In each supplemental appraisal the land values will be corrected to correspond to the changes in surrounding values, as the railway company is entitled to any increase, due to natural causes, based on the cost to reproduce at the time of appraisal. This is a well-established theory, as shown by Mr. Riggs.
No allowance was made for the item commonly known as "adaptation and solidification," except in the item of contingencies and in the consideration of the present value of the ballast. In some recent appraisals, large sums, based on a percentage of the cost of grading, have been allowed for this item. While there is no question that large sums of money are expended in maintaining a safe track on a new bank, and that this expense gradually diminishes as the roadbed becomes solid, due to the pounding of the trains and the action of the elements, this expense is, and properly so, charged to maintenance, and is paid for out of the operating revenues. Now, in the trial of a rate case, exhibits showing the operating expenses, including maintenance charges, are introduced, and to include this same item in the appraisal of the physical property leads to a duplication, for if the passenger or shipper pays for this maintenance charge, it should not be counted as an item of physical value as a basis for determining what is a reasonable rate.
The case is similar to that of a locomotive: When new, it is kept in the vicinity of the shops, because trouble from lack of proper adjustmentand weak parts is likely to develop, and the maintenance charges may be much higher than a few months later when the machine has "found itself" and, as an operating machine, is more efficient than when new. However, no one will insist that it has an added physical value in dollars and cents, or that the excess cost of repairs and maintenance during its early life should be added to its cost of reproduction now; in fact, it is a second-hand machine, and the maintenance charges must be paid for out of its use.
Generally, when a roadbed is turned over to the operating department by the construction department, it is in good line and surface, and if an appraisal were made at that time its condition would be 100%; but as soon as it is placed under traffic, it begins to depreciate, as shown by the fact that it requires constant attention to keep it up. If the roadbed is cross-sectioned at each station and actual quantities calculated from cross-section notes, there would be no depreciation, but if the grading quantities are calculated from profiles of the line, as constructed some time previously, and for a standard width of sub-grade, with a percentage added for shrinkage, and allowance made where banks have been widened, etc., it will probably be found to exceed the actual measured quantities, because the action of the elements in washing the slopes, the wearing of the shoulders of the embankment due to foot traffic, etc., will show some depreciation in quantities. It is common practice to carry the item for grading over to the present-value column at 100%, or, with no depreciation. This practice, together with the present condition of the ballast due to maintenance, and that part of contingencies which covers washing of slopes, filling of ditches, sink holes, etc., certainly takes care of all adaptation and solidification which should enter into a valuation of physical property.
No appraisal was made of the intangible assets. A great many arguments have been advanced for and against such an appraisal, and in South Dakota it was held that the earning ability of any corporation due to its franchise, strategic location, efficient organization, going-concern value, etc., while perhaps an element of value to be considered in a transfer of the property or if assessed on an income basis, should not enter into a valuation which would be used for determining a just and reasonable return on the investment, because the greater the earning power the greater would be the return, and that this condition would produce a never-ending increase in returns; whereas, when the returns reach a point at which they will not only pay a fair dividend on the investment, but take care of any depreciation in the physical condition of the property and make all needed improvements in roadbed, buildings, and equipment, demanded by the traveling public, shippers, increased traffic, or natural causes, they should be kept to that point. There are several hundred miles of railway in South Dakota which have been built out of the surplusearnings of the parent corporation—in other words, with money supplied by the traveling and shipping public—but which are owned by the railways and on which they may earn another surplus for constructing more extensions, etc., etc.
The original South Dakota appraisal, as of June 30th, 1908, on forms similar to those used in Minnesota, has been supplemented by yearly appraisals corrected for all additions and deductions made during the fiscal year. For this purpose a new set of forms[29]was prepared, with the various items classed in accordance with the "Classification of Expenditures for Road and Equipment," as prescribed by the Interstate Commerce Commission, and arranged so as to facilitate showing the yearly changes.
R. A. Thompson, Assoc. M. Am. Soc. C. E.[30](by letter).—This paper is considered by the writer to be the most complete treatise ever written on the valuation of public service corporation property, and the author deserves the sincere thanks of the entire Engineering Profession and all others interested in this most important question. Its presentation is most timely, in view of the agitation, particularly on the subject of railroad valuation, which is now engaging the attention of Congress and the law-making bodies of the several States, as it contains much valuable information relative to decisions of Courts, in addition to clear and concise expositions of the methods in vogue for the appraisement of corporate property, etc.
It is a fact—rapidly coming to be recognized by legislative and judicial bodies—that the prescription and regulation of tolls, charges, and assessments against public corporations cannot be made systematic and intelligent unless there is provided some estimate of the value of the property involved, based on the cost of its replacement or reproduction. Particularly is this true of railroads; and such regulation of the affairs of these corporations as has heretofore been essayed by State and National commissions, has generally been on illogical bases, unsatisfactory alike to the proponents and the companies. Results have been had, it is true, after a fashion, but there have been endless disputes and litigation, with the prime questions involved no nearer solution than before. One has but to contemplate the varied and often antagonistic legislation promulgated by the several States, relating to corporation management, and the many rulings and decisions of the different courts and commissions on the subject of regulation, assessment, and adjudication of corporate rates, revenues, taxes, and tolls, to become convinced of the complicated and tangled condition of the situation, and to realize the necessity for the early establishment of some logical basis on which to establish the fabric of corporate control.
While it is not maintained that an appraisement of the physical property of public service corporations will be the panacea for all such ills, the writer firmly believes with the author that such appraisal, as a beginning, is absolutely necessary, and when effected on some fair and reasonable basis, will contribute largely to the successful solution of many of these intricate problems.
With the estimate of the physical value of a property before it—which represents money actually invested, together with such accruals to costs as it may be determined that the owner is reasonably entitled to have considered—any Court, tribunal, or commission is in a better position to mete out impartial justice, whether it be the regulation of a rate, the assessment of a tax, or the imposition of a fine.
