Chapter IX: Front Matter (9)

This method has the merit of being based on the actual earnings and expenses of the company under investigation and on the value of the physical property as already computed. It does not introduce a mass of purely supposititious figures, nor depend on hypothesis. The proposition is simply this: If a property earns only its operating expenses, including therein proper depreciation reserves, taxes, and such a percentage on its actual invested capital as could be earned by that capital if invested in good non-taxable bonds or other like security, it is worth no more than its physical property is worth. If it earns more than that, it is due to the franchise, going concern, or other intangible elements of value, and, to determine that value, capitalize the surplus.

It takes several years for a property to reach its normal earning capacity after construction is completed, and, in the investigation of a property of comparatively recent construction, where the gross and net earnings show a steady annual increase, the application of a negative or subtractive value should be made with great caution; but 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."

The Courts hold that public service corporations are entitled to earn:

(_a_) Operating expenses,

(_b_) Expenses of maintenance and running repair,

(_c_) Taxes,

(_d_) A sinking fund from earnings to cover depreciation and obsolescence, and

(_e_) A reasonable profit on the fair value of the property.

An investigation of non-physical values should then include an analysis of operating expenses, to determine that additions and betterments to property are not included therein.

The general practice of corporations in the past has been to ignore any reserve to cover depreciation and obsolescence. If, at the beginning of operations of any property, such a sum should be annually set aside out of earnings as should, when invested as a sinking fund, maintain the integrity of the investment, then this amortization fund at any period, plus the depreciated value of the physical property, should equal the amount of the total capital actually invested in the property. In most cases this has not been done, and the Supreme Court in the Knoxville Water Case holds that, by reason of the failure to create such a fund, whether due to carelessness, excessive dividends, or other cause, the company must lose the amount of capital represented by the depreciation that has taken place. In making a computation of intangible values, it is certainly proper to consider the income account as averaged over a period of years, to avoid violent fluctuations of gross or net earnings, and a depreciation reserve should be determined for such years, as it cannot be claimed that, unless such an amortization fund is earned, in addition to other operating expenses and taxes, there is any non-physical value.

Professor Adams covered the depreciation in the Michigan work in the 4% annuity which was deducted before non-physical values were computed. The writer is inclined to go a step farther than Professor Adams, and hold that, before any intangible values can be attached to the property, it should earn not only all operating expenses, taxes, and reserve for depreciation, but also interest on the actual investment equivalent to the return that would be had were the money invested in a non-taxable bond, say 4%, and that any earnings in excess of such a sum might be termed properly "earnings on franchise," or intangible values.

On this basis, then, a rule would be formulated, being that of Professor Adams, with some modifications:

_1._—Deduct from gross earnings from operation the aggregate of operating expenses, including in operating expenses an annual sinking fund to amortize the depreciation and obsolescence, and the remainder may be termed "income from operation."

_2._—To this income from operation add income from investment, giving "total income," which represents the amount at the disposal of the corporation for the support of its capital and for the determination of its annual surplus.

_3._—From "total income," deduct taxes, rents paid for lease of operated property (provided such property is not included in the appraisal), and improvements chargeable to income. The remainder represents the income after all charges against operation of property, and maintenance of the integrity of the capital investment have been cared for.

_4._—From this remainder (_3_) deduct such a percentage of the value of the physical property (representing invested capital) as would equal the income of that capital if invested in government or other non-taxable bonds. The remainder would represent surplus, which, capitalized at a proper rate, would equal the value of intangible or non-physical properties, which is to be added to the appraised value of the "physical property."

_5._—If, instead of a surplus, a deficit occurs, a careful study of all the conditions surrounding the operations of the property should be made, and, if there be no reasonable expectation of increase of earnings, or other modifying conditions, a proper figure, based on the average deficit, should be determined, and, as a negative intangible value, deducted from the value of the physical property.

_6._—In the determination of rates, to be used in computing income and for capitalizing surplus or deficit, the greatest of care must be exercised to adopt such figures as will be proper and absolutely just.