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out of earnings, but to be spread over a number of years, in other words,
as a debt to be amortized, that involves complications, but would seem
to be fairer to the public and certainly more practical than the first;
3, to treat the development expenses, whether paid from earnings or
not, as a part of the capital account for the purpose of fixing the
charge to the public. The last course would seem to be fairest to both
the public and the company, as well as the most practical.

"It may be, as is urged, that a well-conducted enterprise will
charge the cost of developing the business to operating expenses, and
that it would open the door to an overissue of securities to permit the
capitalization of early losses. In answer, it is sufficient to say that we
are dealing, not with proper methods of bookkeeping, not with the
proper capitalization upon which to issue securities, but solely with the
fair return which the company is entitled to receive from the public.
Treating a reasonably necessary and proper outlay in building up a
business as an investment for the purpose of determining the fair
rate of return to be charged is far from holding that it should be
treated as capital against which securities might be issued.

"We do not say as matter of law that the third course above out-
lined should be adopted as an original proposition. That may present
a question of economics, depending on the particular conditions
involved. The commission in this case had to determine the rate to be
charged, not by a new company with no business, but by an old com-
pany with an established business. The first question, therefore, to
determine on this branch of the case was whether the company had
already received a fair return on its investment. If it had received
such return from the start, or if in later years it had received more
than a fair return, the public would already have borne the expense
of establishing the business in whole or in part, and to that extent the
question of 'going value' for the purpose of fixing a present rate would
be eliminated; for it must constantly be kept in mind in dealing with
this problem that the company is entitled to a fair return and no
more. If it has already had it, that is the end of the matter. If it
did not receive a fair return in the early years owing to the establish-
ment of the business, a subsequent rate must allow for that loss or it
will be confiscatory."

The conflict in view, expressed in the concluding sentences quoted
above, and the earlier citation from the U. S. Supreme Court, in
Ames r. Union Pacific, 64 Fed. 165, 176, (1894), is to be noted.



1510 VALUATION OF PUBLIC UTILITIES

Nevertheless, the Federal Court decision has been reaffirmed in a
long line of later decisions, and would seem still to hold, as the position
of the highest Court of the land.

Conclusions.

The Committee recognizes development expense as a possible,
usual, and, in most undertakings, an unavoidable real cost in the pro-
duction of a normal going property, and as quite distinct from going
value as defined by it, and discussed in Chapter YIII upon Intangible
Values. It is measured in nearly all cases by the difference between
the amount which the company is entitled to earn in the early years
and the amount which it actually does earn.

On the basis of original cost, if the accounts are available, the
development expense can be determined from the accounts, taken in
connection with estimates of the proper sums to be allowed for depre-
ciation and for fair return on the investment. If the accounts are
not available, the development expense must be estimated on reason-
able assumptions based on known occurrences in connection with
similar properties. It is commonly the case that the general condi-
tions existing when the original property was created can be ascer-
tained with sufficient accuracy for determining whether or not there
were early deficits and approximately their amount.

For ordinary additions to the original property, in the case of a
prosperous company, there would be no deficiency of earnings, but,
from time to time, large additions might cause a temporary deficit
which should be taken into account.

As development expense is a real cost of producing the original
property, it should not be ignored in the reproduction estimate, and
the Committee believes this to be especially a feature of valuation
which should depend upon reasonable assumptions based on known
occurrences in connection with the property under consideration or
similar properties.

A determination should be made in regard to whether the property
under consideration is a "losing venture" which cannot earn a fair
return on the ''fair value" of the property. In such a case, develop-
ment expense cannot be obtained, because it is based necessarily on
the theory of a fair return. In such cases, also, the development
expense is unimportant, because the return is independent of the "fair
value" of the property deduced either from original cost or reproduc-
tion cost.

It is not to be assumed that merely because the property failed
to earn an adequate return for a certain number of years, the project
was a losing venture. Thus many, if not most, water-works properties
built prior to the Nineties, generally required a period of well over
a decade to develop normal revenue. Their gi'owth was slow diiring



VALUATION OF PUBLIC UTILITIES 1511

the first 15 to 20 years in many cases, nevertheless it cannot be doubted
that higher returns could have been collected from their consumers
in the majority of cases had it been possible to raise the rates.

Properties vary greatly in respect to the length of time required
for developing the business. Some classes of property, like street rail-
ways in or between populous cities, may develop their business to a
profitable stage in a very short time, but in other cases, as, for instance,
a great irrigation project in the Far West, it may be well known in
advance of construction that it will take many years to reach the point
where profitable results can be achieved. The diiference between prop-
erties in this respect is obviously to be ascertained by a study of their
history and of the history of similar properties. '■



1512 VALUATION OF PUBLIC UTILITIES



CHAPTER VIII.



