OAKSi.HDSr* L I B R.ARY OF THL U NIVLR_5ITY or ILLl NOI5 338.7 F663v T VALUATION OF PUBLIC UTILITY PROPERTIES ,imv3aisvvwvvvvvv%>wv%v^ti\in'wvvxiv\rvw%vwvv*w% ro'w-. PublisKed hy the New Yor-k. Compeirty »Succe£«or« to tKeBookDepartments of tKe McGraw Publishing Company Hill Publishing Company Publishers of DooLs for Electrical World TKe Engineering' and Mining Journal Engineering Record American MacKiniM Electric Railway Journal Coal Age Metallurgical and Chemical Engineering Power VALUATION OF PUBLIC UTILITY PKOPEETIES BY HENRY FLOY, A. B., M. A., M. E. CONSULTING engineer; MEMBER AMERICAN INSTITUTE OF ELECTRICAL ENGINEERS, AMERICAN SOCIETT OF CIVIL ENGINEERS, ILLUMI- NATING ENGINEERING SOCIETT, NEW YORK ELEC- TRICAL SOCIETY, ETC. McGRAW-HILL BOOK COMPANY 239 WEST 39TH STREET, NEW YORK 6 BOUVERIE STREET, LONDOX, E. C. 1912 J ^ ^ ' ^ T663 M Copyright, 1912 BY THE McGraw-Hill Book Company PRINTED AND ELECTROTYPED BY THE MAPLE PRESS YORK, PA. PREFACE At the present time there exists no general practice or well formulated theory of the valuation of utility property. This is indicated by the generally confused state of the public mind, the divergent views of those engaged in the work, and the contradic- tory positions taken by the public authorities and courts as to the proper basis of valuing such property. Much important information relating to valuation work exists in various public papers, but heretofore there has been no com- prehensive attempt to digest and compile this material. The author has been engaged for several years past in valuing property aggregating hundreds of millions of dollars. He has devoted much time to the study of the opinions, papers, discus- sions, reports of commissions, and court decisions relating to the subject. He has endeavored in this book to digest this material, in so far as possible and to present a summary of the best practice, with typical examples thereof. The aim has been to indicate, if possible, the line along which theory and practice seem likely to be standardized. No attempt is made to hold a brief either for the necessity of valuing property on the one hand, or the injustice of doing so, on the other. The work relates rather to approved methods of ascertaining values not only of tangible property, but of m- tangible property as well. It treats of appraisals which have become more or less historic, and have helped to establish the precedents of current practice. Since it frequently happens that the valuations of utility property are submitted to the scrutiny of the courts, references are frequently made in this book to the judicial rulings -which, though at times contradictory and somewhat confusing, never- theless indicate the general lines along which valuations must be made in order to render then unassailable. The author has made use in the preparation of this work, of papers which he has previously presented before engineering s"bcieties. These, however, have been revised and elaborated. 211574 vi PREFACE Many other sources of information have been drawn upon, for which the author has endeavored to give credit, with due appreciation of the assistance and co-operation rendered by the various members of the accounting and engineering professions interested in this subject. Henry Floy. New York City, April 2, 1912 CONTENTS Page PREFACE V CHAPTER I.— Introduction 1 General — Purpose — Sale or Transfer — Fixing rates — Capitalization — Taxation — Accounting — Basis. CHAPTER II.— Glossary 13 Application of terms — Nature — Physical value — Scrap value — Wearing value — Service value — Present value — Original cost — Cost to replace new, replacement cost or cost of reproduction — Development expenses— Fair rate, fair value, fair return — Good will — Franchises — Depreciation — Classes of depreciation — Going value — Public utility — Averages. CHAPTER III.— Public Service Commissions 32 Utility commissions — Reasons for the creation of commissions — Results accomplished by commissions. CHAPTER IV.— Making an Appraisal 49 General — Cost of Appraisals — Inventory — Field inspection — Sug- gested procedure. CHAPTER v.— Structur al Costs 62 Unit prices — Contractor's profit — Fluctuating prices — Engineering, contingencies, omissions, etc. — Real estate — The sales method — Calibration of sales method — Final re\'ised values — Block 131 — Part of Block 126 — Paving — Water power. CHAPTER VI. — Development Expenses, Intangible Expenses, Non-physical Costs, Overhead Expenses 91 General — Interest — Taxes — Insurance — Legal and organization expenses — Cost of financing — Working capital — Non-existant property. CHAPTER VII.— Franchises, Good AVill, Going Value, Contracts 129 Franchises — Good will — Going value — Application of principles outlined — Assumptions as to existing plant — Date of valuation — Construction period required — Going value development period — Beginning of operation — Character of plant and order of construc- tion — Beginning of operation of different portions of comparative plant — New construction in going value development period ignored — Operations of comparative plant — Income on unemploy- ed capital — Resulting going value under first trial computation — Recomputation unnecessary for the purpose of this paper — Effect of assumptions as to order of construction on loss of interest during construction item — Contracts. vii viii CONTENTS Page CHAPTER VIII.— Depreciation 168 General — "Absolute" and "theoretical" depreciation — Depre- ciation accounts or reserve funds — Application of depreciation — Appreciation — Fifty per cent, method — Depreciation of non- physical values — Summary. CHAPTER IX. — Appraisals of Public Utility Properties in Greater New York 218 Third Avenue Railroad Company — Metropolitan Street Railway Company — Coney Island and Brooklyn Railroad Company — Kings County Lighting Company. CHAPTER X. — Examples of Important Appraisals 333 Street railway properties in Chicago — Union Electric Light and Power Company, St. Louis, Mo. — Macon Gas, Light and Water Company, Georgia — Northern Pacific Railway, State of Washing- ton — Beloit Water, Gas and Electric Co. INDEX ■ 387 VALUATION OF PUBLIC UTILITY PROPERTIES CHAPTER I INTRODUCTION General. — ^Fifteen or more years ago, the appraisal or valuation of corporation property, was unusual. Inventories of supplies and apparatus for stock-taking or insurance purposes, were common, but valuations of property, in the sense that term is used at the present day, as the basis of sale, capitalization, taxa- tion or the determination of proper rates to be charged for the service rendered, were unusual. The taking over by municipal- ities of privately owned water works may be said to have originated the present era of appraisals and valuations in America. Consequently the water-works engineers were the first of the profession to be drawn into this department of engineering and they have done much excellent pioneer work therein. More recently there has developed a frequent and importunate demand for the determination of the value of corporation property, in all lines, particularly that of so-called public utilities which has called for the services of other experts. A very usual and normal method of ascertaining the value of privately owned property, is, and has been, to consider its net earnings in the present and its prospects for their increase in the future. It was customary to apply this same method in estimat- ing the value of public utility properties, overlooking the fact that their operation and control was specifically limited by fran- chises and special laws under which they were originated, and that as quasi public organizations they were under obliga- tions which did not apply to small competitive, private concerns. Individual initiative and the net profits accruing therefrom, in the case of industrial organizations, are largely modified and 1 2 VALUATION OF PUBLIC UTILITIES restricted through competition, but no such limitation exists with respect to a corporation controlling a monopoly. The history of corporate control and operation of public utilities discloses the fact that, in very many cases, monopolistic control was used unfairly for the purpose of unduly increasing earnings, at the expense of the public, to permit flotation of securities for the enrichment of the individuals controlling the corporation. The necessity, in certain cases, for ascertaining the amount of over capitalization of corporations serving the public regardless of whether the over capitalization results from ignorance, mis- management or necessity, has developed the recent movement for ascertaining the real value of the property, ''both used or useful" in serving the public. This necessity of ascertaining in individual cases the value of corporation property has, as so often occurs, extended until there is a very definite, though unnecessary, demand for the appraisal of all physical property used by public utility corporations, as if that were the whole measure of value. This extreme view is unwarrantable and would result in a useless amount of effort and expense with no necessary accompanying gain. At the same time there are occasions where appraisals of corporation property, both physical and intangible, are necessarj^ and essential to permit a judgment as to the value of its securities or the fairness of its earnings. That this conclusion is correct is indicated by the very reasonable and common sense opinion of the Railroad Securities Commis- sion, expressed in their recent report to the President. The quotation gives a very just and adequate expression of the place and importance a physical appraisal should hold. "In so far as the value of the property is an element in rate regulation the outstanding securities are of so little evidentiary weight that it would probably be of distinct advantage if courts and commissions would disregard them entirely, except as a part of the financial history of the property, and would insist upon direct evidence of the actual money invested and of the present values of the properties. For this and other reasons discussed in the body of the report, your Commission recommends that the Interstate Commerce Commission should have authority and adequate funds to make a valuation of the physical property of railroads wherever the question of the present value of these roads is, in the judgment of that Commission, of sufficient importance. It is hardly necessary to add that your Commission does not believe' that the cost of reproduction of the physical properties, however care- fully computed, is the sole element to be considered in determining the INTRODUCTION 3 present value of a railroad, or that the outstanding securities could or should be made to conform to any such arbitrary standard. "If railroad securities were to be issued only after express authoriza- tion of each particular issue by the Interstate Commerce Commission or other governmental agency, it is difficult to see how the Government can thereafter escape the moral, if not the legal, obligation to recognize these securities in the regulation of railroad rates. In view of the vast extent of the railroad systems of this country and the magnitude of the financial interest involved, iDOth on the part of the railroads and of those who pay the rates, your Commission believes that the possible consequences of such a system of regulation are too serious to warrant its adoption at the present time."* One of the causes of inquiry as to property values has resulted from a growing conviction that through unfair promotion, loose methods of financing, lack of proper maintenance of property or the rapid improvement and development of machinery, which has necessitated the abandonment of the old faster than its cost could be written off as a part of operating expense, capitalization did not represent or even approximately indicate the real value of the property fairly entitled to be considered in case of sale or the basis on which to figure earnings. Over capitalization may arise from a variety of causes. It may have come about in an entirely innocent way, as in some instances it is the result merely of ignorance; freciuently it has been well-intentioned and even proper and necessary in order to rehabilitate worn-out or super- seded property, funds for which could not be provided out of operating income; but in many cases, at least in connection with public utilities, it is the outcome of intentional, fictitious and un- warranted increase in securities through the putting out of stocks and bonds for the purpose of immediate', but what has now come to be considered, unfair profit. There is much, evidently sincere but nevertheless mistaken opposition to the application of any method or theory of appraisal for determining physical, intangible or complete going values of public utility properties. Yet it must be clear that the amount of outstanding securities, their market value, the earnings of a corporation or the book costs of its property without considera- tion of what depreciation — if any — has taken place in physical property, do not, of necessity, indicate even approximately whether the capitalization of a public utility is proper or im- ' Report of the Railroad Securities Commission, 1911. Pages 38-39. 4 VALUATION OF PUBLIC UTILITIES proper. ''Cost is not synonymous with value," capitalization may be artificially large or small compared with the fair value, income may be excessive or insufficient to take care of proper charges, depending on rates, and the proper basis for determining these questions in relation to public utility property at least, is an appraisal of both tangible and intangible values. Physical valuation alone will not give the total fair value but it will usually give a relatively large proportion of the whole. As illustrating the value that may attach to the non-physical part of a property, the testimony of Mr. Andrew Carnegie, recently, before a Congressional Committee, is interesting. Mr. Carnegie stated that he accepted $420,000,000 for property having a book value of $84,000,000, which created an impression in the minds of many, believing physical plant or book value expressed the worth of the entire concern, that Mr. Carnegie had accepted a ''nuisance" value for his undertaking. But such was not the case, as Mr. Carnegie had several times stated that he valued his partners more than his plant, and that given his organization he would reproduce his plant in short order. That the organization was worth the amount paid for it, has been proven by subsequent earnings. One cause for the prevalent objection to any appraisal what- ever of utility properties arises on the part of those who, with a knowledge of the value of certain property, feel that unjust and unfair Court or Commission decisions have been made which were based on incomplete but so-called appraisals. But this is equiv- alent to blaming a court for rendering a decision based on the evidence introduced. If the corporations have failed to furnish evidence that substantiates anything except physical values or have put forward claims for non-physical values without ade- quate proof thereof, why should Courts or Commissions be criti--^ cised? It has been too often the practice to employ engineers to ascertain and testify as to physical values, leaving it to corpora- tion officers, dealing in "glittering generalities," or accountants with records of original costs or attorneys in their briefs to attempt to approve non-phj^sical values, these most intricate of all values. The result has been failure to secure recognition of and allowance for intangible values with consequent wrong done the owners through the errors or ignorance which can be charged only to officials or counsel. On the other hand, there exists a tendency on the part of the public and its representatives, to INTRODUCTION 5 forget, whatever may be accepted to-day as the correct theory of earnings to be properly allowed public utilities, that, with rare exception, it was the practice to grant franchises without ex- pressed limitation as to the amount or basis of fair return, but rather to encourage investors with the expectation of larger profits than might be expected from ordinary commercial business. Consequently, to undertake to now cut down the earnings from public utility properties, to a basis comparable to that demanded by uninvested capital, as the return on the most secure investments, is as absurd and unfair to the original investors as to limit the value of utility property merely to physical plant values, omitting recognition of the intangible elements. A sane and dispassionate view of what should be considered in ascertaining the fair value of utility property, was expressed by the Special Master in the Columbus case and is as follows: "Fictitious values will be disregarded, improvident and unwise ex- penditures will not be taken into account, but only the fair value of the property will be used as a basis, including, however, in such fair value not only the tangible propert}' devoted to the public service, but such intangible value as may be legitimate and may be justly, under all circumstances, credited to the producer on the one hand, and debited to the consumer on the other, so as to bring about the just compensation rightly belonging to the company, and legitimately to be paid for by the consumer. "Necessarily the ascertainment of such value is in all cases a difficult matter, and its final adjustment by the court can rarelj^, if at all, be made with mathematical exactness. All the court can do is, from the evidence, to arrive at such a value as will, all things considered, be fairly equally just to both parties."^ The difficulty of ascertaining the value sought, is increased by reason of: (a) The necessity of dealing with tangible or physical values, as well as intangible and wholly estimated values. (b) The lack of an accepted theory, which results in confusion and non-uniformity, under new and sudden demands to meet unforeseen and unexpectedly developed conditions. (c) The subject involves not alone the broadest engineering ' The Columbus Railway and Light Company vs. the City of Columl^us. Circuit Court of the United States Southern District c<" Ohio, Eastern Division. 6 VALUATION OF PUBLIC UTILITIES knowledge, but also some of the deepest economic questions, in both of which sciences but few men have wide experience. (d) Engineers, who are the usual appraisers, due to the rapid, marvelous and revolutionary developments within recent years, have available in many instances, too few correlated facts and figures on which to base their conclusions. (e) The results obtained under different conditions of opera- tion are so varied, the experience of different engineers on which conclusions must be largely based, are so diversified, and finally, the training, personality and prejudices of many experts so largely qualifies their opinions, that unanimous conclusions have been impossible. Purpose. — The usual object sought in undertaking an ap- praisal of a public utility property is to determine its value for purposes of: (a) Sale or Transfer. — Where a utility property is to be sold to a municipality, corporation or individual, an appraisal prob- ably covering the entire value of the property, certainly that of the physical plant, more or less exact, will be required by the purchaser before closing the sale. Such procedure would be in line with ordinary commercial business sense and indicates how essential a knowledge of the worth even of the physical property alone, is considered, despite the cry of those who argue that valuations of physical property indicate nothing as to real or commercial values. Important valuations for purpose of sale passed on by the Supreme Court are, for example, the Kansas City Water Works case and the Omaha Water Works case. (b) Fixing Rates. — Rate regulation of utilities has become to be accepted as an unquestioned principal of present day civiliza- tion. Any public utility is therefore likely to have its rates questioned, passed upon and fixed by authorized public bodies. Preliminary to and necessary for an intelligent determination of a proper and fair rate information must be had, as to income and the fair value of the property rendering the service for which the rate in question is being fixed. These principals have been so frequently enunciated and established by rulings of various courts, including the Supreme Court, that no argument as to their validity is worthy of serious consideration. The extensive valuations of railroad property in the States of Minnesota and Washington, as well as much of the valuation work of the present Wisconsin Commission has been undertaken to determine proper INTRODUCTION 7 rates, and it is primarily for this purpose that valuation of all the railway properties in the countr}', by the Interstate Commerce Commission, is being urged. (c) Capitalization. — In the past, both private corporations and public service companies have been permitted to issue and use, practically, any unlimited amount of securities which those interested in the organization, for any reason, thought desirable. The result has been an unfair inflation and undue "watering" of securities with consequent loss to investors and discredit to the properties so handled. With the recognition of the right on the part of the public to limit net earnings to a fair return on the value of the property used, there has resulted a strong feeling that capitalization should indicate the value of any given property so that the fair return on the property might bear proper relation to the return on capitalization. In consequence, Public Service Commissions and other bodies authorized to pass on and approve the amount of stock and bonds to be used by Public Service Corporations under their control, have quite generally insisted upon an appraisal of the property in order to intelligently determine the proper amount of capitalization. Where securities are sought to be issued, in addition to amounts already outstanding, to cover property already in existence, appraisals are usually demanded. Where such additional securi- ties are being used to provide funds for new property, the dis- counts at which the securities are to be sold and the disposition of the proceeds therefrom are comparatively easily regulated and are quite generally prescribed by public authorities having con- trol of such matters. W^hile it is the general opinion and usual requirement of public authorities that the issuance of additional securities is only warranted when additions to property, not the replacement or renewal of existing property, are to be made, nevertheless where income is not sufficient to provide for renewals and replacements, the cost of same through the sale of additional securities, has, under occasional and mitigating circumstances, been authorized and approved by Public Service Commissions and supported by opinions of the- courts.^ Allied conditions may warrant the recognition of capitalization covering property no longer in existence, even at the time of issuance, provided the ' Application of the Binghamton Light, Heat and Power Co. Case No. 74. PubHc Service Commission of New^York, Second District, Vol. I, 1910, p. 831. 8 VALUATION OF PUBLIC UTILITIES property, installed in good faith, has been abandoned through changes in the art, inadequacy to comply with local requirements or similar conditions, so rapidly and in such large amounts as to preclude the writing off of such investment without jeopardizing the finances of the corporation or doing injustice to the investors.^ The appraisal of the railroads in the State of Texas, as well as many of those made by the Public Service Commissions of the several States, have been made for purposes of regulation of capitalization. (d) Taxation. — The value of property for purposes of taxation may be appraised on the basis of: (a) Real estate. (h) Going concern. (c) Franchise value. If the appraisal is made simply to determine the value of the real estate and personal property for purposes of taxation, the same as other city property, after proper ascertainment of full value, the local rate of equalization — that is the ratio of average value on which taxes are based compared to the value which property would bring under favorable conditions of sale — should be applied to the full value so that corporation property will be taxed on the same relative basis as other property. Appraisal for going concern value of a corporation may be made to ascertain the proper basis for taxation based on the value as an operating entity. Sometimes this form of tax is based on gross or net income. Sometimes on the output of a generating station or the car-miles run. Appraisal for the purposes of determining the proper amount of franchise tax might apply simply to the value of the property in the public streets, as is the case, for example, in New York State in determining the special franchise tax. There may be other considerations depending on local con- ditions which would require still other division of corporation property but the instances cited indicate the necessity of having carefully in mind the purpose for which the appraisal is to be made and classifying and valuing the property accordingly. The Wisconsin and Michigan State appraisals of the steam roads were for purposes of taxation. (e) Accounting. — ^W^here uniform systems of accounting are »The Milwaukee Railway and Electric Light Co. vs. City Milwaukee. 87 Fed. 577 INTRODUCTION 9 introduced as is frequently the case where Public Service Com- missions are first created, it may be desirable or necessary to appraise property for the purpose of furnishing a basis for opening accounts or revising methods of bookkeeping. Basis. — ^It has been quite generally stated by the courts that no single basis of valuation is to be used alone for determining the fair value of public utility property. The general rule is well set forth by the Supreme Court of the United States where it says: "The basis of all calculations as to the reasonableness of rates to be_ charged by a corporation maintaining a public highway under legislative sanction must be the fair value of the property being used by it for the convenience of the public."^ In order to determine that value, the Court says: "The original cost of construction, the amount expended in perma- nent improvements, the amount and market value of its bonds and stock, the present as compared with the original cost of construction, the probable earning capacity of the property under the particular rates prescribed by statute and the sum required to meet operating expenses, are all matters for consideration and are to be given such weight as may be just and right in each case."^ It is probably impossible to absolutely and exactly fix in dollars and cents, the value of the various elements going to make up a utility property. This is clearly illustrated in deci- sions of commissions, as for example the Wisconsin Commission says in one well-known case: "From what has thus been said it appears to us that for the purposes of this case it is eiiuitable to all concerned to allow the respondent rea- sonable returns in the way of interest and profits on a valuation of about S412,000 for the gas plant and of about $535,000 for the electric plant. The rates of returns that should thus be allowed will be explained later. "^ Again the Public Service Commission of New York, First District, disapproving the plan of re-organization of the Third Avenue R. R. Co. says: "The amount for development charges will be about $3,500,000."^ ' Smyth vs. Ames, 169 U. S. 466. 2 Smyth vs. Ames, 169 U. S. 466. ' State Journal Printing Co. vs. Madison Gas & Elec. Co. Decision dated March 8, 1910. * Case No. 1181. Decision dated July 29, 1910. 10 VALUATION OF PUBLIC UTILITIES The basis on which a valuation is to be made and the way it is to be used, must be carefully considered and kept in mind when making an appraisal. It is possible that a given valuation, when completed, may be used equally well for several purposes, but not necessarily so. From every standpoint, the cost of reproduction, or the original cost or the scrap value of a given piece of physical property at a given time or place, may be accurately determined. That is mainly an engineering question but the "fair value" of utility property will vary for the particular time and case under consideration. The determination of the fair value of a given property to be used as a basis for fixing proper returns or rates to be charged, depends upon the value of the property being lised in the service from which the returns or rates are earned and is ofttimes quite different from the fair value of the total property of any utility, part of which may be held for future extensions or profit or use for extraneous purposes, but all of which would have to be considered and allowed in case of capitalization or purchase or sale, as a whole. Ex-Commissioner of the Public Service Commission of New York, First District, Mr. Ed. M. Bassett, says: "If it is decided that a public utility should be taxed on its total value as a going concern — that is, its commercial, market or sale value — then franchise and going value will be included. If, on the other hand, the public-utility plant is to be taxed precisely as other real estate, the cost of reproduction less depreciation will be the basis. There is no inherent inconsistency in using one method of valuation for tax purposes and another method for rate purposes. The tax, by whatever method assessed, is considered an operating expense in fixing rates, and is therefore borne by the user of the service wherever rates of charge are strictly regulated. Methods of ad valorem taxation must be worked out with an eye single to what is just and practicable in taxation, and methods of valuation for rate purposes must be worked out with an eye single to what is just and constitutional in rate making."' "Different methods of estimating the value of property may properly be employed when it is valued for different purposes. When a valuation is placed on property which has become affected by a public use, for the purpose of ascertaining whether the maximum rate of compensation fixed by law for its use is reasonable or otherwise, it is obvious that the income derived therefrom by the owner before it was subjected to legis- lative control cannot always be accepted as a proper test of value because 1 National Association of Railway Commissioners, Washington, D. C, Oct. 10-13, 1911. INTRODUCTION 11 the compensation which the owner charged for its use ma)- have been excessive and unreasonable. Again, when property has been capitalized by issuing stock, neither the market value nor the par value of the stock can be accepted in all cases as a proper criterion of value, because the stock may not represent the money actually invested, and furthermore because the property may have been capitalized mainly with reference to its income producing capacity, on the assumption that it is ordinary private property which the owner may use as he thinks proper without being subject to legislative control. On the other hand, however, w^hen property is valued for the purpose last stated, it is clear that the owner thereof is entitled to the benefit of any appreciation in value above the original cost and the cost of improvements, which is due to what may be termed natural causes. If improvements made in the vicinity of the property, the growth of city or town where it is located, the building of railroads, the development of the surrounding country and other like causes, give property an increased value, the owner cannot be deprived of such income by legislative action which prevents him from realizing an income commensurate with the enhanced value of his property.'" To illustrate the preceding, all will agree that valuation for tax purposes must be conservative. The price an article would bring at forced sale or during times of financial stringency, per- haps 70 to 85 per cent, of reproduction cost, would be quite generally accepted in American cities, as a fair basis of value for purposes of taxation. If value as security for a loan were being sought, an appraisal would determine the price that could be obtained aside from consideration of the particular circumstances under which the plant was installed. The security value would possibly not exceed 40 to 50 per cent, of reproduction cost, because the most "fluid" securities, namely, stocks listed on the exchange, are not accepted as collateral, at a figure exceeding 75 to 80 per cent, of quoted prices. On the other hand, an investor furnishing the cash and taking stock and bonds in return, will usually and very properly insist that the value of the property is the par value of the securities conservatively issued, although sold at some discount. Thus it will be seen that there may be and easily is a fair and honest distinction between what may be determined as the fair value of property for capitalization, safe taxation or rate fixing purposes. And yet for each value quali- fied as to its exact meaning, there should be but one figure which is the result of a fair, competent and unbiased conclusion based ' Getting vs. Kansas City Stock Yards, 82 Fed., 839. 12 VALUATION OF PUBLIC UTILITIES upon all the facts in the case. Of course, absolute accuracy in appraisal work is out of question. All human beings are liable to make errors and the engineer is not an exception. As far as possible, the personality of the men employed in valuation work must give way to automatic, self-regulating, uniform methods that eliminate the personal element, and focus on attaining the single figure which alone is correct. As the value of a large proportion of all utility corporation property is the result of engineering skill and effort, engineers have naturally been called upon to estimate and determine the values in question. The ascertainment of the value of the in- tangible property, as well as plant value is essentially an engineer- ing problem, because engineers of proper experience and qualifica- tion are best informed, not only as to construction cost, but also as to the expenses involved in getting a property started, and building up an income producing business. This larger field of valuation work, however, has put new responsibilities upon the engineering profession, demanding something more, in the way of knowledge of values, and questions of law and economics, than mere construction has ever before required. So-called appraisals have been and are being made which, while perhaps adecjuate for the purpose intended, are little more than approximate estimates, completed within limited time, lacking in detail and thoroughness of preparation and yet are being used as an exact basis of property valuation. Such estimates should be clearly indentified as to their completeness and accuracy, both in justice to their makers and the owners of the property. Harm has been done by the misuse of such so-called valuations. An appraisal to be reliable and capable of standing the test of cross-examination and appeal to the courts must be prepared with elaborate detail, care and exactness. The importance of making a full and careful inventory with a thorough investigation as to local costs of labor and prices for material is not usually appreciated by those newly interested in appraisal work. Too great emphasis cannot be laid upon this preliminary work neces- sary in making any trustworthy valuation. CHAPTER II GLOSSARY Application of Terms. — The recent and rapid growth of valua- tion and appraisal work has caused the development of new terms or the modification of old ones. Confusion of ideas, difference of opinion, lack of experience, new and sudden de- mands have resulted in non-uniformity and even contradictory use of certain words by the engineering and accounting profes- sion so that some definition, of terms as used by the author, is necessary. One of the Committees of the National Electric Light Associa- tion some time ago undertook to correlate definitions of the terms used in connection with the subject of depreciation, which of course will include many, if not most, of the terms used in the broader subject of valuation. It has been suggested that some of the other National organizations, for example the American Institute of Electrical Engineers, undertake the classi- fication and proper definition of terms used by the engineering profession in appraisal work, but thus far nothing has been done by that organization. As the result of a suggestion in a paper on '' Depreciation as Related to Electrical Properties," read before the American Institute of Electrical Engineers in 1911 in which certain applica- tion of terms was proposed, there resulted, in the discussion following said paper and in the Technical Press thereafter, con- siderable expression of opinion as to the proper meaning of terms used in connection with appraisals and the subject of depreciation, but the chief result was the disclosure of a wide diversity of opinion and considerable variation in the use to be made of many expressions commonly employed in connection with this class of work. The author begs to offer the following explanation and defini- tion of terms as that expressing the more usual meaning applied, by engineers of standing, to their use of the terms indicated. Value. — Academically the word "value" relates to "barter and exchange" exclusively. Writers on Political Economy, 13 14 VALUATIO}^ OF PUBLIC UTILITIES such as John Stewart Mill, have economically defined "value" as a ratio between demand and supply at a given time or place for a commodity or service, or a ratio between the demand and supply at a given time and place of another commodity or service. But one of the principal causes of demand — there are several — is usefulness or utility, consequently ' ' value " may properly be used to measure utility. Even the utility of such an "unexchangeable and unbarterable" article as the human hand, when severed from the body, is measured in dollars by the jury making an award. In valuation work, as a rule, loss of utility results in loss of value, maximum utility determines maximum value. The ratio .of existing to possible utility, measures by the same ratio applied to cost, existing value, in dollars, of the commodity or service. Aside from any attempted definitions which may be purely academic or put forth as a species of mental gymnastics, engi- neers engaged in valuations and appraisals agree that utility has a value which may be expressed in dollars and this is the value; not a sales value, i.e., the price which an individual article would bring if offered for sale; which is to be determined in making an appraisal. If the term related exclusively to barter and sale, only second-hand or scrap values would be considered, which is not the basis on which any appraisal has been or is being made for determining fair values of the "used and useful" property belonging to an operating organization. Physical Value. — As the term indicates, physical value relates to material things or substances, the property which can be "seen and felt." It includes, primarily, "those things which are visible and tangible, capable of being inventoried," but secondarily, certain non-physical charges " which are an insepar- able part of the cost of construction but which do not appear in the inventory of the completed property." These secondary values which are usually included as a part of the physical property are expenditures for such items as: 1. Engineers' and architects' fees, including cost of design and testing all construction and equipment, etc. 2. Administration expenses chargeable to construction, in- cluding superintendence, inspection, accounting, salaries of officers and clerks, consents of authorities and property owners for temporary work or use, legal expenses, rent, printing, store- room expenses, etc. 3. Provision for various incidentals and contingencies, in- GLOSSARY 15 complete inventories, unforeseen requirements, etc., which practical experience has shown to be necessary. It may be questioned whether the expenditure for such in- tangible items as eAgineering and architects' fees, administration and local expenses and charges of such character should logic- ally be included as a part of the physical property or more prop- erly classified with what are hereafter known as " Development Expenses." But it is becoming the general practice to consider these expenditures which are usually a fairly uniform and defi- nite percentage of the cost of the machinery, buildings, and other equipment should very properly be included and made a part of the so-called physical values leaving the other intangible costs which vary widely with the different properties under con- sideration, depending on local conditions, magnitude, method of financing, etc., for a separate classification called development items or expenses. It must be clearly understood that these intangible expenses, whether classified as a part of the physical cost or separated under the head of Development Expenses, are all necessarily and indisputably a part of the total cost of the completed physical property. Scrap Value. — All physical property has a certain scrap or junk value, a "barter and sale" minimum basis beyond which there is no depreciation, hence physical property can only de- teriorate until it reaches its scrap value. This value is simply the fair market price that a purchaser will pay for the property in its disintegrated condition. If a property consisting of its several elements is usable not as junk but as serviceable property elsewhere, a higher price than scrap value is obtainable, and this worth has been characterized as "salvage value" or "minimum going value." If the cost of removal and transportation to its market exceeds the normal junk price of an article, then the scrap or junk value becomes negative and the article is valueless. Wearing Value. — If from the cost — taken on whatever basis is determined to be the correct one — there is subtracted " scrap' ' or "salvage" value of given physical property, the remainder lis a value known as "wearing value," which will deteriorate more or less rapidly and entirely pass away, as regards the in- stallation being considered, at the expired life of said property, I which life ceases through physical decay, inadequacy, obsoles- cence or sudden damage. 