The author's treatment of the unit price question and the contingency item is intelligent and creditable. Engineers are prone to make valuations based on "hindsight" instead of "foresight," on the assumption that no substantial difficulties in construction were encountered, when, in fact, substantial difficulties should perhaps have been anticipated, and may actually have been encountered in the original construction, record of them having been obliterated, however, with the lapse of time.
The author's definition of the value of a property, as the "estimated worth at a given time, measured in money, taking into account all the elements which add to its usefulness or desirability as a business or profit-earning proposition," suggests the advisability of recognizing the other side of the ledger by modifying his statement so as to read: "* * * all the elements which add to, 'limit, or detract from' its usefulness or desirability as a business or profit-earning proposition."
While recognizing the author's view, that there is no separate and independent method of determining franchise value, which is not based on the determination of the value of the property as a whole, by capitalization methods, it must be recognized that going value may be determined independently, and may have a positive value, even though the property as a commercial whole is worth less than the sum of the physical value and the going value.
The Court, appraisers, and the author, alike recognize that there is no one method of valuation of universal application. First cost, reproduction cost, reproduction cost less depreciation, commercial value determined by capitalization, worth of the service to the consumer, and market price of the property, if such exists, all have their weight, in varying degree in different cases. Whatever may be said of, for, or against, these several methods of valuation, relates rather to their significance, and the weight which should attach to the results obtained by them, as evidence of value and of the effect of the modifying local conditions, than to the soundness of the methods themselves.
In this connection it may be of interest to refer to a recent valuation of a water-works property, in the appraisal of which the writer chanced to participate, in which there was finally placed before the board of appraisal a summing up of:
1. The original cost;
2. Reproduction cost less accrued depreciation, plus going value;
3. The worth of the service to the consumers, based on a stated assumption of reasonable increment in value in excess of actual cost, upon which a return (or interest and profit) should be earned;
4. The commercial or capitalized value, on certain assumptions based on present conditions, and also on possible future conditions which might be involved in a renewal of the City contract, which was to expire within two years.
That these determinations of value, from different points of view, had an influence in moulding the opinion of the individual appraisers, there can be little doubt; yet it is probably equally true that in no case was like weight attached to the several items or bases of valuation. Nevertheless, in the final valuation, the consensus of opinion as to the value of the property, as a whole, was remarkably close, the extreme variations in opinion being approximately 8%, more, or less, than the final appraised valuation.
Attention should also be called to the necessity, in any valuation by capitalization of income, such as that outlined by Mr. Riggs and used by Professor Adams in the U. S. Government Valuation of Railroads,[46]of determining whether the plant or property is in what might be termed an over-built, normally developed, or under-built condition; in short, whether the investing public has correctly gauged its momentary physical condition with reference to its bearing on the rates, and whether the earnings are in fact inadequate, commensurate with the service rendered, or excessive. In the long run, due weight will be given to these facts; in a brief period, they may be incorrectly gauged. In water-works properties, unfortunately, there is rarely, if ever, a market price of the securities which can be said to be credible or significant in valuation. Therefore, in the valuation of water-works properties, it is the more important that the appraisers should weigh carefully the present character of the service furnished and the momentary adequacy or inadequacy of the rates as predicated on such service, on the needs of the community, and the existing standards of the day, if full justice is to be done.
In conclusion, the writer reiterates his statement, that he has taken issue with the author in no carping spirit of criticism, but with a recognition of the difficulty and complexity of the work of appraisal, and the conviction that engineers are under a moral obligation to do an educational work in pointedly calling attention to the fact that the going, or going concern, value, of a public service corporation's property is not an intangible value representing an unearned increment, but a very real and substantial item of cost in the property as a whole. While the difficulty may be met by placing going value, as suggested by the writer, in a middle class between physical plant and intangible values, the placing of it in the same class with franchise and other intangible elements of value, as suggested by the author, may, in the judgment of the writer, do a serious injury to corporations, in failing to give expression, in such a manner as shall be clearly within thegrasp of the popular mind, to the fundamental idea of the cost of developing going value. While the writer has no personal interest in the matter, on one side or the other, having served both municipality and corporation in water-works valuations, he feels, nevertheless, that engineers can do a genuine service, alike to the public and to the public service corporation, in laying stress on the fundamental elements of cost and value, and particularly those on which rates should be predicated, in public service corporation property valuation and rating.