Although the author's experience in valuing corporate property has been principally in connection with the Michigan appraisal of railroads, and to him is largely due the credit for devising methods for, and carrying forward to successful completion, this thorough and most excellent work, it is refreshing to note his inclination to give credit to the work of others along the same line in other States, which, it is to be regretted, has not always been the case with writers on this subject. There is no doubt that the work of the Michigan and Wisconsin Boards of Appraisal—conducted under the advice and direction of some of the most eminent and talented engineers and economists in the United States, and practically without regard to expense—is the most complete and perfect of its kind heretofore attempted; yet there are many features in regard to the organization and execution of its details about which there may be an honest difference of opinion, as viewed by those who have been similarly employed.
It is but natural—as suggested by the author—to find the "individual" character of the appraiser (which has been moulded by his environment, training, and former service) reflected in his opinion, and this would be most probable in the organization for, and carrying on the work of, appraising a railroad property, which involves consideration of practically every phase of engineering and economics. The judgment of any man is essentially warped along the lines of his experience, and he is necessarily biased and prejudiced in favor of or against certain practice. As a consequence, therefore, it is not reasonable to suppose that any one man, or set of men, can formulate a system for valuing corporate property which will be perfect in all its details, and be free from objection and criticism.
The writer was employed for a number of years as Engineer for the Railroad Commission of Texas, and had charge of the valuation of railroad property under the Railroad Stock and Bond Law of that State. A paper on the methods used by this Commission was prepared by him and published by the Society.[31]This Stock and Bond Law wasenacted in 1893, and the railroads then existing were valued in 1894 and 1895. The average value of 8,860 miles was $15,844 per mile. This valuation was made by Charles Corner, M. Am. Soc. C. E., now Resident Engineer of the Rhodesia Railways, South Africa, and Mr. H. J. Simmons, now General Manager of the El Paso and Southwestern Railway System. The actual cost of this work is not available, but is estimated at about $2 per mile. The engineers making the appraisal secured maps, profiles, and all available information from the offices of the railroad companies, including all the construction records and estimates of quantities which were preserved. Appraisal was made only after one of the engineers had made a personal examination on the ground, accompanied by assistants to aid in measuring structures and estimating quantities.
All valuations made since 1895 have been of new railroads making application for issuance of securities, and in all cases the deeds for right of way and depot grounds, the contracts for construction, the actual quantities of construction of all kinds, the plans and specifications for all structures and construction, and all other information which the engineer desired, were submitted by the railroad companies to enable an accurate appraisal of the value of the property to be made. It is not possible for valuations of this character to be made under more favorable circumstances. Up to October, 1909, more than 3,500 additional miles had been valued, and in all cases the estimates limited the securities which the companies might issue.
Writers on railroad valuation have generally been inclined to discredit the work of the Texas Railroad Commission and the system of appraisal used by it. One writer, of more or less prominence, has referred to it as the "cheap" method. While it may be true that other appraisals have been more expensive, it is a fact that those of the Texas Commission have served their purpose well, and the railroads, as a rule, have made little complaint. As a matter of fact, it is highly probable that the valuations of railroad property made by the Texas Commission have been of greater utility, as far as the public is concerned, than those of all other States combined, and, at the same time, no injustice has been done the railroads.
It appears that those who have interested themselves in investigating the Texas method of railroad valuation—including the author—have failed to construe the real meaning and intention of the Stock and Bond Law. Apparently, it was passed for the purpose of limiting railroad indebtedness—and is referred to by Mr. Riggs as serving only this purpose—but while its effect has been to accomplish this most successfully, its enactment carried with it a deeper significance.
This law was passed at the same time as the General Railroad Commission Act of the State, which gave to this Board absolute control over all freight rates and tariffs, and also other powers not possessedat that time by any other State commission. The decisions of the highest Courts at that time laid stress on the right of carriers to maintain rates which would afford a reasonable return on stocks and bonds outstanding. Hence, to delegate the regulation of rates to any tribunal by any law which did not carry with it also the right to supervise and restrict mortgage indebtedness to some reasonable extent, appealed to the legislators as being essentially ineffective. The effect of the law has been to reduce steadily the average outstanding stocks and bonds of the railroad companies of the State from an average of $40,802 per mile in 1894 to $31,910 in 1909—and this, too, in the face of a recognized increase in the physical value of the properties—thus depriving the railroads of one of their most potent weapons of offense when contending against the Commission's orders. It is a matter of common knowledge that the indebtedness per mile of railroads of other States has increased greatly during this period. It is also a fact that the railroads of Texas have, except in rare instances, contended that injustice has been done them in the enforcement of this law, and the market value of their stocks and bonds has steadily risen. Also their physical condition is on a par with that of railroads in other Southern and Western States, and their incomes from operation are as substantial. The practice of "watering" their securities has been effectually stopped, as regards local issuance, and any interest which might have accrued on such securities has been saved to the public.
It has been contended that the Texas valuations of 1894-95 were too low, and did not, even at that time, represent the fair value of the properties. This is perhaps true to a certain extent, but it must be remembered that the costs of materials and construction then were less than at any time before or since; and, viewed from the present-day standpoint, they seem to have been inadequate. It must also be considered that real estate values throughout the entire State were very low, compared with present values and with those of lands in other States. Although the writer admits that the margin was very narrow, still he is of the opinion that the valuations as made represented closely the cost of reproduction of the physical properties at the time.
The valuations of 1894-95 stand to-day on the Commission's records as "the value of the property," except in cases where there has been application and necessity for re-valuation. The machinery of the law did not provide that these appraisals should be kept "up to date." The mortgages on these railroads are still outstanding, and there has been no call for another appraisal, except in a few instances. The Commission has decided that in its opinion the "present value" of any of the railroads already appraised is represented by the original valuation plus the value of all permanent improvements and betterments added. This principle has been carried out with those railroads whichhave applied for re-valuation for any purpose, and the Commission has admitted the same in testimony which it has given before the Courts.
