This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
Before leaving this subject, it may be well to call attention to the two different classes of betterment expenses which are generally regarded as being properly financed in two different ways. One class consists of betterments which are certain to yield a definite, traceable return, either in the form of enlarged revenue or in the form of savings in outgo. When a railroad company, for example, decides to construct a tunnel and straighten out its line between two given points, it should be readily possible to calculate not only the cost of the betterment, but also almost the exact amount of savings that it will effect in fuel, labor and the like. When a manufacturer puts in a new piece of machinery in order to turn out a better grade product, he should usually be able to calculate how large will be the increase in the price and total sales of the new product.
The second class of betterments consists of those which are considered desirable and well worth the expense involved, but which will not yield direct and traceable profits. A department store, we will say, decides as a matter of business policy that it should build and furnish a handsome recreation and lunch room for its employees. The officers are satisfied that the result will be to increase loyalty, interest, and efficiency,, and thus indirectly build up the store's prestige and increase its sales. Nevertheless, it will be impossible to arrive at a mathematical calculation of these results. The directors of a bank decide that they will put up a fine new building which will constitute the best kind of a standing advertisement of the bank's stability. Much of the cost of the building, however, will not be represented by any adequate return on the invested capital, and must be regarded, therefore, as a betterment which does not yield traceable results.
By general consent among the officers and directors of great corporations, it is agreed that the first class of betterments may properly be financed by the issuance of fresh securities, if it can readily be shown that the interest or dividends on these securities will be provided out of the enlarged income or the savings made possible by the betterment. The second class of betterments, however, should be provided for out of surplus. They may prove to be highly profitable, but there is no certainty on that point. The only money that should be spent on them, therefore, should be money that has been accumulated out of the profits of the preceding years or that is currently accumulating. In case the judgment of the directors should be wrong, and the betterments should not make for enlarged profits, the corporation would at least escape a loss that would be damaging to its credit.
The Pennsylvania Railroad Company has, perhaps, been the most consistent follower of the principle that has just been presented. In financing $150,000,000 of improvements of the company in New York City terminals, including tunnels under the North and East rivers and the magnificent terminal building, approximately one-half the investment was provided by fresh issues of securities; the other half was provided by charges against the surplus of the Pennsylvania Railroad and allied companies.
Another clear-cut example is furnished in the announcement of the London and South American Railroad Company, which in October, 1914, brought out an issue of £1,000,000 5% redeemable preference stock. According to the London Statist, it was announced that the proceeds were to be used for electrifying certain sections of the suburban systems of the company:
The decision was come to that it would not be right for the whole cost of the work to be charged against capital; it was realized that to some extent the adoption of electric traction is in reality an alteration in the method of working; the one kind of traction merely being substituted by another: Therefore, it was decided that only the cost of the power-house, substations, and the third rail, should be charged against capital account, and that other items, such as alteration of the rolling stock and structures, the bonding of rails, and the various other expenses, should not be a permanent charge upon the revenue of the company.
Too many companies rush ahead blindly in making whatever betterments appeal strongly to the operating officials, without giving sufficient thought to the soundness of their methods of financing the betterments. One of two results is almost certain to follow; either the company provides the fresh capital required too largely by the issuance of securities which may in time become a dangerous burden; or the expenditures for the betterments are unjustly saddled upon the shoulders of those who happen to be shareholders at the time and who are deprived of a portion of the earnings to which they feel rightfully entitled. In this latter case, the policy may be followed either openly, by making direct charges against surplus, or secretly, by including expenditures that are really for betterments under operating expenses.
All these courses of action are objectionable. The real solution is to be found in the careful division of the betterments into the two classes that have been named and in the selection of corresponding methods of financing. In this case it will probably be comparatively easy to convince shareholders that they should be willing to sanction reasonable charges against surplus to pay for betterments of the second class, and it will not be be necessary to conceal these betterments in any form. In that case, assuming also that the gross earnings of the company are carefully and honestly stated, and that operating expenses include all the charges for depreciation and other reserves that should be made, the result will be to arrive at an accurate and just determination of net income.