To illustrate the situation, suppose the corporation wishes to sell $3,000,000 of stock. Assume that the stock is of the "au thorized and unissued" class which the cor poration must offer to its stockholders at par. Let us assume that the essential facts for the purpose of our discussion are these: The corporation has assets which on an ap praisal would be given a reproduction value of $12,000,000. It has net earnings of 10 per cent on this value. Since a bond issue would only confuse the discussion, we will assume that the corporation has no bonds, but has a stock issue of only $9,000,000 of common stock outstanding of a total of $12, 000,000 authorized. We will assume further that the directors estimate that the corpora tion can earn 10 per cent on a further in vestment of $3,000,000, and that they con sider the investment desirable for the better protection of the capital already committed to the enterprise. Stating these facts in tabular form in order to have them more clearly before us: — Let us assume that the stock is selling at 133, or approximately a value of $10 for each one per cent of earnings.
Now let us assume that the corporation arranges to sell $3,000,000 of stock at par, that the proceeds will be advantageously expended on the capital account of the cor poration, and that the corporation will be able to increase its net earnings by the amount of 10 per cent on the new assets. The statement will then change to this form: Obviously, under these circumstances the stock of the corporation, after the issuance of the new stock, will not be worth quite so much as before. Though in the case we have assumed, the issuance of the new stock will not make a great difference, it will, never theless, make a measurable change. If the estimates prove correct, net earnings on outstanding stock will decline five sixths of one per cent. We have placed a theoretical value on the stock for purposes of our dis cussion of $10 for each one per cent of net earnings on the stock. On that basis the stock, after the new stock is issued, should be worth approximately $8.33 less a share than it is worth now.
Clearly this result must follow any issu ance of new stock sold at par whenever the corporation has a real surplus, unless the corporation can increase its rate of earnings by reason of the new capital. It may be that the new capital will enable the making of improvements that will increase the per cent of net income the corporation can earn on capital invested in the enterprise. If it is anticipated that such a result will follow, of course the value of the stock will not decline with the new issuance. Unless the rate of earnings will increase, any issuance at par of new stock of a corporation with an actual surplus must mean a reduction of the amount of surplus to each share of stock outstand ing, or of the total assets for each share with which the corporation can earn an income return for that share. In the case we have
just assumed, the capital and surplus for each share, as measured by the appraisal of the assets on a reproduction basis, amounted to $1333 per share, and, after the issuance of the new stock, capital and sur plus for each share amount to $125. It hap pens that in the problem we have taken, the ratio of assets and the ratio of earnings remains the same. This would pot always be the case. Regularly the market price of the stock would be based on net earnings rather than on assets, and assets taken into consideration primarily as indicating some thing of the probable continuance of earn ings. Though all our discussion about the effect of the new issue, so far as determining exact prices of the stock is concerned, is highly theoretical, probably actual results under similar conditions would approximate our entirely theoretical results.
Under such circumstances as we have dis cussed the corporation can readily obtain new capital on an appeal to its own stock holders. The corporation can finance itself. Acting in accordance with the principles we developed in our discussion of "Trading on the Equity," it may prefer to borrow the new capital it desires. In that event it will ar range for an issue of bonds instead of plan ning to issue more stock. Such circumstances as we have described, however, of a sub stantial surplus, and an income which tends to show that the surplus is not just a matter of bookkeeping, but causes the stock to sell at a considerable premium, do not compel the corporation to resort to borrowing be cause it cannot legally obtain capital in creases in any other way. Let us consider how an appeal to the stockholders for new capital could be made, and the way it would work out.
Assume that our corporation has an nounced its intention of raising new capital by offering to its stockholders at par $3,000,000 of its authorized and unissued stock. Note that the present issued capital stock amounts to $9,000,000. An increase of $3,000,000, under the legal principles we have stated, whereby a stockholder has .a right to sub scribe to new stock in proportion to his present holdings, would give the holder of three shares of the old stock a right to sub scribe to one share of the new. Or, a holder of one share of the old has a right to one third of a share of the new. Though the holder of a single share of the old stock cannot get an actual fraction of a share of stock, the right to a third of a share cannot be taken away from him. This reads like a paradox. We mean that the holder of a single share has the right either to sell his right to subscribe for the new stock, or to purchase the rights of the holders of two other shares, and in this way complete his power to demand a share of the new stock. This is what is meant by a "right" when the term is used in speaking of the offering of new stock to the existing body of stockholders.