Chapter 16: Types of Corporate Actions – Part 2
Remember how your excitement draws near during the festive season? That’s because you know it’s when your employer dispenses a ‘bonus’ without fail each year.
Now, imagine if you get the same from your stock investments.
Yes, it is possible. And that brings us to the next type of corporate issue.
3. Bonus Issue
Bonus issues are shares that a company provides to its shareholders in specific proportions at no cos
So, how does bonus issues work
Let's say you own one share of Crisscross Limited. Currently, its share is priced at Rs. 600 per share.
Now, Crisscross Limited announces a bonus in the ratio of 2:1. That means you will now receive two additional share without having to pay a dime.
But how does it really work?
Well, when bonus shares are issued, the price of the company shares decreases in the same proportion. Hence, in a 1:1 bonus issue, you could see the share price fall by 50%. This also means the earnings-per-share will fall.
So with Crisscross Limited, on post bonus, you now have three shares but the share price has come down to one third — Rs. 200. What this means to your net worth is that it is the same post bonus issue!
But would bonus issue impact the value of your investments?
When bonus shares are issued, it points to the good health of the company. It is also an indication that the company's earnings could rise in the next couple of years or more.
So, in the long run, as the stock prices of the company may increase, you could stand to gain too. Besides, when the share price reduces and becomes more affordable to you, it increases stock liquidity to enable you to sell the share for a smaller amount as per your requirement.
Generally, companies issue bonus shares out of their profits or reserves if it is facing liquidity issues or may not be in a position to distribute cash dividends. Usually, the company converts the undistributed reserves and surplus into equity capital. This way company does not need to pay any cash and can shift the money from Reserve and Surplus head to the Equity Capital head on the balance sheet. For example, a company has a current equity base of Rs. 200 crore, i.e., 20 crore shares of Rs. 10. If a company has Rs. 250 crore surplus in their books, they can shift Rs. 200 crore from this to equity capital by issuing a 1:1 bonus issue.
To be eligible for bonus shares, you should own the share on the record date specified by the company.
4. Rights Issue
Now, let’s try to understand the next type of corporate action, with an example.Say, a sales representative of a certain grooming product reaches out to you every month.
You prefer the brand and product and you look forward to purchasing from the brand representative. On the other hand, your neighbour always seems interested in checking out the products but is never keen to buy them.
A few months later, the product manufacturer releases a new set of products.
Who do you think the sales representative would reach out to first – you or your neighbour?
That’s right. You!
- You love the product
- You have been a loyal customer
- The chances of you buying the product is much higher
You never know, the sales representative might even offer it to you at a discounted price.
And that’s exactly how a rights issue work.
In a rights issue corporate action, shareholders are offered the shares of the same company which would be proportional to the current shares they hold of the company at a price lower than the market price.
Lower than the market price? Won’t that mean a loss for the company?
Not really. Offering shares to existing shareholders means increasing the chances of the same investors buying more shares.
Remember how the sales representative suspected that the probability of you buying the product is higher than your neighbour?
This would help in raising the fresh capital, which is the main purpose of issuing this corporate action.
Does this sound similar to a bonus issue?
Quite the contrary!
Bonus issue affects the shares you are currently holding and it is free of charge. However, a rights issue would require you to pay an additional price for the additional shares.
But do you have to buy them?
No, you do not have to.
You can choose one of the two options. Either take up the rights or allow them to lapse.
As a shareholder, if you do not want to use the rights issue, you may have the opportunity to sell to other investors in the market. But this can only be allowed if it’s a renounceable rights issue.
Can rights issue affect your investments negatively?
Yes. You may want to be wary about the fall in share price after the rights issue is closed. That's why it is important to calculate the ‘ex right price’ and decide on the company's prospects at its current valuation.
Let's take an example.
The current share price of Top Ventures Limited is Rs. 100. Now the company decides to go for right issue in the ratio of 2:5. Top Ventures Limited prices the rights issue at Rs. 85. As an existing shareholder, you now have the opportunity of buying two additional shares at the cost of Rs. 85 for every five shares of Top Ventures Limited that you hold.
That means, post the issue you can calculate the ex-right price as following:
- Cost of initial 5 shares at Rs. 100 per share = 500
- Cost of additional 2 shares at Rs. 85 = 170
- Ex-Right price = (500+170) / (5+2) = 95.71
Did you know?
Reliance Industries announced a rights issue in April 2020 in the ratio of 1:15. This mean 1 share for every 15 shares of RIL offered at Rs. 1,257 per share, at a 14% discount.
Now, you have the basic understanding of the most popular types of corporate actions.
- Bonus issues are shares that a company provides to its shareholders at no cost.
- In rights issues, companies seek to increase their capital by issuing new securities to existing shareholders at a discount.
Surely you must be wondering what steps you can take once the corporate action is initiated. Well, let’s look into that in the next chapter.
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