American Society of Civil Engineers.

Transactions of the American Society of Civil Engineers (Volume 81) online

. (page 127 of 167)
Online LibraryAmerican Society of Civil EngineersTransactions of the American Society of Civil Engineers (Volume 81) → online text (page 127 of 167)
Font size
QR-code for this ebook


all involved in greater or less amounts in the construction of every
property. They are represented by no physical property item which
can be weighed or measured. They attach to the property as a whole.

Reasonable amounts can be determined for each property by a
study of the history and accounting records of that property and



VALUATION OF PUBLIC UTILITIES 1431

of other similar properties similarly located and built under like
conditions.

It is a fundamental principle of valuation recognized by the Courts
and commissions, and accepted by this Committee, that under normal
circumstances the cost of recently created property furnishes the best
basis for determining the reproduction cost of such property.

The Committee recognizes the value of the study of overhead ex-
penses, incurred in connection -with the construction of properties
similar to the one under consideration, but it does not endorse the inclu-
sion of any allowance which does not represent a legitimate expendi-
ture of money or service in connection with the creation of the property
under valuation, merely because such expenditures have been incurred
for other properties. It does, however, endorse the inclusion of suffi-
cient allowances to cover all legitimate expenditures, and it favors
the use of the percentage on physical costs or any other method that
will give fair and correct allowances.

See also the discussion under the caption "Shall Present or Original
Physical Conditions Govern" (pp. 1363 to 1370).

Auxiliary or Collateral Costs. — Some engineers, particularly on the
Pacific Slope, where large public works are more often executed by
day labor than by contract, are in the habit of keeping their cost
record data, and hence of estimating the cost of work, by including
the so-called "Auxiliary" or "Collateral Costs", comprising incidental
road or railroad construction and maintenance during the execution
of the work, machinery and plant required, and various other similar
classes of expenditures incident to the building of the works, in a
percentage, applied to the basic material and labor costs involved in
the various units or classes of work. Thus, for instance, though the
labor, cement, sand, and gravel costs would be included by these
engineers in the unit cost per yard for concrete, the cost, rental, or
maintenance of the machinery used in the mixing of the concrete,
the cost of the construction and scrapping after the completion of
the work of the bins, railroad tracks, towers or travelers of one kind
or another, used in the mixing, delivery, and placing of the concrete,
would be included in the percentage applied to the above stated unit
costs to cover so-called "Auxiliary" or "Collateral Costs". In this
report it is assumed that the auxiliary and collateral costs are included
in the basic unit prices.

Character of the Items Classed as Overhead Charges. — It is deemed
proper by the Committee to present the considerations which prevail
in the allowance of various items of overhead charges, some examples
of actual costs and allowances under each head, and some of the
more authoritative decisions approving such allowances.

(a) — The Cost of Promotion. — The period prior to the commence-
ment of actual construction of physical properties is, in the case of



1-1:32 VALUATION OF PUBLIC UTILITIES

most properties, divided into two parts: the period of promotion and
the period of corporate organization after the promotion has been
brought to a successful issue.

It is clear that the amount of money actually spent in promotion
may have a wide range. In the case of such properties as hydro-
electric power developments, years of time and large sums of money
may be required to secure title to lands and flowages and to bring
the project to such form as to justify the attempt to raise funds for
actual construction. Other properties may involve but little expense
or but little outlay or money. Still other properties may have a large
or small outlay on the initial construction, but the major part of
the property, developing after operation of the pioneer lines, and built
as additions to an existing operating property, may have very little
actual cost of promotion.

