AMORTIZATION the chapter about "Trading on the Equity" we discussed considerations affect ing the desirability of corporate indebtedness. Stating the case briefly, the borrowers in a business by creating a debt take a greater risk on the capital they have:committed, and the lenders accept a lower return and less in fluence in the management for their capital in consideration of a smaller risk.
Let us repeat an elementary matter just for the sake of having the facts directly before us. Take, for example, a business that will aver age a return of, say, 8 per cent on all the cap ital invested in it. Then an investment of $1,000,000 will give an average annual return of $80,000. If by placing a mortgage on the property the managers of the business can borrow $500,000 at 6 per cent, they will, to be sure, have to pay $30,000 annually for this capital, but will have $50,000 left for income on their own $500,000 invested in the business. Borrowing increased their return from the 8 per cent they would have received without the hired capital to 10 per cent. They are running the risk that next year the business may earn only $50,000. In that event they will still have to part with $30,000 to the lenders and have only $20,000 for themselves. Out of a return on the total capital of 5 per cent they will receive only 4 per cent. If the business comes up to expectation, however, and earns an average of 8 per cent on all capital, the owners, who are the shareholders, gain largely. This expectation of greater gain furnishes the regular business reason for bor rowing.
Such a reason, however, is not temporary but permanent. If the transaction is based on a good business principle to-day, it continues good business to-morrow and always. Never theless, in spite of the permanence of such a reason, an individual conducting a business might wisely contemplate paying off his debts, because he is liable to accident and death at any time, and might not wish to have his es tate exposed to the greater hazard of trading on the equity. This consideration of prudence does not apply to a corporation, which is per petual in its nature.
Since to have a debt is good business, why should a corporation which has once created one ever amortize it? There are two rea sons. Amortization (1) permits a corporation to readjust its financial plan to changed or changing conditions, and (2) meets a require ment of those advancing the borrowed money, or procures the money on sufficiently more favorable terms to make the provision for retiring the debt good policy.
In the ordinary situation, if the corpora tion were the only party to the debt bargain it might not amortize the debt at all, or pro vide only for reducing instead of retiring it. From the single standpoint of a debt, as such, being good business, one without any matur ity would be ideal. Some English railroads do have perpetual debts, usually debentures of one form or another. American corpora tions have not commonly adopted such a form of indebtedness. There are a few in stances of it. For example, the Public Service Corporation of New Jersey, operating the traction lines in that populous section ad jacent to New York City, has outstanding about $20,000,000 perpetual interest-bearing certificates. Perpetual indebtedness does not, however, for the present at any rate, accord with the American custom. As a business expedient it is of doubtful propriety. There are other considerations besides the merit of being in debt. American corporate creditors do not want to rely solely on the "market" for converting their asset into cash. They want an obligation to return the principal at a time certain, which they can wait for if they wish. Of course, this is notably true of that vast majority of smaller corporations whose securities never have an active market any way.
From the standpoint of the debtor party a perpetual debt does not afford the corpora tion the desirable periodic opportunity for readjusting financial arrangements in accord with changed conditions in the particular enterprise or the general business situation.