One needs to remember, too, that a par value of capitalization greater than the value of assets may arise from other causes than stock-watering. Suppose a corporation with a capitalization of $1,000,000 has a plant that fairly cost $1,000,000 and is capable of earn ing the anticipated return on the investment.
Assume that on account of a high fire hazard and consequent very high premium charges the managers decided not to insure. If a fire now destroys one half the assets, the cor poration has outstanding a capitalization of $1,000,000 against assets of the cost of only $500,000.
Again disclaiming any intention of entering on a discussion of proper capitalization, we may still perhaps fairly raise one of the ele mentary questions to keep in mind as a back ground of our discussion. Take two corpora tions : — Corporation A Capitalization . . . . . $1,000,000 Actual cost of assets . . . 1,000,000 Net earnings . . . . . 50,000 Corporation B Capitalization . . . . $1,000,000 Actual cost of assets . . . 500,000 Net earnings . . . . . 50,000 Assuming that one corporation is as likely to continue its earnings at $50,000 as the other, and that the relative difference in earning power is not due to a difference in manage ment but to other conditions, obviously the assets of one are worth as much as the assets of the other.
Though some may incline to disbelieve the statement, there are, nevertheless, perfectly straightforward and proper reasons for water ing stock. Promoters and financiers resort to it under circumstances in which they could not possibly take advantage of the dollar mark to sell for more than real value or use the diluted capitalization as a cover to con ceal excessive rates. They cannot take advan tage of the dollar mark when they are dealing with too sophisticated people, and they can not use the diluted capitalization as a cover for excessive rates if the issuing corporation is engaged in manufacture and subject to active competition.
Watered stock can take a very useful and entirely proper part in corporation finance through affording a still further means than those dealt with in the earlier chapters of effecting divisions and recombinations of the incidents of ownership, — income, control, and risk. The commonest resort to stock watering is in so-called underwriting, or syn dicate, operations. They afford the easiest way to illustrate the situation.
Assume that the promoters and bankers are arranging the financial plan for a corporation to engage in a new enterprise which requires the expenditure of, say, $3,500,000. The bank
ers are ready to advance $3,000,000 secured by a mortgage, provided the promoters will put $500,000 in the enterprise. This equity of the promoters, however, is too thin for the bankers to be content with nothing but a fixed inter est return. On account of the thinness of the equity the bankers assume a considerable risk and want a compensating share of speculative profits.
We have already seen several ways in which they might procure this. They might make the bonds participating. The bankers are not, however, going into this enterprise as a per manent investment; they look forward event ually to selling their securities, making their profit on the transaction, and using their funds in a new enterprise. Though participating bonds would assure them a share in the specu lative profits, such bonds are a comparatively unfamiliar security and would sell at a dis advantage in the investment market. The bankers might take convertible bonds, which, as we have seen, would give them an oppor tunity to take advantage of the future pro sperity of the company. Neither of these forms gives the bankers any means of separating what we may call the speculation from the investment. The participating bond indis solubly combines the two, and the convertible bond will not yield any profit through in creased income from the speculation so long as the holder retains any advantage from the investment. In the case of the convertible bond the holder must give up entirely his in vestor's prior claim and come out wholly from the protection of the equity, or he must con tinue content with an income limited entirely to the investment basis. Neither the partici pating bond nor the convertible bond accom plishes what the bankers desire. They want eventually to separate the investment and the speculative parts of their bargain. They may sell the investment and retain the speculation, as part of their bankers' profits. Or they may sell both. In that event they would dispose of the investment to one set of people having the type of mind or requirements calling only for an investment, that is, a limited risk with an assured though limited income, and dispose of the speculation to another entirely different set of people who are willing to assume the greater risk for the chance of the greater pro fit. If in return for their funds they receive both stock and bonds they can do just this.