16 VALUATION OF PUBLIC UTILITIES Service Value. — Physical property, honestly and intelligently purchased with a view to its suitableness for the service intended, aside from some hidden defect or untoward accident, generally maintains its original utility and hence its value, for the purpose of use, practically throughout its life, except for such deterioration as results from wear and tear or deferred maintenance. The life of the property may expire normally through age or prematurely through inadequacy or obsolescence but these two latter classes of depreciation develop quickly so that for the larger part of the time used, the service value of property will approximate the cost. Service value must not be confounded with going value. Service value results from the use of the property in the place and for the purpose for which it was intended. Going value may or may not accrue in addition to, and, over-and-above service value. Going value relates to establishment of earnings while service value exists regardless of earnings. Present Value. — This expression refers to the estimated value of the physical property as it exists at the period being considered. It may have one of several values, some purely academic and artificial as explained more fully hereafter, depending on what application is made of the theory of depreciation and, therefore, present value always needs some qualification or explanation as to the sense in which the term is used. The more frequent application of the term is to that value obtained by deduct- ing, from "original cost" or "cost to reproduce new," the total depreciation, which may be either absolute depreciation or, as used by some authorities, the sum of both absolute, or accrued and theoretical or estimated depreciation. Though usually so, "present value" does not necessarily include a deduction from cost to cover deterioration as is illustrated in the valuation of the Texas Railroads made by the Commission of that State, where no deduction from cost of reproduction was made on account of existing wear and tear or normal deterioration. Appreciation as well as depreciation must be considered in de- termining "present value" as indicated by the Supreme Court. "And we concur with the court below in holding that the value of the property is to be determined as of the time when the inquiry is made regarding the rates. If the property, which legally enters into the consideration of the question of rates, has increased in value since it was acquired, the comi^any is entitled to the benefit of such increase."* ' Wilcox vs. Consolidated Gas Company, 212 U. S. 52. GLOSSARY 17 "Original cost" or "cost of reproduction new," in connection with depreciation of the phj'sical property inventoried is quite generally used in determining present value, but in this connec- tion it is interesting to note the unique opinion of the Iowa Supreme Court, which in view of the numerous decisions of other courts can hardly be considered a safe precedent to follow : "The contention illustrated how inequitable would be a rule arbi- trarily fixing the value as that for which a system might be replaced. Aside from this being impractical it may safely be said that there is hardly an enterprise of this character which, were it destroyed, would be restored as it was before. In ascertaining values in this way, the worth of a new plant of equal capacity, efficiency and durability, with proper discounts for defects in the old and depreciation for use, should be the measure of value rather than the cost of exact duplication."* In estimating "present value" it is perhaps unnecessary to state that "barter and sale," "the price it will fetch," "second hand," "scrap" or "forced sale" values are not the "fair values" to be considered in connection with a "going concern." This has been repeatedly affirmed b}^ the courts, as indicated, for example, by the following decision from the Supreme Court of Maine. "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, there is a right to use it. Nevertheless, it has value as a struc- ture. But, more than this, it is a structure in actual use, a use remuner- ative 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 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 bj^ the fact that it is in use. There is only one value. It is the value of the struc- ture as being used. That is all there is of it."^ * Cedar Rapids Gas Lt. Co. vs. City of Cedar Rapids, 120 N. W. 2 Brunswick and Topsham Water District vs. Maine Water Co.. 99 Maine, 371. 2 18 VALUATION OF PUBLIC UTILITIES In obtaining the depreciated or present value of "used or useful" property, worn out or replaced but still inventoried material, whiph has no value except for sale, may be put in at scrap or salvage value, unless such property is being carried merely to artificially increase values. Original cost is usually taken to mean the actual expenditures made for physical property, including original construction and usually all additions since that time. The term is taken to include those items which are classed as "Development Ex- penses" and occasionally even the value of franchises, good will or going value. Original cost should be shown in the books of the corporations but it is not always there obtainable. Often because of casualty by fire or flood or frequent mergers, con- solidations and reorganizations, old records have been lost and sometimes they have purposely been destroyed in order to obliterate the original cost of the property. Of course, original cost may or may not bear any relation to the present worth of the property being considered. The value of real estate for example may have appreciated largely so that its original cost bears no relation to its present value; on the other hand machin- ery and equipment may have been worn out and replaced by additions without writing off the value of the original property, no longer in existence. Proper bookkeeping methods would of course provide for the increase or reduction of the capital ac- count as property is added or abandoned and discarded, unless possibly the earnings have been so small as to preclude, without unfairness to the stockholders or bankruptcy to the corporation, the inclusion, as a part of operating expense, of the value of property added to replace that already a part of the capital account. Cost to Replace New, Replacement Cost or Cost of Reproduc- tion. — These terms, so much in evidence nowadays and recognized b)'' the courts, refer to an assumed value based on the estimated cost of reproducing the property new on the basis of prices current at the time of estimate — prices that fluctuate consider- ably are averaged for five years preceding the date of the ap- praisal — and is made up to include everything that can be inventoried regardless of original cost, age, service value or present condition as effected by depreciation. Novices in appraisal work frequently fail to appreciate that the terms here being considered refer exclusively to the cost of replacing exist- GLOSSARY 19 ing (with due consideration for inadequacy and obsolescence) physical property by new property of a type in all respects identical with the old. The terms do not refer to the sub- stitution of a different type capable of rendering equivalent service or of equal utility, that would call for new design, ini- proved. apparatus, concerning which engineers would differ widely. Of course, a defect in the reproduction cost theory is that a utility cannot buy its materials, labor, propei'ty at average figures but must make its expenditures when times, and con- ditions or ordinances may require, often during periods of pros- perity which consequently means during periods of inflated prices. Development Expenses. — In connection with the establishment of any utility property as an operating entity, there are certain expenditures necessary for developing and completing the phy- sical structures aside from the expenses of developing the business and producing an income. The former may be classed as "De- velopment Expenses" and the latter as "Going Value," but both items are apart from and in addition to those expenditures relating to the cost of the physical plant. As a class, these expenses are sometimes referred to as "over-head charges," more frequently as "intangible expenses," but as they refer largely to the outlay necessary in getting the physical plant running, the author prefers the quite commonly used term "Development Expenses" which generally cover most or all of the following expenditures. 1. Legal and other expenses of preliminary promotion, in- corporation and organization, procuring consents of property owners, condemnation proceedings, obtaining franchises, con- sents and certificates from Public Service Corporations and other public bodies, sometimes title examinations and insurance. 2. Technical expenses in connection with preliminary work, surveys, expert estimates, etc. 3. Interest on capital and bond issues, wages of superintend- ence and administration not chargeable to construction ordi- narily necessary in connection with putting a property in going order; and also sometimes the deficiency in operating expenses and taxes until the property is put on a paying basis. 4. Taxes of various amounts including corporation tax, mortgage tax, real estate tax, personal property tax, capital and 20 VALUATION OF PUBLIC UTILITIES State tax, franchise tax, etc., which must be i3rovicled and paid until the property is completely a ''going concern." 5. Discounts on securities, brokerage or other customary and necessary expenditures in connection with financing such an undertaking and marketing securities. 6. Reasonable promotion profit, possibly also compensation for risk of capital. 7. Working capital. It will be recognized in connection with the above items that although intangible in nature and having nothing to show therefore which can be ''seen and felt," nevertheless these expenditures are just as definite, just as necessary and just as indisputably a part of the whole value of corporation property as are the physical elements. Fair Rate, Fair Value, Fair Return.— The word "fair" implies justice. What may be a just and fair rate, a fair value or a fair return under a given set of conditions may be equally unreasonable and unfair under other conditions of climate, density of population, cost of fuel or labor and other modifying circumstances. Gas, sold by the cubic foot in both places, does not contain nearly as many heat units in Denver, Colorado, by reason of being about a mile above sea level, as does the same volume in New York, con- sequently the same price per thousand feet in both places, means nothing. Fuel at Norfolk, Va., will produce the same amount of steam at half the cost, compared with Boston, Mass. The prevalent state laws requiring a uniform 2 cent passenger late per mile without regard to cost of construction, quality of service or density of population results in handsome earnings for some railroads and serious deficiencies for others. Rate regislation and attempted regulation without critical study of local conditions or a full analysis of operating statistics will never result in a fair rate. The determination of what may be a fair rate under given conditions is a complex question. It depends upon two fundamental facts to be ascertained. First. — On what is a fair value for the property being used. Second. — On what amount of return beyond operating and all other expenses it is fair to allow the owners for the use of their property. Thus it will be seen that all considerations are qualified by the GLOSSARY 21 adjective which is applied so easily, but the exact limitation and definition of which, for any particular case is always difficult and oft times impossible of exact ascertainment. The courts have held that before deciding what in a given case may be a fair rate, it is necessary to determine both fair value and fair return. Fortunately the Supreme Court* has explicitly stated that the factors to be considered in determining fair value are: ■ " (a) Original cost. (b) Amount expended in permanent improvements. (c) The amount and market value of stock and bonds. (d) Replacement cost. (e) Probable earning capacity. (f) Operating expenses. Of all the elements set forth above to be considered in deter- mining fair value, replacement cost is becoming the most con- trolling and important. It is obtained through a valuation of the property, which can only be made with creditable fairness by the exercise of wide experience, good judgment, honesty and fairness on the part of the individual making up the appraisal. By giving due weight to the relative accuracy and importance of each of these elements of value, the true or fair value is de- termined. When this is fixed, the fair return to be allowed is established by a consideration of local condition, risks of the particular business in question and other attending circumstances. From a knowledge of the fair value of, and return on, the property under consideration and from a knowledge of income, it is possible to fix a rate which is proper and fair to charge for the service rendered. Good Will. — A monopoly, as is generally admitted, has no good will which can be evaluated, and the courts have sustained this view. Good will can only result where competition exists and the tendency of the times is to make no allowance for this ele- ment in a public utility valuation; it being considered that good will belongs rather to industrial enterprises where its value is de- termined by the profitableness of the business; namely, capitaliz- ing the net income. Good will has no value which must be considered in dealing with the subject of Depreciation. ' Covington and Lexington Turnpike vs. Sanford, 164 U. S., 578. 22 VALUATION OF PUBLIC UTILITIES Franchises. — As the term indicates, it is the right to "do busi- ness." Formerly franchises were considered more or less valu- able assets and in some instances, have been recognized and allowed for by the courts; but the present tendency, largely by reason of legislative enactments, is to prohibit the capitalization of franchises beyond the absolute expenditures made in good faith in obtaining said franchises. Depreciation or amortization of franchises depends on their terms and has no relation to de- terioration of the physical property although the expiration of a franchise might easily reduce service value. Depreciation. — Webster defines "depreciation" as the "act or state of lessening the worth of." The Century Dictionary says it is "a fall in value; reduction of worth." In appraisal work it means a reduction in utility, expressed in dollars, due to any deterioration in physical plant by reason of (a) Wear and tear. (b) Age or physical decay. (c) Inadequacy. (d) Obsolescence. (e) Deferred maintenance. The term "Amortization" has been used somewhat indis- criminately for depreciation, but it may more properly be applied only to the laying aside of funds at a uniform rate for the writing off of intangible values or the ultimate replacement of capital investment; and in this sense alone, will be used by the author. The term depreciation, always used in connection with a reduction of value, has, however, three distinct and separate shades of meaning so that the term must be qualified when used to distinguish which one of the following meanings is intended: First. — The annual amount expressed, as a percentage or in dollars, that should be laid aside to renew or replace the article in question at the time of its abandonment. In this use of the term, the loss of worth, which can be made good or replaced through ordinary maintenance or repairs, is not included as a part of depreciation, but is provided as a part of the regular operating expenses. This, until comparatively recently, was the more common use of the term depreciation which was applied particularly to renewals and i^eplacements. Used in this sense. GLOSSARY 23 the term "depreciation" is somewhat academic and theoretical, and may or may not represent any actual financial outlay. "Depreciation does not represent actual expenditure but the amount properly reserved to offset the loss in value occurring to the operating plant."^ Second. — ^The annual amount expressed, as a percentage or in dollars, that should be laid aside to renew or replace the article in question at the time of its abandonment, plus the annual expense of maintenance and repair expended in removing such part of depreciation as is practicable and good economy. This then includes all classes of "lessening of worth" and is the application of the term preferred by the writer and used by the New York Public Service Commissions in their rules for uniform accounting: "The next important step to be taken by the corporation is to deter- mine what amount should be set aside month by month to cover wear and tear, obsolescence and inadequacy — repairs, renewals, replacements and other depreciation."^ Such use of depreciation covers all classes or causes of deteri- oration, regardless of the source or method of worth reduction or by what means it may or may not be removed. Third. — The total amount — it may be the sum of several years of depreciation — expressed in a percentage or in dollars, that must be deducted from the "original cost" or the "cost to re- produce new" in order to obtain the present value. The de- termination of the amount of depreciation at a given time, in connection with the valuation of a property, is merely the summation of the annual accrued amounts of deterioration, which, from the time of installation, have been continuously reducing the worth of the property, less such value as has been restored by expenditures for wear and tear, replacements and renewals. Classes of Depreciation. — The subject of Depreciation from an engineering — not an accountant's standpoint — practically divides itself into several classes, as follows: ' Cunningham vs. Chippewa Falls Water Works and Lighting Company Railroad Commission of Wisconsin. 2 Report of the Commission adopted December 8, 1908, in the matter of "Uniform Systems of Accounts for Public Service Corporations." 24 VALUATION OF PUBLIC UTILITIES (a) Wear and Tear, or Maintenance. — This includes such de- preciation as may ordinarily be removed or offset by proper expenditures at such time as the worn out parts may be econom- ically replaced. Few parts of physical property in use ever become completely worn out; after a certain amount of wear, a point is reached at which good engineering requires their replace- ment; they may be still further used, but only at the cost of economy or safety. With different pieces of apparatus, deprecia- tion due to wear and tear varies widely. It may amount to a small percentage of the whole, as for example the bearings in a generator; or it may amount to a very large percentage, as for example the blading of a steam turbine or the insulation of a high-tension leaded cable. This class of depreciation may be considered to include that due to accidents, such as would result from lightning, fire, or other sudden damage. Even before the moment original construction is complete, deterioration begins and a more or less depreciated condition of the installation as a whole always exists, which condition will- increase until good engineering indicates that the time has come to offset wear and tear by repair. Such depreciation, as related to service value, not always as to sales value, can usually be completely compensated for by expenditures, small, relatively to the value of the entire propert}'. It has been the almost universal custom to include the expense of removing wear and tear, the most obvious class of depreciation, as part of regular operating expense. (6) Age, Physical Decay or Decrepitude. — Depreciation of this sort is due to the aging of apparatus that usually has alife extending over a period of years. Property that is short-lived usually passes away through "wear and tear." In many instances, age depre- ciation will be the same whether the apparatus is used or unused; i.e., a boiler or an insulated wire will deteriorate through the action of the elements practically as rapidly when standing idle as when in continued service. After a given number of years, the expense of maintenance on very many pieces of property will become so large that it is more economical to abandon than replace them. For example, car bodies will in the course of time become so racked that they must be abandoned because the new cost less than repairing the old. (c) Inadequacy or Supersession. — This class of depreciation arises from increased demands of service so as to render the prop- GLOSSARY 25 erty in use inconvenient or uneconomical for continuance of operation, although in every way capable of performing the serv- ice for which it was installed. For example, when street railway service has increased to such an extent that many and frequent small single-truck cars are required to do the work that can be done by larger double-truck cars at less cost and with less inter- ference with street traffic, both economy and necessity compel superseding the smaller equipment with the larger, and thus through inadequacy, investment in the smaller equipment is depreciated before the property is worn out or becomes decrepit. Furthermore, the introduction of heavier cars may make in- adequate the rails and car barns. Inadequacy may and does take place without regard to the length of time the property has been in use or to the amount of service rendered. Inade- quacy, although confused b}' some authorities with obsolescence, is generally distinct from the latter and usually arises from a different cause, although in some cases related to and scarcely distinguishable from obsolescence. Obsolescence. — Obsolescence means the depreciation of property through the development of something newer and either more economical or more of a fad. Like inadequacy, it may necessi- tate the abandonment of property long before it is worn out and in many cases, arises largeh' from demands of the public. What is obsolete in one place ma}' not be effected by obsolescence in another. Note, for example, the recent introduction of P. A. Y. E. cars in the larger cities or the use of open-bench cars in the Borough of Bronx, where they are considered good practice, while at the same time they are by many considered obsolete for the Borough of Manhattan, all within New York City. The substitution of underground conduits and cables for aerial construction required by public authorities is another illustra- tion of this class of depreciation which cannot be prevented by maintenance or offset by repairs; it can only be met by complete replacement. By reason of rapid advance and development in the art, obsolescence has heretofore probably caused the greatest expenditure for depreciation account, unless it is wear and tear; but as time goes on, obsolescence may become a less important factor, though it would probably be at the cost of rapid improve- ment and development. " There is also the question of obsolescence, or such changes as become necessary because of new inventions or because of changes in the art. 26 VALUATION OF PUBLIC UTILITIES In the electrical field in particular, such changes are very frequent. They often make it necessary to discard machinery and other equip- ment of various kinds long before they are worn out. This is an ex- pense that is of the same nature as depreciation and is usuallj^ classed as such. It should be charged to operating expenses the same as other depreciation." ^ (d) Deferred Maintenance. — The several classes of deprecia- tion hereinbefore referred to assume that the property will be kept in good operating condition and efficiency. If the condition of the property is permitted to lapse beyond that of safety or economy in operation there results a condition due to neglect of proper maintenance and regular repairs, a condition known as "Deferred Maintenance," which is measured by the expenditure that may be necessary to offset such neglect and restore the property to good operating condition. Deferred maintenance is only another term for neglect and always reflects to the discredit of the management or the financial ability of a corporation. Going Value. — "Going Value," "Going Concern Value," and "Going Concern" are several terms that have been used to refer to an intangible value beyond that of the physical plant attaching to live, active and operating property. The value in question is generally held to relate to and is evaluated from a consideration of earnings. It has been defined as "the cost of acquiring a given income," also 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 hypothical starting plant, operating at those same rates." There is no element included in the total valuation of utility property concerning which there is greater difference of opinion or more controversy and indefiniteness with regard to methods of its evaluation. The Wisconsin Commission, as well as some of the highest courts have clearly and definitely recognized the value attach- ing to the building up of an income producing business and allowed such value as a part of capitalization. To determine the worth of a going business in dollars, the Wisconsin Com- mission has repeatedly estimated, in connection with the par- ' Decision of the Railroad Commission of Wisconsin, June 2, 1908, City of Dodgeville vs. Dodgeville Electric Light and Power Company. GLOSSARY 27 ticular property under consideration, the necessary expenditure since the business was started, made in carrying the organization to the present state of income, allowing a fair rate of return, necessary depreciation, operating expenses, etc., and compared such estimate with the actual record made by the Company, including all surplus earnings, whether paid out as dividends or not, and by such comparison determined whether or not there remains an excess in the estimated result as compared with the actual result, if so, that difference is considered proper for capitalization as "going value." This theory being based upon cost in the past, cannot in strict logic be used in connection with values which may be made up to represent the cost of reproduction, yet the AVisconsin Commission has so combined the actual cost with estimated cost of reproduction as appar- entl}' the only practicable method of deriving fair value. Judge Lurton in the decision of the Supreme Court in the Omaha Water Works' case, decided May 31, 1910, says: "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 mak- ing 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 Wilcox 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. 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 Wilcox vs. Consohdated Gas Company (212 U. S., 19). Both 28 VALUATION OF PUBLIC UTILITIES cases were rate cases and did not concern the ascertainment of value under contracts of sale."^ Public Utility. — Corporations are of two quite distinct classes, those engaged in industrial enterprises more or less private and competative and those operating as public or quasi public service organizations, known as utility corporations, and monopolist in fact or tendency. All corporations are created in accordance with laws, more or less restrictive, for certain specific objects set forth in their charters or articles of incorporation, but utility corporations have certain rights or franchises accorded them which do not belong to other corporations such as authoi-ity to occupy public streets or other public property, the right of eminent domain, i.e., to take private property for their own use in consideration of the payment of an equitable price for the property taken, the duty of obligation to extend and continue service even though such extension and continuance is not desired,^ with other conditions. The objective, in the crea- tion of all corporations is financial gain, which has heretofore been generally permitted, without other limitation than com- petition, but latterly the utilities have tended to become mon- opolies through buying or crushing competitors and as a result there has developed the theory that such corporations, accorded practically the exclusive business of serving the public, if al- lowed a fair return on the value of their property are entitled to nothing further than that fair return. In order to carry out this program of limiting earnings to a fair return on the fair value of the property, it has been necessary to ascertain the fair value of various utility properties resulting in one of the causes of the very general demand for appraisals and valuations. It will be recognized that the operation of a utility under the "fair return" theory entitles it (a) To earn a reasonable profit on the total fair value, tan- gible and intangible, of its property, over and beyond the proper expenses of operation including taxes and the various classes of depreciation. (b) To render good service to the public at the minimum rate which will insure, under good management, earning the air return on the fair value of the property. 'Omaha vs. Omaha Water Co., 218 U. S., 180. ^Weatherly vs. Capital City Water Co., Ala. 22 So. 140. GLOSSARY 29 "Summarized, these elemental principles are, the right of the com- pany to derive a fair income based upon the fair value of the property at tiie time it is being used for the public, taking into account the cost of maintenance and depreciation and the current operating expenses, and the right of the public to demand that the rates shall be no higher than the services are worth to them, not in the aggregate, but as individuals.'" The primary reason for prohibiting an unlimited rate of return and allowing merely a fair rate considering local condi- tions and exigencies, results from the fact that a corporation which is a monopoly is in a position to raise rates arbitrarily and thus earn excessive and unfair profits while an industrial cor- poration ordinarily is precluded from unfair profits through the workings of competition. Moreover the public, being com- pelled to purchase from a monopoly, insures its earnings with consequent decrease in risk to the success of the corporation. Averages. — The term "average" is often used by engineers in connection with life, quantities and prices of physical property, in the high sounding but loose way the term "fair" is used by the legal fraternity in connection with rates and values. If based on proper premises and not used to conceal omission in working out laborious details, average figures may be most useful and instructive. Frequently, however, the average figures so called are merely guesses or perhaps estimates and not the result of averaging anything but opinion. The mere averaging of simple figures, as for example, the lengths of several pieces of timber is a simple and generally understood process of arithmetic and division, but obtaining the true or "weighted" average of complex quantities is much more of a problem and the source of frequent error on the part of those not fully understanding the matter. Obtaining the weighted average in relation to values is particularly important, when figuring the life of property which one may be desirous of valuing or depreciating. Suppose it is desired to ascertain the average life of a number of different buildings, one a temporary structure, another a wood building, the third of brick and a fourth of monolithic concrete. Assuming that for the buildings named the estimated useful lives will be respectively 5 years, 20 years, 50 years and 100 years, what will be the average life of the buildings with 'Maine Supreme Court, 1893. 30 VALUATION OF PUBLIC UTILITIES respect to their values if the first cost $5,000, the second $10,000, the third $20,000 and the fourth $25,000. Many people would erroneously figure the average life, by the following method, to be 43.75 vears. Type Temporary building, Wood building, Brick building, Concrete building, Estimated life 5 years. 20 years. 50 years. 100 years. 17c 175 years. = 43.75 years. Other persons more experienced with figures would take into consideration the values as follows: Type Temporary building, Wood building, Brick building, Concrete building, Estimated life 5 years time 20 years time 50 years time 100 years time Cost §5000= .525,000 .$10000= S200,000 1520000 = §1,000,000 §25000 = §2,500,000 §60000 = .§3,725,000 3,725.000 60,000 = 62.08 years. But to obtain the true or weighted average life there must be taken into consideration the total dollar value involved in the maximum life period, as follows: Type Estimated life Cost Temporary building, 5 years §5000 Wood building, 20 years §10000 Brick building, 50 years §20000 Concrete building, 100 years §25000 No. renewals in 100 Estimated cost for years 100 years Dollar years 20 §100,000 §500,000 5 50,000 1,000,000 2 40,000 2,000.000 1 25,000 2,500,000 §215,000 §6,000,000 §6,000,000 — — = 27.9 years. GLOSSARY 31 The above correct average life may also be derived as follows: $5000 divided by 5 years = S1000 per year 10000 divided by 20 years = 500 per year 20000 divided by 50 years = 400 per year 25000 divided by 100 years = 250 per year $60000 2150 =27.9 years which is the average estimated life of the property as a whole, based on assumed lives of the several buildings as indicated. CH.