10 June 2013

Capital Structure Flaw of Corporations

Reliance Upon Perpetual Growth


The stock market provides an opportunity for investors of all sizes to participate in the ownership of corporations. The premise for purchasing the stock of a corporation is to obtain equity or owner rates of return on the investment plus the eventual return of the original investment. Question: when and how does a publicly traded corporation plan to repay the original investment?


Generally, a corporation identifies an investment opportunity and issues stock to fund the investment. The investment, such as machinery, has a useful life expectancy. The investor who purchases the stock expects to get a targeted return on the investment plus the recovery of the original investment.

As so far described, the issuance of stock has been tied to a specific investment. In practice, the issuance of stock is blended into the overall corporate ownership and is not tied to a specific investment. The stockholder participates in many investments by the corporation. Regardless, the funds received from stock issuance are used to make specific investments by the corporation.


The corporation uses the proceeds from stock issuance to make an investment, such as machinery, and someday that investment will eventually reach the end of its useful life. When that investment expires, the corporation should retire the originally issued stock. If not, the stock remains on the balance sheet expecting equity rates of returns to be serviced by an expired investment.

Corporations occasionally buy back its own stock, usually to be reissued at a later date, but rarely to "retire" the stock based on an expired investment. A corporation may issue stock to pay down existing debt; however, this is counter to conventional capital theory since equity money has higher ROR expectations than borrowed money. On the other hand, borrowed money has an enforced due date for repayment and equity money does not.

As more stock is issued for other investments, the cash flow to service the expected returns on recently issued stock must also service stock returns issued for past investments whose useful life has expired. This is equivalent to continually borrowing money to pay interest due. In bankruptcy proceedings, the stockholder is last in line to make a claim, and the well is usually dry by the time the stockholder steps up to the bucket.


Stock collapse is prevented by "perpetual growth." As long as the corporation can maintain compounding growth, the event where the returns on current investments can no longer service a disproportionately large equity base can be pushed into the future, but not indefinitely.


The issue is not whether "growth" is a flawed concept. Growth itself is a vague term that has a wide variety of meanings from individual to individual and is generally viewed as "a good thing"; however, the emphasis of compounding growth as an international economic policy measured by the Dow Jones Average or Gross National Product may not encompass all the desired attributes of growth.

An investor wants to recover his equity before investment failure; hence, the search for the greater fool, the greater fool being the investor who buys the stock of a corporation just as perpetual growth slows or ceases. The public stock market is the most opportune market to find the last buyers.

When a corporate stock declines, a diversified corporate portfolio can offset an investor's losses. When an industry declines, a diversified industry portfolio can offset an investor's losses. The diversified portfolio is insurance that the investor will only be fooled part of the time.


Ever-increasing growth, as measured by compounding interest investment concepts, is an inherent flaw embedded in the corporate and debt structure, driving growth to unhealthy extremes.

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