PUBLIC UTILITIES THEIR COST NEW AND DEPKECIATION BY HAMMOND V. HAYES, PH.D. CONSULTING ENGINEER NEW YORK D. VAN NOSTRAND COMPANY 25 PARK PLACE 1913 COPYRIGHT, 1913 BY D. VAN NOSTRAND COMPANY THETLIMPTONTRESS NORWOOD-MASS'U-S-A PEEFACE THE valuation of public utility undertakings is a mixed question of fact, judgment and law. A comprehensive treatment of this subject requires the combined knowledge of the engineer, the economist and the lawyer. The fol- lowing pages, written by an engineer, cannot be offered as an authoritative discussion of the legal questions involved. On the other hand the engineer, who is called upon to prepare and present most of the figures required by courts and commissions as evidence of the value of the property of such undertakings, must have a sufficient knowledge of the legal questions that are at issue to enable him to obtain properly and intelligently the figures needed by the tribunals whose duty it is to assign the fair present value. This must be offered in explanation of the many quotations from decisions of courts and commissions which have been incorporated in the present volume. It has seemed to many who have studied this subject that the precedents are diverse and that much must yet be done before the fair present value of the property of public utilities can be defined. It is a question whether general rules can ever be laid down as to what the fair present value will be in all cases. It would seem as if such value must always be determined by "the well instructed judgment" of a broad minded and impartial tribunal. But even admitting this, a careful reading of all available iv PREFACE decisions shows that much of the diversity is produced by a lack of understanding on the part of the engineer of what is meant by " original cost" and by "depreciation." The efforts of the engineer in most appraisals appear to have been concentrated upon the ascertainment of the replacement cost to the entire neglect of original cost. Moreover, "depreciation" has been confused with "de- terioration" and, as a consequence, the loss in value of a property has been made dependent, in some way or other, upon the physical efficiency of the plant. The object of the present work has been largely to bring to the minds of those, whose duty it is to ascertain the figures representative of value, three distinct issues : first, that it is the duty of the appraiser not to ascertain the fair present value, that function belongs to the court or commission, but to ascertain with accuracy such figures as are necessary evidences of value and loss of value; second, that the original cost can be obtained without inordinate difficulty and is a figure of importance to those who must rule as to what the fair present value should be; and third, that depreciation is affected, only indirectly by inefficiency and that, as a necessary consequence, de- preciation is dependent wholly upon the relation of the age to the life of the perishable property. It is appreciated that, as a practical matter, evidence as to possible value will be offered by experts employed by one side or the other in a controversy, and that, as a necessary consequence, such experts will be inclined to advocate figures most favorable to the interests of their employers. On the other hand, it is a fact that a long step toward the removal of the present apparent diver- sity of rulings will have been made when the experts' PREFACE V figures faithfully represent the true replacement cost, the actual original cost and the real loss in value due to depreciation. It is hoped that the following pages may aid in reaching this desirable and necessary result. HAMMOND V. HAYES BOSTON, June 2, 1913. CONTENTS CHAPTER I PROPERTY VALUATIONS GENERAL CONSIDERATIONS PAGE 1. Purpose of present treatise 1 2. Limitation as to expert evidence relative to property value . . 2 3. Present value dependent upon purpose of appraisal .... 3 4. True present value to be determined by court or commission only 4 5. Figures to be presented as indicating possible present value 5 6. Original cost 6 7. Replacement cost ' . 7 8. Depreciation 7 9. Market value of bonds and stocks 7 10. Capitalization of earnings 8 11. Worth of service to the consumer 8 12. Cost and value 9 13. Value as " going concern " 10 14. Determination of fair present value 14 15. Figures showing value independent of purpose of valuation . . 15 16. Necessity of presenting all figures indicative of possible present value . . 16 CHAPTER II REPLACEMENT COSTS OF PHYSICAL PROPERTY 17. Definition of replacement cost 18 18. Present or original conditions 19 19. General assumptions as to replacement 19 20. New plant identical with old or one of modern design ... 20 21. Effect upon replacement cost of increased difficulty in placing plant . 21 22. Period of construction 23 23. Unit costs 25 24. Mean unit costs developed from curves showing trend of market prices 27 25. Use of weighted mean prices during period of construction . . 28 26. Piecemeal vs. wholesale construction 29 27. Piecemeal construction. Effect of changes and enlargements on cost 32 28. Pavement over construction 33 viii CONTENTS CHAPTER III DETERMINATION OF REPLACEMENT COST PAGE 29. Inventory 35 30. Plant elements 36 31. Costs 37 32. Items included in unit costs 38 33. Units costs Costs of material 39 34. Unit costs Costs of labor 39 35. Unit costs Losses on tools and material 40 36. Unit costs Insurance 41 37. Overhead charges General consideration 41 38. Overhead charges Interest during construction. General consideration 42 39. Overhead charges Interest during construction. Mean weighted time 46 40. Overhead charges Interest during construction. Rate of interest 47 41. Overhead charges Engineering 49 42. Overhead charges Organization expense 51 43. Overhead charges Legal expense 52 44. Overhead charges Contingencies . 52 45. Overhead charges Other possible costs 53 46. Promotion costs 54 47. Sale of securities 56 48. Contractor's profit 57 49. Overhead charges Method of application 57 50. Real estate 61 51. Cost of land affected by cost of hypothetical buildings ... 64 52. Cost of buildings 68 CHAPTER IV VALUE AS GOING CONCERN 53. Value inherent in an operating plant 69 54. Value of plant in use dependent upon purpose of appraisal . 71 55. Fundamental conception of value inherent in "live plant" . . 72 56. Capitalization of present net earnings 73 57. Capitalization of present and anticipated net earnings ... 75 58. Value not dependent upon cost alone 75 59. Capitalization of profits 76 60. Analytical methods of determining value inherent in a live plant 78 61. Wisconsin method 79 62. Reproduction of net earnings method 83 63. Doubt as to inclusion of going value in rate cases .... 85 64. General consideration of value inherent in a live plant ... 87 65. Practical usefulness of methods of determining value in live plant 91 CONTENTS ix CHAPTER V VALUES OF GOOD WILL AND FRANCHISES PAGE 66. Good will and franchise values attributes of value inherent in live plant 94 67. Goodwill 95 68. Franchise General consideration 96 69. Value of franchise in case of sale 97 70. Value of franchise in cases involving the equity of a statutory rate 98 71. Value of franchise in valuations for taxation 100 CHAPTER VI ORIGINAL COST 72. Necessity of an unbiased determination of original cost . . . 102 73. Original cost required by court decisions 103 74. Neglect in past of figures showing original cost 104 75. Abandoned or destroyed plant cannot be given value . . . 104 76. Difficulty in obtaining original cost 107 77. Unit costs 109 78. Piecemeal construction 109 79. Pavement over construction Ill 80. Overhead charges 112 81. Sale of securities 112 82. Cost of developing business 114 CHAPTER VII COMMERCIAL VALUE 83. Three figures to be presented under head of commercial value 115 84. Relative importance of figures representing the market value of stocks and bonds 115 85. Method to be used in ascertaining the market value of stocks and bonds 119 86. Method of ascertaining value based on capitalization of net earnings 120 87. Liabilities 122 CHAPTER VIII THE WORTH OF SERVICE TO THE CONSUMER 88. Decisions as to worth of service 125 89. Rates based on different substituting plant not a criterion of worth 127 90. Rates in other communities not a criterion of worth . . . 