Part 34

The method described as having been used by Professor Adams seems to be at least an advance toward a logical and rational method of getting at the value of corporation property, but it must be acknowledged that we are as yet a long way from a perfect method of appraisal, even of the physical values, to say nothing of the non-physical. He held that as nothing visible or tangible gave support to the latter value, it must be determined on the basis of information secured from the income accounts of the company. This method of measure, it would seem, is not unlike the celebrated dictum on the length of the Chancellor's foot, "some Chancellors have a long foot, and some an indifferent foot, and some a short foot"; therefore, a great English Chancellor says, "the length of a Chancellor's foot should not be taken as a measure of rights in equity." Thus, if the income of the company is to be taken by the appraising engineers, or the gross income, it may have to be given a different interpretation from the net income, and if the surplus earnings depend on transient causes or on excessive rates for service it will lead to a totally erroneous conclusion. The same may be said if the rates for service are too low, or if the company is badly managed, or is carrying a great deal of "dead wood," either in the form of property or of servants. Therefore, it seems evident that he who attempts to follow this method of appraisal must possess almost superhuman judgment of present conditions, and prescience to forecast the future, as well as a grade of wisdom and knowledge of existing conditions of trade and industry which may be also characterized as superhuman. In order to apply Professor Adams' method justly, we must know whether the company is wisely managed, whether its income is a fair income, whether its physical property is all useful and needful, whether its service is what it ought to be as to efficiency and economy, etc. We must assume an ideal condition of commerce and industry, and of property value and management, and then appraise the company's property by comparing it, consciously or unconsciously, with this ideal. Possibly this is the best method devised so far, but surely it leaves a great deal to be desired; and it is difficult to see how different engineers, on different sides of the question, representing different interests, can find any common ground of agreement in Professor Adams' method. Under such circumstances, engineers are likely to differ in their results as much as the length of the different Chancellors' feet.

LEONARD METCALF, M. AM. SOC. C. E. (by letter).—Mr. Riggs has done engineers, and more particularly those interested in valuation works, a genuine service in presenting to the Society this admirable paper.

No shrewd observer can fail to recognize the increasingly insistent demand of the public for greater publicity in the accounting, and a larger measure of governmental control in the operation, of public service corporations. In its best form, such control will be welcomed by the corporations, as giving greater stability to investment in such property; in its worst, it may prove a serious limitation to prompt development of the best standards of service. In the water-works field, the anti-corporation movement has resulted in taking over by the public many such plants. It does not seem likely, however, that we are ready to go farther in the railroad field of operation than to demand reasonable regulation of such corporations.

While the writer has had no experience in railway management or valuation, he has devoted much time and thought to the valuation of, and determination of fair-rate schedules for, water-works properties; therefore, what he may have to say in comment on this paper may be assumed to have direct application to water-works valuation, and to railroad valuation only as the similarity in the public service rendered by these corporations may imply.

In the main, the writer subscribes heartily to the views expressed by the author and the temperate way in which he has expounded them. Space forbids discussion in detail of all the matters alluded to and so well covered by Mr. Riggs. On one important subject, however—the inclusion of the going value, or going concern value, of public service corporation property, in the intangible property values, rather than in physical plant value, and the consideration of it as an intangible value rather than as a real and substantial item of cost to the public service corporation—the writer differs from the author. It is clear, from what Mr. Riggs has said, that this is debatable ground, and, from the care and fairness with which he has expressed his views on this subject, one might almost be led to infer that he invites attack on it. It is in no carping spirit of criticism, however, that the following views are expressed.

As the writer has recently submitted to the Publication Committee of this Society a paper on the "Going Value of Water-Works," written by him in collaboration with John W. Alvord, M. Am. Soc C. E., in which a detailed discussion of this subject will be found, only enough will be said to outline clearly his point of view.

The author says:

"The physical property is that which enables the corporation to do business. Without physical property it could not produce the commodity which it sells. The amount of money actually invested in acquiring that physical property represents the measure of capital on which it is morally entitled to earn interest and profit; and, in the stage of promoting and financing the enterprise, all hope of earnings is based on the amount of money required to construct the property."

He also says:

"It would seem reasonable to say that this difference between the physical value and the value based on earnings represents the 'good will,' 'established business,' or 'going value,' and all other non-physical elements of value."

