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THE VALUATION OF PUBLIC UTILITIES
WITH SPECUL REFERENCE TO
GAS AND ELECTRIC PROPERTIES

by

PAUL THELEN



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UNIVERSITY OF CALIFORNIA
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THE VALUATION OF PUBLIC
UTILITIES

WITH SPECIAL REFERENCE TO
GAS AND ELECTRIC PROPERTIES



BY
PAUL THELEN

Assistant Engineer, California Railroad Commission



UNIVERSITY OF CALIFORNIA PRESS

BERKELEY

1916



THE VALUATION OF PUBLIC UTILITIES*



SYLLABUS

Introduction — purpose and seoiie of paper.

Purpose of Valuation:
(a) Transfer.
(&) Taxation,
(e) Eates.
((Z) Issuance of securities.

Reasons why purpose must clearly be kept in mind.

Valuation report proper involves:

(a) Inventory:

(1) Tangible Capital.

(2) Intangible Capital.

(Classifications of Accounts for Fixed Capital).

(b) Unit Prices for cost to reproduce, etc.

(c) Original Cost:

(1) Non-operative propertj'.

(2) Expenditures unwisely made.

(3) Expenditures involving collusion.
(f?) Cost to Reproduce:

(1) At present day prices.

(2) Actual performance method.

(3) Historical Cost.

(e) Cost to Reproduce Less Depreciation:

(1) Straight Line Method.

(2) Sinking Fund Method.

(/") Contingencies, errors and omissions.
(^) Working Capital.
(K) Development Cost.

Application of results:

(a) Transfer.

(b) Taxation.

(c) Rates.

(d) Issuance of Securities.

Conclusion.



* Address to be delivered before Engineering Students. University of
California, Apr. 6, 1916, under the auspices of the Gas Engineering
Department. ,^



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Tliis [(apcr will cover in a ^^cin'ial way the siihjcct of Utility Valua-
tions, their purpose, scope ami aj)i)lication. Although the audience before
whom this paper is presented consists of students in an engineering class
who are primarily interested in gas and electric utilities, nevertheless
the subject of valuation of these utilities is but a portion of a larger
field; and a discussion which covers this larger field will perhaps be of
more interest to prospective gas and electric engineers than a discussion
which confines itself entirely to the details involved in the valuation of
a gas or electric utility. The general j)rincijiles involved in the valuation
of all utilities are much the same. The subject of Utility Valuations is a
broad one, and will have to be covered in a very general way in order to
come within the time limits which are prescribed.

The purposes for which a valution may be made are many, yet most
valuations are prepared in connection with one of the following classes
of proceeding:

(a) Transfer.
(6) Taxation.

(c) Eates.

(d) Issuance of Securities.

It will be well to state at the outset that the use which is to be made
of a valuation must be clearly kept in mind in preparing any statement
of total values or costs. Thus a valuation which is prepared for the pur-
pose of taxation will include property which would be classed as non-
operative and therefore be excluded if the valution were to be made for
the purpose of rate fixing. A valution made for the purpose of transfer
must, of course, include in its inventory only such property as is con-
templated by the transfer. A valution for issuance of securities must
involve such property as will be hypothecated in the case of a mortgage
or yield income in the case of issuance of stock. We could multiply such
illustrations readily.

If we follow the progress of the science of valuation engineering from
its earlier days, we find that the first valutions were made almost entirely
in connection with transfer of property. Here the valuation report itself
was originally not a matter of great moment because it was the earning
capacity rather than physical properties which had most bearing on
value. It was largely a valuation to determine the depreciated cost to
reproduce, sometimes loosely termed "present value."

