Part 16

In addition to the element of going or business value, Mr. Alvord considers the franchise value, and presents two methods for its determination:

_First._—The physical value, depreciation, and going value are entirely neglected, and the entire valuation is fixed on the basis of its earning power throughout the remaining life of the franchise and its probable sale value.

The probable net revenue for each year of franchise life must be estimated and capitalized at a sum, which, if put at interest, would pay such yearly revenue and extinguish itself at the end of the franchise period. To this must be added the physical value of the plant at the end of the franchise period.

_Second._—The cost of reproduction, depreciation, and present physical value are ascertained, and the going value computed. Then it is determined whether or not the net revenue is paying interest on a capitalized value greater than that indicated by the sum of the physical and business values. If such capitalized figure is less than this combined value, there is, of course, no franchise value; if it is more, there is a franchise value which should be determined by estimating, for the remaining years of the franchise, the excess income over and above that necessary to cancel all obligations (including interest on the physical and business values), and the reduction of these several sums to a basis of present worth.

A number of other articles and papers are listed in the Appendix. Many of these are of great value and are well worth careful perusal, but they offer no definite plan of valuation. Inasmuch as the general principles involved in the valuation of a water-works plant and a railroad plant are similar, it is advisable, in any exhaustive study of the subject, to review the articles descriptive of water-works valuation, and it is a matter of regret that greater consideration cannot be here given to some of the points raised by such engineers as George H. Benzenberg, Past-President, Am. Soc. C. E., Kenneth Allen, Arthur L. Adams, Emil Kuichling, Members, Am. Soc. C. E., and others in their various papers and discussions of this subject.

The _Railway Age_, the _Railroad Gazette_, the _Railroad Age Gazette_, and the _Railway Age Gazette_ contain many editorials and articles on the valuation of railroad properties. These are written mainly from the standpoint of the railway official, and present many matters of interest which are worthy of study prior to undertaking a large appraisal. One series of articles in the _Railway Age Gazette_[13] is a most masterly argument, and it is to be regretted that the author has not disclosed his identity.

The Michigan valuation has been discussed in two papers by Mr. Charles Hansel, whose connection with the work, as a member of the Board of Review, gave him probably a more intimate knowledge of it than any one else, not connected with the actual working organization, who has undertaken to review the work. His first paper, published in 1901,[14] entitled, "What is the Value of a Railroad for Purposes of Taxation?" is a discussion of the work of Professors Cooley and Adams, written while the subject was fresh in his mind. His second paper, an able argument for a Government valuation, appeared in the _North American Review_ in 1907. The one point to which special attention is drawn is Mr. Hansel's astonishing misconception of Professor Adams' plan of work. This misleading statement appears in the first paper and is reiterated in the second. It is of such a character that to pass it unchallenged would be doing great injustice to Professor Adams. He states Professor Adams' plan as follows: Capitalize net earnings and add to the present value of the physical appraisal as found by Professor Cooley.

"The result would be that in case the present value per mile as determined by Professor Cooley is found to be $15,000, and the net earnings by Professor Adams are found to be $1,000, this capitalized at 5 per cent. would equal $20,000, and added to the present value would make $35,000, which would be the sum upon which taxes were to be levied. In other words, if the company actually earns $1,000 it increases its value for purposes of taxation 20 times that amount. If, however, instead of having a net earning of $1,000 it spends that sum in improving the property, it has only increased its taxable property by $1,000."

This statement is not only inaccurate, but involves the other error of assuming that the appraisal figure was to be used for taxation. It was not. It was merely information to aid the legislature in framing new taxation laws. The chief error, however, is in assuming that Professor Adams added the value of the property, as determined by a capitalization of net earnings (which _per se_ is a well-recognized method of valuation), to the value of the physical property. This error probably is due to the flood of criticism which at the time was aimed at any form of non-physical valuation.

Professor Adams finds the net earning in Mr. Hansel's example to be $1,000 per mile. From this, in the method actually used, he deducts an annuity for the support of invested capital, which he assumes to be the present value found by Professor Cooley. In the example given by Mr. Hansel he would deduct 4% on $15,000, or $600 per mile, leaving $400 per mile as surplus, or the earnings due to non-physical elements of value. This, capitalized at 5%, would give $8,000 per mile, which, added to Professor Cooley's figure of Present Value, would make $23,000 per mile, instead of $35,000, as stated by Mr. Hansel.

