CAPITALIZATION 1. Over-capitalization versus stock-watering. Having examined the nature of corporate capital and the instruments by which it is obtained, it is next in order to discuss limitations upon the use of these in struments. Our reader is referred again to a careful consideration of the definitions in Chapter II. Two basic definitions were given: capital, referring to the assets of the corporation; and capitalization, referring to its outstanding securities. The term capitaliza tion has two uses, one quantitative, relating to the total amount or par value of the securities; and the other qualitative, referring to the kind of securities issued. The latter, for purposes of distinction, has been referred to as the "plan of capitalization." The nine chapters just preceding have described the prin cipal securities, or elements, which enter into this plan, and the appropriate uses of each. It is the purpose of this chapter to discuss capitalization from the quan titative viewpoint.
Capitalization may be defined as the total par value of the outstanding capital stock and credit instru ments of the corporation. This is its commonly ac cepted meaning. With some few exceptions, the law permits corporations to borrow on the best terms available; in other words, to sell bonds or other credit instruments at any price obtainable. But stock is presumed to be sold only at par or above. The legal inference is, therefore, that the capital and the capi talization are originally equal, except for the discount lost or premium earned from the sale of bonds or notes.
The par value of the stock issued is presumed at law to equal the actual value of the assets obtained by its sale. If the par value is greater than the actual value of such property, the company is said to be over capitalized, and the stock is worth correspondingly less than par. If, however, the net assets of the cor poration exceed the par value of its outstanding stock, the company is said to be under-capitalized, and the shares are worth correspondingly more than par.
With a free and active market, not subject to man ipulation, the price of the security registers the value assigned to it by the investing public. While these
transactions are not exact indications of actual value, they are accurate enough to serve as a test of capital ization. As a general rule, it may be said that in a normal market a price averaging less than par over a period of time indicates over-capitalization, while a price above par indicates under-capitalization. The "flick" of securities sold chronically upon the ex chabges at prices far below par indicates the vast ex tent of over-capitalization in the United States.
Many futile discussions and erroneous conclusions have resulted from failure to distinguish clearly be tween over-capitalization and stock-watering. Stock watering is the process of intentionally issuing capital stock for overvalued assets. In other words, it is intentionally issuing stock of a par value greater than the actual value of the capital obtained for it. Stock watering is only one of the causes of over-capitaliza , tion. Over-capitalization and under-capitalization are in many instances inevitable conditions which can not be intelligently criticized as such. Stock-watering, however, as a method of over-capitalizing, is subject to serious criticism.
2. Causes of one or more of the following conditions may result in over-capital ization: 1. Stock-watering 2. Depreciation of capital assets 3. Losses from operation 4. Losses caused by disaster or an act of Provi dence.
At the outset, a new corporation cannot be over capitalized unless there has been stock-watering, or bonds have been sold at a discount. The discount on bonds may be considered an addition to the bond in terest, and as such it becomes an operating expense.
Insurance may be carried now against loss from al most any act of Providence, and this is the least fre quent cause of over-capitalization. The hundreds of millions of dollars' worth of corporate property de stroyed in the devastated war districts of Europe and by alien enemies in the United States just before its entry into the World War clearly illustrate the opera tion of this cause of over-capitalization, which cannot well be controlled by the management of the company.