127 91. Profit inherent in worth 128 X CONTENTS PAGE 92. Worth of service to be measured by what it would cost the public to furnish the same service 129 93. Overbuilt plant 130 CHAPTER IX RESERVES FOR DEPRECIATION 94. Investment in perishable property a wasting asset . . . . 133 95. Authority for depreciation reserves 134 96. Current repair and maintenance 136 97. Salvage value 139 98. Wearing value 139 99. Importance of accurate determination of probable life of units 140 100. Creation of depreciation reserves 140 101. Creation of reserve fund by "sinking fund" method . . . 141 102. Creation of reserve fund by "straight line" method. . . . 142 103. Creation of reserve fund Authority for use of "sinking fund" or "straight line" method 142 104. Mean life of plant 144 105. Danger of misconception of mean life 145 106. Adoption of "sinking fund" or "straight line" method of making reserves in practical cases 146 107. Straight line method 147 108. Sinking fund method 149 109. Reserves invested in plant 150 110. Reserves for depreciation 155 CHAPTER X LIFE OF PLANT 111. Life of plant 158 112. Continuation of undertaking 159 113. Interest of public in operation of public utility 160 114. Interest of public in depreciation reserves 161 115. Maintenance and depreciation reserves 163 116. Importance of "life" in a determination of depreciation . . 163 117. Life of a plant unit 164 118. Physical life 164 119. Factors affecting life of plant 165 120. Inefficiency 165 121. Wear and tear of plant 168 122. Obsolescence 169 123. Inadequacy Definition 171 124. Inadequacy Changes in financial policy 172 125. Inadequacy Engineering economy 176 126. Inadequacy Unexpected development 176 127. Operation of factors affecting useful life of plant units . . . 177 128. Probable life of various plant elements 178 129. Limited tenure of holding 180 CONTENTS xi CHAPTER XI DEPRECIATION PAGE 130. Definition 182 131. Physical condition not a direct measure of loss of value . . 183 132. Determination of age 185 133. Mean "life" and mean "age" 186 134. Determination of loss of value a problem in accountancy . . 187 135. Shall loss in value due to age be figured by straight line or sink- ing fund method? 188 136. Return to undertaking based upon fair value of property . . 189 137. Loss in value of plant arising from age 190 138. Loss in value of property consisting of plant and reserves . . 194 139. Justice of the rule as to use of straight line or sinking fund method 196 140. "Pseudo" mean age 197 141. Loss in value of property when all reserves have been held in- vested in outside securities 198 142. Loss in value of property consisting of plant, built partly with reserves, and of reserves 202 143. General consideration of loss in value due to age .... 204 144. Question as to necessity of reserves sufficient to maintain value of original investment 205 CHAPTER XII FAIR PRESENT VALUE RATES 145. Fair present value determined by "well-informed" judgment . 207 146. Two kinds of rate cases, state and court 208 147. Fair present value dependent upon purpose of valuation . . 209 148. Fair present value. Valuation for state regulation .... 210 149. Fair present value. Valuation for court investigation . . . 210 150. Cost new of property State investigation of rates . . . 211 151. Increased value of real estate 212 152. Paving 216 153. Property acquired by gift 216 154. Cost new of property. Investigation by court of statutory rates 217 155. Increased value of real estate 218 156. Cost of repaving 218 157. Property acquired by gift * . . . 218 158. Value inherent in live plant 219 159. Brokerage Discounts 219 160. Tendency of later decisions to establish a fair cost-new . . 222 161. Depreciation 223 162. Method of figuring depreciation in cases involving rates . . 224 163. Returns based upon capital investment 226 xii CONTENTS PAGE 164. Investment in property, not plant, ruled by courts as basis of fair return . 227 165. Dangers resulting from making present value of plant alone the basis of fair rates 229 166. Valuation of new properties 229 167. Working capital 230 168. Fair return 231 169. Fair rate based upon stock only or upon stock and bonds . . 233 CHAPTER XIII FAIR PRESENT VALUE CONDEMNATION OR SALE 170. Market value 235 171. Fair cost-new 236 172. Increased cost of maintenance 237 173. Uncertainty as to life 237 174. Value of franchise 238 175. Depreciation in cases of sale 238 176. Investment of buyer must be full cost-new of a public utility property 239 177. Present value in case of sale 240 CHAPTER XIV GENERAL CONSIDERATION RELATIVE TO THE REGULATION OP PUBLIC UTILITY UNDERTAKINGS 178. Conduct of private undertakings 244 179. Conduct of public utility undertakings 245 180. Dangers involved in regulation of public utility undertakings 245 181. Avoidance of dangers of regulation 247 182. Obligations of public to public utility undertaking . . . 248 183. Obligation of public utility undertaking to the public . . . 250 184. Maintenance of the value of the stockholders' investment. . 251 185. Treatment of depreciation reserves 254 186. General conclussion 255 PUBLIC UTILITIES: THEIR COST NEW AND DEPRECIATION CHAPTER I PROPERTY VALUATIONS GENERAL CONSIDERATIONS 1. Purpose of present treatise. 2. Limitation as to expert evidence relative to property value. 3. Present value dependent upon purpose of appraisal. 4. True present value to be determined by court or commission only. 5. Figures to be presented as indicating possible present value. 6. Original cost. 7. Replacement cost. 8. Depreciation. 9. Market value of bonds and stocks. 10. Capitalization of earnings. 11. Worth of service to the consumer. 12. Cost and value. 13. Value as "going concern." 14. Determination of fair present value. 15. Figures showing value independent of purpose of valuation. 16. Necessity of presenting all figures indicative of possible present value. 1. Purpose of present treatise. The increasing super- vision by state authorities in the United States of the operation of public service undertakings has necessitated valuations of the properties employed by many classes of utilities. Much of the work which has been done in making such valuations has been carried out under the direction of engineers of wide experience, who have formulated methods which have been designed to furnish data upon which the true present value of the property under investigation could be determined with as near an approach to accuracy as is possible. On the other hand, 2 PUBLIC UTILITIES a careful study of the details of the methods used by the various engineers and by the commissions, who have been engaged upon this work, shows a considerable variation both in the theories and principles which have been followed. It is of interest and of great importance that all such variations should be noted and the funda- mental principles, involved in any complete valuation, be defined so clearly that two competent and experi- enced engineers presenting figures as to the value of the same property, independently, would obtain substan- tially the same results. An attempt has been made to record in the following pages the principles, as far as they have been established, which must form the basis of a valuation of the property of a public utility undertaking. References have been given to decisions, which have been rendered in many important cases, bearing upon this subject. 