Part 36

Mr. Riggs states that the valuation should be the same, regardless of the principles at issue. It seems questionable to consider the fair value which involves the non-physical value in costs or tax regulations. Certainly, in the case of street railways in cities, where a percentage is levied on the gross receipts, the non-physical valuation, only representing present value, is necessary. Again, a physical present value for taxation should not include the value of paving in the street in the strip occupied by street-railway tracks. That the street-railway company often pays an arbitrary assessment tax and keeps the paving in repair, though it is in no way responsible for the wear, should be sufficient to offset any obligation for other taxes. In some States this is fixed by the Courts. The physical valuation, however, intended to be used in connection with rates, cost, or capital regulation, should include the cost of paving the railway strip. Referring further to the question of including the paving in the physical valuation of street railways, in the case of a decision of R. W. Tayler, Arbitrator, in the proceedings between the Cleveland Electric Railway Company and the City of Cleveland, on a basis of a renewal of franchises, Judge Tayler said:

"Paving represents actual money expended. It belongs to capital account, and in its depreciated form is worth all the allowance that I have given it."

Also for rate-making and the capital regulation some consideration is certainly due to obsolescence and change of art, while in taxation they should not be included.

In conclusion, the speaker is optimistic enough to believe that the problem of physical valuations will be solved satisfactorily for all concerned. Co-operation of officials of the public service properties, reliable testimony, with a better understanding by the Courts, will certainly tend to clarify the situation. Non-physical values are very difficult to determine, and their intelligent treatment will require some well-defined procedure. Mr. Riggs' valuable paper will go a great way toward producing a correct idea of the general proportion, and will, no doubt, assist in the formulation of proper methods for valuation.

CLINTON S. BURNS, M. AM. SOC. C. E. (by letter).—The author is to be congratulated on the detailed care shown in the presentation of this subject. Perhaps few engineers who have not been called on to cope with the subject of valuation of properties, realize or appreciate the real complexity of the many varied problems encountered in work of this class. To those who are engaged directly in appraisement work, this paper will be a welcome contribution to the literature on the subject.

The author's statement that if a commission of engineers is directed to report the true cost of reproduction, depreciation, or present value of a certain property, the final figures should not differ, whether the report is to be used as a basis for reorganization, sale, rate purposes, or taxation, is open to argument. It seems proper that, if a property is appraised in order to fix a selling price to a Government or municipality exercising its right to purchase, the final figures should be based on current prices of labor and material, because this does no injustice to either party. It is evident that if the seller secures payment for his property based on current prices, he may, if he desires, reinvest the proceeds of the sale in similar enterprises at current prices, so that thereby he secures the same benefits, whether prices are high or low.

It is equally evident that if the purchaser (the municipality) chooses to purchase the property, the right to purchase must be exercised at the particular time permitted by the franchise. If prices chance to be abnormally high at that time, the municipality is exactly on a par with what it would be if compelled to build its own plant at that particular time; while, if prices be abnormally low, the same relative situation still exists. There seems, therefore, to be no possible injustice to either party in using current prices, when the object is a sale or transfer of the property. However, in determining a proper value as a basis of rates, another factor must be considered. It is inexpedient and against public policy to make frequent changes in the rate charged for such commodities as water, gas, or electric current. Theoretically, the rate could be fixed each year, based on an annual valuation of the property, thus permitting a high rate one year and perhaps an abnormally low rate another year; but, practically, this is impossible, for, aside from the inconvenience of such a cumbersome system, no community is well enough informed as individuals to comprehend any reason whatever for ever raising rates. Raising rates is invariably accompanied by a wave of indignation. However, it is apparent that a series of rates based on an annual current price valuation of the property would average exactly the same, during a term of years, as though the property were valued once for all on the basis of the average prices of labor and material for the same term of years, and the rate based on the one valuation thus determined.

If the object of the valuation is to afford data for taxation, the same argument applies as in a case of fixing rates. It thus seems proper that the object of the appraisement should be taken into consideration before it is determined whether to use average prices, or current prices, of material and labor; and, if this is correct logic, the final figures must differ according to the object in view; but, having determined the proper unit prices to be used throughout any appraisement as being the most equitable for the object in view, then, as the author well says, the appraiser must not allow personal prejudices or fancied conditions to influence his course. Above all, an appraiser must not be afraid of his client. He must not allow his personal judgment to be swerved by the latter's desires. It perhaps seldom if ever occurs that an appraiser, representing a municipality, or State, is subjected to this unconscious influence, inasmuch as his employer is merely a temporary public official, and consequently he has no client to fear. He goes into the work with a full knowledge that his employer knows little or nothing of the subject, and his only desire is to reach results which will be unquestionably fair to both parties.

