The author's query: should a corporation which is compelled to abandon appliances while yet serviceable, in response to public clamor, be allowed any item of value in the appraisal on account of such appliances, seems to be best answered in the negative. If the appraisal is for the basis of making rates, the corporation is fully compensated by the fact that its depreciation account provides for all abandoned machinery, and the average past depreciation is usually considered a fair criterion of the future. If the appraisal is for purposes of taxation, it would seem improper to levy tax on abandoned or rejected machinery or equipment. If the appraisal is to determine the present value of a property for sale under condemnation proceedings, it is likewise difficult to conceive any reason for allowing any present value on account of property abandoned or rejected, and, indeed, if such abandoned material had any value at the time of its removal, it is more than likely that such value was converted into cash at that time.
The statement that no appraiser would be justified in placing a going concern value on a property 3 years old, or 10 years old, unless the net earnings were such as to indicate that the property had a commercial value in excess of the physical property, is questionable. "Commercial value" is not exactly synonymous with "going concern value," for, as usually considered, the term "going concern value" represents the difference between a dead structure and a live one. A property might be compelled to operate temporarily at rates insufficient to return the legal rate of interest on the physical value of the property, and while this condition continued, its commercial value would be less than its physical value, and yet this same property is worth more while running than if operation ceased and the business was allowed to die.
Halbert P. Gilette, M. Am. Soc. C. E. (by letter).—In common with others who have written on the subject of appraisals, the author omits consideration of one of the most important elements of the cost of producing the property of a public service corporation, namely, the development expense.
Development expense is the deficit in "fair return" on the investment during the early years of operation, while the business is being developed to a point that will yield a "fair return" on the investment. Unless this development expense is charged to the capital account as fast as it occurs each year, it should draw compound interest up to the end of the development period. Development expense might be regarded as a part of the non-physical value of a plant, and a few years ago the writer so regarded it. Latterly, however, he has come to see that it does not differ one iota in principle from "interest during construction," and, therefore, is properly a part of the cost of production or of reproduction of the property. During the construction period, interest on the investment is charged, and properly so, as a part of the physical cost. Does this interest cease the day after operation begins? Not a whit. The owners of the property are entitled to a fair interest—a "fair return"—on their money, from the day it is invested. At first they receive it in the form of "interest during construction," which is charged to capital account. After operation begins they must either be allowed to earn more than a "fair return" during the fat years following the development period, or the deficit below a fair return incurred during the development period must be treated exactly like "interest during construction" and added to the capital account. If public service corporation managers have chosen the first of these two methods, it does not relieve the appraiser of the duty of adopting the second method; for the object of appraisals for rate-making purposes is to limit capital to a "fair return" on the investment. In brief, if there are to be no "fat years," then every "lean year" must be credited with its deficit as fast as it occurs.
This, the writer concedes, is a radical departure from such precedent as already exists, but we must not overlook the fact that we of to-day are establishing the precedents for appraisals in the future. The whole matter of valuations for rate-making purposes is still in a nebulous form, as far as the public, and indeed, as far as the Courts, are concerned. In the end it will devolve upon engineers to establish logical methods of appraisal. To do so, they must be able to look on the problem both as engineers and as jurists. Up to the present, however, this broadness of vision has not characterized most engineering appraisers, nor is it to be wondered at when the Courts themselves are in a maze.
A great deal has been heard lately about "going concern value." Ultimately, the Courts will hold that, as far as rate-making is concerned, there is no such thing as "going concern value" in the present meaning of the term. "Going concern value," in the final analysis, consists of two elements: First, development expense (as previously defined), and, second, capitalized surplus earnings. Surplus earnings are ascertained by deducting from net earnings both taxes and a low rate of interest on the investment, equivalent to interest on bonds. Many factors may affect surplus earnings; but, that "going concern value" consists largely of capitalized surplus earnings, cannot be denied. What are surplus earnings? The public replies that they are mainly the result of extortionate charges. This is doubtless correct in many cases; hence, any investigation of costs which has for its object rate-making must inevitably lead to repudiation of that part of "going concern value" which is based on surplus earnings, if the surplus is at all large. In a word, we reason in a circle if we capitalize surplus earnings, calling the result "going concern value," and then undertake to use "going concern value" as one of the factors in judging the fairness of rates. To express the problem mathematically, we cannot solve for a variable when the variable is allowed to exist on both sides of the equation. Yet that is precisely what some rate-making bodies are trying to do, and it is precisely what the Courts have often attempted to do.
To escape this confusion there is but one possible step, and that is to eliminate "going concern value" entirely. We must first determine the element of cost, which the writer terms development expense, and we must regard this item as a part of the cost of reproduction. We must next cease to consider small rates of interest as being a "fair return" on this cost of reproduction. When first-class mortgages draw 5%, it is folly to talk of 6% as being a "fair return" on capital invested in a business enterprise, especially when this 6% is figured on the actual cost of reproduction of the property. It may be that 7% is an ample "fair return" in some cases, but in others 10% will be found none too much, considering the small size of the business and the risks involved.
The writer will not at this time discuss methods of determining how a "fair return" should be estimated, but, in general, the process should be as follows: From the gross earnings deduct the operating expenses and taxes to obtain the net earnings. From the net earnings deduct a small rate of interest (equivalent to interest on bonds) on the cost of reproduction. The remainder is profit, and should be expressed as a percentage of the gross earnings. This percentage of profit can then be compared with similar percentages made by merchants, manufacturers, farmers, and other capitalists, and then it can be determined logically by comparison whether or not the profit made by a public service corporation is "fair." We must adopt this method of attacking the problem or we shall inevitably drive capital away from railway and other fields of public enterprise.
The writer estimates roughly that a profit of 10% on gross earnings, as above deduced, is about the same as a direct return of 7% on the cost of reproducing the average steam railway.
In a recent appraisal of a street-railway system, the writer determined the actual development expense of the property, deducing it from the accounting records. It was an astonishingly high sum, even assuming only 7% on the cost of reproduction as being a "fair return." During his appraisal of all the railways in the State of Washington, for the Railroad Commission, the writer made a similar study of development expense, but this was not included in his estimate of the cost of reproduction, as it was then regarded as being a part of the "going concern value" and he was not commissioned to ascertain the "going concern value" of the railways. Not a single railway, as far as he knows, has ever presented to a State Railway Commission, or to the Interstate Commerce Commission, an estimate of its development expense along the lines indicated. Instead, the railway companies have talked in general terms of long construction periods—often claiming 20 years or more—and of great expense incurred in building up the business, and of franchise value, and of a score or more of non-provable costs. The consequence is that they have frequently lost entirely the one great item that they are clearly entitled to, namely development expense, which is an item which can be absolutely proved from their accounting records, and, therefore, rests not on the "hot air" testimony of experts, but on facts that are incontrovertible. In like manner, other public service corporations have often signally failed to prove the full worth of their properties, because their claims for "going concern value" have been ignored entirely. When a franchise expires, the "going concern value" is usually looked on by the public as worthless, nor is this view to be wondered at.