2. Limitation as to expert evidence relative to property value. As will be shown later, the fair present value of the property of an undertaking must be determined by a judicial weighing of figures showing possible pres- ent values determined by radically different methods. Some of these figures can be obtained only by engineers familiar with properties of the character of that under valuation. Other figures can be determined most accu- rately by experts on financial and economic problems. The figures presented, tending to show value based on engineering and economic considerations, involve many questions of law which can be answered only by one hav- ing a full knowledge of the laws bearing on cases of this character. This knowledge of the law is particularly necessary in forming a judgment as to the relative weight to be given, in each particular case, to the several esti- mates of present value presented by the experts. In consequence of the wide range of expert knowledge PROPERTY VALUATIONS 3 required in the determination of fair present value, some of the courts have excluded expert testimony except for the purpose of substantiating the particular figures tending to show the value that can be assigned to a property when determined by methods on which they are qualified by experience and training to speak. They have held that valuation is a mixed question of fact, judgment and law and that the court itself is compe- tent only to assign the true value of the property by a judicial consideration of the facts, figures and law in- volved in each particular case. 3. Present value dependent upon purpose of appraisal. - Most of the valuations which have been made thus far have had for their object a determination of the proper value of the property of an undertaking as a basis for taxation or for a determination of proper rates to be charged for the service or commodity sold by the under- taking to the public. In consequence of this, rulings have been made by the courts and decisions given by public service commissions, which offer many suggestions as to methods of valuation applicable to investigations for these two purposes. But, in addition to valuations designed as a basis for taxation or for rate regulation, appraisals are frequently required to determine the pres- ent value of a property prior to the issue of new securities, or to determine a price fair to the public, as well as to vendor and vendee, when a transfer of the property of a public utility undertaking becomes necessary in a case of sale. It is, therefore, important in any comprehen- sive study of the question of values of property to deter- mine how far the methods of valuation employed must be modified to produce the true present value for any one of these four purposes. Many writers on this subject have contended that the fair present value of a property must be the same for 4 PUBLIC UTILITIES whatever purpose such value may have been determined and that, in consequence, there can be but one method by which the true present value can be obtained. That such is not the case will be apparent when the entire subject of valuation has been fully discussed. As will be presently shown the fair present value of the property of an undertaking must be found by a judicial consider- ation of a number of sets of figures each purporting to show the value of the property at the time of the appraisal when determined from different points of view. Thus, speaking generally, one set of figures may be the value which engineers would place upon the property, another would be based upon what the users of the utility would feel that they should pay for the service rendered, an- other would be what the owners had paid for the prop- erty, another might be based on the earning capacity of the property, and another would be what the invest- ing public at large thought of the commercial value of the property. In most cases each one of these values will be different and possibly no one value will be that which will be assigned as the true present value. The relative weight which will be given to these figures will be different depending upon the purpose for which the appraisal is made, as well as upon the special conditions affecting the property under consideration. 4. True present value to be determined by court or commission only. A careful study of the subject of the valuation of public utility undertakings shows that each one of the sets of figures, described in the last sec- tion as designed to show a value determined from differ- ent points of view, must be obtained without any regard whatever to the purpose of the appraisal. These figures are not designed to show the true present value of the property. The true present value of the property can be established only by the impartial judgment of the PROPERTY VALUATIONS 5 court or commission, weighing the conditions affecting each particular case. Whatever relative weight may be given to these sets of figures, each set should be capable of determination along well established, logical and proper lines, lines which have been defined so well that no controversy need arise as to the reliability of the figures presented. 5. Figures to be presented as indicating possible pres- ent value. Authority for the presentation of these diverse figures has been given by many rulings of the Courts of the United States. This is defined most clearly in a decision of Mr. Justice Harlan in a case relative to the reasonableness of rates: "If a railroad corporation has bonded its property for an amount that exceeds its fair value, or if its capitalization is largely fictitious, it may not impose upon the public the burden of such increased rates as may be required for the purpose of realizing profits upon such excessive valuation or fictitious cap- italization; and the apparent value of the property and fran- chises used by the corporation, as represented by its stocks, bonds and obligations, is not alone to be considered when determining the rates that may be reasonably charged. . . . We hold, however, that the basis of all calculations as to the reasonableness of rates to be charged by a corporation main- taining a highway under legislative sanction must be the fair value of the property being used by it for the convenience of the public. And in order to ascertain that value, the original cost of construction, the amount expended in permanent im- provements, the amount and market value of its bonds and stock, the present as compared with the original cost of con- struction, the probable earning capacity of the property under particular rates prescribed by statute, and the sum required to meet operating expenses, are all matters for consideration, and are to be given such weight as may be just and right in each case. We do not say that there may not be other matters to be regarded in estimating the value of the property. What the company is entitled to ask is a fair return upon the value of that which it employs for the public convenience. On the 6 PUBLIC UTILITIES other hand, what the public is entitled to demand is that no more be exacted from it for the use of a public highway than the services rendered by it are reasonably worth." 1 The figures, therefore, which should be presented to the court or commission in order that it may determine the true present value judicially with " sound and well instructed judgment " are, - 1. Figures showing the original cost of the entire property used and useful to the public at the time of appraisal. 2. Figures showing the cost new at the present time of the same property, i.e., the cost new of reproduction or the replacement cost. 3. Figures showing the loss in value of the invest- ment in the property arising from its years of service, i.e., the depreciation. 4. Figures showing the amount and market value of its bonds and stocks. 5. Figures showing the commercial or capitalized value of the business of the undertaking based upon present as well as possible future earnings, i.e., the probable gross earnings less present or possible future operating expenses. 6. The reasonable worth of the service rendered to the public, i.e., to the consumers or users. 6. Original cost. The original cost is the actual amount of money expended by the undertaking for the property then in use for the convenience of the public. The original cost of the plant is not necessarily what was paid for portions first constructed. If the plant has been extended, the original cost includes the cost of such extensions. It may be that the original plant has been replaced in whole or in part. If such replacements have neither increased nor decreased the value of the plant, then the original cost still holds. If the replacement 1 Smyth v. Ames, 169 U. S. 546, (1898). PROPERTY VALUATIONS 7 has cost more than was paid for the plant that is replaced, then a virtual extension of the plant has been made and the total original cost must be enhanced. If the plant has been rebuilt for less than it cost originally, then the total original cost must be reduced. 