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

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regarded as unlimited, and under which the use of a definitely ascer-
tainable rate-base (not controlled by value) is possible, has so much
in its favor that it will, in time, be generally adopted. This method
is not mentioned by name, but is closely related to the method described
in the report as the "Eeplacement Method." The Unlimited-Life
Method is, to be sure, a replacement method, but not such as would
require the exact amouut necessary in any year for replacements to be
collected from the rate-payers in that year. Neither is its application
limited, as suggested by the Committee, for the Replacement Method.
The replacement requirement under the Unlimited-Life Method is to
be forecast in a reasonable way, and suitable provision is to be made
in the earnings to have the money for making replacements available
when required. It is immaterial how the estimate is made; but it is
essential that all funds collected for replacement purposes be properly
accounted for. If the computation has been at fault, and the replace-
ment fund is found after a time to be inadequate, earnings must be
increased. If, on the other hand, there is inordinate accumulation
in the replacement fund, then the allowance for the replacement
requirement should be reduced. Under the Unlimited-Life Method
of procedure the need of estimating the accrued depreciation of the
entire plant falls away. The rate-base, once determined, remains
unchanged until the plant is extended or modified, o r until the public

* San Francisco, Cal.


desires to put itself into the position of part owner by retiring a part Mr.
of the owner's invested capital. ^'^^ ^'

The soundness of the theory on which the Unlimited-Life Method
of procedure is based seems to have been generally recognized. The
simplicity of its application and the advantage which it has of requir-
ing lowest earnings in the early years of operation, will compel its
general adoption or re-adoption whenever the Courts shall have found
it desirable to modify their recent decisions which heretofore have been
interpreted to hold that value must be made the starting point,
ignoring, apparently, the fact, to which attention cannot be called too
frequently, that value is not the premise for the determination of
earnings, but is created by the earnings.

There is nothing which would prevent the Courts from receding
from the position apparently taken in the Knoxville case, in which
the United States Supreme Court said:

"If, however, a company fails to perform this plain duty and to
exact sufficient returns to keep the investment unimpaired, whether
this is the result of unwarranted dividends, over issues of securities,
or of omission to exact proper prices for the output, the fault is
its own."

This position, if it means rates at all times to yield earnings
which will include so-called depreciation, is not sound doctrine, because
the cases will be rare indeed in which, immediately on the beginning
of operations, the earnings can be made adequate to keep the invest-
ment unimpaired. Some time must be allowed during which the
earnings will fall short of the amount apparently called for by the
decision of the Couit. This time may be only 1 year, or it may be 5
or 10 years. If the opinion of the Court is regarded as applying
with equal force to the years already past as to those yet to come,
which seems to follow from the context in the decision, then either
a sacrifice may be demanded of the owner, or the few rate-payers of
the early years may be required to carry an unwarranted burden.

It is sound doctrine, and reasonable and fair to both the rate-payer
and the owner, to estimate the required earnings so that there will
be no immediate retirement of invested capital, but only suitable
gradually increasing provision for necessary renewals. The renewal
or replacement fund, however, can be regarded at any time as a return
of capital, when the business is to be closed out, or when the public
desires to participate in the ownership. A method of procedure is
thus marked out, which is remarkably simple and makes unnecessary
a consideration of value as the starting point when rates are to be fixed.

The rate-base thereunder will start Avith the capital reasonably and
properly invested, not swelled by appreciation nor reduced by depre-
ciation. This is substantially what Mr. James T. Shaw contends for


Mr. in a statement presented on November 9th, 1915, to the Railroad Com-
runs-y. jjj^ggjQj^ ^f California in the Telephone Rate Case (Application No.
1870), when he asks that the "actual performance" be made the "rate-
base." In his argument, he reinforces the plea, which is being made
by many engineers and economists, that value be regarded as a
"result and not a premise."

Influenced perhaps by an earlier presentation of this subject by Mr.
Shaw, the Public Service Commission of the State of Washington,
in the proceedings relating to telephone and telegraph rates (Cases Nos.
1810 and 1825), on April 25th, 1916, says:

"The statute is silent upon the question of the finding of 'fair
value' or a base for rates. The Commission is directed to find the
"market value', but no one contends that the 'market value' is always
a fair basis for rates. Since the Commission is required to ascertain
the fair, just, reasonable and sufficient rates for telephone service, the
Commission will assume that it is authorized to find a 'rate base.' "

Relating to value as a basis for rate-making, the Commission says :

"If we take this definition of the term 'value' and make such value

the basis for rate-making, each time we increase the return we increase

the desirableness of the property or properties, and on the other

hand if we decrease the return, we decrease that which makes the

thing desirable; and so, if we decrease the return we decrease the

value, and if we increase the return we increase the value."