INTANGIBLE VALUE.

In addition to the physical elements of property discussed in the
foregoing chapters of this report, there are certain elements of non-
physical character that must be considered, and their bearing on the
valuation of public utility properties explained. These elements of
value are called "intangible" for the reason that they cannot be item-
ized, measured, and appraised, like physical units, but must generally
be estimated by a study of the income accoimt, the possible growth or
appreciation in value of property, and other advantages, existing
and potential, that attach to the location, environment, ownership,
or control of the particular property to which they apply.

Meaning of "Intangible" as Used in Valuation.

The term "intangible" is used in the current literature of taxation
to mean bonds, notes, stocks, and money at interest, which, if owned
by a corporation whose property is being appraised, must certainly
be classed as tangible in the inventory. In the valuation of public
utilities, the word "intangible" should be understood as being restricted
to its essential meaning of something incorporeal, not capable of
direct or exact physical measurement, and in this report its meaning
will be thus restricted.

The word "value" has been used very broadly in discussions of
valuation and in Court decisions pertaining to the subject. There is
a distinctly intangible basis for some of its meanings, and the Com-
mittee deems it proper to include the analysis of the word in this
chapter.

The chapter then will cover discussions under the following heads:

Value — in general;
Franchise ;

Going Value — Going Concern Value;
Goodwill;

Efficiency, Favorable Business Arrangements, Design;
Strategic Location;

Leases, Easements, Traffic and Operating Agreements, Water
Rights, Strategic Advantages, Other Privileges.

Value, Tangible and Intangible Bases.

Value may be said to rest on both tangible and intangible bases.
Some meanings of the word are "excellence", "importance", "utility",
"worth". Other meanings are "the desirability of a thing, as com-



VALUATION OF PUBLIC UTILITIES 1513

pared with the desirability of something else"; "the degree of want
felt for a thing, as shown by the relation of supply and demand" ; and,
commercially, "the price at which a thing will sell". This last is the
"exchange value" of this report.

Still other authorized definitions are "the cost to produce"; "the
amoimt of labor necessary to produce". These two definitions furnish
the tangible basis for computing the "physical value". The definitions
leading up to exchange value furnish the basis for the conception of
the intangible element of the term.

We see by this that the conception of the tangible element of the
value of a thing rests on its proper cost or on its production, while
the exchange value, which includes all tangible and intangible ele-
ments of value, rests on the output of the thing or on the results of
its operation. Estimates, in money, of these two conceptions may be
said to approach the same objective from opposite directions and in
an ideal public utility, where the actual net returns are just equal
to fair income on investment, the figures should be equal. Such
equality is obviously a proper aim of regulation. We have then this
equation as ideal for the ideal public utility of the future under con-
stant public regvilation from the beginning, but not applicable in
general to presently existing properties nor to any property without
corresponding contractual obligations —

Tangible value — that is"^ f Exchange value — that is to say,
to say, proper cost, in- I j dependable net earnings, after deduct-
cluding development ex- r ^^ ^ ing a proper depreciation allowance,
pense, less "depreciation ! j capitalized at a rate of return, fair
of valuation". J Lfor the property in question.

Courts and commissions have striven to establish just valuations
of corporate properties for various purposes, such as: a base on which
return on capital shall be computed, or on which taxes shall be assessed ;
a sale made to the public, or against which securities shall be issued.
This base has been variously called "fair value", "real value",
"reasonable value", "the present value", "actual value", "the
value", etc. In the great majority of cases, the properties being con-
sidered have been those not under full and continuous regulation in
the past; and, where the last member of our equation has figured
out larger than the first, the authorities have frequently allowed some-
thing for the excess of exchange value over tangible value which has
grown up around the nucleus of the latter. This excess, when existent,
is called by the Committee the intangible value pertaining to the
property. Such additions to tangible value will be fully discussed
later in this chapter. The object here is to differentiate clearly
between the nature of tangible and intangible values in general, and



1514; VALUATION OF PUBLIC UTILITIES

to show that both have distinct and legitimate meanings, but that the
term "value", standing alone, may lead to misunderstanding of mean-
ing unless qualified by a modifying adjective.

A broad basis for separating tangible from intangible values is
that the former can be ascertained from the proper cost while the
latter can only be computed from a study of the results which may
flow from the use of the properties in question.

