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
municipality exercising 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 employer is 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
values are 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 + 6_x_/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 + 6_x_/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 + 0.2597_x_ = _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.
╒════════════════╤═════════════════╤════════════════╤═════════════════╕
│ Year, dating │ Legitimate │Hydrant, rental │Domestic revenue │
│ from beginning │ profits of the │ taken over by │ of starting │
│of construction.│ going plant. │starting plant. │ plant. │
├────────────┬───┼─────────────────┼────────────────┼─────────────────┤
│Construction│1st│$60,000 + 0.06_x_│ 0│ │
│ period. │ │ │ │ │
│ │ 2d│ 60,000 + 0.06_x_│ 0│ │
│ │ 3d│ 60,000 + 0.06_x_│ $20,000│ $20,000│
├────────────┼───┼─────────────────┼────────────────┼─────────────────┤
│ Business │4th│ 60,000 + 0.06_x_│ 40,000│ 55,000│
│development │5th│ 60,000 + 0.06_x_│ 40,000│ 80,000│
│ period. │6th│ 60,000 + 0.06_x_│ 40,000│ 90,000 + 0.06_x_│
└────────────┴───┴─────────────────┴────────────────┴─────────────────┘
╒════════════════╤═══════════════════════════════════════╤════════════╕
│ Year, dating │ Interest on the starting plant. │ Operation, │
│ from beginning │ │maintenance,│
│of construction.│ │ taxes, and │
│ │ │depreciation│
│ │ │on starting │
│ │ │ plant. │
├────────────┬───┼───────────────────────────────────────┼────────────┤
│Construction│1st│If the physical validation contains an │ 0│
│ period. │ │ item for lost interest during │ │
│ │ │ construction, the same amount must be│ │
│ │ │ credited to the starting plant as │ │
│ │ │ interest earned. │ │
│ │ 2d│ │ 0│
│ │ 3d│ │ $30,000│
├────────────┼───┼───────────────────────────────────────┼────────────┤
│ Business │4th│ │ 50,000│
│development │5th│ │ 65,000│
│ period. │6th│ │ 70,000│
└────────────┴───┴───────────────────────────────────────┴────────────┘
╒════════════════╤═══════════════════╤══════════╤═════════════════════╕
│ Year, dating │Total difference in│ Present │Present worth of the │
│ from beginning │anticipated profits│ worth │excess of anticipated│
│of construction.│of the two plants. │ factor. │profits of the going │
│ │ │ │ plant. │
├────────────┬───┼───────────────────┼──────────┼─────────────────────┤
│Construction│1st│ $60,000 + 0.06_x_│ 95.2│ $57,120 + 0.0571_x_│
│ period. │ │ │ │ │
│ │ 2d│ 60,000 + 0.06_x_│ 90.7│ 54,420 + 0.0544_x_│
│ │ 3d│ 50,000 + 0.06_x_│ 86.4│ 43,200 + 0.0518_x_│
├────────────┼───┼───────────────────┼──────────┼─────────────────────┤
│ Business │4th│ 15,000 + 0.06_x_│ 82.3│ 12,345 + 0.0494_x_│
│development │5th│ 5,000 + 0.06_x_│ 78.4│ 3,920 + 0.0470_x_│
│ period. │6th│ 0│ 74.7│ │
└────────────┴───┴───────────────────┴──────────┴─────────────────────┘
Total going value = 17,005 + 0.2597_x_
_x_ = $231,000
If highly developed metropolitan conditions are present, new business
will be acquired in the hypothetical starting plant much more rapidly
than where such conditions are yet to be developed. For this reason the
problem cannot be based on the early growth of the same plant, and,
there being no exact duplicate of conditions in existence elsewhere, the
estimate of time required for the business development period is purely
speculative, and must be assumed with great care and judgment, else
injustice may be done to one party or the other in the resulting going
value.
It is interesting to note that, in the Michigan appraisal, the allowance
of a percentage for contingencies was bitterly contested by the
railroads as improper. Probably every appraiser who has been connected
with rate cases has seen this same item strenuously insisted on by the
corporations.
The author's query: should a corporation which is compelled to abandon
appliances while yet serviceable, in response to public clamor, be
allowed any item of value in the appraisal on account of such
appliances, seems to be best answered in the negative. If the appraisal
is for the basis of making rates, the corporation is fully compensated
by the fact that its depreciation account provides for all abandoned
machinery, and the average past depreciation is usually considered a
fair criterion of the future. If the appraisal is for purposes of
taxation, it would seem improper to levy tax on abandoned or rejected
machinery or equipment. If the appraisal is to determine the present
value of a property for sale under condemnation proceedings, it is
likewise difficult to conceive any reason for allowing any present value
on account of property abandoned or rejected, and, indeed, if such
abandoned material had any value at the time of its removal, it is more
than likely that such value was converted into cash at that time.
The statement that no appraiser would be justified in placing a going
concern value on a property 3 years old, or 10 years old, unless the net
earnings were such as to indicate that the property had a commercial
value in excess of the physical property, is questionable. "Commercial
value" is not exactly synonymous with "going concern value," for, as
usually considered, the term "going concern value" represents the
difference between a dead structure and a live one. A property might be
compelled to operate temporarily at rates insufficient to return the
legal rate of interest on the physical value of the property, and while
this condition continued, its commercial value would be less than its
physical value, and yet this same property is worth more while running
than if operation ceased and the business was allowed to die.
HALBERT P. GILETTE, M. AM. SOC. C. E. (by letter).—In common with others
who have written on the subject of appraisals, the author omits
consideration of one of the most important elements of the cost of
producing the property of a public service corporation, namely, the
development expense.
Development expense is the deficit in "fair return" on the investment
during the early years of operation, while the business is being
developed to a point that will yield a "fair return" on the investment.
Unless this development expense is charged to the capital account as
fast as it occurs each year, it should draw compound interest up to the
end of the development period. Development expense might be regarded as
a part of the non-physical value of a plant, and a few years ago the
writer so regarded it. Latterly, however, he has come to see that it
does not differ one iota in principle from "interest during
construction," and, therefore, is properly a part of the cost of
production or of reproduction of the property. During the construction
period, interest on the investment is charged, and properly so, as a
part of the physical cost. Does this interest cease the day after
operation begins? Not a whit. The owners of the property are entitled to
a fair interest—a "fair return"—on their money, from the day it is
invested. At first they receive it in the form of "interest during
construction," which is charged to capital account. After operation
begins they must either be allowed to earn more than a "fair return"
during the fat years following the development period, or the deficit
below a fair return incurred during the development period must be
treated exactly like "interest during construction" and added to the
capital account. If public service corporation managers have chosen the
first of these two methods, it does not relieve the appraiser of the
duty of adopting the second method; for the object of appraisals for
rate-making purposes is to limit capital to a "fair return" on the
investment. In brief, if there are to be no "fat years," then every
"lean year" must be credited with its deficit as fast as it occurs.