"To say that rates are to be based upon the value of the property,
using the term in its usual and ordinary sense, is to say that rates
shall be based upon one premise to-day, another to-morrow. So we
must conclude that when the Courts said that rates were to be based
upon 'fair value', they could not have meant to use the word 'value'
in the sense in which the word is ordinarily used and understood."

Some Courts, too, are beginning to recognize the futility of requir-
ing that "fair value" shall be made the "basis of the calculation."
Thus, for example, the Supreme Court of Idaho in a recent decision
(1915), Pocatella Water Company case, Murray vs. Public Utilities
Commission, reversing the Public Utilities Commission of that State,
says in reference to depreciation:

"In other words, if it be demonstrated that the plant is in good
operating condition and giving as good service as a new plant, then
the question of depreciation may be entirely disregarded."

It is the duty of the valuation engineer and the economist to point
out, as occasion arises, that it would be error on the part of the Courts
to insist that "fair value" be made the basis of the calculation when
rates are to be fixed. It may not be easy, however, to secure general
admission that other procedures than the one thus far approved are
sound. The Courts must act with caution, and must be convinced


beyond peradventure before taking a new stand. The writer believes, Mr.
however, that the decisions which seem to determine what should be
made the "rate-base" are not so final or explicit as to be removed
from attack, or at least from possible new interpretation. The decisions
of the Courts which make value the starting point, have been rendered
to prevent confiscation of property and to protect rate-payers from
inordinate exactions. The method supposed to be the only one accept-
able to the Courts is illogical and difficult, and is practically impos-
sible of satisfactory application, and yet there is available a simple,
logical, and perfectly fair method of procedure, the advantages of
which will be generally admitted whenever its application shall have
obtained the sanction of the Courts.

Heretofore, the writer has called the attention of the Profession
to the fact that the ordinary application of sinking-fund methods to
compute the amounts which should go into a depreciation, or into a
replacement, fund are materially in error.* It is self-evident that
the actual term of usefulness of any article will never agree exactly
with the term which was predicted for it when it went into use on
the basis of probable life for articles of its class. When consideration
is given to the departure of the actual term of service of individual
articles from their probable life or expectancy, it will be found that
the computation of the annual depreciation increment or of the annual
replacement requirement is quite different from that computed in the
ordinary way from their probable life.

It is not proposed to present conclusions on this subject, but only
to express regret that the Committee did not take the time to ascer-
tain, approximately at least, the magnitude of the effect of the depart-
ure of the actual useful life of articles from their expectancies.!
The report is silent on this subject, and, being silent, only reflects the
present unsatisfactory state of the art. Any one attempting to apply
any method of procedure which involves a deduction of depreciation
will find difficulty in making provision in the accounting for the
individualized articles which go out of use before the end of their
predicted term of usefulness, as well as for those which serve beyond
this originally allotted term of usefulness. He will find that the
Compound-Interest Method is not, as was originally claimed, an equal-
annual-payment method, even when interest rates are uniform, that
the Sinking-Fund Method might as well be discarded for an approxi-
mation method similar to the Straight-Line Method, and that the
Straight-Line Method imposes an unwarranted burden on the rate-
payers of the early years, which is undesirable and unnecessary. Any
"present-value" method, as already stated, must be accompanied by

* Transactions, Am. Soc. C. E., VoL LXXV, p. 837 ; also, VoL LXXIX, p. 761.
t See "Valuation, Depreciation, and the Rate-Base", by C. K. Grunsky, pp. 104
to 122.


Mr. frequent re- determinations of value. Under all the methods described
.lions. y. j^y ^^^ Committee, except the Replacement Method, bookkeeping will
be a complicated art.

The application of the Compound-Interest Method of procedure
is by no means as simple as the Committee assumes when, on page
1474, it says:

"There is no ambiguity in the foregoing described method; no
chance for confusion ; the method is exactly analogous to that described
under the straight-line theory of depreciation."

