Chapter VIII: Front Matter (8)

The result of the Michigan inspection of rolling stock was to sustain fully the rules for valuation issued by the Master Car Builders Association; and clearly, it is not only proper, but extremely desirable, to apply tables to such equipment as freight cars, which are scattered all over the United States, for it would be absolutely impossible to inspect completely those of any road or system. On the other hand, the life of steel rails cannot be determined by any simple table, because the number of car movements, the weight of motive power, the speed of trains, the location (on curves or on heavy grades), and many other conditions affect their life. This also pertains to buildings, locomotives, and other equipment. The character of service rendered, the nature and extent of repairs, and the way in which they have been maintained, add to or take away from any life assigned by tables, so as to render them valueless in many individual instances.

In placing depreciation, allowance should be made, not only for wear and tear due to use, and decay due to the elements, but also to cover that which is due to obsolescence, or the fact that the facility is of an antiquated or inefficient type, and has been superseded in general use by more efficient and economical devices; this may be called commercial depreciation, as distinguished from physical depreciation. The method to be used in placing depreciation is clearly one of the important things that must be determined by each set of appraisers, and, while the writer believes that the use of expectancy tables would greatly facilitate the work in many cases, the data on which to found a complete set of tables and to support them and justify their use are often lacking; therefore, any use of tables should be safeguarded in every possible manner, and personal inspection of fixed property should always be made.

(_e_) _Immaterial Elements of Physical Property._—There are certain expenses, inseparable from the construction of any public works, which are a necessary and proper part of the cost, and are arranged for in the original financing, but are not capable of identification after the completion of construction work. These expenses are:

(1) Organization,

(2) Legal expenses,

(3) Engineering,

(4) Administration,

(5) General expense.

(1) Organization.—This includes the cost of the original organization of the company, the cost of securing the charter and franchises, arranging the financial plan, and securing the funds for construction.

The latter item is intended to include all salaries and expenses of officials in soliciting and negotiating for funds, the services of trustees, and all other proper expenses which are usual and unavoidable in the process of exploiting a projected enterprise and interesting capital therein. Discount on bonds is not included, and any allowances for "premium," or "bonus," or other cash payment to any party for services in securing funds, which are in excess of legitimate expenses, should receive scant consideration at the hands of appraisers.

(2) Legal Expense.—This is for attorneys and all legal expenses, costs, and fees in the organization and during the construction of the property.

(3) Engineering.—This includes reconnaissance, preliminary and location surveys, supervision of construction, and design and superintendence of special structures. The cost of engineering on some of the more difficult properties becomes a very large sum; on certain small lines it may be comparatively small; and in some cases no engineers have been employed at all; but the items of cost covered by this charge have in every case been expended, even if done under the direction of some superintendent.

(4) Administration.—This comprises the cost of the management during construction—the direction of the enterprise.

(5) General Expense.—This is the cost of the general office organization during the construction period, also numerous minor expenses, not distributable.

It is not possible to build any public service plant without incurring all these expenses to a greater or less degree. They are essential elements of cost, and must go into the value of the plant when completed. It can hardly be argued that cost, which in a large property runs into thousands or hundreds of thousands of dollars, has no value at the commencement of operation, nor does it appear that the value is subject to depreciation as long as the property is an operating plant. The writer holds the view that the line between physical and non-physical elements of value should be drawn as follows:

Any value which attaches to the property by reason of any money expended during the construction is part of the physical property values; while any value due to the operation of the property which is in excess of the physical value is a non-physical or intangible element. If the correctness of this position be conceded, then all the foregoing items are charges against the physical property, and, as long as it is an operating property, these items of value remain part of the physical property, and the writer contends that they should not be considered as affected by depreciation, as long as the property is a going concern.

Different engineers have included in the appraisal other items which are of a somewhat different nature, and some of which are open to argument; among these are "interest during construction." This item is clearly an allowable one, but serious differences of opinion develop as to a proper amount to allow in making an appraisal.

The corporate history of the Ann Arbor Railroad, in Michigan, shows that it was built in sections of from 25 to 30 miles, and that each section was put into operation as soon as built, so that, while the actual period of construction of the complete property extended over 15 years, no section was under construction much more than one year. This is typical of much of the railroad building of the past, and on such a property the interest charge would be comparatively small.

A proper charge in such a case would clearly not be sufficient in the case of a road several hundred miles in length, through mountains, with tunnels, heavy bridges, and other structures which would extend the actual construction over periods of from 3 to 5 or 6 years, and this is particularly true where the road is a main line or artery, and where local traffic is of minor importance.

The computation of the interest charge is complicated by the fact that interest begins to run as the bonds are taken up, and but a small part of the construction money draws interest during the whole period.