7. Replacement cost. Mr. Justice Harlan ruled that the " present cost" of construction should be deter- mined so that it can be compared with the original cost. Replacement cost is such "present cost," and may be defined as that amount of money which would have to be expended at the present time to bring into existence a property identical with that of the undertaking being appraised. It must be obtained by an inventory of all of the property of the undertaking and by a valuation of such property based upon complete and carefully developed units of cost. 8. Depreciation. Depreciation is the loss in value which has occurred arising from the period during which the property of the undertaking has been in service. It must be recognized that depreciation applies only to such of the units of the property as suffer a loss in value due to the years of service and, consequently, is appli- cable principally to the plant units, but many plant units suffer no depreciation and, in consequence, the method of presenting the values of the elements of prop- erty must be such that the factors of depreciation can be properly applied. 9. Market value of bonds and stocks. This method of valuation is known as the " stock and bond method" and consists in obtaining the present value of the com- mercial property of an undertaking by multiplying the par value of outstanding corporate liabilities by their market quotations. "The method of valuing railway properties on the basis of the market quotations of their stocks and bonds is regarded 8 PUBLIC UTILITIES by many as the most defensible of all methods, for the reason that the price of railway securities established on the stock exchanges is the resultant of a combination of the greatest pos- sible number of judgments. Thousands of men are constantly endeavoring to surpass one another in the fullness and accuracy of their knowledge of the value determining factors affecting any given security and to turn their superior knowledge into profits. The inevitable outcome of this process is the estab- lishment of a list of prices which represents the crystallization of the best judgment respecting the value of property; and when these prices are determined" with care "over long periods of time, ... no objection can reasonably be made against their use on the ground of their speculative character." l This method unquestionably affords an excellent basis for comparison with the present values as determined from original cost or replacement cost, but it must be recognized clearly that a commercial value as thus obtained must presuppose the probable continuance of existing rates for the utility sold. 10. Capitalization of earnings. This method of deter- mining the present commercial value of the property of an undertaking consists in capitalizing the net income of the undertaking after deducting operating expenses, depreciation, and taxes, from the gross revenue. This method presents two difficulties, the elimination from operating expenses of the cost of permanent improve- ments which may have been charged to this account rather than to the capital account, and the determina- tion of a proper rate of capitalization. Attention should be called also to the fact that in this method, as in that just described, the income of the undertaking is depend- ent upon the rates charged for the utility sold. 11. Worth of service to the consumer. Fundamen- tally the worth of a service to a consumer is what it would cost him, when working co-operatively with other users 1 U. S. Census Bulletin 21, p. 19. PROPERTY VALUATIONS 9 of the same utility, to provide the same service, taking into consideration that, by obtaining service from an undertaking rather than from a plant built and operated with his and his associates' money, he is relieved from all annoyance, responsibility and risk. It is not a fig- ure intended to show what it might cost individual users to provide a similar service for themselves individually, but when acting as a community. It is not a value capable of determination by comparison with the cost of the same character of utility furnished in other commu- nities. Nor is it necessarily based upon what it would cost to obtain the same result by the use of another util- ity, as, for example, the relative cost of obtaining the same amount of light from gas when the worth of that light obtained from electricity was involved. 12. Cost and value. The object of a valuation is to obtain the true present value of a property, or, stated more accurately, to obtain the value at a particular date which would be fair and just to all concerned under all the conditions prevailing in that special and particular case. It is to be noted, however, that the first two of the above sets of figures are costs, original cost and replace- ment cost, not values, whereas the three last sets of fig- ures are values. The original cost and the replacement cost must be translated into values in some way, in order that they may be comparable with the others and, con- sequently, be of service to the court or commission whose duty it is to weigh all the figures presented as representative of value, and from them assign that value which is fair under all of the conditions of the case. Value is indicative of a desire on the part of someone who does not possess an object and who cannot acquire it without parting with something that he has in exchange for it. It is the difference in desire, measured 10 PUBLIC UTILITIES in money, which is supposed to exist on the part of per- sons with different interests, which creates the variation in present value which may be assigned to the same property depending upon the purpose of the valuation, whether for sale, for rate regulation, for taxes or for the issue of securities. Original cost or cost of replacement, therefore, is not indicative of value necessarily. The cost of the physical property of an undertaking, either when originally con- structed or rebuilt at the present time but not in use, might be very large but such costs would not be indic- ative of the value of the property. The property would have value, would be desired, only when it had been enlivened by operation or could be shown that it could be so enlivened and made capable of producing a return. These two figures, original cost and replacement cost, must be translated into value and this can be done only by including with such cost figures representative of the value inherent in the physical property, produced by the fact that the physical property consists of a live plant, composed of units in co-ordination and articulation with each other, and "thus forming a complete mechanism, capable of performing useful service," productive or potentially productive of a return to the owners. This enlivening factor is frequently called the value of a property as a "going concern." 13. Value as "going concern " It is to be noted that the figures, to be presented as indicating value, are to represent the value of the property of the undertaking. The property of a public utility rarely consists of plant alone. The undertaking has other property of distinct value to it and to the public, which is not apparent or tangible and consequently cannot be made a portion of an inventory as can the physical property. This intan- PROPERTY VALUATIONS 11 gible property consists of the value inherent in the util- ity due to the fact that the utility is operating a "live plant," a plant connected with users. This value inherent in a live plant, or, as it is frequently called, "value as a going concern," has been recognized in most of the later decisions bearing upon the value of the properties of public utilities. The decision of Mr. Jus- tice Lurton in the Omaha Water Case brings out very clearly this intangible value. "The option to purchase excluded any value on account of unexpired franchise; but it did not limit the value to the bare bones of the plant, its physical properties, such as its lands, its machinery, its water pipes or settling reservoirs, nor to what it would take to reproduce each of its physical features. The value in equity and justice must include whatever is contrib- uted by the fact of the connection of the items making a com- plete and operating plant. The difference between a dead plant and a live one is a real value, and is independent of any franchise to go on, or any mere good will as between such a plant and its customers. That kind of good will, as suggested in Willcox v. Consolidated Gas Co. (212 U. S. 19), is of little or no commercial value when the business is, as here, a natural monopoly, with which the customer must deal, whether he will or no. That there is a difference between even the cost of du- plication, less depreciation, of the elements making up the water' company plant, and the commercial value of the business as a going concern, is evident. Such an allowance was upheld in National Waterworks v. Kansas City, (62 Fed. Rep. 853), where the opinion was by Mr. Justice Brewer. We can add .