This would only then be true if all individualized articles would
actually go out of use at the ends of their respective probable life

The Committee has not offered a satisfactory solution of a vexed
question. It leaves the whole matter in confusion. Nevertheless, the
facts presented in the report and the academic discussion of the results
that would be obtained under various methods of procedure, on the
assumption of certain premises, not to be realized in practice, is a
valuable contribution to the literature on valuation and rate regulation,
and will be of material aid in hastening the acceptance of fundamental
principles and the general adoption of a satisfactory method of

The fact that the profit to which the owner of a public utility is en-
titled may be expressed in terms other than as an increment of the rate
of return applied to a rate-base, has not been brought out in the Commit-
tee's report, and yet this deserves discussion, as it smooths the way for
determining reasonable rates without starting with "value." The
purpose of this extension of the writer's discussion''^' is to make this
fact clear. The Courts are compelled to determine whether or not
the allowed earnings are confiscatory. Consequently, they have con-
cerned themselves with value, regardless of how it may have been
built up. The rate-regulating authority, on the other hand, should
be and is free to use any proceeding which to it appears to be con-
venient and equitable in determining what the earnings and, therefore,
the rates should be. This fact does not seem to have been recognized
or accepted by many of the public service commissions, and they,
therefore, following the lead of the Courts, are nearly all concerned
with the value of public utility properties and find themselves forced,
in some cases, as the writer has instanced in his preceding discussion,
to read new meanings into the word "value." If every property to
be valued was new, there would be comparatively little difficulty in
estimating the amount that should be assumed to be reasonably and
properly invested therein^ but there ia serious difficulty when a
property is no longer new. The service i-endered by, or the output

* This is au addition to the previous part of Mr. Grunsliy's discussion.


•of, a property which is mafuTe ' and well-seasoned, is ordinarily better Mr.
than, or at least as good as, the same service or output of a new plant. '™°^ ^'
From the standpoint of the value of the service rendered, therefore,
the rates determined for a new plant should be appropriate, too, for
a plant the parts of v/hich may show all manner of accrued depre-
ciation. Except for the requirement apparently laid down by the
Court that "value", interpreted to mean "present" or "depreciated"
value, is to be taken into account, there is, in other words, no need
at all of considering "accrued depreciation" (not to be confounded
with "deferred maintenance") when rates are to be fixed. Conse-
quently, as already stated, the principle of starting with a rate-base
undiminished by depreciation is fundamentally sound.

When thus determined, however, something more than the rate-
base is to be brought into consideration. The rate-base may express
what the sacrifice was, which the owner had made and on which (to
cover interest and expenses incident to securing money for the
enterprise) he should receive an adequate interest return. In addi-
tion to an adequate interest return on such a rate-base, however, he
may reasonably expect, and certainly is entitled to, compensation
for management, and for business hazards; and he is entitled, also,
to a participation in the prosperity of the commimity which he serves.
In dealing with "value", it has become customary to include therein
some allowance for "going value" and also to fix the rate of retvirn
on the resulting "fair value" higher than ordinary interest rates. A
way has thus been found to permit the utility to earn more than
interest on the investment. The business yields a profit. Unfortu-
nately, it is difficult, if not impossible, to establish any fair or accept-
able rule for determining the fair rate of return which ordinarily
is to include the profit item. That this is difficult is due to the
fact that one utility is of a character involving a large investment
compared with the annual gross income, and another shows the reverse
condition; a large amount of business is done on a small investment.
Water-works may be suggested as of the first class, particularly when
the areas owned for reservoir and water-shed purposes are extensive.
Express companies suggest themselves as belonging in the second
class. Their ownership of property and capital investment may be
but nominal, although their annual receipts are large.

Why not give consideration, therefore, to the volume of business,
to the annual gross income, as well as to a rate-base, when deter-
mining what the earnings should be? In other words, let the profit
be brought into a fair relation to the volume of business, instead of
attempting to predicate it on the rate-base, or that uncertain element,
"value", which is, in part, created by the profit.

When an interest return is allowed to the utility, which will cover
the cost of money borrowed for legitimate enterprises of the character



Mr. of such utility, and this interest rate is applied to a rate-base estimated
Grunsky. ^^^^^ legitimate proi)er investment imdiminished by accrued depre-
ciation, certain profit allowances, about as noted subsequently, will
be found to be appropriate. It is assumed that, in determining
the cost of borrowed money, due allowance will be made for dis-
counts and commissions. The profit allowances, if made as suggested,
would represent compensation in lieu of current appreciation and
interest on the going value, or other elements of value not included
in the rate-base. In the last analysis, however, the capitalization of
this profit allowance would show that intangible values have actually
been created and are demonstrable. The reversal of the usual pro-
cedure appears to be advisable. Instead of starting with the intangible
values which are to be created by the earnings, let the profit be fixed,
and the intangible values will take care of themselves. The sug-
gested profit allowances are as follows :

When gross income

$10 000 about 15%. ..


per year

100 000



14 500


500 000


13.5% . .

67 500

U u

1 000 000



125 000

U .i

3 000 000


10% . . .

300 000

5 000 000


9% . . .

450 000

10 000 000


8% . . .

800 000

20 000 000


7% ...

1 400 000

H ii

40 000 000


6% . . .

2 400 000

ii li

100 000 000


5% . . .

5 000 000

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