Valuation engineering has but rarely been called upon to be of much
assistance in connection with taxation matters. Such valuation statistics
as have been compiled for this purpose have usually been very crude and
the present tendency is to compute the tax on- the basis of gross income



rather than on the basis of invested cost or cost to reproduce or depre-
ciated cost to reproduce. It is true that the tax which is computed as a
function of gross income purports generally to result in the same total
amount of money as the tax computed as a function of the property value
in order that there may be no discrimination between taxation of public
utility properties and taxation of the property of the private individual.
In the good old swashbuckling days a utility had very little need for the
services of a valuation engineer. If the property were to be sold, the
valuation, as far as inventory and appraisal went, was a matter of sec-
ondary importance. If the property were to be taxed, the utility had
little interest in obtaining a complete inventory and making a complete
and all-inclusive cost statement. But these days are definitely gone.
The voice of the people has spoken in no uncertain terms, demanding fair
play for the consumer, publicity of accounts, regulation of rates,
service and issuance of securities, the elimination of discriminatory
practices, etc., etc. The execution of the terms of the resulting legislation
has been placed in the hands of Public Utility Commissions with such
gratifying results that these regulating bodies have grown more and
more in public esteem and in the scope of their activities until at present
there are very few public utilities in the United States which are not
subject to some form of supervision or regulation. Where this super-
vision is of rates or issuance of securities, the utility at once becomes
interested in a most complete and comprehensive inventory and the prov-
ing of every jtossible sort of value; in short,' the valuation engineer
becomes a very respectable gentleman.

The work of the State Commissions, where it calls for the services of
a valuation engineer, has been mainly in connection with rates. The
issuance of securities comes next in order of importance; transfer of
property is involved mainly in condemnation proceedings or actions
brought for acquisition on behalf of an incorporated public; while tax-
ation is a matter over which but few Public Utility Commissions now
have any jurisdiction and it is probably true that these Commissions
would gladly be relieved of the burden of this kind of work which very
soon becomes monotonous and always involves a vast amount of detail.

The valuation report proper as involved in the work of the regulating
body of the present day consists of an inventory, unit prices for each
item in this inventory, and a statement of original cost, cost to repro-
duce and cost to reproduce less depreciation. To this completed unit of
the work are added allowances for contingencies, errors and omissions to
obtain a complete statement of what is termed "plant investment," to
which in turn there must be added, for most purposes, working capital
and, either by the engineer or the auditor, a statement of development
cost.



The iuvcutory cuiisists of a tabulatiuii, in proper groups, of all the prop-
erty which is involved in the valuation proceedings. It is almost always
advisable, in preparing an inventory, to follow the uniform classification
of accounts pertinent to the utility under consideration. These classi-
fications of accounts have been issued from time to time by the Inter-
state Commerce Commission at Washington, D. C, for those utilities
which are concerned in interstate commerce such as steam roads, electric
railways and telephone companies. The State Commissions have wisely
adopted these classifications word for word for their standard, and have
usually prepared additional classifications for such utilities as are sub-
jected to regulation and engaged in business which is not classed as inter-
state commerce. Thus our own California State Commission has issued
uniform classifications of accounts for water corporations, gas corpora-
tions, electric corporations and telephone companies, of which the last is
practically identical with the classification prepared by the Interstate
Commerce Commission. Our Commission further uses the Interstate Com-
merce Commission's Classifications for steam roads and electric railways.

Turning now to this classification for gas corporations, of which a
dozen copies will be available for consultation in Professor Cory's ofiice,
we find that it concerns itself first with asset accounts and liability ac-
counts. Of these, the former includes the fixed capital accounts in which
we are particularly interested in preparing an inventory of plant, and the
material and supplies accounts in which we are interested as a part of
working capital. Then there is an income account and a surplus account,
of which the former includes operating revenue and operating expenses.
We will be interested later on in operating expense in case we desire to
make an analysis of actual performance in connection with such over-
head expenditures as law, injuries and damages, insurance, general ofiice
expenses, etc., all of which occur not only under conditions of operation,
but also during the days of construction and must therefore be considered
in the valuation report.

