Changes in Capital Structure

The preference for an all-common stock capitalization could in many cases prove disadvantageous for the owners of the business.

Not only might it prevent them from "maximising their gains", but more seriously, it might prevent them from earning enough on their capital to support or carry the investment.

We think there is an unanswerable argument in favour of a moderate amount of senior securities (bonds and preferred shares) if:

• (1) such senior securities might be conservatively created and bought for investment under established standards of safety; and
• (2) the use of senior capital is necessary to provide a satisfactory return on the common equity.

A company with only common stock outstanding may change toward the optimal structure by any of several means:

• 1. It may issue senior securities (bonds and preferred shares) pursuant to an expansion move, perhaps involving the acquisition of another business. (Example: Beaunit Mills Corporation changed from an all-common structure in March 1948 to a predominantly senior-security structure in March 1949.)
• 2. It can recapitalize, and issue new preferred stock and common stock - or even new bonds and common stock - in place of the old common. (Example: Ward Baking Company did this, via a new holding-company setup in 1924.)
• 3. It can declare a stock dividend, payable in new preferred shares. (Example: Electric Boat issued such a stock dividend in 1946.)
• 4. It can sell senior securities (bonds and preferred shares) and distribute all or part of the money to the common stockholders. (Example: In effect this was done in the recapitalization of Maytag Company in 1928.)

When a move of the fourth kind is made, it is almost always tied in with a merger or other corporate development - presumably because financial opinion is prejudiced against the sale of senior securities for cash to be distributed to common shareholders, regardless of the logic in the individual case.

Experience amply shows that once management is persuaded that the capital structure should be changed, to create a better earning power per dollar of common investment, it can readily find suitable means of accomplishing this end.

While this is a matter that may be of considerable importance to the stockholders of many companies, we do not think that they are likely to formulate and express independent views thereon until they have made considerable progress in self-education on other points affecting their interest.

Attention to this matter will repay careful thought by security analysts, managements, and enterprising stockholders.



Ref: Security Analysis by Graham and Dodd