The practice in the State appraisals has been to fix a uniform percentage for all properties. This has had in its favor the argument that it was conservative valuation where taxation is the ultimate end, as the amount was less than one year's interest in every case. It would appear to be more correct to use the corporate history of each company, determine the actual construction periods, and use a rate based on the actual time in each case. This can be fixed with a fair degree of accuracy, and a reasonable percentage determined, to equalize the varying periods of time on which the interest runs on different parts of construction.

Discount.—Discount on bonds is claimed by certain railroad men as a proper item for consideration. As has been argued elsewhere, this is not a proper charge against capital. It is an adjustment of the interest rate to the market, or an advance payment of interest; and, in the writer's opinion, should under no consideration be allowed.

Working Capital.—Working capital is another item claimed and conceded in some valuations. It is not a part of the "cost of construction." The money provided for working capital at the outset is not a permanent investment, but is rather a temporary loan paid back out of earnings. The writer fails to perceive any possible argument in favor of adding such an item to the permanent value of the property. In making an appraisal, after the physical value is determined, it is usual to set up a statement of stores, supplies, fuel, and cash on hand, and working capital is certainly shown by the current balance sheet, in the form of cash or accounts receivable. It would appear to have no place in a physical appraisal. Although the items of cash, stores, and supplies were shown in the Michigan appraisal, they did not appear as part of the physical value, nor were they taken into account in computing intangible value, but, being taxable property, they were reported separately.

(_f_) _Contingencies._—The use of a percentage for contingencies in the appraisal in Michigan was bitterly contested by the railroads as improper and excessive. In Michigan 10% was used, in Wisconsin 5½%, and in Minnesota 5 per cent.

Subsequent work in Michigan has demonstrated that the use of as high a figure as 10% was fully justified; and the probability is that the latest Michigan appraisal did not eliminate omissions, inaccuracies of description, and excess cost of construction due to difficulties, to such an extent as to justify much reduction in the percentage.

In making an appraisal, the percentage to be applied to cover contingencies is a proper matter for consideration, and in some cases conditions might well be such that even a smaller allowance than that fixed in Minnesota would be proper, but such cases would doubtless be the exception. The writer believes it to be proper practice to add liberally for the contingency item. The strongest argument against it is that it is incapable of being described and located definitely, and is difficult of exact proof. Therefore it has been claimed that it partakes of the nature of a non-physical element, and that if there be any value over and above the physical property value, it will appear with other non-physical elements reflected in the earnings, and may be properly included in the intangible value if such exists. This argument does not appeal to the writer as being final, and he would advocate the use of such a percentage of physical values as appears proper in each appraisal to cover the error due to the extreme difficulty of securing an exact inventory and construction history of the properties.

(_g_) _Design._—Among the matters which were considered in the Michigan work was that of adaptability, or the economical questions of location, design, and construction. It is possible that in some properties, such as water, gas or electric companies, the efficiency of the plant may be very greatly affected by faulty design, uneconomical arrangement, improper construction, and to such an extent that any cost of reproduction, less any ordinary depreciation, would be greatly in error without further allowance. This may also be true of railroads. Excessive curvature and gradients greatly decrease the tonnage hauled by a given power, without decreasing the cost per train-mile.

It is extremely difficult to treat this as a physical element. It is impossible to reduce it to terms of dollars and cents by any usual or customary methods. It is impossible to separate it from any one of half a dozen other items that may be brought up. It opens the door to endless speculation as to what might or might not take place under somewhat different conditions. For these reasons, it was treated in the Michigan appraisal as a non-physical element of value and dismissed from all consideration in the physical appraisal. This was clearly proper, and the subject is only referred to here for the purpose of making clear that it was fully studied and a definite conclusion reached.

Adaptation.—In the sense that this term is used by Mr. Williams and Mr. Morgan, the appreciation or solidification of roadbed was considered in the Michigan work, but given no place in the appraisal. This is a very proper item to consider, but it would appear to be better to include it directly with the roadbed item in the physical appraisal as appreciation or solidification. There can be no reasonable objection to adding to the contract prices for grading, ballasting, etc., a reasonable amount to cover, not so much the seasoning and settling of the new roadbed, as the actual money disbursed in work on this new roadbed during the first 3 or 4 years of operation in order to bring it up to the proper operating condition. A very considerable part of the money spent on "maintenance of track" for the first few years after a new line is built is in reality deferred construction cost.

(_h_) _Apportionment of Values._—The apportionment of values of locomotives, cars, miscellaneous equipment, shops, and those other parts of the cost which are not susceptible of separation from the operation of the property as a whole, is an interesting and at times a perplexing problem. While the Courts have viewed as equitable the distribution of values between territorial units when made on a track-mileage basis, it is hardly likely that a Court would look with favor on an appraiser appointed by Michigan giving any consideration to values of bridges, track, or buildings in Ohio. Thus far, every State appraiser has concerned himself only with the fixed physical property in his own State, together with his proportionate share of the floating property. The methods that may be considered are track-mileage, car-mileage, locomotive-mileage, and train-mileage.