Since the appraisals which the Texas Commission makes are primarily for the purpose of limiting indebtedness, and the carriers are entitled to have these at least equal the cost of their property—the investment with certain additions to cover promoters' profits—no consideration can be given to depreciation of structures and equipment, although the application for valuation and process of issuing of securities may be had several years after completion. The writer holds that there is strong argument in favor of not taking into account "depreciation," and of estimating the value of the property as being entirely "new," whatever purpose the valuation is proposed to serve. This is apparent, as already stated, when the valuation is to serve as a basis for limiting the issue of stock and bonds. Is there any logical reason why a valuation for this purpose should not also serve—as far as it pertains—as a basis for taxation or for regulating freight rates? As far as the State is concerned—and to be consistent—should not "one" valuation serve all purposes?
Suppose that a State should create a board clothed with powers of rate regulation, taxation, and authority to restrict indebtedness, and also prescribe that it should appraise the value of the property of the railroads, and use that appraisal as the basis for its acts. Would it be logical for that board to make and apply one system of valuation for one purpose and another system for another purpose? Manifestly, it would have declared that a valuation was a "valuation" for all purposes, at least as far as the physical property was concerned; and, when devising a method for making its appraisals, it should incorporate therein all the elements of value which might apply logically to either purpose. The writer believes that "depreciation" of roadbed and structures would have no place in such an appraisal, on the one hand, nor its negative, but fully as intangible and difficult of concrete estimate, "adaptation and solidification of roadbed," on the other.
It should not be understood that the writer maintains that taxation boards should not go beyond the valuation of physical property to arrive at a final basis for assessment. There are certain intangible elements which should be taken into consideration when taxing property, chief of which is the net income. It is only as far as physical valuations apply in either case that he considers that there should be uniformity.
He does not approve at all of incorporating in an estimate of the physical value of a railroad property such an element as "adaptation and solidification of roadbed," which is credited with so much importance in the Minnesota valuation. In the first place, such anelement is incapable of being measured in tangible terms and reduced to a dollars-and-cents basis; second, it cannot be reproduced in the sense that other property is reproduced, and its value does not appear in the capital account of the railroad; and third, it results from the action of the seasons on the one hand, and the working over of the roadbed by the maintenance forces on the other, the cost of which appears in operating expenses. One is constrained to believe that the engineer who insists on incorporating such an element in an appraisal of the physical value of a railroad is hard put to find material with which to swell his estimate. When noting the large difference in value per mile of the railroads of Minnesota, as compared with those of Michigan and Wisconsin—adjoining States—it would appear that undue prominence had been given to this and similar factors.
The writer's experience as appraising engineer for more than 10 years with the Texas Railroad Commission, and for the past 2 years as a construction engineer—having built about 160 miles of railroad in Oklahoma and Texas—confirms his belief that, in the absence of actual figures of cost, right of way and other railroad real estate should be appraised at but little in excess of the market value of abutting property. The practice of the Texas Commission has been to add from 25 to 50 per cent. The conditions under which railroads were built in Michigan, Wisconsin, Iowa, and Minnesota cannot have been radically different from those in the Southern and Western States. In Texas it has been a rare instance when a railroad has had to purchase all of its right of way. Also, contiguous lands have greatly increased in value since the advent of the railroads. It would appear highly illogical to advocate that these increased values should be multiplied by 3—or even 1½—and used as a basis for taxing the railroads on the one hand, or taxing the public on the other, by permitting indebtedness to be issued against it, the interest on which the latter must pay. The railroad recently constructed by the writer traversed fertile and thickly populated areas, already quite well served with transportation facilities. Only a small fraction of the necessary real estate was purchased by the railroad company, and only in a few cases of such purchase did it pay largely in excess of the market value of the land—and these were where the road interfered with houses and other farm improvements. In cities and towns, land was acquired at practically its fair market value. For rural property, the ratios used by Professor Taylor in the Wisconsin appraisal appear to be quite fair, but in cities they are too high—especially for the Southwest. The Minnesota ratios appear to be unreasonably high.
Any appraisal of the physical value of railroads—in the absence of figures as to their actual cost—is necessarily only approximate, and is correct only within certain limits. Especially with regard to the old roads, where original cost data cannot be had, the values appliedto property and construction must be largely speculative. It is impossible to build two railroads in the same territory, on the same specifications, for the same amount; yet, on the basis of cost of reproduction, an appraisal board must apply the same value to each.
The writer believes that unless there is more uniformity as to methods of valuing corporation property, as between the States, all valuations will be more or less discredited, as they should be, by the Courts. It is to be hoped that this paper will be generally discussed by the Profession, and will lead to the adoption of more uniform methods.
Charles H. Ledlie, M. Am. Soc. C. E.(by letter).—The following is suggested as a method of procedure for determining the fair and equitable value of a property:
1st.—Examine carefully the statutes governing corporations of the class under examination.
2d.—Form an opinion as to whether or not the locality can support such a property, by inquiry regarding the different businesses carried on, bank clearings, railroad facilities, what the surrounding country produces, etc.
3d.—Find from the archives of the company a general description of the property, from its conception to the date of appraisement.
4th.—By close examination of the minute books, directors and executive committees, there can be ascertained all the details of organization, issuing of stock, bonds, and other forms of indebtedness, contracts for equipment, supplies used in the construction, etc.
5th.—Obtain from the general manager or the superintendents an explanation of the details of operating and maintaining the property, including the different classes of service, rates, etc.
6th.—Go over the property, examine it carefully, and talk to any and all employees from whom it is thought that any information can be gained.
The foregoing will give a general knowledge of the property under examination, and will enable one to begin the real work. The examiner's assistants must be competent and experienced men.
7th.—Examine all the vouchers, from the beginning of the company down to the date it began operation; classify their contents under the respective heads for the different classes of material used in the construction, for example, pipe, engines, cable, etc.; then prepare blank tables for each heading, having columns for size, quantity, prices, and total; and abstract each voucher. Do the same with the vouchers for labor, general office salaries, general expenses, interest, taxes, legal, etc. This, when completed, will give the detailed cost, as shown by the vouchers.
Next check the vouchers back through the books, and draw up a statement, which will show the total book cost and, no doubt, willdiffer from the voucher total. It is likely that many items will be found for which no vouchers exist, a list of these is made and if the officers cannot give a satisfactory explanation of any of them they are omitted. The total of what remains is added to the voucher total and represents the cash expended for the benefit of the original property, as shown by the books and vouchers.
