Explain bonus or capitalisation issues, Financial Accounting

Q. Explain bonus or capitalisation issues?

A rights issue is a approach of raising finance via the issue of shares to existing equity shareholders. Consecutively to make such an issue a company must have an authorised share capital which exceeds the issued share capital. Companies select to make rights issues for the reason that of a need to raise long term finance and a decision that such a method is the most cost effective or desirable. The finance increased may be used to fund any type of long term investment such as an acquisition expansion of production facilities or overseas investment.

A scrip issue is an issue of shares for which no charge is made. The shares are issued at no cost to existing shareholders and may be called bonus or capitalisation issues. The benefit of a rights issue made to existing investors as opposed to an issue via public subscription is that such investors are assumed to already have some level of commitment to the company. Since such it may prove relatively easy to persuade them to buy shares and certainly easier and less costly than making a public offering. It is though important for the company to explain the reason behind the share issue - what it is going to do with the cash raised. If an investor is to be convinced to pay cash for additional shares then it must be demonstrated that their newly invested cash will be used to earn returns at least equal to those they are currently receiving from their investment. If the return on capital is likely to decline in the company after the rights issue then the issue is unlikely to be successful. Since with any new share issue it is common practice for a rights issue to be underwritten.

The solitary investor in a company which is making a rights issue will be invited to take up or sell his/her rights. If the rights are occupied then the investor will have to make a payment to the company equal to the price of the rights purchased. On the other hand the investor may choose not to increase the scale of his investment and sell the right on the open market. In a proficient market the investor is no better nor no worse off because of choosing to sell his/her rights.

Scrip issues are frequently justified on the basis that there is a need to increase the number of shares in issue in order to bring down the price per share. It is frequently argued that the market 'dislikes' shares which individually have a very high price and by increasing the number of shares in issue the unit share price can be diluted. This is able to be beneficial to shareholders because research evidence suggests that the drop in the unit share price isn't as great as the proportionate change in the number of shares in issue. For instance if 10 million shares are in issue and the current market price is $10 each the market value of the equity is $100 million.

If 10 million shares are at the present distributed via a scrip issue one would expect the share price to drop to $5 leaving the overall equity value at $100 million. The post issue price patch up at say $6. This results in a raise in the value of individual shareholdings together with a rise in the total value of the equity. Individual investors may thus experience some capital gain from a scrip issue. While making a scrip issue a company is converting some of the reserves into share capital and the number of shares (fully paid up) to which an investor is entitled will be expressed in relation to the current holding example a 2 for 5 issues. As previously suggested although the private investor gains no theoretical advantage from this conversion of reserves, there may be a advantage in practice because the shares are now more marketable.

Posted Date: 7/11/2013 8:03:34 AM | Location : United States

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