The method finally used must be such as will give the fairest result for the property under consideration. In some cases one or more of these methods will give a fair value, while in other cases the same system would be most unjust.

(_i_) _Terminals._—There is no one feature of the entire problem so big with possibilities, and so far from solution, as that of terminal property values and their proper assignment. The property must be considered as an operating unit. Its value must be made up of the values of the parts or elements plus an added value that comes from the operation of the whole. The problem would be simplified if what were sought were the value of a certain railroad, but, as it has been presented up to this time, the problem is: what is the value of that part of this railroad in Michigan? or Wisconsin? or Minnesota? A fairly satisfactory solution of many of the value questions has been obtained, but nothing in the way of a solution of the terminal question. A road owns 300 miles of line in Michigan and 7 miles in Ohio. That 7 miles includes its largest terminal; its principal connections are there; it has a fine property, and is in the capacity of landlord to several other roads. What part of that terminal value, if any, is assignable to the State of Michigan? Decidedly, it would not be proper to appraise the entire property as a unit and assign to Ohio only the proportion that 7 miles bears to the whole length; it is equally unfair to appraise it as a Michigan property down to the State line, and add nothing to the value by reason of the terminal.

The influence on the value of the property, of the ownership of terminals in such cities as Chicago, New York, Jersey City, Hoboken, Pittsburg, Detroit, St. Louis, Kansas City, and other large centers of population is tremendous, yet a very large part of the railroad mileage entering those cities belongs to roads which have their largest mileage outside the State in which the terminal is located.

There can be no doubt that the influence of a large terminal affects in a measure the value of every mile of line owned by the company; that this influence is greatest on the principal and direct lines, and less as more remote parts of the system are reached. As yet, no plan has been suggested for determining what this value is or for apportioning it.

The final solution in Michigan was to treat terminal properties within the State exactly as other property was treated, and to assume that, if there was any value assignable to Michigan by reason of outside terminals, it would appear as a non-physical value through the earnings.

When all the phases of this question are considered—the enormous land values, the value due to possession of deep-water terminals, the effect on the business of the entire property by reason of the ownership of such properties as those, for instance, in New York City, Jersey City, and Hoboken—it is evident that no appraisal which has yet been made has established any rule of valuation which may be considered proper for terminals.

It is to be hoped that the work now in progress in New Jersey may be so well supported by the State that it will be possible for the appraisal board to make an exhaustive study of this subject and reach definite conclusions as to the real extent, manner of computation, and proper method of distribution of these values.

(_j_) _Development of the Art._—Is any value assignable to property on account of expenditures by reason of the rapid development of the art? This question seems not to have been squarely asked or answered in connection with any of the past appraisals.

Every piece of material and every facility purchased by a company is bought with a definite expectation that it will have a certain life, that during that term of life it will add sufficiently to the earnings to provide a fund for its replacement and earn a profit. No matter whether or not such a reserve is created on the books, this is the theory, and, under it, accident may wipe out certain new property, other property will outlive its expectation and maintain the average life of the entire group of facilities.

There are countless cases where this will not hold. The rapid development of large cities has compelled electric lines to extend largely. The demands of the people for more frequent and more rapid service, and more modern and larger equipment, have greatly shortened the term of life of power-plant equipment and cars. The rapid development in the art of electricity, the congestion of traffic in streets of cities, the enormous increase of train movements, and the use elsewhere of newer types of cars, have compelled the abandonment of millions of dollars' worth of property and the investment of other millions in new and improved facilities to provide for the increased movements of traffic and increased safety to the public. These changes are not due to the fact that the original installation was defective, but to the demands of the public for frequent, safe, and speedy service, demands which are perfectly reasonable. The query is: should a corporation which complies with public demands be compelled to lose capital invested in facilities which have not yet paid for themselves; and which, under a continuance of conditions which existed when they were installed, or any that might then have been anticipated, would normally have a useful life of several more years, and which were abandoned, not by reason of being worn out or unfit for service, but purely because facilities of a more modern type were called for?

To answer this affirmatively increases the hazard of investment greatly in the large centers of population. To answer it affirmatively in some cases might amount to confiscation of property. The writer inclines to the view that, as far as appraisal is concerned, the value due to the remaining life of the abandoned facility, where such abandonment was in response to legal requirement, and where no element of corporate necessity due to increased efficiency or economy of the new facility enters into the computation, should be added to the value of the facility replacing it. Any consideration that is given such claims by an appraiser must be most careful, as the inference to be drawn from the decision of the Court in the Knoxville Water Case (212 U. S., 1) is that such elements of value will receive scant consideration unless most fully supported.

