Denver and Rio Grande earns, say, 4.50 per cent on its entire capitalization; Central of New Jersey on its entire capitalization earns 16 per cent. Which earns the " ade quate return" and which has the fair capi talization ? Or is it perchance the fact that neither has either ? The futility of general statements and sur face comparisons becomes plain. We cannot determine the adequacy of a return without knowing whether or not the capitalization is fair. Even before that we must settle on some thing which we can accept on general princi ples as an adequate return on capital invested in an enterprise.
It is a truism of economics that any given income from capital represents two things: one, what is called true interest, or the return due to capital as such; the other, the premium for the assumption of the risk in employing the capital in any particular direction. In economic theory true interest is the reward for saving, the compensation'due to the sacri fice of immediate enjoyment. That part of actual interest which we call premium for the assumption of risk is paid as compensation for hazarding the savings in any special investment.
True interest represents that part of in come which the law of supply and demand in relation to capital governs, quite apart from the assumption of risk. If no risk entered into the employment of capital, or if the risks in all uses were exactly uniform, the return at any given moment on all employments of capital would be exactly the same. Such true interest would change from day to day, fluc tuating with the demand and supply. This phenomenon clearly appears in the daily prices paid for money borrowed in transactions in volving approximately similar risks, as call loans, sixty day prime paper, and so on. Quotations, that is, interest rates, vary from day to day, depending on the amount of money seeking employment of the particular kind, the demand for funds in the particular employment, and the changing nature of the risk due to general business conditions which constantly vary.
Besides the risk of the particular employ ment, a time speculation risk enters into any commitment of funds. This is only another form of stating that true interest varies from day to day. At the end of the term for which the funds are committed, will capital be more in demand or less than now ? Will general business conditions be better or worse? This time speculative risk accounts for the fact that the call money rates and the ninety-day rates on risks essentially similar, except for the time element, vary so widely. Though the longer the time the greater the commercial risk, the speculative time risk in the demand and supply of funds is so much more im portant that the influence of the commercial time risk can hardly be traced.
All this elaboration of statement simply at tempts to get at the elements we must con sider in finding the basis of true interest, plus the time speculative risk, to which we must add the premium for risk in the particular employment in order to arrive at our desired adequate return.
We cannot eliminate the time speculative risk. Because the element of time necessarily enters into every transaction, that specula tive risk necessarily inheres in every transac tion. Since a corporation employs its capital as a whole for all intents and purposes in per petuity, it seems that the particular time risk to consider should be that inherent in per petual securities like stocks. Risks of the special employment, however, enter into all such securities to so high a degree that it is impossible to see from them anywhere near true interest plus the time speculative risk.
Though really true interest would have to be on a loan without the time risk, that is, on a call loan, we will hereafter speak of true in terest as if it included the time speculative risk.
We might consider English consols. They offer a perpetual security with a minimum of special risk. They yield an income of, say, 3.20 per cent. Probably this is too low to take as a fair return on a perpetual commitment of capital without special risk, because particu lar privileges such as exemption from taxation, being a legal trustee investment, and so on, much more than offset whatever special risk may be considered as inherent in the security.
Giving up the idea of finding a perpetual commitment of capital with a relatively small special risk, let us consider some long-term securities. United States Government 3s of 1961, which lack the circulation privilege, yield a little less than 3 per cent. Again, how ever, privileges creating special demands for these bonds probably reduce the income from them below normal true interest. Loans like those of the cities of New York, Boston, Philadelphia, and Chicago yield, say, from 3.80 to 4.20 per cent. Such loans involve rela tively little special risk. Considering the special demands created by the fact of tax exemption, and being a legal savings-bank in vestment in those states which most closely restrict the investing of such institutions and at the same time have the most savings-bank funds to invest, it seems highly probable that the effect of such demands more than offsets the slight special risks in securities of this kind, and that they yield a return really less than the estimated true interest on such a long-time commitment. At best that must be only a guess. If a hazard were to be made as to what, at the present time, would be a fair true interest rate on a long-time commitment of capital, the surmise might place it as some where between 48 and 41 per cent. This offers a leeway of one half per cent. Such a possible variation, however, would make a consider able difference to an investor. It amounts to $500 a year on $100,000.