Part 20

The Supreme Court quotes approvingly from the Tennessee Court, as follows (151 U. S., 479):

"The value of the land depends largely upon the use to which it is put and the character of the improvements upon it."

This is stated again and again. It must be remembered that, for railroad uses, the strip must be continuous; that it must be located so as to permit curves and grades which conform to the requirements of the road; that, no matter what damages may accrue to adjacent property, the road must take its strip; that its use is entirely changed and is a structure placed on it which is capable of vastly greater earnings than the property produced before—all these elements add to the cost of the property when it is acquired for railway purposes, and in the same measure to its value under its new use.

In a new country, where transportation facilities are limited and land cheap, this added increment may be little or nothing, but in a thickly settled State, with many railroads, this element will increase with a good degree of uniformity; while, in terminals, the price rises to almost inconceivable figures. It is capable of being determined, and is clearly an element in the cost of reproduction. The writer holds to the view that it is properly to be placed with the physical values, and that it should not be considered as an intangible element of value.

(_d_) _Depreciation._—Thus far, this discussion has not dealt at length with the subject of depreciation, and it is not considered essential to the purposes of this paper that it be done. The State appraisals have raised a question as to the propriety of using mortality or life tables as compared with personal inspection and the placing of a percentage based on individual judgment. Either method is subject to error. It is certainly desirable to secure the opinion of the man who inspects a bridge, or building, or locomotive, as to its physical condition. It may be desirable to use the check secured by the fact that the age of the building is known and also the average life of structures of its class.

The result of the Michigan inspection of rolling stock was to sustain fully the rules for valuation issued by the Master Car Builders Association; and clearly, it is not only proper, but extremely desirable, to apply tables to such equipment as freight cars, which are scattered all over the United States, for it would be absolutely impossible to inspect completely those of any road or system. On the other hand, the life of steel rails cannot be determined by any simple table, because the number of car movements, the weight of motive power, the speed of trains, the location (on curves or on heavy grades), and many other conditions affect their life. This also pertains to buildings, locomotives, and other equipment. The character of service rendered, the nature and extent of repairs, and the way in which they have been maintained, add to or take away from any life assigned by tables, so as to render them valueless in many individual instances.

In placing depreciation, allowance should be made, not only for wear and tear due to use, and decay due to the elements, but also to cover that which is due to obsolescence, or the fact that the facility is of an antiquated or inefficient type, and has been superseded in general use by more efficient and economical devices; this may be called commercial depreciation, as distinguished from physical depreciation. The method to be used in placing depreciation is clearly one of the important things that must be determined by each set of appraisers, and, while the writer believes that the use of expectancy tables would greatly facilitate the work in many cases, the data on which to found a complete set of tables and to support them and justify their use are often lacking; therefore, any use of tables should be safeguarded in every possible manner, and personal inspection of fixed property should always be made.

(_e_) _Immaterial Elements of Physical Property._—There are certain expenses, inseparable from the construction of any public works, which are a necessary and proper part of the cost, and are arranged for in the original financing, but are not capable of identification after the completion of construction work. These expenses are:

(1) Organization,

(2) Legal expenses,

(3) Engineering,

(4) Administration,

(5) General expense.

(1) Organization.—This includes the cost of the original organization of the company, the cost of securing the charter and franchises, arranging the financial plan, and securing the funds for construction.

The latter item is intended to include all salaries and expenses of officials in soliciting and negotiating for funds, the services of trustees, and all other proper expenses which are usual and unavoidable in the process of exploiting a projected enterprise and interesting capital therein. Discount on bonds is not included, and any allowances for "premium," or "bonus," or other cash payment to any party for services in securing funds, which are in excess of legitimate expenses, should receive scant consideration at the hands of appraisers.

(2) Legal Expense.—This is for attorneys and all legal expenses, costs, and fees in the organization and during the construction of the property.

(3) Engineering.—This includes reconnaissance, preliminary and location surveys, supervision of construction, and design and superintendence of special structures. The cost of engineering on some of the more difficult properties becomes a very large sum; on certain small lines it may be comparatively small; and in some cases no engineers have been employed at all; but the items of cost covered by this charge have in every case been expended, even if done under the direction of some superintendent.

(4) Administration.—This comprises the cost of the management during construction—the direction of the enterprise.