The most recent criticism of the Michigan valuation work was in an address[15] before the New York Traffic Club in January, 1909, by Mr. W. H. Williams, Third Vice-President of the Delaware and Hudson Company. This address is devoted to an attack, not only on the work of the Michigan appraisal, but on Professor Adams' work and on the propriety of valuation work being undertaken for any reason. The arguments advanced in this address are such that a discussion of them becomes almost necessary in any complete review of the Michigan work, and it contains so many statements which are erroneous that it would hardly be permissible to pass them without comment. The manifest impatience with all forms of governmental interference with corporations, which so often characterizes the utterances of prominent railway officials, appears in this paper to a marked degree. After stating that the present agitation for a physical valuation appears to be the result of a misconception, on the part of the Interstate Commerce Commission, of Section 20 of the Act to Regulate Commerce, and quoting Professor Adams' suggestion of an inquiry, he says:

"Subsequently, the desire of Governor Pingree to find a means of increasing railway taxation in Michigan gave Professor Adams an opportunity to experiment with his project within the limits of that State."

This is a direct imputation of an improper motive, not only to Governor Pingree, but to Professor Adams. As stated elsewhere, the investigation was to determine whether the railroads were paying taxes on the same basis of valuation as other property in the State—an absolutely proper proceeding. Professor Adams was associated with the Michigan appraisal, but had no connection whatever with the "physical valuation," to which such objection is taken, and his appointment was made after the work of physical valuation had been fully outlined and was well under way.

The opening statement is followed by a brief _résumé_ of the recommendations of the Interstate Commerce Commission and President Roosevelt, and of bills introduced in Congress, also by quotations from Bulletin 21, describing the methods of valuation used in Michigan and a showing that practically a similar basis was used in other States. Mr. Williams then summarizes his objections to the Michigan work:

"(1) No allowance is made for discount on securities sold.

"Discount is a partial capitalization of the commercial risk had in making the investment, and it increases or decreases in proportion to the probability of the earning power of money under existing conditions. Not only is this practice justified by long-established commercial usage, but also by judicial determination."

The correctness of this position cannot be conceded on any grounds of economics or accountancy. It is answered conclusively in an article,[16] elsewhere referred to, as follows:

"There is considerable diversity of opinion as regards the proper treatment of discount on securities sold. There is a distinction between bonds, representing corporate indebtedness and having a definite limitation as to the time of their redemption, and share capital, representing ownership and which as a rule is irredeemable. In relation to the former there can be but one tenable view. If a company can market its 50-year 4 per cent. bonds at 90 per cent. of par, it means that the company's credit is on a 4½ per cent. basis; that it could market a like security paying 4½ per cent. at par. If it elects to issue at the lower rate it is merely sacrificing principal for the sake of a reduction in the annual interest charge; in other words, it is pre-paying interest which would accrue during the life of the issue. If $10,000,000 par value were issued at 90 per cent., the discount would amount to $1,000,000, and the saving in interest to $50,000 per year, or $2,500,000 in 50 years. Obviously the company cannot claim the privilege of capitalizing the discount, while thereby availing itself of the reduction in interest. If such a course were legitimate in the case of a 5 or 10 per cent. discount, it would be equally so if the discount were 50 or 75 per cent., when the absurdity of the proposition would be perfectly apparent. The somewhat general practice of prorating the discount, as a charge against revenues, over the term of the obligation's existence is sound; but this should be done, not in equal installments, but on the basis of the appreciated value of the bond as it approaches par at maturity. There is no apparent objection to charging discount of this nature in a lump sum against an accumulated surplus. The capitalization of discount on stocks, involving as it does the introduction of fictitious values in capital assets, is wholly indefensible."

The writer has failed to note any particular "judicial determination" which approves of the charge of any such item to capital account.

"(2) The interest during construction (3 per cent.) is less than a fair and reasonable return on the investment."

The amount actually paid out for interest on money used during the period of construction will vary, of course, depending on the time of construction and the way in which payments on construction materials are made. On the basis of a rate of 6% per annum and construction lasting one year, only a very small portion of the construction cost will pay 6%, while the great items of rails, buildings, motive power, and equipment will be put into the work from 90 days to 10 months after the commencement of work, and will actually bear but little interest. In the Michigan appraisal the assumption was made that all work must be replaced in one year, and that on long roads partial operation would commence as various sections of the line were completed; and 3% was agreed on as a fair average, perhaps having in mind Governor Pingree's "desire to increase railway taxation." Some assumption must be made. This one, that long roads, covering several years of construction work, are in Michigan put in partial operation as soon as built, is not unreasonable. Such an assumption clearly would not be proper in the case of long lines crossing mountains, or involving such a class of construction as to make it impossible to complete the property short of two or three years; and, in any such cases, the interest charge should be made sufficient to cover.

