About Bonus Shares and Stock Splits

Correct me if I am wrong but I would like to add my 2 bits to this discussions. The balance sheet consists of 2 main columns, viz., Assets & Liabilities (what the company owns or is owed plus its treasury on one hand and how the ownership was funded, capital + reserves, borrowings, what the company owes to others).

The sum of each column must necessarily be equal to the sum of the other column.

On the assets side you have sub-categories which are Depreciated Capital Assets, Investments, Current Assets, and Cash/Bank balances.

The liabilities column is really two sub-columns in one. The first one being Capital & Reserves (or shareholder funds). This is treated as a liability by accountants but in reality these are funds that shareholders invested in the company plus the retained earnings, i.e., shareholders money that is ploughed back in the company. Remember, in theory, shareholders determine how much profit is to be retained by them as dividend and how much to be ploughed back in the company. This is done on the recommendation of the Board of Directors at the AGM. But the shareholders collectively have the authority to accept or reject the recommendations and decide for themselves how the profits are to be apportioned.

The other sub-column is the actual liability, i.e., what the company has borrowed (long term or short term secured or otherwise) plus what the company owes to outsiders (other than shareholders) for goods & services received.

As the sum of both main columns must balance, an increase in fixed assets (Capex) would means one or more of the following five ensuing counter-actions:

1. Increase in Capital + Reserves.

2. Increase in borrowings.

3. Increase in current liabilities, viz., you do not pay for the goods & services being received and thus have the cash for Capex.

4. Decrease in investments (i.e., you liquidateyour investments to generate cash for Capex).

5. Decrease in current assets (i.e., you reduce your inventory or reduce the amount of money owed to you by your customers). This frees money for Capex.

It is clear then that reserves do not get reduced if Capex increases. Reserves add to the net worth of the company. When bonus shares are issued or a stock split takes place, the net worth of the company remains the same. So in such a situation the book value of each share gets reduced by the ratio of the bonus or split.

As a result, the fundamentals of the company being the same, the market reacts to the bonus/split by reducing the price to maintain the same P/E or P/B ratio as before the change.

Why do companies go in for bonus/splits? The main reason is that as the reserves keep on increasing, the value of the share increases. This reduces the liquidity of the share in the market. The bonus/split makes more shares available in the market thereby increasing liquidity as ownership tends to broaden.

Hi Kuldeep

By far the best explanation till date.

Pankaj

In case of a bonus issue, book value is not reduced though it happens in case of split.

Liqudity is a main consideration in case of stock split but bonus issues have lot to do with the increase in earnings of the promoters by way of dividend (companies usually tend to maintain or increase the rate of dividend) than plainly enhancing liquidity. Besides, as a result of capitalization of reserves retained earning are also made untouchable from the creditors in the event of bankruptcy. However, these two benefits to the shareholders are not available in the case of stock split.

Best Regards,
--Ashish

Ashish,
I thought that book value per share of a company is the net worth divided by the number of shares outstanding. So, in case of bonus, too, the book value per share would stand reduced because of the increase in number of outstanding shares since net worth remains the same.
Regards
Kuldeep

Book value is the value which appears in the Balance Sheet of a company. In case of bonus shares, the no. of outstanding shares increase but at the same time share capital also increases with an equal decline in free reserves. Hence, there is no change in book value of one share.

In case of stock split, the no. of outstanding shares increase but the share capital and reserves remain unchanged. Therefore, in the scenario of a stock split, book value per share is reduced.

Aca,
You got the denominator right (no of o/s shares) but the numerator wrong

The numerator is shareholders equity or networth (which remains unchanged in a bonus) and not paid up capital

So book value reduces in consequence of a bonus.

Kuldeep is right

AGILENT

PS Strange, you got the numerator right in case of the split example u cited. How can it be different in case of the bonus example ??

What Aca ... still not got over the football hangover ?

No Football hangover, please go through the standard definitions of book value. Book value for me does not mean the derived book value.

BTW, for knowing how to use reserves for funding expansion, go through Fund Accounting (Use here does not mean payment). Sorry for not writing up as not in the right frame of mind. Today's bomb blasts have disturbed me somewhere deep.

Best Regards,
--Ashish

Ashish
You are truly amazing ...
How can book value meaning be different in case of a bonus versus a split ...

Read your own post where you 'distinguished' between the two

AGILENT

I am not assigning different meanings to book value for a bonus and split. Book value is the value of an asset or liability appearing in the balance sheet. So in 1:1 Bonus, the Book value or face value of a Rs. 10 share will be Rs. 10 while in a 2:1 split it will be Rs. 5. Derived book value of a share is networth divided by outstanding no. of shares. I have never based any calculation or any discussion on it so far.

So thats why I am saying that book value changes in split but not in Bonus.

BTW, thanks for a personal attack.

Best Regards,
--Ashish

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