Charles Hansel, M. Am. Soc. C. E.—So much has been said on the subject of valuation of public utilities that, although the speaker has thought on the subject for ten years, and has done considerable valuation of railroad properties, he finds that he is considerably confused, for the reason that the discussions seem to cover the whole field of engineering, accounting, taxation, and economics; therefore he suggests that, in order to get down to a basis of usefulness, a special committee should be appointed to take this question under consideration.
The speaker had the honor of being associated with the Michigan Commission, as a member of the Board of Review. Professor M. E. Cooley was selected by the State of Michigan to take charge of the work of organization, and Mr. Riggs was the engineer who organized the office and field forces. Both these gentlemen were eminently successful in that very difficult work. Mr. Cooley did this Board the honor of saying that there were so many problems coming up in actually carrying out the work (aside from the theories of taxation, rate-making, accounting, and several other things, which could be found more readily in the Auditor's office than in the Engineer's), that he had asked for the appointment of this Board of Review, to sit as a Court, and to pass on the many complex questions arising from day to day; and he had the satisfaction of coming to the Board every day and saying: "Well, now here is a condition, and how will I handle it?" Of course, actually, he knew more about it than the Board, but he was kind enough to say that he would ask for the Board's opinion. That Board adjudicated all these various questions to the best of its ability, and the speaker has the satisfaction of knowing that the valuation has stood in the Federal Courts. The subjects are so fugitive and so illusive that very much depends on the point of view.
The speaker is now engaged in the actual task of trying to place a valuation on some $300,000,000 worth of property in New Jersey, involving the most important terminals in the United States.
The valuation of public service utilities is the most profound question which has ever been before the Society, and it includes a great deal which is outside of strictly engineering questions; in fact, the discussions do not throw much light on the methods which should be followed in making valuations.
The terminology of a subject is very important; in fact, the speaker has found it so important that in his discussions with the Attorney-General of New Jersey, in reference to the Railroad Tax Law, which he has been asked to re-draft, that draft will be accompanied by a glossary, so that the meaning of certain terms used in that particular Act will be clear.
In this New Jersey work some eighty-seven engineers and assistants are employed, and for their guidance the speaker has prepared thirty-five pages of very carefully considered instructions. These instructions are accompanied by blue prints showing exactly how all field notes must be recorded, with diagrams of trusses, culverts, and the like, and all the elements of railroad construction.
The Tax Law of New Jersey states that, first, the true value of the real estate shall be ascertained; second, the true value of the tangible personal property; and the first law of 1884 stated: "and third, the value of the franchise"; but somebody discovered that there was something besides the value of the real estate, the tangible personal property, and the franchise. They did not know what it was, but there was something else; therefore, in the 1888 law they changed the third division of value to read: "the remaining property, including the franchise."
As an example of one of the difficulties of determining classification, attention is directed to the term, Real Estate, which is broadly, but seldom accurately, understood.
The Interstate Commerce Commission is the highest tribunal in the land, in the matter of railroad accounting, but it affords no help in many important elements of value; for instance, under the Interstate Commerce Commission, real estate includes only such real estate (land) as is not required for railroad purposes. All land actually used for railroad purposes is classified under "Right of Way and Station Grounds."
When the engineers on the New Jersey valuation were sent into the field, it was necessary to specify exactly what elements must be described as real estate, and what as tangible personal property. The division line had to be defined accurately for the reason that all personal property is assessed permanently to the State, while, in the case of real estate, the State receives the taxes on a strip not exceeding 100 ft. in width, and the tax on all property used for railroad purposes outside this strip reverts to the taxing district wherein it is found.
