If the managers of the corporation want to trade on an equity as thin as that, or thinner, they can do so safely only by the creation of a preferred stock-issue. Then if earnings fall below the amount required to pay the pre ferred dividends, control vested in the com mon stock does not pass away from it. In actual practice it will become necessary to finance on preferred stock sooner than this. Generally speaking, bondholders want assur ance that earnings will not fall enough to endanger their interests, and such assurance involves an expectation that they will not fall anywhere near that point. On the other hand, the preferred shareholder wants an ex pectation that earnings will not fall far enough to endanger the payment of his stipulated dividends. This also works out substantially what the common shareholder desires. He wants to feel assured that earnings will not fall to a point to endanger his retaining the control he possesses; he wants the expecta tion, at any rate if the preferred dividend is cumulative, that earnings will be sufficient to pay them.
Here we can properly discuss the size of issues as affecting control. Speaking of con trol in the first chapter, we discussed it for the most part from the standpoint that, if a share of stock of one class possessed equal rights of voting with a share of stock of another class, the control vested in the two shares was the same. We called attention, however, to the fact that if the issues of the two classes were of different sizes, the result might be that the control vested in one class differed essentially in kind from the control vested in the other.
For illustration suppose a corporation capi talized at: $2,000,000 common stock; $1,000,000 5 per cent preferred stock; $1,000,000 5 per cent bonds.
Assume, further, that net earnings amount only to $100,000, or just enough to pay the interest and the preferred dividend. It would be greatly to the advantage of the common shareholders for the corporation not to de clare the preferred dividend, but to keep in vesting the surplus back in the property until such a time as the additional capital invest ment showed effect in earnings large enough to pay dividends on the common stock. Com mon shareholders have a majority of all shares, and directors elected by them in their interest might naturally enough adopt this course of conduct. If they should, it would be difficult to prove that they had not acted within their proper discretion.
Where the preferred shareholders are in the minority they should see to it that their stock is cumulative. If it is non-cumulative
in the case just given, they might lose heavily for the benefit of the common shareholders. Even if cumulative they lose through the de ferred benefit of the dividend, entailing a loss of interest or enjoyment of income during the period through which the dividends are de layed. The greater security through building up a protective margin of earnings in part offsets this.
Another less flagrant way in which the greater size of the common stock-issue in the assumed capitalization might work to the dis advantage of the preferred might arise out of a power in the common to create debt to the disadvantage of the preferred.
Capitalization assumed now stands: — $2,000,000 common; $1,000,000 preferred 5 per cent; $1,000,000 bonds 5 per cent.
If the company earns, say, 6 per cent on its total capitalization, the corporation can dis tribute net in this way: Interest, $50,000; Preferred dividend, 50,000; Common dividend, 140,000; or, stated in approximate percentages, the amount of net taken by Interest, is 20 per cent; Preferred dividend, is 20 per cent; Common dividend, is 60 per cent.
Restated in terms of percentages payable on the several classes of securities: Bonds yield 5 per cent; Preferred yields 5 per cent; Common yields 7 per cent.
Suppose now the common shareholders, seeing that the corporation earns on the total capital a greater percentage than it pays for borrowed money, decide to trade on a little thinner equity and vote to issue $2,000,000 more 5 per cent bonds. We will assume that the company can continue earning 6 per cent on the total capital invested in the business. Capitalization now stands: — $2,000,000 common; $1,000,000 preferred, 5 per cent; $3,000,000 bonds, 5 per cent.
Net earnings now amount to $360,000, dis tributed to Interest, $150,000; Preferred dividend, 50,000; Common dividend, 160,000; and the approximate percentage of net taken by Interest is 42 per cent; Preferred dividend is 14 per cent; Common dividend is 44 per cent.
Restated in terms of percentages payable on the several classes of securities Bonds yield 5 per cent; Preferred yields 5 per cent; Common yields 8 per cent.
Common shareholders have gained an addi tional 1 per cent return by reducing their equity.
How do the preferred stockholders come out in this transaction? Notice that the per centage earned, the margin of safety above the amount required for interest and pre ferred dividend, has fallen from 60 per cent to 42 per cent of net earnings.