If the policy of the management of any public service company is to keep up with the demands of modern civilization, it would appear that such policy should not be discouraged, and, in computing the value of the property, some provision ought to be devised for covering such values as remain in serviceable property at the time of its abandonment in response to public demand; or else the rates for service should be increased sufficiently to compensate the corporation for losses of this nature on the ground that it constitutes an element of extra hazard.

These and like subjects in connection with the appraisal must be taken up during the period of computation and settled. The computing office organization and methods call for no special comment, except to emphasize the need of experienced men, the use of every possible check on the accuracy of the work, and the prime necessity of keeping all notes in such manner that they can be identified and used to re-establish every step taken in the course of the appraisal.

IV.—The Preparation of the Final Figure.

The final form of the work is, of course, so much a matter of personal judgment that even a suggestion may appear to be useless. The use of such a classification as will conform approximately, if not exactly, with that adopted by the Interstate Commerce Commission is more desirable now than it was 10 years ago, as all the roads in the country are using this classification in their accounts, and the more nearly uniform the work of various State appraisals, the better the results will be.

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Footnote 18:

Unchangeable only for the period under consideration and as regards
the purpose of the appraisal. This value varies from year to year,
depending on business conditions and on earnings of the company.

NON-PHYSICAL VALUES AND METHODS FOR THEIR DETERMINATION.

In the published articles treating on the subject of valuation, much stress is laid on the intangible or non-physical elements of value. They have been termed "going concern values," "business values," "good will values," "franchise values," as well as "non-physical" and "intangible" values.

So much of the argument of many writers has been taken up with this phase of the question that it is impracticable to recapitulate the various arguments in support of giving these elements a place in the appraisal.

The writer cannot agree with those who would place any of these elements of value in the physical appraisal.

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 actual investment of capital in a new plant is made with the expectation of earnings. It is not reasonable to attach as physical value, to such a plant, any value in excess of the actual investment. Nor does it appear to be any more reasonable, in the case of an old plant, to assign arbitrary and fictitious values over and above the actual investment remaining in the plant, unless such values are justified and supported by actual earnings in excess of such a rate of interest on the money invested, as it would earn if invested in some non-hazardous security, and—carrying out the clearly-expressed idea of the Courts—such intangible value can only accrue when the rates charged for the service are fair and proper.

The capitalist seeking investment bases his ideas of value on:

(_a_) The market price of stocks and bonds, an estimate of worth
based primarily on actual earnings of the property, but
affected to some extent by outside conditions; or

(_b_) On the capitalized net income, or actual earnings, of the
property; or,

(_c_) In the case of a new property, on an estimate of what the
probable earning capacity of the property will be, where the
business is more fully developed.

Methods (_a_) and (_b_) ignore cost of construction, or present investment in physical property, and base a value on past performances. Method (_c_) is based purely on hypothetical earnings, but the only real measure of value in this instance is the actual amount of capital that has been invested.

No appraiser would be justified in placing a "going concern" value, in excess of original cost, on a new property, nor would he be justified in placing such a 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 business or commercial value in excess of the physical property value.

It would seem reasonable to say that this difference between the physical value and the value based on earnings represents the "good will," "established business," or "going value," and all the other non-physical elements of value.

To take a specific example: it would be impossible to separate the different elements of intangible value of the Michigan Central Railroad, and say that a certain sum of money represented "good will," another sum "established business," still another sum the "franchise value," and still another sum the "going concern."

The "going concern value" of the Michigan Central Railroad is exactly analogous to the going concern value of the hypothetical water-works cited by Mr. Alvord. Instead of having water pipes connected with buildings along the mains, and considerable sums invested in appliances for using the water, there are manufacturing plants located along the railroad, connected with it by side-tracks built by the industry, and depending on the transportation facilities of the road for their connections with their customers, the very life of the manufacturing plant dependent on its connection with the road. This is "connected good will" of the same kind as described by Mr. Alvord. Yet, to fix a value on it by the method described by him involves going into the realm of conjecture and speculation to a degree that could never be sustained.

Difficulties as great would be encountered in an effort to separate and set up any other elements which go to make up the intangible value, and any figure thus determined would be absolutely incapable of proof.

The Courts say that the value must be the "fair value of the property being used," all the conditions being taken into account (169 U. S., 466).