On the other hand, the appraiser who is chosen by the owner of a plant takes hold of the work with a feeling that he is expected to report a value as favorable as possible to his client, and this feeling is reflected in the report, regardless of how sincerely or conscientiously he tries to avoid it.

One of the most intricate and yet interesting problems in appraisement work is the computation of the "going value," or "business value" which should be allowed in addition to the physical value.

In considering a competitive enterprise, such as a railway serving a community in competition with another independent railway, this problem must be treated in a different way than in a non-competitive business, such as a water-works, gas-works, electric plant, street railway, or similar enterprise operating under the protection of an exclusive franchise, or under natural conditions equivalent to an exclusive privilege.

In considering competitive enterprises, it is manifest that a railway operating under conditions more advantageous than its competitor possesses an intangible value equal to the measure of that advantage. It is not clear, however, whether it is more proper to say that the railway possessing the advantage has a positive going value, or whether the less fortunate one has a negative going value. Using the rule formulated by the author, being that of Professor Adams, with some modifications, it is evident that many properties would show negative going values; but, as pointed out by the author, the Courts hold that public service corporations are entitled to earn:

(_a_) Operating expenses;

(_b_) Expenses of maintenance and running repair;

(_c_) Taxes;

(_d_) A sinking fund to cover depreciation and obsolescence;

(_e_) A reasonable profit on the fair value of the property.

It is improbable that a reasonable profit on the fair value of the property could be construed to mean less than the interest or revenue from a like amount of Government bonds or other non-taxable securities.

This ruling of the Courts fixes the rates at such a figure as to preclude the possibility of a deficit; from which it must follow that a negative going value cannot be created by a compulsory reduction in rates, for such action would be confiscation of property to the extent of the negative intangible value thus created; that is to say, if the Courts are right in the above ruling, then all intangible or going values are positive, and must be determined by using the most unfavorably situated railway as the basis of computation in determining the question of reasonableness of rates; and the rates in turn must be reasonable and proper before they can be applied to determine the intangible value. This raises an interesting and far-reaching query. Assume that a negative going value is the result of real competition between two roads such that the "fair value" of the less fortunate competitor is 20% less than its physical value.

If rates are based on this valuation, are they really fair rates? For, suppose the rates had always been maintained at a point where the less fortunate road could just support its physical valuation. Clearly, no rate could then be enforced which would compel it to operate for less than a reasonable profit on the fair value of its property, and the fair value under this assumption is 25% greater than before, due to no effort of its own, but simply to the fact that its competitor has not cut rates, and has thereby preserved the original "fair value" of the less fortunate road, and at the same time increased its own positive going value by an equal amount.

In view of this analysis it is doubtful if it is ever proper to consider the existence of negative intangible values, although it is true that the commercial value does fluctuate, and may be less than the physical value, due to rates which are too low, perhaps, or due to other temporary causes.

The method quoted from Mr. Alvord for determining going value applies to non-competitive enterprises only, as was stated by Mr. Alvord in his paper before the American Water-Works Association. This method is open to the criticism that the forecast of the business of the older works, and of the new hypothetical works as well, is reduced to a monetary value, based on the present rates, regardless of whether or not such rates are reasonable. Rates are subject to legislative control in many States, and there is absolutely no assurance that any other State may not adopt legislation at any time permitting regulatory ordinances to be enforced. Therefore, any forecast of the value of future business must be based on reasonable rates, for otherwise it is merely an unwarranted estimate based on a fond hope.

Taking into consideration the fact that rates must be reasonable, either by virtue of present laws or laws which may become effective at any time, perhaps in the immediate future, going value may well be defined as the present worth of the amount by which the anticipated profits of a going plant, operating at reasonable rates, exceed the present worth of the anticipated profits of a similar hypothetical starting plant, operating at those same rates. With this conception of going value, it is impossible for a non-competitive property to have a negative going value, and every operating plant has a positive going value, even though operating at a loss.

The whole problem hinges on the question of "what is the reasonable rate or proper return," and this should be determined in the aggregate as the starting point. The Courts have persistently dodged the issue, and properly so, whenever that question has arisen, leaving it for consideration in each particular case, depending on the stability of the business, the hazard involved, and various other local factors.