"(3) No allowance is made for working capital with which to carry on the business."

All the appraisals of physical property have been made on the basis of securing a figure representing the cost of reconstructing the property in the condition in which it existed on the date of the appraisal, including only items properly chargeable to capital, cost of road, and equipment. This is not such an item. The writer is of the opinion, however, that it is a proper one to determine and include in any report.

"(4) No allowance is made for wear and tear of material during the period of construction. Assuming eight years to be the life of a tie, and three years the period of construction, a substantial percentage of the period of usefulness is over before the road is in operation. The use of the rails before the track is put in proper line and surface hastens the time when they must be removed."

This deterioration is a necessary incident to any construction work. It has not been customary or usual to take account of it. To add to the amount capitalized on account of this item would be manifestly improper. The only way in which this could be cared for would be in an adjustment of the depreciation reserve when raised to cover that which takes place during the construction period. This reserve, later in the address, is objected to by Mr. Williams as improper accounting:

"(5) No allowance has been made for impact and adaptation. After the line is placed in operation, each fill will sink 1 ft. for every 10 ft. of height. The slope of cuts must be increased to prevent landslides and washouts. The ballast will pound into the roadbed, necessitating additional ballast to secure a standard cross-section."

Part of this objection is covered by the item, "Appreciation of Roadbed," discussed elsewhere. This, perhaps, is a proper item, but a comparatively small one. One of the examples cited is clearly maintenance. This objection is largely covered in the Michigan work by the contingency item.

"(6) A uniform price for earthwork was used, thus ignoring the varying character of soil and length of haul."

This is erroneous. On the Michigan appraisal prices were used for earth, loose rock, and solid rock. There is practically no classification in the Southern Peninsula of Michigan, or, in fact, on 90% of the mileage of the State. The price used was not much out of the way when considered as a fair average for the territory. The same was apparently true of other appraisals. It would not be a proper figure to use in an estimate based on 1909 prices, which are materially greater than those obtaining in 1890-1900.

"(7) A uniform price list for all materials was used, thus ignoring the source of supply and cost of delivery to point of use."

This, again, is not true. Differences were made between the Upper and Lower Peninsulas; and an exhaustive study was made of rates to different sections. It is believed that the prices adopted took all these points fully into consideration. It is true that no effort was made to use different unit prices as between counties, but, in a number of cases, differences in prices were made for different sections of the State, where either local conditions as to production of materials, or traffic rates, seemed to warrant.

"(8) No allowance was made for interference with work on account of labor troubles, condition of the weather, etc., which would vary materially in the different counties of the same state."

True. Nor is such allowance ever made in actual construction, beyond the contingency item. Such items are a frequent source of annoyance, delay, and sometimes of expense, but an expense difficult to separate and set up, and clearly belonging to contingencies.

"(9) No allowance is made for carrying charges until such time as the road was placed on a revenue basis."

True; and such item is not a part of a physical appraisal.

The foregoing nine points are classed as "among other things" open to criticism. The next two quoted paragraphs are introduced to indicate the "other things" as they appear. These are mainly non-physical or intangible elements of value, which, under the method of Professor Adams, are treated _en bloc_, and which, from their nature, it would be impossible to set out and value separately; therefore, no effort is made to answer them point by point, further than to say in general that, if there is any value attaching to these items, it was presumed to have been disclosed by the method of Professor Adams, and to suggest further that had Professors Cooley and Adams had such an advocate of intangible values ten years ago, their labors would have been lightened, as all arguments by railway officials at that time were against the use of any such elements of value in an appraisal.

"No consideration has been given to the leasehold interests.... Therefore it will be seen there remains to be determined many questions vitally affecting the value of the property without regard to its value as a 'going concern.'

"There should be no difference in the basis of arriving at the value, as a 'going concern,' of the property of a railway and any industrial establishment, nor should there be any difference in the basis of valuation for taxation [exactly what Governor Pingree maintained] or other purposes. There is common to both the value due to location, good will, etc."

While the remainder of the address in question contains no specific criticisms of methods of valuation, it does go into a discussion of sundry legal decisions; and conclusions are drawn quite at variance with those set forth elsewhere in this paper. The thing most noticeable in the entire address is the lack of a proper spirit of fairness, an apparent inability to state fully and fairly the position of the men whose views are being opposed, and an undue emphasis in quoting some public official whose views coincide for the time being with the theories which are being advocated. The fact that Mr. Williams quotes from an address of Hon. Robert H. Shields, President of the Michigan Tax Commission, a statement criticising the work of Professors Cooley and Adams, illustrates the latter point.

