DISCUSSION
Fred Lavis, M. Am. Soc. C. E.—The author states that his paper is confined to "a discussion of the methods which should be used in arriving at a correct figure of cost of reproduction and depreciation," and that "it does not take up questions involving the propriety of those figures when reached." In so far as this is concerned, it is probably the most complete compilation of the available information on this phase of the subject which has yet appeared in print. The author refuses to recognize that the consideration of the so-called intangible values has any place in a physical valuation. As, however, there exists such a widespread feeling, especially among those interested in railroads, that physical valuations, for any purpose whatever, are absolutely useless, because these intangible values are not or cannot be included, it does not seem out of place to refer to this phase of the subject at this time, and more especially in view of the fact that many persons, the prominence of whose position entitles them to consideration, have taken this point of view very recently, and their remarks have received considerable publicity. Not more than two weeks ago, Judge Lovett, the head of the Harriman System, expressed the opinion that the theory of valuing railroad property by trying to determine the cost of reproduction was utterly impractical. It seems important, therefore, that we, as engineers, interested in having the question properly understood, should be careful, in referring to valuation, to make it plain that other features besides the value of the physical property are to receive due consideration. The speaker, therefore, proposes to examine some of the arguments advanced by the opponents of valuation to see if the objections most generally brought forward are insuperable.
Some critics of valuation go so far as to say that engineers cannot make a close valuation of even the purely physical property. For instance, Mr. W. H. Williams, Vice-President of the Delaware and Hudson Company, in a paper on this subject,[[19]] states that:
"No engineer in estimating on the several important items of construction work for the year will come within 10 per cent. of the total aggregate cost. Many of the more important items are frequently underestimated 25 to 50 per cent."
He cites, as an especially good illustration, the Panama Canal, the original estimate of the cost of which was $140,000,000, though the present estimate is $300,000,000. Almost every one who has kept in touch with that subject knows why the Panama Canal has cost more than the original estimates, and that the greater cost is no reflection on the judgment of the engineers who made such estimates. One cannot always foresee what changes in plans may be made before construction is completed, and would hardly expect the estimates of the cost of a railroad to be adequate if they were made for a single-track road and a double-track was built. In any event, there is a vast difference in estimating the cost of an engineering work already completed and one which has yet to be started, the difference being largely in favor of a closer estimate of the completed work.
Limitations are often placed on engineers, in connection with work they do, which are afterward forgotten. The speaker was asked not long ago to prepare a report in connection with the valuation of a large railroad property. The time within which the results were required was very limited, and the methods used in the valuation necessarily had to be a combination of the inventory method and reliance, in a great many matters, on the judgment of those making the appraisal. Undoubtedly the result obtained was entirely adequate for the purpose for which it was required, but would hardly stand if an attempt were made to use it as a basis for an argument before a Court of law or a public service commission, though it would not be beyond the range of the experience of many engineers to have a matter of this kind brought forward some time in the future as an absolute statement of fact, with no reference to the way in which the work was done.
It is inevitable, of course, that engineers will differ in their opinions as to some details of methods of making an inventory of the property of a railroad or other public service corporation, and also as to exactly what unit prices should be applied, but in general it is safe to say that any engineer of proper experience and training can make a satisfactory appraisal of the value of the physical property of a railroad, and that if two or more such competent fair-minded engineers, unhampered by any consideration of the purpose for which it is to be made, should make such an appraisal, the variation in the result would be so small as to be negligible. The speaker, however, does not entirely agree with the author, that the purpose for which the appraisal is to be used should be entirely ignored by those who are making it. There can be little doubt as to the propriety of using a properly made physical valuation as a basis for taxation, or as information for the owners, although there may be some as to the methods whereby the so-called intangible values are to be determined in these cases, or even whether they should be considered at all. The greatest difference of opinion arises when an attempt is made to regulate the issue of stocks and bonds, or to fix the rates which should be charged for transportation, on the basis of a physical valuation.
Arguments for and against rate regulation revolve in a circle, and, apparently, there is no starting point which will satisfy every one. The Courts have ruled that the railroads are entitled to such rates as will enable them to earn a fair return on the value of their property; the railroads claim that the only way to determine this value is on the basis of the earning capacity; that is, one side claims that the rates must be based on the value and the other that the value should be based on the rates. It is evident, however, by this time, that the railroads must submit to regulation, therefore a way must be found to break into the circle, and it would seem to be incumbent on them to direct their energies along lines which will tend to make such regulation fair and just rather than to oppose it entirely. There is little claim that unduly large dividends are paid, but there is a feeling in the mind of the public that the railroads are over-capitalized. Is it not possible, therefore, to break into the circle at this point, and decide, by means of a proper valuation, as to the fairness or otherwise of the capitalization? The objection to this, on the part of the railroads, is that the value of the purely physical elements is by no means the whole value of their property, but that something should be added for the so-called intangible values.
To emphasize the difficulties of appraising the intangible values in any way which will permit the application of such value to the determination of rates for transportation, the opponents of physical valuation cite what is now the familiar instance of two mythical roads between the same termini, the first with good alignment and easy grades following a valley, and the second forced into the mountains, having not only heavier grades and more curvature, with consequently a higher cost of operation, but also more expensive construction. The value of the purely physical features of the former, of course, would be much less than those of the latter, but its actual value as a property would be greater. How then should the rates on the two roads be fixed? The fallacy of using this example as an argument against physical valuation as a basis for rate-making is in assuming that there would be two railroads built under such circumstances, with no other features than the two termini and the line between.
One has only to call to mind such examples of competing lines as those of the Denver and Rio Grande between Denver and Salt Lake, the Union Pacific between Cheyenne and Ogden, the Lackawanna and New York Central between New York and Buffalo, or many others, to realize that there are, on all roads of this nature, many other factors than the actual cost of operating through trains between the termini, which determine the through rates.
One would hardly suppose that at this late date any one believes that it is proposed to use only the value of the purely physical property of railroads as a basis for rate regulation, yet the New York Sun, a paper of national prominence and usually most ably edited, devoted a column of its editorial page[[20]] to a discussion intended to show that rate regulation, based on physical valuation alone, was an impossibility.
In addition to citing the example given above, the following is put forward as the reductio ad absurdum of the argument for rate regulation based on physical valuation. It is said:
"Suppose there are two bridges over the Ohio, the cost of the construction of each being the same, one between Cincinnati and Newport and the other twenty miles below where there is nothing but a village on either shore.... On what basis would the proponents of physical valuation, as the determining value in rate making, adjust a toll charge on these respective bridges?"
The example is far-fetched, and in no way applicable to the question of the adjustment of rates on railroads, but inasmuch as it is seriously put forward from a responsible source, it seems worth while to consider it.
Assuming, as apparently the propounder does, that the proposition is uncomplicated by any questions of franchises, public rights in the land on which the bridge and its approaches are built, etc., then there is no question but that the owners of either bridge have a perfect right to charge what toll they please. On the other hand, suppose the permission of the War Department, or some other governing body, had to be obtained in order to build piers in the river, or even to build the bridge at all; the argument used in asking for this permission is that the bridge is needed as a public convenience; or it is desired to occupy certain streets for the approaches, again is used the argument of public convenience, and so on. These privileges are granted on the tacit understanding, at least, that the public convenience is to be served, and the Courts rule that, in such cases, in consideration of the equity which the public has in the property by reason of the rights granted, a fair return on the value of the property, but no more, should be the basis for establishing the rates of toll. Would the Sun claim that the value of the rights and franchises given by the public in such a case, be included in the value of these bridges, and that a higher total income should be derived from one bridge than the other because the value of the streets on which the approaches had been built is greater in one case than the other; or that a greater income should be derived in one case than another because the cities furnish more people than the villages? Is there any particular reason, except for the slightly larger depreciation and cost of maintenance, and, bearing in mind the fact that both bridges cost the same, why, if there is ten times as much traffic on one bridge as on the other, the toll should not be proportioned accordingly, to provide the same income on each?
If the Sun had imagined a bridge built by private individuals, with their own money, between two villages, the inhabitants of which, at the time the bridge was built, having been willing to grant almost any franchises or privileges in order to get the bridge, the villages in course of time growing to large cities, and the old bridge having been replaced by a heavier modern structure, the example might have been more nearly comparable to the railroad situation. In this case, the original toll, of say 10 cents a head, may have, in the early days, only barely returned a meager rate of interest on the investment, or even for some years resulted in a deficit. Would the Sun uphold the owners of the bridge if, since the villages have grown to cities, they still insisted on collecting the original toll, if it could be shown that a new bridge could be built and would be a paying investment with a toll of, say, 2 cents, except for the fact that the original bridge was built in the only location where it was practical to build a bridge at all? Or is it reasonable to say that the foresight and energy of the owners of the bridge, even though it may have been one of the principal factors in enabling the villages to grow into cities, entitle them to capitalize their enterprise on the basis of a 10-cent toll? It cannot be denied that the energy and foresight of the original builders should be recognized in fixing the rate of toll, but there is a limit to the value of this, and it is because of the feeling on the part of the general public that the capitalization of similar intangible values on the part of the railroads and other public service corporations is too large, which, whether true or not, has caused the present agitation against them. If the capitalization is reasonable, there must be some way to demonstrate the fact, and it seems as if a properly made physical valuation, with due allowance for the intangible values, is at least a step in the right direction.
The Sun states in its editorial that:
"The scheme of physical valuation, as a basis for rate making, is flatly rejected as unworkable by practically all the ablest railway authorities of the country, and that the only true measure of value is the earning capacity."
To quote only one, namely: Dr. Emory R. Johnson, who is generally regarded as an authority and not by any means predisposed in favor of the public as against the railroads, it is found that he states in his "American Railway Transportation" that:
"The earning capacity of the railroad cannot be equitably or logically made the sole criterion of value, because the rates, and hence the earnings, should depend to some extent, at least, upon the amount of capital justly entitled to profit."
It would seem to be self-evident that the earnings alone, either gross or net, are not necessarily an indication of the value of the road. Gross earnings are not, because, if a minimum proportion of them is used for maintenance and betterment, the value of the property will steadily decrease; whereas, if the opposite policy be followed, it will increase. On the same principle, the net earnings offer no criterion as to the manner in which the property has been kept up, and alone are, therefore, no measure of its true value.
As an example of the arguments used by some of the opponents of physical valuation, the following quotations are made from an article by Mr. Henry Fink, Chairman of the Board of the Norfolk and Western Railway.[[21]] Referring to the fluctuation in the costs of construction, he says:
"As the cost of materials and labor fluctuates ... it follows that what may be a fair valuation of a railroad one year may not be so one or two years later. Hence, it would be necessary to make new valuations from time to time."
Further, in the same article, referring to a valuation based on the market value of bonds and stocks, he says:
"Unlike the physical valuation, this method has a rational basis.... It is true that prices of stock fluctuate—at times violently—but this difficulty can be overcome in a measure by using the average prices for long periods."
It is strange that it did not occur to so able a man as Mr. Fink that the value of the physical property might also be based on average prices for long periods; the cost of railroad construction and equipment as a whole does not fluctuate nearly so violently as the stock market.
The report on "The Basis of Unit Prices,"[[22]] by W. D. Pence, M. Am. Soc. C. E., the Engineer of the Wisconsin Railroad Commission, in connection with the Appleton Water-works case, is an excellent example of a fair and impartial study of this phase of the subject, and the conclusion of the Commission in this matter can only be regarded as reasonable by any one who is disposed to be at all fair-minded. It says:
"If the standard by which the reasonableness of charges is to be determined should fluctuate with the market prices of material, labor and land, no schedule of rates could be established for any length of time, for, under the circumstances, a rate that would be reasonable to-day might be very unreasonable to-morrow. The principles of the law applicable to the subject certainly involve no such absurd consequences."
Another instance of an argument based on technicalities is found in the Railway Age Gazette.[[23]] In an editorial on Valuation and Rate Regulation, it is said:
"It has been supposed in the past that rate-making is an exercise of judgment. It seems to be assumed by many that after a valuation has been made it will be merely an exercise in mathematics. Suppose the value of a railway for state purposes is $50,000,000. Then, on this theory, all that will have to be done will be to multiply this amount by 6 per cent.—or whatever may be regarded as a fair return—and so adjust the rates as to enable the road to earn, say, $3,000,000 a year," but, the writer goes on to ask, "how are the specific rates to be fixed? A great majority of those who advocate valuation say that they should be based on the cost of the service. The proper method, then, would be to ascertain the exact cost of hauling each commodity and then base rates on these ascertained costs, making them just high enough to allow the road a fair return."