(5) General Expense.—This is the cost of the general office organization during the construction period, also numerous minor expenses, not distributable.

It is not possible to build any public service plant without incurring all these expenses to a greater or less degree. They are essential elements of cost, and must go into the value of the plant when completed. It can hardly be argued that cost, which in a large property runs into thousands or hundreds of thousands of dollars, has no value at the commencement of operation, nor does it appear that the value is subject to depreciation as long as the property is an operating plant. The writer holds the view that the line between physical and non-physical elements of value should be drawn as follows:

Any value which attaches to the property by reason of any money expended during the construction is part of the physical property values; while any value due to the operation of the property which is in excess of the physical value is a non-physical or intangible element. If the correctness of this position be conceded, then all the foregoing items are charges against the physical property, and, as long as it is an operating property, these items of value remain part of the physical property, and the writer contends that they should not be considered as affected by depreciation, as long as the property is a going concern.

Different engineers have included in the appraisal other items which are of a somewhat different nature, and some of which are open to argument; among these are "interest during construction." This item is clearly an allowable one, but serious differences of opinion develop as to a proper amount to allow in making an appraisal.

The corporate history of the Ann Arbor Railroad, in Michigan, shows that it was built in sections of from 25 to 30 miles, and that each section was put into operation as soon as built, so that, while the actual period of construction of the complete property extended over 15 years, no section was under construction much more than one year. This is typical of much of the railroad building of the past, and on such a property the interest charge would be comparatively small.

A proper charge in such a case would clearly not be sufficient in the case of a road several hundred miles in length, through mountains, with tunnels, heavy bridges, and other structures which would extend the actual construction over periods of from 3 to 5 or 6 years, and this is particularly true where the road is a main line or artery, and where local traffic is of minor importance.

The computation of the interest charge is complicated by the fact that interest begins to run as the bonds are taken up, and but a small part of the construction money draws interest during the whole period.

The practice in the State appraisals has been to fix a uniform percentage for all properties. This has had in its favor the argument that it was conservative valuation where taxation is the ultimate end, as the amount was less than one year's interest in every case. It would appear to be more correct to use the corporate history of each company, determine the actual construction periods, and use a rate based on the actual time in each case. This can be fixed with a fair degree of accuracy, and a reasonable percentage determined, to equalize the varying periods of time on which the interest runs on different parts of construction.

Discount.—Discount on bonds is claimed by certain railroad men as a proper item for consideration. As has been argued elsewhere, this is not a proper charge against capital. It is an adjustment of the interest rate to the market, or an advance payment of interest; and, in the writer's opinion, should under no consideration be allowed.

Working Capital.—Working capital is another item claimed and conceded in some valuations. It is not a part of the "cost of construction." The money provided for working capital at the outset is not a permanent investment, but is rather a temporary loan paid back out of earnings. The writer fails to perceive any possible argument in favor of adding such an item to the permanent value of the property. In making an appraisal, after the physical value is determined, it is usual to set up a statement of stores, supplies, fuel, and cash on hand, and working capital is certainly shown by the current balance sheet, in the form of cash or accounts receivable. It would appear to have no place in a physical appraisal. Although the items of cash, stores, and supplies were shown in the Michigan appraisal, they did not appear as part of the physical value, nor were they taken into account in computing intangible value, but, being taxable property, they were reported separately.

(_f_) _Contingencies._—The use of a percentage for contingencies in the appraisal in Michigan was bitterly contested by the railroads as improper and excessive. In Michigan 10% was used, in Wisconsin 5½%, and in Minnesota 5 per cent.

Subsequent work in Michigan has demonstrated that the use of as high a figure as 10% was fully justified; and the probability is that the latest Michigan appraisal did not eliminate omissions, inaccuracies of description, and excess cost of construction due to difficulties, to such an extent as to justify much reduction in the percentage.

In making an appraisal, the percentage to be applied to cover contingencies is a proper matter for consideration, and in some cases conditions might well be such that even a smaller allowance than that fixed in Minnesota would be proper, but such cases would doubtless be the exception. The writer believes it to be proper practice to add liberally for the contingency item. The strongest argument against it is that it is incapable of being described and located definitely, and is difficult of exact proof. Therefore it has been claimed that it partakes of the nature of a non-physical element, and that if there be any value over and above the physical property value, it will appear with other non-physical elements reflected in the earnings, and may be properly included in the intangible value if such exists. This argument does not appeal to the writer as being final, and he would advocate the use of such a percentage of physical values as appears proper in each appraisal to cover the error due to the extreme difficulty of securing an exact inventory and construction history of the properties.

