RECAPITALIZATION By the term "recapitalization" we mean a substantial change in the financial plan of the corporation that does not result from in solvency. Quite the contrary situation is the most frequent cause of recapitalization. Those in control of the corporation bring about an increase in the outstanding securities to make their par present more nearly the actual capital value of the business. This situation frequently arises when an incorporated fam ily enterprise is being turned into one for general market purposes. Many enterprises have their origin, not in an original large promotion, but through the growth of some small business undertaken by an individual or a very small group of individuals. Very likely the business was not =incorporated at the beginning, but was started as entirely a matter of direct individual proprietorship or as a partnership affair. Some of the various reasons for incorporating finally led the pro prietors to take the step of incorporation. The business grew and the owners added to the capital account out of the earnings, so that the present value of the plant is far in excess of the capitalization. It may be that the business has passed through the hands of several generations in this way. Or it may be that the business met with rapid and large success. In recent years the automobile in dustry has presented examples of especially swift expansion, and the building-up of as sets out of earnings. Whatever the business, let us assume that for some reason a time has come when the owners are willing to part with their exclusive ownership and admit outside capitalists to an interest in the business. It may be that one of the present owners wishes to withdraw and the owners are not able or are not ready for any other reason to buy out his interest. Perhaps an owner has died and the beneficiaries of his estate want to liqui date his interest in the business. Very likely the present owners wish now to expand the business more rapidly than they can exclu sively out of earnings. For one of these rea sons, or for any other, they want access to the general market for capital, and are pre pared to part with some of their stock interest. Their present stock, however, is worth too high a premium to be disposed of advantage ously in the general market. So they must recapitalize.
Let us assume the case of a business which has taken advantage of the principle of trad ing on the equity and in times past has bor rowed some capital by issuing bonds, so that its capitalization now stands in this way: Stock $250,000 Bonds 1,000,000 Its earnings, however, show that the capi talization does not represent the actual val ues in the business. Let us say that the in
come account shows in a normal year: Net earnings $525,000 Interest 50,000 Available for dividends $475,000 A careful management would advise carry ing $50,000 of this to a reserve account, and leave for actual distribution $425,000. This approaches 200 per cent on the present capi talization, and would exceed 7 per cent on a capital stock of $6,000,000. Let us assume that an appraisal would show a valuation of assets of $7,000,000 so that the corpora tion, considering its $1,000,000 of bonds, may properly increase its capital stock outstanding by $5,750,000.
The owners decide to increase the capital stock authorized to $8,000,000 and declare a stock dividend of 230 per cent. Let us assume that the purpose of the stockholders in doing this was to permit such of them as chose to dispose of part or all of their ownership in the business, and that, as a matter of fact, the owners of a quarter interest wish to dispose of all their holdings, and enough others wish to realize some cash to dispose of one twelfth more of the ownership of the business. Since the stock is "full paid," they can dispose of it at any price they see fit.
If the recapitalizing were done with a view to providing cash for corporate purposes, the private owners would have agreed to con tribute such a pro rata of the stock dividend to that end. They may sell, let us say, $2, 000,000 of the stock at 90, and raise $1,800, 000 for the corporation. Putting through such a transaction by means of recapitaliz ing would depend upon unanimous consent, and would be practicable only in the case of corporations with a very small number of shareholders.
Sometimes the situation may be just the opposite of that we have described. Though a corporation may be solvent, it may have so large an amount of stock outstanding and its earnings be so small that there can be no hope of a policy of dividend declaration on the existing stock. This situation is more likely to exist with corporations which have large amounts of preferred stock, especially if it is cumulative and has arrears of divi dends. In such case the corporation can sim ply go through the legal procedure for re ducing capital stock.