Chapter C: P. HOWARD, M. AM. SOC. C. E. (by letter).—While there may be no (2)

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.

FAIR VALUE.

"The present value of a railroad property is necessarily very largely a matter of opinion only; it depends upon a vast number of contingencies and uncertainties, a road apparently of great value to-day may soon become worthless by the opening of a competing line having superior advantages or by the competitive struggles of other lines which operate to reduce the income of all; the value of a railroad largely results from the personal characteristics of its officials; the policy pursued by directors for the conservative and economical or progressive and daring, is a great factor in the determination of the current value of the property; a railroad property is not necessarily worth what it would cost to replace it and, on the other hand, it may be worth very much more than that."[34]

REPLACEMENT COST.

"The bill in question makes use of the phrase 'fair value.' Unless there is some legislative necessity, which we do not perceive, we question the advisability of using this phrase.

"It would seem to us preferable to substitute a phrase which indicates the fact that Congress desires an inventory valuation of railway property. By inventory valuation is meant that the property of the several railways shall be listed in detail, and that each kind or class of property so listed shall have assigned to it a valuation to be determined from the point of view of the contracting engineer, and not from the point of view of a court or board of arbitration which, from the nature of the case, cannot judge of what is 'fair value' except in the light of some specific use to be made of the valuation."[35]

As has already been noted herein, and amply verified by quotations, Mr. Riggs is fully aware that replacement cost and real value can rarely, if ever, coincide, and therefore plainly agrees, as to that elementary and essential point, with the writer and disagrees with Professor Adams, who would ignore or destroy every non-physical element of value in the property of all public service corporations. Mr. Riggs' recognition of the inadequacy of mere replacement cost is shown also by the excellent and convincing example which he cites[36] of competitive railway routes between two Michigan cities which were built and are maintained and operated under such conditions that the far more costly of the two, which inferentially has correspondingly higher replacement cost, has much lower earning capacity, both as to gross and net, and is therefore actually worth much less than its less costly competitor. Mr. Riggs explicitly favors full recognition of the non-physical elements in every valuation; and, therefore, may be ranked as an opponent of any such scheme of valuation as that advocated by Professor Adams before the American Economic Association, or in the letter of the Chairman of the Interstate Commerce Commission, hereinbefore quoted.

Mr. Riggs, however, believes that the determination of the cost of replacement is an essential first step toward the ascertainment of real value. He says:

"The worth of the physical property is primarily that on which the
value of the whole property rests."

The thought which the writer would place in opposition to the foregoing is that: Physical property has no value which is not an expression of its adaptation to economic needs. This is only another way of expressing the inevitable economic law, from which there is no escape, either in theory or in practice, that has been stated and sanctioned by the Supreme Court of the United States, as follows:

"But the value of property results from the use to which it is put,
and varies with the profitableness of that use, present and
prospective, actual and anticipated. There is no pecuniary value
outside of that which results from such use."[37]

Mr. Riggs' own definition of value is not inconsistent with the foregoing. He says:

"The value of a property is its estimated worth at a given time,
measured in money, taking into account all the elements which add to
its usefulness or desirability as a business or profit-earning
proposition."

The view of Mr. Riggs is that:

"While ... the worth of the physical property, being the cost of
reproduction less depreciation, is not necessarily the value of the
property, ... the physical worth must bear some very definite
relation to value...."

And he is, further:

"Strongly of the conviction that this relation is such that 'value'
cannot be ascertained without a determination of physical worth."