8th.—Take all the remaining vouchers of the company (it is supposed that the examiner has already been informed by the officers, and by his inspection of the records, of the extensions and betterments which have been made), separate the vouchers for materials, labor, etc., from those on operating, etc. Next classify them by years, and then proceed as set forth in 7th, and add the different yearly amounts to the total of the original plant. This will show the amount of cash expended (according to the vouchers and books) on the property, for its physical plant, organization, etc., from its beginning to the date of appraisement.
Every examining engineer should know (or can obtain) the prices for materials, labor, etc., during these periods of original construction, extension, etc. If the prices are the same, or about the same, as at the time of purchase, the above total stands as the cash expended; if there should be much difference—and sometimes there is—take the detail of the materials as found in the vouchers, affix the proper prices, and do the same with labor, etc., and this total will be what, in the judgment of the examining engineer, the plant should have cost. A mean between this latter total and that in 8th is taken, in order to be fair and equitable. This amount, in place of that given by 8th, is then used as the cash expended on the physical property. If no difference is found in prices, then the total cash as shown by 8th is considered as the total to be hereafter used.
9th.—A careful detailed inventory is now made of the physical property as it exists at the date of examination. This often requires some excavation in order to determine sizes, quantities, and conditions. The prices used to ascertain the total of the inventory are made by taking the average of all those paid for materials, labor, etc., of the same class, during each year of the property's existence. (The writer considers it manifestly unfair to use the current prices in this calculation, for they may be very much below or above those actually paid, and in either event an injustice would be done, whereas, if the average prices are used, the examiner cannot be accused of unfairness.) To this total cost, as shown by the inventory, 5% is added for engineering and superintendence; 3% for general office salaries, 2% for general expenses, 1½% for legal and organization expenses, and from 5 to 10% for contingencies. (This latter percentage depends on the judgment of the examiner, who, after studying the local conditions carefully, can determine from his own experience what difficultieshave been met in the construction. It is not believed that a hard-and-fast rule can, in equity, be laid down for this latter percentage.) This total represents the value of the tangible property, based on the inventory. The inventory cost and that set forth in 8th (or possibly as modified by prices current when the plant was built) are averaged, and this result, plus the supplies on hand, is the fair and equitable amount of cash which has been expended on the property. This is used in finding the "Fair and Equitable Value."
10th.—Next take the inventory of the plant set forth in 9th, affix the current prices at the date of appraisal, and to this total add the same percentages for engineering, etc., as set forth in 9th. This gives the cost of reproducing the property, with the same classes of materials, size and make of engines, etc., as is now in it, to which total add the cost of materials on hand for the total of cash required to be expended at current prices to reproduce the plant as it exists.
It is often found that this latter total is greater than that set forth in 8th, for the reason that the engines, etc., may be of types which are now abandoned or obsolete, and the manufacturing company, having to make patterns, etc., would charge more for them than the original price at the date of purchase.
This reproduction cost at current prices is only to give the examiner information he may or may not require later in the investigation to determine some point that might arise in ascertaining the "Fair and Equitable Value."
The writer considers it unfair to call the reproduction value the cost of a modern plant which will give the same service and output, because one is not dealing with the value of a modern plant, but with that of an existing property.
11th.—From this cost (using the detailed inventory to find the extent of property still in existence), calculate the amount of depreciation for each section of the plant, this being based on the present condition of the different parts and what their future life may be. The total depreciation is then deducted from the result found in 9th, and this remainder is used as the "Fair and Equitable Value" of the tangible property at the date of appraisal.
The intangible value (called by many names) must now be determined. It consists of rights, from the State, county, city, or any one or more combined, which the company must have in order to carry on its business. These rights in nearly all States are taxable, and taxes are collected on them. The Supreme Court of the United States has in the past held that they are property, notwithstanding what State "Courts and Commissions" have set forth on this subject, and in the writer's examinations they will be treated as property until the Supreme Court of the United States decides otherwise.
There are in general three classes of franchises, namely:
I.—Those granted by the State to conduct a business, where no county or city franchise is necessary, only requiring the company to obey the ordinances for excavation, etc. The charter of the Laclede Gas Company, of St. Louis, Mo., is an example of this class.
II.—Those granted by the State to carry on a business subject to a county or city franchise.
III.—Those granted by a city to an individual, singular or plural, or a company, to do business within its limits or a section thereof.
In each case the right may be a contract, for it may require a payment for the franchise granted, either in a lump sum or in yearly installments, or in the form of services rendered, such as for light, etc., free service of some kind, or a combination of any two or all of them.
The manner of determining the value of "Intangible Property" is as follows:
(a) The gross collected earnings are audited for each year during the period the company has carried on its business. The same is done for all vouchers,i. e., operating, maintenance, salaries, legal, general expenses, interest, insurance, and taxes, and includes every item disbursed. Whatever this latter amounts to, is deducted from each year's gross earnings as already found, and the result is the true net earnings or deficit for each year.
(b) The true net earnings are added together and the mean taken; if, in the period from the beginning to the date of appraisement, any deficits are found, these are deducted from the total of the plus-earnings, the result is divided by the total number of years, and this gives the true average net earnings. This is then capitalized at the legal rate of interest of the State in which the property is located. The result is used as the value of the "Intangible Property."
12th.—The amount given by 11th is added to the result obtained by 9th, and this total is the "Tangible and Intangible Value" of the property, and the "Fair and Equitable Value" of the property at date of appraisement.
If it is found that grave mistakes in design or judgment have been made by not employing competent people, and money has been wasted in construction, the plant is re-designed, for the original plant, and its cost estimated. The same is done for each extension, using the prices paid at the different periods, and this result is used in place of 9th, as the cash cost at the date of appraisement.
In determining the intangible value, if it is found that the management has been careless in order to make large net earnings, at the expense of the physical property, estimates are made of what theproperty can be operated and cared for (here the practical knowledge of operation, etc., is necessary), and these results, plus taxes, etc., are subtracted from each year's collected earnings. The mean or average of these results is considered as the true net earnings, which are capitalized and added as set forth in 12th.