It can be readily seen that the physical present value is not always—indeed, is not often—the "fair value." The "fair value" may be more, or less, than the present value of the physical property. It would seem to be reasonable to interpret the Court's meaning of the term "fair value" to be the value as a business or commercial property, taking into account the actual investment existing in the property, together with any favorable conditions which would enable it to earn, on rates which were fair and reasonable to the consumer, an income in excess of a usual rate of interest on the actual investment, or any unfavorable ones which under the same rates would reduce its earnings to less than usual interest. If such an interpretation be allowable, it would appear to be correct practice to use a "fair value" made up of two elements: a physical value, representing the investment, and a non-physical value, representing all the elements which affect that investment to give it favorable or unfavorable financial returns. Is it not, then, proper to conclude that the non-physical or intangible value, composed of all these various elements of value, can only be determined absolutely by a study of the earnings and operating expenses? Is not this clearly what the Court had in mind in the Nebraska Rate Case?

Much of the argument on the subject of "going" values and other kindred elements of value consists of statements of theory and generalities, and may be said to be merely argument to support the theory that there is an intangible element of value. If work of valuation is to be of any real benefit, must it not give a definite result? Must not this result be based on absolute facts?

In securing the present value of any physical property the fixed and certain facts are:

The inventory of property owned.—This is absolute.

The cost of reproduction of the different elements.—This is
capable of determination within very close limits.

The depreciation.—This is in a measure a matter of judgment,
based on the experience, not only of the engineers making
the appraisal, but of the entire scientific world; and, if
properly made and properly checked, there should be no very
wide divergencies in results.

The items of general expense.—These, based on available
statistics, must be estimated. The exact determination of
these items will be made comparatively easy as statistics
based on the uniform classification of accounts become
available.

It is believed that the physical values, when secured along the lines suggested, are definite enough to be accepted as a fair estimate of the amount of capital actually invested in the property, and that, if a sufficiently large force of men experienced in the construction, operation, and financial management of the kind of property under investigation is engaged on the work, the element of uncertainty due to errors of personal judgment can be largely eliminated.

The next question to be determined is whether there is, at the time of the appraisal, any non-physical value, and, if so, to select a method for computing it that will give a result that can be definitely supported as to the particular property under investigation. A study of the income accounts of the property being valued should be made. If the property is not earning a sufficient sum to pay its operating expenses, and taxes, and to set aside a fund to cover depreciation and obsolescence, there is clearly no intangible value of any sort to be added to the physical value. If, however, after all these charges are taken care of, there is a net earning which is large enough to pay 4 or 5% on the physical property and still leave a surplus, is it not perfectly reasonable and proper to hold that this surplus represents earnings on all intangible elements of value?

The contention that all the different elements of non-physical value merge into one intangible value, not capable of separation, will doubtless be objected to by many engineers and corporation managers.

Among the elements adding value to property have been described:

_1.—"Going Concern" Value._—Professor Mead defines this as the value due to the fact that a plant has consumers actually utilizing its product, and that it is in actual and successful operation and has its business developed. This value is the worth of the plant in excess of a similar plant without connections, and constitutes an asset in the consideration of its physical value. Mr. Alvord has used the term "connected good will" as applicable to this element of value.

The writer does not concede that "going concern" is a proper element to consider in the physical value, as it does not represent any part of the cost chargeable to capital, and the physical valuation should be confined to the determination of capital invested.

It has already been argued that to the physical property as inventoried should be added proper figures to cover organization, legal expense, administration, engineering, and contingencies. All these items are in the nature of additions on account of the fact that the property is a "going concern." It is maintained that these costs should carry to the present value column as values, for the reason that all these services rendered in connection with the creation of the property remain, unimpaired in value, as long as the property is operated. When, however, a property ceases to be operated, and is abandoned and dismantled, not only do all these elements absolutely disappear, but also all increments of value by reason of the special use of the property are wiped out, and there exist only a lot of partly worn out and partly obsolete machinery and equipment, salable at scrap values, buildings constructed for a purpose which renders them unfit for other use, and land partly salable at going prices and much that will not sell at all.

As long as a gas-works, a water-works, or a railroad is in operation and earning, it is a "going concern," and all increments which attach to its physical property as a whole continue to exist, even if the physical value of the property is greater than a fair value. That fair value can be determined and reached by means of a negative non-physical value.

In view of these things, it would seem to be highly improper to add to physical value anything more for "going concern." In the final report of U. S. Judge R. W. Tayler, Arbitrator in the Cleveland Street Railway matter, in December, 1909, the following language supports the above contention:

"I allow nothing for going value, except in so far as that is the
result of the necessary expenditure of money in building the road,
acquiring its land, power-houses, and equipment, and putting them
into successful operation. The expenditures for these purposes are,
and necessarily must be, included in the valuation of the physical
property."

_2.—Developed Business._—It is perfectly clear that the "fair value" of a property must take into account the established business of the concern. This really is covered by the "going concern values," as defined by Messrs. Mead and Alvord. The only manner in which this can be determined intelligently is by an analysis of income accounts.