It is exceedingly difficult to comprehend just what Mr. Riggs means when he describes the relation between real value (which he recognizes so clearly as value in use) and cost of replacement as "very definite." Certainly, he does not mean that it is a constant relation, or one which can be ascertained until there has been independent determination of both of the aggregates whose relation it expresses. In fact, the emphasis which Mr. Riggs places on replacement cost has led him into the grotesque fallacy of arguing that a correct estimate of real value is only to be attained by ascertaining: (first) cost of replacement, (second) real value, and (third) correcting the aggregate first obtained by applying whatever "very definite" relation (ratio) is necessary to make it agree with the second aggregate, which was from the beginning the only aggregate really wanted. The accuracy of this characterization of his proposed procedure is made perfectly clear by the following quotation:

"... the true method of valuing a corporate property is first to
determine the cost of reproduction of the property and its
depreciation, and modify this figure by any applicable positive or
negative non-physical elements of value."

It is submitted that the clear meaning of the foregoing is that both replacement cost and real value as derived from use must be separately and independently ascertained, and that, these aggregates having been compared, the former is to be corrected by whatever allowance for non-physical value may be required to make it agree precisely with the latter. The obvious suggestion flowing from this discovery of his theory is that only value in use is wanted, as that is the only real value, and as it must be separately ascertained in any event, no other and _pseudo_ value need be taken. The essential character of the method is as described, even when it is applied through determination of the annual value of the use and the assignment of one portion of such annual value to return on the capital value of the physical property and another portion to return on the capital value of non-physical property. The real nature of the method is not even effectually concealed by the capitalization of the income assigned to physical property at one rate and the income assigned to non-physical property at a different and higher rate. In fact, if it is necessary to conclude that a portion of the net annual income of railway property is normally paid to, or in respect of, a portion of capital entitled to a lower rate of return, and the remainder to or in respect of a remainder of capital entitled to a higher rate, the appraisal of the physical property is an excessively costly, cumbersome, and inaccurate expedient for determining the amount or value of either portion of the capital. Yet that is exactly what was done in Michigan by Professor Adams, the "valuation" he then made being completed before he altered his view by deciding that the non-physical elements of value are entitled to no consideration whatever, and that only cost of replacement is worthy of inclusion in an official "valuation."

But is there any real distinction between the "physical properties" and the "immaterial elements," such as the foregoing extract seems to assume? Is not the superficial appearance of such a distinction plausible but deceptive? A locomotive is an entity; so is a railway. The separate parts of a locomotive are most of them independently valuable; so are the separate parts of a railway; but a large share of the value of the locomotive is the result of the nice adjustment of these separate parts to each other and to the work to be done.

Take a hundred different-sized locomotives, each adapted to different work under different conditions, and separate each piece of metal; it would be possible to value all these parts, but the aggregate would be far less than the value of the locomotives from which they were taken. Again, it would be possible to construct from these parts a hundred locomotives of such poor design, their respective parts so out of adjustment and balance, that they would be worth even less than the parts out of which they were assembled. The highest paid intelligence has not yet contrived the perfectly balanced locomotive, but a large part of the so-called "physical value" of every locomotive represents this sort of highly paid intelligence put forth at every stage from the opening of the mine where the ore was obtained to the delivery of the completed locomotive. Take ten railways of a thousand miles each, every one of them efficiently constructed, and equipped with proper terminals, stations, signals, rolling stock, and trained employees, and each properly adapted to the requirements of its territory and traffic; separate them into piles of ties and rails, groups of locomotives and cars, acres of land, unorganized bodies of men of varied capacity and training; what sort of intelligence will it require to build up out of these masses ten railways as efficient and useful as those that originally existed? Why, then, should the "physical value" of the locomotive include the assembling of its parts in proper balance and the "physical value" of the railway exclude the cost of the much more complicated adjustment of its elements of machinery and labor and location to each other?

At an early point in his discussion, Mr. Riggs makes an announcement, highly becoming on the part of one who proposes to deal with the problem solely from the point of view of a civil engineer, that he does not intend to argue the public utility of any sort of valuation, but only the method by which it may best be made, should one be determined upon. He says:

"This 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—it does not take up questions involving the propriety
of those figures when reached. The propriety or legality of using
such figures as a basis for an assessed valuation, as a basis for
rate-making (rate-making being an art in itself involving
complications as great as those encountered in valuation), or any
arguments as to the justice or injustice of legislation restricting
issues of stocks or bonds, will be conceded no place in this paper.
It is assumed that all these questions would have been taken up and
a satisfactory answer reached before a valuation could have been
ordered."