The writer holds that consumers or purchasers should not pay for avoidable error or ignorance, and the amount of the securities issued on the property is not considered as entering into the matter of "Fair and Equitable Value"; when they do, the method is somewhat different.
The mean true net earnings are used in determining the intangible value, because franchises have average values, as earnings and expenses fluctuate in corporations, and, when intangible values are to be considered, they must not be based on the last year's net earnings, for if they are, they may give a very large result in one year and a small one in the next; therefore, to be fair, the mean true net earnings should be the basis of the intangible value. If the company has been over-capitalized, and no sinking fund or depreciation has been set aside, it is the present owner's misfortune. If the company calls something a betterment, and it is found that the betterment has only replaced something, it is not allowed, but is classed as maintenance; on the other hand, if the replacement is larger, and capable of rendering greater results, such as a larger engine, pipe, cable, etc., the cost, less the cost of what it replaces, is allowed as a betterment, and if the old part is sold the proceeds are deducted from the betterment charge, for if it is credited to maintenance, it increases the true net earnings. This is often done, but is not the correct way to treat the matter, for it increases the intangible value.
13th.—When new rates are to be established for a period of future years, the manner of determining the "Fair and Equitable Value" is the same as has been heretofore set forth. The new rates are based on averages, and the first step necessary is to ascertain what gross revenue the company must have in order to pay all classes of operating expenses, maintenance, depreciation, taxes, interest on the "Fair and Equitable Value" of the property, and a reasonable profit.
To obtain this amount, the procedure is as follows:
(a) Find the percentage of increase of the operating expenses for each year over the prior one, for a period of generally five years preceding the date of examination (a longer time may be taken if, in the opinion of the examiner, it is necessary), and then ascertain the average annual increase of the percentages. The result thus obtained is taken as the increase percentage for the operating expenses for the new period of time.
(b) In order to determine what the operating expenses will average during the time the new contract is to run, take the amount of thelast year's operating expenses as a basis and add to it the percentage found by (a). This total is the operating cost for the first year of the new contract. The amount for the second year is found by adding to the cost of the first year the percentage found by (a), and so on for each year of the new period. These results are added together and their average is then used as the mean cost of operation for each year during the full period.
(c) The same method is followed for maintenance and taxes, in order to find the average maintenance and taxes for the new contract's life.
(d) Depreciation on the plant begins from the date of appraisement, and is estimated on the physical property by using for each section the percentages used in determining the "Fair and Equitable Value."
(e) Interest at the rate of 6% is allowed on the "Fair and Equitable Value," and 6% profit.
The question of extensions and betterments to the original plant must now be taken into consideration.
(f) The amount of the betterments and extensions have already been found for each year of the property's existence, and an average of them is taken as the amount the company will spend on extensions, etc., during each year of the new contract. On this sum 6% interest and 6% profit is allowed, and, for depreciation, the same percentage as used in the original plant.
It will be seen that all the expenses of operation, etc., of these extensions have been allowed in (b), where the increase has been added for each year for these extensions and betterments, as they are assumed to increase the cost of operation, etc.
(g) The amounts found by (b), (c), (d), (e), and (f) are now added together, and to the sum 5% is added for interest, taxes, operation, etc., which may be caused by the necessary increase in capital expenditures, for a greater growth than could be foreseen at the time the new rates were established, for losses, etc. This total is used as the basis for establishing the new schedule of rates.
14th.—The next step is to determine what part of the amount found by (g) must be paid by the different classes of consumers.
(I) First ascertain the yearly percentage of increase in the output of the plant for the five years before the new contract is to go into effect (or longer if, in the opinion of the examiner, it is necessary); then find the average increase of percentage during the before-mentioned five years. Add to the last year's output the percentage found above, this result representing the output for the first year of the new contract. Continue this operation for each year in the same way as the operating expenses were found in 13th (b). Theaverage of these results will be the average estimated output during the life of the new contract.
(II) Next find the amount of the total output each class of consumers used during each of the five years, and then find the average yearly use during this period. Put these into percentages of the amount of the average output for the five years, and then use the percentages as the amount each class of consumer will use of the average output found in (I) during the period of the new contract.
This gives the average amount of the output each class of consumers will use during the average life of the new contract.
(III) Next find the average percentage of the total revenue each class of customers paid during the five years. Take these percentages as the average percentage each class will pay of the average revenue necessary during the time the new contract is to run.
(IV) Having found the average amount of the required revenue that each class must pay, and the average amount of the total output each class will use, dividing the former by the latter for each case will give the rate each class is to pay during the new period.
It is often found in plants that large extensions have been made to supply a special contract for a long period of time, and these extensions are set aside for the exclusive use of this contract. In such cases exclude the cost, etc., of this part of the plant from the "Fair and Equitable Value" in the matter of adjustment of rates.
In determining the operating expenses, etc., in such a case, find the percentage of the total output this special output amounts to; then, using this percentage, find what part of the total power-house expenses of all kinds are caused by this special contract. This result is deducted from the total power-house expense, and the remainder is the power-house cost of furnishing the consumers with their share of the total output. If it is found that special employees are required to deliver this special output, their cost is deducted, and the same for the maintenance material used. Taxes and interest on the cost of this special equipment are found by ascertaining the percentage this cost of the special equipment bears to the whole plant.
The above results are deducted from the total operating, maintenance, taxes, and interest disbursements, and "Fair and Equitable Value," and the remainders are used as the cost of the last year's expenses for furnishing the consumers with their share of the product and the "Fair and Equitable Value."
The same method is used in determining the revenue paid by the consumer.
The above result,i. e., cost of operating, etc., is then used as the basis for estimating the expenses for the period of the new contract, as heretofore set forth.
If the charter comes under Class II or III, the city no doubthas incorporated a clause for the adjustment of rates, and the method used above is followed.
15th.—Where the franchise has expired and is going to be renewed, the same method holds.
