Underwriters reason in much the same way. They are content with a smaller compensa tion for thus secondarily supplying the funds than the bankers required in case they had to find the funds directly. The bankers have al ready done the work of investigating the pro ject in order to draw a conclusion about its merits, and can pass on the results of this in vestigation with their expert opinion to the underwriters. The project could not go ahead without the support of the bankers. They oc cupied a better strategic position in bargain ing, and made a corresponding exaction. They agreed to supply the whole of the re quired funds, in this case $3,000,000, whereas each of the underwriting capitalists agrees only to supply part, some, say, $25,000, and some, $50,000. No particular underwriter was necessary to the bankers. These reasons sufficiently explain why the bankers could make a better bargain with the underwriters than the promoters could make with the bankers. The underwriters want a cash com pensation, which, when secured, they can count as so much certain. They would not as sume so large a risk for a cash compensation of the size they are hoping for. Again the stock bonus serves to complete the pay.
Everyone taking this common stock, so far, knows perfectly well that it represents only a right to earnings made above a cer tain amount. If the earnings never exceed a certain amount, the stock will never be really worth anything. As the expectation grows better and better founded that the corpora tion will earn in excess of the sum required for prior charges, the common stock may com mand speculative prices based on the proba bility that the corporation will be making something available for dividends.
If the underwriting were without restric tion as to sale, were not, in fact, really an underwriting, but essentially a placing of the securities in the hands of capitalists, any one of the capitalists, without waiting for the cor poration to establish an earning power, might resell part, or all, of his participation. He might find someone ready to purchase the underlying security, the lien on the property with the promise of a definite income, but not ready to pay anything for the speculative chance. The capitalist might sell some of his bonds, without any stock, to this investor for 85. Remembering that the capitalist paid $900 for each $1000 bond and $500 par value of stock, we may infer that the investor valued the stock as worth not in excess of $10 a share, and the capitalist valued it as being worth at least that. Accepting this as a fair appraisal of the speculative value involved, we can estimate a cash equivalent of the bar gain the bankers made with the promoters.
For each $857.10 the bankers received a $1000 par value bond and $1000 in par value of stock. According to the estimate just made the money equivalent for this stock would be $10 for every $100 par value. So, if, instead of accepting part of their compensation in the speculative possibilities of the stock, the bankers had made a straight loan, taking a mortgage, or bonds issued under a mortgage, as security, they would have paid $757.10 for each $1000 5 per cent 25-year bond. In other words, they would have demanded interest at the rate of about 71 per cent to compensate them for the risk assumed.
To continue arranging a financial plan in accord with this idea, we will assume that the promoters take their compensation, for the $500,000 of funds they supply, in common stock at par. Holding strictly to the idea of an absolutely "dry" capitalization, we will not allow the bankers to take bonds at a dis count, but for the $3,000,000 of funds they advance to get only $3,000,000 par value of bonds. These bonds will have to bear about 71 per cent interest to meet the bankers' esti mate of the worth of capital and compensa tion for the risk involved. The corporation would then be capitalized at: $3,000,000 71 per cent bonds; 500,000 common stock.
When the corporation now makes 10 per cent on the funds supplied, the 21 per cent advan tage over the 71 per cent paid for the bor rowed money, which the promoters have gained by trading on the equity, will make earnings available for dividends on their stock amount to 20i per cent, and if earnings rise to 15 per cent on the funds supplied, they will be 60 per cent, whereas under the "watered stock" scheme of financing the promoters would have available for their securities ap proximately 18 per cent and per cent, re spectively, in the two cases.
Looked at from the standpoint of probable permanence of organization, which makes the better plan? Under the "watered-stock" plan the corporation would continue without fore closure or receivership so long as it earned, net, $175,000. It will have to earn over 22 per cent more, under the " dry " plan, or $225,000, net, to keep out of reorganization.
When earnings of the corporation reach a point where the public will purchase its bonds and stock for income, they will sell at a rela tive disadvantage compared with lower yield securities. Investors dislike to purchase bonds at a high premium because, to keep their prin cipal unimpaired, they must set up an amorti zation fund to provide for the premium. Even stock above $100 a share sells at some disad vantage because the standard blocks of 10, 50, and 100 shares mount up to sums that tend to keep many people from buying.