Exchange Value. — Exchange value is the desirability of the prop-
erty, estimated in money, where there is a ready market for properties
of the kind considered; exchange value is synonymous with market
value, and may be said to be the price which a willing and intelligent
buyer will pay a willing and intelligent seller. In the case of a utility
property furnishing service to the public, this price will be a function
of its existing or potential dependable net earning capacity, or of
the additional earning jKJwer that may accrue to its owner through
the control of the property in question. It is the second member of
the above equation. If the property is operating under a limited
franchise, the limit will have a bearing on the dependable feature of
the earnings or other advantages, and the price will be discounted
accordingly. It will be influenced largely by the intangible element
in the value of the business as well as by the tangible value of the
property measured by cost.

Since exchange value is determined by a consideration of dependable
income and beneficial results, existing and potential, it will automatic-
ally include all intangible values pertaining to the property, so that
the value of franchise, going value (not development expense), good-
will etc., cannot be itemized separately in a schedule.

Fair Value. — The "fair value", of Courts and commissions is
intended no doubt to meet the definition given in the Glossary: ''A
value which is fair to the parties affected". In very many cases where
"fair value" has been determined by public authority it has been made
up of the present cost value of the property, as nearly as that could
be determined, with reasonable allowance for depreciation plus an
addition for such intangible features as the controlling authority
deemed proper to add to the tangible amount. It has been held time
and again by Courts that the "fair value" of a public utility property
cannot be determined by a mathematical formula, by which, it is
reasonable to infer, is meant a precise estimate based only on an
inventory of the physical property.

It will be noted that, in all cases where additions of an intangible
nature have been made to the physical inventory, such additions have
been in very round nxunbers; like $285 000 in the Kansas City Water
case; $40 000 in the Newburyport Water case; $75 000 in the Gloucester
Watpr ca>o; $150 000 in the Bristol and Warron Water case; $1.5 000



VAIA'ATION OF PUBLIC UTILITIES 1515

iu the Galena Water case, etc. The roundness of these sums suggests
that they were not arrived at by mathematically capitalizing earnings,
but by some process of compromise or adjustment which seemed
equitable to the Court.

In no recent case before the higher Courts has a valuation been
fixed for a public utility property by capitalizing earnings to the
exclusion of consideration of its tangible value measured by cost. This
procedure seems rational, for the reason that the ''fair value" sought by
the (/Ourts and commissions is wanted for some purpose of regulation;
and, as the object of regulation is to secure justice for both the owners
and consumers, it is not conceivable that a value based simply on
a consideration of the present or estimated net earnings could be
taken as a just base for any of these purposes.

Present earnings may be too low to command capital or to main-
tain the existing enterprise, or higher than the service rendered may
warrant. They are often ' adventitious, empirical, and based on
what the patrons can or will pay. To use them as the sole basis for
determining "fair value", would be to render regulation nugatory.

If it is held that fair earnings, for the property as a whole, might
be assumed as a starting point, it is pertinent to inquire on what such
earnings should be based, or how should they be assumed. It is dif-
ficult to use value of service, to the consumer, per se, because it cannot
generally be computed or assumed, as it is generally intangible and with-
out a basis from which to start. Heat and electric units, energy
measured by horse-power and similar units, are constant the world
over, and of service to mankind; but no one would claim that
their money equivalent is the same everywhere. An inland city
of New England, for instance, should pay far more for such units
than should a city at the pit-mouth of a coal mine in West Virginia.
This illustration means that the cost of service should gauge, to a
greater or less extent depending on circumstances, the price or value
of it. A substitute plant might furnish service at a less cost, but it
has been shown that substitute plants do not generally furnish a
safe criterion of value. Hence — in view of the impracticability of
assuming fair earnings, and the difiiculty, if not uncertainty, attending
their computiition by other means — the cost of service, as produced
by the plant under review, should be accepted as generally the most
significant measure of the value of the service, and of the fair
earnings to be derived therefrom. The reasonable value for regulation
purposes must be largely deduced from the cost basis, with proper
consideration of all the attendant circumstances and conditions —
as for instance, the value of water rights in regions where water for
irrigation has come to have, in fact, a commodity value.

In the opinion of the Committee, "fair value", that is say, the
valuation to be assumed in regulation, should be deduced in each case



1516 VALUATION OF PUBLIC UTILITIES

as it arises, giving full recognition to the tangible values existing in
the property, however acquired, and full recognition to the intangible
values, so far as they are applicable to the purposes in mind; that
exchange value should be deduced largely by a consideration of the
beneficial results flowing, or reasonably expected to flow, from the use
of the property; and that when the word "value" is used alone, the
text or modifiers should show clearly, and to the extent that may be
equitable, whether tangible or intangible value, or the sum of the
two, is meant.

Franchise.

This term is defined in the Glossary as:

"The authority granted by government to a person or corporation
to create and operate a public service property, to use public property,
and often to condemn property."

