The prime purpose of any company’s existence is to maximize the shareholder’s wealth. Businesses run operations throughout the year, earn profits (or bear losses), and make strategic and operational decisions about the company. Finance Management makes three key decisions; dividend policy of the company, Financing decisions, and Investment decisions.
All these three decisions are linked and often affect each other. How the company will reward its shareholders for their risk-bearing investments?
Which positive cash flow projects to invest and how to finance the projects?
Remember Equity Shareholders face more risk than Debt financers so their expectations of higher returns are always justified. Financial Managers may decide on different dividend policies after consulting major shareholders and considering the effects of their policies on the company. A company may decide any policy from:
- No dividend policy
- A Constant Payout
- Residual approach
The dividend decision comes from the management based on a choice between the dividend relevancy and dividend irrelevancy theories.
In the practical world, the finance managers decide about dividends on the availability of the cash (not profits), shareholders’ expectations, and the “signaling” effect on the company share price.
When the management decides to issue dividends to shareholders, it may take different forms to pay the shareholders e.g. cash payments, bonus shares, preferred shares, etc.
Two common and often overlapping decisions are Bonus Issue (a dividend decision) and a Stock Split (a Finance Decision).
A Bonus Issue is where the management offers existing shareholders dividends in the form of “bonus” shares in proportion to their number of shareholding.
A Stock Split is a decision to increase the number of existing shares; the total number of shares is divided into a larger number of shares.
Although both these decisions seem dividend decisions but the implications are wider on the company overall.
These decisions are affected by the availability of the cash resources and depend on future investment plans of the company too.
From the Shareholders’ point of view, there are certain similarities and benefits of both these decisions, before that we’ll look at what each of these decisions accounts for.
The prime difference between a bonus issue and a stock split is that in a bonus Issue the management decides to pay shareholders in the form of new shares.
When management has surplus cash or a regular payout dividend policy they oblige the shareholders with extra or “bonus” shares.
This is typically a “how and how much” of cash to pay to the shareholders decision rather than “to pay or not to pay”.
Why the finance Managers opt for a Bonus issue instead of a Dividend payout?
- Bonus Issue requires less cash than a total dividend payout
- The management can decide on the ratio of bonus issues depending on cash availability. E.g. a 2 to 5 bonus issue or a 1 to 10 bonus issue.
- Unlike dividend payout; a bonus Issue can be a one-time decision which makes it easier to manage shareholders’ expectations.
However from the Shareholders’ point of view:
- An increased number of share means lower dividend per share
- Shareholders do not get cash immediately and may have to sell the bonus shares to meet their expected returns
- A signaling effect of “no cash” for dividends and a lower stake in total shareholding.
When a company performs well its share prices increases, further with time, and unfortunately reach a point where the share price is too high to be purchased.
Finance management cannot control the share prices directly; low demand for shares will affect the company adversely.
One solution to this problem is a “Stock Split”; the total number of outstanding shares is further divided into a larger number of shares.
This option increases the number of shares without paying any cash and decreases the share price.
- Commonly a Finance Management decision to reduce share prices, to make it more attractive for stock buyers
- Involves low or zero cash for a Stock Split decision
- Helps management deal with cash liquidity problems
- The decision does not change the total market capital value of shares
In conclusion, A Bonus Issue and a Stock Split both do not generate any direct cash payouts to shareholders. However, both are important financial decisions that affect the company Share prices and liquidity of the company which is often a more critical success factor than profits.
While Bonus Issue is more of a Dividend policy decision, A Split Issue is more a Financing Policy Decision.