The argument supporting the allowance of cost of promotion is
ably stated in the decision of the Michigan Eailroad Commission in
the hearing on the application of the Northern Michigan Power Com-
pany for authority to issue securities. The decision, written by Com-
missioner Lawton T. Hemans, discusses "Cost of Promotion", in
connection with the cost of acquisition of lands for hydraulic pur-
poses, as follows (19 A. T. and T. Co. Com. L-253-254, June 11th,
1913) :

"Another item which it seems to the Commission is properly in-
cluded in the value of lands for hydraulic purposes, under the Com-
mission's general designation of 'reasonable compensation for the time,
energy and ability bestowed in their acquisition', is the item quite gen-
erally denominated 'promoter's profit', but which this Commission be-
lieves would be more truly descriptive if denominated 'cost of promo-
tion'. The man who devotes his genius to enlisting support for great
enterprises of public benefit, which his clearer foresight and keener
vision has first perceived in the great world of material development, has
performed services quite as valuable to the public as the engineer who
later makes computations, plans and specifications, or the man who
in any other jjosition contributes to the creation of the utility.

"In passing upon the value of services of this character, the New
York Public Service Commission has said that such services 'should
be fairly and even liberally rewarded by the public which receives the
benefit of these works. Such rewards, however, should be put upon
a clear basis of business principles, should be of sufficient magnitude
to encourage rather than discourage enterprise, and should not he
so great as to make an exorbitant demand which is perpetual in its
nature upon the community to be served. They are to be treated
simply as just payments for services performed for the corporation,
which services are valuable and in many cases even indispensable.
Such services should be paid for upon the basis of what they are fairly
worth, having regard to all the circumstances of the case'. (In re appli-
cation, Rochester, Corning, Elmira Traction Co., 1 P. S. C, 2d D.,
N. T., 166.)



VALUATION OF PUBLIC UTILITIES 1433

"In the above case the award was made upon the basis of five
per cent, on the entire cost of the enterprise, which had a total cost
approximating seven million dollars. Other awards have been made
by the 'New York Commission of varying percentages upon the esti-
mated cost of the particular utility.

"In the matter under consideration, request is made to include in
capitalization as compensation for promotion, two and one-half per
cent, on the estimated cost. The Commission is persuaded that in cases
of tjiis character the item of cost of promotion attaches peculiarly
to the lands and flowage rights of the development, for, if it is to
be justified, as we have indicated our belief it should be, as com-
pensation for a peculiar service incident to every comprehensive
scheme of material development, then it should in principle inure
to the value of the thing in relation to which the particular service
was rendered. It should be compensation to the pioneer, rather than
to those who claim neither originality of conception or to have assumed
any of the risks of development."

That this element of cost is recognized by the Interstate Com-
merce Commission is shown by the provision, in the account designated
as "Organization Expenses" for

"* * * Cost of preparing and distributing prospectuses; cost
of soliciting subscriptions for stock; cash fees paid to promoters, and
the actual cash value (at the time of the organization) of securities
paid to promoters for their service in organizing the enterprise."

Examples of actual costs of promotion are difficult to cite, for
the reason that the accounting for such costs has been as a rule under
the head of general expense, or of organization, and have been merged
with other costs which belong properly in organization, administration,
or legal expenses.

(h) — The Cost of Financing. — When the project of the promoter
has been investigated and found to be sound, and after a plan for the
financing of the company has been adopted, there is incurred consider-
able expense in connection with the issue and sale of stocks or the
issuing and marketing of bonds and the payment of commissions to
brokers. There can be no question as to the necessity for such expen-
ditures. They are unavoidable, and should be allowed in proper
amount.

Whether discount on securities is an allowable item, is an open
question. Discount may be a partial capitalization of the commercial
risk had in making the investment, it may be an indication of lack of
credit on the part of the company, or it may indicate that the interest
rate on the bonds is lower than the conditions of the market would
warrant, and the discount is in effect an adjustment of the interest rate
or a prepayment of interest. If the company secures the benefit of the
low interest rate, it would be unfair to capitalize the discount. !Nor
would it seem any more fair to capitalize excessive risk or poor credit.



l-iS-i VALUATION OF PUBLIC UTILITIES

That regulating authorities and Courts are not in perfect accord, is
shown by the conflicting opinions quoted.