The statement is made again and again that the Michigan work was a physical valuation; that no attempt was made to secure a "fair value" (the language of the Courts), and that the value as a going concern was not attempted to be given. In no case is the statement made that Professor Cooley had charge of the physical valuation in Michigan, and that Professor Adams took this physical valuation, and, under his method, treated it as one element, and with it and other data derived from a study of the reports and earnings of the company, undertook to determine a "non-physical," "intangible," "franchise," or "going concern" value, which included all tangible elements, and which, added to the physical value, was assumed by Professor Adams to give the true value. Had such a statement been fairly made, no possible objection could be raised to the making of any number of points against the correctness of the methods used by Professor Adams.

"Certainly it cannot be denied that a road between New York and Chicago, 950 miles in length, passing through a manufacturing district, is of greater value than a road 1,200 miles in length, between the same cities, but passing through a hilly and undeveloped territory a portion of the distance, and through a farming section for a greater portion of the remaining distance; yet the advocates of a physical valuation would have us believe that there is no difference in the value of the two if they can be reproduced to-day at the same cost."

This statement is entirely unfair to every man who has been in responsible charge of valuation work in recent years in the United States. No theory has ever been favored by any honest-thinking advocate of a valuation. In the first place, no interstate valuations have ever been made, and no parallel case to the one assumed is to be found, except for very short sections of roads, a very marked instance having been referred to elsewhere in this paper. Such a condition as assumed would be reflected in the earnings of the companies to such an extent as to cause the non-physical element of Professor Adams as used in Michigan to correct largely or wholly the inequality and inaccuracy of the physical valuation; such at least was the theory, and, if carried to its logical end by the use of negative non-physical values, such would be the result.

The final arguments of Mr. Williams' address are devoted to an attack on the plan outlined by the Interstate Commerce Commission for valuation, and on some of the accounting methods of the Commission—points not proper to be discussed in this paper—but it is difficult indeed to read them without noting the apparently studied misrepresentation of the real attitude of Professor Adams and the Commission, and the evident object of the entire address to create a wrong impression regarding what has been done, and a prejudice against the men who have been engaged on State appraisal work and those who advocate the appraisal of properties as a proper step in the way of securing such information as will enable an intelligent consideration of the great corporation problems that must be solved.

Footnote 12:

_Proceedings_, Am. Water-Works Assoc., 1902.

Footnote 13:

Commencing with the issue of January 22d, 1909.

Footnote 14:

The _Railroad Gazette_, April 19th, 1901, Vol. XXXIII. No. 16. p. 271.

Footnote 15:

_Railroad Age Gazette_, April 2d, 1909, p. 761.

Footnote 16:

_Railroad Age Gazette_, January 29th, 1909, p. 219.

THE DETERMINATION OF ELEMENTS OF VALUE AND METHODS OF VALUATION BY THE COURTS.

The preceding narrative of methods of appraisal work logically leads up to the question: Will these methods that have been adopted in various appraisal undertakings stand the test of the Courts? After all, the final seal of approval must be stamped on a method by the highest Courts before it can be said to be a definitely fixed and determined principle for general use in valuation.

In a careful perusal of many papers on this subject, quotations from judicial decisions will be noted which are literally correct as far as they go, but which are incomplete and often very misleading; and often such incomplete quotations are presented as to convey an entirely wrong impression of the full decision. In order that no such charge may lie against this paper, the quotations given are full enough to indicate clearly the intent of the Court, even at the expense of undue length.

An examination of all Federal and Supreme Court cases which bear on the subject of property valuation has been made, and quotations at length from some of the older cases, establishing precedent, together with citations to more recent decisions, are submitted. It is believed that the points of principle and method, in so far as they have been determined by the highest Courts, are quite fully set forth.

A study of the complete methods of the railroad valuation in Michigan, in connection with these decisions, discloses the fact that they comply with the requirements of the earlier cases, that all matters affecting value be taken into consideration, and that in the more recent decisions the detailed methods adopted in the Cooley physical appraisal have been sustained as to very many points. In no case have any of such methods been unfavorably criticized, and, while at this date the Supreme Court has not squarely passed on the propriety of any method for securing non-physical or intangible values, it has fully sustained the general position of Professor Adams in several important points. In addition to the complete examination of Federal cases, certain very interesting and valuable State cases have been examined, and some of them are quoted.