Equity is such an asset class which is rather easy to understand but complex to operate. Though, trading is a simple job, what follows trading is sometimes difficult. Have you ever wondered how your trades get cleared? How does the exchange operate? What goes in the risk management by the exchange? One such factor which adds to the complexity of the equity operations is Corporate Action. Corporate Actions relate to the events like issue of dividends, rights issues etc. Specifically we are going to talk about two critical and very common corporate actions- Bonus Issue and Stock Splits.
A Split, as the name suggests, refers to breaking down of a stock into a predetermined ratio. Understand that here, all the existing shares are broken down or say disintegrated. No additional shares are issued. Naturally the stock price falls by the same ratio, it is important to note that here; the face-value of shares is also reduced. So for example, if the stock is split in a ratio 1:2, i.e. each share is split into two, both – the face-value as well as the price is reduced by half.
After understanding what a stock split means, it makes us think what must be the rationale behind such a corporate action? Generally the stock is split so as to make it more attractive for the investors. Psychologically, people would prefer 5 investments worth $20 each, rather than one worth $100- every thing remaining same. This is the main reason why companies go for a split. Besides, like a good herbal medicine, it also doesn’t have any side effects, as in it doesn’t change the overall capital structure of the company.
A Bonus issue refers to extra number of shares allotted to the existing share holders of the company. In other words, it means that all the existing share holders of a company will be entitled to receive a predetermined amount of the shares from the company. A direct impact of this is that the stock price declines so as to maintain the market capitalization of the company intact.
It is important to understand here that unlike stock split, the face-value of the shares do not change, as a result, the total issued capital increases. So where do these extra shares come from? The company ploughs back some part of its earnings as reserves. These reserves are used to issue the bonus shares to the shareholders.
Companies normally issue bonus shares as a means to distribute excess cash to the share holders probably that is the reason why bonus issues are also called as stock dividends. Unlike stock splits, a bonus issue does have an impact on the capital structure of the company, in that it increases the issued equity capital of the company.
Some market participants look at corporate actions as signals sent by the management. Without any doubts, the management is well armed with the material information regarding the company. As a result, some market participants are of the view that, the actions taken by managers must be watched closely and implications should be derived from it. Besides a possible implication that the management sees no attractive projects in the near future, bonus issues can also mean that the management feels that the company’s shares are overvalued in the market. Though I personally don’t support such claims, these information may come handy when analyzing a corporate action.
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