Turning now to the fixed capital accounts, we see that they are divided
into intangible capital and tangible capital of which the former includes
four, secondary sub-divisions and the latter five primary divisions, which,
are again sub-divided so as to show a total of thirty-six secondary divi-
sions. It is this classification which must be followed faithfully and con-
scientiously, if confusion is to be avoided. If it is strictly followed, it
becomes a very easy matter to locate in a valuation report any particu-
lar inventory item which may be under discussion. Thus if the utility
insists, after the valuation report is completed, that certain gas regula-
tors temporarily in stock in the store room have been omitted, it is only
necessary to turn to this classification and note that gas regulators are
chargeable to Account C-25, though if they were in the store room as of



the (late of the valuation, it would be reasonable to follow the clue that
if they were not listed under Account C-25 they would be found under
Stores and Supplies, which is an asset account and is included in the
statement of working capital which usually follows the completed state-
ment of plant accounts.

The five primary sub-divisions into which the tangible capital is
divided are:

(fl) Landed capital.
(&) Production capital.

(c) Transmission capital.

(d) Distribution ea]3ital.

(e) General capital.

The property chargeable to the thirtj'-six secondary accounts under
these five primary accounts is largely subject to count in the field, though
there must alw^ays be a general identification of the inventory from the
office, in order that the work in the field should include all the properties
of the utility and should not include properties belonging to others. Thus
the identification of the inventory from the office might state with re-
spect to production capital that certain blocks of land were owned by the
company and that all of the holders, generators, buildings, fences and
piping included in the lay-out belonged to the utility. It might be perti-
nent to remark here that in the case of a utility which has come into
existence since uniform classification of accounts have been as satisfac-
tory as they are at the present date, an inventory can frequently be
worked out entirely from office records. An engineer of experience, how-
ever, can never conscientiously recognize such an inventory as having the
same weight or accuracy as one which is based on the field inspection.

This sub-division of tangible capital into five groups makes it pos-
sible for the valuation engineer to distribute the work among responsible
assistant engineers each one of whom may be familiar with one certain
class of property, and not necessarily with any other class. Thus it is
usually good practice to have the Landed Capital, Account C-5, Land de-
voted to Gas Operations, handled by an assistant engineer who devotes his
entire time to lands, rights-of-way, etc. Similarly the building accounts
seem to constitute a group by themselves; also the so-called "overhead
expenditures," which are shown under Account C-35 and labeled "Un-
distributed Construction Expenditures," usually require the personal at-
tention of the engineer who is responsible for the entire valuation. These
so-called overheads include allowances for engineering, supervision, law,
injuries, taxes and miscellaneous expenses, and are based largely upon
judgment and experience, and it is but seldom that a satisfactory actual
performance in a particular ease is available for fixing the amount of



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these arhitiary percentages. The jnoperty whicli is listed under I'ro-
duction Capital, Transmission Capital and Distribution Capital may usu-
ally to advantage be left to a man who is familiar with construction and
operation of gas utility properties. If this work needs to be further sub-
divided as a matter of expedition, the responsibility for Production Capi-
tal can be given to an engineer who is familiar with machinery and its
installation, while the mains which are involved in Transmission and Dis
trinution Capital can be assigned to an engineer whose experience with
hydraulic pipe lines has rendered him competent to discuss trenching,
pipe laying, backfill, settling, replacing paving, etc.

After the inventory of such tangible property as can be found in the
field is completed it becomes necessary to apply a unit price to each item
in the inventory. In obtaining such unit prices for the column of Cost to
Eeproduce, the engineer is guided largely by whichever theory he is fol-
lowing in establishing the column of figures representing Cost to Eepro-
duce. Inasmuch as these theories w'ill be discussed later on under the
topic "Cost to Eeproduce," the subject need not be pursued further here.