Then the article goes on to point out the difficulties of doing this, which of course we all know, and finally concludes that: "The theory of basing rates absolutely on the cost of service is unjust and impracticable." In the present state of the art this is probably true, but why is it necessary to change the present theory of rate-making because the rates are to be lowered or raised? If, for instance, it is shown that it is necessary to reduce the rates sufficiently so that the net earnings will be reduced, say, approximately 10%, is it beyond the capacity of the traffic officials of a railroad to adjust their rates accordingly?
In an editorial in another part of this same issue the Gazette advocates the raising of rates to meet higher prices of supplies and higher wages; it is surely as feasible to lower rates as it is to raise them, and, even though it were necessary to base rates on the cost of service, it does not seem as if that would be entirely impractical, inasmuch as it is the whole argument advanced for raising the commutation rates on the railroads entering New York City. Will the Gazette say that the arguments put forward by these railroads are all wrong? Mr. Fink, in the article[[24]] already referred to, states:
"It cannot be said that ... railroads make tariffs; they can only adjust them to varying conditions."
"Adjusting freight rates is practical work of men who have special training for it and large experience. They may not all be able to explain underlying principles, such as the value of service, but they have used this principle for years, and apply it, intuitively in every case which comes before them."
Surely this body of men is equal to whatever adjustment may be necessary. Rates will probably never be arranged to suit every individual shipper; but if the people, as a whole, believe that the railroads are fairly capitalized on a reasonable basis of value, and the rates, in the aggregate, are adjusted so that unduly high profits are not made, individual complaints of injustice may easily be taken care of.
The most important considerations affecting the regulation of railroad rates arise in attempting to fix the amount which shall be considered a fair return on the investment. If a certain rate of interest is fixed as the maximum which may be earned, all incentive toward improvement or progress is removed. The effect of this would be, of course, to retard all development. Once a railroad was earning its legal rate of interest, there would be no necessity of cutting down grades, building larger locomotives to handle larger trains, investigating the economics of operation and location, in order to introduce the thousand and one economies which are being developed day by day, or for our railroad presidents to lie awake nights thinking how they are to save that million dollars a day for the benefit of the always ungrateful shipper. This objection against rate regulation, and incidentally against physical valuation, can undoubtedly be overcome. One proposal which has been made is somewhat along the lines on which it is proposed to finance the New York Subways, the profits to be divided between the railroads and the State, after a certain rate of interest had been earned. There is nothing novel about this, as several railroad charters have been granted with a provision that all earnings, over an amount necessary to provide a certain rate of interest, should be paid to the State. Another suggestion[[25]] is that the reasonable rate of return be fixed as a percentage of the gross income, irrespective of the amount of capital required to produce it. There are probably other ways in which this might be worked out and adjusted, and this phase of the subject surely does not present any insuperable objections.
That the railroads have little to fear, in regard to capitalization, from a properly made valuation, is shown by the results in the State of Washington, where the valuation was undertaken solely for the purpose of fixing rates, the result being a determination of the market value of the three principal railroads of the State—the Northern Pacific, Great Northern, and Oregon Railroad and Navigation Company—at an amount considerably in excess of their capitalization.[[26]] It is true that rates were lowered in this case on some commodities, but it does not necessarily follow that every change of rates on the basis of valuation must be toward a lower scale. Railroad rates are low and have stayed low while the cost of everything else has been raised, and yet, while this fact is well known to the general public, they still believe that, in some way or another, the railroads are getting or have been getting more than their proper share of profits. Evidently there is something wrong somewhere, and it is not going to be set right by calling the public fools and ridiculing their presumption for meddling in any way with railroad affairs. Mr. F. W. Whitridge, the Receiver of the Third Avenue Railroad, of New York, while stating[[27]] that he had only just discovered that there was such a thing as valuation, at the same time held up the whole scheme to ridicule, though he admitted that:
"The people of this country have, I think wisely, made up their minds, in consequence of great corporate abuses, that public service corporations should be subject to regulation, etc."
He nevertheless ridicules the efforts of the authorities, particularly their endeavors in the matter of valuation, with its "irreverence for facts." They seem, he says, "to be singing the song of the Banderlog who dreamed of
"'Something noble, grand, and good
Won by simply wishing we could.'"
Valuation, however, has gone far beyond the point where it can be considered a visionary scheme, or can be held up to ridicule; and it has been worked out far enough to show, at least, that there is a rational basis, on which a determination of values can be made, which will do justice to both sides; furthermore, the Supreme Court of the United States has not only ruled that valuation must necessarily be precedent to rate regulation, but has gone so far as to specify at least some of the elements which must be taken into account, and it may be worth while noting that, in spite of the author's criticisms of the Washington State Valuation, it is the only one, thus far, in which an attempt has been made to comply with the rules laid down by this Court. The results in Washington, however, indicate clearly the need of regulation of the railroads, as a whole, and not varied regulation by individual States of the parts of systems within the borders of each.
Arguments on either side can be prolonged indefinitely, and many good reasons for and against physical valuation are advanced from time to time, just as they may be on any proposition. Some of the principal objections have been referred to here in an endeavor to show that they are not insuperable; the point which concerns us now is that to-day we are confronted with a fact and not a theory, and that fact is that the railroads are going to be regulated, and that their proper development is held back and general business is hampered by the feeling of uncertainty as to the outcome. Physical valuation is not a panacea for all evils, but a properly made valuation of the physical elements, with a due allowance for the intangible values, based possibly on some such method as that developed by the Washington State Commission or by Professor Adams in Michigan, is surely as good a way of breaking into the circle of argument as any that has been proposed thus far.
The equipment of freight trains with air brakes and safety couplers was practically forced on the railroads by the pressure of public opinion led by laymen, yet one will hardly find a railroad man now who will not admit that this is good practice, not only from the standpoint of safe operation, but from that of economy as well. The early attitude of the railroads in this matter is already being quoted by the advocates of valuation, and inasmuch as we have to admit, as we surely do, that a start is going to be made somewhere along the line of obtaining some more definite information in regard to the true relation of the value, capital, and profits, of railroad properties, than the mere statement by the railroads themselves that they are all that is good and fair, would it not be wise on their part to do all they can to have the start made properly rather than oppose it? Some of the most prominent and progressive railroad men of the country have already arrived at the point of believing and saying that regulation properly carried out may not be an unmixed evil, in fact, would probably be beneficial, but they still balk at valuation, without, however, suggesting any other means whereby the general public is to obtain the information on which to base an intelligent opinion as to how such regulation is to be carried out.
The speaker does not for a moment underestimate the difficulties incident to the determination of the intangible values, or forget the difference between the problem presented by the comparatively new lines in the State of Washington and a valuation of, say, the Pennsylvania Railroad or the New York Central. No one who gives any real thought to the problem pretends that the value of a railroad is the value of its purely physical property; but, because the matter of determining the intangible values is difficult and complicated, is it necessary that we should sit back and fold our hands and say "it can't be done"; that in the whole country there is no man or body of men, or engineers, if you please, with brains and ability enough to solve the problem? As for cost, is it not worth $10,000,000, which is more than $40 per mile for all the railroads in the country, or about three times as much as the cost of the most careful appraisals yet made, to have the question put once and for all on a stable basis, satisfactory to all, if the problem be approached in a fair, broad-minded, common-sense way, by engineers big enough to command the respect of both sides? Aside from the question of rate regulation, is it not worth this much to the railroads of the country to be able actually to prove that the amounts at which they are capitalized are reasonable, as in the great majority of cases they probably are?
There are one or two points which, it seems to the speaker, cannot be too strongly emphasized:
First, that valuations properly made may be the means whereby confidence may be restored, not only in the mind of the general public, but in that of the investor; but, in order to obtain this result, the railroads should urge, with all the power they possess, the necessity of having such valuations made by a body of men, some of whom, at least, should be engineers, big enough to entitle their opinions to the respect of both sides, and thoroughly qualified by training and experience for the work.
Second, that, as far as possible, regulation should be general or national, so as to avoid the complication of dividing all roads at the State lines, and of having different regulations in different States.
Third, that there need not necessarily be any relation between rate regulation and rate-making. Rate regulation can well be confined to rates in the aggregate, rate-making applies to the adjustment of individual rates, and must necessarily be the work of men well versed in all the varied elements which control it and the particular conditions affecting the business of each particular road. The speaker believes that valuations made in this way and with these objects in view will do no harm to the railroads, and will do much to restore confidence and give us the much needed peace and quietness to carry out necessary development.
Charles H. Higgins, Assoc. M. AM. Soc. C. E.—Mr. Riggs' able and timely paper is of great interest and worth to all concerned with the matter of values, whether of public service corporation property, or other property; and what engineer is not concerned with values?
One cannot but wish that an index accompanied the paper, as its usefulness would be thereby greatly increased, particularly as, by its arrangement, such subjects as depreciation, non-physical values, etc., are treated of in many different portions of the paper.
The Wisdom of Having a Physical Valuation.—It is hard to understand how any thoughtful person can now doubt this, for we are in a period of regulation and taxation of public service corporations, and the only question is whether they shall be regulated and taxed with a full understanding of the investment involved, or by arbitrary methods, such as the 2 cents per mile passenger rate, which has been so popular in many States, under widely different conditions and irrespective of the cost of the service.
The time would seem to have arrived when the thoughtful public service corporation manager would welcome a fair valuation of the company's property, as protection against legislation conceived in ignorance of the capital invested.
Relation Between Railroads and Other Properties.—The relation between appraisals of railroad and of water, gas, and traction companies is very close, and the same general principles apply. In the former, however, it is complicated more often by the fact that the lines of a railroad extend through many States, with terminals in one or two, and, further, that the railroads have many subsidiary, controlled, or dependent companies, such as coal, lighterage, terminal, car, warehouse, contracting, elevator, stock yard, and supply companies, often owned, wholly or in part, by men in the railroad management. Agreements with these companies may greatly affect the non-physical values, as determined by the methods advocated in this paper, which may otherwise be sound.
Valuation of All Properties.—The author says that the valuation of all railroad properties in the country "would be of interest." It would be more; it would be of value infinitely greater than the cost. The mere presence of light prevents many vices, and this is as true in corporation practices as in the streets. It is in accord with Dr. Woodrow Wilson's "pitiless publicity"; and, which is, perhaps, more important, it is the basis, or should be, of all legislation concerning the regulation of these great highways.
One and Only One Fair Value.—Nothing in Mr. Riggs' paper is of more value than his insistence that there is one and only one fair value of the physical property of a railroad, no matter for what purpose it is to be used. How futile are the misdirected efforts of those who would have it otherwise, for, no matter what the purpose of the appraisal may be, who can foresee the use that may be made of it when it becomes public property?
Cost of Reproduction.—Cost of reproduction less depreciation seems to be the established method—that recognized by the Courts—for arriving at the value of the physical property. Cost, as the author contends, can only be an element in determining the present value, for the owner of a stone bridge has as much right to any appreciation in the value of masonry as the owner of land has in the increased value of his property; and, though the cost early in the life of the structure is usually near its value, it may lose that position. What relation exists between the value of the Pyramid of Cheops and its cost? Now, as then, our unit measure of value is changing. Cost is certainly of historic interest, but present value is the subject for present uses.
The points in favor of inspection to determine the physical condition of the object to be valued are convincing, where the structure may be readily inspected. Mortality tables mean little without a history of maintenance. With perfect maintenance there would be no physical depreciation.
Maintenance versus Depreciation.—Depreciation and maintenance are interdependent, so much so that some engineers have advocated dropping the term, "depreciation," and substituting "deferred maintenance." A little thought will make this clear. While this term would not apply in the case of a single rail or car, it is not illogical when applied to a system, built and renewed piecemeal and maintained at a certain standard of usefulness, that is, on all well-managed undertakings of magnitude, units are constantly being replaced, thus maintaining a standard of efficiency. This standard, on the entire system, is usually found to be between 70 and 90% of the cost of reproduction. Some items are even improved, and the cost is charged to the maintenance account, such as that referred to in the paper as "consolidation and adaptation" of roadbed; and only a few, such as steel rails, steadily and progressively become less useful, and even these have a bottom value, that of scrap steel. Nor are examples numerous where all the rails are laid at one time, and they are extremely rare where all are replaced at approximately the same time. When the rails on a street or section are renewed, the cost cannot properly be charged to capital account, except in so far as the new rails are of a more valuable type than the old ones; for, if this were done, there would be no limit to the capitalization as time goes on. Furthermore, the moment it is admitted that, by reason of a change in the art, we may have depreciation through obsolescence, we admit that through a change in the art we may have appreciation through the opposite of obsolescence. This being the case, the use of "mortality tables" to determine present value is misleading, unless it is done with the full itemized accounts of maintenance, which are seldom, if ever, available. The author's position in regard to the need of inspection of each item is well taken.
