An issue of bonus shares represent a distribution of shares in addition to or instead of, the cash dividend to the existing shareholders. The shares are distributed proportionately. A bonus issue does not affect the shareholder's wealth. It however, has the following advantages:
(a) Tax benefit
When a shareholder receives cash dividend from the company, he pays tax but a bonus issue does not attract taxes. The shareholder can sell the new shares received to generate cash and thereby realize a capital gain which is currently not taxable.
(b) Indication of higher profits in future
The issue of bonus shares is normally interpreted by shareholders as an indication of higher profitability especially in an inefficient market. This is because a bonus issue is declared by management when they expect a rise in earnings to offset additional outstanding shares. The bonus issue thus convey important information to the market.
(c) Increase in future dividends
If a company has been following a policy of paying fixed dividend per share and continues it after the declaration of the bonus issue, the total cash dividend the shareholder receives will increase because of the increase in the number of shares.
(d) Conservation of cash
A company that issues bonus shares conserves cash that would otherwise have been paid as dividend. This is particularly important if the company is facing cashflow or liquidity problems.