talization of $1,000,000 but an actual capital of only $800,000. (3) In the statutory sense, when referring to the provision for a certain amount of capitalization in the articles of association, it means the amount of stock authorized to be issued, all of which amount may or may not be subscribed. Bonds are not mentioned in articles of association, except when the amount of bonded indebtedness is limited by statute. (4) Or capitalization is all the actual property of the corporation. This is the definition used in tax statutes. (5) In yet another sense it is the par value of all the stocks and bonds issued, which is the amount of accountability acknowledged by a corporation. This is the definition generally accepted in financial practice. (6) In a legal sense, however, the bonds are not included in the capitalization, but are regarded in their true light of debt owing by the corporation. Capitalization, in the customary judicial interpretation, represents the joint and several interests of the stockholders in the corporation, and so far it is synonymous with capital stock, and is, when the corporation is new and without losses or profits, the amount paid in, or subscribed to be paid in, by the subscribers to stock, either to forward the corporate business or to satisfy creditors of the corporation. When the corporation has been doing business for some time, the term is sometimes modified to mean the sums paid in, or to be paid in by subscribers, with the addition of all profits and gains and the subtraction of all losses and depreciations. Then the term is synonymous with "capital." In discussing corporate finance, the word will be used in the fifth sense, while in referring to the statutory provision of capital stock in the articles of association, the word will be used in the third sense.

§ 27. Determining the Amount of Capitalization.

The amount of capitalization of a corporation is one of the chief things to be determined precedent to filing a charter. When a professional promoter organizes a corporation, he has his plans so carefully made that he knows exactly what the capitalization should be. Unprofessional organizers should know as much and

should have their knowledge based on reliable figures. It is necessary to the later financial stability of the corporation.

In the first place, unless the stock and bonds of a corporation are sold at a premium, the par value of all the securities represented in the total capitalization must equal the amount of money required to be invested in the real estate and plant of the corporation, and part, if not all, of the running capital. Usually part of the running capital is borrowed from a bank, unless bonds. can be sold which bear a lower rate of interest than would be necessary to pay the bank. When it is possible to provide part of the running capital through the sale of commercial paper, as may usually be done, it will often be found profitable to do so. Thomas L. Greene says: "With few exceptions, where firms [or companies] have command of practically unlimited sums of their own, business success is possible only through the aid of the money lender. Let us suppose, for illustration, that a firm employs a capital of $1,000,000 in its business, one half of which it borrows from the banks on its commercial paper at six per cent. interest. We will suppose also that the firm 'turns its capital over' six times a year, which is only another way of saying that its volume of annual sales is six times the capital. Assuming that our firm is enabled to earn two per cent. net upon its sales, the resulting profits, $120,000, amount to twelve per cent. upon the capital employed. As under our assumption the firm is paying six per cent. on the amount borrowed, or $30,000 yearly, it follows that the actual earnings upon the firm's own capital are $90,000, or eighteen per cent., a handsome return made possibly only through the borrowing of money which can be used to extend the volume of trade and to earn something for the firm over and above the percentum of interest paid. The actual profits earned under this system vary in different trades, though usually the volume of business is in inverse proportion to the percentage of profit on the annual sales. Whatever sum we select or whatever earnings we assume, the principle underlying the illustration is the same. Of course a part of the capital of such firm or corporation in business must be invested MOD. BUS. CORP.-3

in credits granted to customers and in some form of merchandise in stock." The amount the company can borrow is the amount of its credit, based on the value of the company's property at forced sale, the value of the property in which the money borrowed is to be invested, and the business reputation of the proprietors and managers of the company. "To borrow one-half of one's necessary capital, in money or goods, is common," says Mr. Greene. The amount of credit a company deserves is the problem of commercial banking. Corporations just starting in business cannot usually command as large credit as old established businesses. The most conservative banks give preference in discounts to paper based on actual commercial transactions, over that secured by stationary capital. The most important function of a commercial bank is, by the use of the capital it controls, "to bridge over the periods of credit which necessarily intervene between production and consumption, in such a manner as to give back to each producer, or middleman, as quickly as possible, the capital invested by him in such products in order that he may use it over again in new production and new purchases." From these suggestions one may guess approximately the amount of money a company should be able to borrow on commercial paper, taking into consideration local financial conditions. The commercial paper of established concerns is frequently floated over the country among banks through the agency of brokers in commercial paper.

