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

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embankments, and along the slopes of railroad cuts. They are pro-
duced by compacting under the action of the elements; through use,
such as the running of trains of a common carrier; through the skillful



1500 VALUATION OF PUBLIC UTILITIES

direction of labor, of a common carrier or other public service corpora-
tion, in checking wastes on the slopes of embankments, and encourag-
ing the growth of vegetation: — the final result being a solidified condi-
tion of the entire roadbed or other form of construction with greater
compactness in the case of banks, and the drying out of cuts and the
solidification of the slopes of cuts. The results of solidification and
seasoning are a reduction in the cost of maintenance of the property
of any common carrier, or the property of any public service corpora-
tion that receives any form of protection due to age and the action of
the elements, combined with properly directed maintenance labor.
Rip-rap becomes more settled, compact and secure; trees and shrubs,
planted for ornamentation or snow protection, increase in usefulness
and value with age and care. In railroad property a higher value is
evidenced by the fact that trains can be run at greater speed and with
greater safety; and that the expense of operation is reduced, and
fewer accidents occur, after many years have passed since the property
was a completed new one.

It is generally conceded that appreciation in the form of solidifica-
tion and seasoning continues over a long period of years. For example,
a railroad 40 years old is much better than one 5 years old. In
measuring all forms of appreciation which may occur, however, it is
necessary to have a full knowledge of what methods have been used
by common carriers in process of construction and in the period of
physical development following the construction period. A railroad
property is not a finished product when the construction forces have
put its parts together and turned it over to the operating department.
The subsequent work done upon it, and the quantities subsequently
added to it to produce the finished product, should be covered by the
cost of reproduction rather than under appreciation.

Take, for example, the Virginian Railway, 444 miles long; track-
laying was started in 1905 ; train service was begun on some parts of
the line in 1907; operation was begun under difiiculties in 1910; bal-
lasting, etc., was completed in 1915. In the 8 years (1907 to 1914,
inclusive), during which physical development period the first stage
of solidification was in progress, the excess cost of ordinary labor per
mile of track totaled $1 630.

Again, on the Big Sandy low-grade line of the !N"orfolk and Western
Railway, 59 miles long, tracklaying was started in November, 1903,
and operation was begun under difficulties in 1904, with some con-
struction work in progress until 1907. During the 3 years of the
physical development period, while some construction work was still
under way and the first stage of solidification was in progress, the
excess cost per mile of ordinary section labor was $3 090 more than
that during the 3 years immediately following.



VALUATION OF PUBLIC UTILITIES 1501

The items of cost in general maintenance labor, sucli as these in-
curred during the period between the beginning of the operation of
any portion of a railroad and the final completion thereof by full
ballasting, etc., which generally covers a period of several years, is an
item of cost to the property, whether it is charged to construction
accounts or not; and it most frequently has not been so charged in
the past. Hence, in determining the cost of reproduction new of a
property, this item of cost, which will vary in different sections of the
country, as shown by the two examples, the extreme case given being
in a difficult country, so far as control of slopes is concerned, must be
added to the cost of reproduction as determined by measurable imits.
Care should be taken in analyzing these costs that they may not be
duplicated in reproduction cost or appreciation and in development
expense.

In addition to this, however, there is an increased value that comes
to such a property by reason of solidification and seasoning, due pri-
marily to time and use. that continues for many years after the entire
completion of a railroad.

Adaptation. — Adaptation is the adjustment of the physical prop-
erty to its environment and purposes, and is brought about in the
course of time by the action of the elements combined with labor. For
example, in the case of a stream, where by successive floods the stream
may deepen and scour out its channel and make more safe adjacent
embankments. After a railroad is in operation, many changes are
made in roads and drainage, as between the railroad and adjoining
lands, all traces of which are lost in a few years thereafter; likewise,
culverts originally built are found to be too small and are necessarily
enlarged, or the approaches and outlets are changed. Briefly, there-
fore, adaptation is exemplified in improvement in drainage, both on
the right of way and outside the limits of the right of way, which has
been made from time to time by the forces of the railroad company
or other public service corporations, the value of which cannot be
determined by measuring items of quantity at the date of valuation.
It is an item of charge to the cost of reproducing a roadbed or dams,
canals, and embanlcments of the class mentioned, of the drainage area
in connection with the dam of a water company. This class of appre-
ciation should be taken into consideration along with solidification and
seasoning.

The best method of estimating appreciation due to solidification,
seasoning, and adaptation appears to be by comparing the cost of
maintaining a new road, directly after it has been entirely completed,
with the cost of maintaining an old road in the same district imder
similar conditions of traffic.

