CAPITALIZATION AND THE STATE state regulation of corporation finance may rest on one or more of three general purposes: 1. To protect creditors.
2. To protect prospective shareholders.
3. To protect the general public from hav ing to pay an excessive return on capital invested in the business.
Since the protection of creditors is purely a legal matter, it does not enter into the scope of our discussion here. In the chapter on "Watered Stock" we went into the question of protecting prospective purchasers of cor poration securities, and shall not take it up further. Our subject at this point is the pro tection of the general public from the ex action, in the form of rates or other pay ment for service, of an excessive return on capital.
So far the demand for state regulation of the financial arrangements of corporations in order to prevent a possible excessive charge has not been much made with reference to any but public utility corporations. Al though already a few people begin to advo cate a more general state supervision of charges, most of those who consider the ques tion so far are content to rely on competition to control the charges of manufacturing and commercial corporations. People rather com monly feel, however, that the state must care fully scrutinize the charges of corporations that are wholly or partly monopolistic, or of an inherently monopolistic nature.
Immediately the question arises, What is a fair or an unfair charge? The usual reply says that a charge which gives more than an ade quate return on a fair capitalization is not a fair charge. It goes on to explain that the state must not allow corporations to fix rates to earn a return that on its face appears no more than adequate, but is really exorbitant because based on an excessive capitalization.
Ordinarily the argument does not go much farther than this. It does not bring out any statement of what is either an adequate re turn or a fair capitalization. Yet it would seem necessary to determine each precisely before it were possible to discuss the fairness of a rate dependent on both.
What is an adequate return? If you want to buy into the railroad business to-day you can purchase Denver & Rio Grande Railroad preferred stock at a price to yield you, say, 7.09 per cent on your capital.' Or, if that in
vestment does not please your fancy, you can buy Central Railroad of New Jersey common stock at a price to return you an income of say, 2.85 per cent. Denver & Rio Grande preferred pays 5 per cent dividends, non cumulative, and the total earnings of the road available for dividends amount to 8.12 per cent on the stock. Central Railroad of New Jersey common pays 8 per cent dividends and the road earns 18.6 per cent on the stock. In the case of the Denver & Rio Grande the fact that you cannot get more than the present 5 per cent dividend, on account of the rate lim ited in the preference, and the apprehension that you may get less because the earnings are not so greatly in excess of the amount re quired for the preferred dividends, determine the price you pay for the stock, and conse quently the return on your capital. Central of New Jersey, on the other hand, offers you an 8 per cent dividend that you feel absolutely confident of, and the hope that you will get some of the 10 per cent it is earning on the stock beyond that. So you would have to pay, say, 280 for the Central of New Jersey stock, but could buy the Rio Grande pre ferred for, say, 70.
Suppose you try to escape the life of hopes and fears of stocks into the seeming compara tive Nirvana of bonds, and get the calming assurance that the railroad must pay the stip ulated income. You can take your choice be tween Pennsylvania Railroad consolidated 4s of 1943 at, say, 103.25, giving you a return of 3.80 per cent on your investment, or of Wabash first refunding and extension 4s of 1956 at, say, 63, giving you a return of about 6.50 per cent.
Obviously we cannot come to a decision about the fairness of a charge by considering simply one class of capitalization, or what the company may choose to pay immediately in dividends, but must consider total capitaliza tion and what the company earns available to pay returns on that capitalization. For the classification of the capital, its priorities, and so on, hardly concern the public in this mat ter. Let the corporation arrange its capitali zation as it sees fit, and trade on any equity it may care to.