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.
The basic objection to the granting of subscription privileges is the same objection which applies to all special dividends or bonuses - they inevitably give a speculative character to stock which might otherwise tend to enter the class of investments or semi-investments. A stock receives a dividend, let us say, of 8% per annum, and this dividend has been continued over a series of years and is protected by an ample margin of earnings; naturally the shareholders may look forward with some confidence to the period when the dividends will be increased to a normal level of 10% or 12%, and in view of this expectation the stock will probably sell at a high figure. We will suppose, however, that the directors, in place of building up a surplus and getting ready for regular 10% dividends, decide to grant a special subscription privilege worth $5 to $10 per share, in this way increasing the amount of capital stock upon which dividends must be paid and making it impossible to expect more than the indefinite maintenance of 8%, dividends. What will be the result? The shareholder, to be sure, will have obtained his subscription privilege, which is desirable, but he will have lost perceptibly in the market value of his holdings and he will have lost the chance of a permanent increase in dividends within the near future.
On the other hand, let us suppose that the directors have raised their new capital by having the preferred stock underwritten at or about its market price. Assuming that this new capital could be used as advantageously as the old capital, they are in position to go ahead a little later with the expected increase in dividends.
From the standpoint of the permanent owner of the corporation's shares, there can probably be little question but that the steady and dependable dividend policy better serves his interests. It is only from the point of view of the speculative purchaser that the granting of special "rights" and bonuses with the resulting rapid fluctuations in stock market prices is desirable. Sometimes, it may regretfully be admitted, the directors of a corporation find it to their personal advantage to know in advance that the granting of a subscription privilege is anticipated. On the basis of private information, which is not available to all the other stockholders, they may buy or sell with the certainty of making individual profits.
From the standpoint of the community there is considerable sentiment against the granting of subscription privileges on the part of public service companies in so far as they constitute a method of stock-watering. In 1896 the Massachusetts legislature passed an act referring particularly to gas and electric light companies, which includes the following:
In case of an authorized increase of capital stock, the shares shall be offered proportionately to the share-holders at not less than the market value thereof at the time of increase. This value is to be determined by the Board.
In Great Britain electric light and tramway companies may offer new shares to shareholders at par, even though the market value may be much higher. The usual practice, however, is to offer the new shares at only a few points under the market value. But there are still many cases where the shareholders receive substantial bonuses in the shape of "rights".