Another problem, which is of especial interest in illustrating some of the principles discussed, arose in connection with the proposition to finance the construction of a short railroad and the establishment of a steamship service in one of the southern states. The whole project involved an investment, including terminals, of about $4,183,000. The probable gross earnings after two years from date of opening the road to operation, were calculated at $2,018,000; operating expenses were estimated at 65%, say $1,300,000, and taxes and insurance at $80,000, making the total expense, $1,380,000, and leaving a net revenue of $626,125 from which to meet fixed charges and provide a surplus. It is estimated also, that there would be a deficit close to $100,000 during the first two years of operation. Equipment was expected to cost $1,650,000. The total capital required was as follows:

Cost of construction............

$4,183,000

Cost of equipment............

1,650,000

Loss in first two years of operation.............

100,000

Working capital.............

500,000

Total................

$6,433,000

A certain amount of capital required for the earlier stages of construction is necessarily tied up without any income to pay the interest on it, until the road is put in operation. To take care of this expense it would be well to form a construction company to build the road and furnish all other necessary property and cash. The construction company should be prepared to hand over to the railroad company $600,000, that sum being required to cover the loss of the first, two years of operation and to provide working capital. The construction company should also pay interest, taxes, insurance, etc., up to the time the property is handed over to the railroad company. In exchange for the railroad and the cash, the railroad company would then turn over all its securities to the construction company, which securities the construction company would sell and out of which it would derive its profit. The promoters of the railroad would naturally be the owners of the construction company.

On the basis of normal earnings of $626,125, the corporation might be capitalized as follows:

Nominal Value

Cash

Receipts to

Corporation

Fixed and Contingent Charges

5 1/2% first mortgage bonds on all property, exclusive of equipment, to be disposed of at 90 with a bonus of two shares of common stock to each $1,000 bond............

$4,000,000

$3,600,000

$220,000

6% one to ten-year serial equipment notes...............

1,500,000

1,500,000

90,000

Annual payment during first ten years of operation to retire above notes...........

150,000

7% cumulative stock to be disposed of at 90, with a bonus of common to each five shares of preferred.............

1,500,000

1,350,000

105,000

$7,000,000

$6,450,000

$565,000

This leaves a balance of $61,125 a year available for contingencies out of the income of the first ten years.

The common stock required for bonuses to purchasers of the first mortgage bonds and of the preferred stock, is $1,300,000. The promoters of the enterprise will want some pay for their services, and will probably want to retain control of the company. They should, therefore, issue approximately $4,000,000 of common stock to the construction company. Under the above estimates $2,700,000 will be left for themselves.

For the first ten years - unless the earnings should largely increase - the common stock could not expect to receive any dividends. It will be noticed that $150,000 worth of serial notes is to be retired each year, and that the interest on that amount each year should be added to the balance available for contingencies. At the end of ten years, not only will there be no interest to pay on the notes but the annual payments on the principal will cease. Thereafter $301,125 may be disbursed as dividends on the common stock. This means about 7 1/2 % earnings on the common stock.

It will be noted that in the above arrangement, first mortgage bonds are issued to an amount approximately equal to the actual cost of the property mortgaged. This may seem to be, and is in fact, somewhat reckless financing; yet it must be assumed that the project itself is worth something and that the rails, buildings, and real estate, which are the chief items in cost, are worth more after they are laid down and the railroad is ready for operation, than their actual cost. The preferred stock is more than equivalent to the remaining balance of all the tangible assets and is partly offset by good-will. The proposed common stock issue of $4,000,000 is offset wholly by good-will. The amount of each class of security that may safely be issued has been determined rather with reference to the earnings than with reference to the assets. It is assumed that there is little likelihood of failure to meet the fixed charges amounting to $460,000.