In one case of a western railroad the cost of maintenance of a new
line, 175 miles long, was compared with the cost of maintenance of an



1502 VALUATION OF PUBLIC UTILITIES

old line of the same length. In 2^ years the excess cost spent on
the new road, to make it comparable with the old one, aggregated
$1 400 per mile.

Another way is to assign a direct percentage to the grading
quantities.

In California allowance was made of 2% a year for 5 years on all
earth and loose rock quantities, and 1% per year on all solid rock quan-
tities, for solidification and seasoning. This might be used as a
minimum, to which should be added $600 per mile for all roads more
than 5 years old.

Care must be taken in estimating appreciation that items of labor
and expense, included therein, may not be duplicated in development
expense.



VALUATION OF PUBLIC UTILITIES 1503



CHAPTER VII.



DEVELOPMENT EXPENSE.
The Nature of Development Expense.

The Committee recognizes two principal periods in the creation
of a going concern operating a physical property for the production
of a commercial commodity, be that commodity water, gas, electricity,
sugar, textiles, or any other thing, or the transportation of persons,
property, or thought. These two periods are:

1.— The construction period, which covers the interval from the
inception of the enterprise to the beginning of regular oper-
ation.
2. — The development period, which covers the interval from the
beginning of regular operation to the time when efficiency
and profitableness of operation shall have been achieved.

Corresponding with the two periods recognized, the Committee
divides costs into two classes — construction costs and development
expense. The estimated cost of construction includes all costs incurred
during the construction period, and, as will appear, may include cer-
tain costs incurred during the development period.

Development expense is of two kinds: (a) the cost of tuning up
the physical property and bringing it to present operating efficiency;
and (&) the cost of acquiring the business.

The cost of tuning up the property and bringing it to its present
state of operating efficiency stops at the end of what may be called the
physical development period, which is usually included within the
development period as previously defined, and the cost may be included
in the cost of construction.

The cost of acquiring the business usually extends throughout the
development period, though there are cases in which a profitable
business develops at the very beginning.

The physical development cost, which should be included as a part
of the construction cost, comprises the items of work required to bring
the property to an efficient operating condition, such as: the extra
work required on new embankments to maintain tracks in proper
operating condition ; the cost of testing and sometimes of re-adjusting
and remodeling all sorts of machines to make them operate properly,
or to increase their efficiency; the making good of defects which have
become visible after a property becomes operative; and a great
variety of other expenses incidental to the first operation of a prop-
erty, which are not incurred in subsequent years after that same
property has reached full operating efficiency.



1504 VALUATION OF PUBLIC UTILITIES

The Committee also recognizes going value, as defined by it, as
quite independent of development expense, and discusses it in Chapter
VllI on Intangible Value.

Development Expense as a Part of Original Cost.

On the basis of original cost, the development expense in any one
of the early years when the earnings are deficient will be obtained
by deducting the actual receipts from the gross amount that the owner
of the property is entitled to earn in that year. Such gross amount is
the sum of these items :

(a) The expenditures for operating expenses and taxes;

(6) A sum to offset the waste of capital through depreciation;

(c) A sum representing a fair return on the investment, includ-
ing money, and the money value of services and of other con-
siderations.

The difference between the actual and the fair gross receipts for
tlie first year is the development cost for the year, which should be
added to the investment at the beginning of the second year in
order to obtain a basis for estimating fair return for that year. By
following the same course for successive years, adding the develop-
ment cost for each year until there is no further deficiency of earnings,
a sum will be reached which will represent the amount of the invest-
ment at the end of the development period, and the difference between
the investment at the beginning of operation and at the end of
the development period will represent the development expense.

It should be noted that the development cost obtained in the manner
recommended includes also the physical development costs of those
years when the earnings were deficient. So far as possible, these should
be separated from the total sum found, and included as a part of the
construction cost of the physical property.

After the property originally built has attained adequate and
steadily maintained earning capacity, the ordinary additions of subse-
quent years may involve little or no additional development expense,
except for the cost of testing and tuning up plant units, because there
will be no deficiency of earnings caused by such additions, but, from
time to time, additions may be made of such magnitude that the
earnings will again become temporarily deficient.

Losing Venture. — Fair dealing demands that the development ex-
pense actually incurred in tuning up and developing the business of
a normal property be properly recognized, and the Committee believes
there is no more equitable way of doing this under normal conditions
than by including it as a part of the capital account. It recognizes,
however, that there may be abnormal conditions luider which this
method should not be followed, as, for instance, where the net



VALUATION OF PUBLIC UTILITIES 1505

receipts are unnecessarily low on accoiint of bad management, or where
bad judgment has been used in the location or design of the plant, so
that the property is bound to be a "losing venture".