\PTER 111 PUBLIC SERVICE COMMISSIONS Utility Commissions. — In a broad sense the term Commission has come to include Federal, State and Municipal Committees or Boards having supervision of so-called Public Utility Corpora- tions, such as railroad, gas, electric-light, street-railway, water- power, water-works, express, telephone, telegraph and even pipe-line, wharfage or compress companies. Although few important valuations have yet been made by Municipal and none by Federal Commissions, much of the appraisal work that has been done by the State Commissions is of such high quality, although wrought out, in many instances, under disadvantageous circumstances, that it should receive due credit and recognition. The opinions, in most cases, show such thought and painstaking effort; the conclusions are usually so logical and the decisions based on valuations have been so frequently accepted as to give them a status comparable to those of a Court of Justice, that some knowledge of the procedure and appraisal work of Public Service Commissions is essential to a broad study of the subject of valuations. Control of corporations was for many years unsuccessfully attempted through direct legislative enactment. Such methods alone are not sufficiently precise or adequate to cope with the complicated, constantly shifting and rapidly developing condi- tions of the social, political and economic life of the American people. More recently, control of public utility corporations has been especiallj^ undertaken through National or State Com- missions, usually clothed with radical authority. The success attending this method of regulation, where attempted, has been so marked that it has now become generally recognized as the most effective means yet devised for corporation control. The experiment was first tried by the State of Massachusetts, which created a Board of Railway Commissioners as far back as the early sixties. In 1885 a Gas and Electric Light Commission was created and given jurisdiction- over Gas and Electric Com- panies, but the Telegraph and Telephone Companies are con- trolled by a Board of Highway Commissioners. The Massa- 32 PUBLIC SERVICE COMMISSIONS 33 chusetts Commissions have interested themselves particularly in matters relating to the incorporation capitalization and issuance of securities of Massachusetts Companies the quality of service rendered and have done little with regard to making appraisals of property. Other states soon followed the lead taken by Massachusetts. Minnesota in 1899 created a Railroad and Warehouse Com- mission, which was given supervision over Express Companies, Grain Elevator and Commission Houses, but not over Electric Light, Street Railway, Telephone or Power Companies. The investigation of express rates l^y the Minnesota Commission is said to have cost some $30,000 and is w^ithout question the most exhaustive investigation, with regard to Express Companies, ever made in this country. The Railway valuation by the Minnesota Commission, made for rate making purposes, took three years to complete, and established a precedent in this class of works. Texas in 1891 appointed its Railroad Commission for the purpose of ascertaining "as early as practicable the amount of money expended to procure rights of way and the amount of money it would require to re-construct the railroad bed, track and depots and transportation and to replace all the physical property belonging to the railroads." This Commission has already appraised over 93 per cent, of the main trackage of the State. New York comparatively early established its Railroad Commission and in 1905 a commission controlling the Gas and Electric Corporations but in 1907 both Commissions were replaced by two Public Service Commissions, having control of railroads, gas and electric utilities but not water companies. One commission has supervision over Corporations within the City of greater New York and the other over the balance of the State, including Telephone corporations within New York City. Dur- ing the year just closed the commission of the Second District, authorized securities for the corporations under its jurisdiction amounting to $162,581,718.52, as follows: Steam railroads, $119,718,937.52; electric railways, $24,323,500; gas and electric corporations, $17,952,581; telephone companies, $581,700. The total amount authorized during the four and one-half years of the Commission's existence is $566,460,507.86. 3 34 VALUATION OF PUBLIC UTILITIES The Commission of the First District for the year 1911 received reports from 153 utility companies. Some $79,944,177 worth of securities were passed on for approval, but the Commission only allowed 820,548,819. The more important work of the Commis- sion at present is in connection with Street Railway, Elevated and Subway transportation, the Commission laying out routes and awarding contracts for Municipal Subway construction to the amount of S29,000,000 during the year 1911. The passen- gers carried on the surface, elevated and subway lines aggre- gated 1,603,908,253 affording a revenue of $83,751,414 for the year 1911. Wisconsin started with a Railroad Commission, later placing the control of Express Companies under the Commission in 1905, and two years afterward including Gas, Electric, Heating, Water, Telegraph, Telephone, Street and Interurban Railways, and more recently Water Power Companies. The law makes no dis- tinction between privately and municipally owned utilities, demanding the same methods of accounting from and applying the same regulations to both. The Commission began its original valuation of the steam railroads of the State in 1903, which was soon thereafter completed. In 1909 it made a re- valuation of the railroads which showed a considerable increase compared with the one made six years previously. Appraisals of other utilities are constantly being made, as the commis- sion makes it a rule to ascertain the value of corporation property before fixing rates. The work of the Wisconsin Commission is pre-eminent. The Commissioners have been men of standing, integrity and industry and their decisions give evidence of pains- taking effort and much originality. As indicating the care with which they handle their work it may be stated that out of a thousand utilities in the State, the Commission has appraised less than one hundred to date, although that means a very much larger proportion of the total investment in corporation property than the relative figures indicate. In 1905 the State of Washington created a Railway Commis- sion, later enlarging it to a Public Commission having jurisdiction over practically all utilities including Warehouse Companies but excepting municipally owned plants. The railway Commission has made appraisals of the larger proportion of the Railways in that State. Oregon started with a Railway Commission in 1907 and PUBLIC SERVICE COMMISSIONS 35 endeavored to create a Public Service Commission in 1911, but the matter has been held a^vaiting a vote of the people next autumn. Nebraska created a Railway Commission in 1906, having jurisdiction over Telephone and Telegraph Companies in addition to the Railroads, Steam, Interurban and Street as well as Irriga- tion Companies, Agitation over a Commission having control of all utilities has begun. The Railway Commission of Georgia was created in 1879 and in 1907 was given jurisdiction over Express Companies, Gas and Electric Light, Power, Cotton Compress, Dock, Telephone and Telegraph Companies. The Commission has interested itself more particularly in regard to rates and stock and bond issues, than in appraisals and valuations. Maryland created a full fledged Public Service Commission in 1910, having oversight of 280 corporations to which during the past year it authorized the issuance of $48,000,000 of securities. The Commission is now actively engaged in physical appraisals and rate c^uestions. Oklahoma has a Commission created in 1907, having jurisdic- tion over railways and other utilities including Express, Oil Pipe and Water Companies. This Commission is not as liberally provided with powers as the Commissions of most other States and has petitioned the legislature for larger authority. California has recently passed a public utility law becoming effective in March giving its State Railroad Commission control of all service corporations and it is expected, with the broad powers accorded, the Commission will undertake work on a broad scale. For some years the State of Connecticut has had a Railroad Commission and in 1911 the legislature created a new Commis- sion to have charge of all Public utilities, thus superseding the Railroad Commission. The Governor appointed to the new . Commission the members of the old Commission so that its methods and personnel are practically continuous. Vermont, Colorado, Florida, Georgia, Iowa, Illinois, Indiana, Maine, Pennsylvania, Missouri, South Carolina and Rhode Island have each had a Railroad Commission for some years but their work is largely routine. In 1909 Arizona, and during the year 1911 the states of Ohio, Kansas, Maryland, New Hampshire, Nevada and New Jersey 36 VALUATION OF PUBLIC UTILITIES created Commissions to control and regulate public utilities on principles similar to those embodied in the laws of the states of New York and Wisconsin. The penalties provided for a vio- lation of the Kansas law, which in some instances becomes a felony, are exceptionally rigorous. At present in almost every state where Commissions are not already in existence the legis- latures have been or are considering the question of creating some sort of Public Utility Commission. Reasons for the Creation of Commissions. — For many years competition has been held to be the proper means for regulating rates; believers in the Sherman Act and its enforcement still cling to that theory, but the extravagant waste and loss involved in acceptance of this policy, as applied to public utilities at least, has, as a general rule, always resulted in an increased cost to the consumer. Regulation of rates by governmental authority, is of course incompatible with free competition. It would seem to be self-evident that the theory on which regulation is based can only be sustained by the recognition of a monopoly. Whatever may be said against governmental regulation of private industrial corporations, which are perhaps automatically controlled through competition, does not apply to what are termed Public Utility Corporations, which are, or properly may be, monopolies. The necessity for regulation by the public arises, in the first place, because the exercise of franchise rights by certain cor- porations, while academically not exclusive, is nevertheless practically non-competitive; therefore, one of the ordinary checks arising through competition does not in such cases apply. Unlike the individual or ordinary business corporation, a public utility corporation frequently cannot begin business without being organized under special and specific laws. Such corpora- tions may be granted unusual franchises; for example, the right of eminent domain, and are recognized as existing for service to the public in a manner, and with privileges entirely unique and distinct from those of ordinary business undertakings, and are therefore acknowledgedly subject to special regulation and control. Even ordinary business corporations which have no special privileges granted, if uncontrolled, may, as the result of unusual commercial acumen linked with a large aggregation of capital — illustrated for example, in the case of the so-called "trusts" — create a wrong which organized society will very properly step in and limit, control, or prohibit. Business trusts PUBLIC SERVICE COMMISSIONS 37 are in effect monopolies, because competition as a practical matter is out of the cjuestion, and hence regulation in their cases is also essentially necessary. The underlying principle of monopolies, cooperation, is a legitimate product of our present civilization; it may be controlled but should not l^e prohibited. In the second place, regulation of utility cooperations compet- ing for the same business is required from the very nature of the business itself. If they are allowed to compete fully and freely, experience indicates that they will ultimately engage in a war of annihilation, the expense of which is in the end borne by the security holder or the public. Up to a few years ago, political economists believed and argued that the only regulation required for all commercial operations was free and unrestricted com- petition: "Because the experience of mankind had not developed essential monopolies, and it was believed that every problem which would arise would be solved by giving full play to the spirit of competition. * * * "Whether that system of deaUng with railroad corporations will succeed or not can be ascertained by viewing their history in the State of New York, and the experience which was had in this State demon- strated that it did not work to the advantage of the public and that the evils connected with the system were simply enormous and unendurable. Competition could not exist upon railroads."^ The principle of State or Federal control and regulation of corporations is not new, although the application of this principle has recently been greatly broadened. Liberty has so largely grown to mean unrestricted license the recent statement of the old fact that the Public can demand and take from the individual, and even more from the corporation, anything '' from his pocket- book to his life inclusive" was as startling as true. The only precedent to the taking is the public necessity with the proper method of remuneration. In theory then, regulation is correct if only the application is practicable and fair. Control of monopolies must therefore be regulated by the legislature, but as is generally recognized, the legislature has no authority to delegate this right, which includes both judicial and legislative functions, to an administrative board; practically, however, it is possible for a legislature to effect regulation 'F. W. Stevens, address A. I. E. E. dinner, 1908 38 VALUATION OF PUBLIC UTILITIES through a committee or commission by defining the powers and determining the policy of its committee or commission. The result is in effect that the commission ascertains the facts and conditions in each case and administers the law as laid down by the legislature, therefore its function is neither judicial nor legislative. The relative function of the Commission in its relation to the legislature has been established by the Supreme Court of Wisconsin. "The division of the governmental powers into executive, legislative and judicial, while of great importance in the creation or organization of a State, and from the viewpoint of institutional law and otherwise, is not an exact classification. No such exact delimitation of governmental powers is possible. In the process of enacting a law there is frequently necessary the preliminary determination of a fact or group of facts by the legislature, and it is well settled that the legislature may declare the general rule of law to be in force and take effect upon the subsequent establishment of the facts necessary to make it operative or to call for its application. * * * The legislature may delegate any power, not legislative, which it may itself rightfully exercise. This power to ascertain facts is such a power as may be delegated. * * * This law establishes, and thenceforth assumes, the existence of rates, charges, classifications and services, discoverable by investigation but undis- closed, which are exactly reasonable and just. It commits to the Rail- road Commission the duty to ascertain and disclose that particular rate, charge, classification or service. The law intends that there is only one rate charge or service that is reasonable and just. When the order of the commission is set aside by the court, it is because this reasonable and just rate, charge, classification or service has not yet been correctly ascertained. When the order of the commission has been rescinded or changed by the commission because of changed conditions it is because there is a new reasonable rate to be ascertained and disclosed applicable to such new conditions and fixed by force of law immediately when the new conditions came into existence. But the theory and the mandate of the law is that this point is always discoverable although not always discovered. Until it is discovered and made known the former rates and service prevail. The order of the commission is prima facie evidence that the rate, charge or service found and fixed by it is the particular rate, charge or service declared by the legislature in general terms to be lawful and to be in force. If it were conceded that the commission had power or discretion to fix one of several rates, either of which would be just and reasonable, it would be hard to say that this was not a delega- tion of pure legislative power to the commission. But the theory of PUBLIC SERVICE COMMISSIONS 39 this law is to delegate to the commission the power to ascertain facts and to make mere administrative regulations. * * * * * * * "The notion that commissions of this kind should be closely restricted by the courts, and that- justice in our day can be had only in courts, is not conducive to the best results. Justice dwells with us as with the fathers; it is not exclusively the attribute of any office or class, it re- sponds more rapidly to confidence than to criticism, and there is no reason why the members of the great Railroad Commission of this State should not develop and establish a system of rules and precedents as wise and beneficent within their sphere of action as those established by the early common-law judges. We find the statute well framed to bring this about. "^ The argument has been made that corporation control and limitation of earnings by Public Service Commissions will remove all incentive for development, originality, economy or improvement, that when a corporation has reached the maximum rate of return allowed there no longer remains any reason or ambition for increasing earnings. That a just return on the value of the investment or property is not alone the basis to be considered in fixing the proper rates or allowable earnings of a corporation is indicated by published statements and decisions of more than one Commission. Not only the propriety, but the necessity, of permitting compensation for good service and efficient management has been stated by the Public Service Commission of New York, First District, in its discussion of ''Uniform Systems of Accounts." "It is not the purpose of public regulation by reducing rates to take from a corporation all the proceeds of enterprise and thrift that it may earn beyond a reasonable dividend. If a thrifty and intelligent corpo- ration can, at a smaller expense to itself, supply a public service, than a careless and incompetent corporation, the former should not be compelled to charge the public less than the latter. To do so is to discourage progress and economy." Despite this fair statement of intention an examination of the rulings of state commissions shows a tendency to place all corporations on the same footing as regards the returns to investors; that is, regardless of whether capital has been invested and conserved in a judicious and intelligent manner or in an ' Minneapolis, St. Paul & Sault Ste. Marie Ily. Co. vs. Railroad Com- mission of Wisconsin 136, Wisconsin, 146. 40 VALUATION OF PUBLIC UTILITIES inefficient way, the precedents established indicate that about the same profit will be allowed in either case. Such procedure, of course, does away with all incentive to improve the earnings by cutting down operating expenses, or to decrease the price, or introduce new apparatus or modern methods. It removes the stimulus heretofore existing with the individual, to make the very best showing possible, and hence is a reasonable, valid, and practical objection to control by Commissions. One method of offsetting this very decided disadvantage has been evolved by the application of the London sliding scale, so-called because originating in London, England, and now in use in a number of places, particularly in Boston, Mass. The principle is a profit- sharing one, in which the investors are entitled to a definite rate on their investment with a fixed price for their product to the consumer. Every decrease in price, as for example 5 cents per unit in the case of gas at Boston, entitles the investors to an increase of 1 per cent, in their rate of dividend. An objection to this plan is that while it may be perfectly fair for a term of years, improvements in methods of manufacturing may so largely reduce the manufacturing costs as to entitle the investors to abnormally large dividends, at which time a readjustment of the base for price of product and rate of dividend would result in seriously depreciating the securities held by the owner at the time of such adjustment. This London scale, however, is at present the best practical method evolved for automatically adjusting prices and profits as between the public and the corporation. Admitting that Commissions are in existence, that they are likely to remain and exercise supervision of public utilities it is apparent that they will require and insist upon appraisals of corporate utility property, perhaps both tangible and intangible, certainly the tangible, when there are involved questions which effect rates, also usually when considering questions of sale or capitalization and sometimes even in tax cases. Results Accomplished by Commissions. — Individuals interested in corporations in many instances presuppose that regulation by Public Utility Commissions means unfair rulings against the corporations and espousal of the cause of the people. In case Public Service Commissions should degenerate into mere machines for use by the demagogue or politician, such results may be feared, but so many of the State Commissions are constituted of I I PUBLIC SERVICE COMMISSIONS 41 honorable men whose intentions and integrity are of the highest, whatever may be said of their lack of knowledge or experience, that actually there is little cause to complain that the corporations alone are receiving unfair treatment. Mistakes have been made and improper decisions have been rendered, but these are im- partially distributed as between the corporations and the public. The Commissions in existence show by their record that on the whole both the corporations and the public may expect impartial treatment. The corporations usually desire to operate as a monopoly, and the creation of Commissions is now predicated on the assumption that a monopoly will be recognized and allowed under proper regulation and control. The attitude of the Public Service Commissions with regard to the avoidance of competition and the recognition of a controlled monopoly, has been repeatedly affirmed notably in the decision of the Public Service Commission of New York, First District in the Long Acre case^ and of the Second District in the case of the Binghampton Light, Heat & Power Company, where that Com- mission said: "A Public Service Corporation is in its nature an essential monopoly." * * * "A monopoly by the very fact of being a monopoly gets all the business there is." * * * "With a monopoly, if the density of the business gives extravagant profits, it is the duty of the state to cut down the price so that the monopoly obtains only reasonable returns. The evil of the monopolies is that uncontrolled they can charge prices which will give excessive and unreasonable profits."^ This properly means that while on the one hand adequate service will be required and a limit to returns on property will be fixed by the investment, value and proportionate risk of the business, on the other hand property rights will be protected and conserved, competition and waste eliminated and a fair return allowed. Corporations that have been found lax on mismanaged as to the upkeep of their physical property, that were employing improper accounting methods resulting in the impairment of property or capitalization have been compelled to correct their 'Long Acre Electric Light and Power Co. Order 607. Report, 1908, Vol. II, p. 139. Public Service Commission of New York, First District. -Application of Binghamton Light, Heat & Power Co. Decision Aug. 4, 1909. Public Service Commission of New York, Second District. 42 VALUATION OF PUBLIC UTILITIES methods. The mcreased stability of public utility securities due to their issuance under regulation has caused their acceptance by fiduciary corporations in a way that was impossible before regulation was undertaken. The methods of accounting and publicity insisted upon by Commissions result in a systematization and classification of corporation expenditure, which afford as never before, a knowledge of and confidence in costs not heretofore possible to either the public or the corporations. Abnormal and unfair bond issues have been prevented, increased comfort and safety in operation both to the public and employees have been secured, maintenance of equipment and provision for deprecia- tion funds have been insisted upon, while extortionate rates on the one hand and a fair return to the investor on the other hand, even through an increase of rates, have been insured where the properties can be made to produce such results. Some of the universally acknowledged beneficial results of the appointment of State Commissions has been the retirement of Public Service Corporations from interest in and control of politics, and the abandonment of differential rates, discrimina- tion and rebates to favored customers. Prof. H. B. Mayer, member of the Interstate Commerce Commission and formerly Chairman of the Wisconsin Commission, says of this matter "The whole State of Wisconsin was streaked and plastered with discrimination in the rate utilities" and it has been estimated that this favoritism cost the Wisconsin Companies some $2,000,000 annually. In New York State the railway and lighting companies, which were accustomed to con- tribute liberally to campaign funds, have practically discontinued doing so since the commissions were appointed, resulting in a purification of public affairs, regarding which there is no question. The Governor of Wisconsin in a recent statement said: "As evidence of prosperity under commission regulation the last an- nual report of the Wisconsin Commission shows that during the year the operating revenues of electric utilities increased 20 per cent., their net income 29 per cent., and new construction for the year 145 per cent. The operating revenues of water utilities meanwhile increased 7 per cent., their income 13 per cent., and new construction 24 per cent. Gas utilities increased their operating revenues 3 per cent., tlieir net income 15 per cent., and new construction 24 per cent. Telephone utilities in- creased their operating revenue 11 per cent., their net income 9 per cent., PUBLIC SERVICE COMMISSIONS 43 and construction for the year 14 per cent. Railway and traction lines on the average increased their operating revenues 13 per cent., their net income 8 per cent., and construction an equal amount. All utilities in Wisconsin are in a more flourishing condition now than ever before and are planning to extend their operations far into the future. Taking a longer period, as we may in the case of railway regulation, which was begun earlier, the results are even more striking. For the fiscal year ended June 30, 1905, the total mileage of railroads in Wisconsin was 6931 and the total operating revenue $50,144,702.43. This was the year im- mediately before commission regulation of railroads began. Five j'ears later, or during the fiscal year ended June 30, 1910, the total mileage had increased to 7209, an increase of 278 miles, and the total operating revenues amounted to $65,055,928.76, an increase of nearly $15,000,000. Thus, notwithstanding the decrease in transportation rates and improve- ment in service enforced by the Railroad Commission, the operating revenues of the railroads of Wisconsin increased approximately 30 per cent. As an indication of the general prosperity of the State meanwhile it may be worth mentioning that under these new poUcies the deposits in commercial and savings banks in Wisconsin increased in round numbers during this five years from $187,000,000 to $276,000,000, or 51 per cent." Progressive and honest corporation management working with a fair and intelligent Commission will accomplish the best things both for the corporation and the public. That this view^ is being accepted by the corporation men themselves is indicated for ex- ample by the following quotation from the last annual report of President Vail to the Stockholders of the American Telephone & Telegraph Company : " Public control or regulation of Public Service Corporations by perma- nent commissions has come, and come to stay. State control or regulation should be of such a character as to encourage the highest possible stand- ards in plant, the utmost extension of facilities, rigid economy in opera- tion, rates that will warrant the highest wages for the best service, and such certainty of return on investment as will induce investors not only to retain their securities, but to supply at all times all the capital needed to meet the demands of the public. Such control and regulation can and should stop all abuses of capitalization, of extortion, of overcharge, or of unreasonable division of profits." The remarkable commentary to be made on the preceding is that the good work being accomplished by Commissions and the justice of their orders and rulings is based on an appraisal of the properties under their supervision, already made or tentatively assumed, w^hich establishes the essential fairness of their decisions. 44 VALUATION OF PUBLIC UTILITIES The National Association of Railway Commissioners believing that the first step to be determined, in fixing the basis upon which a carrier can fairly claim the right to earn, is a "true and reliable valuation of the tangible properties" and in order to ascertain exactly what had been done in the way of physical valuation and taxation of railways by the different states, sent a communication to each, receiving the following interesting replies.^ Arkansas. — No valuation unclertaken. Arizona. — Commission just created. Connecticut.— No physical valuation ever made. The properties are taxed as follows, quoting from letter: " The value for taxation is ascertained by adding the amount of bonds and floating indebtedness to the market value of the stock. In case of a line running into more than one State, the statutes provide for prorat- ing the value according to mileage ; also for deductions of amounts spent for properties wholly within the State." California. — No valuation undertaken by the commission. Properties are taxed on the ad valorem basis. Values fixed by the State Board of Equalization. Colorado. — No physical valuation ever made. Properties are taxed on the ad valorem basis as follows: Railroad companies make returns to the state board of equalization, showing — First. — Stock and bond value of entire road, crediting to Colorado its mileage proportion of main track within the State. Second. — Capitalization net earnings in Colorado on an 8 jier cent, basis. Third. — The physical value as returned by the corporations them- selves. An average of three above values is taken as the basis for taxation. Florida. — Nothing done by the Commission in the matter of valuing properties. Georgia. — No physical valuation ever made. The value for taxing purposes is made by the comptroller-general. In case any dispute arises with the railway company as to the value fixed by him, a board of arbitrators is provided for. Iowa. — Nothing has been undertaken by the commission. Illinois. — No valuation undertaken by the commission. Properties are taxed on the ad valorem basis, the valuations being fixed by the state board of equalization. Indiana. — No physical valuation has been undertaken. Idaho. — Has no commission. * Proceedings of the twenty-first Annual Convention National Association of Railway Commissioners. Nov. 16-19, 1909. J PUBLIC SERVICE COMMISSIONS 45 Kansas.^No physical valuation has been undertaken. Properties are taxed on the ad valorem basis by the state tax commission. Louisiana. — No valuation undertaken. Maine.— The commission is not charged with the duty of valuing the railroad property. Michigan. — The state tax commission has made a complete physical valuation for taxation purposes. Missouri. — No physical valuation ever made. The state board of equalization values the property for taxing purposes by fixing an arbi- trary assessment per main-line mileage, terminals valued separately ; also fixing a franchise value; quoting from the letter of the commission as follows : "In short, the railroad property in this State is assessed on its main- line mileage, its terminals, and its franchises, but no rule has been adopted by which the values used are ascertained. Missouri law requires all property to be assessed at its actual cash value, but it has become the practice in this State to assess upon a valuation which shall secure revenue sufficient to supply the needs of each county; hence it is that there is no uniformity in the assessment, each county being assessed as the needs of the county demand." Montana. — No valuation ever made. ]\Iassachusetts. — The board has not attempted any valuation for rate-making purposes. Properties are taxed upon the ad valorem plan. The information contained in the letter from the tax commissioner throws so much light upon tlie taxing of railroad property that it is given in full, as follows: "The theory of the Massachusetts law is that the taxable value of a railroad is properly found by ascertaining what the public will pay for the railroad upon our tax date, namely. May 1. What the public will pay is easily computed by multiplying the number of shares outstanding by the price at which these shares sell on the market on ]\Iay 1. The result of such a multiplication is a value called in our statute ' the value of the corporate franchises.' We ehminate from this value such part of it as is proportional to the fraction of the mileage of the railroad situ- ated outside of this Commonwealth upon the theory that for the pur- poses of taxation Massachusetts is not concerned with the value of the railroad not in Massachusetts. From the value remaining after this deduction, we deduct further the value of the real estate and machinery of the railroad taxed by the cities or towns of Massachusetts through which the railroad passes or in which it owns such real estate and machinery. Machinery in this connection is onlj^ such fixed machinery as is attached to or erected upon real estate owned by the corporation. Every railroad corporation operating in Massachusetts has been given bv the Commonwealth a right of wav five rods wide all of the distance 46 VALUATION OF PUBLIC UTILITIES between the terminals. The cities and towns are not allowed to tax the corporation for any real estate or machinery within this right of way. The cities and towns, therefore, tax the corporations only upon such real estate and machinery as is owned by the corporation outside of this right of way. To give a concrete example of the method by which the tax is computed we will assume that a railroad corporation has out- standing upon May 1, 100,000 shares of stock which are selling in the market on that day at $200. The value of the corporation franchise of this railroad is found to be, therefore, $20,000,000. We find that one-fourth of the mileage of the railroad is outside of Massachusetts. Therefore, we eliminate one-fourth of this $20,000,000 and have a resulting value of $15,000,000. The cities and towns of the Common- wealth report to us in the aggregate that they tax the corporation upon real estate and machinery owned by it within their limits of $7,000,000. We subtract this $7,000,000 from the $15,000,000 and have left $8,000,000 as being the value of the corporate excess upon which the Commonwealth assesses a tax at the rate prevailing for the given year. The rate this year is $17.35 per thousand of valuation. " It thus appears that a railroad corporation pays taxes, first, to the cities and towns in which it owns real estate and fixed machinery, and, second, to the Commonwealth upon whatever other net value (if any) is shown by the selling price of its shares of stock. "The value of the real estate and machinery of the corporation situ- ated in the cities and towns is determined in every case by the board of assessors elected by and serving each city or town. ' Other than as herein specified there has never been made any de- termination of the value of the property of railroad corporations in Massachusetts." Minnesota. — The commission has undertaken to make a physical valuation of all the railway properties. This was completed December 20, 1908.- The cost of the work averaged $8.12 per mile of main line roadway. The railway properties are taxed upon the gross earnings basis. New York. — First district: Confined to New York City and comprises the city railway lines. The public-service commission has undertaken a physical valuation of the above properties. This is now nearly com- pleted. These values are for use in any proper case in which values are one of the factors. Second district: The commission has as yet not undertaken the work of valuing railroad properties. New Jersey. — No valuation has been undertaken by the commission. A special commission has been named which is now engaged in valuing the property for taxation purposes. New Hampshire. — No valuation has been made. PUBLIC SERVICE COMMISSIONS 47 North Dakota. — No valuation undertaken. Nevada. — No physical valuation has ever been made. The following extract from the letter of the commission indicates' how the taxes are levied and affords an example showing the advantage of having a reli- able valuation made : " The 'taxation of railroads in Nevada is fixed by the State Board of Assessors, composed of the assessors of each county, with the governor presiding, which meets on the second Monday of January each year. At every meeting of the board each railroad is taken up separately and the valuation of the same is fixed at the discretion of the board, the capitalization, bonded indebtedness, cost per mile, and earning power of each road being taken into consideration before an assessment is fixed. '■ At the last meeting of the board of assessors, held on the second Mon- day of January, 1909, the governor called upon the railroad commission for such data as it had concerning the valuation and earning power of all railroads operating in the State. This information was readily furnished by the commission from the annual reports on file, and from testimony submitted by several of the companies in suits that were pending at the time in the United States circuit court, wherein the railroads were attack- ing the maximum freight rates fixed by the railroad-commission law of 1907. This testimony tended to show the high valuation of railroads in Nevada, for the purpose of rate making and was greatly at variance with the figures submitted by the several companies before the board of assessors for the purpose of assessment. "As an example of the great disparity between the assessed valuation of railroad property and the value of the same for rate-making purposes we will cite the case of the Central Pacific Railway, leased by the Southern Pacific Company. In the affidavits of Mr. C. B. Seger, the auditor of the Southern Pacific Company, it was testified that the value of the Central Pacific Railway in Nevada was 166,253,187.21, or $146,936.73 per mile of line, while the assessment of this property in 1908 was, on the main line, $17,500 a mile, and on sidetracks, rolling stock, and other property the value was fixed at $6,691.36 a mile, mak- ing a total assessment of $24,191.36 a mile as against the value for rate-making purposes of $146,936.73." Oklahoma. — The commission is now engaged in making physical valuation, expecting to have same completed within two years' time. Ohio. — No physical valuation has ever been made. Properties are taxed on the ad valorem basis and are valued by boards of county auditors of the counties through which the road runs. These assess- ments are afterwards passed upon by the state board of equalization. The value as fixed by this board is afterwards apportioned to each county on a mileage prorate. 