In a Montana rate case (198 Fed., 1003), Judge Hunt says:

"The master allowed 15 per cent, of $562 715.89, or $84 407.38, as
a necessary and usual item of cost of reproduction. There was no
evidence offered on behalf of the Railroad Commission tending to dis-
pute the conditions which the witnesses for the complainant said existed
generally throughout investing communities, namely, that a railroad,
such as the one under investigation, is only able to make its financial
arrangements by regarding as a part of the construction cost to which
it is subjected a discount representing the difference between the
amount derived from the sale of its bonds and the amount which the
bonds must eventually cost the company. Recognition of discounts on
securities, based upon the considerations just expressed, has been made
by the courts. Of course there never could be any allowance whereby
a corporation can be allowed to capitalize its own lack of credit; but
where the bonds are sold at a reasonable discount, and bear a low rate
of interest, it would seem to be the equivalent of selling the bonds at
par with a high rate of interest. Here the 15 per cent, seems to be
reasonable, the testimony showing that upon such a discount the bonds
are put upon an equality in marketable conditions with the bonds of
some of the very largest and most successful railroads in the country."

Commissioner Hemans, in the Northern Michigan Power Company
case, says:

"The application filed herein makes request for the allowance of an
item of 2J per cent, on the cash cost of construction and physical prop-
erties to cover the item of banking and brokerage. Unquestionably
every comprehensive development of the character being considered
finds it expedient to enlist the services of a reputable broker who must
be compensated for the investigation he shall make into the basis of
the securities, which, if found satisfactory and desirable, he shall
recommend to his clientage, but it is a service that is incidental to the
sale of the securities or the borrowing of capital. It is an item most
intimately connected with bank discount which is in part the rate which
a given concern must pay for its loans. We believe that under pre-
vailing practices, in view of the discount at which it is desired that the
bonds to be authorized herein may be sold and at which like securities
are sold, there is no justification for the inclusion of this item in
capitalization, but that it should be included with the bond dis-
count and ultimately extinguished by amortization from the profits of
operation."

In the Des Moines gas case (238 U. S., 153), already quoted, Mr.
Justice Day quotes the Master, as follows:

"Time and money expended in the promotion of the enterprise in
the organization of the company and interesting capital therein, includ-
ing also legal expenses, obtaining the necessary franchise as well as
the costs of incorporating the company."



VALUATION OF PUBLIC UTILITIES 1435

The Committee is of the opinion that the cost of financing should
include all fair costs for interesting capital and issuing and market-
ing securities. Discount on securities should not be included in capital,
but should be amortized over the period of the life of the securities.
The fair cost of financing will depend on the probable rate of return,
the credit of the promoters, and the degree of hazard attending the
project. If a sufficiently high rate of return is assured and the credit
of the promoters is good, the cost of financing should be low, little more
than an ordinary brokerage rate. Poor credit should not be considered
in estimating cost of reproduction, but probable rate of return and the
hazard of the enterprise should be considered, and the fair cost of
financing estimated as affected thereby.

(c) — The Cost of Organization. — Under this caption is included a
class of expenditures common to all properties, distinct from "Cost of
Promotion" in that they usually follow the promotion, and are incurred
after the project is assured. There may be many cases in which they
merge with the cost of promotion. There are undoubtedly some cases
where "Cost of Promotion", "Cost of Financing", and "Cost of Organi-
zation" may all be includible under the head of organization. The
class of expenses specifically referred to includes costs connected with
incorporation and securing a charter, cost of securing franchise, local
grants, consents of property owners, consents of the Government, as
in case of construction over or under navigable waterways, and all
other expenses connected with the organization of the company which
is to build the property, and the securing of all the necessary rights,
grants, and privileges necessary to permit it to proceed with actual
construction.

lu Bonbright vs. Geary (210 Fed., 44), already quoted, there were
included "The legal expenses of organization."

