Part 18
"I think the method of valuation applied by the report to land, plant, mains, services, and meters lawful. To 'working capital, Coke and Coal Company, and Astoria' the above considerations are not applicable, and these items will be treated separately."
The Court's review of the third question raises no points of special interest as to valuation.
The question as to amount of "working capital" is taken up, and that term is defined as:
"The amount of cash necessary for the safe and convenient transaction of a business, having regard to the owner's ordinary outstandings both payable and receivable, the ordinary condition of his stock, or supplies in hand, the natural risk of his business, and the condition of his credit; and unless these matters, and perhaps others, be looked into, no comparison can be drawn between one business and another, or even between those of the same general nature."
In this instance it is of interest to note that the Court reduced the "working capital" from $3,616,000 to $1,616,000.
Perhaps the most novel and interesting part of this decision is that dealing with the intangible elements of value. The master was unable to separate the two elements, good will and franchise value, but gave their combined value.
"From the testimony I think it apparent that what is here meant by good will is the organization of complainant, long established, and doubtless well manned and equipped. Such organization is clearly of value, because without it neither tangible nor intangible property can be profitably managed. Yet the organization itself is but a method of utilizing that which is invested, it is really dependent for its existence and continuance upon the franchise, without which there can be no useful organization. Tangible property has a certain value entirely apart from franchise or right to continue business, but good will in the sense of the organization for the business of furnishing gas, can have no existence whatever apart or detached from the franchise conferring the necessary privilege. Would any one think of capitalizing good will of this kind and distributing its assumed value in the shape of new shares among stockholders new or old? I think the most ingenious financier could not imagine such a proceeding, and, if this good will be not property capable of such capitalization and distribution, I do not think it property capable of capitalization as against the State.
"Finally, this claim of good will seems to forget that for many years the price and distribution of complainant's gas has been regulated by law. A citizen is entitled to have a clean street before his house because he pays taxes, _inter alia_, for that purpose. He is much more plainly entitled to have complainant's gas in his house because the company must give it to him if he pays for it. I think it apparent that the conceivable good will of a gas company in this city is about equal to that of the street-cleaning department of the municipal government."
Is a public service corporation entitled to add the value of its franchise to the assets from which a fair return may lawfully be demanded? This question is taken up and discussed exhaustively by the Court (157 Fed., 872 to 879), and while it is clear in reading his judgment that he does not believe it sound doctrine to invest a franchise with value, yet, after citing a large number of cases, he reaches the conclusion that he is "compelled" to consider franchises, not only as property, but as productive and inherently valuable property, and to add their value, if ascertainable, to complainant's capital account before declaring the rate of return.
This case went to the Supreme Court of the United States, where, under the title Willcox _vs._ Consolidated Gas Company (212 U. S., 19), citation is made to many cases in connection with the matter of franchise value. The decision of the Court is:
"The value of real estate and plant is to a considerable extent a matter of opinion, and the same may be said of personal estate when not based upon the actual cost of material and construction. Deterioration of the value of the plant, mains, and pipes is also to some extent based upon opinion. All these matters make questions of value somewhat uncertain."
The Supreme Court permitted the tangible values found by the lower Court to stand. It concurred with the lower Court in that it was not a case for a valuation of good will. It concurred with the lower Court in holding that the company was entitled to the benefit of any increase in tangible values, and that such increases should appear in the appraisal. It did not agree with the Court in the increase of franchise value above that which was capitalized in 1884, with the consent of the State of New York, and reduced the franchise value figure to $7,781,000. On this basis, the estimated return, under the new rate on the valuation of $55,612,435, was 5½%, which rate, in view of all the circumstances, is held to be not confiscatory and to be a not unreasonable return on the investment. The franchise value, as commented on in these cases, is referred to at considerable length in the following pages.
On January 4th, 1909, the case of Knoxville _vs._ Water Company (212 U. S., 1) was decided. This, in some respects, is of greater value to the engineer than any others cited, in its determination of methods. In this the appraisement of the tangible property was made in minute detail, the sum of $10,000 was added for "organization, promotion, etc.," and $60,000 for "going concern."