^ nothing to the reasoning of the learned Justice, and shall not try to. That case has been approved and followed in Gloucester Water Company v. Gloucester, (179 Mass., 365), and Norwich Gas Company v. city of Norwich, (76 Conn. 565). No such question was considered in either Knoxville v. Knoxville Water Company, (212 U. S. 1), or in Willcox v. Consolidated Gas Company, (212 U. S. 19). Both cases were rate cases, and did not concern the ascertainment of value under contracts of sale." * 1 City of Omaha v. Omaha Water Company, 218 U. S. 212, (1910). 12 PUBLIC UTILITIES In another case the Court says: "Nevertheless it has value as a structure. But, more than this, it is a structure in actual use; a use remunerative to some extent. It has customers. It is actually engaged in business. It is a going concern. The value of the structure is enhanced by the fact that it is being used in, and in fact is essential to, a going concern business. We speak sometimes of a going con- cern value as if it is or could be separate and distinct from structure value so much for structure and so much for going concern. But this is not an accurate statement. The going concern part of it has no existence except as a characteristic of the structure. If no structure, no going concern. If a structure in use, it is a structure whose value is affected by the fact that it is in use. There is only one value. It is the value of the structure as being used. That is all there is of it. ... The district obtains and the company yields its plant, its struc- ture; but it is the structure as being used, with the rights to use it as stated; no less, no more. We apprehend that some difficulty in discussion has arisen from attempting to differ- entiate in logic what is inseparable in fact. The property taken is a single thing, to which belong certain characteristics which affect its value. The thing cannot be taken without these characteristics. If it is attempted to value the thing separate from its inherent characteristics, elements which add value to the thing are omitted. If these elements are omitted, the owner fails to receive the full and fair value of the thing, and thereby is denied just compensation." l The opinion of Mr. Justice Lurton above quoted clearly indicates the distinction which must exist between cost and value when the plant has been quickened or vitalized by operation. The original cost and replacement cost must be presented, therefore, in such a way as to show not only the cost of the physical property but the value inherent in that property as a "live" plant, productive or potentially productive, of a return to the owners. Fundamentally the value inherent in a live plant is meas- 1 Brunswick & Topsham Water Dist. v. Maine Water Co., 59 Atl. 539, (1904). PROPERTY VALUATIONS 13 ured by its earning capacity, and this earning capacity, except for the control exercised by the State over Public Utilities, would be due to some characteristics of the prop- erty inherent in the position of the plant or of its opera- tion. /THus in the case of a railroad the trend of tonnage down^fade rather than up grade; of the density of pop- ulation and traffic as related to the location of the road; of the value to the road of facilities for producing business for the road, such as grain warehouses or elevators, flour mills, saw mills and manufacturing establishments of all kinds; of the low cost of fuel; of ownership of water- power rights sufficient to provide for electrical operation on mountain grades; of the availability of skilled em- ployees; or of reasonable costs of living. All of the con- ditions of this character may tend greatly to enhance the value of the property but they are all characteris- tic of the plant location, are inherent in the plant as an operating organization and, in consequence, any values that may attach properly to them must be considered as a portion of the value of the property. "The value of a railway system does not depend upon the mere cost of its embankment or its equipment. It is rather a question of location, of connections, of terminal facilities, of enterprises along its line; and shall nothing be allowed to the foresight and ability which have marked out and perfected that system?" 1 But in the case of a public utility, the state has the power to say what rates and, consequently, what return can be earned by the organization operating under con- ditions of a location which has been granted to it. The state need not consider the relative advantages of one undertaking as compared with another offering substan- tially the same service. Each undertaking stands by itself and, in .case of a controversy which is carried to 1 Interstate Commerce Commission Reports, Vol. IX, p. 402. 14 PUBLIC UTILITIES the courts, the court decides simply whether the rates imposed will afford such a low return upon the present true value of the property as may be deemed confisca- tory of the property of the undertaking. All of the rul- ings of the counts, however, recognize that the live plant, the plant enlivened by successful operation, is more valuable than the bare bones of the physical plant, and agree that some enhancement in value should be made by them in a determination of the true present value of a property. The value inherent in a live plant includes other ele- ments than that of its value as a going concern, such as the value of "good will" or the value of the " franchise rights." Whether or not definite values can be attrib- uted to each of these factors individually, and whether such values, if present, can be included as a part of pres- ent value of a property in all cases, will be considered in a later chapter. 14. Determination of fair present value. The court or commission, depending upon the nature of the case, is alone competent to assign the true present value of the property of an undertaking. For the purpose of aiding such decision, the above six sets of figures have been ruled by Mr. Justice Harlan as requisite. In form- ing its decision the tribunal must base its judgment upon the facts and figures applying to each particular case. No hard and fast rules have ever been laid down and probably never can be laid down to govern all cases. This is clearly indicated in the decision rendered in the Spring Valley case which is quoted below : "He is entitled to a fair return, not always upon the cost of the property, because it may have cost too much; not always upon the outstanding indebtedness, because it may be in excess of the real value of the property; not always upon the total amount invested, because some portion of that which is acquired PROPERTY VALUATIONS 15 by the investment may be neither necessary nor presently use- ful for the public service; but upon the fair present value of that which is used for the public benefit, having due regard always to the reasonable value of the service rendered. Each case must depend very largely upon its own special facts, and every element and every circumstance which increases or depre- ciates the value of the property, or the service rendered, should be given due consideration, and allowed that weight to which it is entitled. It is, after all, very much a question of sound and well-instructed judgment." 1 These figures derived and presented in accordance with the rules formulated in the succeeding pages provide the tribunal with complete and accurate information as to possible values of the property. With the infor- mation afforded by these figures carefully and logically determined, a decision can be formed as to a present value which will be fair to all parties concerned. In some cases one figure representative of value may be given more weight than it would be in another case. In many cases the present value will be a compromise figure for the reason that a public service corporation differs from a private undertaking in that the tribunal must consider what is fair to the public as well as to the under- taking. Likewise in a case of sale, the present value must be a fair one looking to the interests of the public as well as to those of the buyer and seller. 