Dead versus Live Properties.—These, perhaps, are not happy expressions, but they serve to emphasize a vital distinction which must be made in the valuation of properties. The difference may be as great as between a corpse and a man; here, also, the distinction is hard to define. We say the soul has departed, or the spark of life is extinguished, but these expressions do not contain a satisfactory scientific definition. So, as Mr. Riggs points out, the physical property of a going business may not be valued as so much junk, even if the non-physical values are to be determined separately.
The Franchise a Contract.—The Courts hold a franchise to be a contract, something often forgotten, both by the public and by corporations. The speaker, however, understands this only to mean, even where the franchise is in perpetuity, that the property of the corporation cannot be taken for public use without just compensation. In a sense, then, there can be no such thing as a perpetual franchise. Using the word franchise with its restricted meaning, the unreasonableness of the rates may be measured by the value of the franchise.
Physical versus Non-Physical Values.—The following division has been made by the author between physical and non-physical property, for the purpose of valuation:
"That the Physical Value, or present value of the physical property, should fairly represent the actual capital invested in the property at the date of appraisal; that it should be made up of the sum of the various elements which constitute the cost of reproducing the property together with any appreciation which may have been added to any of them, less all depreciation.
"That the Non-Physical Value is the difference between the 'fair value' as defined by the Courts, or the reasonable value of the property as a business or producing property, and the physical value, or actual present worth; and that the only proper method for determining such values involves a study of income accounts.
"This Non-Physical Value may be: positive, or a value in excess of the physical property, or negative, or less than the physical value. In the case of a property having a negative intangible value, a deduction should be made from the physical value."
This division is convenient but arbitrary. It is the division of an engineer rather than of an economist; for these so-called non-physical values are like the breath of a man's life; without them, the physical value is like the discarded body. Again, the use of negative non-physical values, while convenient, may not be wholly logical. These remarks are not directed at Mr. Riggs, for he is careful to say that he is dealing only with active enterprises, and not with those which are inert, and the speaker realizes that he is not attempting primarily to build up a logical argument, but to formulate certain rules to overcome practical difficulties met by all who have attempted valuation work. As many who have not given this matter much thought are apt to be misled by the distinction made between physical and non-physical values, they should bear in mind that the line between them is like the equator, an imaginary one.
Water.—"The water is as much a part of the cost of putting that line there as the rails," remarked a corporation official, of admirable character and wide experience, pointing to a trolley line from the window of a Pullman car; and, bearing in mind what he meant by "water," this is undoubtedly so. The cost of promoting the enterprise, the discount on the hazard, the loss of interest during its infancy, the labor of building up the undertaking—these are all real elements of cost, and may remain in the property as value, but, like all other items of cost, they have their reasonable limits, which, in each individual case, can be determined within narrow bounds.
Purpose of a Valuation.—As Mr. Riggs points out, there are four reasons for a valuation: Taxation, rate-making, purchase, and control of the issue of securities, one of which is usually the primary cause for the valuation being made; and he argues that there can be but one "fair value" of the physical property, whichever of these reasons may prompt the appraisal. This is fundamental, for "fair value" is used in the sense of true value, which, to the writer, seems to be a more apt expression. It is rather surprising that it does not appear in the paper. Its use, of course, is old; in the Constitution of New Jersey, 1875, we find: "Property shall be assessed for taxes under general laws, and by uniform rules, according to the true value." Each of the three matters, taxes, rates, and authorized capitalization, are interdependent and, in the long run, cannot be considered separately. This can be emphasized by a reductio ad absurdum: Modern civilization is so dependent on transportation by rail that unquestionably all taxes could be raised by assessment on the railroads, if these roads were allowed to fix their rates and were protected in the collection of them; but how would this method differ from that of the Romans, of farming out the collection of taxes? Not materially, and no one advocates a return to that method. This is absurd, but it serves to emphasize the relation between taxes and rates. Taxes can only come from the rates.
Overhead Charges versus Unit Values.—There is much in various parts of this paper concerning overhead charges, but very little about the items considered in determining the unit values or unit prices used; and does not the latter greatly affect the former? For example, in discussing the Michigan appraisal, the author says:
"For many items, such as clearing, grubbing, earthwork, masonry, etc., the price was fixed by agreement during the discussion at a figure which represented the fair average cost of this particular item during the 5-year period preceding the appraisal."
The "fair average cost" under what conditions? This word "cost" is understood by different men in as many different ways as the word value. Mr. Riggs very clearly gives the items included in "fair value" as finally arrived at by him, but it would seem to be as important to define "fair cost" as used in arriving at the unit prices, for otherwise the chain has a weak link.
What may be considered a fair cost per unit of measure for a particular item differs greatly: First, with the point of view and breadth of horizon of the man stating such cost; and second, with the methods of letting contracts and accounting with which he may be familiar, as applied to such items of work. Because of the first, a fair average unit cost may mean one thing to a contractor, another to a division engineer, still another to a chief engineer, and a fourth to a manager or consulting engineer; and because of the second, the understanding of the term may differ among men of the same class. All of this quite aside from what may be termed the personal equation of the individual. Thus the subject of overhead charges can only be discussed profitably in the light of knowledge concerning what has already been included in fixing the unit prices used. For example, the element of hazard common to all construction, but differing in degree on different classes of work, may be included in the unit cost used, or it may be added as a percentage to resulting sums, but it cannot rightly be included twice. This is equally true of other elements of cost of a similar character.
The foregoing is pertinent, for any valuation will probably be attacked in the Courts, and the unit values will be one of the most tempting points for assault, for the very reason that this wide difference of understanding in regard to cost, and particularly in regard to unit costs, exists. This same difference of understanding is usually the reason for the wide difference in unit costs testified to by able engineers and, consequently, for the distrust often felt for such testimony. The methods followed in taking expert testimony usually work to make "confusion worse confounded." The judge or layman, hearing two engineers testify to widely different unit prices as a fair average cost for certain work, forms a low opinion of their judgment, or worse, whereas the real difficulty may, and usually does, lie in a different understanding of the meaning of the term "cost," or "unit cost." To the speaker, this seems to be the weakest point in an admirable paper.
Paving.—Whether the value of the paving between and for a space outside of the tracks is an element of value in a street-car line, or whether the cost incidental to the construction and maintenance is in the nature of a tax, is a much disputed point in all valuations of street-railway properties, and an important one, for it may amount to $15,000, or more, per mile. It is interesting to remember that the custom of requiring street-railway companies to maintain the pavement between the rails and for a space of about 2 ft. outside of them, which has become almost universal, developed during the use of horses to draw the cars, the animals causing great wear on that portion of the street. This question of values is a difficult one. It would seem that the most tenable position is that: If the fee to the pavement is not in the company, and if the rule concerning cost of reproduction less depreciation is to be followed, the cost of taking up and relaying the pavement is an element of value in the physical worth of the track, for it would be impossible to reproduce the track without incurring the cost of such work.
S. D. Newton, Assoc. M. Am. Soc. C. E. (by letter).—The general scope of this paper is admirable. The author's views and definitions are unusually sound, clear, and forcibly expressed. To one minor detail, however, the writer is unable to subscribe. Referring to "the physical property element of value," he states that:
"This consisted of those things which are visible and tangible, capable of being inventoried, their cost of reproduction determined, their depreciation measured, and without which the property would be unable to produce the commodity on the sale of which income depends."
Take the case of an industrial spur for some minor industry along a line of railroad. It is often a question in the minds of the management whether or not the car-load business done by such an enterprise is sufficient in quantity to warrant the expense of a spur track. There are probably other facilities in the neighborhood which could be used to take care of this business at the expense of some inconvenience; in a large proportion of cases, the railroad will handle the business anyway, and the spur can in no sense be called a necessity. Still, it is visible, tangible, and capable of being inventoried, and should be included in an inventory of the property the same as any track or section of track belonging to the Company. This may also be said of an extra settling basin or filter bed in the case of a water-works plant. If such basin or bed were not in existence, and a leak should occur in the original plant, the business of supplying water to its customers could, in all probability, be carried along in some manner until the break could be repaired; nevertheless, such a tank or bed is desirable, and its value should most certainly be included in an inventory.
Take the extreme case of a piece of machinery which is utterly broken down or so far out of date as to be entirely worthless for the purposes for which it was designed. Yet such machinery has, at least, a scrap value, and as such it should be included in the inventory as part of the tangible assets of the concern at the date in question.
Of course, in many instances, certain interests endeavor to have inventoried items which should either be omitted altogether or included at a much reduced valuation from that sought to be placed on them, and, in such cases, the very best judgment of the appraising engineer must be called into play in order that injustice may not be done to either party; but to say, as Mr. Riggs' definition virtually does, that nothing should be inventoried which can, either with or without inconvenience, be dispensed with, is absurd, and the writer does not believe that such is the meaning the author intended to convey. Probably, if the word "economically" were inserted in the definition, it would more nearly represent the proper idea.
William V. Polleys, M. Am. Soc. C. E. (by letter),—In his very thorough and painstaking paper Mr. Riggs states that it is confined to a discussion of methods for arriving at a correct figure of cost, and disclaims any intention of considering the propriety of using said figure when reached.
Inasmuch, however, as he devotes the next eight or ten pages to a dissertation on law, political economy, rate-making, finance, and advice to railroad employees, with a word of encouragement to the good, and firm reproof to the bad ones, it is fair to assume that he intends this disclaimer in a Pickwickian sense, and that the real intent of the paper is to show that the physical valuation of property is, with certain determinative, corrective factors, a proper standard for gauging taxation, bond issues, and kindred evils.
Is it not a fact, however, that taxation is based on a much more intangible structure, and that the net earnings must necessarily have more to do with it than the physical valuation of the property—whether it be that of a wicked public service corporation, or that of an honest haymaker—rather on what their property can produce, than on what it would cost to produce the property? Is it not rather a battle of business acumen between the taxer and taxee, a battle which, among other things, is regulated more or less by the fact that an extreme in either direction will bring disaster to one or both, followed by the inevitable reaction and readjustment?
Take, for instance, an extreme case: A manufactory is erected on comparatively worthless ground. A million dollars or more is invested in a plant, with the result that surrounding real estate values go up with a bound. Supposing that the manufacturer has not made any previous arrangements for immunity, and the assessors are both acute and honest, the property will be taxed for a large figure, which tax, if the factory is making money, will be paid, with more or less grumbling, up to the economical breaking point. Suppose that, owing to a sudden permanent change in business conditions, it becomes impossible to operate this plant, and it is abandoned. A corps of experts may be thrown into the mill, before the last employee has left the building, and may carefully scrutinize and caliper the machinery, count the bricks in the wall, tap the stay-bolts in the boilers, and bore into the furniture to see whether it is solid or veneer, and when they are through and their figures are all in, they have not arrived at anything that is of the slightest use as a basis for a bond issue or taxation, and very little that would be of use for sale. In such an extreme (but by no means unheard-of) case physical value bears no relation to real value.
This is not to say that a physical valuation is without worth, and even great worth in some cases; it is merely offered as an opinion that the physical value is in many (and probably most) instances a very treacherous guide to the real value—a far poorer guide, as a general rule, than the accounting department; a minor quantity, in fact.
It seems doubtful whether there is a scientific way of arriving at the true value of a going property by the physical-valuation route. There is too large a percentage of values which, being intangible, are matters of judgment. At best, the determination of value must be that of opinion, and the worth of that opinion hinges principally on the practical qualifications and disinterestedness of the person who gives it.
Unfortunately, or fortunately, as the point of view may be, the disinterested person is not apt to be qualified, nor the qualified person to be disinterested, and it seems extremely probable to the writer that, while weapons may be changed and excuses vary, the tax war will be waged as of yore, and the fool and his money will continue along diverging paths until something more ingenious than physical valuation is invented, however well the valuation may be made.