48 VALUATION OF PUBLIC UTILITIES Oregon. — The commission is now engaged in making a physical valuation of all the railway properties. Properties are taxed on the ad valorem basis, the valuation being fixed by the various county assessors. Pennsylvania. — No physical valuation ever made. Properties are taxed on the ad valorem basis and are valued by the auditor-general taking the average market value of the stocks and bonds each year. Rhode Island. — No valuation undertaken by the railroad commis- sioner. Railroad property is taxed on the ad valorem basis, the values being fixed by each town separately, the various towns taxing the railroad property located within their respective territory. South Dakota. — The commission is now engaged in making a com- plete physical valuation of the railroad properties. South Carolina. — No valuation undertaken by the commission. Properties are taxed on the ad valorem basis. The value is an arbitrary one, being fixed by the comptroller-general, secretary of state, attorney- general, state treasurer, and chairman of the railroad commission. Texas. — The commission undertakes to value all the physical proper- ties of the railway company and keep the values corrected up to date. These values are made with a view of being used by the commission chiefly for regulating the use of stocks and bonds. The values are available for and are used by the tax commission when undertaking to fix the values for taxing purposes. Vermont. — No valuation undertaken. Wisconsin. — No valuation made by the railway commission. Prop- erties are taxed on the ad valorem basis and a complete physical valu- ation has been made by the tax commission. Wyoming. — No railway commission. Washington. — Complete i^hysical valuation has been made by the commission. In this State the commission has gone farther than the authorities in any other State, in that the values after having been completed have been separated, showing the value to be assigned to the state uses and interstate uses when being considered for rate-making purposes. CHAPTER IV MAKING AN APPRAISAL General. — An appraisal of utility property is essentially a piece of engineering work, but it involves qualifications broader than mere construction, more exacting than making ordinary- examinations and reports. The object to be attained is a definite, logical one — ^namely, to ascertain a fair value at a given time, for particular, specific property. Yet the attainment of the object sought, is at best difficult, and usually impossible of exact precision, owing to the fact that no two properties are exactly alike, prices fluctuate, the personal equation varies, property conditions are changing, the workmen are liable to err, self- attainment is ever present, the object sought tends uncon- sciously to prejudice the expert favorably or unfavorably, and diverse interests bring pressure to bear so that under these various influences the individual honestly endeavoring to obtain a just, final and single figure, will probably find the result differs from that of another expert equally honest and industrious, the difference between them depending on the dissimilarity in methods, effort, experience, prejudice and influence. From an engineer's standpoint, it would seem as if the making of an appraisal would result in but one set of figures, and that the engineer is not interested in the purpose for which the valua- tion is undertaken. To a limited extent, this is correct, but as more fully explained in another chapter, value has several modifications of meaning, and the particular value as determined by the purpose of the appraisal, must be clearly understood and appreciated by the individual in charge of making the valuation. There can be but one value, one set of figures truly representing original cost, reproduction cost at a given time, or present worth of property in a given condition, but while there is one set of figures for each value there may be several values. There should be no confusion of thought or misapprehension as to the fact that there is only one legitimate definite value for property, estimated on a given basis. Original cost for a particu- lar machine will be always the same, but its reproduction value will vary from year to year, depending on the conditions of the 4 49 50 VALUATION OF PUBLIC UTILITIES market, in the same way the present value will depend upon whether or not repairs and up-keep have been well maintained or the parts allowed to deteriorate so that deferred maintenance is apparent. Thus it will be seen that while the valuation of property is primarily an engineering calculation, the value finally sought will depend upon the basis of the valuation. That the particular value, as original cost, replacement cost or present value, which may be sought in any given investigation will not and must not be modified by the purpose for which it may be used or the effect it may produce goes without saying. Perhaps such statement is superfluous, in view of the engineer's code of ethics, but the thought needs emphasis in view of the frequent irreconcilab^'lity of engineering figures, and the too prevalent and sarcastic comments on the unreliability of all expert opinions. The following points have been quite generally accepted as forming the theory or basis on which to proceed in making an appraisal: (a) Ascertain, and keep clearly in mind the particular value to be determined in order that an intelligent appreciation of the end, and purpose of the appraisal may be fully accomplished. An individual in charge of an appraisal cannot be looked upon as a mere machine, and the weakness of many valuations has been due to the fact that the engineer in charge has been so considered. He has been instructed to ascertain a certain particular fact, one of the several parts going to make up the complete answer, and in consequence, failing, perhaps, to fully understand the entire matter, or precluded from offering suggestions or advice which in many instances would be invaluable, there has resulted an incomplete solution of the problem which always causes dissatis- faction, and sometimes disaster., (b) Thoroughly appreciate that an appraisal is not- made for the purpose of ascertaining a "scrap" or "junk" value of the property unless under exceptional conditions, as more fully explained in the discussion of depreciation. Valuation work is usually for the purpose of ascertaining the worth of property, either in its service to the public or for purposes of sale, or taxa- tion as an operating entity. Therefore the value that physi- cal elements of the property may have, separate and apart from the other elements, or for use in some other place, for a different purpose, is not the usual value desired when making an appraisal. MAKING AN APPRAISAL 51 "The true value of a line of railroad is something more than aggre- gation of the values of the separate parts of it, operated separately. It is the aggregate of those values plus that arising from a connected operation of the whole, and each part of the road contributes not merely the value arising from its independent operation, but its mileage pro- portion of that flowing from a continuous and connecting operation of the whole. The value of property results from the use to which it is put, and varies with the profitableness of that use, past, present and prospective, actual and anticipated. There is no pecuniary value out- side that which results from such use. " In the nature of things it is practically impossible, at least in respect to railroad property, to divide its value and determine how much is caused by one use to which it is put and how much by another." ^ (c) Realize that the final figures obtained as the result of an appraisal should be free of all doubt as to their reliability, in order that their sponsor may be able, if necessary, to satisfactor- ily stand cross-examination in a Court of law. Such figures can only be obtained through the application of methods that are eminently fair, conservative, wrought out with an expenditure of the necessary time, reasonable care and in sufficient detail to insure accuracy and correctness. Aside from experience in engineering work, the knowledge of Court procedure, clear cut conceptions of value, with a high sense of fairness, and integrity will be found helpful in preparing estimates of value. (d) Understand that throughout the progress of the work, it will be found necessary to exercise tact, judgment, equipoise and patience, aside from having the necessary qualifications in the way of engineering experience, conscientiousness, persever- ance, and good common sense, so that the final figures represent the appraiser's honest opinion of the value of the property under local conditions. In making appraisals there is a constant tendency to confuse original cost with cost to reproduce new, at the time of the ap- praisal. The extent to which this error exists, even among those supposed to be authorities, is remarkable. For example, in some of the decisions of the New York Public Service Commis- sion First District, the cost to reproduce new or present value of machinery, apparatus and buildings, is used in connection with assessed value, or original cost of real estate, to obtain what is ^ Cleveland, Cincinnati, Chicago and St. Louis Railway vs. Backus 154 U. S., 444. 52 VALUATION OF PUBLIC UTILITIES indicated as reproduction cost. In a similar way, the Wisconsin Railroad Commission ordinarily estimates the deficit from opera- tion or cost of building up the business of a corporation during the early years, which amount it uses, in connection with the appraised value of the physical property on the basis of reproduc- tion cost, in order to obtain the total value of the property in question. As has been suggested elsewhere under " Going Value" such procedure w^ould seem illogical, in that the physical property has been valued on the theory of the cost of reproduc- tion, while the capitalized deficit, or going value, is made up from a consideration of the past history of the company, based on actual costs, where obtainable. Theoretically there is no reason why the cost of building up the present business, like the value of the physical plant, should not be based on an estimated cost of reproduction. Original cost, cost of reproduction, new and present values are not synonymous, and cannot be mingled indiscriminately. All three values are of service in determining the fair value of property, but no single one of these three is the only fair value. The courts have held that while original cost is of use in determining fair value, it is not the only controlling factor; they' have indicated that cost of reproduction, at any given time, shall be considered as one of the standards of value, but they have not suggested setting up a standard which is a com- bination of these two separate and distinct bases of valuation. Cost of Appraisals. — ^The expense of making an appraisal will naturally depend on the extent of the property, the thoroughness with which the work is to be done, and to a lesser degree, upon the time allowed, and the grade of men employed on the work. An appraisal to be used for the purpose of opening new ac- counts, can be made rather general and, of course, would not be nearly as elaborate and expensive as an appraisal to be submitted to a Public Service Commission, as a basis of fixing rates. Prop- erty that represents a considerable investment and is of a uniform type, so that the inventory is brief, and the unit prices few, can be appraised at an expense of not over 20 to 30 cents per thou- sand dollars, of property valued. On the other hand, where there are many structures of various types, with expensive but unexposed foundations, many and varied elements, making the compilation of the inventory and the determination of the unit prices, an arduous and time-consuming task, the expense of the appraisal work may run up to a dollar or more per thousand MAKING AN APPRAISAL 53 dollars, of property valued; from 60 to 75 cents per thousand dollars, is usually considered a very satisfactory cost for the appraisal of large lighting, traction, and similar properties, but considerably lower figures obtain for steam railroad valuation. The figures given, of course, do not include any expenditures for court proceedings, arbitrations, expert testimony, or counsel fees. The appraisal of the railroads by the Railroad Commission of Texas in 1894 and 1895, covering 8860 miles and appraised at $15,844 per mile, has been estimated to have cost about $2 per mile. In that case, the railroad companies furnished the ap- praisers with maps, profiles, construction records, estimates of quantities, and such other information as was available, thus saving considerable expense, although inspectors personally examined the property, checking the measurements of structures and estimating quantities. The Minnesota State appraisal of the steam roads cost 8.12 per mile of main line. The following has been stated with regard to the cost of the valuation of the Michigan Railroads, appraised at an average of SI 5,290 per mile of single track, exclusive of the non-physical elements, first made in 1900, under the direction of the State Legislature: "No complete statement of the total cost of the work of valuation in Michigan has ever been issued as a public document. The cost of the work, including salaries of appraiser, engineers, assistants, clerks, all expenses of the Board of Review, all expenses connected with Pro- fessor Adams' non-physical appraisal, also all office rent, stationery, supplies, telegraph, telephone, and railroad expenses, printing and binding — in short every dollar chargeable to the Michigan railroad appraisal of 1900— footed up to $70,60^.21. The exact mileage of roads in the State was: Main track 7,082.35 miles Second track 164.83 miles Branches 730.92 miles Spurs and sidings 2,904.70 miles Total 10,882.80 miles Average cost per main-line mile $9.97 Average cost per total track mile 6.50 "The exact figures of cost of the subseso .20 .10 ).00 .90 .80 .70 .00 K50 .,40 :so 1 2T-f- I 1 3 — t 1 .00 ^ ' ' .90 .SO ,70 .60 ■i — I — t .60 .10 .30 .20 J 1 .00 i 1 .CO .50 .40 — I r ' l/ - .30 .10 .00 .90 .80 TT - .70 ^ 1 .00 .i>0 I .40 .30 1 1 .10 .00 .90 .80 .70 .CO >,50 .40 •30 • 20 .10 .00 h \ IIUJ ) .90 .80 "T .CO L50 .40 j^t 1 1 .20 1 t.oo i .80 }.b0 i .40 T" i .30 .20 v^^ e .10 J.OO ; 1 Jan. 1905 $1.80 1.60 ^1.40 I u Q> ft 1.20 o o ^1.00 0.80 0.60 July 1905 Jan. 1906 July 1906 Jan. _ July 1907 1907 Jan. 1908 July 1908 Jan. 1909 July 1909 j j j k , k ^ ^ ? j ; ; 3f X (■*. ■> t . e-$0.995- ■> t . l^„ > ' X :: : X . e Jan. July Jan. July Jan. July Jan. July Jan. July 1905 1905 1906 1906 1907 1907 190S 1908 1909 1909 Fig. 2. On the accompanying insert page are given curves showing the fluctuations in prices of cast iron pipe and certain metals during the past 13 years, and also Portland cement prices for 31 j^ears to date. The wide fluctuations in the price of copper, the uni- form price of steel rails, since the control of prices by the steel STRUCTURAL COSTS 67 corporation, and the gradual reduction in the price of cement, are noteworthy and interesting. As indicating the method of ascertaining average prices, the data used by tiie author in de- termining a fair average price for insulated lead-covered cables for use in an appraisal made in 1909, are shown in Fig. 2. The prices actually paid, for the particular class of cable indicated, by a number of different corporations in New York City, were first averaged for each, usually the result being plotted, as of January, in each year. Then the average of the total was obtained from a consideration of prices, regardless of the quantities of cable purchased, as indicated by the straight line. From a study of these curves, it will be seen that great injustice may be done by taking the momentarily low price of an article, which fluctuates widely. Even averaging the price for a five year period does not always result in strict justice to either the corporation or the public. For example, the price of copper varied from a minimum of 11.5 cents per pound in 1902 to a maximum of 25.1 per pound in 1907. If an appraisal were taken during the year 1908, when the price was under 16 cents per pound, injustice would be done the corporation if it had purchased a large amount of copper in the early part of 1907 at the prices then existing. Similarly, the use of the prices of 1907, in the appraisal of corporation copper which had been purchased in 1904 and 1905, would be unfair to the pul:»Iic. Valuing cable which cost over $1.50 in 1907, at 99.5 cents, is to an extent un- fair to the corporation. On the other hand, if purchased for less than 80 cents in 1908 the price of 99.5 is unfair to the public so that only reasonable justice can be expected or meted out by using the average prices. Engineering Contingencies, Omissions, Etc. — It has become an accepted rule, in valuation work, to add a general percentage to the " general contractor's cost " or the " base cost " of the physical property, to cover the exj^ense of engineers' or architects' fees, contingencies, incidentals, omissions of inventory, errors, city inspection, administration and legal expenses during construc- tion, with other similar items. The percentage allowed may vary between wide limits, from a minimum of 8 per cent., customarily used by the Wisconsin Commission to cover all of these items to as high as 10 per cent, for contingencies and incomplete inven- tories alone, allowed in the State valuation of the Michigan Railroads. For engineering and architects' fees, 5 per cent, is 68 VALUATION OF PUBLIC UTILITIES by far the more usual allowance, and if applied to all the physical plant, aside from real estate and supplies, is fair and reasonable. It is quite customary, and usually necessary, both for individ- uals and corporations where doing construction for private use, or public service, to employ engineers and architects. The charge for such services rendered is usually based on the cost of the work which is supervised. The architects' charges have been more or less of a standard for the other professions, so that the following extract from the ''Schedule of Charges" recently adopted by the. New York "Local Chapter" of the American Institute of Architects, is an interesting guide as to such charges: 1. The Architect's professional services consist of the necessary con- ferences, the preparation of preliminary studies, working drawings, specifications, large scale and full size detail drawings, and of the gen- eral direction and supervision of the work, for which, except as herein- after mentioned, the minimum charge, based upon the total cost of the work complete, as estabhshed by the American Institute of Architects, 1908, is 6 per cent. 2 Residential work: Private dwellings within the limits of the city of New York, On the first $50,000 of cost 8 per cent. On the balance of cost, the minimum fee of 6 per cent. Private dwellings outside of the city of New York, in- cluding stable and other dependencies. On the first $50,000 of cost 10 per cent. On the balance of cost 8 per cent. (The graduated commission applies only to the above two classes of residential work.) 3. Monumental, decorative and landscape work, special interior and cabinet work, alterations to existing buildings, in all cases whether in connection with fed- eral, municipal, or other work 10 per cent. 4. Designs for fabrics, furniture and fixtures, lighting fix- tures, and special decorative work 15 per cent. 5. Articles not designed by the architect, but purchased under his direction 6 per cent. The engineers, whether electrical, mechanical or civil, have usually charged 5 per cent, for entire supervision similar to the architects, although they have not held too uniformly to this rate as they are not bound together by jDrecedent and organi- STRUCTURAL COSTS 69 zation as strongly and historicalh' as are the architects, so that even 10 per cent, or 12 per cent, is sometimes charged. Where organizations have kept an exact record of the cost of doing their own engineering, it has been found that such cost will not usually amount to much less than 5 per cent, on the cost of the property engineered. Except with respect to very large investments and investments of certain character, such as subways or complicated constructions, the percentage may run considerably above 5 per cent, as evidenced by the following : "The engineering cost of the Rapid Transit Commission (New York City), from June 1, 1900, to July 1, 1907, was 6 per cent. The engineer- ing cost of the Pennsylvania Railroad for its tunnels (under the Hudson and East Rivers and the Island of Manhattan) was 5.8 per cent.; of the Boston subway, 9.9 per cent.; the Boston tunnel and subway, 9.17 per cent.; and the East Boston tunnel, 6.17 per cent.; the engineering cost of the Center Street subway, practically completed under the Pubhe Service Commission (New York City), was 6 per cent.; the present engineering cost to date of the 4th Avenue subway, not yet completed, is 7.8 per cent., and the evidence shows the total charge will run down to at least 6 per cent. "The expense of making the Tri-Borough plans was $4.54,823.47, and upon a basis of a cost to construct said subway of $120,000,000, the engineering expense would be 0.37 per cent. The engineering cost of preparing the plans of the Pennsylvania tunnels was 0.7 per cent." (It should be noted that the last two items of expense given do not cover the whole engineering expense involved.) ******* " My own conclusion is that the engineering expense of the Commission has been reasonable and if the great number of new subways which the city needs are to be constructed under the jurisdiction of the Public Service Commission, the people of the City of New York must expect that the engineering cost will run about 6 per cent, as in the past."* The Railroad Commission of Wisconsin allows 5 per cent, to cover engineering, based on the cost of all physical property, except stores and supplies, whether for gas, electric, railway, telephone or water-works corporations. The Public Service Commission, First District of New York, has been accustomed to allow 5 per cent, for engineering, and a total of 15 per 1 Report dated May 31, 1911, to Gov. John A. Dix by John X. Carlisle, page 6. 70 VALUATION OF PUBLIC UTILITIES cent, to cover all the items, engineering, omissions, adminis- tration, etc., which is added to the cost of physical property, except real estate, rolling stock and stores and supplies. The Traction Valuation Commission of Chicago similarly allowed 5 per cent, for engineering, and on most property a total of 15 per cent, for engineering, incidentals and organization, except on rolling stock, tools, supplies and real estate. The St. Louis Public Service Commission allows 5 per cent, for engineering on all items of construction, except real estate. In the Consolidated Gas case the Master allowed 10 per cent, for "engineering and miscellaneous expense" on plant, which allowance was sustained by the Supreme Court decision. The United States Circuit Court of Ohio in the Columbus Railway & Light Co. case allowed 9 per cent, of the cost of the physical property for "general engineering, miscellaneous and other expense." In the appraisal of the steam roads the Railroad Commission of Washington al- lowed 3 1/2 per cent, on the cost of physical propert}-, aside from real estate, stores, equipment and working capital, to cover engineering. The same Commission in the Puget Sound Electric Railway case allowed 7 per cent, tor "superintendence by competent electrical engineers as distinguished from the services of construction engineers" and an additional 3 per cent, for "engineering and superintendence by constructing engineers." In the appraisal of the Michigan railroads for the State Com- mission 4 per cent, was allowed for engineering, based on the value of the permanent way and structure, but not the equipment. It has been argued that little or no percentage should be added to cover omissions of inventory or errors in pricing, when making an appraisal, on the ground that every item of the plant is recognizable and capable of identification. Theoretically this statement is correct, but estimates of reproduction must be recognized as quite different from estimates made on plans and specifications for work proposed to be done, which makes the quantities definite, whereas such exact information is frequently lacking when making an appraisal, and it is impossible to make full examination of buried structures. Any one who has had practical experience in the emploj'ment of the class of men that must be engaged in the making of inventories and applying prices, recognizes the absolute impossibility of including each item of physical property, and the accurate pricing thereof. To STRUCTURAL COSTS 71 test the truth of this statement, it is only necessary for one to attempt to list every item in a particular room within a limited but reasonable time; when the list is complete, a leisurely check- ing it over will almost surely disclose certain items which have been omitted. Experience shows that items aggregating thou- sands of dollars in value are frequently omitted from inventories that are made under the ordinary stress of appraisal work, so that a reasonable addition, covered by a percentage, must be provided if a fair appraisal is sought. This percentage allow- ance will vary from 1 or 2 per cent, to 15 or 20 per cent., de- pending upon local conditions. The Public Service Commission of New York, First District, has, with one exception, uniformly allowed 5 per cent, for con- tingencies, incidentals, incomplete inventories and administra- tion expenses, during construction. In the single instance referred to, no allowance for omissions of inventory or error in pricing, was considered necessary. The Wisconsin Commission quite regularly allows 3 per cent, to cover legal expenses prelimi- nary to construction, organization expenses, insurance, com- mission (not discount on bonds) and contingencies. 5 per cent, was allowed for contingencies in the state's appraisal of the Minnesota steam railroads. In the appraisal of the Chicago traction companies' properties, the Commission allowed 5 per cent, for incidentals, organization and incomplete inventories. The St. Louis Public Service Commission has allowed 5 per cent, for contingencies in addition to "some special percentages for contingency." Real Estate. — The proper value to be allowed for real estate and right of way in appraisals is a question on which there is a wide difference of opinion. There would seem to be no logical reason why real estate or right of way, belonging to a utility company, should be valued on any other »basis than that of similar property owned by an individual or corporation. It is undoubtedly true in many instances, that the building of utility properties, particularly railways, has increased the value of real estate to the owners of property adjoining, or in the vicinity of the new roads. In cases of sale or taxation, the increased value of such property is the only value considered, and it would seem as if the railway company, for example, should also benefit by the general rise in price. The acceptance of the theory that the corporation is entitled to increases in the value 72 VALUATION OF PUBLIC UTILITIES of its real estate logically includes the statement that any decrease in value of the property must be also accepted by the corporation. It is conceivable that the use of property for car-barns or gas-works might depreciate the value of land in the vicinity, which as a general rule should be taken as the gage by which to measure the value of utility property. This position has been repeatedly affirmed by the courts, including the Supreme Court, which quotes with approbation a lower court, as follows: " The value of the land depends largely upon the use to which it can be put, and the character of the improvements upon it."' Regarding the proper basis of evaluating real estate Judge Hough in the Consolidated Gas Case held as follows: "As to the realty, the values assigned are those of the time of inquiry; not cost when the land was acquired for the j^urpose of manufacture, and not the cost to the complainant of so much as it acquired when organized in 1884, as a consolidation of several other gas manufac- turing corporations. It is objected that such method of appraise- ment seeks to confer upon complainant the legal right of earning a fair return upon the land values which represent no original invest- ment by it, does not indicate land especially appropriate for the manu- facture of gas, and increases apparent assets, without increasing earning power. Analogous questions arise as to plant, mains, services, and meters; the reported values w'hereof are the reproductive cost less depreciation, and not original cost to the complainant or its predecessors. It appears by indisputable evidence that some of the last items of property cost more than new articles of the same kind would have cost at the time of inquiry; that some are of designs not now favored by the scientific and manufacturing world, so that no one now entering upon a similar business would consider it wise to erect such machines or obtain such apparatus. In every instance, however, the value assigned in the report is what it would cost presently to reproduce each item of property in its present condition, and capable of giving service neither better nor worse than it now does. As to all of the items enumerated, therefore, from real estate to meters inclusive, the complainant demands a fair return upon the reproductive value thereof, which is the same thing as the present value properly considered. To vary the statement: complainants' arrangements for manufacturing and distributing gas are reported to be worth the results above tabulated if disposed of (in commercial parlance) "as they are." Upon authority I consider this method of valuation correct." * * * 'Columbus Southern Railway vs. Wright. 151 U. S. 481. STRUCTURAL COSTS 73 "The value of the investment of any manufacturer in plant, factory or goods, or all three, is what his possessions would sell for upon a fair transfer from a willing vendor to a willing buyer, and it can make no difference that such value is affected by the efforts of himself or others, by whim or fashion, or (what is really the same thing) by the advance of land values in the opinion of the buying pubhc. It is quite immaterial that such value is affected by difficulties of reproduction." ******* "Indeed the causes of either appreciation or depreciation are alike unimportant, if the fact of value be conceded or proved." ******* "Nor can it be inferred that such (American) government intended to deny the application of economic laws to valuation of increments earned or unearned, while insisting upon the usual results thereof in the case of equally unearned, and possibly unmerited, depreciation."^ In the Kansas City Stock Yards Case, the Circuit Judge quotes the Supreme Court: "It is not always reasonable to cast the entire burden of the depreciation on those who have invested their money in railroads" and adds: "The converse of this proposition is equally true. If the investor may not bear all the burden of the depreciation, he should not enjoy all the benefit of the appreciation." "If improvements made in the vicinity of the property, the growth of city or town where it is located, the building of railroads, the development of the surrounding country and other like causes, give property an increased value, the owner cannot be deprived of such income by legislative action which prevents him from realizing an income commensurate with the enhanced value of his property."^ Some argument has been advanced that the proper basis of valuation is the assessed value, but as such value is usually a conservative, and ''hard-times" value, below the price at which property can be purchased under ordinary conditions, it is not a proper basis of valuation, except for taxation purposes where the real estate of corporations should be placed on the same basis as other real estate. An appraised value of real estate, which depends on the opinion of experts, will usually be found to be a very variable quantity. 'Consolidated Gas Company vs. City of New York. 157 Fed. 849. 2 Cotting vs. Kansas City Stock Yards 82 Fed. 839, 846. 74 VALUATION OF PUBLIC UTILITIES While the best experts base their opinions on some knowledge of actual transfers, a large element of personal judgment usually enters into their conclusions. Probably the safest method to pursue in determining the perplexing question of land value, is based on a study and comparison of bona fide sales of land adjoining or near the property being valued. In many instances, however, such method cannot be used in that property may have been held for years, in large tracts, without change of ownership. Under such circumstances, the judgment of the real estate expert is probably as fair a guide as can be used in determining values. The Railroad Commission of Wisconsin has devoted much time and study to the proper method of determining real estate and right of way values. It has found that railways are "willing to pay two and a half to two and three-quarter times the market price of land, before they will use their power of condemnation in rural districts," but this value is largely due to the necessity of buying a comparatively narrow strip, perhaps 100 ft. wide, running through the land. In the well-known Madison case, the Wisconsin Commission's engineer, Mr. W. D. Pence, sub- mitted a memorandum fully explaining the methods used by the engineers of that Commission, which methods are approved by the Commission, and therefore here quoted at length. "The Sales Method. — The sales method of valuing real estate was used partially in the Michigan railwa}' appraisals of 1900-1901, and in the light of the experience gained in that work the method was adopted in the Wisconsin steam road valuation made under the provisions of the Ad Valorem Assessment Law of 1903. It has since been exten- sivelj' used in Wisconsin and elsewhere in connection with important valuations of public service properties for both rate-making and taxation purposes, and is generally accepted as a valuable aid to the judgment by experts engaged in such valuation work on a large scale. The sales method may be defined as a plan or process for the systematic collection and comparison of data relating to real estate transfers for the purpose of estimating true market realty values. It consists in a study of the transfers of neighboring property having conditions or characteristics similar to the land whose value is to be determined, and is intended to duplicate, as nearly as may be, the mental or judicial processes ordinarily employed by the so-called 'local real estate expert,' with a view to arriving at results approximating those which would be reached by such local expert acting without bias or suggestion. The sales method is capable of application in a variety of ways; in fact, is STRUCTURAL COSTS 75 as flexible in its possible applications as are the varied methods employed by individual local experts. Two interpretations of the sales method have been most commonly employed. In one of these the area and consideration in each sale of similarly situated land is found, and the average unit price (per sc^uare foot, per foot frontage, per lot, per acre, etc.), ascertained, and this unit applied to the tract under investigation. The other application of the method introduces what, in many cases, is believed to be an additional safeguard, consisting of the use of the average assessed value of adjacent or similarly situated lands, in com- bination with an average ratio or percentage representing the rela- tionship of the assessed value of transferred lands to the total con- sideration paid for such transferred lands in the district or locality under consideration, all of these figures being based on the 'ground values' exclusive of the improvements thereon. Such use of assess- ment figures is designed to introduce, as far as may be, the results of the judicial processes of the assessor, who, at least in theorj-, serves^ on behalf of the public as an unbiased expert in the matter of relative ' valuations, and who attempts to make allowance for the pecuUar attributes or characteristics of individual parcels of real estate in any given locality or neighborhood -of a city. In the broader and more flexible applications of the sales method, the expert adopts one or the other of the processes just outlined, or blends the two together in such fashion as to yield the most consistent and trustworthy final result. In the process of valuing a tract of land involving conflicting data, as in the case under consideration, the expert user of the sales method on this flexible basis derives a series of tentative results similar to the results representing the judgments of individual local experts. The judicial function involved in the discriminating selection of data and in the derivation of final results is exercised along essentially parallel lines with the two classes of experts here compared. The further act of the judgment in selecting a final preferred valuation figure in the light of a group of preliminary or tentative results is identical in the two cases. In the particular valuations here considered, the similarity of the basis is further emphasized by the fact that the results by the sales method represent the composite judgment of four members of the Commission's expert staff, as against an equal number of local real estate experts employed by the company. The foregoing state- ment relates to the revised or final figures submitted at the conclusion of this memorandum, these figures replacing the preliminary or tentative land valuations formerly submitted on behalf of the Com- mission's staff. Although it is frankly conceded that the tentative land valuation figures first reported were derived bj^ a comparatively restricted application of the sales method, issue is here taken with certain claims made in the argument by counsel for company. In view 76 VALUATION OF PUBLIC UTILITIES of the repeated favorable reference by counsel to the judgment of the assessor with respect to relative values ('Argument on Behalf of Company,' pp. 30, 31, 32, 37, 39), the criticism of a similar use of the assessor's judgment by the Commission's experts need scarcely be considered, except with respect to the misapprehension by counsel ('Argument,' p. 43), as regards the fluctuation of the assessment ratio in MacUson. Entirely aside from the claim that assessment ratios should not be depended upon in making land valuations, counsel contends that, in any event, a general assessment ratio should not be used in the case under consideration, chiefly because of a supposed 'radical difference as between different sections or locahties' in the city of Madison. For the purpose of throwing some hght on this point, Mr. A. E. James, statistician of the tax commission, was requested to prepare a comparative exhibit based on Madison city sales for a period of years, classified with respect to kind or locality as follows: Group 1 Business section. Group 2 Best re.sidence .section. Group 3 Middle clas.s residence section. Group 4 Poor residence section. "Table A gives, in condensed form, the results of this investigation, which covered some 905 verified real estate transfers during the four year period, 1905-1908, with an aggregate con.sideration of approxi- mately $3,000,000. A somewhat similar, though less discriminating, comparison made in 1906 covering sale and assessment figures for the seven-year period ending with 1904 affords the following general average ratios for the four groups of property of 71 per cent., 67 per cent., 65 per cent, and 64 per cent., respectively, with an average for the aggregate for the seven-year period of 66.7 per cent. To bring the comparison still closer to the point at issue, 'locality ratios ' were cora- l)uted from carefully verified transfers within an area of some 26 blocks, including a district of from three to four blocks in all directions from the tracts owned by the ]\Iadison Gas and Electric Company. The results of these compilations for a period of six years, ending in 1908, are embodied in Table B, which also includes the revised general ratios for the entire city for the corresponding years. The ratio for the three years, 1906-1908, for which most recent data as to present values are available, average 65.6 per cent, local, as against 64.7 per cent, general. "The foregoing comparisons do not justify the claim of coun.sel with respect to the extreme variations at Madison. The contrary appears to be the case. "The question as to whether the general or local assessment ratio should be applied, or assessment figures be used at all, depends entirely STRUCTURAL COSTS 77 on circumstances which the expert, famihar with the use of the sales method, will investigate and take into account before reaching his final judgments as to the value of a given tract of land. In this particular instance the values of the local and general ratios chance to differ but little. TABLE A.