In the Des Moines gas case (236 U. S., 153) there were included
"legal expenses obtaining the necessary franchise, as well as the costs
of incorporating the company."

In the Knoxville case (212 U. S., 1) the sum of $10 000 was allowed
for "Organization, Promotion, etc." The Court assumed this to be
a proper allowance without deciding.

(d) — Engineenng . — As an "Overhead Charge" there should be
included all engineering costs not capable of specific assignment to
property units or special parts of the property.

The general engineering charge, in the case of most properties, is
a very considerable item, in some cases amounting to a large per-
centage. The percentage differs with the character of the works and
with the care and skill exercised in their construction.

In the case of a railroad property, general engineering includible
as an "Overhead Charge" would cover all the reconnaissance or gen-
eral investigation of the territory through which the line was to run.



1436 VALUATION OF PUBLIC UTILITIES

the preliminary surveys, the final location, the general supervision of
the chief engineer and assistants whose time is devoted to general,
not specific, work, all services of consulting engineers not capable of
definite assignment to specific units of property, and much of the
expense of the office staff of the chief engineer's office.

In the case of most old properties, it is difficult to draw exact lines
between these general engineering expenses and the engineering and
inspection during construction, and in many instances it may be
desirable to include all engineering as an overhead charge.

In connection with a water-works property, large expenditures
must be made for investigations of drainage areas, general surveys,
plans and specifications, and general supervision of all constrviction.

In the illustrations cited of actual engineering costs, no attempt
has been made to segregate general engineering charges and direct
supervision, all preliminary, general and direct charges being lumped.
In case the segregation can be made, it will be found in every case
that the overhead charge for general engineering is a very considerable
item, which cannot be overlooked or dismissed because of charges to
direct supervision.

Examples of actual costs of engineering indicate that there is a
rather wide range in the percentage, even on the same kinds of prop-
erty, due to the presence or absence of a large number of property
units which carry high costs of direct supervision. This goes far
toward supporting the argument of the Committee that these figures
should be analyzed.

The construction of an important dam or aqueduct, built in place
and requiring skill in designing, and a careful inspection of every part
of the work as it is built, requires a larger expenditure for engineering
than a large cast-iron pipe line, where the cost of laying the pipes in
a trench is but a small percentage of the total cost of the line, and the
work progresses so rapidly that the inspection cost is small in pro-
portion to the total cost. The charge to direct supervision would be
much greater in one case than in the other, and if such charge be
made, general engineering overhead charge will be more nearly com-
parable with other like properties.

The cost of engineering varies, not only with the class of work,
but with the character of the design and method of its execution —
whether by day labor or contract, and in the latter case the nature of
the contract. Works may be built with little inspection, from crude
designs prepared by unskillful engineers, with the result that the cost
of works may be large, although the percentage paid for engineering
may be small. Works skillfully designed and efficiently constructed
imply a larger cost for engineering, which should be recognized in any
valuation when the works give evidence of such skill and efficiency.



VALUATION OF PUBLIC UTILITIES l-iS'I'

(e) — AdminisWation. — Under this head should be included all
allowances to cover the salaries and expenses of executive officers
during the period of construction. Also all clerks and other employees,
office rent, and expenses in connection with the supervising, accounting,
and other offices, except law or engineering.

This allowance should cover, when necessary, all general police
and sanitary department employees.

These expenses, like those for engineering, vary, depending on
the character and location of the work, legal requirements, and
methods of construction followed.

As accounting records have been kept in the past, they are difficult
of exact analysis by examination of old records of construction, as
they have often been merged with other accounts. There has been such
a universal recognition of the propriety of the inclusion of an allowance
in proper amount that no argument is considered necessary.

(/) — Legal Expense. — The law expense incident to construction
will vary greatly, depending on the character of the work, the popu-
lation in the territory in which the work is being done, and the laws
which control the operations of corporations as to securing rights or
as to construction.