15. Figures showing value independent of purpose of valuation. It is the tribunal which determines which figure representative of value must be given weight or by how much such a figure should be modified. The experts, engineer or accountant, cannot change the method of valuation by means of which the figures which they are to present to the tribunal are to be derived in order to produce their conception of present value. The orig- 1 Spring Valley Water Works v. San Francisco, 165 Fed. 680. See also Ames v. Union Pacific R. R., 64 Fed. 165. 16 PUBLIC UTILITIES inal cost can be but one definite figure. It may be a figure difficult to obtain, and two accountants may derive different results, but each is seeking the same result work- ing along the same lines and their results can be checked in most cases. The same is true of replacement costs. In most cases two experienced engineers will agree with reasonable accuracy upon the replacement cost of the physical plant. The principles to be employed in deter- mining overhead charges and the intangible values must be formulated so carefully that there can be little or no possibility of controversy as to the total replacement cost. Likewise the loss in value of the property due to age, that is to say the depreciation of the property, should not be subject to controversy, provided it is determined by experts familiar with the art employed by the utility, with the condition or age of the perishable property and with the fundamental principles relating to depreciation. The same is true of the other figures which experts must develop and present to the tribunal. 16. Necessity of presenting all figures indicative of possible present value. The difficulty of obtaining original cost in the cases of many of the older and larger undertakings has tended to cause this item representative of value to be neglected. In fact, in very many cases of valuation, the entire efforts of the appraisers appear to have been concentrated upon a determination of the reproduction cost-new at the present time, even in some cases neglecting entirely the depreciation in the value of the property which has resulted from its years of serv- ice. As will be seen later, cost-new at the date of the appraisal cannot be accepted, in many cases, as a proper criterion of value, at least theoretically. Moreover, no practical business man would accept as reliable a figure purporting to represent value which gave no indication PROPERTY VALUATIONS 17 of the earning capacity of the property. All of the sets of figures, which have been noted above and will be considered more carefully in later portions of this trea- tise, should be presented, for what they may be worth, to the tribunal whose duty it is to give to each what may seem to be its proper importance as evidence of a fair present value. CHAPTER II REPLACEMENT COSTS OF PHYSICAL PROPERTY 17. Definition of replacement cost. 18. Present or original conditions. 19. General assumptions as to replacement. 20. New plant identical with old or one of modern design. 21. Effect upon replacement cost of increased difficulty in placing plant. 22. Period of construction. 23. Unit costs. 24. Mean unit costs developed from curves showing trend of market prices. 25. Use of weighted mean prices during period of construction. 26. Piecemeal v. wholesale construction. 27. Piecemeal construction. Effect of changes and enlargements on cost. 28. Pavement over construction. 17. Definition of replacement cost. The replacement cost of a plant may be defined as the sum of money which would have to be expended at the present time to con- struct a plant similar in all respects to that which is already in service. Replacement cost is the cost to-day of a plant substan- tially identical with that which is in use and useful to the public at the time of the appraisal. Replacement cost, or, as it is frequently termed, cost of reproduction or cost-of-reproduction-new, has been given various meanings in the past, most of which are due to an attempt to make replacement cost accord with the original or actual cost. Original cost and replace- ment cost must be entirely divorced from each other. If the original cost cannot be determined from the books or records of the undertaking, an attempt may be made to derive the original cost by studies based upon past REPLACEMENT COSTS OF PHYSICAL PROPERTY 19 prices and conditions, but the replacement cost must be the cost at the present time under existing conditions. 18. Present or original conditions. It is frequently argued that the cost of reproduction to-day is not fair, in many instances, to those who constructed the property originally under more adverse conditions than would be found at the present time. This difference may be per- fectly true but such increased cost would be included in the figures representing the original cost. The original cost is the cost under past conditions. The replacement cost is the cost under existing conditions. There may be a wide divergence between these two figures, but both are presented to the court or commission and that tribunal will decide which figure, taken in connec- tion with the others presented to show present value, will represent most nearly the true and fair present value. 19. General assumptions as to replacement. Re- placement cost of a plant cannot be determined without making certain general assumptions which are funda- mental to the entire work of an appraisal. It is impor- tant that these assumptions should be fully recognized and so defined that all appraisals, by whomsoever made, should follow as far as possible the same methods. In determining the replacement cost of a plant the follow- ing assumptions must be made: 1. That it is perfectly possible at the present time to construct a similar new plant in the same position as that occupied by the plant now in existence and under process of valuation. 2. That the new plant can be constructed in some definite period of time. 3. That the fair present costs can be obtained for the land, material and labor used in the plant. The first of these assumptions involves two questions, one, shall the replacement cost be figured upon new 20 PUBLIC UTILITIES plant identical in all respects with that in existence or upon new plant of modern design; the other, can a new plant be placed where there is an older one existing. 20. New plant identical with old or one of modern design. It has been contended that the replacement cost of a plant should be that which it would cost to con- struct a new plant, modern in all respects and capable of furnishing the same service as that afforded by the older plant then under investigation. In other words, what it would cost a competitor to build a new and up-to-date plant of the same size and furnishing the same service. The fallacy of this argument is apparent when it is re- membered that the valuation is made for the purpose of finding the present value of existing property. The re- placement cost is one of the figures presented to show the cost-new of that property and from such cost-new must be deducted the depreciation which the property has suffered from its years of use. If the replacement cost should be made to show the cost-new of a different prop- erty, made up of units different either in size or in charac- ter, it would be utterly impossible to determine with any approach to accuracy the present value of the existing property. It is true that the rule as to identical plant should not be carried out too rigidly. Some units of plant may be no longer manufactured and could not be obtained, at the present time, without abnormal cost. In such cases the purpose of the appraisal would be carried out more accurately and more satisfactorily by using the cost of the nearest modern substitute. This line of reasoning appears to be that which has prevailed generally in valuations made in the United States. The Wisconsin Commission has said: "From the facts we have so far obtained, the indications are that, in this state at least, the instances are not very nu- REPLACEMENT COSTS OF PHYSICAL PROPERTY 21 merous where the inventory and construction of the established plants can not be followed with a reasonable degree of safety." 