In referring to going value, he says:

"* * * Yet, to fix a value on it by the method described by him [Mr. Alvord] involves going into the realm of conjecture and speculation to a degree that could never be sustained. * * * It can be readily seen that the physical present value is not always—indeed, is not often—the 'fair value.' The 'fair value' may be more, or less, than the present value of the physical property."

"* * * Is it not, then, proper to conclude that the non-physical or intangible value, composed of all these various elements of value, can only be determined absolutely by a study of the earnings and operating expenses? * * *"

He also says:

"The contention that all the different elements of non-physical value merge into one intangible value, not capable of separation, will doubtless be objected to by many engineers and corporation managers. * * *"

"The writer does not concede that 'going concern' is a proper element to consider in the physical value, as it does not represent any part of the cost chargeable to capital, and the physical valuation should be confined to the determination of capital invested."

Quotations might be multiplied. Those cited, however, will suffice to recall the author's view, and to make clear the point with which issue is taken.

Is Mr. Riggs right in his contention that going value is in fact an intangible value; that going value is not an element of real cost to the company, involving investment of capital; that going value, therefore, should not be included in physical plant value; and that the company is not morally entitled to earn interest and profit on it?

The writer contends that going value is as real an element of cost, in the property of any public service corporation, as is the cost of any portion of its physical plant. It pertains, however, to the business, rather than to the physical plant, of the corporation.

Whatever the difficulties of its computation may be, whatever the methods used—whether that adopted by the Wisconsin Public Service Commission (which is essentially one of determining the original cost of the going value and not its reproduction cost), or whether that perhaps first outlined by Mr. Benezette Williams and George H. Benzenberg, Past-President, Am. Soc. C. E., in the Middle West, and by William Wheeler, M. Am. Soc. C. E., in the East,[42] a method which seeks to determine the reproduction cost of the going value, rather than its original cost—the going concern value has come to be recognized, by water-works appraisers at least, as a substantial element in the cost of the plant, and hence as differing essentially from the franchise element or so-called unearned increments of value.

Is not going value in a "between" class—a middle ground between tangible and intangible values—tangible in that it has involved real cost and expenditure of money; intangible in that it is not as readily calculated as are other reproduction cost items, is dependent fundamentally on the earnings of the company, and that there is no tangible equivalent to show for the expenditure, except the existing income of the corporation? Surely its character is quite different from that of the franchise, as ordinarily found, the value of which, while real, from the rate-payers' point of view, seems to be made out of whole cloth; in short, seems to be of fictitious value.

Certainly, the conjectural and speculative character of the computations—as referred to by Mr. Riggs—involved in the determination of going value is no excuse for failure to recognize going value as a real element of cost, rather than as an intangible value. As a matter of fact, the variation in the views on going value, by engineers who have given this subject particular study, while greater than the variation in their estimates of the reproduction cost of the physical plant, is still far less than the variation in their views on franchise value.

As bearing on the proper basis for rate-making, the author's statement, that the "* * * physical property represents the measure of capital on which it [the public service corporation] is morally entitled to earn interest and profit * * *" cannot be admitted, equitably or legally; and it is not to be assumed that Mr. Riggs desired to imply that this sentence summed up his final views.

Are we not, however, approaching a basis of rate-making, predicated on the earning, by public service corporations, of operation and maintenance expenses, depreciation allowance, and return (_i. e._, interest and profit) on reproduction cost of the property, less accrued depreciation, plus going value, plus a nominal allowance for the franchise and other intangible values of the corporation? Is it not possible that the recent depression in the business world has been due, in considerable measure, to the shrinkage in the values ascribed to franchise and other intangible value in public service corporation property?

If we are approaching such a limitation, it is the more important that the public should be educated to the fact—not theory, for it is a fact—that going value, or going concern value, is a real element of cost, covering an outlay in effort and money on the part of the corporation, and as such is as much entitled to earn a return (interest and profit) as is the other capital invested in plant. It is not on any items of real and necessary cost to the corporation that the public objects to paying tribute, but on the "unearned increments" and the virtual monopoly "privileges" enjoyed by the corporation and created, in large measure at least, by the public itself and by normal conditions of growth and development for which the public, rather than the corporation, was perhaps responsible—though in many cases it may be urged truly that the corporation itself, rather than the public, has been responsible for the development.