16th.—Where the franchise has expired and the city has paid a certain amount for service, and is to buy the property, the same method is used, except in determining the intangible value. For determining the latter, the amount the city pays for service is deducted from the gross collected revenue. From expenses is deducted the same percentage as the amount of the city's payment is of the gross revenue; a net revenue is found from this, the taxes paid are deducted, the remainder is capitalized as heretofore set forth, and is the intangible value. Whatever the latter amounts to is added to (or deducted from, in case of deficit) the "Fair and Equitable Physical Value," and the result is the price the city should pay.
Cities generally claim, and so do their "experts," that they should only pay junk value, or the cost of a modern plant to give the same results. This is eminently unfair, because the city buys a property which is in full operation and it receives the full revenue, in addition to obtaining service for itself at a less cost than it heretofore paid. The difference between the cost to the city of furnishing the service itself, and what it paid the company, is profit, but there is a charge against this of loss in taxes. These two latter items, namely, profit and taxes, generally balance each other, although the writer has known of cases where the city was the gainer.
There are many points which can be advanced to establish the fairness of the methods outlined herein, but they would take some time to explain, and therefore the writer has only set out the plan he follows in his examinations, hoping that it may be of some aid in establishing a uniform method which will be upheld by the Courts.
It may be stated that recently this method was used in an examination, going back thirty-five years, and the results were accepted by both sides without question.
The writer has refused a number of examinations when told in advance what result must be found, as well as in "expert" work, where the examiner is expected to help make a case, regardless of his honest judgment, for, by accepting such work, the engineer hurts his reputation and lays the Profession open to such remarks as Judge Lacombe recently made in the case of the Peoria Water-Works Companyvs.Central Railway Company.
The writer is fast coming to the conclusion that a great deal of legal trouble is caused by the decisions of commissions, the members of which have not had experience in these matters. If a commission consisted of an able lawyer, a financial man, and an engineer who has had a broad operating experience, its decisions would carry weight, and the Courts would not be burdened with so many appeals.
William G. Raymond, M. Am. Soc. C. E.(by letter).—This is, perhaps, the best paper on the valuation of public service property that has yet appeared. The author's analysis is very clear, and his arguments are convincing. Three points the writer would like to consider; two of them briefly.
The item, "going value," even if it is determined on logical reasoning, as suggested by Professor Mead, would seem to be a dangerous item, and one which might result in absurdities when estimated by an unscrupulous, ignorant person. Moreover, the term has been differently defined, and there is no certainty as to just what it means. The writer sees no reason for the existence of such a term, or of such a separate quantity as this term is supposed to represent.
The term, "franchise value," or, "value of the franchise," is used to represent the difference between the capitalized net earnings and the value of the physical property. Of course, there is such a difference, either positive or negative, but there seems to be some objection by the Courts to calling this "franchise value." The writer, therefore, would suggest that, since franchise value is a very elusive item, depending on the life of the franchise, the attitude of the community toward the corporation, the activity of competing corporations, and numerous indeterminate items, the term, "business value," or, "going concern value," be used instead of "franchise value." "Going concern value" is not as good a term as "business value" or "value of the business," because it may be assumed to include both the value of the business and the value of the property. "Value of the business" would presumably include the value of the franchise, and perhaps would not always be represented exactly by the difference between the capitalized net earnings and the value of the physical property, but would be this difference affected by some judgment percentage resulting from a consideration of the probable continuance of the franchise.
Mr. Riggs has truly said that the value of the physical property must not be made to depend on the purpose for which the valuation is made; that, for the business for which it is used, the value of the physical property is the same, regardless of the purpose for which a valuation is desired; but valuations are made for different purposes, and, while there is room for argument as to the proper valuation to be used for capitalization, taxation, or sale, there are perfectly definite methods suggested for valuing property for these purposes. The writer has never seen a statement—that appealed to him as at all rational—of a proper method of valuing property for rate-making. Indeed, the writer has said[32]that "proper traffic rates have no relation to valuation except that the minimum net income should be at least sufficient to pay interest on the physical valuation." The writer is not absolutely certain of the correctness of this position, for a studyof the public right to regulate a corporation which is performing a semi-public function seems to indicate that the public has a right to say, not only that rates shall be non-discriminatory, but also that they shall be reasonable.
Now, the writer is familiar with three bases for the determination of what constitutes reasonableness of rates. One, which applies to rates as a whole, is this: That the net income should produce not more than a reasonable interest rate on the actually invested capital. Another is the rate that the traffic will bear, and the third is a rate that represents what the service is worth to the purchaser. Of course, a difficulty arises in determining reasonable rates on any one of these three bases.
The only difficulty with the first one is in determining what is a reasonable interest rate on invested capital, and, as far as the writer has read, no Court has yet determined what this is, although some Courts have held that 5% is a not unreasonable return, that 8% is a not unreasonable return, and, if the writer's memory serves him right, that even 15% is a not unreasonable return.
There is great difficulty in the determination of what the traffic will bear. It is a matter of the exercise of judgment and of experiment, and must be applied to a considerable extent to particular rates, for particular commodities, for particular places.
The third basis would seem to be the most difficult to use, although it is one which has recently been established in important Court decisions, and is mentioned by Mr. Riggs. What is a monopoly-provided service worth to the user or purchaser? Suppose that a gas company charges $1.60 per 1,000 cu. ft. for gas, and a very considerable part of the populace living in the city served purchases gas at this price. Presumably the purchasers pay what the service is worth to them, and what they are willing to pay rather than suffer the inconvenience of tallow candles, oil lamps, or to pay a high price for electric lights. Suppose that through a period of five years, by a series of reductions voluntarily made, the price of gas finally reaches $1.15 per 1,000 cu. ft. Is this gas worth any less to the consumer at the end of the five-year period than it was at the beginning? So far as the writer can see, it is, for only one reason, namely, that it can be had for less; but this has been a voluntary reduction on the part of the supply corporation, and who shall say that the service is not worth less than $1.15 to the consumer, or who shall say that it was not worth less than $1.60 at the beginning of the period suggested? The figures here given represent an actual case which has occurred during the last five years, within the writer's knowledge. There seems to be a growing feeling among the people that rates as a whole must be fixed so as to yield only a reasonable return to the corporation, and, apparently only for want of the suggestion of a better method, a reasonablereturn has been held to mean a reasonable return on the capital invested. Believing that there may be some ground for the claim that rates as a whole should be thus fixed, and that the return should not be unreasonable, let us consider how what is reasonable may be determined.