The vexatious question as to whether machinery is to be considered as real estate or personal property was settled by the New Jersey Law, which says that tangible personal property shall include all machinery; but it left unsettled the question: what is machinery? After careful consideration, real estate was divided into 74 classes, and all other tangible elements were classified as personal property. Some of the items ofreal estate are: ash-handling machinery and the like, chimneys, cisterns, conveyors, dams, locks, lock machinery, electric wiring, piping, heating, interlocking, signaling, pavements, reservoirs, shop fittings, tanks, telegraph lines, track, track scales, transfer tables, water-works, etc., etc. Generally speaking, all items of a fixed character were included in the 74 divisions of real estate.
The difficulties of determining all the elements of real estate are mentioned simply to call attention to what at first glance seems quite simple, but on close examination is found to have great complexities.
The question of useful life depreciation, direct and indirect, due to decrepitude or obsolescence, or both, is one of the illusive questions; and then comes the value of the franchise.
The valuation of railroad property in New Jersey is further complicated by the requirements of the State Tax Law, which specifies that the value of the remaining property, including the franchise, shall be determined after the "true value" of the real estate and tangible personal property have been determined.
The speaker will not attempt a discussion of franchise values, as it is a subject which requires the most profound study.
The author states that he is appalled at the speaker's misconception of the method of determining non-physical value used by Professor Adams in Michigan. The speaker is perfectly familiar with that method, and, although having the greatest respect for Professor Adams' opinions, is compelled to draw attention to two important elements of that formula which are open to objection.
Professor Adams establishes his annuity on the depreciated value, rather than on the cost, or the reproduction cost, which, in the speaker's opinion, does not determine the proper annuity or reasonable fixed charges to be deducted from net income before net surplus is established. Bonds are generally sold at a considerable discount, and represent the full cost plus this discount, consequently, the interest on bonds or fixed charges will be greater than an annuity established on cost, "reproduction cost," or "present value." Would it not more nearly establish fixed charges or annuity, to take the cost plus discount and commissions as the basis on which to apply the annuity rate?
While Professor Adams' formula establishes a larger net surplus for capitalization than the method suggested by the speaker, he in effect destroys this net surplus by charging against it all betterments chargeable to income. It is quite clear that this gives the railroad company a chance to absorb all net income into betterments, and thus wipe out all net income, in which case there would be no net surplus to capitalize, consequently, no non-physical or franchise value, and the total value established under this plan would be less than if the property had not been improved by the betterments—reductio ad absurdum.
In reference to the question of whether or not the method of valuation should be the same, regardless of the purpose to which the value is to be applied, the speaker cannot agree with the author, and believes that it is quite consistent to establish different values for different purposes.
The completion of a large public utility, planned on such a scale as to provide for the requirements of many years to come, utilizing but part of its capacity, and earning less than its operating expenses and fixed charges, with its rates of toll fixed by law, must be considered in a different way than a well-established public utility, with business forcing it to its utmost capacity, and with tolls not fixed by law. There are many important elements bearing on this consideration of value, and the purpose of the valuation should be known before attempting to establish the value.
In New Jersey the work is complicated further by the necessity of establishing the value of 122 separate railroad corporations, and the assignment of all property outside the 100-ft. strip to each of the 450 taxing districts through which the 122 corporations, with their many branches and spurs, are operating.
In order to determine the quantities and materials in the permanent way and structures, nine engineer corps were organized, each corp consisting of six men. With this force the center line of the main running track was measured, and the exact distance in each taxing district recorded. Cross-sections of the roadbed were made as often as changes in the natural surface required, and accurate measurements and notes were made of all structures; and, although in many cases the engineers were able to secure the plans of the more important steel structures, the field parties were required to obtain sufficient data to compute the tonnage in case it was impossible to get these plans.