— COMPARISON OF ASSESSMENT RATIOS WITH REFER- ENCE TO KIND OF PROPERTY. BASED ON A SECTIONAL DISTRIBUTION OF MADISON CITY SALES. Year Group No. of sales Total assessment Total con- sideration Assess't ratio per cent. 1905 1 2 3 4 4 54 68 152 $16,400 127,365 126,870 200,225 $26,100 188,321 203,555 354,614 62.83 67.63 62.32 56.47 Total sales, 1905 278 $470,860 $772,590 60.95 1906 1 2 3 4 10 41 47 110 $52,100 97,470 91,650 144,880 $82,600 143,100 132,038 224,400 63.08 68.10 69.41 64.56 Total sales, 1906 208 $386,100 $582,138 66.33 1907 1 2 3 4 3 48 42 127 $21,200 151,520 104,570 199,158 $30,680 229.430 160,730 328,707 68.10 66.04 65.06 60.58 Total sales, 1907 220 $476,448 $749,547 63.58 1908 1 2 3 4 6 45 44 104 $213,000 140,770 78,200 157,000 $269,825 237.350 131,745 266,590 78.94 59.30 59.35 58.89 Total sales, 1908 199 $588,970 $905,510 65.03 05-1908 1 1 groups, 905 $1,922,378 $3,009,785 63.87 Summary for four years by 1905-1908: group 1. . . 23 (2%) 188 (21 %) 201 (22%) 493 (55%) $302,700 517,125 401,290 701,263 $409,205 798.201 628,068 1.174,311 73 96 2 64.78 63.89 59.71 3 4 1 Grand total, four years 905 (100%) $1,922,378 $3,009,785 63.87 78 VALUATION OF PUBLIC UTILITIES TABLE B. — COMPARISON BETWEEN ASSESSMENT RATIO FOR THE IMMEDIATE LOCALITY OF THE MADISON GAS & ELECTRIC COMPANY'S PROPERTY WITH CORRESPONDING VALUES OF THE GENERAL ASSESSMENT RATIO FOR THE ENTIRE CITY OF MADISON Year No. of sales Locality assessment ratio, per cent. Assessment ratio for entire city, per cent. 1903 6 8 9 3 4 10 62.8 75.2 61.6 61.1 68.9 66.8 64.0 1904 62.9 1905 62.0 1906 65.4 1907 63.6 1908 65.0 Average.... 66.1 63.8 "Calibration of Sales Method. — In viewof the close similarity as to fundamental basis of the sales method as compared with the local expert method of valuing real estate, particular interest and importance attaches to any specific cases affording a direct comparison of actual valuation results by the two methods made under normal or balanced conditions. The results of two such comparisons on a large scale are fortunately available for the present discussion, one involving some 300 blocks (more than 3 square miles) of representative residential property in the city of St. Paul, the other of some 500 acres of valuable railway terminal lands in the city of Milwaukee. "The St. Paul investigation was conducted by Mr. T. A. Polleys, .secretary of the Chicago, St. Paul, Minneapolis & Omaha Railway Company, who for a number of years had made extensive studies of real estate sales and valuations in Wisconsin, Minnesota and neighboring states. After serving on a committee made up of local real estate experts, charged with the inauguration of a reform in the basis of asses- sing real estate in the city of St. Paul, Mr. Polleys conceived of a plan for calibrating or testing the accuracy of the sales method of valuing lands, with a view of stimulating local interest in the matter. To this end he chose the district in the westerly portion of the city of St. Paul, comprising over 300 platted blocks, extending from Western Avenue on the east to Cleveland Avenue on the west (a distance of 3 1/2 miles), and from Marshall Avenue on the north to Osceola Avenue on the south (a distance of nearly a mile), as indicated by the shaded rectangle on the accompanying map. The district was selected for the reason that STRUCTURAL COSTS 79 the great activity for several preceding years would insure ample sales data upon which to base estimates of value, and because of the representative characteristics of the territory, such as the following: Values ranging from one dollar to over one hundred dollars per foot front; a portion of the lots built over and a portion vacant; some localities increasing very rapidly in value and others little or none; the area com- paratively uniform in topography, although somewhat broken in places; in short, a district affording a wide range of conditions for such a com- parative test. The process was directed to the determination of the correct average 'ground ' value per foot, exclusive of improvements, in a given year (1907) for a distance of one block along a given street, each block frontage being termed a 'locality' for the purposes of this test. The average ground values per foot front for each of the 277 'localities' was ascertained by a flexible application of the sales method, the work being performed chiefly by ]\Ir. PoUeys personally, who then requested some fourteen highly qualified real estate experts in the city of St. Paul to submit their estimates of the same values. In order to arouse interest in the investigation, Mr. PoUeys charted his own determin- ations and submitted duplicate copies of the same to each of the experts, with the urgent request, however, that they should not be influenced by his figures, and further that values be submitted only on those blocks where they had direct personal knowledge of values. The experts served without compensation, acted independently of each other, that is, without conference or collusion of any sort, and, so far as known, were entirely free of bias or suggestion in preparing their estimates of value. Of the fourteen experts invited some twelve submitted more or less complete responses, most of them asking for additional time for fuller dehberation as to values. The condensed results of this re- markable investigation are shown in the accompanying Table C, and the complete exhibit for a single representative street (Lincoln Avenue), comprising some 21 locahties, are given in Table D. In further illustra- tion of the methods pursued in these studies, there are submitted with this memorandum, in addition to the map, a copy of a paper describing this investigation (Real Estate Valuations, by Thomas A Polley.s — Proceedings Minnesota Academy of Social Sciences, Vol. I, pp. 59-7S, 1907). I am also able to submit as information, through the courtesy of ^Ir. PoUeys, the original figures of the twelve experts and the reduction sheets leading to the final comparative figures, these papers having been loaned to the Commission's engineer during a recent personal investigation of the conditions surrounding this test of the sales method. While on the ground, conference was held with the president of the St. Paul real estate exchange, who participated in the PoUeys investi- gation and who regards the sales method as an exceedingly valuable aid to the judgment, subject to limitations of a character in certain situations which are recognized and felt by all local experts who are called upon to value lands. 80 VALUATION OF PUBLIC UTILITIES TABLE C— COMPARISON OF RESULTS BY TWO METHODS OF VALUING REAL ESTATE (A) BY LAND SALES METHOD; AND (B) BY LOCAL EXPERTS. INVESTIGATION BY THOS. POLLEYS, AT ST. PAUL, MINN. Ciassification of Property Average value No. of per front foot blocks Excess (B) over (A) (A) (B) Amount Per cent. Group 1 Less than SIO per front foot .... 96 2 SIO to S20 per front foot , 69 3 S20 to S40 per front foot ' 82 4 Above S40 per front foot 30 Totals 277 S6.15 14.10 28.55 63.10 S6.70 15.45 29.55 63.20 SO. 55 1.35 1.00 0.10 9.0 9.6 3.5 0.2 S20.9O S21.75 I $0.80 3.8 TABLE D.— POLLEYS' INVESTIGATION OF SALES METHOD OF VALUING REAL ESTATE COMPARISON OF RESULTS ALONG LINCOLN AVENUE, ST. PAUL Average ground value per front foot Along Lincoln Avenue (3 1/2 mUes) (A) By land sales process (B) By local experts No. of experts 1. Dale to St. Albans 2. St. Albans to Grotto. . . . 3. Grotto to Avon 4. Avon to Victoria 5. Victoria to Milton 6. Milton to Chatsworth. 7. Chatsworth to Oxford 8. Oxford to Lexington. . 9. Lexington to Dunlap 10. Dunlap to Griggs 11. Griggs to Syndicate 12. Syndicate to Hamline. . . 13. Hamline to Albert 14. Albert to Pascal 15. Pascal to Saratoga 16. Saratoga to Snelling 17. Macalester to Cambridge. 18. Cambridge to Bald%\-in. . . 19. Baldw-in to Fair\iew. . . . 20. Fair\'iew to Prior 21. Prior to Cleveland S47.00 49.00 49.00 50.00 35.75 29.00 27.50 24.00 15.00 12.00 8.50 8.50 7.00 7.00 5.00 5.00 9.00 9.00 9.00 3.50 3.50 Value Excess (B) over (A) Amount Per cent. S50.85 51.20 51.80 51.65 36.05 29.85 26.55 24.20 16.45 12.20 8.90 9.35 8.05 7.95 6.40 5.90 9.35 9.20 9.20 3.90 4.10 $3.85 2.20 2.80 1.65 0.30 0.85 0.95 0.20 1.45 0.20 0.40 0.85 1.05 0.95 1.40 0.90 0.35 0.20 0.20 0.40 0.60 8.2 4.5 5.7 3.3 0.8 2.9 3.5 0.8 1.0 1.7 4.7 10.0 15.0 14.0 28.0 18.0 3.9 3.2 2.2 11.4 17.2 Average for 21 blocks S19.75 $20.60 SO. 85 4.3 STRUCTURAL COSTS 81 "Tables C and D show, in the last column, the percentages variation between the results of the sales method and the averages of the results of the local experts. It is seen that the tendency of the sales method is to give deficient results to an average amount of 3.8 per cent, for the entire 277 localities or blocks. "This result or tendency is strikingly confirmed by the other instance above referred to, consisting of the valuation of terminal lands belonging to the Chicago, ^Milwaukee & St. Paul Railway Company in the city of Milwaukee, made in 1903 under the auspices of the Tax Commission. These lands amounted to upward of 500 acres in the aggregate, scattered through some 15 wards or assessment districts of the city, and having an aggregate valuation of approximately S6. 000,000. The market value of these railroad lands was determined by specially (luali- fied local real estate experts under the personal direction of Mr. F. W. Adams, the secretary of the railway company, who preserved a re- markable balance of judgment throughout the work. The state valua- tion staff, under the personal direction of Prof. W. D. Taylor, engineer for the state board of assessment, used the sales method on a basis consistent with local conditions. The final results differed by only 3.5 per cent., the results by the sales method being the lower, as in the Polleys investigation. "As a result of the elaborate series of tests above described, it appears that, taking the results by the ' local expert method ' as a basis, the ' sales method ' tends to give slightly lower results, the difference appear- ing to be about 4 per cent, on the average. "Final Revised Values. — The final valuation figures for the two tracts of land submitted by the Commission's valuation staff in the light of all available evidence, including the testimony submitted by the local experts and the results of the comparative tests of the sales method above described, are as follows for the year 1908: "Block 131. — The revised valuation of block 131 is placed by the Commission's staff at S42,000, with a possible range from $37, 000 as a minimum to $47,000 as a maximum. "Part of Block 126. — The valuation of this tract presents special difficulties, owing chiefly to extreme scarcity of trust-worthy sales figures in the immediate locality. The revised valuation of this tract is placed by the Commission's staff at $18,000 with a possible range from $16,000 as a minimum to $20,000 as a maximum." The decision in the Madison case then continues with the opinion of the Commission as to value of the methods used by its engineers as follows: "The preceding memorandum submitted by the engineer appears to us to be of the greatest importance. It describes the methods used by the engineer and his staff in determining the value of real estate and 6 82 VALUATION OF PUBLIC UTILITIES shows that these methods, when properly employed, are scientific and that they lead to correct conclusions. The engineers of the staff have employed these methods very extensively in the valuation of real prop- erty in all parts of the state, and generally with satisfactory results. The engineers are also unbiased in their attitude toward proceedings such as those involved here. They are witnesses for neither petitioner nor respondent and have only one aim in mind; namely, that of arriving at the truth through the application of correct methods of investigation, and their experience and training entitle them to be classed as experts in such matters. It is, of course, a fact that the determination of the market value of any piece of real property is ultimately a matter of judgment, and that no method of valuation yet discovered will disclose the exact value or do much more than indicate, within perhaps fairly narrow limits, the figure at which the value should be placed. But it is believed that the methods thus employed by the staff are the best that have thus far been used for this purpose. While in actual appU- cation they may not disclose the actual figure at which the value should be fixed, they cannot fail to be of the greatest importance in appraisals of this kind. When properly employed, they will disclose facts that indicate approximate values, and facts that are of the greatest aid to the judgment in arriving at the fair value in each particular case. "The main question involved in the valuation of a utility for rate- making purposes is to find the fair value, or that value upon which the investors are entitled to reasonable returns and which is equitable as between the investors on the one hand and the customers on the other. This appHes as much to the valuation of the real property of the utility that is used or useful in connection with the services it renders, as to any other part of the property that is so used, or to the plant as a whole. In this particular case, this value would seem to be somewhat lower than the valuation which was claimed by the respondents and consider- ably greater than the estimated value of the real property by the petitioner's witnesses. The facts indicate that the fair value is found about midway between the maximum and minimum values as deter- mined by the staff. In fact, it is our judgment that it should be placed at about $44,500 for the lots located in block 131 and at about $17,500 for the lots in question in block 126, or at about $62,000 for both. Of these amounts, according to the estimates of the engineer in his first valuation, about 83 per cent, of the former item should be allotted to the gas plant, while 17 per cent, of the former and all of the latter should be allotted to the electric plant."* In valuing city property, it is quite customary to add 10 per cent, for plottage, namely the extra cost of acquiring property ' State Journal Ptg. Co. vs. Madison Gas & Electric Co. Decision dated Mar. 8, 1910, p. 528 — Railroad Commission of Wisconsin. STRUCTURAL COSTS 83 in small pieces and bringing it under a single ownership. In the same way, 25 per cent, of the value of an inside lot is added to determine the value of a corner lot. For narrow strips of land 100 ft. wide or less, used for right of way from one-third to five times the value of the adjoining land is added to cover the increased cost of such pieces. The Public Service Commission of New York, First District, has used appraised values, assessed values, and double the assessed value, in determining the fair value of real estate, in its various decisions. The Board of Railway Commissioners of South Dakota, in appraising the railway properties of that State, took 2 1/2 times the actual cost of farm land at the time of appraisal, as the value allowed for right of way. The Texas Commission has usually added from 25 to 50 per cent, additional to the value of adjoining land, to obtain the value allowed in the valuation of the steam roads of that State. While the steam railroads usually prefer to purchase necessary real estate outright, the inter-urban electric roads, telephone, telegraph and transmission companies very frequently purchase the right to use property or easements instead of taking title to real estate. Such investments result in an increase in the in- tangible property, as of course the companies purchasing such rights of way have no title whatever to the real estate, to show for their investment. Paving. — There exists considerable difference of opinion and some confusion of thought as to whether the value of pavement over structures in streets should be included in appraisals and allowed as part of capitalization. If the fundamental purpose of the inquiry is to ascertain the actual investment made, then only the cost of such paving as was laid by the corporation should be considered, if the cost of reproduction new of such pavement as was put down at the expense of the corporation is sought, then such treatment of the paving may be proper, but when the problem is to find the cost of reproduction new of property at a particular date, the estimated cost of paving necessary to be laid in replacing the substreet structure, should be taken. It is assumed in every case that the pavement in the street does not belong to the corporation whether the structure in the street has been installed before or after the laying of the pave- ment. Of course if the pavement has been laid first, and the 84 VALUATION OF PUBLIC UTILITIES structure afterward the expense of placing the pavement must be borne by the corporation, and under such circumstances as these, there is usually little question but that the estimated cost should be allowed the corporation as a part of its expense of construction, and is therefore proper for capitalization. The Wisconsin Commission^ has uniformly ruled that in a valuation for rate purposes the cost of pavement reproduction will not be allowed unless the pavement has been laid at the expense of the cor- poration. This view has been taken, though somewhat equivo- cally, by the Iowa Supreme Court which held that the cost of pavement over gas mains laid before the pavement was put down, should not be included as part of the value on which rates should be based, expressly ignoring the expense that would be incurred in case it were found necessary to remove the pipes at the expiration of the franchise, or for other cause, explaining that most of the paved streets were paralleled by unpaved alleys or parkways, in which pipes might be laid without removing the pavement and admitting ''undoubtedly the values of the pipe are somewhat enhanced because of their location, but the immediate cost of opening and replacing the pavement is not the criterion for the value which should be adopted."- The Public Service Commission of New York State, First District, has both allowed and excluded the value of all pave- ment over street sub-structures. It was allowed for example in the Third Avenue Railroad Co. Reorganization Case,^ but in several recent decisions the value of such paving as has been laid after the structures were in place has been excluded. The present attitude of this Commission is clearly set forth, for example, in its recent opinion published a few months ago in the case of Kings County Lighting Company, where in passing on the company's claim for an allowance for all paving over its structures the commission says: "The practical effects of such a theory are interesting and important. Suppose a locality at the time a gas company was started and its pipes ' State Journal Printing Co. vs. Madison Gas & Elec. Co., decided March 8, 1910 (4 W. R. C. R. 501, 554); Ashland vs. Ashland Water Co., decided Nov. 1, 1909 (4 W. R. C. R. 273, 307); Racine vs. Racine Gas Light Co., decided Jan. 27, 1911 (6 W. R. C. R. 228, 240). => Cedar Rapids Gas Light Co. vs. Cedar Rapids 120 N. W. 966. ' Case No. 1181 Plan of Reorganization Third Ave. Railroad Co. Decision dated July 29, 1910, Public Service Commission, First District, New York. STRUCTURAL COSTS 85 laid were content to have unpaved or cheaply paved streets, cobble- stone, macadam or gravel being used. Suppose that the people come to demand better paving, being dissatisfied with earlier conditions, and that asphalt, brick or granite block with a concrete base is laid throughout the area. Naturally, the people appreciate that they must pay the cost of the rei^aving; but according to the theory of counsel for the company, the gas consumer must also pay-more for gas. In other words, every time the streets are improved, not only do taxes or assess- ments go up, but higher gas rates are justified, notwithstanding the fact that the company may not have paid one dollar in connection there- with. If this theory is correct, citizens must consider in connection with every civic improvement its effect upon rates for gas, electricity, telephone service, water, transportation and every other service which involves the use of the subsurface of the streets. If such improvement increases the cost of reproducing the undertaking supplying such service, higher rates will thereby be justified than would be reasonable before such improvement is made. "Applying the theory of counsel to the case in hand, he asks that in ioto about $250,000 or 1300,000 be added in determining the "fair value" of the property, such sum including not merely the net cost of the paving, but 'overhead charges' amounting to 20 per cent, or thereabouts. A return of 10 per cent, thereon would be from $25,000 to $30,000. Upon the basis of actual sales for 1910, this is equivalent to from 4 to 5 cts. per thousand. Thus, the net result of counsel's theory is that this Commission is asked to fix a rate higher by 4 or 5 cts. than would otherwise be reasonable, and the reason offered in essence is that since the Kings County Co. laid its mains and services the city of Brooklyn and later the city of New York has materially improved the paving over those pipes without expense to the company. "The company's counsel apparently relies upon a single thesis to maintain his theory. He may not claim that the pavement is the property of the company, for it is not in any degree. The company may not alter the pavement without the city's permission, nor sell, transfer or remove it, and in case the company does take up its pipes and leave the street, the pavement must be restored. Secondly, the company did not lay the new paving. It was laid by the city after the company's pipes were in the ground. In the third place, the new paving represents no expenditures upon the part of the company. This fact is important, for it is conceivable that a company might not own certain })roperty, might not have actually constructed it, and yet the expense of such construction, if paid by the company, might properly be included in the amount upon which the company would be entitled to earn a fair return. But in this case, the new pavement under discussion does not represent any investment or expenditure by the company. 86 VALUATION OF PUBLIC UTILITIES The relaying of the original paving does and it has been included in 'net cost' as above set forth. "^ The above quotation very fairly sets forth the usual argu- ments for omitting from corporation valuation such part of paving as has not been laid at the expense of the corporation, but such partisans apparently fail to appreciate the illogical posi- tion of setting out to obtain the cost of re-production, and then instead of taking that cost to include only such part of said cost as appeals to them. If the date of construction is to be the test, then original costs should be considered; if the date of ap- praisal is the test, then cost of replacement throughout must apply. It is manifestly illogical and unfair to pretend to figure the cost of re-producton and then omit certain items from such basis of valuation apparently for the reason that the inclusion of such items would result in a considerable increase in the value of corporate property. Because a corporation has had the judgment and foresight to install its structures in advance of or coincident with paving, perhaps carrying its investment for years without profit, that is no reason for excluding a part of the cost of replacement any more than it would be to omit increase in real estate values. As the New York Commission itself says in the decision above referred to, the Supreme Court has held "in order to ascertain that value (fair value being used for the conven- ience of the public) the original cost of construction, the amount ex- pended in permanent improvement, the amount and market value of its bonds and stock, the present as compared with the original cost of construction, the probable earning capacity of the property under regular rates prescribed by statute, and the sum required to meet operating expenses, are all matters for consideration, and are to be given such weight as may be just and right in each case." ^ So that the cost of reproduction is not the only necessary con- sideration, but one of the considerations which should be used, there exists no judicial pronunciamento for taking a part of the estimated cost of reproduction and leaving out the other part. More important than conclusions of commissions or opinions of State Courts is the decision of the Supreme Court, which, in at least one case is pertinent. The Consolidated Gas Company questioned the right of the New York State Legislature to reduce ' Case No. 1273 J. G. Mayhew vs. Kings County Lighting Co., decision dated Oct. 20, 1911, Public Service Commission, First District, New York. 2 Smyth vs. Ames 160 U. S. 466. STRUCTURAL COSTS 87 the price of gas in New York City from $1.00 to 80 cents. It was admitted that the city, at its own expense, had built costly pavements over the gas mains of the company, and that the subsurface of the streets had become so crowded with other structures since the mains were laid, as to increase the cost of their laying, thus making the cost of reproduction So, 560,000. 00 greater than the original book cost, yet the Special Master and the Judge of the Circuit Court expressly recognized and allowed such increased value which in appeal was later approved or at least not objected to, by the U. S. Supreme Court in determining the value on which a fair rate of return should be based. The exact wording of the Supreme Court in the gas case is so definite and illuminating as to the time of valuation and increase in values allowable that we quote it. "And we concur with the court below in holding that the value of the property is to be determined as of the time when the inquiry is made regarding the rates. If the property, which legally enters into the consideration of the question of rates, has increased in value since it was acquired, the companj- is entitled to the benefit of such increase. This is, at any rate, the general rule. We do not say there may not possibly be an exception to it, where the property may have increased so enormously in value as to render a rate permitting a reasonable return upon such increased value unjust to the pubUc. How such facts should be treated is not a question now before us as this case does not present it. We refer to the matter only for the purpose of stating that the decision herein does not prevent an inquiry into the question, when, if ever, it should be necessarih' presented." ' Water Power. — The valuation of a water power is one of the most complex and difficult problems in appraisal work. The cost of the dam, building and machinery, of course, does not represent the total value of a developed water power. Before any installation of plant, the undeveloped water power had a dormant value. The determination of the value of water powers has been attempted in at least two distinct ways. (a) Market price, — that is the price that might be paid for power, based on local opinion, market quotations or future expectations. In Wisconsin, testimony adduced before the Railroad Commission, indicated that water powers in that • Wilcox vs. Consolidated Gas Co. 212 U. S. 19. 88 VALUATION OF PUBLIC UTILITIES State were worth about $80 per H. P., on the basis of uniform power throughout the year. (b) Capitalization of an amount somewhat less than the difference between the sum of the fixed charges and operating expenses of the hydraulic plant, compared with similar costs of a steam plant located at the market to be supplied from the hydraulic plant. The capitalization of the difference in the cost of operating a hydraulic compared with a steam plant, has several times been considered by the Railroad Commission of Wisconsin. The attitude of the Commission is indicated, for example, in deter- mining the price to be paid by the city of Kaukauna for the local electric plant, which included a lease for 200 H. P. per- manent power, and 100 H. P. revocable power, when it says: "In considering this lease the company's engineer concluded that the same has a value for the 200 H. P. for permanent power. He figures that if the 200 H. P. were used every hour in the year at the rate of 3 1/2 lb. of coal per horse-power-hour and that such power were generated by steam, the coal cost would amount to $11,200. The difference between this cost and the $2000 per year, if the water cost $10 per H. P. with the cost of operation of the steam auxiliary when the water was low being considered, would give a saving of approxi- mately $3460. This value, capitalized for the 76 years which the lease has yet to run, would give a present value of this lease of $43,136. "The city's contention as to the value of this lease is about as follows: The fact that the rent is to be readjusted every 10 years is held as a point which makes it very likely that each year the adjustment will have the tendency to bring the price per H. P. up to just what it is worth. It maintains that for the present 10-year period the price per H. P. will likely be $12 to $12.50 and that there is no way of telling what the price may be for the next 10-year period. The fact that the buildings and plant equipment of the electric company stand on leased ground belonging to the canal company is also considered as a detrimental feature of the contract. The attitude of the canal company to get full value out of the water power is considered as sufficient reason for saying that this lease is really of no value, but a distinct liability, inasmuch as back rental must be paid. "In making a determination as to the value of the lease the real point would seem to be: Can a saving in operation cost of this utiUty be made by using the water power, and, if so, just what such saving may be? If we consider the 200 jDermanent H. P. and figure a load factor of 50 per cent., which would be very good for a plant of this kind, we would find 876,000 horse-power-hours needed in the operation STRUCTURAL COSTS 89 of this plant for a year. Assuming then, the 3 1/2 lb. of coal per horse- power-hour and deducting 983,410 lb. of coal which the company- report shows was necessary besides the water power, we have 2,082,590 lb. of coal necessary in addition to what was used in the operation of the plant. Using $4 per ton for coal, we have a fuel cost of $4165. The water power cost, assuming $12 per H. P. would be $2400, would result in a saving of $1765 by using the 200 H. P. of water power. This being a saving in operation, a deduction must be made for the operating expense of taxes, which the electric company must pay by virtue of the lease. The taxes on the water power amount to $500 at least. This leaves a saving of $1265 per year. In connection with this saving, it should be remembered that the present 10-year period, during which time the $12 per H. P. rent would seem reasonable, has only six more years to run. There is no way to forecast what amount maybe asked for and agreed upon for the next 10-year period. It would seem rea- sonable to suppose that the canal company will bring the rent up to just such a point as will give only a large enough margin of saving to keep the electric company from going over entirely to steam-power gen- eration. What this point may be is not known, but the fact remains that an arbitration is provided for in 10-year periods, and considering the disposition of the canal company to get as much as possible for this power, the future value of this lease beyond the present 10-year period is certainly speculative. It is not to be considered that any arbitration board would act unjustly in its award. We must assume that any such board will fix the rental at a fair figure regarding what the value of such power is generally rated at the time of the arbitration."^ The market price obtainable for water power is somewhat analogous to the market price of securities of any utility prop- erty. It depends ultimately on the earning power and in states where rate control is possible, may lead to erroneous conclu- sions. Where no rate control exists other than that arising through competition, the value of a water power is clearly determined by the cost of generating power, in a competitive market, from some other source of energy, such as fuel. In any consideration of the value of water power, it is im- portant to differentiate between uniform power and that wdiich fluctuates, depending upon the rainfall, or other conditions. Ordinarily a much higher price per H. P. for uniform power is allowable than that which is only available during times of high * In redetermining just compensation to be paid Kankauna Gas, Electric Light & Power Company. Decision, dated Dec. 26, 1911. Railroad Com- mission of Wisconsin. 90 VALUATION OF PUBLIC UTILITIES water, although occasionally a hydraulic plant supplementing the supply of another station can obtain a uniform price for all of its output regardless of variation in delivery. An approximate but quick way of ascertaining whether a water power is worth anything or not, considered on the basis of earnings and ignoring its reproduction value, is to assume figures with regard to the cost of its operation and maintenance, as shown, by way of illustration, in the following table: Labor of operation 2 per cent. Oil, waste supplies and extras 1 1/2 per cent. Repairs 11/2 per cent. Taxes 1 per cent. Depreciation 2 per cent. Sinking Fund 3 per cent. Total 11 per cent. If the cost of installation, complete, is $100 per H. P. and the developed energy can only be sold for $15 per H. P. per year, it will be seen that the water power really has little value, unless prospective, because the return on the investment will only amount to the difference between the sum of the items given in the table, $11.00, and the price obtainable, $15.00, consequently no financier, with his eyes open, will invest in as uncertain a project as a water power which will only bring a return of $4.00 on every $100.00 put in, that is, 4 per cent. A CHAPTER VI DEVELOPMENT EXPENSES, INTANGIBLE EXPENSES, NON-PHYS- ICAL COSTS, OVERHEAD EXPENSES General.