C. P. Howard, M. Am. Soc. C. E. (by letter).—While there may be no material differences of opinion as to the principles on which a physical valuation should depend, such a detailed description of organization and methods as that presented by the author should be of great service to others undertaking similar investigations.
It may not be amiss, however, to mention certain features affecting the non-tangible values which should be more fully considered in any general discussion of the subject.
The author calls attention to one or more particulars in which the methods of the Michigan appraisal may "fail as a method of determining a value for use as a basis of rate-making." Later, after quoting various court decisions, he dismisses this phase of the subject with the words: "In view of these dicta, it is needless to argue whether a rate of 6% or 10%, or 15%, or more, be reasonable."
A value for purposes of rate-making might more properly be called a "permissible value." The writer holds no brief for the corporations, and would not like to fall under the imputation of being "apparently incited by, either the direct interest of corporations, * * * or an effort to confuse the subject of valuations," but will venture the following, which, while it does not exactly represent any particular case, it is hoped may be recognized as an illustration drawn from life.
A, B, C, and their associates, being familiar with a certain territory, its resources, transportation facilities, and growing development, believe that the time has come to build another railroad through their State or States. They have made careful estimates of the amount of tonnage that may be expected from the development of its mines, timber, farms, etc., and conclude as follows:
First.—The road, completed along the most approved lines, will cost, with equipment, $50,000,000.
Second.—It will take five years to construct and equip the road and put it in fair running order.
Third.—The traffic, when fully developed according to their hopes and expectations, will eventually afford at usual tariffs a handsome profit, say, from 8 to 12% per annum on the capital invested. This condition, they believe, in all human probability, will be attained in from 5 to 10 years after completion.
Fourth.—That half the traffic anticipated will pay 5% on the investment.
Fifth.—They are obliged to admit (though the chances of this are so remote as to be in their opinion negligible) that, due to unforeseen causes, obstruction, competition, etc., there is a possibility that, as has so often happened in the past, the enterprise may prove a financial failure, or that the period of prosperity may be postponed so far into the future as to amount to practically the same thing.
Here is a bold undertaking; but were it $5,000,000 instead of $50,000,000, the conditions would be essentially the same. Nevertheless, they have the courage of their convictions and go ahead.
Now, with all the risks and uncertainties attending an enterprise of this sort, if the ultimate profits were limited in advance to 5 or 6% on the capital invested, less depreciation, who but the Government itself could afford to build a railroad?
Evidently, when an existing railroad makes small additions from time to time to extend or take care of its business, the risk is not so great. Such extensions will continue more or less under any limitations.
For rate-making, it is evident that an appraisal based on earnings will utterly fail of its purpose if made during the lean years immediately following construction. If made some years later, when the property has begun to pay, the risk and necessary financial loss of the lean years should be remembered, as any one building a road in the future will necessarily have the same problems to meet, together with the expenses of interest, depreciation, loss from operation, etc., both during the construction and the lean years following, all of which must properly be considered a part of the real cost of constructing and developing a property.
J. E. Willoughby, M. Am. Soc. C. E. (by letter).—The determination of the cost of reproducing the property of any steam railway involves, together with other items, an estimate of the present cost of:
First.—The acquirement of the right of way, to the extent, in the form, and on the location of that held in connection with the railway to be reproduced;
Second.—The construction thereon of the roadway, to the form and dimensions, and of the materials which the roadway to be reproduced exhibits; and
Third.—The seasoning and adaptation of the roadway to the state of perfection which the roadway to be reproduced exhibits at the time the estimate of cost of reproduction is made.
The first conception, for fixing the cost of the several items, is to consider the railway to be reproduced as being non-existent at the time the estimate is made, but having the environment which then exists along the operated railway, although that environment may be largely of the railway's own creating. The cost of the right of way is to be fixed as ungraded and unimproved property attached and forming a part of the adjoining improved property, which adjoining property will be entitled to receive, in addition to the market value of the land taken, all consequential damages due to the taking off of the right of way in the form and location that the land has actually been taken, and for the purpose of railway construction and operation. This adjoining property is to give credit on the consequential damages for the incidental benefits which it derives, if any, from the construction and operation of the railway.
In fixing these values, the drift of public sentiment—the bias of juries of view and of trial juries—at the time the estimate of cost of reproduction is made must be considered, since that sentiment may affect enormously the cost of the right of way. The amount to be paid for a right of way is in the end that which a condemnation court will award. The question as to whether or not the right of way was originally donated can no more enter into the determination of the cost of reproduction, for the purpose of lessening the estimate of cost of acquiring the right of way, than the fact that donations of lands or bonds (or of convict labor and slave labor, as in the South prior to 1860) made by governmental authority or private enterprise, at the time of the original construction, can be used to reduce the reproduction cost of the excavation made in the formation of the roadway.
No rule as to the sale of property for commercial purposes in the vicinity of an operated railway can be rightfully adapted as covering the line as a whole. While the cost of right of way through farm or timber lands bears a general relation to the value of those for agricultural purposes, where improvements thereon bear but a small proportion to their total value, this relation is wholly wanting in the cost of a right of way through a village or city or at any point where the improvements on the property bear a large proportion to its total value. The relation is also wanting where a right of way is obtained through agricultural lands devoted to special purposes, like that of country homes for the rich. It is also wanting where the right of way is taken out of the narrow river lands in the Appalachian Mountains, where the total value of the whole farm is dependent on the small acreage of flat land along the river bank. The general rule of prefixing a constant to the current selling price of lands, in order to determine the estimated cost of right of way, should be limited to agricultural and timber lands, and to those which, owing to their extent, the carving out of the right of way does not wholly destroy for the continuation of agricultural and timber operations.
For villages and cities, and for lands devoted or adapted to special purposes, an accurate estimate of the cost of reproduction of the right of way can be determined only by a specific investigation of the conditions in each community. While it is difficult to conceive all the activities and sentiments which have growth in, from, and of railway operation, as being in existence without the railway, it is only through such an assumption that one can estimate correctly the make-up of the items of cost of reproducing a railway as such railway may now exist. To assume that the railway, not existent for the purpose of estimating the cost of reproduction, will now receive the donations of land and moneys that were made half a century ago, is merely going back to a determination of what the road has actually cost; and that is contrary to the intent of the theory of the cost of reproduction. The conception of a parallel line is not correct, for it imposes thereby a further burden on properties which have already contributed to the public good, probably to an extreme extent, and gives an abnormal cost for right of way, as shown when a railway seeks to enlarge its terminals in a crowded community, or to find a new entrance into a populous city.
So, too, in estimating on the formation of the roadway, one must consider the roadway to be reproduced as being obliterated—all cuts and borrow-pits refilled, and all embankments and spoil banks removed from the right of way—but all other lines of transportation, except the railway to be reproduced, must be considered as being in existence as they actually are at the date when the estimate of cost of reproduction is made, and that such other lines of transportation are available for bringing in machinery, tools, teams, materials, and supplies for the construction of the railway to be reproduced. It is only by such an assumption that the benefit of the improved means and methods of construction now prevalent can be obtained; but it is not permissible to estimate for the construction of a railway with different grades, alignment, roadbed, widths, or with different materials than that of the railway to be reproduced merely because such construction at this day might be actually cheaper or better than to construct it in exact duplication. For example, if the rock cuts on the roadway to be reproduced be only 18 ft. wide, with ¼:1 slopes, one must not figure on the greater economy of steam-shovel excavation, because the steam shovel cannot be worked in cuts of that width; nor can the spoil from such cuts be carried long distances to eliminate a possible solid-rock borrow originally made elsewhere, because long hauls are practicable in steam-shovel work, but wanting in excavations where the mule is the transportation force. So, too, it is not permissible to estimate on reinforced concrete bridges to take the place of more costly cut-stone arches, if cut-stone arches are the structures that have been actually built. The idea of cost of reproduction is not synonymous with the idea of the cost of building a railway capable of serving the same transportation purpose. If all our railways were to be built anew, in the light of our present knowledge, and with our present traffic offerings and financial resources, vast changes would be made in the character of construction. The physical fact of existing construction prevents a theoretical substitution of what is the best construction for any community, together with its costs for the construction which was actually made years ago.
In the event that an estimate of reproduction costs be made for a State as a whole, or for a great railway system as a whole, the conception of reproduction is modified so that the construction may take the form of progressive construction, the principal lines being built first and the less important lines afterward. This method will require the estimate for interest during the construction period to be greater.
The money cost of the seasoning and the adaptation of the roadway to such a condition as will permit heavy trains to be run at high speeds, is great, but the amount is not readily ascertained. An estimate of cost of reproduction, to be true, must consider this item; and probably the more usual method of ascertaining it is to assume it to be an amount in some proportion to the cost of the excavation. This proportion will vary with the character of the material through which and of which the cuts and fills are made, and with the methods of construction necessarily adopted. There are many railways on which this cost will exceed 25% of the total cost of excavation.
After the estimate has been made, including the item for seasoning and adaptation, there should be added a contingent fund to cover the omitted work, consisting of small borrow-pits and ditches, undetermined foundations, unexpected conditions encountered, unavoidable "force account" work, minor changes of streams and highways, damages to adjoining lands due to the methods of construction and to diversion of water, etc. This item will not exceed 5% of the cost of the roadway if the estimate be accurately made.
The more convenient form into which an estimate of cost of reproduction of a steam railway is to be put is to follow the sub-accounts, as prescribed by the Interstate Commerce Commission for Expenditure for Road. Each item given in that accounting has a place in the estimate. These comments are confined to the items covering the roadway, namely, Right of Way and Station Grounds, Grading, Tunneling, Bridges, Trestles, and Culverts.
Henry C. Adams, Esq.[[28]] (by letter).—To the writer this paper seems to be the most complete and comprehensive discussion of the general question of valuation of property invested in public service industries that has come under his notice. It is especially important in that it is a summary of the discussion on this most difficult subject during the past ten years, and the writer thoroughly agrees with the general conclusions reached by Mr. Riggs.
There is one point, however, which might possibly have been developed more completely, and that is the treatment of discounts, which presents itself from time to time in the general discussion. Mr. Riggs quotes with approval the following:
"If a company can market its 50-year, 4 per cent, bonds at 90 per cent. of par, it means that the company's credit is on a 4½ per cent. basis; that it could market a like security paying 4½ per cent. at par."
This is, of course, correct as far as the mathematics of the proposition is concerned, but it seems to overlook that peculiar psychology of the market which enables a corporation to secure a larger amount of actual cash for a given interest annuity when bonds are sold at a discount than when they are sold at par.
Aside, however, from the accuracy of the above quotation and of Mr. Riggs' apparent acceptance of it as the final word on discounts, one may ask if it recognizes all the elements necessarily involved in a discussion of the problems raised by discount financiering. From the literature of the subject one may read the following claims: Discount is a measure of the risk involved in a new enterprise; discount is a market adjustment that reflects the current value of money; discount is a sacrifice of principal for a slightly reduced interest annuity; discount is a dividend declared before the dividend is earned; and many cases are cited in which a discount is merely a promoter's fee for services rendered.
The writer does not care to discuss at this time these various points of view from which discounts may be regarded. They are mentioned merely to suggest that the subject is not as simple as some writers seem to think. Any valuation of public service industries, from whatever point of view it may be regarded, must, from the nature of the case, touch the problem of fundamental equities; and one of the elements of this problem which has not as yet been fully analyzed is this element of discounts. From the point of view of taxation, such an analysis is not perhaps essential; but if the valuation is to be used as a basis of determining reasonable rates, or as a measure of reasonable capitalization, it seems to be essential.
The writer is sure this discussion will not be construed as in any sense a criticism on Mr. Riggs' paper; it is rather a suggestion of an unwritten chapter in the literature of valuation. The American Society of Civil Engineers is to be congratulated in securing from one of its members so complete and satisfactory a discussion of the principles and methods for the valuation of public service corporation property.
Carl C. Witt, M. Am. Soc. C. E. (by letter).—The appraisal of the railway property in Michigan was a wonderful performance in a great many ways, not the least of which was the thoroughness of the work, considering the short time available, and the writer desires to express his appreciation of this paper, as it is a valuable addition to the meager literature on this subject.