Such a basis of rating, while still dependent on sound judgment and judicial treatment, is nevertheless not beset with the speculative element involved in the capitalization theory, which, Mr. Riggs himself admits, fails as a basis of rate-making except when predicated on fair rates.

If the writer's contention, that going value is a real element of cost in the property of any public service corporation, is sound, Mr. Riggs' statement that, "It appears to be doubtful whether the Court can be construed as approving such an element of value in rate cases," and his interpretation of Judge Tayler's ruling in the Cleveland Street Railway matter,[43] must be challenged.

Certainly, as applied to water-works valuation, Mr. Riggs' statement is not justified. The Maine cases clearly include going value as an element of value on which rates should be predicated; by inference, so does the Kansas City case. In the Knoxville case it was in fact allowed by the Master.

In equity it cannot be doubted that going value should be included in the base on which the returns are predicated, if, as contended, it involves real cost to the company; for the company must be permitted to earn a fair return on this cost, or to liquidate it in some way, as otherwise the corporation would suffer substantial property loss—from 10 to 20%, more or less, of the reproduction cost of its property. This would be contrary to public policy, for, with such an outlook, capital would not enter this field of enterprise, except at increased rates of return, commensurate with this added hazard. To assume such increased rates of return is to provide another means of liquidating such a loss.

As to "good will," it has seemed to the writer more proper to use this term in private competitive corporation enterprises, as applied to the element of value corresponding to the going value of the quasi-municipal or public service corporation enterprises, which latter are in effect controlled monopolies. If the term is used in its more colloquial sense, such as the effect on earnings of having, in the office of the corporation, men who meet the public pleasantly, who are good "mixers," and who are active in getting business, the value is substantially included in the consideration of the income, in the manner involved by going value determination and franchise valuation.

The depreciation question has been discussed so fully elsewhere that the writer only calls attention to the fact that, while physical and functional depreciation only are to be considered in a review of the present physical condition of any plant, in considering a fair-rate schedule, provision should also be made for contingent depreciation, covering such items as cost incident to change in street grades or construction of subways; placing structures under ground, which were previously above ground; serious loss due to injury by electrolysis, the distribution of which over a period of years rather than inclusion in the operating cost for one year, is to be preferred, alike from the public and from the corporate point of view, from the fact that it spreads the burden to be borne by the rates, and prevents violent fluctuation in prices or valuation of the public service corporation's property. The public pays dearly for all hazards. It is wise, therefore, to pursue the conservative course in providing adequate funds to meet extraordinary conditions, and to give stability to the investment of the corporation. Moreover, such funds can be carried in a separate account which can readily be watched; any excess can be credited to future reduction in depreciation account requirements, while a prolonged deficit cannot perhaps be recovered by the corporation, in the light of the Knoxville decision.

The comment that no hard-and-fast rule can cover determination of proper depreciation allowances, is amply justified. In its final analysis, it is a matter of good judgment, experience, and judicial temper.

The author's statement that the organization, legal, engineering, administration, and general expense accounts, "should not be considered as affected by depreciation, as long as the property is a going concern," is not quite clear. Obviously, this is true with regard to all the early organization expenses, as these expenses are incurred once for all, and constitute a continuing asset similar to other elements of plant cost. If, however, the author refers therein also to the engineering and contingent item added to many of the reproduction cost items making up the physical property, exception must be made; for when an old structure, the life of which is gone, is replaced with a new structure, new engineering costs are incurred, and the engineering element of cost incident to the installation of the original structure no longer inheres in the plant. It, too, has passed away with the life of the structure, and, therefore, its cost should be liquidated, or provided for in the depreciation account, as well as the cost of the structure to which it was incident.

In the same way the "interest-during-construction" item is not a continuing asset, but should be liquidated with the complete depreciation of the portion of the structure to which it relates. The replacement of the structure will involve new "interest-during-construction" charges, commensurate with the time required for construction. The value of the initial "interest-during-construction" costs will have disappeared with the original structure and, therefore, should be taken care of by the depreciation account.