A franchise of this kind frequently, either explicitly or by implica-
tion, grants protection from competition by similar enterprises.

Various Functions. — A franchise is said to be perpetual when it is
so granted, or when granted for a very long period; limited, when its
term is relatively short or definitely stated; and terminable, when it
may be revoked at any time. Terminable franchises are often per-
petual in fact, and are sometimes called "indeterminate franchises''.

We may divide the possible functions of a franchise into three
parts :

1. A license to do business, to operate a public utility, for

instance, taking toll from consumers for its output;

2. A grant to use public property, like streets, for subways, pipea,

tracks, overhead wires, etc. ;

3. A protection from competition.

Generally, in the past, a franchise has been a free grant from the
public, and the obvious inference is that the grantee shall perform
the service contemplated at a rate to the public such that only a fair
return on the capital and effort expended will be secured, including of
course proper recognition of the risk involved. If it were supposable
that consideration of a franchise would add materially to the capital
base, so that rates for service would thereby be enhanced above a
fair return, we should be confronted with the anomaly of the public
granting a corporation the right of unlimited usury in its dealings
with the public.

Court Decisions. — A leading decision of the United States Siipreme
Court, not concerned with rate regulation, plainly asserts that the
franchise has value. In this case (Monongahela Navigation Co. v.
United States, 148 U. S.. 312. March 27, 1893V the Court said:



VALUATION OF PUBLIC UTILITIES 1517

"So before the property can be taken away from its owners, the
whole value must be paid; and that value depends largely upon the
productiveness of the property, the franchise to take tolls."

This was a case of the United States taking over from the Canal
Company a very old property, and the total award, which was much
greater than the cost of reproduction of the physical property, was
based on the profitableness of the plant.

In the New York Consolidated Gas case (Willcox v. Consolidated
Gas Co., 212 U. S., 19, January 4, 1909), relating to rates for gas, the
question of the value of franchises was treated at considerable length.
This company was created by the consolidation of seven independent
companies in 1884, and at that time the State authorities sanctioned
the issue of additional capital to represent the value of the franchises
as then determined to a sum amounting to $7 781 000. Later, in 1907,
the value of the franchises of the company was under consideration,
and it was assumed by a master in one case, and by the Federal Court
in another, that the franchises had increased in value from the sum
above stated to $20 000 000 and $12 000 000, respectively, the increase
corresponding to the increase in the value of the physical plant.
The United States Supreme Court, in 1909, sanctioned the con-
tinuance of the original $7 781 000 of franchise value allowed by
the State authorities in 1884, for the reason that its capitaliza-
tion had been authorized at that time, but it refused to allow
any increase of franchise value due to growth of business after
that time. The caution as to precedent contained in the second
quotation below shows that the Courts are reluctant to recog-
nize the propriety of capitalizing franchise values. The Court
said (at pages 44 and 48) :

"It cannot be disputed that franchises of this nature are property
and cannot be taken or used by others without compensation."

"What has been said herein regarding the value of the franchise
in this case, has been necessarily founded upon its own peculiar facts,
and a decision thereon can form no precedent in regard to the valua-
tion of franchises generally where the facts are not similar to those
in the case before us. We simply accept the sum named as the value
under the circumstances stated."

In the case of Kennebec Water District v. Waterville (97 Me.,
185, December 27, 1902), the Court said (at page 218) :

"It [defendant's claim] is that the value of a franchise depends
upon its net earning power, present, prospective, developed and capable
of development, at reasonable rates, that the value to be assessed is
the fair value to the seller and not the buyer, and that 'just compensa-
tion' means full compensation for everything or element of value taken.
* * * The appraisal must be made having in mind what we have
already said concerning the character and duration of the franchise



1518 VALUATIONS' OF PVBI.rC UTILITIES

and reasonableness of rates. While with these limitations, the owner
is entitled to receive the value of the franchises, having reference to
their prospective use as now developed, and to the future development
of their use, consideration must also be had of the fact that further
investment may be necessary to develop the use, and of the further
fact that at any stage of development the owner of the franchise will
he entitled to charge only reasonable rates under the conditions then
existing. But, subject to such limitations, we think it should be said
that the owner is entitled to any appreciation due to natural causes,
such as, for instance, the growth of the cities or towns in which the
111 ant is situated.

And further (at page 220) :

"But we cannot assent to the proposition that the capitalization of
income even at reasonable rates can be adopted as a sufBcient or satis-
factory test of present value. Such a capitalization would fix at the
present time a specific value which would continue for all time to



Online LibraryAmerican Society of Civil EngineersTransactions of the American Society of Civil Engineers (Volume 81) → online text (page 136 of 167)