— The expenditures made for the actual construction of the physical plant are only a part of the total cost of any com- pleted property. "There can be no true test other than the physical valuation, and to such physical valuation there may be added certain other items." ' The present line of division between the costs of the physical plant and those of the non-physical elements of a utility property is a more or less variable and arbitrary one. There exists such a considerable difference of opinion among those conversant with the subject as to just the proper class in which these non-physical costs shall be grouped that no generally accepted theory has yet been established. As has been indicated in the preceding pages, good practice inclines to the inclusion, with material property, of those items of expense which are inherently a part of physical plant cost and are largely regulated thereby, that is, such expenses as manu- facturers' profit, the charges of sub-contractor, or general con- tractor, engineers' or architects' fees, as well as such company superintendence, clerk hire, office and legal expenses and such other incidentals which, as a part of the administration of the work of construction, may logically and properly be included with the cost of the physical structure. Those other items of cost which are incurred through originating and completing the arrangements necessary but preliminary to the beginning of construction, such as legal and technical expenses, interest on capital which is used in preparing the entire property to begin the earning of an income, taxes, both those in connection with the organization of the company, and those accruing during the construction period, as well as discounts on securities, brokerage, ' Des Moines Water Company vs. City of Des Moines, Decision of Judge McPherson, dated September 16, 1911, U. S. Circuit Court for Southern District of Iowa. 91 92 VALUATION OF PUBLIC UTILITIES reasonable promotion profit, also working capital, and, under certain conditions, superseded plant, explained more fully in detail in the following pages, may be properly grouped under the head of " Development Expenses." Some writers and experts have used "development" in con- nection with the expenditures made in developing an income, that is, after the physical structure and commercial organization are prepared to begin service, it will require appreciable time in which to put the business on a paying basis, and during that period the deficits accruing have been capitalized as '' Develop- ment Cost" but the more general classification of such items, namely those incurred in developing income, is covered by one of the usual definitions of ''Going Value." The line of demarkation between expenses accruing on account of capital lying idle while the property is being prepared for service, made a part of capitalization, and that expense charge accruing later on account of failure of the investment to earn a fair return, either capitalized or charged to operation, is at the point where the structural plant as a whole or its several parts or units are completed, ready to begin operation and commence to earn an income. "The proper period for the capitalization of Development Expenses ends when operation actually begins." "Securities ought not to be issued to cover operating expenses, fixed charges or dividends after that time (beginning of operation) except possibly in a most unusual case when such jiroeedure is absolutely necessary to preserve the undertaking."* It must be admitted, however, that owing to the prevailing lack of uniform practice, some of the intangible elements grouped under "Development Expense" have been included, and in certain methods of estimating, must be considered a part of "Going Value." On the other hand, some authorities consider that certain, such items as interest during early operation, should not be capitalized at all, either under the head of "Development Expenses" or "Going Value," but rather paid out of earnings, the same as any other operating expense. "But it ordinarily happens, during the first few years of operation, that the company does not earn a fair return. How, then, are the ' Opinion dated July 29, 1910, denying application Third Avenue Railroad Company. Public Service Commission of New York, First District. EXPENSES 93 investors to be made whole? There are two solutions: one is to capital- ize the losses or deficiencies below a fair return, and all the other elements which are said to be included in 'going-concern.' " "The other solution is to charge all such expenses to operation, to attempt to make no fine-spun distinctions, and then to jiermit the company to charge in later 3'ears rates sufficient to offset its deficiencies below a fair return in the first few years.'" The Public Service Commission of New York, First District, has used the term "Development Expenses" in its printed opinions and decisions, for some years. It will be seen that the items covered by the term correspond to those mentioned by the author: "There are certain expenses connected with every undertaking which are not represented by physical property but which must be incurred before the j^lant is operated. These relate to the initial promotion of the scheme and the organization of the company. In- vestors must be interested, lawyers and engineers must be consulted, and franchises and permits must be secured. Interest and taxes during the period of construction must be paid, and as there are no earnings, they must be included as part of the cost of the undertaking. There are also other expenses connected with the experimental and trial operation of machinery and the adjustment of ^■arious parts, etc., which antedate operation."^ "The foregoing items of valuation do not include any allowance for easements or for other real estate values in excess of the assessed valua- tion. Neither do they make any allowance for franchise A'alues nor for a considerable amount of development expenses, as, for example, interest during period of construction on capital used in construction, reasonable profits of promoting the enterprise, preliminary legal ex- penses of organization and other legal preliminaries, cost of complying with various preliminarj' requirements of law. All of these items would be absolutely essential disbursements in the reproduction of any existing railroad, and they would add considerably to the figures of valuation given in the foregoing estimate if proper allowance were made for them It is to be borne in mind in this connection that physical assets are not the only real and valuable properties of a company upon which it is entitled to a fair return. There are numerous ' Opinion and order, dated June 23, 1911, in the matter of the gas and electric rates, charged by the Queensborough Gas and Electric Company. Public Service Commission of New York, First District. ^ "Opinion and Order dated June 23, 1911, Public Service Commission of New York, First District, in the matter of the gas and electric rates charged by the Queensborough Gas and Electric Company. 94 VALUATION OF PUBLIC UTILITIES other elements which may be properly regarded as capital charges to be considered."* In the Brooklyn Borough and Kings County matter, the Public Service Commission of New York added over 23 per cent, for "preliminary and development items," including working capital, to the present value to obtain the grand total. In another decision relating to the Kings County Company, the same Commission added 16 per cent, to the net cost includ- ing real estate to cover Development Expenses, and in the Queensborough Gas and Electric Company case, over 22 per cent, to present value to cover Development Expenses and working capital. The Public Service Commission of New York, Second Dis- trict, has very concisely stated its views with regard to many of the items included in Development Expenses in their opinion on the application of the Rochester Corning Elmira Traction Company, for authority to issue securities to provide funds for a proposed electric road. After giving the estimates cover- ing the cost of producing the physical plant, the Commission ■ says : "Although the foregoing is believed to be as nearly a correct estimate of the actual cost of the road as can be made in the absence of exact knowledge as to quantities, we deem it wise to add thereto 5 per cent. for any unforeseen contingencies, or an aggregate amount of $316,435. To cover the cost of legal expenses, organization tax, tax upon stock to be issued, the expense before the Board of Railroad Commissioners in procuring a certificate of public convenience and a necessity, the expense before this Commission upon this proceeding, the expense of marketing the securities of the company, engineering and other details not necessary to specify with particularly, we have computed the amounts capable of reasonably precise computation and think it best upon the whole to allow for all items of this character an additional 5 per cent, amounting to the sum of $316,435. We have also allowed for working capital the sum of $100,000, and for the services of those engaged in organizing the enterprise another 5 per cent, upon the estimated cost. The aggregate of these several percentages is the sum of $1,049,305, which with the estimated cost, makes a total of $7,378,020." * Case No. 351. Page 9. Monheimer vs. Brooklyn Union Elevated Com- pany, Brooklyn Heights Railroad Company, etc. Opinion and Order Public Service Commission of New York, First District. EXPENSES 95 "This is in brief a rough sketch of the process observed in reaching the allowance of capitalization which we propose to make. It should be noted that the percentages which we have allowed are wholly based upon the circumstances of this case, many of which it is impracticable to detail with any degree of fullness at this time. It is to be understood that none of these allowances are to be regarded as binding upon the Commission in case of applications of other companies. It has not been designed to estabhsh any precedent in the determination of these amounts, and the Commission will feel itself at liberty in other applica- tions of like character to proceed absolutely upon the circumstances of each case and fix allowances for services and expenses of the character of those under discussion upon such principles and for such reasons as may approve themselves at that time. " It should, however, be understood that applicants must always be prepared to give evidence of services rendered and expenses incurred to the end that the commission may be prepared to make such allowance in capitalization as the facts of the case may justify. "If we deduct from this sum 84,000,000 for the amount of the auth- orized capital stock, the remainder would constitute a bond issue of $3,378,020. Unquestionably these bonds will not sell at par, and an allowance should be made for the discount necessary to float them upon the market. No proof has been offered as to the amount for which they can be sold. We are unwilling to consent to their being put upon the market at less than 85. Making the proper computations for selling them at this figure, and also allowing for interest upon the bonds for one year at 5 per cent, to be paid from the proceeds, a total issue of bonds to the amount of .14,207,914 would be necessary. Making the author- ization for bonds $4,210,000 and stock issue $4,000,000, we have a total issue of stock and bonds of $8,210,000. The interest charge at 5 per cent, upon these bonds would be $212,500 as against the assumed charge of $216,000 hereinbefore set forth." ^ Mr. B. J. Arnold, of Chicago, one of the most prominent con- sulting engineers engaged in appraisal and valuation work, in discussing reproduction values in relation to intangible values, has testified that in addition to the value of the physical equip- ment, there are intangible values, which he called " Develop- ment Expenses," and covered by additional allowances to provide for: "Legal Expenses in connection with: "PreHminary promotion, organization and incorporation of company, ' Application Rochester Corning Elmira Traction Co. Decision, March 30, 1908. Public Service Commission, New York, Second District. 96 VALUATION OF PUBLIC UTILITIES consent of State Commission, propertj' owners' consent, consents of local authorities, consolidation of companies, and terminal arrange- ments, also for trackage right of way, agreements bridge terminal arrangements, and leases between companies." "Technical expenses in connection with: "Preliminary survey and location of line, estimates of cost, estimate of earnings, preparation of prospectus, maps, for property owners' consents and consents of local authorities." "Promotion expenses: ' Cost of organization prior to actual construction." "Profits of promotion including original organization and consolida- tion, 5 per cent, to 10 per cent, on $8,700,000." "Financial expenses: "Discount and commi.s.sion on sale of securities 5 per cent, to 10 per cent, upon capitalization. Interest and taxes during construction, 3 per cent, to 6 per cent, on the approximate value of the physical property, taking that interest for approximately a year's time as a maximum, and for six months as a minimum." "Permanent right of way." "Property owners' consents, bridge charges." "Fill on Coney Island Avenue." "Change of grades on Coney Island Avenue. Coney Island Avenue right of way." "Cost of obtaining trackage rights. Bridge arrangements and exchange of power arrangements." "Additional sales value." "Cost of acquiring real estate." "Equity in terminal at Coney Island." "Real estate not used in operation of road." " Buildings not used in the operation of the road." "Working capital."* The Railroad Commission of Wisconsin has not divided the non-physical expenses, to be added to the cost of the structural plant in ascertaining the total value of property, along the same lines as indicated above. With the physical plant has usually been included on allowance of 12 per cent, for engineer- ing and supervision, interest during construction, contingencies, etc., with a separate estimate of going value or "earning value," so that in the same way the Commission recognizes the necessity ^Minutes of testimony, Case No. 1134, September 15, 1909. Monheimer vs. Coney Island & Brooklyn Railroad Company, Public Service Commission of New York, First District. EXPENSES 97 of allowances for development expenses in one class or another. For example, in discussing corporation accounts, it says: "These accounts, with the records upon which they are based, should show the cost of each of the different parts of the plant, the cost of engineering, superintendence and management, the amount that was allowed as interest on the capital during the construction period, the amount, if any, at which the bonds were discounted, the basis upon which the stock was issued, the promotion expenses, if any, the basis upon which the contracts for construction were let, the cost of the franchises that were obtained, and all other items Con- tractors' profit is an item that usually enters into the cost Interest on the cost during the period of construction would seem to be one of the necessary elements that should be included in the total cost of the plant The fact that interest on the capital used must be paid is too well settled to be questioned here Whether this (discount on bonds) is a legitimate cost to be included in the cost of construction will perhaps depend upon the circumstances in each particular case. If the utihty is needed, and the capital for it can be had on no better terms, then it is difficult to say on what grounds such discounts should not be included in the cost of the plant. To so include it has been and is the almost universal practice As a rule is it not safe to enter upon the erection of works of this character without having provided for efficient supervision of the same. Such supervision costs money, and this cost ordinarily is a proper charge to construction Owners and promotors are undoubtedly as much entitled to fair compensation for legitimate and valuable services, as any one else In the construction of plants of this kind, a great deal of capital is required, and this cannot be had without cost. The services of engineers and superintendents must also be obtained, and this is combined with another class of outlays. In addition to this, something should also be set aside for insurance and contingencies of various kinds. These items are legitimate outlays in undertakings of this character, and are usually placed at from 10 to IS per cent, on the remaining expenses of the cost of construction.^ "The element of cost, by reason of interest during construction, is one which cannot be escaped. It is present to some extent, no matter what the method of financing the construction may be." "The amount of the working capital required by the plant, rather than the question as to whether something should be allowed for such capital, is the issue raised by the testimony."^ 1 Hill vs. Antigo Water Co. Decision August 3, 1909, Railroad Commis- sion of Wisconsin. * State Journal Printing Company vs. Madison Gas & Electric Company. Decision, March 8, 1910. Railroad Commission of Wisconsin. 7 98 VALUATION OF PUBLIC UTILITIES The propriety, necessity and legitimacy of making appro- priate allowances for the items generally grouped as Develop- ment Expenses, in valuing property, has never been questioned by properly informed individuals, Commissions or Courts. Although the term as such, may never have been used judicially, frequent decisions expressly recognize and justify allowances being made for these items of expenditure. "Of the other items, those for organization and the expense of procuring franchise are not shown by the testimony to have been illegitimately expended, nor considering the period of time over which the various items were expended, and the different organizations through which the properties went, an unreasonable charge for that purpose. "The discount of $22,800 upon certain bonds sold by one of the constituent companies, was a reasonable discount for the negotiating of bonds of that character, at the time they were sold, and the amount of such discount represents actual cost to the Company. "In any estimate for replacement value, allowance should be made for all engineering expenses, miscellaneous expense and other expense accruing during the construction of a plant, costing the indicated sum, would seem to be reasonable not only in view of his testimony, but in view of the testimony of other witnesses in the case. "The figures referred to, contained no allowance for interest upon the amount invested, and accident insurance, during the construction period, which should be necessary if a plant of this kind, description, value and price were to be built. Such interest charges are obviously proper to be added."' In the hearings before the Public Service Commission of New York, First District, in the Coney Island "Ten Cent fare case,"- Mr. Frank R. Ford, of Ford, Bacon & Davis, introduced during his testimony a very exhaustive analysis of the items that, in the case of a New York Company, must be considered in making up an estimate of the expenses covering the period pre- vious to beginning construction. Mr. Ford's exhibit is so com- plete and will be of such service as a guide to anyone interested in considering Development Expenses that the table in full is here reproduced. ' Report of special Master, Circuit Court of the United States, Southern District of Ohio. Columbus Railway & Light Co. vs. City of Columbus. ^ Case No. 1134, J. Monheimer vs. Coney Island & Brooklyn Railroad Company. Public Service Commission for the First District, New York. EXPENSES 99 bC ■< o 03 C ^° .2 Pi o bC 3 C (U c a - • m ^ s s J .s O -73 ^1 ■! d a 3 ^ n a S i S a ^ j: a m iC J .a "3 i 3 o M j: "■ o^ o a o o „ a jj ^ d a ^ ^ « m a-^.^-^ d .- '-S ■-;3 a — " u " 3 "^ 5 fc< M O) d j2 ii ^ -4= a a -2 5 =« ° S "= H ^ > t« O m o u M e a d A -n d o & d Ol d c4 ■s. 0. d £ a a "o '$ g d "E 03 d d _o d o 6 a d o 6 *^ d 0; a a 03 a 3 § o Q <; w a a So- ■*! 03 — ^ O I '^ I I -S '^ J a c ^ ■S S a> a " W CL, O w S dS^ flSaa •2 s,5 s d sr^ d ^ o. ^ bC d o O &< o 100 VALUATION OF PUBLIC UTILITIES o o Q < o . a> © ^ ^ O o s.?, a s -n 5 •Jj s ^ c„ 13 S a.":: s i fl >> s ® fl CM --^ & O S •= a-B -^ ?. " C3 fl C S K „ •2 .2 M is S 5 ° c ii rt =5 £ ; 2 S o t:X ^ o a.- Woo < O 0, g U 3 ^ s a & a C "J - I §15 ■s fl a c fl .- k( o i a a CD -a o ^ a ^ (^O « c H >■ c; Z QO ^ Sr" c. ■ •3 5 S '^ .2 ^ a c s 5- o . a ■« ■ ^ a c ;fl fl o 3 cj c •- c5d EXPENSES 101 s fc; a o O C3 O S O d G3 ro fO C DD (-4 g g o S o S q 2-?^ ^ d g g c8 rt d oj tiD =v (y '^ C. o "5 d a^n £-^o PM o "S ^ <*-! u d 0) d c3 o ^ •? d 0. a a g « ^ iJ , . t; o d © ^ '^°'^-SSd£-§ ^ o -2 a ° " g -a ^ ^ g .a c o ^ d B a -r rt 5 ? < t< a 102 VALUATION OF PUBLIC UTILITIES < % O O Q < O I— ( < 1-5 o o oq «8 Q GQ H-l >H H 12; o a s 2 'a o a a 2 8 a p a a a O a 5 a^ -2 g S g ■ - -a =3 ^ s § § 1 ' J3 1 s 0. tH 1 a c3 O 1 1 o 2 § £ -0 2 5 8 1 S . o o 13 cS •a d a < •B 13 to =* 13 fc ■« s 1^ g s o d aj a =^ fl m S =3 », M .2 o S >• 8 g g § 'S g « a J ■= .§ J g S " u '" fli O HO •f -a in £ i 1 §82 |g| a":: c t % ^ Ph O a; h S 1 1 i o • •3 0. b 3 a C j3 J3 2 '^ i 1^ 01 a a S H o s a o a a J s Ui -^ ;:; ■a 03 C a O. "3 ■s ^ a ^ III 1 .ti 03 5 s . a ■c ^ Ml is tl2 o 3 o a f ^0) cu • t^ '^ ^ a E -- ° ° * 3^ « 0) B H S 9 ** a IT i3 g-Si — a a C3 =; CJ C3 Qj ^ o C (S a O g M " rii§i c; c3 t T3 g (U a a •— c s £ § =5 0, o ^ O g S tj ^ Ph PU < O 1 i^ i a >. c >- >1 g H 2 -g 2 73 "^ ■~, S §2 M Ij U ■q 03 a 03 c3 2 -^ a •g =^ 1 o >> > 3 £ O.CO -5 ^ '? §5 'S o 03 fen C 1^ p a c ■g 13 ffl 1 § 1 :i J ^ 1 •2 -S fc 1 ■■& ^ a ^ 1 ■2.2 |^-«« bS2^ eu a, Q 5 < < ^ 1 § 2 g 2 <2 o rt « o if ^^ -a o -^ ■=* s > asl ^ a 2 o ^ 8 s i 2 > o P5 S 0) J2 o H s> 6 "a •£ fc a t. i; S3 2 C3 -0 C 1 "J s i 1 g s s gg Oh a m a .2 Sm ^ g g J2 a 2.'%-- o =^ H _K CQ e o IS o ^ 1 H Z; < CJ N T iJ ■x. < ■P H S Ph Q < U u H 1:^ D n J > < > O Oh Ch ' < s s S T. o "o c ,C o 2 a; 2 M C o S 1 £ > 3 e 'C ■J — o » n e c. ■3 3 .t; =5 c =3 K g S o .C T3 *- C3 O *i S =i =2 ?^ r la _2 a O ^' 43 =3 ^ a ■0 a < a o < jC ci o ^ aj o t: a a o c, o 5 ^ iJ ^ o t- o •^ t; -c •= u a a '^ g =3 C3 I a m a: tt be c o ^ a a a — ■s a a < a a o "S _ J= " ^ "t^ a "S c3 0) 2 c3 104 VALUATION OF PUBLIC UTILITIES o o p o Pi I— I M o o CQ =8 P I— I >^ W ;?; o u ^ 2 S o. g T3 a .S 8^^ 55 2 5 (U g. ^ t> o § o g" a S g O fa S ?^ a -§ o o 0> (rt « > >• c6 •43 § g a -s o TJ •o ■H ID s >, cd >: •^ q5 W o3 >, g to «.2 g j3 a a ^ ^-§^ a to S o 5 <2 S « :3 g « ■^ ti Z o ^ •2 o m H Oh o ■u O 0? 13 > o H m o o H a r. < r> be o o o bc (D ^ -a .3 o a ^ ^ o 3 -^ c3 J3 ii ^ o S g Cii ^ " a j= -^ d H O M T3 2 s •C 3 t o 3neral 563 WO Appo s o o §-=o a w ^ o •43 -si ^ X 3 PLI d "rp fe d d a O o o o C5 a w a d h z o ^ o s o ,2 ° ' — S- -^ ^ ?. -a C3 2 M ° o o tc o C^ d o'C a S •« o. a g •■s £ s a Sow B » 'is 5 "^ "3 ^ o -a „ § S -S fl c 2 S "^ -5 T3 9 63 O o m "-^ ii^ ■^ m d u o d ~ C3 o n o o d b(l d d & -7^ T) c H o o eJ H C3 U O 106 VALUATION OF PUBLIC UTILITIES •S Cl, '-5 1^ O O P ^ H o Q (D '5b u « cS c. "1 •a -^ «^ -, '^ i g ^ § 9 ci t" o S O a> ^ C c3 O dn 01 > 00 611 SP C3 C if • C3 .- rt "^ 3 s •« ?■ 5 =3 c .2 § ° ^ S S a"^ I |g P "2 ^'■o 9 ■" a as I =5 S cS Si ~ S a ECM ■S 0) rt Si "" ^ s *^ ^ w M a ^ "3 >- es S g ° g £ o o g ^ _ a O H ta <; S 2 ^ C -5 tK 9 " o o .s o a oj d " g ^ o |.a§l||- S M ^ . -3 to g ggo|||.| t) 03 O c5 U 9 ,S s 's cc H H H H Pi :< H oi SE-o a a s 1 _0 03 rn o a a < a 6 O a _o ci a C5 -a: H o Pi o t' a S 5 S o ? c! tT !< dl 5 o S E Ph a a o a o S c3 O Pi H a a H Ph o ^ g 9 s .a EXPENSES 107 t4 u 4^ (U 0) OQ o s a a ■" o Ci a d ^ ■? a o a QJ a 0) a> e a -M J= a -a m a H e3 u d ^ i C3 o. 0) T3 o 2 o a 5 u si a a oi t- 1 2 a 2 a 0- o .3 i! d 1 u 1 1 'a a X ■? -3 a 01 d a H t-l o o X B .3 o B c3 13 £5 tn a _d a c ■»- "m s-2 6 E £ 2 -3 £ d "d 5 '^ "S a 0) a 'S 0) a d 'B oj 01 a o c a 6 <: M -j; O FLi M 1 6 B 'o 6 2 ■3 S d a a ci OJ o d a u a bT a u d a s j: Oi s s o 2 a '% o a o a +i d o a ■6 a . 1 a c a g a £ a c M _fl a; a o a o a 0) -a a a 2 'o B a Oi a £ c a •c 2 o a •3 _^ 1 a "2 " a a 01 _g _a 0) a d u s OJ a 2 _e a a sc d a g 1 C3 a ■a .£ c o a a u a 1 8 ■a 1 C a a; o CJ B i a £ 1 a £ a -0 a _o 3 Si B 1 d tc o a d a o a 1 o -a i ^ if d S a a ^ 2 a 2 "o 1 3 a o •5 u 1 c a O O =3 o B ■B a a a c3 a OJ o _a o a ci -3 a a d a o B V o a 'm e 0) -3 "0 1 "o B -13 a CO in d "5 d d « a _d a 2 d a d _3 u B _d a d 1- a a g a; >i "d QJ O a a (- a 0) >, "d OJ ^ g e3 g ^ B B o S d a d oj d 0) u a; u -M B '*^ tj QO o ciH <; S O ■3 PL( O CL| cK a< "^ S <: Q 1 E B o a _a O £ ■3 e "d a g a a ■c 2 1 o 2 "5 O Q >> T3 1 o o c3 to 3 c 01 u t a o g C5 0) O a Q Z o o H o d > M d o B s: o a IB la d.9 fi 0) "o B _o 1 o a B ■>> cJ u u s T. _a > B a •c 3 O a o u a 4) -c a o a £ u O T3 a C3 a) o a £ 2 o > £ B a z H 2 w Q Q O P9 2 £ a a a a a £ ■T3 a d fi £ 2 a a si 2 a a g £^ «S d 111 B a £ B ■? a 3 S£ a ■& d 2 a > a _o a "o a u _o; 6 "£ 2 d s B d ti d s| T3 S CJ > "a 2 d g OJ CO oj "C -a 3 a C3 a S aj g B S 2 a d B d "o B d g§ 108 VALUATION OF PUBLIC UTILITIES -n C s> S -tf h c3 a o "O (3 O 'S '^ M O s ^ 1 •«* ** s o 1 I !2; < .« Oh o s g O ■-S O 1 Q g < O ^ -2 § a P5 1-5 i 1— 1 S ,• ; < 1 Jl * « & •B o j -o -a m "3 apers an signmeni O ^§ o "S „- tf u S^ pq o ^ M CJ <« g I. 12; H Q ^ Z cj W c .2 Is 'S O Q o H O O g § a a tf &H fe -1 "u o T3 S a m -1^ o s o u Q a g PM i-S >J ° s ^ 3 PS a o O f* H H jj ■S -o S tele rcco offi X ai - 1 ^ o 1 fl a K 2 S O o -2 tf Oh « ix. !» O > c - g u =s o a o _ O o '3 tf »! a « .2 Uh 3 m C M a m a §■ a 1 a S a a 3 c3 3 C3 -1 P-( "J (!< O Ph 111 ^« OJ "S M ^ a-s .2 • o 2* ^ E s a S fl i; c a.e^ § a M. K. & T. Ry. Co. vs. Love 177 Fed. 493. 2 Hamilton Gas Company, Ltd., vs. Mayor, Councillors and Burgesses of the Borough of Hamilton, 1910, App. Cas. 300. FRANCHISES, GOOD WILL, CONTRACTS 143 undertaking, as such, from being included within the term 'gas works and plant' employed." ^ The position taken in the above case, by the Privy Council, was reaffirmed in a decision rendered last year, in the matter of the appeal of the City of Perth, with regard to the value of the Perth Gas Company's plant, which the city was purchasing. The question was whether the purchase price should be based on the value of the physical property, or this thing, plus the value as a "going commercial concern," the Privy Council holding that " in the absence of an express provision to the contrary, the transaction which it contemplates, is the sale and transfer, with the consent of the encumbrancers to the respondents of the appellants' commercial under- taking as a going concern ; not only of the physical apparatus by which they carry on their business, but also of their statutory powers; and that the whole must be included in the calculation of the purchase money." ^ Sometimes the courts of America have taken going value as to include an}^ value that may accrue by reason of good will or fran- chises, but in other cases have expressly stated that these other items were not included. Second. — ^A very frequent use of the term ''going value" is that of "capitalized losses," namely, the capitalization of losses incurred during the first few years after a corporation begins business. With comparatively few corporations has it been found that from the moment construction of the physical plant is complete and operation begins, the gross income will be suffi- cient to provide, not alone the cost of operating the property, but in addition fixed charges, taxes and a fair return on the invest- ment. There is usually a formative period with every corpora- tion, which may extend over a few months, or a considerable number of years, during which time, expenses, due possibly to operation or probably by reason of the necessity of providing for depreciation, and certainly to cover more or less of the fixed charges; and a fair return on the investment must be furnished from other sources until the gross income is sufficient therefor. This expense, cost or charge has been recognized, both by the courts and public service commissions, as being as much a part of the total sum going to make up the fair value of corporation ' Hamilton Gas Company, Ltd., vs. Mayor, Councillors and Burgesses of the Borough of Hamilton, 1910, App. Cas. 300. ^ Perth Gas Company, Ltd., vs. Mayor and Councillors of the City of Perth. Law Reports, Aug. 1, 1911, part 3, page 506. 144 VALUATION OF PUBLIC UTILITIES property, as is the physical plant, and therefor equally proper for capitalization. Some authorities, while recognizing that early losses are apt to occur in the starting of any corporation, conclude that such losses are not properly a part of capital, but should be considered a part of operating expense, to be made good by allowing somewhat larger earnings at a later period. The Wisconsin Public Service Commission in many of its decisions has estimated and allowed the worth of going value in connection with ascertaining the reproduction cost of a total property. The method in brief is to consider the operating deficits accruing through building up a business to a point where the gross income is sufficient to cover normal operating expenses, maintenance, fixed charges, depreciation and profit. Its basis of reasoning has been most fully set forth in its well-known Antigo Water Case decision and order, from which the following quota- tions are taken: " But new plants are seldom paying at the start. Several years are usually required before they obtain a sufficient amount of business or earnings to cover operating expenses, including depreciation and a reasonable rate of interest upon the investment. The amount by which the earnings fail to meet these requirements may thus be regarded as deficits from the operation. These deficits constitute the cost of building up the business of the plant. They are as much a part of the cost of building up the business as loss of interest during the construc- tion of the plant is a part of the cost of its construction. They are taken into account by those who enter upon such undertakings, and if they cannot be recovered in some way, the plant fails by that much to yield reasonable returns upon the amount that has been expended upon it and its business. Such deficits may be covered either by being regarded as a part of the investment and included in the capital upon which interest is allowed, or they may be carried until they can be written off when the earnings have so grown as to leave a surplus above a reasonable return on the investment that is large enough to permit it. When capitaUzed, they become a permanent charge on the consumers. When charged off from the surplus, they are gradually extinguished. (These facts alone, however, do not always furnish the best or most equitable basis for the disposal of such deficits.) Whether they should go into the capital account, or whether they should be written off, as indicated, are questions that largely depend on the circumstances in each particular case." "The cost of developing a business of waterworks may be made up of many different kinds of expenditures It may also include FRANCHISES, GOOD WILL, CONTRACTS 145 losses to the investors because of the fact that the plants in their earlier years fail to earn enough to meet all the requirements for operating expenses, including depreciation and a reasonable return upon the investment. If the direct outlays for securing business are charged to operating expenses as thej- should be instead of to the capital account, then the cost of acquiring a paying business would be represented by the deficits or by the amounts by which the gross earnings fall short of covering the cost of operation as stated including fair returns to the investors." " But while such losses will have to be met by the investors, it is not expected that these sacrifices will be anything but temporary. The investors fully expect and in most cases rightly so, that these losses will be made good as soon as warranted by the business of the plant. They usually regard such deficits as an additional investment upon which, unless the whole amount is refunded to them in some form, they are entitled to the same returns as on the rest of their capital. Unless they are so compensated it is manifestly clear that no money from private sources is likely ever to be invested for such purposes, except perhaps in a few rare instances for philanthropic reasons." "It would seem further that there is no principle of justice upon which the service can be had on any other terms." "It thus appears that the cost of building up the business of a plant is in most cases as unavoidable as the cost of the construction of the plant itself; that when such costs are incurred they must be reimbursed in some form by the consumers in order that capital may be secured; that such reimbursement is equitable as between investors and con- sumers; and that this is a just method of dealing with such costs for other reasons. If this is sound, it also follows that the cost of the business must also be taken into consideration in determining the value of the plants for rate fixing purposes." " This would seem to apply with special force where by law the rates are limited so as not to yield more than reasonable returns upon the investment. While such legislation may not be a guarantee against losses of any kind, it is clear that if the rates fixed under these laws should not include anything for the cost of building up the business, there would be no way in which these costs could be made good to the investors. In that event these costs would become a permanent loss to them; and the consumers, in turn, would be relieved from paying a reasonable return on a part of the investment or on the capital that is devoted to furnishing them with the service in question. This is a situa- tion of which the investors are taking due notice, and which is entitled to due consideration. If not taken into account, it will tend to keep new capital from entering this field as well as to prevent exact justice to capital which has already entered the same. The former would 10 146 VALUATION OF PUBLIC UTILITIES result in hardships or inconveniences to the consumers ; the latter would apparently be unjust to at least many of the present investors in such utilities." "They should not include items that have been incurred under other than usual conditions, or items that could have been avoided by the exercise of ordinary care and business judgment." ' The Wisconsin Commission has repeatedly reaffirmed its adherence to the rule thus laid down in the Antigo case. In State Journal Printing Company vs. Madison Gas & Electric Company, decided March 8, 1910, the Commission not only strongly reiterates the rule laid down in the Antigo case, but again makes use of tables similar to those used in the earlier case to determine the cost of establishing the business (pp. 580-587). At page 585 of its opinion in the Madison case the Commission says: "For public utilities which, under both the common and the statute laAv, under normal conditions are only entitled to reasonable returns on the investment, justice as well as equity appears to demand that the amounts, if any, by which they, under ordinary conditions, have failed to earn such returns, should be considered in fixing values and rates for such plants. In fact, such consideration would in most cases seem to be absolutely necessary in order to secure the capital required." In Ripon vs. Ripon Light & Water Company, decided March 28, 1910, the Commission applies the same rule and prepares tables on the same basis, reviewing the earnings and expenses of the property during a period of fifteen years, saying at page 16: "During a considerable portion of its period of operation the gross earnings of the respondent company have not been high enough to cover operating expenses, including the promotion of business, depreciation and a reasonable return in the form of interest and profits. Such defi- ciencies must be met by the owners of the property, either in the form of additional capital put into the business, or the absence of a return upon their investment, and can be said to constitute an additional investment necessary to building up the business." The same principle is reaffirmed by the Wisconsin Commission in its decision in the Chippewa Falls Lighting Company case, decided June 14, 1910, quoting at length from the Antigo decision (see pp. 314-315). In the Fond du Lac Water Company case decided by the same Commission August 19, 1910, the history of » Hill et al. vs. Antigo Water Co. 3. W..R. C. R. 623, 711, 712. FRANCHISES, GOOD WILL, CONTRACTS 147 the property and examination of its gross and net earnings is carried back over a period of twenty-four years (see Table I, page 520 of that decision), the Commission saying at page 459, after stating the method of computation of past deficits which was the same as they applied in the Antigo case: "The amount by which the value of the plant on August 1, 1909, as thus computed exceeds the tentative valuation of physical property may under this method be termed the going value of the property. This method of estimating the going value follows quite closely the methods discussed by this Commission in the cases of Hill vs. Antigo Water Company and in State Journal Printing Company vs. Madison Gas & Electric Company, and it would seem that no further discussion is required herein." Such method of fixing going value may permit the inclusion in capitalization of such expenditures as are made for furnishing electric fixtures free of cost, installing house wiring, or gas stoves at less than cost, the donation of gas, electricity or water for public amusement or benefit. Also the cost of displa}^ advertis- ing, canvassing, or instruction of customers or other expenses which help develop income more rapidly than normal. The best informed usually prefer that such expenses should not be capitalized and made a continuous burden on the public, but rather that they should be included as a part of the operating expense, thus keeping down capitalization. It has been pro- posed that the cost of holding the present business, or such ex- pense as would be included as a part of the normal conservative growth of the business, should be charged to operating expense, while the cost of getting new business