"The latter sum we understand to be an expression of the added value of the plant as a whole over the sum of the values of its component parts, which is attached to it because it is in active and successful operation and earning a return. We express no opinion as to the propriety of these two items in the valuation of the plant for the purpose for which it was valued in this case, but leave that question to be considered when it necessarily arises. We assume without deciding, that these items were properly added in this case. This valuation was determined by the master by ascertaining what it would cost to reproduce the existing plant as a new plant. The cost of reproduction is one way of ascertaining the present value of a plant like that of a water company, but that test would lead to obviously incorrect results if the cost of reproduction is not diminished by the depreciation which has come from age and use.... The cost of reproduction is not always a fair measure of the present value of a plant which has been in use for many years. The items composing the plant depreciate in value from year to year in a varying degree. Some pieces of property, like real estate for instance, depreciate not at all, and sometimes, on the other hand, appreciate. But the reservoirs, the mains, the service pipes, structures upon real estate, stand-pipes, pumps, boilers, meters, tools, and appliances of every kind begin to depreciate with more or less rapidity from the moment of their first use. It is not easy to fix at any given time the amount of depreciation of a plant whose component parts are of different ages with different expectations of life. But it is clear that some substantial allowance for depreciation ought to have been made in this case.
"The company's original case was based upon an elaborate analysis of the cost of construction. To arrive at the present value of the plant large deductions were made on account of the depreciation. This depreciation was divided into complete depreciation and incomplete depreciation. The complete depreciation represented that part of the original plant which through destruction or obsolescence had actually perished as useful property. The incomplete depreciation represented the impairment in value of the parts of the plant which remained in existence and were continued in use. It was urgently contended that in fixing upon the value of the plant upon which the company was entitled to earn a reasonable return, the amounts of complete and incomplete depreciation should be added to the present value of the surviving parts. The Court refused to approve this method, and we think properly refused. A water plant with all its additions begins to depreciate in value from the moment of its use. Before coming to the question of profit at all the company is entitled to earn a sufficient sum annually to provide not only for current repairs but for making good the depreciation and replacing the parts of the property when they come to the end of their life. The company is not bound to see its property gradually waste, without making provision out of earnings for its replacement. It is entitled to see that from earnings the value of the property invested is kept unimpaired, so that at the end of any given term of years the original investment remains as it was at the beginning. It is not only the right of the company to make such a provision but it is its duty to its bond and stockholders, and, in the case of a public service corporation at least, its plain duty to the public. If a different course were pursued the only method of providing for replacement of property which has ceased to be useful would be the investment of new capital and the issue of new bonds or stock.... 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 upon over issues of securities, or of omission to exact proper prices for the output, the fault is its own. When, therefore, a public regulation of its prices comes under question, the true value of the property then employed for the purpose of earning a return cannot be enhanced by a consideration of the errors of the management which have been committed in the past."
The Court holds that there was error in only considering the operations of the company for a period of one year, and that this should have extended to enough time to remove danger of abnormal business conditions and observe the effects of certain ordinances.
The decision of the Supreme Court, in the Omaha Water-Works case, decided on May 31st, 1910 (_Supreme Court Reporter_, July 1st, 1910), is of general interest in its discussion of the procedure of appraisers in making a water-works appraisal, and in the distinction drawn between appraisals and arbitrations; but it does not touch on appraisal methods or elements of value, except to discuss "going values." The language of Judge Lurton on this point is as follows:
"The option to purchase excluded any value on account of unexpired franchise, but it did not limit the value to the bare bones of the plant, its physical properties, such as its lands, its machinery, its water-pipes or settling reservoirs, nor to what it would take to reproduce each of its physical features. The value, in equity and justice, must include whatever is contributed by the fact of the connection of the items making a complete and operating plant.
"The difference between a dead plant and a live one is a real value, and is independent of any franchise to go on, or any mere good will as between such a plant and its customers. That kind of good will, as suggested in Willcox _vs._ Consolidated Gas Company (212 U. S., 19), is of little or no commercial value when the business is, as here, a natural monopoly, with which the customer must deal, whether he will or not. That there is a difference between even the cost of duplication, less depreciation, of the elements making up the water company plant and the commercial value of the business as a going concern is evident. Such an allowance was upheld in National Water Works Company _vs._ Kansas City (62 Fed., 853), where the opinion was by Mr. Justice Brewer. [This decision is quoted in the foregoing pages.] We can add nothing to the reasoning of the learned Justice, and shall not try to. That case has been approved and followed in Gloucester Water Supply Company _vs._ Gloucester (179 Mass., 365, and 60 N. E., 977), and Norwich Gas and Electric Company _vs._ Norwich (76 Conn., 565). No such question was considered in Knoxville Water Company (212 U. S., 1) or in Willcox _vs._ Consolidated Gas Company (212 U. S., 19). Both cases were rate cases and did not concern the ascertainment of value under contracts of sale."