It does not seem desirable that the general rule should be modified
because of these exceptions. In the application of the rule to specific
cases, it will not be especially difficult to distinguish between profitable
properties and distinctly losing ventures, but it may be difficult to
distinguish legitimate development expense from the cost of bad
management, in connection with those properties that are neither
very profitable nor distinctly losing ventures.

Amortization v. Capital Charge. — It is sometimes urged that,
although development expense is a real expense incurred in devel-
oping a property and its business, that part which is not a con-
struction cost should be separated from other costs and repaid
by means of earnings in excess of a fair return on the "fair
value" of the property as soon as practicable after the business has
increased to such an extent that excess earnings may be obtained
by the maintenance of the previously existing rates. This requires
the maintenance of the high initial rates for a longer period than would
be necessary if the development expense is included in the return base.

When it is thus included, the deficiencies in the early years are
made good by the greater earnings throughout all subsequent years,
resulting from the larger return base on which earnings are predicated.
The inclusion of development expense in the return base appears to
have advantages in that it furnishes a more definite and simple method
of accounting, and permits the adoption of normal rates at an earlier
period than under the other plan. The cost of developing the business
is just as much a part of the cost of producing the property, as is
the cost of the physical items. Moreover, the Committee sees no
reason, in principle or in equity, why this element of cost should be
amortized, any more than the cost of the physical property.

Difficulties.— In the determination of development expense there
may be difficulty in determining what is a fair return, not only because
of possible differences of opinion as to what is a proper percentage to
adopt as a return on investment, but because of the difficulty in deter-
mining a proper sum for the depreciation allowance to be used in com-
puting the gross fair earnings. This difficulty is minimized if the at-
tempt is made to determine these sums only for the first few years of
the life of a property, when there is a deficiency of earnings, and is
greatly increased if the attempt is made to determine the fair return
and the proper depreciation allowances for a series of years, while
the deficiencies are being offset. Practical attempts to determine the
net excess or deficiency of earnings in a long series of years, in the case
of properties of considerable age, have shown that a slight difference
in the percentage assumed for the fair return will cause such very



1506 VALUATION OF PUBLIC UTILITIES

great variation in the estimated development expense as to show that
the method will not give trustworthy results when applied to moat
existing properties.

The Committee recognizes that public regulating bodies having
control of both the accounting and the rate-making of the utility
from the beginning of its operation may in the future adopt other
methods which will offset such losses or amortize them, but these
methods should not be applied to existing properties.

The Courts have ruled that the effects of regulation cannot be made
retroactive, and that one cannot go into the "unregulated past".

Ames V. Union Pacific, 64 Fed., 165, 176 (1894). Mr. Justice
Brewer. "The same rule controls if a railroad property is sought
to be appropriated. N'o inquiry is open as to whether the o^vner has
received gifts from States or individuals, or whether he has as owner
managed the property well or ill, or so as to acquire a large. fortune
therefrom. It is enough that he owns the property, has the legal
title; and so owning, he must be paid the actual value of that property.
If he has done any wrong in acquiring or using the property, that
wrong must be redressed in a direct action therefor, and cannot
be made a factor in condemnation proceedings. These propositions
in respect to condemnation proceedings are so well settled that no
one ever questions them. The same general ideas must enter into
and control legislation of the kind before us [rate regulation]."

Public Service Gas Co. v. Board of Public Utility Commissioners,
N. J., 87 Atl., 651 (1913), which was sustained by the Supreme Court
of New Jersey, 87 Atl., 657 (1913).

"But as we have indicated above, the business thus acquired must
be regarded as a legitimate part of the property of the company. We
cannot equitably project back into the imregulated past a nome of
prices that might to-day be regarded as fair and adequate, and assume
that actual rates exacted in the past, in so far as they exceed what
are now deemed fair, have not lawfully become the property of the
company. If these high rates in the past have been employed by the
company to acquire an intangible property in the shape of extensive
patronage, that expectation of patronage is theirs and on its fair
v^alue the company is entitled to a return. It may or may not be a
subject of regret that regulation was so 'long deferred; but deferred
regulation is no excuse for refusing at present to allow a fair return
upon what is the lawful property of the company."

Therefore the Committee holds that development expense cannot
fairly be assumed to have been amortized in the past in old properties
by excessive earnings, and that it should be included in present valua-
tion, whatever changes in policy as to future costs or increments in
value may be made by the regulating body hereafter. Moreover, the
Committee thinks that in future regulation it is sovmder public policy
not to amortize development expense.



VALL'ATiOX OF P|-B[,K.' UTILITIES 1507

The determination of tiie proper rate of return is a matter to
be decided by the Courts or regulating bodies, and an engineer, in
making an estimate of development expense in the manner recom-
mended, should state the rate of return on which it is based, so thai
the Court or commission will have the means of modifying the estimate.