should be charged to capi- tal account. Theoretically, such a division appears perhaps logical and equitable, but in practice for most companies at least, it will be found difficult to separate the costs so that many feel that the capitalization of any such costs, is not conservative business management. To definitely determine what expenditures are legitimate and what part of them are not, is not always an easy matter. The difficulties in the way of doing this are also increased by the fact that the early records of the plants are, as a rule, either inaccessible or incomplete. But even at this the task is not insurmountable, while there may be a lack of data in some cases, there may be an abundance of such facts in others. The conditions which obtain 148 VALUATION OF PUBLIC UTILITIES for some plants may be a fair indication of the situation for others, where the circumstances are similar. In any event, what consti- tutes the normal cost of developing the business, like the cost of the physical value, the fair rate of profit and other elements, is a question which can only be determined by investigation of the particular property under consideration. "In addition to those mentioned, there is also another element that should receive some consideration in fixing the cost of the business, and that is the profits the plants have earned since they reached a paying basis. If these profits are so large as to be considerably above those ordinarily obtained, it is conceivable that strict justice between invest- ors and consumers might require that these excesses should be treated as an offset to early losses, and that in this way all or a part of the earlier losses may have been wiped out. In dealing with this feature of the situation, however, it should be borne in mind that the risks involved are much greater at first than later on, when the adaptability of the plant has been proven and when its business has been secured; and that since risks are one of the leading elements that determine the rate of profit, the rate of returns to which the investors and those who carry on the business are entitled may be considerably higher during the earlier and more risky periods than is the case later. Just how much importance should be attached to the difference in the earnings as between the earlier years and later years, is not clear. Much depends on how the operating expenses including depreciation, have been treated, and what sums have been included therein, or excluded there- from. In this connection a great deal may also depend on such defini- tions as have been placed on the word "reasonable" as appUed to the rate of returns. These are matters, however, that to a considerable extent, are subject to proof, and may therefore be disclosed on the proper kind of inquiries." ^ In order to better illustrate the theory adopted by the Wisconsin Commission in building up the cost of going value or the "cost of service" value, the accompanying typical diagram is introduced. It will be seen that the first year is wholly occu- pied with plant construction, during the second year partial operation is begun and extended until the plant is wholly in operation at the beginning of the third year, from which point operating expenses, interest on the cash invested, taxes and depreciation are assumed to increase at a uniform rate, mean- while business expands normally, gross earnings improve at an 1 Hill vs. Antigo Water Company 3 W. R. C. R. 623. > 1 FRANCHISES, GOOD WILL, CONTRACTS 149 increasing rate until income gradually exceeds expenses and a profit is realized. During the construction period, with little or no income, a deficit rapidly accumulates by reason of accruing interest, taxes and depreciation to meet which money must be borrowed at interest, further increasing the deficit, which, until the time earnings equal operating expenses, is capitalized as a part of the total expenditure necessary to create a going property. Thus according to the theory of the Wisconsin Commission utilities are entitled to recover early losses, not the result of mismanagement, provided no more than a fair return has mean- while been earned on the investment. - y^ ^■^^ Interest on Deficit ^ tsM—j L. V ■-Deficit — Interest 1 2 5 6 7 8 9 10 11 12 13 14 Years Fig. 3. — Illustration of the method of computing going value, as used by the Wisconsin Commission. The Supreme Court of Oklahoma in the Pioneer Telephone case, recognized the fairness and logic of the method of determining going value used by the Wisconsin Commission quoting from the decision of the Commission in the Antigo case and deciding that the Oklahoma Railroad Commission erred in failing to make a similar allowance, in the case under its jurisdiction. The Court then finds that the going concern value of the telephone company is equal to 20 per cent, of the cost of reproduction of its plant on the sum of which two items the commission erred in not permit- ting earnings as a fair return. "Subscribers are not obtained without expenditure of money, labor and time, during which the capital invested in the plant earns nothing and often fails to pay operating expenses. The customers must be 150 VALUATION OF PUBLIC UTILITIES connected with the system of the plant, trained emploj-ees must be obtained, and a system of operation must be estabUshed. Few indus- tries, if any, involving an investment of $90,000 or more, can be made self-sustaining from the first day of their operation. The uncontradicted evidence in tliis case discloses that appellant's plant for the years pre- ceding the first hearing, failed to produce revenue sufficient for operating expenses, current repairs and lay aside an amount for depreciation. During the time of development there is a loss of money actually expended and of dividends upon the property invested. How shall this be taken care of ? Must it be borne by the owner of the plant ? Or by the initial customers ? Or shall it be treated as part of the invest- ment or value of the plant constituting the basis upon which charge shall be made to all customers who receive the benefits from the increased service rendering power of the plant by reason of these expenditures ? It seems that the last solution is the logical, just and correct one. If rates were to be charged from the beginning so as to cover these expendi- tures and earn a dividend from the time a plant is first operated, the rate to the first customers would be in many instances, if not in all, so exorbitant as to be prohibitive and would be so at the time when the plant could be of service to them. On the other hand, the public cannot expect as a business proposition or demand as a legal right that this loss shall be borne by him who furnishes the service; for, investors in public service property make such investments for the return they will yield; and, if the law required that a portion of the investment shall never yield any return, but shall be a total loss to the investor, capital would unwillingly be placed into such class of investments, but the law in our opinion does not so require. Private property can no more be taken in this method for public use without compensation, than by any other method. When the use of the property and the expenditures made during the non-expense paying and non-dividend paying period of the plant are treated as an element of the value of the property upon which fair returns shall be allowed, then the burden is distributed among those who receive the benefits of the expenditures and the use of the property in its enhanced value. "^ In estimating going value from a consideration of and allow- ance for a fair return during early years when same has not been earned, common sense and good judgment must be used. In the Coney Island and Brooklyn Railroad rate case, before the Public Service Commission of New York, First District, the engineer of the company submitted an estimate of the going value of the property based on the earnings for a period of some sixty years previous. The value of the property at the close of each year ^ Pioneer Telephone & Telegraph Co. vs. Westenhaven. 118 Pacific 354. FRANCHISES, GOOD WILL, CONTRACTS 151 was taken separately and the net earnings applied to the princi- pal, less the amount required for a fair return, the balance being carried forward in the same way that going value is estimated by the Wisconsin Commission. Thus, in the case of the company referred to, the deficiencies were carried forward from year to year at compound interest and eventually showed an amount aggregating more than the value of the physical property, which the expert claimed should be considered the capitalization upon which a return at present should fairly be allowed. This of course is carrying the matter to extremes. It can hardly be argued that the original Horse Railroad, which had clearly demon- strated itself a business failure should be added, investment, passed dividends and all, to the value of the electrical system and the latter be made to pay returns on an investment which had never proved itself of value. The criticisms which can fairly and logically be made to the method of estimating going value adopted by the Wisconsin Commission are: (a) The reproduction cost of the physical plant is increased by the actual cost in the past of building up the present busi- ness instead of by an estimated cost of reproducing a like business. (b) The expenditures made in the past in building up the present business are usually assumed to have iDeen properly and advantageously made, which may or may not have been the case. (c) No scientific theory or definite rule has been determined fixing the period during which the deficits in income shall be permitted to be capitalized, resulting in inequality as between corporations and possible encouragement of mis- management and capitalization of unwise expenditures. Third. — Going value has also been used to mean the value that obtains from capitalizing the present net earnings of a corpora- tion, i.e., the value of a created income. In this sense it is closely allied to good will and may perhaps be fairly applied in determin- ing the value of the business of a private corporation, but has no place in consideration of value on which to base a fair return when considering a public utility corporation operating as a con- trolled monopoly, for the reason fully explained under ''Good Will." Such evaluation based on the total net earnings, would 152 VALUATIO?^ OF PUBLIC UTILITIES include in going value, the value of good will, franchise, etc., unless these were first separately valued. It has been suggested that the modification of this method, used in determining "immaterial properties" value, in the appraisal of the railroads by the State of Michigan, namely the capitalization of net earnings remaining after deducting a fair return on the value of the appraised physical property, is erroneous and misleading because the same total valuation would be obtained by capitalizing total net income regardless of plant values. Moreover the method used is based on an assump- tion that income is proper, hence rates are fair which is simply basing values on rates, which perhaps proved a satisfactory method of establishing values for purposes of taxation. The Supreme Court in the Kansas City Water Works case says "The city steps into possession of a property which not only has the ability to earn, but is in fact earning. It should pay, therefore, not merely the value of a system which might be made to earn, but that of a system which does earn." Fourth. — Although the trend of modern movement is toward the reduction rather than the creation of non-physical values, going values have been allowed, particularly in waterworks appraisals, based on the present worth of estimated earnings including those of future business growth. The method consists in estimating the present worth of excess earnings of an existing plant compared with those of a hypo- thetical plant, between the date of valuation and the time the earnings of the assumed plant shall equal those of the existing plant. A very complete and valuable paper explaining this method of determining going value has been jointly and recently presented by two well-known and competent authorities on appraisals, particularly those relating to waterworks, Mr. L. Metcalf and Mr. J. W. Alvord. As no better exposition of this theory has been presented, the author has attempted to summarize this paper and quotes therefrom, at length. Going value as defined by Messrs. Metcalf and Alvord relates exclusively to "the cost of acquiring a given income," being a value "between" a tangible and intangible value, the former representing physical property and the latter, as here used, estimated value, going value being an actual cash expenditure, FRANCHISES, GOOD WILL, CONTRACTS 153 as estimated to produce certain results. The present worth of going value, to be logically determined, must be based on the cost of reproduction and may be estimated by determining the difference in earning capacity between the existing property and a hypothetical new property which has been called the "Com- parative Plant." The construction of the hypothetical plant is assumed to begin at the date of appraisal and to progress as rapidly as practicable, beginning business as completion of parts will permit, and steadily acquiring and increasing business until the total amount equals the amount of business that is estimated shall be done by the existing company, at its present rate of prog- ress at that time of equality in the future. The estimate for the existing plant is independently completed and then the esti- mate for the comparative plant is made on the assumption that as fast as plant construction permits the new company takes the business of the old company, without competition, the use of the property of the existing company being discontinued as the new plant is ready to render service. Going value is, as stated by the authors: "The sum of the present worths of the annual excess in net earnings, or return, from the existing plant, as compared with those from the comparative plant, in the period of years from the date of valuation to the time when the earnings of the comparative plant can reasonably be assumed to e(iual those of the existing plant, is then the measure of the going value of the existing plants." The matters to be considered in figuring going value based on a comparison of an existing and hypothetical plant are: (a) The time required to construct the hypothetical plant. (b) The time required for the earnings of the hypothetical plant to overtake those of the existing plant. (c) The capacity of the existing plant in relation to present business. (d) The depreciation charges of each plant. (e) The gross income, with rate of increase, for each plant. (f) The operation, maintenance, depreciation, taxes and other similar expenses omitting return on the investment. To indicate exactly the application of the principles outlined by Messrs. Metcalf and Alvord, the following example is quoted from their paper in the Transactions of the American Society of Civil Engineers, Vol. LXXIII. 154 VALUATION OF PUBLIC UTILITIES APPLICATION OF PRINCIPLES OUTLINED Assumptions as to Existing Plant. — For the sake of illustration, and to make clear the principles which have been discussed, the writers have assumed a typical case in order to show the steps necessary to deter- mine the going value of a large property on the comparative method herein outlined. ASSUMED ANNUAL GROSS INCOME, OPERATING EXPENSES AND NET INCOME FOR EXISTING AND COMPARATIVE PLANTS 1910 1910 1911 1912 1913 1911 1915 1916 1917 1918 1919 1920 1921 1922 1923 usuuuou 1400000 1300000 - . — — " :§ ot* i^^ V\a nt ^'' *^ ^ >2S. £. < oss ^ ^ *y ■' 1100000 S s r" 1 o Eh 1^ O H CQ CO O ^ > < 1 H o o a 5 «^ CO - o Q O ;?; I— I Q H CO P^ H 12; "O c ^ o c C c -co 2 03 o o o O c §■ q. o_ o c" q. c c o" =S 3 g ■a s o o o ^ Q >~- o ■5 > s c ^ IN •rf K e t--" s X go" 4«» .H M ^ o^- " o O o o o c o o o o o o o o — - "^ t£ ^-^ ^ o' o" ^* o* c c3 *r c3 t- o o o •S 3 >- t- o:_ co_ X o .S o a Q '^ X C ■M S M ^ ^ ^ ^ ^ S s fc. ■3 '-S 'o o o_ p_ o o o -a S > ^-^ o" g" O o" c Q M c 3 in o o o o c o §^ =3 S^ "^ TO c^ fc. " Sn »» s S €^ X •- ^ ^ ^ ^ ^ c ^ mping ;ion foi larged ply am usion ( lame >o 1 o s 1 1 c c g 8 ■>!" IM 3 ci C ft 5 " «» «© -J '^ ^ ^ o ^ C Qi o o o =3 . o o o_ o ■ft 2 ^ g g" g"' g" II TO >o TO «# ^ rn c ^ t, ^ . «"2 M g = o S " S-j: = K 03 o o o M § 8 CO 8 £|S|1S^ ^ «» lg ^ ^ ^ ^ o ^ § g § g g 8 g 1 1 ^^ o" Q o o" o" o o" IN o O o o o 'E , Tl< 05 00 >fl ■^^ ^ 0) f^ .2 C. ■*" «# Q 'a o -f^ 03 Q ^^ C ^ (N cc •* "fl £) 5 c o O) 5 o 35 > 1 > > > > > > >> — t- L. Lh ^ t- c3 c c rt c c C3 ^ 3 3 3 = C J C S E C H ca ci d C3 03 c c3 •^ s 1-5 -5 -5 -5 -5 ' 158 VALUATION OF PUBLIC UTILITIES 4. Pumping station for enlarged supply and extension of same after the year 1913 by the installation of additional pumping units; 5, Storage dam and impounding reservoirs. The real estate, water rights, and rights of way are assumed to be distributed in the several divisions to which they appertain. The cost of engineering and contingencies is also included under the several individual items cited above. The interest during construction, however, as well as the going value, remains yet to be determined. Beginning of Operation of Different Portions of Comparative Plant. — It is assumed that by January 1, 1912, the small supply from pond or driven-wells will be available. The filter plant and main pumping station is assumed to be completed and ready for service as of January 1, 1914, the additional pumping units installed thereafter being ready for service between Januarj^ 1, 1915 and 1916. It is assumed that on or about January 1, 1915, the storage dam and impounding reservoirs can be put into service, though not finally completed until January 1, 1916, and that the pipe distribution system built in any year is available for service the following year. Loss of Interest During Construction. — In Table III has been computed the loss of interest during construction on this plant, based directly on the assumptions made as to the order of construction shown in Table II and the discussion following, and on the further assumption that the dividing line for the charges for loss of interest on construction account and on operating account is drawn at the point of completion and putting into service of any revenue-producing unit of the plant. TABLE III. — COMPARATIVE PLANT Interest During Construction Total net physical value, Average Total net physical value exclusive of going value amount on Interest and interest during and interest during which on construction, exclusive construction interest is amoimts of going value Date chargeable for one full year to capital in Column 4 at 6 per cent. During year To date, December 31 During year To date account (1) (2) (3) (4) (5) (6) (7) ■ 1910-19H . S800,000 8800,000 $400,000 S24,000 $824,000 $824,000 1912 1,700,000 2,500,000 1,650,000 99,000 1,799,000 2,623,000 1913 2,100,000 4,600,000 1,550,000 83,000 2,183,000 4,806,000 1914 1,900,000 6,-500,000 2,650,000 159,000 2,059,000 6,865,000 191.5 1,300,000 7,800,000 1,4.50,000 87,000 1,387,000 8,252,000 1916 800,000 8,600,000 500,000 30,000 830,000 9,082,000 Total allowance for lost interest-during-construction item $482,000 FRANCHISES, GOOD WILL, CONTRACTS 159 Thus, loss of interest during construction is allowed on the average amount of investment during the year 1910 at the rate of 6 per cent., on the assumption that the work built during that j^ear cannot be revenue producing until after the year 1911, pending completion of the water- supplying works. Similarly, interest is allowed during the year 1911, not only on the investment during the year 1910, but on the investment during the year 1911. After January 1, 1912, however, the interest on the investment in pond or driven-well supply is assumed to be charged to operating cost as fixed charges, and not to capital account under the head of interest lost during construction, for the reason that it is assumed that this portion of the plant, being available through the agency of the pond or driven-well suppl}^ and the distribution pipe system built up to that date, is now in the revpnue-producing class. Similarly, interest lost during construction is charged to capital account on the filter plant, during the years 1912 and 1913, and thereafter to the operating ac- count as fixed charges, for the reason that the filter plant is assumed to be in revenue-producing operation after January 1, 1914, when it is assumed to have been completed, although the water-works plant as a whole is not assumed to be finished until January 1, 1916. New Construction in Going Value Development Period Ignored. — No consideration is taken of the new construction re. ^ H C ' 'E 0"= c ^ S ii '-3 £ C^:= ^ y « HH r,-. 3 C t-, SS« 3 MPUT ON U ivestor _ o .2 w c3 > ^ fe ^ -^^ bO a s h3 si ^ o ^ S 3 a; TRIA INTE tids of H ^ 02 tf .s fe > w Cl" f-" t--" CD m" rt oi" -;<■■ -< •7" Tt< u-; t^ M —1 . 1 . •=0 -* ^T M -H III o o 3t on ilf of nn 7 at r cent. goooogggooo o ef s' GO o lo" ■<)<' t>r -T m" — T ^" ,-." 00 1 .°^ — OJ «© Ol Cl mn 6 at er cent. goooooooooo « ? 1 >> ^^ q q. q. q q c_ o o 8 o S M ci n -rf X o" cc X cf ?r ot Tf" a o a O M (M (M « rH III 3 Q, 6- •* CC W -H III o 3 c 2 **« g2S2S2°^S=' = ■^ > 3 C "l. 1 c 5 i: -n S q qooooooooo 3 E r. 3 0) ^-v ■*" Qo" as" o" pf cT c-i" Li" o" cf CO o t^ Clt^XOOOO!-l-v05'>5i.^ T3 Am with or CO tion the ** -h" of of -<" -h" _o "o. & . 2CCOCCCCCOO c •g -^ .2 M = -S sSSSSSSSSSo 3 S t^ •?, -5 " £ ^s =5 O — S -r 1--: rr" x' -i' -r" t^" § 2 » .2 r t. 3j S > ^ d S - O = S«c=igi2- 1 77 < .S ^ S c- .s e 00 lo w -. Ill o t fe V .»^ _C T3 C . 1" '*• ooooooooooo "o rotal sume Bstme 1 date lumn plus lumn •q<" T}> of u~ -h" o" ic r-." of of -V t^ t^X-HOJOO'-O-rXO) g ■* X -H CO q. t-, x_ x_ X a otal invest- nt to date omparative (phy.sical) plant and interest luring con- ooooooooooo c 8 8 8 8 8 8 8 8 8 8 8 -r r: :o i-o 01 01 of oi oi oi oi « r? Ol 01 O O I.- X X X X X X 3 ^-^ X q, x_ x_ oi_ c_ o_ o o o o of -t o" x" o" of of of of of P-l Oi u ^ E a CD ^ INet income from operatio (.see Column Table 5 ooooooooooo a o oooooooo x o" of o" o" x" r-" of o" «o 0^3CDX^^«o^!0 «© -H01C0'*Omi^I> S £ SS 1 u -5 o t. H c 4) i 5 Q -O O-HOlCO^LOfflt^-XOiO 0)05C3020)00!0>0!0101 "S >> s $ — 53 J3 11 162 VALUATION OF PUBLIC UTILITIES construction in the assumed existing plant and hence also in the com- parative plant, is therefore 19,082,000. The going value, however, is not yet known, and, therefore, must be determined by a series of approximate computations. The franchise is assumed herein to have nominal value only. As a first trial, assume a going value of $1,800,000. Under this assumption, the total value (or cost to the investor) of the existing plant would be as follows : Physical plant $8,600,000 Loss of interest during construction 482,000 Assumed going value 1,800,000 Total value $10,882,000 Therefore, the investor who has concluded to build a new hypothetical plant, instead of to purchase the old plant, is assumed to have in hand the sum of $10,862,000, as of January 1, 1910. He is assumed further, to adopt the same order of construction for the new comparative plant as shown in Table II. Under these assumptions. Tables VI and VII result. TABLE VII— FIRST" TRIAL GOING VALUE COMPUTATION AS OF JANUARY 1, 1910 Year Total net return Present worth of excess earnings of existing over comparative plant ending December 31 (1) Existing plant (2) Compara- tive plant (3) Excess of existing plant (4) Period of years <5) Factor at 6 per cent. (6) Amount (7) Cumula- tive amount (8) 1910 1911 1912 1913 1914 1915 1916 1917 1918 1919 1920 $600,000 619,000 638,000 659,000 676,000 693,000 708,000 724,000 737,000 751,000 766,000 $410,000 275,000 249,000 261,000 316,000 392,000 490,000 581,000 666,000 727,000 762,000 $190,000 344,000 389,000 398,000 360,000 301,000 218.000 143,000 71,000 24,000 4,000 1 2 3 4 5 6 7 8 9 10 0.9434 0.8900 0.8396 0.7921 0.7473 0.7050 0.6651 0.6274 0.5919 0.5584 $179,000 306,000 326,000 315,000 269,000 212,000 145,000 90,000 - 42,000 13,000 2,000 $179,000 485,000 811,000 1,126,000 1,395,000 1,607,000 1,752,000 1,842,000 1,884,000 1,897,000 1,899,000 Resulting Going Value . Assumed Going Value. $1,899,000 1,800,000 Error on First Trial Computation. $99,000 FRANCHISES, GOOD WILL, CONTRACTS 163 Resulting Going Value under First Trial Computation.— In Table VII is shown the result of the first trial computation of going value. It will be noted therein that the going value, which was assumed to be $1,800,000, was found to be approximately $1,899,000, involving an error in assumption of $99,000. Were a going value of $1,900,000 assumed in the second trial com- putation, the resulting going value would be found to be somewhat less than that sum, on account of the greater amount of interest accruing on the unemployed capital, which tends to reduce the going value, the other items remaining substantially the same. Probably closer results would be obtained by assuming for the second trial computation a going value of $1,880,000. Recomputation Unnecessary for the Purpose of This Paper.— As going through the somewhat laborious process of recomputing Tables VI and VII would not .shed any additional light on the principles enunciated, it is unnecessary, for the purpose of this discussion, to follow through this recomputation. Enough has been said to illustrate the principles involved by the method of computing going value suggested by the writers. For the second trial, assume a going value of $1,880,000. The total value of the plant under discu.ssion would then be: Physical plant $8,600,000 Interest during construction 482,000 Assumed going value (second trial) 1,880,000 Total value $10,962,000 In the second trial computation, therefore, it should be assumed that the builder of the comparative plant starts, as of January 1, 1910, with the sum of $10,962,000 in hand. Effect of Assumptions as to Order of Construction on Loss of Interest during Construction Item. — It will be apparent, from the foregoing discus- sion, that the larger the allowance for the loss of interest during con- struction item, the smaller will be the resulting going value, for the rea- son that, the gross income and operating expenses remaining the same, the amount of unemployed capital in the hands of the builder, will be increased. This, in turn, increases the interest accretions on unem- ployed capital, which have to be deducted from the net income of the existing plant in determining going value. The effect, therefore, of these deductions is to decrease the going value. It is obvious, how- ever, that the decrease in going value is not ecjual to the increase in in- terest charges, for the reason that the interest allowances on unemployed capital are assumed at a lower rate than the loss of interest during construction item, and the present worths of the annual differences 164 VALUATION OF PUBLIC UTILITIES in net income are taken in determining going value as of any given date, instead of the arithmetical sum of those differences. Some interesting deductions and comments have been made by Mr. F. P. Stearns, in attempting to ascertain a uniform figure which may be used in appraising going value, based on certain data as to the valuation of water-works property, includ- ing going value, furnished by Mr. J. W. Alvord. "If one takes the data from this table/ omitting the places having less than 10,000 inhabitants and the one place having a population of more than 100,000 — the former being omitted because of their small size and the latter because it is hardly possible that it could be supplied from its original works — and also omits one case where there was com- petition between two rival plants, the following minimum, average and maximum results are obtained:" Average population 34,555 Average net value of physical property $774,567 Average going value 133,269 ' Minimum $1.65 Average 3 . 86 Maximum 6.90 Going value per capita . Percentage of value of net physical property represented by the going value Minimum 10.5 Average 17.2 Maximum 34.6 "Mr. Alvord calls attention to the lack of relation between the going value and the value of the physical property, and yet an average of the results attained in a number of cases where rational methods were used will give approximately this relation in the case of a normal plant. "In the typical illustration u.sed by Messrs. Metcalf and Alvord, the statistics are as follows : Population 300,000 Net value of physical property, including interest during construction $9,082,000 Going value 1,897,000 Going value per capita $6 . 32 Percentage of value of net {physical property repre- sented by the going value 20 . 9 " The writer can easily conceive that there may be an actual deficiency in the returns during the earlier years of the operation of a normal ^ Proceedings American Water Works Association, 1909, page 206. I I FRANCHISES, GOOD WILL, CONTRACTS 165 water-works plant which will equal $133,000 for a plant valued at $774,000 and supplying 34,000 people, but he cannot conceive that, during the growth of such a plant to a net value of $9,082,000, with ability to supply 300,000 people, there can be an added deficit amounting to $1,764,000, or any sum approximating this amount, due to the devel- opment of the business incidental to the additions made from time to time."^ Practical application of the method hereinbefore described and illustrated for determining going value has been in several cases, notably that of the Macon Gas Light and Water Co. The figures used in the valuation for sole purposes of the Macon plant, together with diagram illustrating the method of ascertaining the going value of that plant are given in full in Chapter X. From the preceding, it will be seen that the suggested theory of appraising going value, involves many assumptions and a large forecast of the future, based on the history of a property, which may or may not be a proper basis. The assumption that the business of any corporation, will continue to increase in the future along lines indicated by its recent history, is perhaps more applicable to waterworks valuations than to most other utilities; certainly many gas, electric light and railway companies would object to any such proposed method of determining their going values. Any predication of future profits on the previous rate of increase in business, in America, must not ignore the fact of the recent, rapid increase in population of the cities which may have caused a greater income to any given utility than the normal increase from territory, already served. To figure that going value can be determined from the con- sideration of the actual gross and net incomes in past- years, assumes that past rates have been fair, which may or may not have been the case. The method of determining going value under consideration, omits any proper consideration of the deficits, if any, which occurred during the early history of the corporation, and such deficits, as explained in the preceding pages, is the basis of going value recognized and allowed for by the Wisconsin Commission and other authorities. 'Transactions American Society of Civil Engineers, Vol. LXXIII, Sept., 1911, page 365. 166 VALUATION OF PUBLIC UTILITIES Contracts. — ^Although the Public Service Commissions have, as a rule, denied the right of capitalization of contracts between corporations and public bodies, such as franchises and licenses, beyond the actual cost legitimately extended in obtaining them, they may be capitalized under certain circumstances. The Supreme Court in the well-known Consolidated Gas case al- lowed the value of S7, 500,000 for franchise. The Public Service Commission of St. Louis, in the appraisal of the property of the Union Electric Light and Power Company, capitalized, at 8 per cent., the rentals saved through an agreement with the local telephone company to the use of the latter's poles, allowing S80,000 therefor in the value of the property of the Light and Power Company. Utility corporations very often have sought to capitalize the net returns from profitable contracts. Ordinarily, such capitalization is not properly allowed on the ground clearly set forth in a recent decision of the Public Service Commission of New York. "The contention of the company as represented by the testimony of this witness in substance is that the profits from this contract for its remaining life shall be capitalized, that the amount thus reached shall be added to the fair value of its i^roperty and that the rates shall be such as will provide a fair return thereon. In other words, the city or the tax-payers must pay an exorbitant price for street lighting, and yet the general consumers must pay enough to yield an ample return (10 per cent, is urged) upon the capitalized value of such abnormal profits, capitalized upon a basis of 4 1/2 or 5 per cent. The absurdity of such a contention is apparent. Paraphrased, it is that the more the city pays the more the consumer must pay. If there is any relation- ship between these two factors, it is that the more the city pays, the less the consumer should pay, and this has been recognized in many franchises for water and lighting plants. Indeed, the original contract and its history indicate that street lighting and the price obtained therefor have always been very important factors, and at the beginning were the chief concern of the company. Apparently, the original plant was built principally with a view to this business, and the contract was a very important inducement to the company to begin operation. It is obviously unfair that this very contract should be used to make the I^ublic pay a higher rate than they otherwise would. "The argument of the company proves too much, for, if it is correct, it could be argued that every contract should be similarly treated. The public lighting contract resembles other contracts between company and FRANCHISES, GOOD WILL, CONTRACTS 167 consumers. All are property, and presumablj- all are profitable. Those that are could be capitalized if this one may, and the more profitable they are, the higher must the rates to others be placed. Conversely, if any one should not be profitable, the capitalized loss should be subtracted from the fair value of the other "property," and the rates lowered accordingly. "It should be noted further, that' the company does not claim that the contract itself represents any investment or that any deposit, fee or payment was required by the authorities. "The Commission can find no reason in law or equity which would justify the capitahzation of the street lighting contract and the inclusion of such capitalization in the 'fair value' upon which the company is entitled to earn a fair return from the sale of gas to general consumers. It is unnecessary, therefore, to consider the methods of determining its value." ^ 1 Case 1273, Mayhew vs. Kings County Lighting Company, Decision dated October 20, 1911, PubHc Service Commission of New York, First District. CHAPTER VIII DEPRECIATION General. — There is to-day probably no subject requiring more illumination and coordination by the engineering profession than that of depreciation. The recent generally recognized necessity on the part of individuals and corporations, and the increasingly insistent demands by commissions, legislatures, and courts for proper allowances covering the reduction in worth of physical properties — be it more or less rapid — has resulted in a divergence of thought and a lack of uniformity of practice that is bewildering. The important and wide use actually made of depreciation both in figuring operating expenses and net earnings, as well as in the determination of present values of physical properties, through appraisals, for purposes of taxation, rate making, capitalization or sale, make the subject of paramount importance to the engi- neer, so that the almost total absence, not alone of an approved theory of depreciation, but even the marked meagreness of authoritative literature on the subject, is striking. While certain methods have been developed and some general principles have been widely accepted, nevertheless, trustworthy engineering data on depreciation are exceedingly scarce, the application of methods of estimating depreciation varies widely and even the terms employed are used in a vague and contradictory manner. It must be admitted that where engineers of experience, good judgment and integrity, appointed even by opposite "sides" may be expected to approximately agree on the ''original cost" or the "cost to reproduce new" they differ much more widely in attempting to determine depreciation. This in part arises from honest differences of opinion, as the problems are not possi- ble of exact mathematical solution and the gradations from one class of depreciation to another are frequently so gradual as to be barely distinguishable; and yet, a consideration of what deprecia- tion — if any — has taken place in the physical property of every corporation must be had, in order to obtain a safe — though it may be very approximate — indication as to proper or improper capitalization. 