Markets mostly go ecstatic every time some company issues or is likely to issue bonus shares. The ecstasy provides an example of market-irrationality. What does issue of bonus shares mean to the shareholder?
Companies are allowed to use their undistributed profits, certain reserves and share premium amount for the issue of bonus shares. After the issue of bonus shares, such profits, reserves or share premium amount, as the case may be, go down and the share capital and the number of outstanding shares correspondingly go up. Companies do not receive any funds. No difference is made to the capital employed by the company and its net worth, and, as a corollary, no difference is made to its earning capacity. Thus, effectively, the company now will have more outstanding shares than it had before the issue of bonus shares.
As the result, the book value of share will stand reduced proportionately. For example, suppose you have a share, whose pre-bonus book value is Rs 200. You get one share as bonus against one original share. The new post-bonus book value of share will be Rs 100 and you will have two shares instead of one. The total value in your hands pre and post bonus remains the same Rs 200. One thing should become clear here: that issue of bonus shares in no way enhances the value of the company.
If undistributed profits are used for the purpose of issue of bonus, it means the shareholder is getting what he sacrificed as dividend. If share premium amount is used for the purpose, it means the effective cost of share is brought down, something Reliance Power is trying to do. If it is accepted that the issue of bonus shares in no way enhances the value of the company, then the post bonus value of Reliance Power as a company should remain the same.
Then why should share price go up before announcement of issue of bonus shares? And why should it go down after announcement of bonus shares is made? If it is accepted as a basic premise that issue of bonus shares is nothing but a further division of the total value of the company which value is presumed to have been correctly determined, then the value of one share is nothing but the number arrived at by diving the total value of the company by the number of outstanding shares.
Thus, if the value of the company remains constant, then a larger number of shares will reduce the value of one share proportionately. Thus, theoretically, there is no reason, except irrational behaviour, why share price should go up before announcement of bonus. However, once issue of bonus shares is announced, it has reason to bring down the value of one share as there will be more outstanding shares competing for share in the total value of the company.
Source: Times of India Mumbai, 25th Feb 2008, Page 25
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