More recent appraisals, made by States traversed by the same railway systems as those involved in the Michigan appraisal, have been made with a freedom from opposition by railway companies due to the educational effect of this pioneer work. Particularly is this true of the recently completed appraisal, by the Board of Railroad Commissioners of South Dakota, of the physical property of the railways in that State, of which work the writer was the Engineer in charge. No opposition was met; in fact, some of the railway companies had established regular departments for furnishing inventories and appraisals, had completed the necessary field work in South Dakota before the inventory had been requested by the State, and were able to furnish a very complete appraisal in a short time after the request for it was made.
This appraisal was made in compliance with an act of the Legislature of 1907, which required the Board of Railroad Commissioners to ascertain the true cash value of all the property of every railroad company in South Dakota used in the operation and maintenance of their respective roads. No attention was paid to the purpose of the appraisal, but one of the first uses made of the information thus secured was in the litigation following the passage of an act by the Legislature of 1909, prescribing a maximum passenger fare of 2 cents per mile on all railroads operating within the State. In connection with a rate case of this kind, some questions have been raised regarding proper bases for land values, the use of an item for adaptation and solidification as an element of physical value, the value of the intangible assets, etc.
The lands of all railway companies were appraised at a cost to reproduce or re-purchase at the time of appraisal, regardless of the original cost of the property. The sales method was used for determining the market value of adjoining property. There has been a very large land movement in South Dakota in the last five years, and as most of the country is prairie, with similar soil over large areas, it was not difficult to determine the average market value of the land for farm purposes, at the date of the appraisal, and the gradual trend of values for five years previous to that date. An average multiple of 250% was used to arrive at the cost of reproducing or purchasing the right of way. This multiple was based on investigations made of recent right-of-way purchases, and inasmuch as there are no large terminals in South Dakota, the same average multiple was used throughout the State for both town and farm property, investigation showing that town property could be secured for slightly less and farm property for slightly more than the average multiple used.
In each supplemental appraisal the land values will be corrected to correspond to the changes in surrounding values, as the railway company is entitled to any increase, due to natural causes, based on the cost to reproduce at the time of appraisal. This is a well-established theory, as shown by Mr. Riggs.
No allowance was made for the item commonly known as "adaptation and solidification," except in the item of contingencies and in the consideration of the present value of the ballast. In some recent appraisals, large sums, based on a percentage of the cost of grading, have been allowed for this item. While there is no question that large sums of money are expended in maintaining a safe track on a new bank, and that this expense gradually diminishes as the roadbed becomes solid, due to the pounding of the trains and the action of the elements, this expense is, and properly so, charged to maintenance, and is paid for out of the operating revenues. Now, in the trial of a rate case, exhibits showing the operating expenses, including maintenance charges, are introduced, and to include this same item in the appraisal of the physical property leads to a duplication, for if the passenger or shipper pays for this maintenance charge, it should not be counted as an item of physical value as a basis for determining what is a reasonable rate.
The case is similar to that of a locomotive: When new, it is kept in the vicinity of the shops, because trouble from lack of proper adjustment and weak parts is likely to develop, and the maintenance charges may be much higher than a few months later when the machine has "found itself" and, as an operating machine, is more efficient than when new. However, no one will insist that it has an added physical value in dollars and cents, or that the excess cost of repairs and maintenance during its early life should be added to its cost of reproduction now; in fact, it is a second-hand machine, and the maintenance charges must be paid for out of its use.
Generally, when a roadbed is turned over to the operating department by the construction department, it is in good line and surface, and if an appraisal were made at that time its condition would be 100%; but as soon as it is placed under traffic, it begins to depreciate, as shown by the fact that it requires constant attention to keep it up. If the roadbed is cross-sectioned at each station and actual quantities calculated from cross-section notes, there would be no depreciation, but if the grading quantities are calculated from profiles of the line, as constructed some time previously, and for a standard width of sub-grade, with a percentage added for shrinkage, and allowance made where banks have been widened, etc., it will probably be found to exceed the actual measured quantities, because the action of the elements in washing the slopes, the wearing of the shoulders of the embankment due to foot traffic, etc., will show some depreciation in quantities. It is common practice to carry the item for grading over to the present-value column at 100%, or, with no depreciation. This practice, together with the present condition of the ballast due to maintenance, and that part of contingencies which covers washing of slopes, filling of ditches, sink holes, etc., certainly takes care of all adaptation and solidification which should enter into a valuation of physical property.
No appraisal was made of the intangible assets. A great many arguments have been advanced for and against such an appraisal, and in South Dakota it was held that the earning ability of any corporation due to its franchise, strategic location, efficient organization, going-concern value, etc., while perhaps an element of value to be considered in a transfer of the property or if assessed on an income basis, should not enter into a valuation which would be used for determining a just and reasonable return on the investment, because the greater the earning power the greater would be the return, and that this condition would produce a never-ending increase in returns; whereas, when the returns reach a point at which they will not only pay a fair dividend on the investment, but take care of any depreciation in the physical condition of the property and make all needed improvements in roadbed, buildings, and equipment, demanded by the traveling public, shippers, increased traffic, or natural causes, they should be kept to that point. There are several hundred miles of railway in South Dakota which have been built out of the surplus earnings of the parent corporation—in other words, with money supplied by the traveling and shipping public—but which are owned by the railways and on which they may earn another surplus for constructing more extensions, etc., etc.
The original South Dakota appraisal, as of June 30th, 1908, on forms similar to those used in Minnesota, has been supplemented by yearly appraisals corrected for all additions and deductions made during the fiscal year. For this purpose a new set of forms[[29]] was prepared, with the various items classed in accordance with the "Classification of Expenditures for Road and Equipment," as prescribed by the Interstate Commerce Commission, and arranged so as to facilitate showing the yearly changes.
R. A. Thompson, Assoc. M. Am. Soc. C. E.[[30]] (by letter).—This paper is considered by the writer to be the most complete treatise ever written on the valuation of public service corporation property, and the author deserves the sincere thanks of the entire Engineering Profession and all others interested in this most important question. Its presentation is most timely, in view of the agitation, particularly on the subject of railroad valuation, which is now engaging the attention of Congress and the law-making bodies of the several States, as it contains much valuable information relative to decisions of Courts, in addition to clear and concise expositions of the methods in vogue for the appraisement of corporate property, etc.
It is a fact—rapidly coming to be recognized by legislative and judicial bodies—that the prescription and regulation of tolls, charges, and assessments against public corporations cannot be made systematic and intelligent unless there is provided some estimate of the value of the property involved, based on the cost of its replacement or reproduction. Particularly is this true of railroads; and such regulation of the affairs of these corporations as has heretofore been essayed by State and National commissions, has generally been on illogical bases, unsatisfactory alike to the proponents and the companies. Results have been had, it is true, after a fashion, but there have been endless disputes and litigation, with the prime questions involved no nearer solution than before. One has but to contemplate the varied and often antagonistic legislation promulgated by the several States, relating to corporation management, and the many rulings and decisions of the different courts and commissions on the subject of regulation, assessment, and adjudication of corporate rates, revenues, taxes, and tolls, to become convinced of the complicated and tangled condition of the situation, and to realize the necessity for the early establishment of some logical basis on which to establish the fabric of corporate control.
While it is not maintained that an appraisement of the physical property of public service corporations will be the panacea for all such ills, the writer firmly believes with the author that such appraisal, as a beginning, is absolutely necessary, and when effected on some fair and reasonable basis, will contribute largely to the successful solution of many of these intricate problems.
With the estimate of the physical value of a property before it—which represents money actually invested, together with such accruals to costs as it may be determined that the owner is reasonably entitled to have considered—any Court, tribunal, or commission is in a better position to mete out impartial justice, whether it be the regulation of a rate, the assessment of a tax, or the imposition of a fine.
Although the author's experience in valuing corporate property has been principally in connection with the Michigan appraisal of railroads, and to him is largely due the credit for devising methods for, and carrying forward to successful completion, this thorough and most excellent work, it is refreshing to note his inclination to give credit to the work of others along the same line in other States, which, it is to be regretted, has not always been the case with writers on this subject. There is no doubt that the work of the Michigan and Wisconsin Boards of Appraisal—conducted under the advice and direction of some of the most eminent and talented engineers and economists in the United States, and practically without regard to expense—is the most complete and perfect of its kind heretofore attempted; yet there are many features in regard to the organization and execution of its details about which there may be an honest difference of opinion, as viewed by those who have been similarly employed.
It is but natural—as suggested by the author—to find the "individual" character of the appraiser (which has been moulded by his environment, training, and former service) reflected in his opinion, and this would be most probable in the organization for, and carrying on the work of, appraising a railroad property, which involves consideration of practically every phase of engineering and economics. The judgment of any man is essentially warped along the lines of his experience, and he is necessarily biased and prejudiced in favor of or against certain practice. As a consequence, therefore, it is not reasonable to suppose that any one man, or set of men, can formulate a system for valuing corporate property which will be perfect in all its details, and be free from objection and criticism.
The writer was employed for a number of years as Engineer for the Railroad Commission of Texas, and had charge of the valuation of railroad property under the Railroad Stock and Bond Law of that State. A paper on the methods used by this Commission was prepared by him and published by the Society.[[31]] This Stock and Bond Law was enacted in 1893, and the railroads then existing were valued in 1894 and 1895. The average value of 8,860 miles was $15,844 per mile. This valuation was made by Charles Corner, M. Am. Soc. C. E., now Resident Engineer of the Rhodesia Railways, South Africa, and Mr. H. J. Simmons, now General Manager of the El Paso and Southwestern Railway System. The actual cost of this work is not available, but is estimated at about $2 per mile. The engineers making the appraisal secured maps, profiles, and all available information from the offices of the railroad companies, including all the construction records and estimates of quantities which were preserved. Appraisal was made only after one of the engineers had made a personal examination on the ground, accompanied by assistants to aid in measuring structures and estimating quantities.
All valuations made since 1895 have been of new railroads making application for issuance of securities, and in all cases the deeds for right of way and depot grounds, the contracts for construction, the actual quantities of construction of all kinds, the plans and specifications for all structures and construction, and all other information which the engineer desired, were submitted by the railroad companies to enable an accurate appraisal of the value of the property to be made. It is not possible for valuations of this character to be made under more favorable circumstances. Up to October, 1909, more than 3,500 additional miles had been valued, and in all cases the estimates limited the securities which the companies might issue.
Writers on railroad valuation have generally been inclined to discredit the work of the Texas Railroad Commission and the system of appraisal used by it. One writer, of more or less prominence, has referred to it as the "cheap" method. While it may be true that other appraisals have been more expensive, it is a fact that those of the Texas Commission have served their purpose well, and the railroads, as a rule, have made little complaint. As a matter of fact, it is highly probable that the valuations of railroad property made by the Texas Commission have been of greater utility, as far as the public is concerned, than those of all other States combined, and, at the same time, no injustice has been done the railroads.
It appears that those who have interested themselves in investigating the Texas method of railroad valuation—including the author—have failed to construe the real meaning and intention of the Stock and Bond Law. Apparently, it was passed for the purpose of limiting railroad indebtedness—and is referred to by Mr. Riggs as serving only this purpose—but while its effect has been to accomplish this most successfully, its enactment carried with it a deeper significance.
This law was passed at the same time as the General Railroad Commission Act of the State, which gave to this Board absolute control over all freight rates and tariffs, and also other powers not possessed at that time by any other State commission. The decisions of the highest Courts at that time laid stress on the right of carriers to maintain rates which would afford a reasonable return on stocks and bonds outstanding. Hence, to delegate the regulation of rates to any tribunal by any law which did not carry with it also the right to supervise and restrict mortgage indebtedness to some reasonable extent, appealed to the legislators as being essentially ineffective. The effect of the law has been to reduce steadily the average outstanding stocks and bonds of the railroad companies of the State from an average of $40,802 per mile in 1894 to $31,910 in 1909—and this, too, in the face of a recognized increase in the physical value of the properties—thus depriving the railroads of one of their most potent weapons of offense when contending against the Commission's orders. It is a matter of common knowledge that the indebtedness per mile of railroads of other States has increased greatly during this period. It is also a fact that the railroads of Texas have, except in rare instances, contended that injustice has been done them in the enforcement of this law, and the market value of their stocks and bonds has steadily risen. Also their physical condition is on a par with that of railroads in other Southern and Western States, and their incomes from operation are as substantial. The practice of "watering" their securities has been effectually stopped, as regards local issuance, and any interest which might have accrued on such securities has been saved to the public.