168 DEPRECIATION 169 "Absolute" and "Theoretical" Depreciation. — Before under- taking to discuss proper methods of estimating and allowing for depreciation, it is essential to have clearly in mind just how depreciation actually takes place and in what way it effects physical property. Where property is no longer of service, it must be depreciated down to the value at which it may be sold, even though that value is as low as scrap value. On the other hand, apparatus that is in use and rendering a service economically, may for the purpose for which it was intended, be as valuable as when originally installed, although its age may be approaching the limit of its life. Take for example a steam engine which though having been in use for the greater part of its estimated life is, through proper maintenance, in as good condition to render service as at any time in its history. If its annual maintenance charge is no greater than in the earlier years of its history, its "service value" to the company as a going piece of property is as great as when first installed. What then do we mean by depreciation? Reference to Fig. 5 indicates graphically several ways in which depreciation actually takes place, as well as usual methods heretofore adopted in considering and evaluating depreciation. Assume that a given piece of physical property has an esti- mated life of twenty years, represented by the abscissa B, and that it has a given value in dollars, shown by the length of the ordinate A. Let the ordinate C represent the worth in dollars of the apparatus as scrap or junk, then the abscissa C D will represent the scrap value throughout the life. This line is usually approximately a straight line, deviating therefrom simply by fluctuations in the value of scrap material, which is usually w^ithin fairly narrow limits. The point D is the value of the apparatus in question at the end of its life. It may reach this value through any one of several methods of depreciation, shown graphically by the curves No. 1, 2, 3, 4, 5 and 6. Curves 1, 2 and 6 may be said generally to represent " absolute depreciation"; and curves 3, 4, 5 "theoretical depreciation." Considering " absolute depreciation," curves 1 and 2 represent the values, during any period of their lives, of most pieces of physical property, determined from the standpoint of bargain and sale for use elsewhere. The salable value of new apparatus depreciates very rapidly from the moment installed and then 170 VALUATION OF PUBLIC UTILITIES gradually during the remainder of its life down to " scrap value." The values thus illustrated are independent of the service for the' particular installation for which the apparatus has been pur- chased and installed. Curve 1 may fairly represent the worth of certain pieces of property such as: a. Special machinery, the value of which, for use in connection other than that for which it has been installed, would necessitate such a large expenditure for modification of design to make it useful elsewhere that little more than scrap value can be obtained from same. 6. Property the cost of removing which, compared to its cost new, is relatively high; for example, ties for track, or wooden poles of a transmission line. Curve 2 represents sales value for more easily transported property, as for example the rolling stock or synchronous con- verters of a street railway system or transformers and meters of a lighting company. DEPRECIATION 171 The classes of depreciation indicated by the curves 1 and 2 might properly be called salvage values and approximate scrap or junk values, the principal difference being the property is sold for what it is worth as a unit rather than for its dismembered elements. It will be evident at once that depreciation of these classes cannot fairly be used in determining the value, on the basis of barter and sale in the general market, of the physical property of an operating entity. That this is true and the view taken by the courts, will be evident from consideration of the decisions in the Consolidated Gas and other similar cases and even in the Knoxville Water case, which is generally considered the most radical decision in the way of depreciating physical value. Curve 6 indicates depreciation due only to wear and tear until just before the close of life, at which time other classes of dete- rioration may appear. The curve is based on the assumption that the apparatus in question will be used for the purpose for which it was installed, throughout its life, and being maintained in good operating efficiency, 100 per cent., is just as good for the purpose of use as the day it was installed, aside from such slight deterioration as results from wear and tear. That is, the value of the apparatus or construction, being used for its original purpose, is equal to its cost, new or original, less the evaluation of the wear which has taken place; for example, a few tubes in a boiler might be so badly burned as to render the boiler unfit for service. The value of the boiler as a whole in its assumed con- dition is practically worth little more than scrap, but by the expenditure of a few dollars in renewing the burned-out tubes the value of the unit, say for the purpose of original installation and use, is equal to the value of a new boiler. In any large system there is constantly a large number of parts always approaching the time of renewal. At any given instant of appraisal some such parts will be found completely worn out and the value of their replacement must be deducted from the cost new in order to obtain the real, actual and "absolute" deprecia- tion at the instant of appraisal. But assuming the property as a whole is kept in first-class operating condition, that there is no inadequacy, obsolescence, or deferred maintenance and ignoring such slight deterioration as results from wear and tear at any given instant which may be apparent in detail parts in the sys- tem, the depreciation effecting the value of the plant for the 172 VALUATION OF PUBLIC UTILITIES purpose installed may be considered nil practically throughout its life, as an operating property. In a given unit just before the close of life other classes of depreciation than wear and tear may set in or deferred maintenance may be allowed to appear, in which case, of course, depreciation must be considered, but otherwise the value of the property for its original use is equal to the cost to reproduce new, and it is the real value of its physical property to a "going concern." This value or its equivalent is that generally allowed in ''purchase and sale transactions," and has been recognized by public service commissions and legal authorities. "If the present value exclusively were to be taken as the basis, respondent would not receive credit for having installed any part of its plant at full cost. The present value, as of June 30, 1908, must, therefore, be increased by the amount of the estimated depreciation on that part of the plant which the company installed new."^ "Of the physical plant alone, the most equitable valuation for rate- making purposes appears to be best represented by the original cost of the plant and by the cost of reproducing it."^ This "service value" would also seem to be recognized by the courts both in rate cases and in determining valuations for sale.^ "Probably a fair statement would be that the physical value of the plant is its value as a performing plant for the purposes for which it was designed."* If any contrary position were assumed, namely, that only "sales value," indicated under most favorable circumstances by curves 1 and 2, were to be used in determining present value, then a large portion of every going property would be practically valueless the day after construction and installation was com- pleted, because the expense of removal would amount to more than the cost of new in the open market: for example, ties in a railway property; foundations and settings for machinery; pipe, deeply buried; cross-arms and many wooden poles. ^ F. B. L. Fullmer vs. Wausau Street Railroad Co., Railroad Commission of Wisconsin, April 1, 1910. ^ G. W. Hill et al vs. Antigo Water Company, Railroad Commission of Wisconsin, August 3, 1909. ^ City of Omaha vs. Omaha Water Co. 118 U. S., 202. Wilcox vs. Con- soHdated Gas Co., 212 U. S., 19. * Columbus Railway & Light Co. vs. City of Columbus, Circuit Court U. S. Southern District of Ohio, report of Master, page 34. DEPRECIATION 173 The classes of depreciation above discussed are going on con- stantly in any physical installation. They are at work and in evidence at any time despite the honest effort and even extrav- agant expenditure of the management to provide against and forestall depreciation. Property — except real estate or road bed — cannot usually be maintained at 100 per cent, of its original value and ultimate economy seeks only 100 per cent, operating efficiency. The complete physical plant of a going property would not ordinarily have a higher ser\-ice value than 90 or 95 per cent., although it is conceivable, in case of a water power or other property including a large amount of real estate the value of which had risen rapidly, the service value might be 100 or 110 per cent. On the other hand, the realizable sales value of a property might be as low as 20 or 30 per cent, or even less. There is considerable undue importance attached to the ratio of present value to reproduction cost new as expressed in per- centage in connection with appraisal work. Many properties that have been appraised have been found to have present values of from 75 to 85 per cent, of the replacement cost, but that is no reason why such figures must necessarily be found in any new appraisal. If the property under consideration has been largely renewed, the percentage, particularly of a railroad, would run higher than the figures given. On the other hand, it is con- ceivable that a gas property in existence for a period of years and still giving satisfactory service to the public, might show figures considerably below those quoted. \Yith regard to keeping and accumulating of " depreciation funds" or "reserve funds" as they have been called, at first thought and superficially, it would seem that the sum of the plant value (the present value determined by appraisal) and the depreciation fund (where one is necessary) should at a given time equal the replacement cost, but as the depreciation fund will have been based on original cost which may be quite different from replacement cost, the depreciation fund in that case will not equal necessarily the difference between present and replacement values. As a property kept in good operating condition will ordinarily not be found to be in a condition below from 75 to 85 per cent, of the cost of reproduction, a fund larger than 15 to 25 per cent, would never be required, even on the theoretical basis proposed by some engineers and, as a practicable matter, a sum equal to from 3 to 5 per cent, of the original value 174 VALUATION OF PUBLIC UTILITIES would ordinarily provide a fund for emergencies which would be amply sufficient for a property uniformly maintained. In contradistinction to determination of present value by the use of depreciation expressed in the curves 1, 2 and 6, which may be termed "absolute," the curves 3, 4, and 5 indicate several classes of "theoretical" depreciation which have been quite widely used in some cases for estimating present values, but more often for determining the yearly theoretical deterioration for purposes of establishing depreciation funds, which, however, is quite a different subject. Making a theoretical estimate of the probable, future, average, annually accruing deterioration of certain property to provide an item in book-keeping accounts of operating expense has nothing whatever to do, in making an appraisal, wuth fixing the definite amount of absolute, actual or accrued depreciation which depends upon the present condition of physical property, determinable from inspection and not upon historical documents, depreciation funds, or disputed theoretical conclusions. Nevertheless, the erroneous application of rates of depreciation in the attempt to determine present commercial values for purposes of capitalization is fairly common, one of the most notable cases, because of the large amounts of -money involved, being that of the Public Service Commission of New York, First District, in the matter of the Third Avenue Railroad Reorganization. ^ These three curves 3,4, and 5 represent classes of depreciation which seldom, if ever, occur in practice but are convenient for purposes of estimate, particularly curve 3, which represents what is called "straight line depreciation." As indicated, it assumes a gradual and constant reduction in the value of prop- erty throughout its life. The significance is that if, from the cost of apparatus, the value to be obtained at the end of its life, namely, the scrap value, is deducted, the remainder divided by the assumed life, in years, of the apparatus, will give the amount in dollars to be laid aside annually to accumulate a fund sufficient to replace the property at the end of its life without interest. Curve 4 is closely related to curve 3; the annual depreciation fund, however, being less because it is assumed that the uniform amount of money laid aside annually during the life of the prop- erty will be put out at interest and compounded so that owing 1 Case 1134, Opinion of Public Service Commission, First District, New York, Disapproving Plan of Reorganization, July 29, 1910. DEPRECIATION 175 to the accumulation of interest the amounts annually laid aside will be less than in the case of "straight depreciation." Curve 4 is called the "sinking fund" method. Curve 5, a modification of curve 4, is based on the assumption that, instead of laying aside a regular amount annually and com- pounding, the amount laid aside will be small at first, gradually increasing in amount as the earning power of a property increases, as it generally does, with its life. These amounts are then assumed to be put out at compound interest so as to aggregate original cost of the apparatus at the end of its life. No general rule has been developed as to the proper amounts to begin laying aside or in what proportion they shall increase; but it is clear that the smaller are the amounts in the beginning the larger they must be toward the end of the life of the apparatus. This latter plan of providing depreciation funds has the advan- tage of more nearly proportioning the annual depreciation payments in accordance with revenue, and for most pieces of property will more closely approximate the deterioration actually taking place. A fourth plan of determining ''theoretical" depreciation has been used to limited extent. It consists in assuming a given life for the property in question, ascertaining the annual rate of depreciation and then applying that rate uniformly to the principal diminished in amount each year by the deduction for deterioration. For example, if the principal invested were $2000 and the rate assumed is 10 per cent., the amount charged off for depreciation the first year would be S200, leaving the principal, S1800 on which 10 per cent, or S180 would be charged off the second year, and $162 the third year, etc.; thus the amount charged off becomes progressively less and the life of the property 'becomes, theoretically at least, infinite. Of course this method can be modified from the "straight line" depreciation illustra- tion used above to the "sinking fund" method, if desired. From the preceding it will be seen that any one of these four methods of estimating depreciation is based on absolutely arbi- trary assumptions. Practically there is no more logical reason per se why the fund — if necessary — to replace the property at the end of its life should be provided in any one of the several methods suggested by the curves rather than in any other of the several methods. Each method will accomplish the same result, but it will be seen at a glance that in applying curves 3, 4 or 5, 176 VALUATION OF PUBLIC UTILITIES the amounts to be laid aside annually will vary considerably, and to that extent effect net income; similarh', the effect on the worth of the owner's investment will also vary with the curve used, being appreciably less for "straight line" depreciation. Where the lives of property considered are relatively short, the result of using any one of these three curves is less pronounced; but where the lives are long, running to 50 or 100 years, the difference for the major portion of their lives is marked. The fourth plan suggested has not the advantage of being sound theoretically or advantageous practically. The "straight line" method of depreciation has been more largely used than any other probably because the lives of much apparatus is brief; and, furthermore, the application of this method is the most simple, direct, and easily understood, and hence favored by many who are non-technical men, and natu- rally incline toward the more easily appreciated elements of the questions which they are compelled to consider and discuss. There are three other methods of determining the depreciated value, that is the present value, of physical property which should be mentioned. The first consists in estimating the cost of purchasing and installing second-hand or used apparatus of the type and character of that installed and equivalent for the same work. The difficulty of carrying out this method in practice is the impracticability of finding duplicate used apparatus and obtain- ing fair or uniform standards of price thereon. The second proposal of some authorities is that the depreci- ated value of a plant should be determined by comparison with the cost of a most modern installation designed to do the same work. The impracticability of this theory arises from (a) the inability of the respective parties interested to agree on what is the proper theoretical plant; (b) the assumption that old property should always be renewed regardless of its usefulness or cost of its replacement. This method has apparently received some encouragement from the courts, as indicated by the quotation from the decision in the Cedar Rapids case, referred to under "Present Value." A third method of ascertaining present value is to make an estimate of the cost of reproducing the physical property new and deducting therefrom the estimated expense of putting the existing property in a condition equal to new. The difficulty DEPRECIATION 177 of determining present condition compared with new, and the cost of the changes offer problems on which there can seldom be found agreement. None of the three methods just mentioned above are generally favored. As indicating the possible error in attempting to estimate "theoretical" depreciation, it is frequently found that the length of life assumed has been greatly surpassed by apparatus which is still giving reliable and satisfactory service. For example, the life of the ordinary steam engine may be taken at 20 5'ears, but it is not uncommon to find engines still in use that are very much older than this. The writer noted, within a few months, that a vertical engine installed in England in 1856 had recently been equipped with condenser, supplied with superheated steam, and was still in use at 55 years of age, giving economical and satisfactory results. Cases of this kind will illustrate the necessity for personal inspection in determining depreciation and the need of experience and common sense in the application of any rules of depreciation. For apparatus still giving satisfactory service after the expiration of it's assumed life, it is only fair in estimating theoretical depreciation to allow a value greater tnan scrap value; the minimum value of all types of engines, boilers, pumps, heaters, condensers, line transformers and shafting is at present being taken by the Wisconsin Com- mission, for example, at 25 per cent.; generators, motors, rotaries, arc lamps, wood and iron poles, 20 per cent.; station transformers, 40 per cent.; storage batteries, 35 per cent., and switchboard instruments and electric meters, which must be kept in a high state of repair, 80 per cent, as the minimum percentage of re- duction cost for apparatus still in use though theoretically ''dead." It is the practice of the Wisconsin Commission, in addition to estimating depreciation in relation to expired life, to further modify their results with respect to the condition of the appara- tus appraised, that is whether it is found to be in good, fair or poor condition. If in good condition, 100 per cent, of the value allowed on the basis of expired life is taken; if in fair condition, 90 per cent, of the unexpired life is allowed; but if in poor con- dition, only 80 per cent, of the unexpired life as figured is allowed. The decision as to the condition of the apparatus good, fair or poor 12 178 VALUATION OF PUBLIC UTILITIES is determined by an inspector whose experience, judgment and common sense form the basis of his conclusion. As 3, 4 and 5 per cent, are rather common rates of return on funds allowed to accrue with interest, the curves on the accom- panying plate, Fig. 6 , are given, being reproduced from the author's paper appearing in the June, 1911, Proceedings of the American Institute of Electrical Engineers. The curves indicate the values in percentages that obtain at any given time for ap- paratus having lives varying from 5 to 100 years. The abscissa graduated from to 100 indicates the age, the ordinates to 100 indicate either the percentage of depreciation to be subtracted from the cost to obtain theoretical present value or the percent- age of the original value direct. To use the curves, start from a point on the abscissa indicating the life already expired, follow the vertical until it intersects with the curve marked with the assumed life of the property being considered, then follow the horizontal to the left and read from the ordinate the percentage of depreciation or the remaining present value as may be de- sired. Uniform or "straight line" depreciation, for the lives indicated by the diagran^ may be obtained by drawing a straight line from the two points connected by any of the curves and reading from it instead of from the curve. The fund that will accumulate at the end of any number of years through the annual laying aside of a uniform amount and putting that out at compounded interest, is determined by the following formula. (See Table IX.) The sum to be laid aside annually at compound interest to accumulate a given amount at the end of a number of j^ears is determined from the following formula. (See Table X.) (1 -^Rr—i where F = the accumulated amount in dollars at the end of iV years. D = the annual amount of dollars laid aside at interest compounded every twelve months. R = Xh.e annual rate of interest expressed as hundredths of a dollar. A7 = the number of vears the amount is annuallv laid aside. 100 10 90 1 1 H I M 1 1 M ! 1 1 ! 1 1 ffffff ffl CURVES SHOWING THEORETICAL DEPREClATIOM BASED ON ANNUALDEPOSITS COMPOUNDED YEARLY AT 3, 4 & 51 DURING LIFE. DEPRECIATION 179 During the past few years, a large and varied assortment of figures have been offered by more or less competent authorities as to the proper rates of depreciation to be applied to different classes of physical property in accumulating depreciation funds or in the determination of present values. These figures, while interesting and carrying the weight of individual authority have, in no sense, been judicially approved, the writer therefore has undertaken to set out in a table, shown in the following pages, Table XI, figures that have been used by commissions or others in rendering decisions which have in effect, largely become law. The figures for ''straight line" depreciation, given as those of the Wisconsin Commission, are derived by the Author from tables giving the lives of various property as used at present, by the Wisconsin Commission, but subject to change at any time. While these tables show accepted rates of depreciation, which include as a rule some allowance for obsolescence and inadequacy, they should always be considered as tentative and subject to modification for any particular case, they cannot be applied in- discriminately and they must be used with conservatism and good judgment. They are given as indications of what has been done and the line of procedure heretofore followed. It would seem that we can only advance by a thorough understanding and knowledge of what other people are doing in treatment of the subject of depreciation, and these tables are given because they show figures which have been approved in important cases and as indicating what fairly may be expected by those who are interested in utility companies when they have to appear before Courts or Commissions. The re-adjustment of rates based on the use of such figures and their acceptance both by the Public Service Commissions and public utility companies, certainly establishes them much more firmly than mere engineering opinions and gives them in effect the semblance of law\ The figures given refer to "straight line theoretical deprecia- tion" and have been applied to electrical properties, the life of the apparatus of which is noticeably short compared with many other classes of property, such as water works, gas plants, etc. As will be recognized the figures given have been used foi- rate-making, sale and capitalization cases. 180 VALUATION OF PUBLIC UTILITIES VH.S es n 3 >> & >. 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(N CO OS IN lO T»< rl< -:)< Cl ^ 10 t^ 10 OS i> M CD t> OS CO 03 ■* ^ OS CO -»H OS OS 10 CO OS (» OS 10 OS •* CO CO 00 in CO OS 00 CO in •* CJ 01 IN 00 00 10 CO OS 00 (>• t^ CO 10 10 in ^ Tfl •* CO CO CO CO CJ CI CI IN CI CJ Tfl CO CI t-H ■^ q q q q q .-I d d d d d d d d d d d d d d d d d d d d d d d d d d d d i -H fq CO ■* lO CO t> 00 OS CI CO -ti 10 CD t^ 00 OS CJ CO ■* in CO h- 00 OS T— t I— 1 fH fH iH f-H r-l 1-H r^ S CJ CI CJ IN CJ CJ CJ CI CJ tS DEPRECIATION 187 .-H (N -t" CO CO CO CO 03 IN t^ ■* N O) CO L3 OD CO CO 05 IN CO 03 t- •^ CO 00 CO 05 uo 00 ■* LO 00 CO CO 10 Cl 01 t^ CO U3 00 CO LO 00 00 C-l C>1 CO ^ 03 f~ O) CO 1^ Cl -H CO t^ «0 t^ O o 10 •* -t> Tf 03 03 CO Cl 0000 CO o o o o o ® ° ° °. q q q q d d d d d d 6 6 6 6 d d d d d d d d d d d d d d d d d d d •* (N CI T}< lO CO 05 CO (N CO 05 03 10 03 -^ CO UO Tf CO 00 U3 LO Cl CO rH 03 ■* rf <-l ^ O ^ t^ -f t^ IN CO C-l t^ CO C) t- Cl Cl -f CO t^ CO CO CD rt r) O O >C -f< 05 -)> -t< CO 01 ^ CO 00 'f CO 05 CO CO 05 05 ■05 03 t^ CO lO CO OO 05 lO t^ CO CO 20 CO t^ IN 05 05 Cl 00 t^ Cl 00 Cl Cl 00 O --I IN ■* t^ -rf M 0\ l~- C^l 00 CO C5 CO CI 05 CD 00 i^ CO CO CO CO -f CO 6? lO •* CO (M -< 05 05 00 00 t- t- CO CO CD LO LO LO 10 -V 03 Cl Cl lO o o o o o q q q q q q q q q 06666 d d d d d d d d d d d d d d d d d d d d d d d d d ■* 10 CO -H lO 00 01 05 t^ lO 00 ~ U3 N If 00 IN >c •* CD t^ ■* 05 'f CD 05 05 10 ^ C^l "3 05 ':1< t^ CO CO •o CO t^ t^ 03 LO Cl 10 Cl Tf CD 03 -H 05 CO -H CO CO ^ ^ 10 -ti ^ lO CO 00 Cl CI f t^ 00 t^ Cl t^ Tt< LO CO 00 t^ 00 05 'f CO -t^ 00 t^ 00 "O -n CO 00 00 •v 00 CO LO CO CD Cl t^ t~ C5 LO CO "S> l> CT> (M CO 05 -r 00 00 GO -r 05 CJ 00 LO -H CD 03 'V t^ t^ CO ■X UO 6? CO ^ 'J' CO IM (N -H 05 CO oo t^ r^ t^ LO T 00 Cl Cl •*> rt r^ -. 00000 0000 q q q q q q q q q q q q 6 6 6 6 6 d d d d d d d d d d d d d d d d d d d d d d d ^ O) t^ t~ (N 00 t^ Oq CO 05 00 05 ■* CO >o 05 10 IN -f >c 05 CD ~ 00 05 uo 00 3 -^ CO >o lO t^ CO 00 >0 03 00 T)< 03 O) oo lO ■rfi 00 CO IN Cl 00 f- CO m 00 CO •* t^ CO 05 -H 03 t^ 05 Tf Cl Cl -H r- UO -t* 05 t^ t-. CO lO Tt< -- t^ 00 CO 00 CO IN -t< CO CO CO 00 Cl 00 LO LO 05 -V Cl t» 00 00 00 01 -H CO iO 00 (N CO 10 10 Cl 00 10 -H 00 in Cl Cl CO t^ Cl 00 ■^ Cl 05 S? t^ CO >o 10 ■* CO IN IN -^ rH 00 00 t^ t- t^ CO LO Tf CO IN IN -. 8 ■* 00000 q q q q q q q q q q q q q 6 6 6 6 6 d 6 6 6 6 d d d d d d d d d d d d d d d d d d d d CO (M CO lO CO -il" 10 00 N 00 05 00 CO 00 CO CD t^ 03 Cl CO U3 OS OS Cl rt CO t>. CO •* 10 -* CO CO pH OJ r-l t- IN IN (N 00 CD ■* rt Tf CD t^ CO Cl 05 M CO 00 -^ Cl -^ (N -H (N OS 00 ■^ CO IN l> t- 00 00 lO t^ CO 05 CD 03 03 00 ^ OS -f CO t^ uo 05 t^ t^ 1< l> uo 05 00 -H 00 00 IN 05 05 CI t^ LO LO CD CO CO 00 CD S 00 LO CO LO 6? CO CO 'I' 1.0 t^ 01 IN CO 05 CO 00 IN I^ 03 00 -fl o> Cl t 03 05 00 t^ CO "O 't' 'li CO IN IN CO 00 t~ t^ CD LO -r CO Cl Cl •** CO 00000 ° 9 9 °. q q q q q q q q q q q 6 6 6 6 6 d 6 6 6 6 d d d d d d d d d d d d d d d d d d d CO CO C^l C^l CO 05 05 M Tf >o 00 t^ 00 rf --1 w Tf t^ CO CO CD LO CD W t^ (M 05 CD -< 05 c^ t- CO CO 00 CO 'Ttt CO 1-H CO 10 10 t^ >o 05 5 05 uo 10 t~ CO 05 00 CO CO -H 05 CO »— 1 05 CO C) Ci 00 05 10 Cl t^ 03 10 05 Cl U3 CO t^ CO UO uo CO rH 05 f lO (M CO -< 10 -»> CO 05 05 00 CO CD t^ -tl 00 ^ 03 CD Tf LO Cl ■* 05 -< CO >o 00 — 1 -1< oo CI t~- CD CI t^ CO 05 LO Cl CO CO CD CO Cl 05 CD ES r-l 05 05 00 t^ CO 10 >o -^ CO 03 01 OJ 05 05 t^ CO U3 -!f CO CO IN Cl -- (M -H -H rt -< CO o_ C5 0000 q q q q q q q q q q q q q q d d d d d 6 6 6 6 d d d d d d d d d d d d d d d d d d d d d (N CO CO CO lO lO IN CO ^ CO "O CO 00 CO 00 03 Cl 03 Cl CO Cl uo -H oo ■* lO CO >o t^ ^ 00 10 CO 10 >n t^ t^ 05 05 10 uo t^ LO Cl CD Cl Cl -^ •^ ■* CJ IN 00 CO rt 05 » (N IN 00 CD ^ CO rt t^ 05 Cl •0 CO 'f 00 10 05 05 ■* tT) r-i •!< C) CO t^ •^ CO CO t- CD t^ o> -i> t^ Cl 05 f CO •^ 'tl Cl U3 B? 00 00 00 05 ^ CO CO 05 C<1 ■i< 05 't 05 LO CO Cl 00 LO 05 t^ CO 00 uo CD Cl 05 ^ 05 00 00 t^ CO lO >0 Tf< t CO C) 0) 05 05 t^ LO -T+< -f 00 03 Cl Cl (N IN (M -- .-H -H Q 00000 q q q q q q q q q q q q q q q q q q d d d d d d d d d d d d d d d d d d d d d d d d d d d d d d d i2 rH (N CO ^ m CO I^ 00 05 IN CO •* 10 CO t^ 00 05 U3 uo uo U3 U3 ^ ^ CO CO CO CO CO CO CO CO CO CO Tt< If If •^ •* ■<}< ■* f -t Tfi uo 10 CO i> t^ 00 00 OS 05 188 VALUATION OF PUBLIC UTILITIES TABLE XI APPROVED RATES USED IN ESTIMATING THEORETICAL DEPRECIATION (Maintenance not included) Property Depreciation per cent, per year Authority Remarks Straight line Aerial Lines Air Brakes Air Compressors Arc Lamps 5 5 4-5 61 15 8 5 3i-4 10 5 61 5 10 61 5 50 wearing value 5 3i-10 li 2 2-4 2 2 5 50 mainte- nance cost 6i St. Louis P. S. C Wisconsin P. S. C Traction Val. Comm. . . . Wisconsin P. S. C Union Elec. L. & P. Co. Chicago Con. Tract. Co. Belting St. Louis P. S. C Wisconsin P. S. C Traction Val. Comm B. J. Arnold versy, Atlanta, Ga., 1899. Union Elec. L. & P. Co. Boilers Chicago Con. Tract. Co. Coney Island & Brooklyn adopted by P. S. C, N. Y. (Water Tube) (Fire tube) (Water tube) (Fire tube) Bonds Wise. P. S. C. Wise. P. S. C P. S. C, N. Y. Street Lighting Contro- versy, Atlanta, Ga., 1899. Union Elec. L. & P. Co. Chicago Con. Tract. Co. St. Louis P S. C Traction Val. Comm. . . . Breeching and Con- Wise. P. S. C Traction Val. Comm Traction Val. Comm.. . . E. G. Connette P. S. C, N. Y. Chicago Con. Tract. Co. Buildings (Brick) (Wood) Cables Underground (high tension) . . Underground (low tension) (Aerial lead covered) Wise. P. S. C. 3rd Ave. case, adopted by P. S. C, N. Y. St. Louis P. S. C versy, Atlanta. Ga., 1899. Union Elec. L. & P. Co. P. S. C, N. Y. Wisconsin P. S. C. P. S. C, N. Y. DEPRECIATION 189 APPROVED RATES USED IN ESTIMATING THEORETICAL DEPRECIATION. Continued (Maintenance not included) Property Depreciation per cent, per year Authority Remarks Straight line (Underground lead covered) . . . (Underground lead covered) . . . Coal and Ash Han- dling Machinery. . . 4 5 7 5 10 4 5 5 5 10 6i 1 2 2 8J-12i 3-5 5-7^ 5 6 J 5 6§ 5 6§ Dependent on observed wear 6i Wisconsin P. S. C. St. Louis P. S. C Traction Val. Comm. . . . Union Elec. L. «fe P. Co Chicago Con. Trac. Co. 3rd Ave. case, adopted by P. S. C, N. Y. Wisconsin P. S. C. Traction Val. Comm. . . . B. J. Arnold Coney Island & Brooklyn adopted by P. S. C, N. Y. 3rd Ave. case, adopted by P. S. C, N. Y. Street Lighting Contro- Wisconsin P. S. C. St. Louis P. S. C versy, Atlanta, Ga., 1899 Union Elec. L. & P. Co. Cross Arms Engines (Steam) (Steam) Wisconsin P S. C St. Louis P. S. C Wisconsin P. S. C. Traction Val. Comm. . . . B. J. Arnold P. S. C, N. Y. Union Elec. L. & P. Co. Chicago Con. Trac. Co. (Steam) adopted by P. S. C, N. Y. 3rd Ave. case, adopted by (Gas) Wisconsin P. S. C. Wisconsin P. S. C. Wisconsin P. S. C. P. S. C. N. Y. (Steam, slow speed) (Steam, high speed) Street Lighting Contro- Feeders St. Louis P. S. C Traction Val. Comm. . . . Wisconsin P. S. C. versy, Atlanta, G a., 1899. Union Elec. L. & P. Co. Chicago Con. Trac. Co. (W P. Insulation) 190 VALUATION OF PUBLIC UTILITIES APPROVED RATES USED IN ESTIMATING THEORETICAL DEPRECIATION.- Continued (Maintenance not included) Property Depreciation per cent, per year Straight line Authority Remarks Foundations — Machinery. Fuel Oil Handling Machinery Generators . (Modern type) . . . (Obsolete type)... (Steam turbo) . . . Heaters (Feed water, closed) (Feed water, open) Meters (Electric switch- board) (Electric service) (Electric) Motors (Railway)... (Railway) (Railway) (Railway) Paving Same as life of apparatus supported Same as life of apparatus supported 3-8 5 5 6i 5 10 4-6 3* 3J 5 6i Trac. Val. Comm.. Henry Floy Trac. Val. Comm. Trac. Val. Comm. B. J. Arnold Henry Floy Wisconsin P. S. C. Wisconsin P. S. C. Wisconsin P. S. C. Arbitrators St. Louis P. S. C. Trac. Val. Comm. Wisconsin P. S. C Wisconsin P. S. C 3* By inspection. 5 10 50 wearing value 50 Wisconsin P. S. C. Wisconsin P. S. C. St. Louis P. S. C. Trac. Val. Comm. B. J. Arnold Henry Floy . B. J. Arnold. Henry Floy. . Chicago Con. Trac. Co. 3rd Ave. case, adopted by P. S. C, N. Y. Chicago Con. Trac. Co. Chicago Con. Trac. Co. Coney Island & Brooklyn, adopted by P. S. C, N. Y. 3rd Ave. case, adopted by P. S. C, N. Y. Street Lighting Contro- versy, Atlanta, Ga., 1899. Union Elec. L. & P. Co Chicago Con. Trac. Co. . . Union Elec. L. & P. Co. Wisconsin P. S. C Arbitrators Chicago Con. Tract. Co. Coney Island & Brooklyn adoptedbyP. S. C.,N- Y. 3rd Ave. case, adopted by P. S. C, N. Y. Street Lighting Contro- versy, Atlanta, Ga., 1899. Coney Island & Brooklyn adopted by P. S.CN.Y. 3rd Ave. case, adopted by P. S. C, N. Y. DEPRECIATION 191 APPROVED RATES USED IN ESTIMATING THEORETICAL DEPRECIATION.- Continued (Maintenance not included) Property Depreciation per cent, per year Authority Remarks Straight line Piping and Covering 4-4i 6 5 5 5 6§ 2 5 54-8i 2i 10 5 5 5 6i 5 6§ 4 4 5 3i 5 5 5 6i 3 10 Traction Val. Cowm B. J. Arnold Chicago Con. Trac. Co. adopted by P. S.C, N. Y. Wisconsin P. S. C. P. S. C, N. Y. Poles (Steel) St. Louis P. S. C versy, Atlanta, Ga., 1899. Union Elec. L. & P. Co. 3rd Ave. case, adopted by (Wood in con- crete) (Wood in earth).. (Iron) Wisconsin P. S. C. Wisconsin P. S. C. Wisconsin P. S. C. P. S. C, N. Y. Traction Val. Comm. . . . B. J. Arnold lanta, Ga., 1899. Chicago Con. Trac. Co. adopted by P. S.C, N.Y. 3rd Ave. case, adopted by (Small steam).. . . Wisconsin P. S. C. Arbitrators P. S. C, N. Y. Street Lighting Con., At- Rolling Stock (Open car bodies). (Open trailer St. Louis P. S. C Trac. Val. Comm Trac. Val. Comm Trac. Val. Comm Trac. Val. Comm B. J. Arnold lanta, Ga., 1899. Union Elec. L. & P. Co. Chic. Con. Tract. Co. Chic Con. Tract. Co. (Closed car Chic. Con. Tract. Co. (Trucks) (Closed and open Chic. Con. Tract. Co. (Trucks) B. J. Arnold adopted byP. S.C, N.Y. adopted by P. S.C, N.Y. (Car bodies and equipment) Stack Wisconsin P. S. C. Traction Val. Comm B. J. Arnold P. S. C, N. Y. Chicago Con. Tract. Co. Coney Island & Brooklyn adopted by P. S.C, N.Y. (Steel) 192 VALUATION OF PUBLIC UTILITIES APPROVED RATES USED IN ESTIMATING THEORETICAL DEPRECIATION. Continued (Maintenance not included) Property Depreciation per cent, per year Authority Remarks Straight line Stokers. (Fixed parts) (Moving parts).. . Storage Batteries. . . . Switchboard and Wiring 5 20 5 5 3 6 5 5 8 10 5 5 Dependent on observed wear Dependent on observed wear 50 wearing value. 50 wearing value. 8i 5J 5 6i 6J 5 31 6S Traction Val. Comm. . . . Traction Val. Comm. . . . Chicago Con. Tract. Co. Chicago Con. Tract. Co. 3rd Ave. case, adopted by Wisconsin P. S. C St. Louis P. S. C Traction Val. Comm.. . . B J Arnold P. S. C, N. Y. Union Elec. L. & P. Co. Chicago Con. Tract. Co. Coney Island & Brooklyn adopted by P. S.CN.Y. 3rd Ave. case, adopted by (Modern type) . . . (Obsolete type)... Telephones Wisconsin P. S. C. Wisconsin P. S. C. St. Louis P. S. C Wisconsin P. S. C. Tract. Val. Comm Tract. Val. Comm Tract. Val. Comm Tract. Val. Comm B J. Arnold P. S. C, N. Y. Union Elec. L. & P. Co. Track (Rail Joints) . (Ties) Chicago Con. Tract. Co. Chicago Con. Tract. Co. (Rails) (Special work) . . . (Straight and special work) . . . (Straight and special work) . . . (Special work) . . . (Straight track) . . Transformers (Station Service) . Turbines (Steam) Chicago Con. Tract. Co. Chicago Con. Tract. Co. Coney Island & Brooklyn adopted by P. S.C.N. Y. 3rd Ave. case, adopted by Wisconsin P. S. C. Wisconsin P. S. C. Wisconsin P. S. C. Wisconsin P. S. C. St. Louis P. S. C Wisconsin P. S. C. Wisconsin P. S. C St. Louis P. S. C P. S. C, N. Y. Union Elec. L. & P. Co. (Water) (Steam) Union Elec. L. & P. Co. DEPRECIATION 193 APPROVED RATES USED IN ESTIMATING THEORETICAL DEPRECIATION.— Concluded. (Maintenance not included) Property Depreciation per cent, per year Straight line Authority Remarks Wire Trolley Allowance of 80.5 lbs. per 1000 ft. for wearing value. of No 1/0 wire Tract. Val. Comm. Trolley AUowance of 106.8 for No. 2/0 Tract. Val. Comm. From observa- tion B. J. Arnold W. P. 50 maintenance cost Henry Floy Trolley 1/0 under 1 minute headway 50 Wisconsin P. S. C. Trolley 2^0 under 1 minute headway 40 Wisconsin P. S. C. Trolley 3/0 under 1 minute headway 33^ Wisconsin P. S. C. W. P. 6i Wisconsin P. S. C. W. P 7i Arbitrators Chicago Con. Tract. Co. Chicago Con. Tract. Co. Coney Island & Brooklyn, adopted by P. S. C, N. Y. 3rd Ave. case, adopted by P. S. C. N. Y. Street Lighting Con., At- lanta, Ga., 1899. Depreciation Accounts or Reserve Funds. — A recognition of the various classes of depreciation continuously at work on physical property with the means taken to compensate for deterioration or the conservation of the original investment, whether through expenditures made as a part of regular operating expense or from accumulated funds or even through assessments on investors — provided capitalization is not thereby increased — has no necessary connection with the bookkeeping classification of the expenses or the amounts that may or may not have accumulated in reserve funds. While wear and tear have com- monly been borne as a part of operating expense, it is equally important that the other classes of depreciation, or annual provision for accruing deterioration, be made a part of the cost of operation if the investment is to remain intact. In all cases involving a consideration of the expenses of keeping a property in operation, there should invariably be included allowances to cover all ultimate depreciation and replacement. For a small company or where relatively large proportions of the invested capital are locked up in few or single pieces of property, it is preferable to accumulate, in advance out of operating income, reserve funds from which to provide for all classes of deprecia- 13 194 VALUATION OF PUBLIC UTILITIES tion. But such method may be unnecessary and possibly an inexpedient accounting complexity with large corporations, where the investments in any single piece of physical property are small relative to the total investment. The truth of the above will be at once recognized from the following illustration. If the company which erected the M