The field parties were also instructed to note the character of the land and improvements adjoining railroad property, and record such other information as was necessary for a comprehensive understanding of the conditions attendant on the construction of a railroad in that locality.
The time allotted for the completion of the work is one year, and although this is a comparatively short period in which to introduce a premium system in field work, it was decided to inaugurate such a system as would be as nearly satisfactory as possible under the conditions. A record of each field force for each day in each month was made on profile paper, using the horizontal lines to represent the number of tracks, and the vertical lines to represent distance. Two horizontal lines were allowed for single track, four for double track, and so on. One mile was allowed for each vertical division of the paper, and, in awarding the premium, there was taken into consideration,not only the extent of territory covered by each field party, but much consideration was given to the field notes, and a cash prize was awarded each month.
The results of the organization and encouragement to the field parties are shown by the very great increase in the amount of work per man of the field parties, which was nearly 300% during the time the parties were in the field.
A great many questions hinging on interstate commerce, and involving Fundamental, State, Federal, and International Law, are embraced in the broad view of the valuation of railroad properties. The movement of rolling stock through various States, and between the United States, Canada, and Mexico, and the determination of the situs and domicile of floating equipment, are subjects which, not only require considerable knowledge of railroad operation, but involve many questions not clearly determined by the Courts.
The subject is of such great importance that steps should be taken to formulate methods of procedure, and, at the Annual Meeting of the Society, the speaker will offer a resolution requesting the appointment of a Special Committee to determine the proper methods to be used in the valuation of public utilities.
J. Martin Schreiber, M. Am. Soc. C. E.—Engineers and those generally interested in the valuation of public service properties are fortunate in having the valuable information embodied in this paper. Although there are some points on which the speaker differs with the author, the following remarks are only offered in order to bring out, from experience, some further phases of the subject, rather than as an attempt to criticize.
A great deal is heard about the exact cost of reproduction, also arguments in reference to the proper allowance for contingencies, probably only involving a small percentage. The speaker questions the propriety of advocating the exact cost figures. The carefully checked cost figures of reliable contractors, with first-class engineering organizations, submitting proposals on the same construction, are often found to vary from 5 to 15% from the total cost. Different organizations will sometimes be the cause of figures varying 5% or more, depending on the efficiency and experience of the corps. A clever purchasing agent will reduce an apparently precise estimate on equipment or supplies as much as 10%; on the other hand, the condition of the market may be such that the actual price paid exceeds the estimate by the same percentage. Engineers who are responsible for estimating on, and the execution of, construction projects generally add more than 10% for contingencies, as it is practically impossible to anticipate them, and a precise estimate is almost certain to fall short. It is unfortunate that it is almost impossible to sustain contingencyfigures on the witness stand; for that reason, probably, it would be more satisfactory to the lay mind, and to the various courts, boards, etc., which are required to pass on valuations, and do not thoroughly understand the technicalities of the situation, if engineers would drop the contingency item and modify the quantities or the unit prices.
If it is possible to estimate the exact cost of reproduction, certainly considerable variation may be expected from independent sources in computing depreciation and present values. Yet there are reputable engineers who would have one believe (assuming that they know the cost of reproduction) that by a simple field inspection they are able to compute the exact present value.
Some time ago, the speaker heard an expert testify in the interest of a certain city, for tax purposes, with reference to the value of a piece of street-railway track. He first stated the valuation for reproduction, and then the definite present value. The latter was greatly in excess of the actual value. The expert, who was an engineer of considerable standing, on cross-examination, did not know the height of rail from top of head to bottom of groove, either at the joint or any other part in its length; he did not know the exact depth of flange of the car wheels which operated over that track, the headway, or the exact weight of the cars used. He had assumed the condition of the ties, and that the track was ballasted. Finally, he was compelled to admit that his determination of the depreciation, by simply a field inspection, was a very rough approximation. Now, it is not in every case in the past that a corporation attorney, even with engineering assistance, has been able to point out unfair testimony. Many times the speaker has heard incompetent testimony admitted, on the general principle that the witness was an engineer of note, even though his record had been made in other specialities. Too much stress cannot be put on this phase of the subject, and the speaker is glad that the author has mentioned the fact that the personnel of those doing appraisal work should be of the highest order. In the past it is probable that the failure to discriminate properly in accepting incompetent testimony (not to mention prejudiced testimony) was automatic, and this is the most important reason for much of the hostility of officials of public service properties toward all forms of investigation, as the author mentions.