It has been contended that the Texas valuations of 1894-95 were too low, and did not, even at that time, represent the fair value of the properties. This is perhaps true to a certain extent, but it must be remembered that the costs of materials and construction then were less than at any time before or since; and, viewed from the present-day standpoint, they seem to have been inadequate. It must also be considered that real estate values throughout the entire State were very low, compared with present values and with those of lands in other States. Although the writer admits that the margin was very narrow, still he is of the opinion that the valuations as made represented closely the cost of reproduction of the physical properties at the time.
The valuations of 1894-95 stand to-day on the Commission's records as "the value of the property," except in cases where there has been application and necessity for re-valuation. The machinery of the law did not provide that these appraisals should be kept "up to date." The mortgages on these railroads are still outstanding, and there has been no call for another appraisal, except in a few instances. The Commission has decided that in its opinion the "present value" of any of the railroads already appraised is represented by the original valuation plus the value of all permanent improvements and betterments added. This principle has been carried out with those railroads which have applied for re-valuation for any purpose, and the Commission has admitted the same in testimony which it has given before the Courts.
Since the appraisals which the Texas Commission makes are primarily for the purpose of limiting indebtedness, and the carriers are entitled to have these at least equal the cost of their property—the investment with certain additions to cover promoters' profits—no consideration can be given to depreciation of structures and equipment, although the application for valuation and process of issuing of securities may be had several years after completion. The writer holds that there is strong argument in favor of not taking into account "depreciation," and of estimating the value of the property as being entirely "new," whatever purpose the valuation is proposed to serve. This is apparent, as already stated, when the valuation is to serve as a basis for limiting the issue of stock and bonds. Is there any logical reason why a valuation for this purpose should not also serve—as far as it pertains—as a basis for taxation or for regulating freight rates? As far as the State is concerned—and to be consistent—should not "one" valuation serve all purposes?
Suppose that a State should create a board clothed with powers of rate regulation, taxation, and authority to restrict indebtedness, and also prescribe that it should appraise the value of the property of the railroads, and use that appraisal as the basis for its acts. Would it be logical for that board to make and apply one system of valuation for one purpose and another system for another purpose? Manifestly, it would have declared that a valuation was a "valuation" for all purposes, at least as far as the physical property was concerned; and, when devising a method for making its appraisals, it should incorporate therein all the elements of value which might apply logically to either purpose. The writer believes that "depreciation" of roadbed and structures would have no place in such an appraisal, on the one hand, nor its negative, but fully as intangible and difficult of concrete estimate, "adaptation and solidification of roadbed," on the other.
It should not be understood that the writer maintains that taxation boards should not go beyond the valuation of physical property to arrive at a final basis for assessment. There are certain intangible elements which should be taken into consideration when taxing property, chief of which is the net income. It is only as far as physical valuations apply in either case that he considers that there should be uniformity.
He does not approve at all of incorporating in an estimate of the physical value of a railroad property such an element as "adaptation and solidification of roadbed," which is credited with so much importance in the Minnesota valuation. In the first place, such an element is incapable of being measured in tangible terms and reduced to a dollars-and-cents basis; second, it cannot be reproduced in the sense that other property is reproduced, and its value does not appear in the capital account of the railroad; and third, it results from the action of the seasons on the one hand, and the working over of the roadbed by the maintenance forces on the other, the cost of which appears in operating expenses. One is constrained to believe that the engineer who insists on incorporating such an element in an appraisal of the physical value of a railroad is hard put to find material with which to swell his estimate. When noting the large difference in value per mile of the railroads of Minnesota, as compared with those of Michigan and Wisconsin—adjoining States—it would appear that undue prominence had been given to this and similar factors.
The writer's experience as appraising engineer for more than 10 years with the Texas Railroad Commission, and for the past 2 years as a construction engineer—having built about 160 miles of railroad in Oklahoma and Texas—confirms his belief that, in the absence of actual figures of cost, right of way and other railroad real estate should be appraised at but little in excess of the market value of abutting property. The practice of the Texas Commission has been to add from 25 to 50 per cent. The conditions under which railroads were built in Michigan, Wisconsin, Iowa, and Minnesota cannot have been radically different from those in the Southern and Western States. In Texas it has been a rare instance when a railroad has had to purchase all of its right of way. Also, contiguous lands have greatly increased in value since the advent of the railroads. It would appear highly illogical to advocate that these increased values should be multiplied by 3—or even 1½—and used as a basis for taxing the railroads on the one hand, or taxing the public on the other, by permitting indebtedness to be issued against it, the interest on which the latter must pay. The railroad recently constructed by the writer traversed fertile and thickly populated areas, already quite well served with transportation facilities. Only a small fraction of the necessary real estate was purchased by the railroad company, and only in a few cases of such purchase did it pay largely in excess of the market value of the land—and these were where the road interfered with houses and other farm improvements. In cities and towns, land was acquired at practically its fair market value. For rural property, the ratios used by Professor Taylor in the Wisconsin appraisal appear to be quite fair, but in cities they are too high—especially for the Southwest. The Minnesota ratios appear to be unreasonably high.
Any appraisal of the physical value of railroads—in the absence of figures as to their actual cost—is necessarily only approximate, and is correct only within certain limits. Especially with regard to the old roads, where original cost data cannot be had, the values applied to property and construction must be largely speculative. It is impossible to build two railroads in the same territory, on the same specifications, for the same amount; yet, on the basis of cost of reproduction, an appraisal board must apply the same value to each.
The writer believes that unless there is more uniformity as to methods of valuing corporation property, as between the States, all valuations will be more or less discredited, as they should be, by the Courts. It is to be hoped that this paper will be generally discussed by the Profession, and will lead to the adoption of more uniform methods.
Charles H. Ledlie, M. Am. Soc. C. E. (by letter).—The following is suggested as a method of procedure for determining the fair and equitable value of a property:
1st.—Examine carefully the statutes governing corporations of the class under examination.
2d.—Form an opinion as to whether or not the locality can support such a property, by inquiry regarding the different businesses carried on, bank clearings, railroad facilities, what the surrounding country produces, etc.
3d.—Find from the archives of the company a general description of the property, from its conception to the date of appraisement.
4th.—By close examination of the minute books, directors and executive committees, there can be ascertained all the details of organization, issuing of stock, bonds, and other forms of indebtedness, contracts for equipment, supplies used in the construction, etc.
5th.—Obtain from the general manager or the superintendents an explanation of the details of operating and maintaining the property, including the different classes of service, rates, etc.
6th.—Go over the property, examine it carefully, and talk to any and all employees from whom it is thought that any information can be gained.
The foregoing will give a general knowledge of the property under examination, and will enable one to begin the real work. The examiner's assistants must be competent and experienced men.
7th.—Examine all the vouchers, from the beginning of the company down to the date it began operation; classify their contents under the respective heads for the different classes of material used in the construction, for example, pipe, engines, cable, etc.; then prepare blank tables for each heading, having columns for size, quantity, prices, and total; and abstract each voucher. Do the same with the vouchers for labor, general office salaries, general expenses, interest, taxes, legal, etc. This, when completed, will give the detailed cost, as shown by the vouchers.
Next check the vouchers back through the books, and draw up a statement, which will show the total book cost and, no doubt, will differ from the voucher total. It is likely that many items will be found for which no vouchers exist, a list of these is made and if the officers cannot give a satisfactory explanation of any of them they are omitted. The total of what remains is added to the voucher total and represents the cash expended for the benefit of the original property, as shown by the books and vouchers.
8th.—Take all the remaining vouchers of the company (it is supposed that the examiner has already been informed by the officers, and by his inspection of the records, of the extensions and betterments which have been made), separate the vouchers for materials, labor, etc., from those on operating, etc. Next classify them by years, and then proceed as set forth in 7th, and add the different yearly amounts to the total of the original plant. This will show the amount of cash expended (according to the vouchers and books) on the property, for its physical plant, organization, etc., from its beginning to the date of appraisement.
Every examining engineer should know (or can obtain) the prices for materials, labor, etc., during these periods of original construction, extension, etc. If the prices are the same, or about the same, as at the time of purchase, the above total stands as the cash expended; if there should be much difference—and sometimes there is—take the detail of the materials as found in the vouchers, affix the proper prices, and do the same with labor, etc., and this total will be what, in the judgment of the examining engineer, the plant should have cost. A mean between this latter total and that in 8th is taken, in order to be fair and equitable. This amount, in place of that given by 8th, is then used as the cash expended on the physical property. If no difference is found in prices, then the total cash as shown by 8th is considered as the total to be hereafter used.
9th.—A careful detailed inventory is now made of the physical property as it exists at the date of examination. This often requires some excavation in order to determine sizes, quantities, and conditions. The prices used to ascertain the total of the inventory are made by taking the average of all those paid for materials, labor, etc., of the same class, during each year of the property's existence. (The writer considers it manifestly unfair to use the current prices in this calculation, for they may be very much below or above those actually paid, and in either event an injustice would be done, whereas, if the average prices are used, the examiner cannot be accused of unfairness.) To this total cost, as shown by the inventory, 5% is added for engineering and superintendence; 3% for general office salaries, 2% for general expenses, 1½% for legal and organization expenses, and from 5 to 10% for contingencies. (This latter percentage depends on the judgment of the examiner, who, after studying the local conditions carefully, can determine from his own experience what difficulties have been met in the construction. It is not believed that a hard-and-fast rule can, in equity, be laid down for this latter percentage.) This total represents the value of the tangible property, based on the inventory. The inventory cost and that set forth in 8th (or possibly as modified by prices current when the plant was built) are averaged, and this result, plus the supplies on hand, is the fair and equitable amount of cash which has been expended on the property. This is used in finding the "Fair and Equitable Value."
10th.—Next take the inventory of the plant set forth in 9th, affix the current prices at the date of appraisal, and to this total add the same percentages for engineering, etc., as set forth in 9th. This gives the cost of reproducing the property, with the same classes of materials, size and make of engines, etc., as is now in it, to which total add the cost of materials on hand for the total of cash required to be expended at current prices to reproduce the plant as it exists.
It is often found that this latter total is greater than that set forth in 8th, for the reason that the engines, etc., may be of types which are now abandoned or obsolete, and the manufacturing company, having to make patterns, etc., would charge more for them than the original price at the date of purchase.
This reproduction cost at current prices is only to give the examiner information he may or may not require later in the investigation to determine some point that might arise in ascertaining the "Fair and Equitable Value."
The writer considers it unfair to call the reproduction value the cost of a modern plant which will give the same service and output, because one is not dealing with the value of a modern plant, but with that of an existing property.
11th.—From this cost (using the detailed inventory to find the extent of property still in existence), calculate the amount of depreciation for each section of the plant, this being based on the present condition of the different parts and what their future life may be. The total depreciation is then deducted from the result found in 9th, and this remainder is used as the "Fair and Equitable Value" of the tangible property at the date of appraisal.
The intangible value (called by many names) must now be determined. It consists of rights, from the State, county, city, or any one or more combined, which the company must have in order to carry on its business. These rights in nearly all States are taxable, and taxes are collected on them. The Supreme Court of the United States has in the past held that they are property, notwithstanding what State "Courts and Commissions" have set forth on this subject, and in the writer's examinations they will be treated as property until the Supreme Court of the United States decides otherwise.
There are in general three classes of franchises, namely:
I.—Those granted by the State to conduct a business, where no county or city franchise is necessary, only requiring the company to obey the ordinances for excavation, etc. The charter of the Laclede Gas Company, of St. Louis, Mo., is an example of this class.
II.—Those granted by the State to carry on a business subject to a county or city franchise.
III.—Those granted by a city to an individual, singular or plural, or a company, to do business within its limits or a section thereof.
In each case the right may be a contract, for it may require a payment for the franchise granted, either in a lump sum or in yearly installments, or in the form of services rendered, such as for light, etc., free service of some kind, or a combination of any two or all of them.
The manner of determining the value of "Intangible Property" is as follows:
(a) The gross collected earnings are audited for each year during the period the company has carried on its business. The same is done for all vouchers, i. e., operating, maintenance, salaries, legal, general expenses, interest, insurance, and taxes, and includes every item disbursed. Whatever this latter amounts to, is deducted from each year's gross earnings as already found, and the result is the true net earnings or deficit for each year.
(b) The true net earnings are added together and the mean taken; if, in the period from the beginning to the date of appraisement, any deficits are found, these are deducted from the total of the plus-earnings, the result is divided by the total number of years, and this gives the true average net earnings. This is then capitalized at the legal rate of interest of the State in which the property is located. The result is used as the value of the "Intangible Property."
