Any business is run by finances, there are two ways a company can finance its operation.
Either through debt finance or equity finance. Debt financiers look for mortgages against their cash and seek a return on it, the cost associated with debt financing is higher.
Shareholders also seek return for their investments, but that can be in the form of regular dividend payments or in the form of share price capitalization in the long run.
Any company’s main objective is to maximize shareholders’ wealth by creating value in products and investing in positive NPV projects.
Capitalization refers to the concept of creating value using an asset, or in accounting terms may refer to converting short term costs/profits to long-term.
Generally, when associating with profits or reserves, the term capitalization means the conversion of accumulated profits to shareholders’ equity.
A company’s income statement reflects the amount of retained earnings and profits for the current period, and the balance sheet shows the same amounts accumulated over the life of the company (Updated to the latest reporting date).
When a company generates profits, it may decide to utilize it in different ways e.g. investments in projects, pay off debts, or issue dividends.
When a company has surplus cash and accumulated profits, and it does not have any projects to invest in, the management may decide to convert those profits to shareholders’ equity.
There are very few options for the company management for converting profits in equity directly, one of such options is issuing of Bonus Shares. Important: The Dividend issue is different from equity capitalization.
The management may decide to use the Bonus Issue option for various purposes, the Prime purpose being the share capitalization.
Also, when a company has no positive NPV projects in the short-term, the management may decide to utilize the reserves to reward the shareholders.
In some cases, the company may be facing covenant from the debt financiers for not issuing any dividends until a certain amount of debt is paid off.
In that situation, to satisfy the shareholders the management may decide to issue bonus shares instead of cash dividends.
One important factor with profit capitalization is that when the company pays its reserves accumulated over the years in the form of bonus shares the profits are permanently converted into share capital.
The profits and reserves can be used for investing purposes too, which eventually also results in positive cash flow and increase the share price of the company.
The indirect methods of investing the profits and share price increase are rarely successful in the capitalization of profits.
From the shareholders’ perspective, the capitalization of profits in the form of Bonus Issues may signal negatively.
The increased number of shares will result in lower EPS, and the pressure to maintain the dividend payout ratio will increase.
The shareholders receive the bonus shares in proportion of their existing shareholdings, so it does not affect their voting rights.
In an efficient market, a profit capitalization may also mean that a company does not have any positive NPV projects to invest in, business expansion plans, or any research and development processes going on.
Profit capitalization achieves the strategic objective of wealth maximization for the shareholders, as temporary reserves are cultivated back to the share capital.
If the Bonus Issue of shares option is used, the shareholders may have the option of selling the bonus shares to the outsider investor too.
In an indirect approach, when the management decides to pay off debts or invest in positive NPV projects with the accumulated profits, the end result is also the share price increase which is another form of Capitalization.
In conclusion, capitalization of profits or reserves refers to the share capital. Given the choices the profits may be used for investing, debt pay off, or Share and dividend issues.
The shareholders’ wealth maximization is achieved when periodic profits are converted to permanent Share Capital.
The total market capitalization for the company, however, does not change with this practice, as reserves or profits are converted from one form to another.