Company officials know that they are often compelled to employ and train specialists to furnish, within fairly accurate limits, the very information which is being sought, and naturally they are skeptical about the data presented by those who, though not intimate with the property, purport to give exact cost figures. Any one who is able to point out a consistent method whereby these exact figures may be obtained surely will obtain credit for a valuable contribution toward the solution of the complex subject of valuation.
Referring to the valuation of the property of the Detroit United Railroads, mentioned in the paper, the Director of Appraisals for the city estimated that the cost of the complete appraisal of the property, which includes about 220 miles of single track, would be from $3,000 to $4,000. Approximately, $25,000 has already been spent, not including the expense sustained by the company, which furnished a large proportion of the information.
Probably correct present value estimates which include depreciation may not be even fairly approximated without intimate knowledge of the particular property, and this should embody operation, policy of management, past performance, study of historical cost (as far as the records will permit), estimated cost of construction, and actual cost of maintenance. The life of a piece of track or equipment, disregarding obsolescence and extraordinaries, generally depends on the type and details of construction, the service it has done, and the service that will be required of it. Renewals should be made when the cost of repairs reaches a certain figure, other conditions being favorable. It is a fact that able engineers, intimately acquainted with the case at issue, and employed on the same property, often have conflicting ideas in reference to the life of track or equipment, one recommending immediate renewal and another advocating longer operation.
The speaker does not intend to argue against the possibility of placing fairly accurate values on reproduction or present value, but wishes to bring out the fact that it is not as simple as the lay mind is often led to believe. Further than that, he is of the opinion that the following is essential for economical and satisfactory valuations for all concerned:
(1) There should be co-operation of the appraisers with the public service property officials, including operators, engineers, and their records.
(2) Present values should be determined by:
(a) Cost of reproduction,
(b) Mortality tables,
(c) Data of performance,
(d) Field examination.
(3) The organization for the appraisal work should be of sufficient scope, and should be allowed the time and funds which the project reasonably requires.
(4) The appraisers should be carefully selected, the personnel including men who have had wide experience in the particular class of operation; and specialists should be obtained if necessary.
Mr. Riggs states that the valuation should be the same, regardless of the principles at issue. It seems questionable to consider the fair value which involves the non-physical value in costs or tax regulations.Certainly, in the case of street railways in cities, where a percentage is levied on the gross receipts, the non-physical valuation, only representing present value, is necessary. Again, a physical present value for taxation should not include the value of paving in the street in the strip occupied by street-railway tracks. That the street-railway company often pays an arbitrary assessment tax and keeps the paving in repair, though it is in no way responsible for the wear, should be sufficient to offset any obligation for other taxes. In some States this is fixed by the Courts. The physical valuation, however, intended to be used in connection with rates, cost, or capital regulation, should include the cost of paving the railway strip. Referring further to the question of including the paving in the physical valuation of street railways, in the case of a decision of R. W. Tayler, Arbitrator, in the proceedings between the Cleveland Electric Railway Company and the City of Cleveland, on a basis of a renewal of franchises, Judge Tayler said:
"Paving represents actual money expended. It belongs to capital account, and in its depreciated form is worth all the allowance that I have given it."
Also for rate-making and the capital regulation some consideration is certainly due to obsolescence and change of art, while in taxation they should not be included.