We have said nothing so far about unit prices for the column of
original cost. This is because figures would usually be derived figures,
obtained by segregating the total expenditure actually incurred on a
given piece of work among the inventory units, and then applying the
unit prices thus obtained back again as a matter of multiplication to
reach the total which is the original cost, and which was accepted as
being correct. Consequently unit prices are rarely shown in connection
with the column of total original cost, though the unit prices used in
connection with the cost to reproduce are frequently obtained from an
examination of original cost records. Since the figures of depreciated cost
to reproduce are obtained as a percent of cost to reproduce it is not cus-
tomary to work out unit prices for this column.

Leaving unit costs now, we come to the three columns of total cost,
which are as follows:

1. Original Cost.

2. Cost to Eeproduce.

3. Cost to Eeproduce Less Depreciation.

Under Original Cost, it is usual to show actual expenditures, as taken
from the books, after they have been carefully scrutinized to see that
none of these expenditures include collusion. Also in connection with
the work on the inventory items certain non-operative properties may be
found and there may occur expenditures unwisely made. The non-
operative property must be eliminated in a rate case, though not in a
taxation matter and may frequently be included in the issuance of securi-
ties and may or may not be included in ease of transfer. It is a rare



matter nowadays to unearth evidences of collusion tliough it would be
entirely easy to give specific instances. The ancient and most used de-
vice of allowing the grading on the railroad to be done at exorbitant
prices by an independent organization whose officers are also the officers
of the railroad company has l)een used once or twice in this state within
the last decade under conditions that resulted in an original cost to the
company very much in excess of a legitimate cost to reproduce. Similarly
a mechanical engineer has occasionally received small private commis-
sions or bribes in connection with the purchase of rolling stock or shop
machinery, and many small irregularities can be unearthed in the office
of the purchasing agent; however, it may be said that the valuation en-
gineer but rarely unearths any expenditures involving considerable
amount of dishonesty. An entirely different matter is presented in case
a utility purchases a small plant to be included in its own larger plant,
and pays for this small plant some amount of money or securities which
exceeds the cost to reproduce of the elements constituting the plant. The
gas utility may under the classification charge the entire cost to Account
C-37, Plant Purchased in Lieu of Plant Constructed. However, the cer-
tainty that valuation proceedings will be had at some time in the near
future frequently causes the utility to distribute this "cost of plant pur-
chased" among the thirty-six accounts preceding. The utility will quite
generally attempt to make such distribution in an honest manner and finds
that it has paid in excess of the sum of such amounts as can properly be
distributed to the tangible capital accounts. There is left something like
10 per cent to 25 per cent of the purchase price, which has to be shown on
the books somewhere as having been expended and it is customary to
show this under Account C-2, Franchises, or one of the other intangible
accounts. When the valuation engineer finds this condition in original
cost he uses his discretion. He may include or not include this charge in
his column of original cost, but in any event he states the facts in detail
so that the regulating body to which he reports may have the facts at
its disposal and make such use of them as the particular proceeding may
demand.

Coming now to the column of Cost to Eeproduce, it is seldom that the
engineer has specific instructions as to the conditions under which he is
to reproduce the plant. He may reproduce an electric railway system or
a gas utility piecemeal in the order in which it was originally constructed,
thereby increasing the unit costs over what they would be if the entire
plant were considered as a unit. To offset this he obtains an "Interest
during Construction" considerably less by the piecemeal method than it
would otherwise be. Also he must decide whether he will reproduce at
present day prices or according to the actual price which the utility paid,
or whether he will cover the entire life of the utility and get a weighted



