Rights Issue vs. Bonus Issue Explained

Two common ways for a company to issue more shares are a Rights Issue and a Bonus Issue.

While both result in the investor holding more shares, the underlying mechanisms and implications are quite different.

Let's break down these two concepts and understand their key distinctions.

Understanding the Rights Issue

Imagine a company wants to raise additional capital for expansion, debt reduction, or other strategic initiatives.

One way to do this is through a Rights Issue.

In this scenario, the company offers its existing shareholders the right to buy additional shares at a discounted price, usually below the current market price.

Here's how it typically works:

• Entitlement: For every certain number of shares you currently hold, you receive the right to buy a specified number of new shares. For example, you might receive one right for every five shares you own.
• Subscription Price: The company sets a price at which these new shares can be purchased, which is usually lower than the prevailing market price to incentivize shareholders to participate.
• Tradability: These rights are often tradable on the stock exchange for a specific period. If you don't want to buy the new shares yourself, you can sell your rights to someone else who does.
• Taking Up the Rights: If you choose to exercise your rights, you'll need to pay the subscription price to the company within the specified timeframe to receive the new shares.
• Lapsing of Rights: If you don't take up your rights or sell them before the deadline, they will typically lapse and become worthless.

The primary purpose of a Rights Issue is to raise capital for the company.

Understanding the Bonus Issue (Stock Dividend)

A Bonus Issue, also known as a Stock Dividend, is a different ballgame altogether.

In this case, the company issues additional shares to its existing shareholders for free. No extra payment is required from the shareholders.

Here's how it generally works:

• Proportional Allocation: Shareholders receive new shares in proportion to their existing holdings. For example, a 1:5 bonus issue means you'll receive one additional share for every five shares you currently own.
• No Cash Outflow: You don't have to pay anything to receive these extra shares.
• No Change in Underlying Value: While you now hold more shares, the overall market capitalization of the company remains the same (at least initially). Consequently, the price of each individual share will adjust downwards proportionally.

The primary purposes of a Bonus Issue are often to:

• Increase Share Liquidity: By increasing the number of outstanding shares, the price per share might become more affordable, potentially attracting a wider range of investors and increasing trading activity.
• Reward Shareholders: It's a way for the company to reward its shareholders without having to pay out cash dividends, which can be beneficial if the company wants to conserve cash for reinvestment.
• Capitalize Reserves: A bonus issue can be used to convert a company's accumulated profits or reserves into share capital.

Key Differences: Rights Issue vs. Bonus Issue

Rights Issue: Upsides and Downsides for Shareholders

Upsides:

• Potential for Increased Investment: Shareholders who believe in the company's future can increase their stake at a potentially attractive discounted price.
• Tradable Rights: If you don't want to buy more shares, you can still benefit by selling your rights.

Downsides:

• Potential Dilution: If you choose not to take up your rights and don't sell them, your percentage ownership in the company will decrease.
• Need for Additional Investment: Participating requires you to invest more money.

Bonus Issue: Upsides and Downsides for Shareholders

Upsides:

• Increased Number of Shares: You end up holding more shares in the company.

Downsides:

• No Immediate Increase in Value: The overall value of your holding remains the same immediately after the bonus issue (e.g., if you owned 100 shares at $10 each, worth $1,000, after a 1:1 bonus issue you'd have 200 shares at $5 each, still worth $1,000).

Why Companies Choose Each Method

Companies typically choose a Rights Issue when they have a specific need for capital infusion. This could be for funding expansion projects, making acquisitions, or reducing debt.

A Bonus Issue, on the other hand, is often used when the company wants to reward shareholders without a cash outlay or to make its shares more accessible to a wider range of investors by lowering the per-share price.

Conclusion

While both Rights Issues and Bonus Issues involve the issuance of additional shares to existing shareholders, they serve different primary purposes and have distinct implications for investors.