In conclusion, the speaker is optimistic enough to believe that the problem of physical valuations will be solved satisfactorily for all concerned. Co-operation of officials of the public service properties, reliable testimony, with a better understanding by the Courts, will certainly tend to clarify the situation. Non-physical values are very difficult to determine, and their intelligent treatment will require some well-defined procedure. Mr. Riggs' valuable paper will go a great way toward producing a correct idea of the general proportion, and will, no doubt, assist in the formulation of proper methods for valuation.
Clinton S. Burns, M. Am. Soc. C. E.(by letter).—The author is to be congratulated on the detailed care shown in the presentation of this subject. Perhaps few engineers who have not been called on to cope with the subject of valuation of properties, realize or appreciate the real complexity of the many varied problems encountered in work of this class. To those who are engaged directly in appraisement work, this paper will be a welcome contribution to the literature on the subject.
The author's statement that if a commission of engineers is directed to report the true cost of reproduction, depreciation, or present value of a certain property, the final figures should not differ, whether the report is to be used as a basis for reorganization, sale, rate purposes, or taxation, is open to argument. It seems proper that, if a property is appraised in order to fix a selling price to a Government or municipalityexercising its right to purchase, the final figures should be based on current prices of labor and material, because this does no injustice to either party. It is evident that if the seller secures payment for his property based on current prices, he may, if he desires, reinvest the proceeds of the sale in similar enterprises at current prices, so that thereby he secures the same benefits, whether prices are high or low.
It is equally evident that if the purchaser (the municipality) chooses to purchase the property, the right to purchase must be exercised at the particular time permitted by the franchise. If prices chance to be abnormally high at that time, the municipality is exactly on a par with what it would be if compelled to build its own plant at that particular time; while, if prices be abnormally low, the same relative situation still exists. There seems, therefore, to be no possible injustice to either party in using current prices, when the object is a sale or transfer of the property. However, in determining a proper value as a basis of rates, another factor must be considered. It is inexpedient and against public policy to make frequent changes in the rate charged for such commodities as water, gas, or electric current. Theoretically, the rate could be fixed each year, based on an annual valuation of the property, thus permitting a high rate one year and perhaps an abnormally low rate another year; but, practically, this is impossible, for, aside from the inconvenience of such a cumbersome system, no community is well enough informed as individuals to comprehend any reason whatever for ever raising rates. Raising rates is invariably accompanied by a wave of indignation. However, it is apparent that a series of rates based on an annual current price valuation of the property would average exactly the same, during a term of years, as though the property were valued once for all on the basis of the average prices of labor and material for the same term of years, and the rate based on the one valuation thus determined.
If the object of the valuation is to afford data for taxation, the same argument applies as in a case of fixing rates. It thus seems proper that the object of the appraisement should be taken into consideration before it is determined whether to use average prices, or current prices, of material and labor; and, if this is correct logic, the final figures must differ according to the object in view; but, having determined the proper unit prices to be used throughout any appraisement as being the most equitable for the object in view, then, as the author well says, the appraiser must not allow personal prejudices or fancied conditions to influence his course. Above all, an appraiser must not be afraid of his client. He must not allow his personal judgment to be swerved by the latter's desires. It perhaps seldom if ever occurs that an appraiser, representing a municipality, or State, is subjected to this unconscious influence, inasmuch as his employeris merely a temporary public official, and consequently he has no client to fear. He goes into the work with a full knowledge that his employer knows little or nothing of the subject, and his only desire is to reach results which will be unquestionably fair to both parties.
On the other hand, the appraiser who is chosen by the owner of a plant takes hold of the work with a feeling that he is expected to report a value as favorable as possible to his client, and this feeling is reflected in the report, regardless of how sincerely or conscientiously he tries to avoid it.
One of the most intricate and yet interesting problems in appraisement work is the computation of the "going value," or "business value" which should be allowed in addition to the physical value.