The writer does not read into the language of this decision an approval of a separate element of value to be called "going concern value" or "going value" in addition to other non-physical values, but rather a recognition of the fact that certain non-physical elements of value, by whatever name they may be called, must be taken into account in arriving at the fair and equitable final figure of value of a live and operating concern for the purpose of carrying out a contract of sale.
It appears to be doubtful whether the Court can be construed as approving such an element of value in rate cases.
It thus appears that the United States Courts have laid down a few rules, which may be regarded as fixed and definite and must be followed, but that many important questions have not yet been decided. The value to be determined must be a "fair value" of the property being used for the convenience of the public. The par value of stocks and bonds may not alone be considered (although it may be considered), the market value of stocks and bonds, original cost plus cost of additions, the probable earning capacity, the cost of reproduction, depreciation, appreciation, all these, and any others that will throw light on the "fair value" must be taken into account and given the weight to which they are entitled. Any fictitious book values due to over-issues of stock and bonds are to be given no weight, but the appraisal must give the fair value, in the light of all the facts, of the property in actual use at the time of the appraisal.
There are several decisions of the State Supreme Courts which discuss these subjects, but an examination of a number of these gives practically nothing more, in the way of definite conclusions as to method, than has been cited. Perhaps the most complete and painstaking consideration of appraisal problems by any Court was that given by Judge Savage of the Supreme Court of Maine (97 Maine, 185, and 99 Maine, 371). These were neither rate cases nor taxation cases, but proceedings under statute to require from the Court instructions to a board of appraisers appointed to value the plants. In the later or Brunswick case, Judge Savage elucidates a number of points left not altogether clear in the Waterville case. The Brunswick decision contains some interesting views on "going value," and the Court's remarks on the general difficulties in making rules for an appraisement are exactly to the point:
"There are many difficulties, if not dangers, in attempting to formulate rules which are to be applied to facts not yet ascertained. While it may be easy enough to state rules in the abstract, it is much more satisfactory in an opinion of the court, to express them in terms which are applicable to the facts in the precise case in hand.... It must be always understood that our answers to these questions are intended to be given only in the most general and comprehensive terms, which may, or may not, be found to be fitted to the facts which may subsequently be developed. No other course would be wise or safe.... A public service property may or may not have a value independent of the amount of rates, which for the time being may be changed. A public service company may, under some circumstances, be required to perform its services at rates prohibitive of a fair return to its stockholders, considering their property as an investment merely....
"Now, what is the property which the district has taken by power of eminent domain? In the first place it is a structure, pure and simple, consisting of pipes, pumps, engines, land rights, and water rights. As a structure, it has value independent of any use, or right to use, where it is, a value probably much less than it cost, unless it can be used where it is, that is, unless there is a right to use it. Nevertheless, it has value as a structure. But, more than this, it is a structure in actual use, a use remunerative to some extent. It has customers, it is actually engaged in business, it is a going concern. The value of the structure is enhanced by the fact that it is used in, and in fact is essential to, a going concern business. We speak sometimes of a going concern value as if it is, or could be, separate and distinct from structure value—so much for structure and so much for going concern. But this is not an accurate statement. The going concern part of it has no existence except as a characteristic of the structure. If no structure, no going concern. If a structure in use, it is a structure whose value is affected by the fact that it is in use. There is only one value. It is the value of the structure as being used. That is all there is of it."
The Court then argues that, as the structure is being used under authority and by virtue of franchises, it is more valuable. The franchise, however, is limited; other and competing franchises may be granted; a franchise may exist entirely independent of a structure. He holds that the structure is more valuable with the franchise.
"It is a structure in actual use, and with a right on the part of the owner to use it and to charge reasonable rates to customers for services rendered. It is threefold in discussion but it is single in substance."