Two pages after the foregoing paragraph, under the sub-heading "The Relation of Public Service, or Quasi-Public Corporations, to the People," Mr. Riggs proceeds to violate the wise, though self-imposed restriction, and devotes no less than eleven pages to a defense of the project on grounds of alleged public policy. In these pages he concludes that such a valuation as he proposes—not a mere determination of replacement costs, but a real valuation, with proper allowance for all elements of value in use—would be of service in connection with (_a_) taxation, (_b_) public control of rates, and (_c_) public control of issues of capital securities.

In supporting valuation as an expedient in taxation of railway property, Mr. Riggs seems to rely on a table made up from Professor Adams' Bulletin No. 21, as expert employed by the Federal Bureau of the Census, which table shows that the assessment of the railways of Wyoming for taxation purposes in 1904 was but 7.5% of their commercial valuation, as estimated by Professor Adams, and that this ratio varied greatly throughout the different States, running as high as 114.4 in Connecticut. Of course, nearly every one knows, even if Mr. Riggs does not, that the relation between the real value and the assessed value of all other kinds of property varies greatly from State to State, and even in different portions of the same State. On account of this variation, no table such as that offered by Mr. Riggs in support of his argument can have any value unless supplemented and explained by data covering the assessment of other kinds of property. It is worth noting, _en passant_, that the so-called "Commercial Valuation," on which Mr. Riggs rests this part of his argument, assigns a value equivalent to $32,054 per mile to the railways of Michigan and one of $45,211 per mile to the railways of the prairie State of Nebraska. Possibly this variation in the estimate of value is partly expressed in the conclusion that Michigan railways are assessed at 70.9% of their value and Nebraska railways at but 18.5 per cent. Obviously, there is no more need of uniformity among the States in the taxation of railway property than in their methods of deriving revenue from other kinds of property.

Also, Mr. Riggs admits that, when the Michigan valuation for taxation was made, it was not diminished, as it should have been, by the use of negative, non-physical value. This is fully equivalent to an admission that the method was unjust to every railway not capable of earning the full return on its replacement cost. He says:

"The use of a negative or subtractive non-physical value was
considered, and advised by Professor Adams....

"Professor Adams and his associates, therefore, applied only
positive values, where any such were found, although advocating the
use of negative values."

And, of the method then used, he says:

"... 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."

And again:

"... where the earnings have been fairly uniform and stationary for
a period of years, and the property does not earn a sufficient sum
to care for depreciation and annuity, it is clear that the value as
an earning investment is less than the determined physical value,
and that the physical valuation should be reduced by some amount to
arrive at the 'fair value.'"

In his argument favoring the use of a valuation in rate-making, Mr. Riggs affords no support to Professor Adams' contention that, for that purpose, only replacement cost should be considered, and that, after fixing the rates on the basis of the least favorably located and least efficient line, so as to afford it a bare return on its replacement cost, the surplus earnings at the same rates of its more favorably located or better operated competitors should be confiscated under the guise of a special tax. This extraordinary proposal, the character of which is so illuminating as to the attitude toward railway property and investments of the most prominent and persistent advocate of so-called "physical valuation," is best stated in Professor Adams' own words, which are as follows:

"I cannot evade the conclusion that equity, as between various
classes of roads, can never be attained until all the excess of
revenue over the Constitutional limit be made a contribution to the
public treasury, and that this contribution be made as a substitute
for all taxes of all kinds and all sorts."[38]

On the contrary, Mr. Riggs distinctly upholds the right to earnings in excess of the bare return, at the minimum rate of interest, upon the cost of replacement, saying, _inter alia_:

"It is contended that the determination of rates that will be just
and fair to all competing companies involves other consideration
than the valuation of either physical or intangible properties, and
that when all these rate-making problems are properly solved, there
will remain large intangible values on the well-designed plants."