(_g_) _Design._—Among the matters which were considered in the Michigan work was that of adaptability, or the economical questions of location, design, and construction. It is possible that in some properties, such as water, gas or electric companies, the efficiency of the plant may be very greatly affected by faulty design, uneconomical arrangement, improper construction, and to such an extent that any cost of reproduction, less any ordinary depreciation, would be greatly in error without further allowance. This may also be true of railroads. Excessive curvature and gradients greatly decrease the tonnage hauled by a given power, without decreasing the cost per train-mile.

It is extremely difficult to treat this as a physical element. It is impossible to reduce it to terms of dollars and cents by any usual or customary methods. It is impossible to separate it from any one of half a dozen other items that may be brought up. It opens the door to endless speculation as to what might or might not take place under somewhat different conditions. For these reasons, it was treated in the Michigan appraisal as a non-physical element of value and dismissed from all consideration in the physical appraisal. This was clearly proper, and the subject is only referred to here for the purpose of making clear that it was fully studied and a definite conclusion reached.

Adaptation.—In the sense that this term is used by Mr. Williams and Mr. Morgan, the appreciation or solidification of roadbed was considered in the Michigan work, but given no place in the appraisal. This is a very proper item to consider, but it would appear to be better to include it directly with the roadbed item in the physical appraisal as appreciation or solidification. There can be no reasonable objection to adding to the contract prices for grading, ballasting, etc., a reasonable amount to cover, not so much the seasoning and settling of the new roadbed, as the actual money disbursed in work on this new roadbed during the first 3 or 4 years of operation in order to bring it up to the proper operating condition. A very considerable part of the money spent on "maintenance of track" for the first few years after a new line is built is in reality deferred construction cost.

(_h_) _Apportionment of Values._—The apportionment of values of locomotives, cars, miscellaneous equipment, shops, and those other parts of the cost which are not susceptible of separation from the operation of the property as a whole, is an interesting and at times a perplexing problem. While the Courts have viewed as equitable the distribution of values between territorial units when made on a track-mileage basis, it is hardly likely that a Court would look with favor on an appraiser appointed by Michigan giving any consideration to values of bridges, track, or buildings in Ohio. Thus far, every State appraiser has concerned himself only with the fixed physical property in his own State, together with his proportionate share of the floating property. The methods that may be considered are track-mileage, car-mileage, locomotive-mileage, and train-mileage.

The method finally used must be such as will give the fairest result for the property under consideration. In some cases one or more of these methods will give a fair value, while in other cases the same system would be most unjust.

(_i_) _Terminals._—There is no one feature of the entire problem so big with possibilities, and so far from solution, as that of terminal property values and their proper assignment. The property must be considered as an operating unit. Its value must be made up of the values of the parts or elements plus an added value that comes from the operation of the whole. The problem would be simplified if what were sought were the value of a certain railroad, but, as it has been presented up to this time, the problem is: what is the value of that part of this railroad in Michigan? or Wisconsin? or Minnesota? A fairly satisfactory solution of many of the value questions has been obtained, but nothing in the way of a solution of the terminal question. A road owns 300 miles of line in Michigan and 7 miles in Ohio. That 7 miles includes its largest terminal; its principal connections are there; it has a fine property, and is in the capacity of landlord to several other roads. What part of that terminal value, if any, is assignable to the State of Michigan? Decidedly, it would not be proper to appraise the entire property as a unit and assign to Ohio only the proportion that 7 miles bears to the whole length; it is equally unfair to appraise it as a Michigan property down to the State line, and add nothing to the value by reason of the terminal.

The influence on the value of the property, of the ownership of terminals in such cities as Chicago, New York, Jersey City, Hoboken, Pittsburg, Detroit, St. Louis, Kansas City, and other large centers of population is tremendous, yet a very large part of the railroad mileage entering those cities belongs to roads which have their largest mileage outside the State in which the terminal is located.

There can be no doubt that the influence of a large terminal affects in a measure the value of every mile of line owned by the company; that this influence is greatest on the principal and direct lines, and less as more remote parts of the system are reached. As yet, no plan has been suggested for determining what this value is or for apportioning it.