It may safely be conceded that this fair profit is something in excess of the return from Government bonds, and for the purpose of this discussion it matters not what figure is assumed as the fair profit—whether 5, 6, or 10%, or what-not—the theory is the same in any case. This is perhaps best explained by a practical illustration:

Take, for example, a water-works system, the physical present value of which has been determined by the method of reproduction to be $1,000,000, and denote the going value by the unknown quantity, _x_; suppose, further, that 6% is considered a reasonable return on the "fair value"—not yet determined, the "fair value" being $1,000,000 plus the going value, _x_. Therefore, the rates must be such as to produce in the aggregate an amount equal to the operating expenses, maintenance, taxes, sinking fund, and depreciation, and still have a profit of 6% on the fair value of the property. The anticipated profits of the going plant, therefore, are exactly 6% of ($1,000,000 + _x_) = $60,000 + 6_x_/100 per annum. The anticipated profits of the hypothetical starting plant will be negative at the start, and gradually increase, finally reaching a maximum of $60,000 + 6_x_/100 per annum.

It must be remembered that, in estimating the operating expense and income of the starting plant, as well as the going plant, the figures must be confined rigidly to the plant as it is found at the date of valuation, and in no case should any account be taken of income or operating expenses due to probable future extensions of the distribution system. Many appraisers overlook this point, and predicate the anticipated profits of the going plant on the past growth of the income account, forgetting that a considerable portion of this growth is due to extensions into new territory, and not to any material increase in revenue from the territory already served. To include income from new territory in the forecast of income is just as fatal an error as to include the anticipated expenditure of new capital in the present physical valuation. Either of these procedures is really an estimate or appraisement of some other plant, rather than the one actually under consideration.

To complete the numerical illustration, suppose it is determined that the time required to construct the hypothetical starting plant is 3 years; that a portion of the plant is put into operation at the end of the second year, taking over fire-hydrant rental equivalent to $20,000; that the revenue from private sources aggregates $20,000 during the last year of construction; that the expenses of operation, maintenance, taxes, and depreciation amount to $30,000 during this year. After the time of completion of the plant has elapsed, it has the total credit for fire-hydrant rental, and it is assumed that the revenue from private sources and the cost of operation, maintenance, taxes, and depreciation increase as shown in Table 14, which illustrates the method of computing the going value, and gives the resulting value for the case just stated.

Therefore, 171,005 + 0.2597_x_ = _x_; hence, _x_ = $231,000. This result is based on the assumption that the starting plant earned no interest during the construction period. If an allowance for lost interest during construction has been made and added to the capital account already being included in the physical appraisement of $1,000,000, then this must be charged back against the going value found above. This is clearly evident, because the calculations to determine going value date from the beginning of the construction period, and the lost interest during construction, therefore, is provided for in the result. Most appraisers allow an item for lost interest amounting to the legal rate of interest running for half the construction period, which, in the illustration under discussion, would be $90,000; deducting this sum, if previously included, gives $141,000 as the going value.

There seems to be no good reason for allowing lost interest during construction as an item in the physical valuation of a property, any more than for allowing all of the lost interest, up to the time when the property begins to yield a return equal to the rate of interest. It is one of the problems in finance, and is much better treated as an element in the going value, as shown in the above illustration.

One of the most difficult factors on which to agree in computations of this nature is the element of time required for the hypothetical starting plant to acquire the business. Were it not for this uncertainty, going value could be computed with mathematical precision by the method suggested.

In determining the physical valuation on the basis of cost of reproduction, such items as cost of taking up and replacing street paving over the pipe lines, cost incurred by reason of sewers and drains encountered, interference due to electric wires and conduits, interference of traffic, and other metropolitan conditions which add greatly to the cost of construction, must be allowed. Wherever such metropolitan conditions exist, there must also be present a corresponding necessity for the use of water under pressure. People use water because of necessity or convenience, and not on account of any feeling of obligation or loyalty to the water company.

TABLE 14.—COMPUTATION OF GOING CONCERN VALUE, BASED ON REASONABLE RATES.