Professor Adams has himself admitted that there is no possibility of utilizing any valuation for the purpose of fixing specific rates, as such a task is far beyond the capacity of any conceivable system of cost accounting. Supplementing this admission, Mr. Riggs' opposition to the plan proposed by the former and its gross injustice, so apparent to every one but its author, destroys the last element of plausibility in the suggestion that any sort of valuation could be of utility in that connection. The writer is not overlooking the fact that the Courts, when under the necessity of repelling efforts to confiscate railway properties under the guise of rate regulation, and in view of the form in which this necessity has commonly presented itself, have accepted "fair value" as an element of importance in their inquiries; but if the railways are entitled to charge rates based on the value of the services they perform, it is clear that the question whether a rate or a schedule of rates is reasonably adjusted to the value of the service or services is very different from the question whether a fair return upon fair value has been allowed. Assuming, however, the need of an appraisement in every litigated case involving railway schedules, it is evident that each case would have to have its own appraisement, for value is ever changing and unstable. Mr. Riggs himself says:

"It is true that the 'value' of a property is an unstable figure,
subject to fluctuations due to natural or artificial causes, and
that a material change in value may occur suddenly...."

Professor Adams proposed to keep his replacement cost up to date by annual accretions equal to annual expenditures for extensions and betterments; but this plan is illogical and inconsistent, for it proposes to ignore that very essential difference between original cost (less a proportionate allowance for wear and tear) and present worth, which is the very basis of the argument in favor of any valuation at all. Equally obvious objections, growing out of the instability of the ascertained value of any particular date, apply to any plan which does not provide for a re-appraisement every time the aggregate is to be used.

The objections to the use of any valuation for rate-making which have been cited are valid, and should be convincing, but they are insignificant by the side of the fundamental objection that, as Mr. Riggs says, "as a business proposition, the value of any property depends on its earnings," while those who would thus utilize a valuation are attempting to reverse the fact and make earnings depend on the value. Such a reversal is impossible. Ascertain real value and you have a consequence of earnings, past, present, and prospective, nothing else; use this as a basis for a rate schedule and you get, as a mathematical result, the present rates. The only way to derive any other result from this method would be to use as the basis some figure other than the real value, a method which would only be resorted to through moral turpitude or intellectual incapacity. One might almost assume that Mr. Riggs knows this, for he says:

"Value is given to a property, either by reason of the fact that it
is an instrument for earning profit, or that it does earn profit or
gives promise of profit."

The substance of Mr. Riggs' argument on capitalization control is that American railways are not often over-capitalized, but such evils do obtain in other industries, and therefore railway issues of capital securities ought to be restricted.[39] Unfortunately, he gives no clue to the methods he would have applied, nor as to how far he would go in interference with the normal action and interaction of commercial forces in determining what securities can and ought to be issued. Railways are not over-capitalized. Table 9, a comparison of official valuations and capitalization, originally compiled by Mr. Slason Thompson, is instructive.

TABLE 9.

═════════════╤═════╤═══════════════════════╤════════════════════
State. │Year.│Valuation by commission│State proportion of
│ │ or tax board. │ capitalization.
─────────────┼─────┼───────────────────────┼────────────────────
Minnesota │1907 │ $411,735,194│ $334,979,691
South Dakota │1909 │ 106,494,503│ 108,911,000
Wisconsin │1909 │ 284,066,000│ 249,299,060
Texas │1909 │ 413,000,000│ 412,465,743
Washington │1908 │ 186,007,490│ 153,493,940
─────────────┼─────┼───────────────────────┼────────────────────
Total │ │ $1,401,303,187│ $1,259,049,434
─────────────┴─────┴───────────────────────┴────────────────────

────────────────────────────────────────────────────────────────
Excess of total valuation over total capitalization $142,253,753
════════════════════════════════════════════════════════════════