_3.—Cost of Handling Business._—A railroad with heavy grades, bad curves, poor equipment, or unskilful management is not nearly as valuable a property as one having good line and grades, and far-sighted, economical, and skilful management, and which handles its business at a lower cost per unit.

In such cases the differences in location and management are bound to show in the earnings, adding to the physical value of one property and possibly taking from the value as shown by the physical appraisal in the case of another.

_4.—Good Will and Established Organization._—These are valuable assets. It is difficult, indeed, to attach exact weight to these elements of value, except as they are shown in the intangible value indicated by the earnings. In most cases of public service companies, as is argued elsewhere, it is doubtful if such elements are entitled to any place in a public valuation.

_5.—Franchise Values._—These cover various specific items arising out of the ownership of special franchises, or, out of the general rights granted by law to corporations.

All these elements of value have been presented, and have been supported by able arguments. No one has offered a method of separating them. While there is universal recognition of their existence, in the case of many properties, they are supported by nothing visible or tangible. They are practically inseparable, one from another. They are not always present, and the application of any such arbitrary rule as that suggested by Mr. Alvord would make it possible to place values which were purely fictitious. Therefore, it follows that, if they are to be considered at all, they must be treated as parts of one intangible value, and that value must be derived from a study of the income account of the property.

There are other points to be noted as reasons why no such elements of value may attach to the physical property.

Any value of an old and well-established property in excess of a fair return on its physical property (in other words, any intangible value) must be limited and restricted, when used for rate-making purposes, by the value to the consumer of the services rendered. The Courts hold so squarely that the rates charged for services must not be more than the particular service is worth, and that the Company may exact a fair return on property actually being used, that it is not conceivable that any valuation which attempts to attach fictitious elements of value to physical property can be sustained.

This argument is not intended as an attempt to show that intangible values are improper and that where they exist rates should be lowered. 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. It is further contended that the work of valuation should separate the tangible and intangible elements, so that the further work of rate-making or assessment may not be complicated by improper elements which are included among the items of the physical properties.

In consideration of franchise value, the history of the corporation should be investigated with a view to determine what part the public played in the creation of the property.

The granting of aid bonds, of public lands, and of aid money to railroads, the giving of encouragement to water-works companies by the payment of excessive hydrant rentals, are illustrations of the fostering and development of public service utilities by the public to such an extent as to justify in a large measure the claim that in many cases the allowance of an intangible value is improper as against the public.

A further consideration in the matter of intangible values is the fact that they all partake more or less of the nature of "good will," and the question very properly arises, in the case of a purchase by the public, or of a rate-making valuation: "Should the public be compelled to pay for its own good will?" In the case of such a corporation as a street-railway company in a large city, any value arising from a surplus of earnings is due to the franchise, established business, or going value, or good will of the citizens of that city. This element of value frequently sustains an excessive bond indebtedness. At the expiration of the franchise period the citizens of that city consider a purchase, and are asked to pay, among other things, for their own good will. In view of the attitude of the Federal Courts in the Consolidated Gas Case, and the language of the lower Court in disallowing the item of "good will," which judgment was sustained by the Supreme Court, it is very evident that any attempt to fix arbitrarily a value on such an item in an appraisal is not likely to be supported successfully. The grounds named by the Court are:

Tangible property has a value apart from any franchise or good
will value.

The franchise, conferring the privilege to be a corporation, to
use public property, to be free from competition, and to
enjoy many other privileges, has some value apart from
tangible property.

Good will can have no existence as apart from or detached from
the franchise conferring the necessary privilege. Such good
will (by itself) is not capable of being capitalized and
distributed among stockholders.

Citizens are entitled to have gas (or water) because they
pay for it, exactly as they are entitled to have clean
streets (and, in the same way, police protection or fire
protection), because they pay taxes among other things
for that.

The Court, therefore, finds that there is no good will value in connection with the gas business in the City of New York, although it is said, elsewhere in the finding, that it is the best, most favorably located, and most prosperous business of its kind in the country.

Judge Tayler, in the Cleveland Railway arbitration, says:

"I allow nothing for good will. A street railway company which has a
monopoly, and especially if it has a franchise value remaining, can
have no good will value."

Judge Lurton, in the Omaha Water-Works Case, says:

"That kind of good will, as suggested in Willcox _vs._ Consolidated
Gas Co., is of little or no commercial value when the business is,
as here, a natural monopoly with which he must deal, whether he will
or no."