Development Expense as a Part of Reproduction Cost.

Tlie foregoing discussion relates to development expense as a part
of the determination of the original cost of a normal property, and,
as it is a real cost in connection with the original property, it is also
a proper element to include in reproduction cost, but the difficulties
of determining the development expense of reproduction cost are
greater than in the case of original cost, because of the assumptions
which it is necessary to make.

Shall it be assumed that the development expense will be based
on the conditions which existed when the various parts of the property
were created, or on the expense that would be involved if the property
were to be re-created under the conditions existing at the time of valua-
tion? Shall it be assumed that the existing business is ready and
waiting, or that it has to be re-acquired at the time of valuation?

If the property under consideration has grown by additions made
from time to time, so that it is now several times as large as when
originally constructed, there would be, on the basis of the conditions
which existed when the property was created, a large percentage for
development expense in connection with the original property, because
there had to be an actual acquisition of business at that time; but,
on the other hand, there would be a very small percentage of develop-
ment expense attributable to the additions.

If based on reproduction under existing conditions, the develop-
ment expense would apply to the entire property reproduced.

The Committee believes, as already indicated, that development
expense is a real cost in the production of a going property, and thai
it should not be ignored in the reproduction cost. It is somewhat
difficult of determination in any case, by reason of the necessity of
distinguishing between proper deficits and deficits due to management,
in ordinary properties which are neither very profitable nor losing
ventures, but no such difficulty of estimation should prevent its
inclusion, when present, and when its amount is estimated as well as
possible. It is especially a feature of valuation which should depend
on reasonable assumptions based on known occurrences in connection
with the property under consideration or similar properties in other
cases.

Attitude of Courts and Commissions.

Development expense has been generally recognized in recent years
by both Courts and commissions, usually under the title of "going



1508 VALUATION OF PUBLIC UTILITIES

value". Sometimes these bodies have used the terms "going value"
and "going concern value" to represent the intangible values of a
going concern as compared with a dead one, but many times the terms
are used with a meaning corresponding to the definition of development
expense given by the Committee.

Going Value (Development Expense) Discussed. — A very complete
discussion of going value is given by Judge Miller of the New York
Court of Appeals in the Kings County Lighting case (People ex rel.
Kings County Lighting Co. v. Willcox, 210 N. Y., 4Y9, March 24,
1914). He gives (at page 492) the following definition of going value,
which agrees closely with the definition of development expense adopted
by the Committee, and the decision, although using the term "going
value", may be considered as relating to development expense.

"I define 'going value' for rate purposes as involved in this case
to be the amount equal to the deficiency of net earnings below a fair
return on the actual investment due solely to the time and expenditures
reasonably necessary and proper to the development of the business and
property to its present stage, and not comprised in the valuation of
the physical property."

This case was one in which an appeal was made from the Court
below, and four questions were asked. The one relating to develop-
ment expense was as follows (at page 481) :

"(1) Was the relator entitled, upon the facts shown in the record,
to have the commission make an allowance for going value in deter-
mining the value of the relator's property used in the public service?"

The opinion is too long to reproduce in full in this place, but the
more pertinent parts are as follows :

''It is now generally recognized that 'going value', as distinct from
'good will', is to be considered in valuing the property of a public
service corporation either for the purpose of condemnation or rate
making, but there is a wide divergence of view as to how it is to be
considered."

*******

"The difficulty of determining 'going value' will not justify the
disregarding of it. Rate making is difficult. But that will not justify
confiscation. The difficulty, however, will lessen, as it does in most
cases, when we cease to think about the subject vaguely. What then,
is 'going value', and how is it to be appraised?

"It takes time to put a new enterprise of any magnitude on its feet,
after the construction work has been finished. Mistakes of construc-
tion have to be corrected. Substitutions have to be made. Economies
have to be studied. Experiments have to be made, which sometimes
turn out to be useless. An organization has to be perfected. Busi-
ness has to be solicited and advertised for. In the case of a gas
company, gratuitous work has to be done, such as selling appliances
at less than a fair profit and demonstrating new devices to induce



VALUATION OF PUBLIC UTILITIES 1509

consumption of gas and to educate the public up to the maximum point
of consumption."

* * * # -K- * 4{

"To view the matter in another aspect, take the case of a public
service corporation with a plant constructed just ready to serve the
public. It is going to take time and cost money to develop the highest
efficiency of the plant and to establish the business. Three courses
seem to be open with respect to rate making, viz. : 1, to charge rates
from the start sufficient to make a fair return to the investor and
to pay the development expenses from earnings, a course likely to
result in prohibitive rates except under rare and favorable circum-
stances; 2, to treat the development expenses as a loss to be recouped



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