A bonus issue is more advantageous for the investor in the long run because he gets more shares
What would make you happier? Your dividend in the form of a 'bonus issue' or cashback? Let's simplify both the concepts before delving into their pros and cons. Let's assume, a company announces a dividend at 20%. In case of a cash dividend, the company will pay out 2 per share (assuming a face value of 10). In case of a bonus issue, however, shares will be allotted to shareholders for free. If the company announces a 2:1 bonus, two shares will be given out for each share held, to its shareholders.
Payout decision depends on a lot of factors, the primary consideration being the company's liquidity position as cash dividends imply immediate cash outflows. Other factors include access to capital markets, general state of the economy and management's perception of investment opportunities and so on.
How do the two differ?
Dividend:
Cash dividend implies immediate cash inflow for investors. Such distribution, a sign of company's growth and stability, reinstates investors' faith in the stock, particularly the small investors. It plays positively on the stock price reflecting investor confidence, given a company's sound dividend payout record.
Bonus:
In case of a bonus issue, the biggest advantage for the company is enhancement of its equity base. A bonus issue indicates that the company is in a position to service a larger equity. However, it does not impact the balance sheet of the company as it is effected by capitalisation of free reserves. Companies benefit in the long run since liquidity of the stock increases. From an investor's perspective, there is no impact on the net worth, since, earnings per share (EPS) also decline with an increase in equity. Let's say, a company's net profit before the bonus issue is 1 crore and the number of shares are 10 lakh. The EPS stands at 10. Now, if the company announces a 1:1 bonus issue, the increase in the number of shares (to 20 lakh) brings down EPS to 5.
However, in the long run, bonus issues may prove advantageous, since, more number of shares mean more dividends, if the company does keep up with the same rate of dividend. Theoretically, the market price of the stock, post bonus should adjust in proportion to the increased capital, but in reality this may not happen on account of a boost in investors' confidence.
Tax implications
Dividend:
Any dividend, interim or final, that is received from an Indian company is not taxable in the hands of the shareholder. However, Indian companies paying such dividends have to pay a dividend distribution tax (DDT) 15% plus surcharge and education cess. Further, dividend and DDT are not tax deductible in the company's hands leading to double taxation of earnings.
Bonus:
There is no tax implication when bonus shares are awarded. But when they are sold, they may be taxable, depending on the time for which they are held. The taxman considers the cost of these bonus shares nil. Let's say X holds 100 shares of company A which were bought for 1,000. After declaring a 1:1 bonus, X was allotted another 100 shares. Capital gains will be computed on the basis of difference between sale consideration and cost of acquisition. The cost of original shares is 1,000 while the cost of bonus shares will be considered nil. If shares held for more than 12 months are sold on a recognised stock exchange and Securities Transaction Tax has been paid, capital gains (long-term) arising on the sale is exempt from tax. But if the same shares are held for less than 12 months, capital gains (short-term) are taxable at 15% plus education cess.
So what does the whole discussion boil down to? Despite the pros and cons, shareholders welcome both payouts. They are, therefore, good tools by companies to cash in on investors' psychology. While bonus issues are preferred by companies to conserve cash and increase market float of shares, dividends are preferred by cash rich companies.
