Cash Dividend vs Bonus Units with a Liquidity Need
An investor owns 10,000 units of an open-end income fund. On the record date, the fund's NAV is PKR 105.00 per unit before any distribution. The fund announces a cash distribution of PKR 5.00 per unit. Investors may elect cash or bonus units, with bonus units issued at the ex-distribution NAV. The investor is retired and needs PKR 40,000 from the fund this quarter to meet expenses; the rest is long-term savings. The fund's ex-distribution NAV is expected to be PKR 100.00. Assume no tax and no other liabilities or accruals. The investor currently has no cash reserve outside the fund. The fund's offering document says distributions are paid within five business days after the record date, while redemption proceeds settle in two business days.
1. Calculate the investor's units, cash, and total value immediately after the distribution under (a) cash election and (b) bonus election. Show that the two are equal before spending.
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Cash election:
- Cash distribution = 10,000 x PKR 5.00 = PKR 50,000.
- Ex-distribution NAV = PKR 100.00.
- Remaining units = 10,000; unit value = 10,000 x 100 = PKR 1,000,000.
- Total = PKR 1,050,000.
Bonus election:
- Bonus units = 50,000 / 100 = 500 units.
- Total units = 10,500.
- Unit value = 10,500 x 100 = PKR 1,050,000.
- Cash = 0.
Both positions are equal before spending. The NAV falls from PKR 105 to PKR 100 because the distribution transfers value out of the fund; the distribution is not an extra return. The investor's economic wealth is unchanged at the moment of distribution.
2. Given the need for PKR 40,000 this quarter and no cash reserve, which election should the investor make? Explain the liquidity and behavioural trade-offs.
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Cash election is the cleaner choice. It delivers PKR 50,000 automatically, so the investor can meet the PKR 40,000 need and keep PKR 10,000 as a buffer without selling units. After spending, the investor has 10,000 units worth PKR 1,000,000 plus PKR 10,000 cash, or PKR 1,010,000.
Bonus election requires a sale: 40,000 / 100 = 400 units. The investor is left with 10,100 units worth PKR 1,010,000. That is economically the same as the cash election after spending, but it depends on executing a sale at the expected NAV, possibly paying an exit load or transaction cost, and possibly triggering a taxable capital gain. It also adds timing risk: the bonus units may not be available for sale immediately, and the NAV can move before settlement.
Because the investor has no outside cash reserve and a known quarterly expense, the cash election is more robust. The investor should still keep the extra PKR 10,000 as a reserve rather than reinvesting it automatically. If the investor did not need the cash, bonus units would be a simple way to compound, but that is not this case.
3. If the investor elects bonus units but then needs PKR 60,000 instead of PKR 40,000, what should they do and what risks should they consider?
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Under the bonus election the investor holds 10,500 units at PKR 100, worth PKR 1,050,000. To raise PKR 60,000, sell 600 units at PKR 100, leaving 9,900 units worth PKR 990,000. Under the cash election the investor would have PKR 50,000 cash and 10,000 units; to raise the extra PKR 10,000 they would sell 100 units, leaving 9,900 units and no cash, also PKR 990,000. The two routes are equivalent before costs.
Risks to check: any exit load if the sale falls within the fund's restricted period; the actual redemption NAV versus the assumed PKR 100; settlement time; capital gains tax; and the possibility that the investor is forced to sell after a market fall. The investor should also consider whether a systematic withdrawal plan or a money market reserve would reduce the need to sell units at short notice. The key lesson is that a bonus election does not create extra cash; it simply changes the form in which the distribution is held.