In the first place, it appeals to the writer that the invested capital is not the proper basis for estimating reasonable rates. If it shall be finally established that a corporation is entitled to realize only a reasonable interest rate on the capital invested, there will be no more public service corporations organized; but, if the reasonableness of the return may be based on the capital invested and the business done, there will still be good inducement to capable men to engage in public service business.
It would seem that the rate of return that is reasonable differs for the capital invested and for the business done—that is to say, if the capital invested is $1,000,000, an ordinary investment return of from 4 to 5% may be sufficient; and if the business done with this million-dollar plant amounts to $10,000,000 a year, a reasonable return may be 10% or even 15% of the whole.
Now, as has been suggested by Mr. Riggs, it is manifestly impossible to capitalize the net earnings as a basis for determining reasonable rates, because these net earnings are the result of certain rates already established, the reasonableness of which may be in question; and if, instead of speaking separately of interest rate on capital actually invested and profit rate on business done, it is desired to obtain a value on which to base reasonable rates, the following is suggested as a method: Determine the physical value and the annual interest on this physical value at an assumed reasonable rate, say 5%; determine the annual expense of conducting the business, and assume a business man's profit rate, say 15%, and find the profit that should be earned on the business done. This, added to the total interest charge, should give the net income, over and above operating expenses, that may be considered reasonable, and this sum, capitalized at any given assumed reasonable interest rate, would give a value which might with reason be used as a basis for rate-making, rates being deemed to be reasonable as a whole which furnish from year to year a simple reasonable interest rate on this established value. Of course, there is no necessity for establishing such a value, as the reasonableness of the rates will be determined when it is learned that they produce not more than a fair interest rate on the actual physical value of the property plus a fair profit rate on the business done.
This method is not free from the objection that what is a reasonable interest rate and what is a reasonable profit rate have never yet been fixed, but it is much easier to fix these separately than to fix what is a reasonable return on the capital actually invested or the physical valuation of the property.
W. H. Williams, Esq.(by letter).—Before entering upon the discussion of the more essential elements of the problem presented by this paper, it seems worth while to correct one or two misapprehensions under which Mr. Riggs seems to labor, and to call attention to the rather extraordinary temper in which he approaches the grave questions with which he deals.
Mr. Riggs' first serious misapprehension is that railway officers, as a class, are, with substantial unanimity, opposed to any official valuation of railway properties, and that this opposition was voiced through the writer's discussion of Professor Henry C. Adams' paper in favor of valuation, at the last annual (December, 1909) meeting of the American Economic Association. Of course, on that occasion, the writer spoke, as he now speaks, only for himself, but, more than that, he then expressly disclaimed any such opposition, undertook to make suggestions as to the manner in which a proper valuation could be obtained, and directed his criticisms plainly at a proposal which contemplated, as he then observed:
"An incomplete and misleading valuation bearing the stamp and carrying the weight of governmental sanction, which can be of no practical advantage to the Government, the public, or the railways; but may easily injure the public and the railways by disturbing the confidence of the former and hampering the activities of the latter."
The writer then added:
"It seems very clear that such a valuation as is proposed would be wholly useless to the Government for any practical purpose, because it would omit so many factors essential to any fair appraisement of the worth of the enterprises as going concerns."
Bearing in mind that the foregoing was addressed to the particular proposal made by Professor Adams, that being the topic on which the writer was invited to speak, a proposal expressly limited to the ascertainment of cost of reproduction less depreciation (the equivalent of cost of replacement with second-hand materials in a condition equivalent to that of the materials in use and hereinafter referred to as "cost of replacement") under the pseudonym of "physical value" (or sometimes "inventory value"), it would seem as though Mr. Riggs should sympathize with the writer's view, rather than with that of Professor Adams. Certainly, Mr. Riggs is fully aware of the inadequacy of mere cost of replacement to serve any useful purpose, for, after saying that:
"No account may be taken of the purpose for which the resultant figure of value is to be used; and the result should not vary, no matter what the purpose may be."
He says, in another place:
"* * * it is clear that the worth of the physical property, being the cost of reproduction less depreciation, is not necessarily the value of the property. * * *"
And, defining what he calls the "non-physical or intangible elements of value," says:
"These are those things which, added to or taken from the worth of the physical property, make up the value, and include whatever accrues to the property by reason of its operation, or by reason of grants, contract rights, competition, or location, which at the time of appraisal affect favorably or unfavorably the worth of the property."
The second misapprehension that is worthy of notice seems to have grown out of a curious sensitiveness, on the part of Mr. Riggs, as to any suggestion, other than his own, of criticism of any work undertaken or theories advanced by Professor Adams. As to every reader, other than Mr. Riggs, it is surely quite unnecessary to say that no attack has been made upon Professor Adams by the writer at the New York meeting of the American Economic Association or anywhere else. Certainly, it will be conceded that some difficulty would attend an effort to respond to an invitation to discuss before a scientific body a paper written by one of its members without making any allusion to the author of the paper or to his views or work, and those who have any knowledge of the history of official railway valuations in the United States, and especially of the proposal to undertake a Federal investigation of cost of replacement, are fully aware that Professor Adams has been from the beginning, and now is, the Hamlet of the drama, without whom it would become dull and lifeless. Strangely enough, Mr. Riggs seems to wish to deny to Professor Adams this prominence, for he says:
"Professor Adams was associated with the Michigan appraisal, but had no connection whatever with the 'physical valuation,' to which such objection is taken, and his appointment was made after the work of physical valuation had been fully outlined and was well under way."
