Free lunch? Not quite...

In the latest in our series on understanding the stock markets, John Andrew explains the rationale behind scrip issues, in which a company will offer its investors `free' extra shares

Free shares, in the sense that shareholders are better off after receiving them, are not as rare as hens' teeth. But they are nevertheless unusual.

Founder shareholders in some of the Government's privatisation issues received free "loyalty shares" and, of course, members of building societies such as the Halifax which have decided to adopt public limited company status will receive free shares.

However, the "free" shares generally encountered by shareholders normally leave them no better off. In City jargon these are known as scrip issues. Technically they are a capitalisation of reserves. This sounds complicated, but it is very straightforward.

Suppose a company begins life with the issue of one million shares at pounds 1 each. The proceeds will raise pounds 1m, which we will assume is used to buy assets for the business. Let us now put the clock forward a few years.

Assume over that period the company has done well and while the shareholders received dividends, the company also ploughed back pounds 9m of profits into the business. The accounts still show share capital of pounds 1m and reserves of pounds 9m.

This is a simplification, but suppose the company's shares are now priced pounds 10 (the shareholders' funds are pounds 1m + pounds 9m = pounds 10m; pounds l0m divided by pounds 1m = pounds 10 per share).

Let us suppose the directors announce a scrip issue and every shareholder will receive one extra share for every one they own. In City parlance this is called a 1-for-1 scrip issue. Each shareholder's holding in the firm will double. The company is still worth pounds 10m, but the number of shares has increased from one million to two million. Each share is now worth pounds 5 (pounds 10m divided by two million shares).

So why does a company have a scrip issue? The popular explanation is that the shares are considered "expensive". In other words, pounds 10 a share may be a barrier for new investors, whereas they will buy at pounds 5.

This defies logic, but, if you look at the price of shares quoted on the London Stock Exchange, you will notice that prices are generally under 1,000 pence.

As Stuart Valentine, Director of Proshare, the organisation to promote share ownership, says: "A scrip issue just proves the old adage that there's no such thing as a free lunch - or a free anything else for that matter."

So what does an investor have to do when a company announces a scrip issue? The answer is usually "nothing". Shareholders will receive notification of the scrip issue from the company. This includes a timetable for the procedure. One of the pertinent pieces of information will be the "records date".

All those on the shareholder's register at that time will be entitled to the scrip issue. Five to ten days afterwards, the shares will be quoted "ex scrip" on the market. This means the share price has been adjusted for the issue. The letters "xc", where "c" stands for "capitalisation", will appear after the price of the shares quoted in the press.

As soon as the new certificates are ready, they will be mailed to shareholders. Those wishing to sell their entire holding before their new certificate arrives may do so, for stockbrokers will be aware of the situation. However, it must be made clear when the sale instructions are given that you wish to sell "old" shares which are equivalent to a certain number of "new" shares.

When the new certificate arrives, it must be forwarded to the broker who dealt with the sale.

Your broker will always be pleased to answer any questions that you have and to give guidance

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

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