What is a Free Issue (Scrip Issue)?
A free issue, commonly referred to as a scrip issue, is a method used by companies to reward existing shareholders by issuing additional shares at no extra cost. The issuance of these bonus shares is typically proportional to the number of shares already owned by the shareholders. Essentially, it’s a way of distributing excess profits in the form of additional shares rather than cash dividends.
By doing so, the existing share capital is restructured, providing shareholders with more shares, which could potentially result in higher dividends in the future, without any immediate cash outlay from the recipients. This move can also increase the liquidity of the company’s shares in the market.
Examples of Free Issue
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Company A: Let’s say Company A decides to issue a free issue on a ratio of 1:5. This indicates that for every 5 shares that a shareholder owns, they will receive 1 additional share for free. If John owns 100 shares, he will receive 20 additional shares (100 / 5).
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Company B: Suppose Company B declares a 2:10 scrip issue. This signifies that for every 10 shares a shareholder has, 2 new shares will be issued for free. If Mary has 50 shares, she will receive 10 extra shares (50 / 10 * 2).
Frequently Asked Questions (FAQs)
Q1: Why do companies issue additional shares for free?
A: Companies might issue additional shares to reward existing shareholders, increase liquidity, and make their shares more attractive without having to pay cash dividends.
Q2: How does a free issue affect the market price of the shares?
A: The market price per share generally decreases proportionally since the number of shares in circulation increases while the company’s market capitalization remains the same.
Q3: Are free issues taxable?
A: Depending on the jurisdiction, free issues might not be immediately taxable, but selling the shares in the future might incur capital gains tax.
Q4: What is the difference between a free issue and a stock split?
A: In a free issue, shareholders receive additional shares at no cost, increasing the total number of shares they own. In a stock split, the number of shares increases, but the value and equity proportions remain the same, as shares are split into smaller denominations.
- Bonus Shares: Shares distributed by a company to its existing shareholders at no extra cost, often synonymous with free issue.
- Rights Issue: A process where companies offer additional shares to existing shareholders at a discounted rate before the shares are offered to the public.
- Stock Split: A corporate action to divide the existing shares into multiple shares to boost liquidity while keeping the market capitalization the same.
- Capitalization Issue: Another term for a free issue, where a company capitalizes its reserves by issuing new shares to shareholders.
Online References
- Investopedia Free Issue
- Corporate Finance Institute: Scrip Issue
- The Balance: What is a Stock Split and How Does it Work
Suggested Books for Further Studies
- “Financial Accounting: An Introduction” by Pauline Weetman - An excellent resource for understanding fundamental and advanced accounting principles.
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen - Offers insights into various corporate finance topics including equity management and corporate actions.
- “Advanced Accounting” by Joe Ben Hoyle, Thomas Schaefer, and Timothy Doupnik - Covers complex accounting practices and equity transactions.
Accounting Basics: “Free Issue” Fundamentals Quiz
### What is a free issue?
- [x] A process where a company issues additional shares to existing shareholders at no cost.
- [ ] A method of issuing bonds to raise capital for the company.
- [ ] The issuance of new shares to the general public.
- [ ] Payment of dividends in cash to shareholders.
> **Explanation:** A free issue, or scrip issue, involves a company issuing additional shares to its current shareholders without any associated cost.
### What is the primary effect of a free issue on the existing shareholders?
- [ ] Reduces their total shareholding.
- [ ] Increases the market price per share.
- [x] Increases the number of shares they own.
- [ ] Requires them to buy additional shares.
> **Explanation:** A free issue increases the number of shares owned by existing shareholders since they receive additional shares at no extra cost.
### Why might a company decide to issue bonus shares?
- [x] To reward existing shareholders and increase share liquidity.
- [ ] To reduce their liabilities.
- [ ] To convert debt into equity.
- [ ] To acquire another company.
> **Explanation:** Issuing bonus shares can reward shareholders, increase the number of shares in the market, and potentially boost share liquidity.
### What typically happens to the market price of shares after a free issue?
- [x] It decreases proportionally to the increase in the number of shares.
- [ ] It increases due to the additional shares.
- [ ] It remains the same.
- [ ] It varies unpredictably.
> **Explanation:** The market price generally decreases proportionately due to the increase in the volume of shares while the market cap remains constant.
### What indicates a free issue in a 1:5 ratio?
- [x] Shareholders receive 1 additional share for every 5 shares they hold.
- [ ] Shareholders receive 5 additional shares for every 1 share they hold.
- [ ] Shareholders receive 1 share for every 5 shares held by the company.
- [ ] Shareholders receive 5 shares for every 1 share held by the company.
> **Explanation:** In a 1:5 free issue ratio, each shareholder receives 1 additional share for every 5 shares they already own.
### What is another name for a free issue?
- [ ] Rights Issue
- [ ] Stock Split
- [ ] Dividends
- [x] Scrip Issue
> **Explanation:** A free issue is also known as a scrip issue, where additional shares are given to shareholders without cost.
### How does a free issue benefit shareholders?
- [ ] By providing them with an immediate cash dividend.
- [x] By increasing their total shares and potential future dividend receipts.
- [ ] By reducing their taxable income.
- [ ] By reducing the company’s share capital.
> **Explanation:** Free issues increase shareholders' total shares, thus potentially increasing their future dividend receipts.
### What is the effect of a free issue on a company's market capitalization?
- [ ] It significantly increases.
- [ ] It significantly decreases.
- [x] It remains the same.
- [ ] It removes liquidity from the market.
> **Explanation:** The market capitalization remains the same since the total value of shares isn't affected; only the number of shares increases.
### How might the stock market typically react to a company announcing a free issue?
- [ ] Decrease in stock liquidity.
- [x] Positive sentiment due to shareholder value.
- [ ] Immediate drop in overall company value.
- [ ] Dilution of shareholder equity.
> **Explanation:** The announcement of a free issue can often lead to positive sentiment as it indicates shareholder value enhancement.
### In which situation would a free issue be more beneficial than a cash dividend distribution?
- [ ] When shareholders prefer immediate cash.
- [ ] When the company has low equity.
- [x] When the company wants to conserve cash while rewarding shareholders.
- [ ] When planning a major corporate acquisition.
> **Explanation:** A free issue is useful when a company wants to reward shareholders but conserve cash, as no cash outflow is required.
Thank you for embarking on this journey through our comprehensive accounting lexicon and tackling our challenging sample exam quiz questions. Keep striving for excellence in your financial knowledge!