It is true that the scheme devised by Professor Adams, and adopted at his suggestion by Governor Pingree, required the employment of civil engineers for the preliminary work which necessarily had to precede the final "valuation" by Professor Adams, but the bare statement of this fact is utterly misleading. Professor Adams' own testimony in one of the Michigan tax cases happily places his responsibility for the whole plan entirely beyond controversy. He said:
"In 1900 I was called upon by the Michigan State Tax Commission to determine whether railroads were paying a tax rate on their value equal to the rate on other property. With that problem in view, I formulated this inventory plan. * * *"[33]
Any discussion of the proposal for a National inquiry concerning cost of replacement which omits to show that its most persistent advocate, Professor Adams, has advocated and actually conducted orcontrolled several successive "valuations," in Michigan, as Statistician to the Interstate Commerce Commission, and as special employee of the Bureau of the Census, made in accordance with other methods than those which he now proposes to apply, is seriously inadequate; as seriously inadequate as it would be to omit to state that, using what purported to be the same method, Professor Adams, by changing the details of its application and decreasing the rates of interest used in his computations, raised his "valuation" of Michigan railways from $152,958,202 to $177,689,292 or 16.17%, each of the two calculations being presented to the public, with assurances that it disclosed the actual taxable value, and there being barely eighteen months between them. The writer is by no means alone as an object of Mr. Riggs' dissatisfaction because of public criticisms of Professor Adams' plan for estimating cost of replacement. Thus, of a statement in which Professor Taylor, who conducted the Wisconsin inquiry, questioned the validity of some of Professor Adams' methods, he writes:
"Undoubtedly this statement was made in good faith, and has gained currency by not having been corrected, but it is not the fact."
In another place, referring to a statement of comparative costs to the respective States for valuation work, made by the Railroad Commission of the State of Washington, he says:
"It does not appear to be good taste either to criticize costs of work in other States, or compare the costs in Wisconsin and Michigan with the cost in Washington."
Referring to a paper by Charles Hansel, M. Am. Soc. C. E., who took part in the Michigan valuation, Mr. Riggs says:
"The one point to which special attention is drawn is Mr. Hansel's astonishing misconception of Professor Adams' plan of work. This misleading statement appears in the first paper and is reiterated in the second."
Again, of the report of the expert of the Washington Railroad Commission, who had the temerity to declare that it found "little value" either in Professor Adams' methods or his estimates of the cost of the work, Mr. Riggs says:
"Such sentences, and others which, by inference if not by name, reflect on work executed by men of high professional standing, are hardly in good taste, even if true, in a report to a railroad commission of another State."
Yet Mr. Riggs does not fail to criticize the method of "valuation," applied by Professor Adams in Michigan, in terms quite as definite as any used by others.
Thus, he condemns the method used to estimate the value of the non-physical elements appertaining to the Michigan railways, on the grounds (first) that it made this value a mere derivative of the ratesexisting, and (second) that it made no allowance for negative values when cost of replacement exceeded real value, saying:
"It will be seen that, in the case of a property in which the surplus earnings depend on excessive rates for service, it will fail as a method of determining a value for use as a basis of rate-making; and it fails, in the form in which it was used in 1900 and 1902, to bring out those negative or subtractive elements which may be determined from the income accounts, in the case of properties which do not earn a fair return on the investment."
Of the published statistics of American railways, compiled in the office of which Professor Adams is the responsible head, derived from annual reports made in accordance with forms prescribed by the Interstate Commerce Commission under his guidance, and containing items selected from and depending on the uniform railway accounting system devised by Professor Adams and imposed on the carriers by the Commission, Mr. Riggs writes:
"The published statistics are in such form that only the careful student of affairs can understand or analyze them, and but few of the public officials who receive them are able to read the reports of the properties and comprehend them."
Railway officers fall quite generally under Mr. Riggs' condemnation, for, of them he says:
"As a body * * * it is doubtful if any equal number of men, of equal intelligence, have as limited a knowledge of the fundamental truths of government, or knowledge so colored by bias. It is also doubtful whether any equal number of men have in their ranks so few who bear an active part in the duties and activities of citizenship, or who exercise large influence on their neighbors."
Such assertions as the foregoing need no comment; their intemperance is their most effective refutation; yet a few recent examples may be cited: Paul Morton resigned as Vice-President of the Atchison, Topeka and Santa Fe to become Secretary of the Navy in Mr. Roosevelt's cabinet; Jacob M. Dickinson, General Solicitor of the Illinois Central, became Mr. Taft's Secretary of War; his successor with the Illinois Central, William S. Kenyon, later became Special Assistant of the Attorney-General; Lloyd W. Bowers, General Solicitor of the Chicago and Northwestern, was Solicitor-General of the United States from early in Mr. Taft's administration until his death a few months ago. Thus, within but four or five years, the Federal Government took four of its highest officers from the railway officers located in only one of the country's great cities—Chicago.
Of a recent address by one of the ablest and most public-spirited of railway officers, he says:
"This address well expresses the spirit of the railway managers and employees toward all forms of investigation, and the complete lack ofunderstanding, on the part of these managers, of the legal and moral relations which they bear to the communities which they serve."
Belonging to this so hateful class, and having also ventured to question whether Professor Adams has said the last and most perfect word on the subject of railway valuation, the writer is neither surprised nor disheartened to find that he, also, has caused Mr. Riggs undisguised dissatisfaction. It is a misfortune apparently inseparable from his profession and his conception of his obligations to his employers and to the public.
As has been already noted herein, the question is not whether railway property shall be officially "valued," but rather (first) as to how the "value" which is to be ascertained is properly to be defined, and (second) how the determination of "value," as properly defined, can be made most accurate.
The essential difference between the view advocated before the American Economic Association by Professor Adams and that of the writer was, and is, that the former now desires to exclude all elements of value which are not physical and tangible, while the writer holds that, if it is worth while to ascertain, on a general scale, at the cost of a necessarily large expenditure of taxpayers' money, and as to a particular date, so unstable a fact as railway value, the kind of value the ascertainment of which could be of sufficient utility to warrant the effort can be nothing less significant than the "fair value" which the Courts have said is a proper element for consideration in fixing reasonable rates of charge. The fundamental difference between these two conceptions of value is admirably indicated by the following quotations, both of which rest on the authority of the Interstate Commerce Commission.