12th.—The amount given by 11th is added to the result obtained by 9th, and this total is the "Tangible and Intangible Value" of the property, and the "Fair and Equitable Value" of the property at date of appraisement.
If it is found that grave mistakes in design or judgment have been made by not employing competent people, and money has been wasted in construction, the plant is re-designed, for the original plant, and its cost estimated. The same is done for each extension, using the prices paid at the different periods, and this result is used in place of 9th, as the cash cost at the date of appraisement.
In determining the intangible value, if it is found that the management has been careless in order to make large net earnings, at the expense of the physical property, estimates are made of what the property can be operated and cared for (here the practical knowledge of operation, etc., is necessary), and these results, plus taxes, etc., are subtracted from each year's collected earnings. The mean or average of these results is considered as the true net earnings, which are capitalized and added as set forth in 12th.
The writer holds that consumers or purchasers should not pay for avoidable error or ignorance, and the amount of the securities issued on the property is not considered as entering into the matter of "Fair and Equitable Value"; when they do, the method is somewhat different.
The mean true net earnings are used in determining the intangible value, because franchises have average values, as earnings and expenses fluctuate in corporations, and, when intangible values are to be considered, they must not be based on the last year's net earnings, for if they are, they may give a very large result in one year and a small one in the next; therefore, to be fair, the mean true net earnings should be the basis of the intangible value. If the company has been over-capitalized, and no sinking fund or depreciation has been set aside, it is the present owner's misfortune. If the company calls something a betterment, and it is found that the betterment has only replaced something, it is not allowed, but is classed as maintenance; on the other hand, if the replacement is larger, and capable of rendering greater results, such as a larger engine, pipe, cable, etc., the cost, less the cost of what it replaces, is allowed as a betterment, and if the old part is sold the proceeds are deducted from the betterment charge, for if it is credited to maintenance, it increases the true net earnings. This is often done, but is not the correct way to treat the matter, for it increases the intangible value.
13th.—When new rates are to be established for a period of future years, the manner of determining the "Fair and Equitable Value" is the same as has been heretofore set forth. The new rates are based on averages, and the first step necessary is to ascertain what gross revenue the company must have in order to pay all classes of operating expenses, maintenance, depreciation, taxes, interest on the "Fair and Equitable Value" of the property, and a reasonable profit.
To obtain this amount, the procedure is as follows:
(a) Find the percentage of increase of the operating expenses for each year over the prior one, for a period of generally five years preceding the date of examination (a longer time may be taken if, in the opinion of the examiner, it is necessary), and then ascertain the average annual increase of the percentages. The result thus obtained is taken as the increase percentage for the operating expenses for the new period of time.
(b) In order to determine what the operating expenses will average during the time the new contract is to run, take the amount of the last year's operating expenses as a basis and add to it the percentage found by (a). This total is the operating cost for the first year of the new contract. The amount for the second year is found by adding to the cost of the first year the percentage found by (a), and so on for each year of the new period. These results are added together and their average is then used as the mean cost of operation for each year during the full period.
(c) The same method is followed for maintenance and taxes, in order to find the average maintenance and taxes for the new contract's life.
(d) Depreciation on the plant begins from the date of appraisement, and is estimated on the physical property by using for each section the percentages used in determining the "Fair and Equitable Value."
(e) Interest at the rate of 6% is allowed on the "Fair and Equitable Value," and 6% profit.
The question of extensions and betterments to the original plant must now be taken into consideration.
(f) The amount of the betterments and extensions have already been found for each year of the property's existence, and an average of them is taken as the amount the company will spend on extensions, etc., during each year of the new contract. On this sum 6% interest and 6% profit is allowed, and, for depreciation, the same percentage as used in the original plant.
It will be seen that all the expenses of operation, etc., of these extensions have been allowed in (b), where the increase has been added for each year for these extensions and betterments, as they are assumed to increase the cost of operation, etc.
(g) The amounts found by (b), (c), (d), (e), and (f) are now added together, and to the sum 5% is added for interest, taxes, operation, etc., which may be caused by the necessary increase in capital expenditures, for a greater growth than could be foreseen at the time the new rates were established, for losses, etc. This total is used as the basis for establishing the new schedule of rates.
14th.—The next step is to determine what part of the amount found by (g) must be paid by the different classes of consumers.
(I) First ascertain the yearly percentage of increase in the output of the plant for the five years before the new contract is to go into effect (or longer if, in the opinion of the examiner, it is necessary); then find the average increase of percentage during the before-mentioned five years. Add to the last year's output the percentage found above, this result representing the output for the first year of the new contract. Continue this operation for each year in the same way as the operating expenses were found in 13th (b). The average of these results will be the average estimated output during the life of the new contract.
(II) Next find the amount of the total output each class of consumers used during each of the five years, and then find the average yearly use during this period. Put these into percentages of the amount of the average output for the five years, and then use the percentages as the amount each class of consumer will use of the average output found in (I) during the period of the new contract.
This gives the average amount of the output each class of consumers will use during the average life of the new contract.
(III) Next find the average percentage of the total revenue each class of customers paid during the five years. Take these percentages as the average percentage each class will pay of the average revenue necessary during the time the new contract is to run.
(IV) Having found the average amount of the required revenue that each class must pay, and the average amount of the total output each class will use, dividing the former by the latter for each case will give the rate each class is to pay during the new period.
It is often found in plants that large extensions have been made to supply a special contract for a long period of time, and these extensions are set aside for the exclusive use of this contract. In such cases exclude the cost, etc., of this part of the plant from the "Fair and Equitable Value" in the matter of adjustment of rates.
In determining the operating expenses, etc., in such a case, find the percentage of the total output this special output amounts to; then, using this percentage, find what part of the total power-house expenses of all kinds are caused by this special contract. This result is deducted from the total power-house expense, and the remainder is the power-house cost of furnishing the consumers with their share of the total output. If it is found that special employees are required to deliver this special output, their cost is deducted, and the same for the maintenance material used. Taxes and interest on the cost of this special equipment are found by ascertaining the percentage this cost of the special equipment bears to the whole plant.
The above results are deducted from the total operating, maintenance, taxes, and interest disbursements, and "Fair and Equitable Value," and the remainders are used as the cost of the last year's expenses for furnishing the consumers with their share of the product and the "Fair and Equitable Value."
The same method is used in determining the revenue paid by the consumer.
The above result, i. e., cost of operating, etc., is then used as the basis for estimating the expenses for the period of the new contract, as heretofore set forth.
If the charter comes under Class II or III, the city no doubt has incorporated a clause for the adjustment of rates, and the method used above is followed.
15th.—Where the franchise has expired and is going to be renewed, the same method holds.
16th.—Where the franchise has expired and the city has paid a certain amount for service, and is to buy the property, the same method is used, except in determining the intangible value. For determining the latter, the amount the city pays for service is deducted from the gross collected revenue. From expenses is deducted the same percentage as the amount of the city's payment is of the gross revenue; a net revenue is found from this, the taxes paid are deducted, the remainder is capitalized as heretofore set forth, and is the intangible value. Whatever the latter amounts to is added to (or deducted from, in case of deficit) the "Fair and Equitable Physical Value," and the result is the price the city should pay.
Cities generally claim, and so do their "experts," that they should only pay junk value, or the cost of a modern plant to give the same results. This is eminently unfair, because the city buys a property which is in full operation and it receives the full revenue, in addition to obtaining service for itself at a less cost than it heretofore paid. The difference between the cost to the city of furnishing the service itself, and what it paid the company, is profit, but there is a charge against this of loss in taxes. These two latter items, namely, profit and taxes, generally balance each other, although the writer has known of cases where the city was the gainer.
There are many points which can be advanced to establish the fairness of the methods outlined herein, but they would take some time to explain, and therefore the writer has only set out the plan he follows in his examinations, hoping that it may be of some aid in establishing a uniform method which will be upheld by the Courts.
It may be stated that recently this method was used in an examination, going back thirty-five years, and the results were accepted by both sides without question.
The writer has refused a number of examinations when told in advance what result must be found, as well as in "expert" work, where the examiner is expected to help make a case, regardless of his honest judgment, for, by accepting such work, the engineer hurts his reputation and lays the Profession open to such remarks as Judge Lacombe recently made in the case of the Peoria Water-Works Company vs. Central Railway Company.
The writer is fast coming to the conclusion that a great deal of legal trouble is caused by the decisions of commissions, the members of which have not had experience in these matters. If a commission consisted of an able lawyer, a financial man, and an engineer who has had a broad operating experience, its decisions would carry weight, and the Courts would not be burdened with so many appeals.
William G. Raymond, M. Am. Soc. C. E. (by letter).—This is, perhaps, the best paper on the valuation of public service property that has yet appeared. The author's analysis is very clear, and his arguments are convincing. Three points the writer would like to consider; two of them briefly.
The item, "going value," even if it is determined on logical reasoning, as suggested by Professor Mead, would seem to be a dangerous item, and one which might result in absurdities when estimated by an unscrupulous, ignorant person. Moreover, the term has been differently defined, and there is no certainty as to just what it means. The writer sees no reason for the existence of such a term, or of such a separate quantity as this term is supposed to represent.
The term, "franchise value," or, "value of the franchise," is used to represent the difference between the capitalized net earnings and the value of the physical property. Of course, there is such a difference, either positive or negative, but there seems to be some objection by the Courts to calling this "franchise value." The writer, therefore, would suggest that, since franchise value is a very elusive item, depending on the life of the franchise, the attitude of the community toward the corporation, the activity of competing corporations, and numerous indeterminate items, the term, "business value," or, "going concern value," be used instead of "franchise value." "Going concern value" is not as good a term as "business value" or "value of the business," because it may be assumed to include both the value of the business and the value of the property. "Value of the business" would presumably include the value of the franchise, and perhaps would not always be represented exactly by the difference between the capitalized net earnings and the value of the physical property, but would be this difference affected by some judgment percentage resulting from a consideration of the probable continuance of the franchise.
Mr. Riggs has truly said that the value of the physical property must not be made to depend on the purpose for which the valuation is made; that, for the business for which it is used, the value of the physical property is the same, regardless of the purpose for which a valuation is desired; but valuations are made for different purposes, and, while there is room for argument as to the proper valuation to be used for capitalization, taxation, or sale, there are perfectly definite methods suggested for valuing property for these purposes. The writer has never seen a statement—that appealed to him as at all rational—of a proper method of valuing property for rate-making. Indeed, the writer has said[[32]] that "proper traffic rates have no relation to valuation except that the minimum net income should be at least sufficient to pay interest on the physical valuation." The writer is not absolutely certain of the correctness of this position, for a study of the public right to regulate a corporation which is performing a semi-public function seems to indicate that the public has a right to say, not only that rates shall be non-discriminatory, but also that they shall be reasonable.
Now, the writer is familiar with three bases for the determination of what constitutes reasonableness of rates. One, which applies to rates as a whole, is this: That the net income should produce not more than a reasonable interest rate on the actually invested capital. Another is the rate that the traffic will bear, and the third is a rate that represents what the service is worth to the purchaser. Of course, a difficulty arises in determining reasonable rates on any one of these three bases.
The only difficulty with the first one is in determining what is a reasonable interest rate on invested capital, and, as far as the writer has read, no Court has yet determined what this is, although some Courts have held that 5% is a not unreasonable return, that 8% is a not unreasonable return, and, if the writer's memory serves him right, that even 15% is a not unreasonable return.
There is great difficulty in the determination of what the traffic will bear. It is a matter of the exercise of judgment and of experiment, and must be applied to a considerable extent to particular rates, for particular commodities, for particular places.