╒════════════════╤═════════════════╤════════════════╤═════════════════╕ │ Year, dating │ Legitimate │Hydrant, rental │Domestic revenue │ │ from beginning │ profits of the │ taken over by │ of starting │ │of construction.│ going plant. │starting plant. │ plant. │ ├────────────┬───┼─────────────────┼────────────────┼─────────────────┤ │Construction│1st│$60,000 + 0.06_x_│ 0│ │ │ period. │ │ │ │ │ │ │ 2d│ 60,000 + 0.06_x_│ 0│ │ │ │ 3d│ 60,000 + 0.06_x_│ $20,000│ $20,000│ ├────────────┼───┼─────────────────┼────────────────┼─────────────────┤ │ Business │4th│ 60,000 + 0.06_x_│ 40,000│ 55,000│ │development │5th│ 60,000 + 0.06_x_│ 40,000│ 80,000│ │ period. │6th│ 60,000 + 0.06_x_│ 40,000│ 90,000 + 0.06_x_│ └────────────┴───┴─────────────────┴────────────────┴─────────────────┘

╒════════════════╤═══════════════════════════════════════╤════════════╕ │ Year, dating │ Interest on the starting plant. │ Operation, │ │ from beginning │ │maintenance,│ │of construction.│ │ taxes, and │ │ │ │depreciation│ │ │ │on starting │ │ │ │ plant. │ ├────────────┬───┼───────────────────────────────────────┼────────────┤ │Construction│1st│If the physical validation contains an │ 0│ │ period. │ │ item for lost interest during │ │ │ │ │ construction, the same amount must be│ │ │ │ │ credited to the starting plant as │ │ │ │ │ interest earned. │ │ │ │ 2d│ │ 0│ │ │ 3d│ │ $30,000│ ├────────────┼───┼───────────────────────────────────────┼────────────┤ │ Business │4th│ │ 50,000│ │development │5th│ │ 65,000│ │ period. │6th│ │ 70,000│ └────────────┴───┴───────────────────────────────────────┴────────────┘

╒════════════════╤═══════════════════╤══════════╤═════════════════════╕ │ Year, dating │Total difference in│ Present │Present worth of the │ │ from beginning │anticipated profits│ worth │excess of anticipated│ │of construction.│of the two plants. │ factor. │profits of the going │ │ │ │ │ plant. │ ├────────────┬───┼───────────────────┼──────────┼─────────────────────┤ │Construction│1st│ $60,000 + 0.06_x_│ 95.2│ $57,120 + 0.0571_x_│ │ period. │ │ │ │ │ │ │ 2d│ 60,000 + 0.06_x_│ 90.7│ 54,420 + 0.0544_x_│ │ │ 3d│ 50,000 + 0.06_x_│ 86.4│ 43,200 + 0.0518_x_│ ├────────────┼───┼───────────────────┼──────────┼─────────────────────┤ │ Business │4th│ 15,000 + 0.06_x_│ 82.3│ 12,345 + 0.0494_x_│ │development │5th│ 5,000 + 0.06_x_│ 78.4│ 3,920 + 0.0470_x_│ │ period. │6th│ 0│ 74.7│ │ └────────────┴───┴───────────────────┴──────────┴─────────────────────┘

Total going value = 17,005 + 0.2597_x_ _x_ = $231,000

If highly developed metropolitan conditions are present, new business will be acquired in the hypothetical starting plant much more rapidly than where such conditions are yet to be developed. For this reason the problem cannot be based on the early growth of the same plant, and, there being no exact duplicate of conditions in existence elsewhere, the estimate of time required for the business development period is purely speculative, and must be assumed with great care and judgment, else injustice may be done to one party or the other in the resulting going value.

It is interesting to note that, in the Michigan appraisal, the allowance of a percentage for contingencies was bitterly contested by the railroads as improper. Probably every appraiser who has been connected with rate cases has seen this same item strenuously insisted on by the corporations.

The author's query: should a corporation which is compelled to abandon appliances while yet serviceable, in response to public clamor, be allowed any item of value in the appraisal on account of such appliances, seems to be best answered in the negative. If the appraisal is for the basis of making rates, the corporation is fully compensated by the fact that its depreciation account provides for all abandoned machinery, and the average past depreciation is usually considered a fair criterion of the future. If the appraisal is for purposes of taxation, it would seem improper to levy tax on abandoned or rejected machinery or equipment. If the appraisal is to determine the present value of a property for sale under condemnation proceedings, it is likewise difficult to conceive any reason for allowing any present value on account of property abandoned or rejected, and, indeed, if such abandoned material had any value at the time of its removal, it is more than likely that such value was converted into cash at that time.