One property may be situated so that few if any obstructions are
placed in the way of its construction, and another similar property,
in another State, may have not only to pay large sums for legal
services necessary to carry out the reqi;irements of statutes and ordi-
nances, but may have to resort to extended litigation before the work
is completed. This fact makes necessary a consideration of the his-
tory of the property in connection with the allowance for "Legal
Expense". This allowance has been made in nearly all past valuations.
It is a proper allowance, and should be made in such amount as will
adequately cover the expense in each case.

ig) — Interest During Construction. — Before the construction of
works of magnitude can be undertaken, financial arrangements must
be made for the advance of the necessary funds. If the period of
construction involved be comparatively short, such as one or two
years, it has generally been found advantageous, if not necessary, to
borrow the entire sum needed in advance of construction. If, on
the other hand, the period of construction is a long one, such as from
5 to 10 years, as is true in the case of most large properties, or large
parts of properties which have been built during one construction
period, instead of developing from small beginnings, it is generally
found advantageous to make arrangements for the advance of stated
sums at different times during the construction period. Generally,
bankers and underwriting syndicates prefer, how^ever, to make arrange-
ments on the basis of purchase of the entire bond issue, though the
bonds be delivered at stated intervals in blocks, and allowance be



1438 VALUATION OF PUBLIC UTILITIES

made for repayment of a nominal rate of interest, such as 2% on
unexpended bank balances.

Necessary financial arrangements involve the payment during the
construction period of interest on the funds borrowed, or advanced
by the owner of the property. It is logical to include these interest
payments in the construction cost of the property up to the time when
the workable units of the plant are put into actual revenue-producing
operation; then the interest payments involved by the investment in
the unit of operating property should be accounted in development-
expense during the period involved in the acquisition or establish-
ment of the business to the point where the earnings are sufficient
to meet the fixed charges, as well as the operating expenses and depre-
ciation allowance; thereafter, the interest payments should be
accounted as fixed charges, to be met from the net revenue or divisible
earnings of the property.

The determination of the exact time vv'hen the dilferent workable
units of the property may fairly be assumed to have crossed the dividing
line between the "construction-period" and the "physical development-
period" is difficult; but this is not a matter of controlling importance
if proper allowance be made for the development expense element of
the value in the property.

All the arguments for the inclusion of a proper allowance for
"Interest" are stated so fully by the Wisconsin Eailroad Commission
in the Madison Gas and Electric Company case (4 Wis. E. C. R.,
501-541, decided March 8th, 1910), that no further discussion appears
to be necessary :

"While all these points are interesting, and contribute to an intel-
ligent discussion and determination of the question at issue, it would
seem that the interest during construction, correctly allowable in
a valuation under ordinary conditions, would be interest at the current
rate on the cost of each part of the plant during its construction. The
element of cost by reason of interest during construction is one which
cannot be escaped. It is present to some extent no matter what the
method of financing the construction may be. From the time the
investment for construction is made until the completion of the
entire plant enables the investment to become active as an integral
part of a working whole, there is the element of interest, for that in-
vestment is necessarily involved and is necessarily idle until the
completion of the plant to a working point. The fact of interest,
like the fact of depreciation, is present, no matter what method is
employed for financing it. This is as true when the money is fur-
nished by the owners as when it is borrowed by them. The theory
upon which such interest rests is sound, and remains so even in isolated
cases where the investors decide to charge no interest, and choose to
donate the same to the consumers in the way of lower charges for the
services rendered. Even if the company let a contract for the com-
plete construction of a plant, to be paid for in no part until wholly



VALUATIOX OF PUBLIC UTILITIES 1439

completed to the operating point, interest cost would come in as a
part of the contract price, even though not expressly set forth. In
that case the contractor would have to ask a higher price to cover



Online LibraryAmerican Society of Civil EngineersTransactions of the American Society of Civil Engineers (Volume 81) → online text (page 127 of 167)