Suppose now that a period of business de pression sets in and causes a decline of 10 per cent in gross earnings. Assume, too, that the management cannot keep maintenance up and at the same time effect a reduction in the cost of operating. This might very well be essentially the case. Since we will make the same assumption in the set of figures we will adopt for comparison to bring out the situa tion, it does not, anyway, affect the sound ness of our argument. On this decline of 10 per cent in gross we have, therefore, this showing for the consolidated income account of the subsidiaries: Income account after gross has declined ten per cent Gross income . $450,000 Operating expense. 250,000 Net income 200,000 Interest.... 150,000 Surplus available for dividends 50,000 Owing to the inflexible nature of the interest charge a decline of 10 per cent in gross earn ings has cut the surplus available for divi dends in two. Then with respect to the hold ing company we have this showing: Net earnings of Holding Company D . . . $50,000 Interest charge of Company D 50,000 A decline of 10 per cent in the gross earn ings of the subsidiaries has entirely wiped out the margin of safety for the bonds of the hold ing company, which, before the period of business depression, had earnings available for interest of twice the amount required.
Compare this situation with what the situa tion would be if D were an operating company able to show net earnings of twice the interest charge, with all the conditions of operating the same as for the subsidiary operating com panies just set forth. We will assume then that an operating company shows net earnings of $100,000. Working under the same condi tions with an operating ratio of 50 per cent, the cost of operating then would be $100,000, and we have as an income account for our Corporation D as an operating company: Income account of Corporation D as an operating company Gross earnings $200,000 Operating expense 100,000 Net earnings . 100,000 Interest . 50,000 That is, we have just the same relationship between net earnings and interest charge as before when our Corporation D was a holding company. Earnings available for interest are twice the amount required for that purpose. Now, let us again assume a decline of 10 per cent in gross earnings during a period of business depression, and we find our income account of corporation D as an operating company makes the following showing: - Income account of Corporation D as an operating company after gross has declined ten per cent Gross earnings $180,000 Operating expense 100,000 Net earnings 80,000 Interest charge 50,000 When D was a holding company we found that, under the conditions stated as to the subsidiaries, a decline of 10 per cent in gross earnings of the subsidiaries reduced the earn ings of D available for interest from twice the amount required right down to an amount leaving not a dollar in excess of the interest charge. With D as an operating company making earnings available for interest of twice the amount required, then suffering a decline of 10 per cent in gross, we have a margin of safety of earnings available for in terest of 60 per cent in excess of the amount required. We have kept the same conditions in the cases compared. In both cases we assumed that the corporation would not be able to reduce operating at all on the decline of gross. The results would not have been different essentially if we had made some reduction in the operating cost in both cases. Our only reason for not doing so has been to keep the problem as simple as possible.
This discussion has traced through the ar gument to show the difference there may be between the earnings of a holding company and those of an operating company due to possible existing fixed charges of the subsidi aries in the case of the holding company. We
will go on with the discussion to show the possibility, unless guarded against, of in creasing the fixed charges of the subsidiaries, and the effect of such an increase on the safety of the bonds of the holding company.
Let us assume an existing situation of the holding company as before: Capitalization holding Corporation D Bonds 5 per cent $1,000,000 Stock 1,000,000 Debt of subsidiaries Corporation A has ....$1,000,000 5 per cent bonds Corporation B has.... 1,000,000 5 per cent bonds Corporation C has.... 1,000,000 5 per cent bonds For the purposes of this discussion we must make an assumption as to the actual total investment in the enterprise as a whole car ried on by these three operating companies and the holding company. Let us assume, then, that the enterprise represents a total capital investment of $4,000,000. If dis tributed equally among the operating com panies this would give an equity in each of $333,333.33 above the par of the bond issue. Then assuming a gross income of the sub sidiaries of $500,000, and the same operating conditions as before, we have: — Consolidated income of subsidiaries Gross earnings $500,000 Operating expenses 250,000 Net earnings. e50,000 With net earnings, then, of $250,000 on a commitment of $4,000,000 of capital to the en terprise, it appears that the business earns 6.25 per cent on the actual investment. Now, let us assume that for some reason the management of the enterprise wishes to ex tend the plant, and has Corporations A and B each issue an additional $1,000,000 of bonds, which are disposed of at 80, and use the pro ceeds in plant extension. This makes an additional investment in plant of $1,600,000. We will assume that the business earns the same rate of return on this additional invest ment as on the capital originally committed, or 6.25 per cent. Then net increases by just $100,000. Let the operating ratio remain at 50 per cent. Since net was $250,000 before, it is now $350,000. With an operating ratio of 50 per cent, the operating expenses will, of course, be $350,000, and the gross $700,000. Stating this in tabulated form and we have: New income account Gross earnings . $700,000 Operating expense . 350,000 Net earnings 350,000 Interest charge (increased on account of the $2,000,000 new bonds) . 250,000 Surplus available for dividends 100,000 On the showing we have made we have in creased the debt of the subsidiaries, but have not caused any increase in the earnings of the holding company. Now, assume that gross earnings decline 10 per cent and we have this showing (assume that the operating cost is not reduced) : New income account on decline of ten per cent in gross Gross earnings $630,000 Operating expense.. 350,000 Net earnings 280,000 Interest . 250,000 Surplus available for dividends 30,000 That is, we have available for dividends on the consolidated earnings of the subsidiaries, or as the net income of our holding company, the sum of $30,000. But the holding company has an interest charge of $50,000. Before the increase in the debt of the subsidiaries a decline of 10 per cent in gross reduced the earnings of the holding company available for interest from twice the amount required for that purpose down to an amount which left no surplus. Since the increase in the debt a corresponding reduction in gross of the sub sidiaries would reduce the earnings of the holding company available for interest down to only 60 per cent of the sum required.