The final solution in Michigan was to treat terminal properties within the State exactly as other property was treated, and to assume that, if there was any value assignable to Michigan by reason of outside terminals, it would appear as a non-physical value through the earnings.

When all the phases of this question are considered—the enormous land values, the value due to possession of deep-water terminals, the effect on the business of the entire property by reason of the ownership of such properties as those, for instance, in New York City, Jersey City, and Hoboken—it is evident that no appraisal which has yet been made has established any rule of valuation which may be considered proper for terminals.

It is to be hoped that the work now in progress in New Jersey may be so well supported by the State that it will be possible for the appraisal board to make an exhaustive study of this subject and reach definite conclusions as to the real extent, manner of computation, and proper method of distribution of these values.

(_j_) _Development of the Art._—Is any value assignable to property on account of expenditures by reason of the rapid development of the art? This question seems not to have been squarely asked or answered in connection with any of the past appraisals.

Every piece of material and every facility purchased by a company is bought with a definite expectation that it will have a certain life, that during that term of life it will add sufficiently to the earnings to provide a fund for its replacement and earn a profit. No matter whether or not such a reserve is created on the books, this is the theory, and, under it, accident may wipe out certain new property, other property will outlive its expectation and maintain the average life of the entire group of facilities.

There are countless cases where this will not hold. The rapid development of large cities has compelled electric lines to extend largely. The demands of the people for more frequent and more rapid service, and more modern and larger equipment, have greatly shortened the term of life of power-plant equipment and cars. The rapid development in the art of electricity, the congestion of traffic in streets of cities, the enormous increase of train movements, and the use elsewhere of newer types of cars, have compelled the abandonment of millions of dollars' worth of property and the investment of other millions in new and improved facilities to provide for the increased movements of traffic and increased safety to the public. These changes are not due to the fact that the original installation was defective, but to the demands of the public for frequent, safe, and speedy service, demands which are perfectly reasonable. The query is: should a corporation which complies with public demands be compelled to lose capital invested in facilities which have not yet paid for themselves; and which, under a continuance of conditions which existed when they were installed, or any that might then have been anticipated, would normally have a useful life of several more years, and which were abandoned, not by reason of being worn out or unfit for service, but purely because facilities of a more modern type were called for?

To answer this affirmatively increases the hazard of investment greatly in the large centers of population. To answer it affirmatively in some cases might amount to confiscation of property. The writer inclines to the view that, as far as appraisal is concerned, the value due to the remaining life of the abandoned facility, where such abandonment was in response to legal requirement, and where no element of corporate necessity due to increased efficiency or economy of the new facility enters into the computation, should be added to the value of the facility replacing it. Any consideration that is given such claims by an appraiser must be most careful, as the inference to be drawn from the decision of the Court in the Knoxville Water Case (212 U. S., 1) is that such elements of value will receive scant consideration unless most fully supported.

If the policy of the management of any public service company is to keep up with the demands of modern civilization, it would appear that such policy should not be discouraged, and, in computing the value of the property, some provision ought to be devised for covering such values as remain in serviceable property at the time of its abandonment in response to public demand; or else the rates for service should be increased sufficiently to compensate the corporation for losses of this nature on the ground that it constitutes an element of extra hazard.

These and like subjects in connection with the appraisal must be taken up during the period of computation and settled. The computing office organization and methods call for no special comment, except to emphasize the need of experienced men, the use of every possible check on the accuracy of the work, and the prime necessity of keeping all notes in such manner that they can be identified and used to re-establish every step taken in the course of the appraisal.

IV.—The Preparation of the Final Figure.

The final form of the work is, of course, so much a matter of personal judgment that even a suggestion may appear to be useless. The use of such a classification as will conform approximately, if not exactly, with that adopted by the Interstate Commerce Commission is more desirable now than it was 10 years ago, as all the roads in the country are using this classification in their accounts, and the more nearly uniform the work of various State appraisals, the better the results will be.

Footnote 18:

Unchangeable only for the period under consideration and as regards the purpose of the appraisal. This value varies from year to year, depending on business conditions and on earnings of the company.

NON-PHYSICAL VALUES AND METHODS FOR THEIR DETERMINATION.