory gap that was later addressed in the case of mutual funds through amendments to the Income Tax Act. Ultimately, investors should focus on the fundamental strength and growth prospects of companies rather than assuming that bonus issues or stock splits create additional economic value.
Key Insight: Bonus issues and stock splits increase the number of shares but do not create real economic value for shareholders.