In considering a competitive enterprise, such as a railway serving a community in competition with another independent railway, this problem must be treated in a different way than in a non-competitive business, such as a water-works, gas-works, electric plant, street railway, or similar enterprise operating under the protection of an exclusive franchise, or under natural conditions equivalent to an exclusive privilege.
In considering competitive enterprises, it is manifest that a railway operating under conditions more advantageous than its competitor possesses an intangible value equal to the measure of that advantage. It is not clear, however, whether it is more proper to say that the railway possessing the advantage has a positive going value, or whether the less fortunate one has a negative going value. Using the rule formulated by the author, being that of Professor Adams, with some modifications, it is evident that many properties would show negative going values; but, as pointed out by the author, the Courts hold that public service corporations are entitled to earn:
(a) Operating expenses;
(b) Expenses of maintenance and running repair;
(c) Taxes;
(d) A sinking fund to cover depreciation and obsolescence;
(e) A reasonable profit on the fair value of the property.
It is improbable that a reasonable profit on the fair value of the property could be construed to mean less than the interest or revenue from a like amount of Government bonds or other non-taxable securities.
This ruling of the Courts fixes the rates at such a figure as to preclude the possibility of a deficit; from which it must follow that a negative going value cannot be created by a compulsory reduction in rates, for such action would be confiscation of property to the extent of the negative intangible value thus created; that is to say, if the Courts are right in the above ruling, then all intangible or going valuesare positive, and must be determined by using the most unfavorably situated railway as the basis of computation in determining the question of reasonableness of rates; and the rates in turn must be reasonable and proper before they can be applied to determine the intangible value. This raises an interesting and far-reaching query. Assume that a negative going value is the result of real competition between two roads such that the "fair value" of the less fortunate competitor is 20% less than its physical value.
If rates are based on this valuation, are they really fair rates? For, suppose the rates had always been maintained at a point where the less fortunate road could just support its physical valuation. Clearly, no rate could then be enforced which would compel it to operate for less than a reasonable profit on the fair value of its property, and the fair value under this assumption is 25% greater than before, due to no effort of its own, but simply to the fact that its competitor has not cut rates, and has thereby preserved the original "fair value" of the less fortunate road, and at the same time increased its own positive going value by an equal amount.
In view of this analysis it is doubtful if it is ever proper to consider the existence of negative intangible values, although it is true that the commercial value does fluctuate, and may be less than the physical value, due to rates which are too low, perhaps, or due to other temporary causes.
The method quoted from Mr. Alvord for determining going value applies to non-competitive enterprises only, as was stated by Mr. Alvord in his paper before the American Water-Works Association. This method is open to the criticism that the forecast of the business of the older works, and of the new hypothetical works as well, is reduced to a monetary value, based on the present rates, regardless of whether or not such rates are reasonable. Rates are subject to legislative control in many States, and there is absolutely no assurance that any other State may not adopt legislation at any time permitting regulatory ordinances to be enforced. Therefore, any forecast of the value of future business must be based on reasonable rates, for otherwise it is merely an unwarranted estimate based on a fond hope.
Taking into consideration the fact that rates must be reasonable, either by virtue of present laws or laws which may become effective at any time, perhaps in the immediate future, going value may well be defined as the present worth of the amount by which the anticipated profits of a going plant, operating at reasonable rates, exceed the present worth of the anticipated profits of a similar hypothetical starting plant, operating at those same rates. With this conception of going value, it is impossible for a non-competitive property to have a negative going value, and every operating plant has a positive going value, even though operating at a loss.
The whole problem hinges on the question of "what is the reasonable rate or proper return," and this should be determined in the aggregate as the starting point. The Courts have persistently dodged the issue, and properly so, whenever that question has arisen, leaving it for consideration in each particular case, depending on the stability of the business, the hazard involved, and various other local factors.
