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 Company _vs._ 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 study of 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 reasonable return 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 or controlled
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 rates
existing, 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
of understanding, 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.