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average of all expenditures, iu which case he obtains what is called a
historical cost which should then be reconcilable in a very satisfactory man-
ner with the adjusted orifjinal cost of the books. Inasmuch as the work of all
the regulating bodies is subjected in some degree to review by the courts
we must primarily look for help and guidance to the decisions of the
Court. ]f we seek here, however, for a statement as to whether present
day prices mean the quotation of the hour, which would probably be un-
reasonable, or the quotations of the last twelve months, or three years, or
five years, or the quotations of the last several years projected into the
future, we find very little assistance. For purposes of transfer, it seems
that the present day prices should be given considerable weight. For
purposes of rates it seems that the historical cost, in so far as it parallels
investment or sacrifice, should be given most weight except perhaps in
the case of lands. Between these two methods stands what has been
termed by Mr. James T. Shaw of the Pacific Telepihone and Telegraph
Company in his argument in Application 1870 before the California Com-
mission as the "actual performance" method. This method involves a
careful scrutiny of the actual expenditures of the last three years or
five years and the application of these unit costs to all items of property.
We will not here enter into a discussion of the merits of the various
possible costs to reproduce, but will pass on to the last column "Cost to
Eeproduce Less Depreciation. ' ' In the earlier days of valuation engineer-
ing the distinction between the terms "cost" and "value" was not as
clearly recognized as it is today and this third column was quite generally
labeled "present value," The term was so very misleading that in spite
of its brevity, it has quite generally been rejilaced by the term "Cost to
Reproduce Less Depreciation." However, inasmuch as there are many
diiferent methods of estimating depreciation, the term is no more definite
than the term "cost to reproduce." Fortunately the instructions which
the valuation engineer receives are quite usually specific with respect to
the use by him either by the straight line depreciation method, or the
sinking fund depreciation method. Volumes upon volumes of discussion
on the merits of these two methods might be cited. There was a time
when the straight line method was much in favor. We believe that the
time will come when it will be used but rarely. We have prepared quite
recently a lengthy article on the fundamental conceptions involved iu the
two methods, and have been urged by so many public utility men and
others to have the thesis published, that you may possibly find it in one
of the next issues of Engineering and Contracting. The former or
straight line method is clearly a method for retiring the investment year
by year, and if in a rate case a depreciation allowance is granted the
utility on the straight line basis then the interest return on the invested
principal must decrease year by year as this invested principal is retired.



9

If on the other hand the rates accorded the utility include an allowance
for depreciation which is based on the sinking fund method then there
is no retirement year by year of the capital invested and the interest
return on the investment remains a constant, year by year. Inasmuch as
the straight line method is a re-payment year by year to compensate for
the wearing out of the property and does not involve any interest rate
of money, then if we take a property which cost $100, which will have to
be replaced in twenty-five years and whose salvage value at the time of
replacement is zero, it will be seen that the necessary annual depreciation
allowance on straight line basis is i^-, of $100.00 or $4.00. By the sinking
fund method, we do not re-pay the principal year by year in annual in-
stallments, but make such allowance as will, during the life of the prop-
erty, compound to a sum equal to the cost of the property whose integritj'
is being guaranteed by this depreciation fund. Thus instead of paying
$4.00 annually in the case cited above, we need to pay but $1.82. This
seems to be advantageous to the rate payer, but it is so only in the earlier
years. Thus if we add together the straight line depreciation and the
interest return on the diminishing principal for one curve and add to-
gether the sinking fund depreciation and a constant interest return on
the original investment for another curve, and allow these two amounts
to vary as ordinates with time as an abscissa, we obtain two curves
which, with the average utility, come to an intersection at from five to
fifteen years after the inception of the utility. Before this intersection
the straight line method demands higher rates than the sinking fund
method; after this intersection, the reverse is true.

Thus far we have covered in a very brief and general manner that
portion of the valuation report which includes the inventory, the unit
prices and the three columns of cost which are usually demanded in such
a report. We have already indicated that in addition to the property
which can be inventoried as tangible property and identified and counted
in the field, there are two other classes of property which come into the
total plant which are not susceptible of such treatment. One of these
is the so-called overhead expenditures which are classed as tangible capi-
tal and which involve allowances for engineering, law, etc. These ex-
penditures might be distributed during construction days to those ac-
counts in connection with which they would be incurred. Such distribu-
tion, however, would frequently be arbitrary and but little good would
be accomplished by it. Consequently these expenditures, though many


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Online LibraryPaul ThelenThe valuation of public utilities with special reference to gas and electric properties → online text (page 1 of 2)