It may safely be conceded that this fair profit is something in excess of the return from Government bonds, and for the purpose of this discussion it matters not what figure is assumed as the fair profit—whether 5, 6, or 10%, or what-not—the theory is the same in any case. This is perhaps best explained by a practical illustration:
Take, for example, a water-works system, the physical present value of which has been determined by the method of reproduction to be $1,000,000, and denote the going value by the unknown quantity,x; suppose, further, that 6% is considered a reasonable return on the "fair value"—not yet determined, the "fair value" being $1,000,000 plus the going value,x. Therefore, the rates must be such as to produce in the aggregate an amount equal to the operating expenses, maintenance, taxes, sinking fund, and depreciation, and still have a profit of 6% on the fair value of the property. The anticipated profits of the going plant, therefore, are exactly 6% of ($1,000,000 +x) = $60,000 + 6x/100 per annum. The anticipated profits of the hypothetical starting plant will be negative at the start, and gradually increase, finally reaching a maximum of $60,000 + 6x/100 per annum.
It must be remembered that, in estimating the operating expense and income of the starting plant, as well as the going plant, the figures must be confined rigidly to the plant as it is found at the date of valuation, and in no case should any account be taken of income or operating expenses due to probable future extensions of the distribution system. Many appraisers overlook this point, and predicate the anticipated profits of the going plant on the past growth of the income account, forgetting that a considerable portion of this growth is due to extensions into new territory, and not to any material increase in revenue from the territory already served. To include income from new territory in the forecast of income is just as fatal an error as to include the anticipated expenditure of new capital in the present physical valuation. Either of these procedures is really an estimate or appraisement of some other plant, rather than the one actually under consideration.
To complete the numerical illustration, suppose it is determined that the time required to construct the hypothetical starting plant is 3 years; that a portion of the plant is put into operation at the end of the second year, taking over fire-hydrant rental equivalent to $20,000;that the revenue from private sources aggregates $20,000 during the last year of construction; that the expenses of operation, maintenance, taxes, and depreciation amount to $30,000 during this year. After the time of completion of the plant has elapsed, it has the total credit for fire-hydrant rental, and it is assumed that the revenue from private sources and the cost of operation, maintenance, taxes, and depreciation increase as shown in Table 14, which illustrates the method of computing the going value, and gives the resulting value for the case just stated.
Therefore, 171,005 + 0.2597x=x; hence,x= $231,000. This result is based on the assumption that the starting plant earned no interest during the construction period. If an allowance for lost interest during construction has been made and added to the capital account already being included in the physical appraisement of $1,000,000, then this must be charged back against the going value found above. This is clearly evident, because the calculations to determine going value date from the beginning of the construction period, and the lost interest during construction, therefore, is provided for in the result. Most appraisers allow an item for lost interest amounting to the legal rate of interest running for half the construction period, which, in the illustration under discussion, would be $90,000; deducting this sum, if previously included, gives $141,000 as the going value.
There seems to be no good reason for allowing lost interest during construction as an item in the physical valuation of a property, any more than for allowing all of the lost interest, up to the time when the property begins to yield a return equal to the rate of interest. It is one of the problems in finance, and is much better treated as an element in the going value, as shown in the above illustration.
One of the most difficult factors on which to agree in computations of this nature is the element of time required for the hypothetical starting plant to acquire the business. Were it not for this uncertainty, going value could be computed with mathematical precision by the method suggested.
In determining the physical valuation on the basis of cost of reproduction, such items as cost of taking up and replacing street paving over the pipe lines, cost incurred by reason of sewers and drains encountered, interference due to electric wires and conduits, interference of traffic, and other metropolitan conditions which add greatly to the cost of construction, must be allowed. Wherever such metropolitan conditions exist, there must also be present a corresponding necessity for the use of water under pressure. People use water because of necessity or convenience, and not on account of any feeling of obligation or loyalty to the water company.
TABLE 14.—Computation of Going Concern Value, Based on Reasonable Rates.
TABLE 14.—Computation of Going Concern Value, Based on Reasonable Rates.
TABLE 14.—Computation of Going Concern Value, Based on Reasonable Rates.