This case is largely taken up with a discussion of the reasonableness of rates which furnish a basis for the estimate of value. There is no specific attempt to describe methods of procedure. That is left to the appraisers. These two Maine Cases, together with a valuable paper[17] thereon by Leonard Metcalf, M. Am. Soc. C. E., constitute an extremely valuable addition to the literature of appraisements.
It is clear, from a study of all the cases referred to in this paper, that the Courts have laid down a line of precedent which is equitable and just, that the interests of both public and corporations will be safeguarded, and that the likelihood of any unfair or improper valuations passing the scrutiny of the Supreme Court is but remote.
Footnote 17:
_Transactions_, Am. Soc. C. E., Vol. LXIV, p. 1.
PHYSICAL VALUES AND METHODS FOR THEIR DETERMINATION.
All the foregoing narrative of methods adopted in recent valuations, review of judicial opinions, and comment on the expressed opinions of various engineers and railway officials, is presented as being proper and necessary to support the contention that the Michigan valuation, while not the first appraisal work, was the first valuation work of large magnitude undertaken by any State; that it was a work which established many precedents; and that the complete discussion of methods and principles in connection with and following this appraisal has given it probably a greater general value than any similar undertaking. The Wisconsin work, which immediately followed that of Michigan, was along lines similar to those of the Michigan physical valuation, and carried the work forward, adding to and strengthening certain of its features. Without any impropriety, it may be claimed that these two appraisals have laid down the general lines on which this class of engineering effort will be largely directed in the future.
It is desirable, in closing this paper, to indicate such general methods of procedure in valuation practice as may be said to have been thoroughly established by precedent, and to present such argument as will support the contention that such methods are proper.
The fact has been emphasized, again and again, by every writer on the subject, that problems of this class are not capable of exact mathematical solution; that, no matter how much care may be exercised in the execution of the work, the result is tempered by the personal judgment of the men engaged on it, and that only when it is executed by men of experience, sound judgment, and high moral worth can it have a definite, final, and just result.
This feature of appraisal work cannot be too strongly emphasized. The value of the work depends on the character of the men doing it, their experience in design, construction, and operation of properties, and their absolute fairness and freedom from prejudice.
That there will be many large valuations undertaken in the near future, there appears to be no doubt. These valuations will be made as a necessary preliminary to three classes of corporate control: rate-making, taxation, and the regulation of capitalization.
The Courts hold that the value must be "the fair value of the property used for the public," and that the corporation:
"may not impose upon the public the burden of such increased rates as may be required for the purpose of realizing profits upon [such] excessive valuation or fictitious capitalization." (Smyth _vs._ Ames.)
This language is repeated, again and again, so that it is clear that any valuation, to be sustained by the Courts, should:
_1._—Be based on a careful study and analysis of all the information applicable to the case in hand; and
_2._—That it must separate the various elements so that every step of the work may be reviewed and supported.
Public interest demands that, in any valuation, certain figures shall appear which shall show the amount of _bona fide_ capital actually existing in the property at the date of appraisal.
The fact that a given amount of money was invested in building a railroad in 1880, and that certain other sums were spent for additions in subsequent years, does not necessarily indicate that these amounts of capital will still be found in the property in 1910.
The removal of timber from surrounding lands, the destruction of industries and the removal of tracks leading thereto, the destruction of equipment and facilities, the depreciation in value of adjacent property, along with wear and tear, and obsolescence, have gone to effect the destruction or loss of capital on many Michigan railroads. The case in 212 U. S., 1, clearly directs that the valuation must not take into account this destroyed capital, but must return a "fair value of the property as it is."
On the other hand, the amount of money actually spent in producing a given property in the past may be far below the present value. The appreciation of value of lands by reason of development of cities and growth of industries, the increase in cost of the materials entering its construction, and many other causes, may lead to an appreciation of the value of the property, and this appreciation should appear in the valuation and the company be entitled to the benefit of it. It is in the nature of an increase of the investment, and should appear as capital.
It is clear that there are two classes of elements of value in the final value of a public service property: those which are physical, and those which are intangible. There are various of the physical elements of value which are not material or susceptible of inventory, but which, nevertheless, attach themselves to the physical property, are capable of determination, within reasonable limits of certainty, and should be taken into account and computed as physical property.
In the subsequent discussion of physical and intangible values, it is attempted to differentiate between such elements as should attach to the physical value, or capital remaining in the plant, and the purely intangible or franchise values.