The method of making allowances for interest during construction, suggested by the author,[44] accords closely with that used by Mr. Alvord and the writer in a recent valuation of a large water-works property, in which the "interest-during-construction" charges were limited, and the contributions to depreciation account were begun, at the date on which any workable unit of the property was assumed to be available for service and to begin to earn a return on its investment cost, even though the structure, as a whole, was not assumed to be completed for a considerable period of years thereafter. Thus, for instance, it might be assumed that as soon as the supplying works in a water-works project were in operation, the investment in them and in the distribution pipe system laid up to that time, would cease to be credited further with "interest-during-construction" allowances, and would be compelled to earn interest through the water rates or income from water supplied to consumers—the fact that the interest charge could not be wholly met, immediately at this time, being taken care of in the resulting increment in going value.

Such a theory, of course, does involve a determination of the probable order and rapidity of construction of the component parts of the property, and this is usually made, in water-works valuation, in the estimate of the reproduction cost of the property.

For the sake of completeness, in reference to the legal decisions of importance in valuation proceedings, attention is called to the Pennsylvania case, Brymer _vs._ Butler Water Company (179 Pa., 231), referred to in the closing discussion on the writer's paper on "Water-Works Valuation."[45]

In this case Justice Williams, speaking for the Supreme Court of Pennsylvania, says:

"By what rule is the Court to determine what is reasonable and what is oppressive? Ordinarily, that is a reasonable charge or system of charges which yields a fair return upon the investment. Fixed charges and costs of maintenance and operation must first be provided for. Then the interests of the owners of the property are to be considered. They are entitled to a rate of return, if their property will earn it, not less than the legal rate of interest; and a system of charges that yields no more income than is fairly required to maintain the plant, pay fixed charges and operating expenses, provide a suitable sinking fund for the payment of debts, and pay a fair profit to the owners of the property cannot be said to be unreasonable."

The Pennsylvania Court, therefore, in the words of William S. Wallace, Esq., recognizes the single standard:

"The Single Standard, according to the Brymer case, while acknowledging the full right of the public to regulate such public corporations, also recognizes as a prime factor its private character and the rights which accrue to it in that capacity, ... and holds to what seems to me the only rational and practicable basis, that a fair return, after deducting the charges above enumerated, _is_ a reasonable rate"; whereas, "the Double Standard basis of fixing a reasonable rate seems to accentuate the public side of the corporation and rather ignores the private element."

As to the propriety of the inclusion of a substantial recognition of franchise value as a basis for rating, the layman may well confess to perplexity, in the light of the conflicting nature of the two important recent United States Supreme Court opinions referred to—the Knoxville case, and the Consolidated Gas Company case—for, while substantial allowance was made for franchise value, in the Consolidated Gas Company case decision, in large measure apparently on account of its earlier recognition by the legislature, in the Knoxville case, in spite of legislative recognition of such value, and similar approval of the issue of securities predicated on such recognition, the United States Supreme Court failed to make similar allowance for franchise value.

The author's treatment of the unit price question and the contingency item is intelligent and creditable. Engineers are prone to make valuations based on "hindsight" instead of "foresight," on the assumption that no substantial difficulties in construction were encountered, when, in fact, substantial difficulties should perhaps have been anticipated, and may actually have been encountered in the original construction, record of them having been obliterated, however, with the lapse of time.

The author's definition of the value of a property, as the "estimated worth at a given time, measured in money, taking into account all the elements which add to its usefulness or desirability as a business or profit-earning proposition," suggests the advisability of recognizing the other side of the ledger by modifying his statement so as to read: "* * * all the elements which add to, 'limit, or detract from' its usefulness or desirability as a business or profit-earning proposition."

While recognizing the author's view, that there is no separate and independent method of determining franchise value, which is not based on the determination of the value of the property as a whole, by capitalization methods, it must be recognized that going value may be determined independently, and may have a positive value, even though the property as a commercial whole is worth less than the sum of the physical value and the going value.

The Court, appraisers, and the author, alike recognize that there is no one method of valuation of universal application. First cost, reproduction cost, reproduction cost less depreciation, commercial value determined by capitalization, worth of the service to the consumer, and market price of the property, if such exists, all have their weight, in varying degree in different cases. Whatever may be said of, for, or against, these several methods of valuation, relates rather to their significance, and the weight which should attach to the results obtained by them, as evidence of value and of the effect of the modifying local conditions, than to the soundness of the methods themselves.

In this connection it may be of interest to refer to a recent valuation of a water-works property, in the appraisal of which the writer chanced to participate, in which there was finally placed before the board of appraisal a summing up of:

1. The original cost;

2. Reproduction cost less accrued depreciation, plus going value;