The proper amount of capitalization, in the sense in which it includes bonds, is determined with reference to the net earning capacity of the future corporation. The average per cent. of net earnings of a period of years, calculated from the experience of other companies in the same line of business, but with reference to its own output, may be taken as a basis, thus allowing for years of low prices or slack demand; or a more conservative estimate of earnings may be made altogether on the basis of the off years in price or demand, thus putting the company in a position where it can meet its interest obligations without question. If the company to be organized has special advantages over others in the same line of manufacture, advantages which will

increase the average of its net earnings, these also should be taken into account at a conservative figure. Likewise, disadvantages, if there are any, should be estimated and deducted. After calculating the amount of net profit, provision should be made out of it for a reserve fund for the purpose of extending, repairing, and improving the equipment of the company, for investment in high class bonds which can be pledged as collateral for the raising of funds when money is scarce, or for use in forwarding the "integrating" process by buying into companies which produce materials to be used by this company, or in obtaining favorable connections for controlling trade by obtaining interests in other companies of the same kind. A careful business policy would require in a manufacturing concern a reserve of from forty to fifty per cent. of the net profits. An average annual reserve of at least fifty per cent. of the net profits for use in one or all these ways will put a company on a much safer competitive footing and thereby assure a much greater stability to the investment value of its stock. So, in figuring the capitalization, and particularly in connection with the interest on bonds and the dividends on cumulative preferred stock, not only the net profits should be considered, but also the policy with respect to reserves. The capitalization, therefore, should be placed at whatever figure the net profits, minus the reserve, will permit, figuring the amount of interest to be paid on bonds and the amount of dividends to be paid on preferred stock and estimating a fair dividend for the common stock. Then, as the earnings increase, the capitalization may be increased from time to time, or the bonded indebtedness may be increased. As to the amount of common stock, particular consideration should be taken of the fluctuations in profits of the business, so that the issue of common stock shall be conservative. It is better that large dividends shall be paid in prosperous years on a conservative common issue than that the company shall be so highly capitalized that in poor years the common shall receive little or no dividends. The end sought in capitalizing should be to make the market value of the stocks and bonds correspond as nearly as may be with their par value. The worth of the corporation,

measured by its earning capacity, should correspond to the combined par value of its stocks and bonds. This is the ideal and comparatively practicable condition.* Where this is not the case, a company is either over-capitalized or under-capitalized. Where

*There seems to be a tendency on the part of the public to limit the amount of capital of a corporation that is justly entitled to profits. Professor Emory Johnson, in American Railway Transportation, points out that the earning capacity of a corporation cannot equitably or logically be made the sole criterion of value. To determine how much capital is justly entitled to profits (a social question the genesis and development of which will not be here discussed), Professor Johnson says the cost of reproduction of the corporate property and the earning capacity must be considered together. "Definite rules for applying this method were worked out by a state tax commission in Michigan in 1900. In determining the value of the physical properties of the railroad-its roadbed, rolling stock, terminals, etc.-the cost of duplication was made the basis of valuation. The railroad company's franchise, the special concessions granted to it by public authority, and the special commercial opportunities upon which its business depended-that is to say, all the non-physical or immaterial elements of its propertywere valued in accordance with their earning capacity. To ascertain the value attributed to these non-physical properties a method suggested by Professor Henry C. Adams was followed. According to the method devised by Professor Adams, the value of these immaterial properties was determined (1) by deducting aggregate expenses of operation from gross earnings and adding the income from corporate investments; (2) by deducting from the total income thus obtained an amount properly chargeable to capitalthat is, a certain per cent. on the appraised value of the physical properties-rents paid for the lease of property operated, and permanent improvements charged directly to income; (3) by capitalizing the remainder at a certain rate of interest. This method of valuation gives a basis for capitalization that seems to be equitable to all parties in interest-the public, the investor and the company." There are probably conservative corporations that will desire, in capitalizing, to take into consideration this tendency on the part of the public to hold corporations to more strict accountability for the value of property on the basis of earnings when considering the amount to be paid in taxes. Deducting the larger taxes would, of course, leave a smaller net profit from which to pay dividends and interest and would tend to reduce the capitalization.