In connection with a consideration of franchise values, the following points are raised by the Federal Court in the Consolidated Gas Cases (157 Fed., 872-879):

"Should a corporation have a right to demand an income return,
separable from any return upon its tangible property, from its right
to place gas mains in the public streets and maintain them for its
private profit, a right which it did not buy from city or state or
pay therefor any legal valuable consideration? The Court thinks not,
because 'Return can be expected only from investment, and he that
invests must part with something in the act of investing.' Does any
company invest its franchise in its business? It does not part with
its franchise in the same way it parted with money or money's worth
in acquiring or creating mains or plants. The investment of property
was made, not in the franchise, but under the franchise, and on the
faith thereof. The franchise is but a part of the power or
sovereignty, allotted to a private person for the benefit of all,
and only incidentally given for private emoluments.

"What is the value of a franchise to perform a certain service,
under which no money is invested and no service yet performed? What
is it worth apart from performance under it?

"Unless it can be seen to possess inherent value entirely apart from
the earning capacity of the subsequent investment or from the actual
earnings resulting from such investment, the value asserted or
claimed is but a duplication of that derived from the use of the
tangible property when so invested.

"The concepts of the nature and value of franchises are seen dimly
and confusedly because of the failure to distinguish between
productive and non-productive property. Land, money, chattels may by
industry and intelligence be made productive without a franchise;
but no excellence in these desirable qualities can ultimately render
a franchise productive without the use of money, chattels, and land
in connection therewith, and when the juncture is made the earning
capacity of the real and personal property, plus the franchise and
plus intelligence and industry, is really no greater than it would
be without the franchise, for the franchise has added no producing
power to the realty or personalty; it has but authorized their
employment in a particular way and protected the owners while so
employing them."

The Court emphasized the fact that the particular way in which they are used is in performing a function of the State—in doing a service for the public which the public might do equally well for itself, in the following language:

"I can imagine no more than three ways in which the value of a
franchise can be stated. It is valuable: (1) because it authorizes
the gainful use of private property in a particular manner; (2)
because once obtained it is often difficult or impossible to get
another like it; (3) because it may be used to injure or hinder
another enterprise, although itself conferring or securing nothing
of value.

"The third method of statement has been accurately, though
colloquially, described as a 'nuisance value,' and is so obviously
illegitimate as to require no discussion. The second method of
statement, when carefully considered, asserts that because the
sovereign has deemed it advisable to entrust a public work to one
citizen or a body of citizens such quasi monopolistic grant confers
the right to charge for the service more than would be just or
lawful were the occupation open to all. Nor does it change the truth
of the last statement that the difficulty of procuring franchises
produces, and long has produced, a traffic in them. On every private
sale of franchise property, the price paid is so much money lost to
the public by official incompetence or worse, and such sale can
confer on the vendee no right to compel the consumer to repay him a
price that should have been paid to the State. For these reasons, I
believe that on principle a franchise should be held to have no
value except that arising from its use as a shield to protect those
investing their property on the faith thereof, and that, it renders
fruitful, it possesses no more economic value for the investor than
does an actual shield possess fighting value, apart from the soldier
who bears it."

It will not do to leave this decision without calling attention to the fact that the foregoing quotations are but argument advanced by the Court, and that he found a franchise value, following the reasoning of the Supreme Court in cases cited heretofore, and other cases, and upon the doctrine that:

"Private citizens may acquire vested property rights through a
series of even erroneous decisions; rights so firmly vested that it
becomes unconstitutional for the court which persisted in error
suddenly to rectify its mistakes to the detriment of those who had
securely rested upon the decisions sought to be invalidated."

After citing numerous cases, and considering methods of valuing franchises, the Court says:

"I think it obvious, as I have endeavored heretofore to point out,
that either for the purpose of condemnation or regulation the value
of a franchise depends wholly upon what is earned under it and I
believe the best way of finding out how much a franchise, separately
considered, is worth, is to ascertain what those persons desirous of
continuing operation under it consider it to be worth. In a
corporation whose stock is freely bought and sold, such value is
measured by the success attending the sale of stock based entirely
upon capitalization of the franchise; yet the value of stock issued
only in consideration of the franchise is obviously dependent on
earnings after the stock based on tangible property has received a
satisfactory dividend * * * yet it will always be true that, unless
the whole net return, compared with the value of tangibles, is above
a satisfactory return on tangible investment alone, the addition of
stock issued for franchise will be regarded as 'water,' and detract
from the value of the entire issue, and I think this conclusive
proof that value on a franchise depends wholly on what actual
investment can earn."