1 The Courts of the State of Maine in cases involving the valuation of water works have favored valuations based upon plants identical with those found in service. " We think the inquiry along the line of reproduction should, however, be limited to the replacing of the present system by one substantially like it. To enter upon a comparison of the merits of different systems to compare this one with more modern systems would be to open a wide door to speculative inquiry, and lead to discussions not germane to the subject. It is this system that is to be appraised, hi its present condi- tion and with its present efficiency." 2 21. Effect upon replacement cost of increased diffi- culty in placing plant. Clearly, a new plant, built at the present time by a competitor, for example, designed to furnish the public with the same service, would in many cases be much more expensive to place than was the case when the older plant was constructed. As an illus- tration, the case of the subway plant of a telephone com- pany may be taken. In many cases in large cities the system of underground ducts and conduits was built at such an early date that relatively few obstructions were met as compared with what would be found at the pres- ent time. A new plant would be, therefore, much more expensive to construct. The contention could be made that, as the streets are so filled at the present time with underground pipes of various kinds including the con- duit system under appraisal, the replacement cost, due to this fact alone, would be very much greater than the original cost. Replacement presupposes the non-exist- ence of the present plant, and that no more obstructions would be met at the present time than probably were 1 Wis. R. R. Com. Rpts., Vol. 3, p. 637. 2 Kennebec Water Dist. v. City of Waterville, 54 Atl., p. 19. 22 PUBLIC UTILITIES found when the original plant was constructed. The replacement cost, therefore, must be based upon a con- duit of the same size and character situated in the exact position occupied by the present structure. If it were ruled that the value of the present conduit was what it would cost to place a new one wherever space could be found at the present time for it in the streets, then the present conduit would prove an obstacle to the new and be itself a means of enhancing its own value, which is manifestly an absurdity. This contention has been fairly met in the Enid case, where the ruling of the Court was that, - "The plant, in our opinion in arriving at its cost of repro- duction new, should not be considered as an existing obstruc- tion upon the streets which would have to be worked around in constructing a new plant of a similar kind." 1 The case of land may be cited as another illustration of this condition. An undertaking in acquiring the land needed for its operation may have been obliged, in many cases, to purchase the buildings found upon the land and to remove them as unsuitable for their future needs. The original cost of the land was enhanced by the then value of the buildings and the expense which was incurred in their removal. In many cases the undertaking may have constructed special and, possibly, very expensive build- ings suitable for its needs. In determining the fair pres- ent value of the land it would not be proper to enhance the value of the land at the date of the appraisal by the cost of the present buildings and by the cost of removing them. In other words, it cannot be considered as an " ex- isting obstruction ... in constructing a new plant of a similar kind." The method to be followed in dealing with such a case will be considered later. 1 Supreme Court of State of Oklahoma, Pioneer Tel. & Teleg. Co. v. E. H. Westenhaver et al., 118 Pac. 354 (1911). REPLACEMENT COSTS OF PHYSICAL PROPERTY 23 22. Period of construction. The replacement cost is an estimate of the cost of reconstruction at the present time of a plant identical with one in existence. It is impossible to make such an estimate without a definite assumption as to the time that will be required to bring together the materials needed and to perform the work necessary in placing the materials in the plant and fitting the plant for operation. It is impossible to conceive of the replacement of the plant of a large public utility as of a certain day. Time and usually much time before or after the date assigned for the valuation would be required in replacing such a plant. The question, therefore, to be decided in each partic- ular case is what length of time should be allowed for the construction period. The period of construction is clearly the time from the inception of the undertaking up to the time when the plant is turned over to the oper- ating forces and is put into service. The point to be settled appears to be whether, in determining replace- ment costs, the entire present plant must be constructed and turned over as a complete plant, equal in size to that under valuation, or whether the hypothetical replacing plant shall be constructed piecemeal, in parts as large as may have been or would be built in a reasonable and practical construction of a new and similar plant. As already stated, much time would be required in building a plant as large as that of most large utilities, a telephone company for example. In a recent investiga- tion as to the time which would be required to replace a telephone plant of fair size, about 300,000 stations, experts have testified that it would take about seven years to make the necessary surveys for the new plant, obtain the required material and construct the plant. Moreover, that, 24 PUBLIC UTILITIES "It would be probably four or five years before he could take on any subscribers at all, and after that period he could commence joining up on such exchanges as were ready." . . . "If the work is to be done in a thoroughly efficient manner it ought to take that time. Hurried work as a rule is not satis- factory work." l There can be no reasonable question that, to construct a telephone plant costing $50,000,000.00 or more, an ex- penditure at an average rate of more than $10,000,000.00 a year would not be possible if the work is to be well done. It must be definitely understood that these fi'gures are based on the supposition that the conditions, under which the new plant is supposed to be constructed, are no pres- ent plant, no engineering plans, no organization either in headquarters or in the field. There is every reason for feeling that a period of construction of five years for a plant of such size is conservative and fair. In the case of the construction of water works, it has been stated: "The period and rate of construction of any comparative plant will be determined by the ability to plan and build wisely and economically. Experience has shown that, except in cases where the work is so scattered as to make possible its subdivision into a large number of contracts, the annual expend- iture of a sum in excess of $1,000,000.00 is not an easy matter." 2 The two above cases are given as an illustration of the line of reasoning which must be followed in each partic- ular case in determining the period of construction, that is the period of time between the initiation of the work and the completion of a structure identical with that in existence. It does not seem reasonable to contend that no por- 1 Sir John Gavey's Testimony before Select Committee on Post Office, 1905 Report pp. 37 & 39. 2 Leonard Metcalf and John W. Alvord, Proc. Am. Soc. Civil Engi- neers, Vol. 37, p. 165. REPLACEMENT COSTS OF PHYSICAL PROPERTY 25 tion of the replacing or comparative plant can be put into service until the entire plant has been completed, that is to say, until the end of the construction period. It is not the way the original plant was constructed nor would any new undertaking contemplate such a plan. On the contrary, every effort would be made by the man- agement to get such portions, as could be completed, into service at as early a date as possible. The result of this is that, for portions of the plant, the period of con- struction is less than the period of construction of the plant as a whole. The time of construction is one of the most important assumptions which must be made in a determination of replacement costs. It enters as an im- portant consideration in a decision of the unit costs, interest during construction and other factors entering as a portion of the work of valuation. 