The third basis would seem to be the most difficult to use, although it is one which has recently been established in important Court decisions, and is mentioned by Mr. Riggs. What is a monopoly-provided service worth to the user or purchaser? Suppose that a gas company charges $1.60 per 1,000 cu. ft. for gas, and a very considerable part of the populace living in the city served purchases gas at this price. Presumably the purchasers pay what the service is worth to them, and what they are willing to pay rather than suffer the inconvenience of tallow candles, oil lamps, or to pay a high price for electric lights. Suppose that through a period of five years, by a series of reductions voluntarily made, the price of gas finally reaches $1.15 per 1,000 cu. ft. Is this gas worth any less to the consumer at the end of the five-year period than it was at the beginning? So far as the writer can see, it is, for only one reason, namely, that it can be had for less; but this has been a voluntary reduction on the part of the supply corporation, and who shall say that the service is not worth less than $1.15 to the consumer, or who shall say that it was not worth less than $1.60 at the beginning of the period suggested? The figures here given represent an actual case which has occurred during the last five years, within the writer's knowledge. There seems to be a growing feeling among the people that rates as a whole must be fixed so as to yield only a reasonable return to the corporation, and, apparently only for want of the suggestion of a better method, a reasonable return has been held to mean a reasonable return on the capital invested. Believing that there may be some ground for the claim that rates as a whole should be thus fixed, and that the return should not be unreasonable, let us consider how what is reasonable may be determined.
In the first place, it appeals to the writer that the invested capital is not the proper basis for estimating reasonable rates. If it shall be finally established that a corporation is entitled to realize only a reasonable interest rate on the capital invested, there will be no more public service corporations organized; but, if the reasonableness of the return may be based on the capital invested and the business done, there will still be good inducement to capable men to engage in public service business.
It would seem that the rate of return that is reasonable differs for the capital invested and for the business done—that is to say, if the capital invested is $1,000,000, an ordinary investment return of from 4 to 5% may be sufficient; and if the business done with this million-dollar plant amounts to $10,000,000 a year, a reasonable return may be 10% or even 15% of the whole.
Now, as has been suggested by Mr. Riggs, it is manifestly impossible to capitalize the net earnings as a basis for determining reasonable rates, because these net earnings are the result of certain rates already established, the reasonableness of which may be in question; and if, instead of speaking separately of interest rate on capital actually invested and profit rate on business done, it is desired to obtain a value on which to base reasonable rates, the following is suggested as a method: Determine the physical value and the annual interest on this physical value at an assumed reasonable rate, say 5%; determine the annual expense of conducting the business, and assume a business man's profit rate, say 15%, and find the profit that should be earned on the business done. This, added to the total interest charge, should give the net income, over and above operating expenses, that may be considered reasonable, and this sum, capitalized at any given assumed reasonable interest rate, would give a value which might with reason be used as a basis for rate-making, rates being deemed to be reasonable as a whole which furnish from year to year a simple reasonable interest rate on this established value. Of course, there is no necessity for establishing such a value, as the reasonableness of the rates will be determined when it is learned that they produce not more than a fair interest rate on the actual physical value of the property plus a fair profit rate on the business done.
This method is not free from the objection that what is a reasonable interest rate and what is a reasonable profit rate have never yet been fixed, but it is much easier to fix these separately than to fix what is a reasonable return on the capital actually invested or the physical valuation of the property.
W. H. Williams, Esq. (by letter).—Before entering upon the discussion of the more essential elements of the problem presented by this paper, it seems worth while to correct one or two misapprehensions under which Mr. Riggs seems to labor, and to call attention to the rather extraordinary temper in which he approaches the grave questions with which he deals.
Mr. Riggs' first serious misapprehension is that railway officers, as a class, are, with substantial unanimity, opposed to any official valuation of railway properties, and that this opposition was voiced through the writer's discussion of Professor Henry C. Adams' paper in favor of valuation, at the last annual (December, 1909) meeting of the American Economic Association. Of course, on that occasion, the writer spoke, as he now speaks, only for himself, but, more than that, he then expressly disclaimed any such opposition, undertook to make suggestions as to the manner in which a proper valuation could be obtained, and directed his criticisms plainly at a proposal which contemplated, as he then observed:
"An incomplete and misleading valuation bearing the stamp and carrying the weight of governmental sanction, which can be of no practical advantage to the Government, the public, or the railways; but may easily injure the public and the railways by disturbing the confidence of the former and hampering the activities of the latter."
The writer then added:
"It seems very clear that such a valuation as is proposed would be wholly useless to the Government for any practical purpose, because it would omit so many factors essential to any fair appraisement of the worth of the enterprises as going concerns."
Bearing in mind that the foregoing was addressed to the particular proposal made by Professor Adams, that being the topic on which the writer was invited to speak, a proposal expressly limited to the ascertainment of cost of reproduction less depreciation (the equivalent of cost of replacement with second-hand materials in a condition equivalent to that of the materials in use and hereinafter referred to as "cost of replacement") under the pseudonym of "physical value" (or sometimes "inventory value"), it would seem as though Mr. Riggs should sympathize with the writer's view, rather than with that of Professor Adams. Certainly, Mr. Riggs is fully aware of the inadequacy of mere cost of replacement to serve any useful purpose, for, after saying that:
"No account may be taken of the purpose for which the resultant figure of value is to be used; and the result should not vary, no matter what the purpose may be."
He says, in another place:
"* * * it is clear that the worth of the physical property, being the cost of reproduction less depreciation, is not necessarily the value of the property. * * *"
And, defining what he calls the "non-physical or intangible elements of value," says:
"These are those things which, added to or taken from the worth of the physical property, make up the value, and include whatever accrues to the property by reason of its operation, or by reason of grants, contract rights, competition, or location, which at the time of appraisal affect favorably or unfavorably the worth of the property."
The second misapprehension that is worthy of notice seems to have grown out of a curious sensitiveness, on the part of Mr. Riggs, as to any suggestion, other than his own, of criticism of any work undertaken or theories advanced by Professor Adams. As to every reader, other than Mr. Riggs, it is surely quite unnecessary to say that no attack has been made upon Professor Adams by the writer at the New York meeting of the American Economic Association or anywhere else. Certainly, it will be conceded that some difficulty would attend an effort to respond to an invitation to discuss before a scientific body a paper written by one of its members without making any allusion to the author of the paper or to his views or work, and those who have any knowledge of the history of official railway valuations in the United States, and especially of the proposal to undertake a Federal investigation of cost of replacement, are fully aware that Professor Adams has been from the beginning, and now is, the Hamlet of the drama, without whom it would become dull and lifeless. Strangely enough, Mr. Riggs seems to wish to deny to Professor Adams this prominence, for he says:
"Professor Adams was associated with the Michigan appraisal, but had no connection whatever with the 'physical valuation,' to which such objection is taken, and his appointment was made after the work of physical valuation had been fully outlined and was well under way."
It is true that the scheme devised by Professor Adams, and adopted at his suggestion by Governor Pingree, required the employment of civil engineers for the preliminary work which necessarily had to precede the final "valuation" by Professor Adams, but the bare statement of this fact is utterly misleading. Professor Adams' own testimony in one of the Michigan tax cases happily places his responsibility for the whole plan entirely beyond controversy. He said:
"In 1900 I was called upon by the Michigan State Tax Commission to determine whether railroads were paying a tax rate on their value equal to the rate on other property. With that problem in view, I formulated this inventory plan. * * *"[[33]]
Any discussion of the proposal for a National inquiry concerning cost of replacement which omits to show that its most persistent advocate, Professor Adams, has advocated and actually conducted or controlled several successive "valuations," in Michigan, as Statistician to the Interstate Commerce Commission, and as special employee of the Bureau of the Census, made in accordance with other methods than those which he now proposes to apply, is seriously inadequate; as seriously inadequate as it would be to omit to state that, using what purported to be the same method, Professor Adams, by changing the details of its application and decreasing the rates of interest used in his computations, raised his "valuation" of Michigan railways from $152,958,202 to $177,689,292 or 16.17%, each of the two calculations being presented to the public, with assurances that it disclosed the actual taxable value, and there being barely eighteen months between them. The writer is by no means alone as an object of Mr. Riggs' dissatisfaction because of public criticisms of Professor Adams' plan for estimating cost of replacement. Thus, of a statement in which Professor Taylor, who conducted the Wisconsin inquiry, questioned the validity of some of Professor Adams' methods, he writes:
"Undoubtedly this statement was made in good faith, and has gained currency by not having been corrected, but it is not the fact."
In another place, referring to a statement of comparative costs to the respective States for valuation work, made by the Railroad Commission of the State of Washington, he says:
"It does not appear to be good taste either to criticize costs of work in other States, or compare the costs in Wisconsin and Michigan with the cost in Washington."
Referring to a paper by Charles Hansel, M. Am. Soc. C. E., who took part in the Michigan valuation, Mr. Riggs says:
"The one point to which special attention is drawn is Mr. Hansel's astonishing misconception of Professor Adams' plan of work. This misleading statement appears in the first paper and is reiterated in the second."
Again, of the report of the expert of the Washington Railroad Commission, who had the temerity to declare that it found "little value" either in Professor Adams' methods or his estimates of the cost of the work, Mr. Riggs says:
"Such sentences, and others which, by inference if not by name, reflect on work executed by men of high professional standing, are hardly in good taste, even if true, in a report to a railroad commission of another State."
Yet Mr. Riggs does not fail to criticize the method of "valuation," applied by Professor Adams in Michigan, in terms quite as definite as any used by others.
Thus, he condemns the method used to estimate the value of the non-physical elements appertaining to the Michigan railways, on the grounds (first) that it made this value a mere derivative of the rates existing, and (second) that it made no allowance for negative values when cost of replacement exceeded real value, saying:
"It will be seen that, in the case of a property in which the surplus earnings depend on excessive rates for service, it will fail as a method of determining a value for use as a basis of rate-making; and it fails, in the form in which it was used in 1900 and 1902, to bring out those negative or subtractive elements which may be determined from the income accounts, in the case of properties which do not earn a fair return on the investment."
Of the published statistics of American railways, compiled in the office of which Professor Adams is the responsible head, derived from annual reports made in accordance with forms prescribed by the Interstate Commerce Commission under his guidance, and containing items selected from and depending on the uniform railway accounting system devised by Professor Adams and imposed on the carriers by the Commission, Mr. Riggs writes:
"The published statistics are in such form that only the careful student of affairs can understand or analyze them, and but few of the public officials who receive them are able to read the reports of the properties and comprehend them."
Railway officers fall quite generally under Mr. Riggs' condemnation, for, of them he says:
"As a body * * * it is doubtful if any equal number of men, of equal intelligence, have as limited a knowledge of the fundamental truths of government, or knowledge so colored by bias. It is also doubtful whether any equal number of men have in their ranks so few who bear an active part in the duties and activities of citizenship, or who exercise large influence on their neighbors."
Such assertions as the foregoing need no comment; their intemperance is their most effective refutation; yet a few recent examples may be cited: Paul Morton resigned as Vice-President of the Atchison, Topeka and Santa Fe to become Secretary of the Navy in Mr. Roosevelt's cabinet; Jacob M. Dickinson, General Solicitor of the Illinois Central, became Mr. Taft's Secretary of War; his successor with the Illinois Central, William S. Kenyon, later became Special Assistant of the Attorney-General; Lloyd W. Bowers, General Solicitor of the Chicago and Northwestern, was Solicitor-General of the United States from early in Mr. Taft's administration until his death a few months ago. Thus, within but four or five years, the Federal Government took four of its highest officers from the railway officers located in only one of the country's great cities—Chicago.
Of a recent address by one of the ablest and most public-spirited of railway officers, he says:
"This address well expresses the spirit of the railway managers and employees toward all forms of investigation, and the complete lack of understanding, on the part of these managers, of the legal and moral relations which they bear to the communities which they serve."
Belonging to this so hateful class, and having also ventured to question whether Professor Adams has said the last and most perfect word on the subject of railway valuation, the writer is neither surprised nor disheartened to find that he, also, has caused Mr. Riggs undisguised dissatisfaction. It is a misfortune apparently inseparable from his profession and his conception of his obligations to his employers and to the public.
As has been already noted herein, the question is not whether railway property shall be officially "valued," but rather (first) as to how the "value" which is to be ascertained is properly to be defined, and (second) how the determination of "value," as properly defined, can be made most accurate.
The essential difference between the view advocated before the American Economic Association by Professor Adams and that of the writer was, and is, that the former now desires to exclude all elements of value which are not physical and tangible, while the writer holds that, if it is worth while to ascertain, on a general scale, at the cost of a necessarily large expenditure of taxpayers' money, and as to a particular date, so unstable a fact as railway value, the kind of value the ascertainment of which could be of sufficient utility to warrant the effort can be nothing less significant than the "fair value" which the Courts have said is a proper element for consideration in fixing reasonable rates of charge. The fundamental difference between these two conceptions of value is admirably indicated by the following quotations, both of which rest on the authority of the Interstate Commerce Commission.