In this particular instance stock to the amount of $7,781,000 had been issued in 1884 and divided among stockholders without any consideration, which stock represented the company's own valuation of its franchise at that date. The Court, in fixing a value, held that it would be proper to increase it proportionately to the increase in tangible property; this he did, fixing the franchise value at more than $12,000,000. The Supreme Court of the United States, in disposing of this, says (212 U. S., 47):

"But although the state ought for these reasons [applicable to this
case—not general], to be bound to recognize the value agreed upon in
1884 as part of the property upon which a reasonable return can be
demanded, we do not think an increase in that valuation ought to be
allowed upon the theory suggested by the Court below. Because the
amount of gas supplied has increased to the extent stated, and the
other and tangible property of the corporations has increased so
largely in value, is not, as it seems to us, any reason for
attributing a like proportional increase in the value of the
franchises. Real estate may have increased in value very largely, as
also the personal property, without any necessary increase in the
value of the franchises. Its past value was founded upon the
opportunity of obtaining these enormous and excessive returns upon
the property of the company, without legislative interference with
the price for the supply of gas, but that immunity for the future
was, of course, uncertain, and the moment it ceased and the
legislature reduced the earnings to a reasonable sum, the great
value of the franchises would be at once and unfavorably affected,
but how much so it is not possible for us to see. The value would
most certainly not increase."

The Court did not concur in the increase of the franchise value, and, in dismissing this subject, says:

"What has been said herein regarding the value of the franchises in
this case has been necessarily founded upon its own peculiar facts,
and the decision can form no precedent in regard to the valuation of
franchises generally where the facts are not similar to those in the
case before us."

It appears, then, from this, the latest case, that:

_1._—The view of the lower Court that a franchise or intangible value is not separable, and that if there be a value it must be determined from the earnings, is concurred in by the Supreme Court.

_2._—That the arbitrary increase of franchise value, by the lower Court, proportional to the normal increase of the physical property, is not concurred in.

_3._—Inferentially, it appears that the acquiescence of the State in the franchise value of 1884 is the main reason for permitting that value to stand, and it would seem to follow, from the reasoning of the Court, that it is very questionable whether any franchise or intangible value based on excessive rates should be allowed to stand.

Another view of franchise values, as stated by George H. Benzenberg, Past-President, Am. Soc. C. E., in discussing water-works franchises, is as follows:

"Some contend that a franchise is simply and purely a privilege
given by the municipality to a water company to utilize the streets
for the purpose of laying a system of pipes through which it may
distribute and deliver water. It is not a license to do business,
but a privilege to use public streets, alleys, and grounds. * * * If
that interpretation is the proper one, the value of the franchise,
if the property is to be purchased by a municipality, is
comparatively nothing. If the property is to be purchased by another
company, it represents all of the great value that such franchise
possesses to the original holder, together with all the privilege it
confers; but in the event it is purchased by the city, it is
dispossessed of that certain element of value, and I think for that
reason it is stipulated in many of the ordinances that no value
shall be placed on the franchise by appraisers."

In the paragraph just quoted, it is evident that the term "franchise" is used in a restricted sense, and refers to the ordinance or contract from a municipal corporation granting the right to operate on specific terms, rather than the broad use of the word as indicating all rights derived from general laws or special contracts or grants. The point, however, is applicable to the case of any corporation occupying public ground.

It is believed that enough argument has been adduced to show that any attempt to give separate value to the different elements that enter into the intangible value of a property is a very risky proceeding on the part of appraisers, and to support further the contention that, as a business proposition, the value of any property depends on its earnings; that the franchise simply protects the owners of the property in their enjoyment of those earnings; that the value of the franchise merges in the "fair value" of the property, and that the franchise can have no special value of itself unless the earnings of the property are in excess of a usual and fair rate on the actual investment. In case there are surplus earnings, they measure and determine not only the value of the franchise, but also the value of all other non-physical elements. If this be true, any readjustment of rates, any restriction of operations, or other form of legislative control which would unfavorably and violently affect earnings, is bound to hold down franchise or non-physical values; as it would not seem possible to read into the various decisions any intention on the part of the Court to base the right to demand fair return on anything but the "fair value of the property being used."

The writer, therefore, reaches the following conclusions regarding non-physical values:

_1._—That all the different non-physical elements of value are inseparable.

_2._—That in the case of very many properties, no non-physical value can attach, and in many cases this value will be a negative or subtractive quantity.

_3._—That in the case of properties located so as to secure either a monopoly of business in a congested territory, or in which the construction, location, strategic position, or economic excellence of design, is such that, on a schedule of rates which is fair and reasonable for competitors less advantageously situated, an earning is secured which is in excess of usual returns, a non-physical value of considerable magnitude may very properly be assigned.

_4._—That, for the computation of non-physical values, the income account of the property under consideration affords the only legitimate basis, but even then consideration must be given to duration of franchise, reasonableness of rates, and other modifying conditions, and also, possibly, the purpose for which the appraisal is made may determine whether or not a non-physical value may be used. The language of the Court in the Knoxville and Omaha cases apparently leaves this a very open question.

This brings us substantially to the conclusion reached by Professor Adams in 1900, and a careful study of the method laid down by him shows nothing that cannot be accepted as fair and reasonable. His plan should be extended so as to cover subtractive values or the case of properties showing a deficit.