23. Unit costs. In forming a decision on this ques- tion, the real object of the investigation must be kept constantly in mind: it is to determine, with the least possibility of controversy, what it would cost at the pres- ent tune to construct a plant substantially identical with that in existence and similarly placed. It is easily con- ceivable that a large plant could not be constructed in a relatively short period of time without producing an abnormal increase in cost due to the unusual demand for labor and material. It is clear that any such abnormal enhancement in cost would be contrary to the purpose of the investigation. It seems clear, therefore, that quo- tations as of a special day for all of the units of a plant would not be a satisfactory method of obtaining the costs to be used in a valuation. On this question the Wisconsin Commission has ruled: "Average or normal costs, however, are not always easily determined, and this for the reason that the prices of the vari- ous elements that enter into this cost vary very greatly from 26 PUBLIC UTILITIES time to time. Plants built when the prices of material, labor and other elements are high will cost much more than if con- structed when these prices are lower. In the case of the orig- inal cost of construction of plants which have been extended from year to year, such fluctuations in prices are apt to be of less importance because the additional cost of extensions made when prices were high are likely to be offset by lower costs for extensions made when prices were lower. In the case of the cost of reconstruction the effect is apt to be greater. If this cost is figured on the prices which prevailed at the time of the appraisal, it may differ greatly from the cost that would have been obtained from the prices that prevailed either a short time previously or a few months later, as well as from the cost that would have been obtained from average prices. Owing to these variations cost-values based on prices as of the date of appraisal would not seem to be equitable for either rate-making or condemnation purposes. In order to be fair for the former purpose it is more than likely that the rates would have to be changed with every change in prices and con- sequently in the cost, and such changes would not only be im- practicable but contrary to public policy, which ordinarily requires the greatest possible stability in the rates. In the latter case they might result in either abnormal losses or abnor- mal gains to those from whom the property was taken. While there may be something to be said in favor of using the prices which prevail at the date of the appraisal in computing costs, it appears that when taken as a whole present prices for these purposes are much less satisfactory and equitable than aver- age or normal prices. What is thus true for the cost of the physical plant, may also, to some extent, be true of the cost of building up its business." 1 The most definite ruling on this subject is probably that of the Maine Courts relative to the valuation of water companies. This ruling is that present costs shall be based on " prices prevailing at a time in advance of or prior to the date of taking, corresponding to the probable period of construction." 1 Wis. R. R. Com. Rpts., Vol. 3, p. 624. See Cedar Rapids Gas Light Co. v. City of Cedar Rapids, 120 N. W. 966 (1909). REPLACEMENT COSTS OF PHYSICAL PROPERTY 27 This ruling defines a method which is logical, reasonable and fair. It would seem, therefore, that, for an appraisal made at or prior to the date of taking, the mean costs of labor and material entering into the plant during a period in the past equal to the construction period, as above defined, should be used as the fair present cost. As a matter of interest, the methods of determining fair present costs which have been used in some of the largest appraisals made in this country are given below : In appraisals of railway property made for the State of Michigan, "the basis of unit prices varied somewhat according to circumstances. The underlying principle appears to have been to use the average prices for a term of years for such com- modities and items of property as had been and would prob- ably continue to be subject to large fluctuations in market prices; as, for example, the price of copper wire, which was taken as an average of the market quotations for the preced- ing seven years, and the price of the steel rails, which was taken as an average of the prices for the preceding ten years. . . . Other items of property, not subject to extreme fluctuations within brief periods of time, current prices were adopted." l The Wisconsin Commission has adopted "a five-year average basis for unit prices as far as consistent with circumstances." * The Texas Railroad Commission in a valuation made by them in 1903 of the property of the railroads within that State used costs based on current market prices. A valuation of the railroad property in the State of Washington made use of unit costs based upon prevailing prices of material. 24. Mean unit costs developed from curves showing trend of market prices. In order to obtain an accurate estimate of replacement cost, there is need of figures showing normal prices of material and labor at the pres- ent time or during a time in the past equal to the period of construction. There can be no doubt that quotations 1 Wis. R. R. Com. Rpts., Vol. 5, p. 231 (1910). 28 PUBLIC UTILITIES as of one day for all of the material required for the replacement of the plant of a large utility would be unfair and would give no indication whatever of the normal prices which are required in estimating the replacement cost. On the other hand, even the prices, which have prevailed in the past during a period equal to the period of construction, may have been so influenced by market conditions as not to afford a perfectly fair mean cost for use in a valuation. This condition is very conspicuously presented in the case of copper. The market fluctua- tions of copper have been such that wide variations in the unit costs for that material would be found depending upon the date and length of the period of construction. To eliminate as far as possible such market fluctuations and obtain the normal prices as of the present time, the prices which have prevailed in the past for material subject to wide market fluctuations have been plotted. By drawing a line between the high and low prices such as will represent a fair mean price, it is possible to deter- mine a figure freed from market irregularities. This method has been employed by the Wisconsin Commission in several recent cases 1 as a means of checking the accu- racy of figures obtained by the use of the mean prices during a period of construction, usually assumed by that Commission as five years. It is a method which should be used as a check, at least, for all material subject to wide variations due to market conditions. 25. Use of weighted mean prices during period of construction. In one or more important valuations, claims have been made for costs of material based on the weighted mean costs of material purchased by the under- taking in the past during a period equal to the assumed period of construction. It was claimed that higher 1 Wis. R. R. Com. Vol. 7, p. 84 (1911). Cast iron water pipe. See also Floy, Valuation of Public Utilities, p. 65. REPLACEMENT COSTS OF PHYSICAL PROPERTY 29 prices for material and labor are found usually at times of greatest industrial activity and, as a consequence, the money expended by the undertaking could not be meas- ured by the mean of the prices alone. These prices should be weighted, it was claimed, by the amounts of material actually paid for and used in the property under valuation. It must be apparent that such a contention is hi direct contradiction to the principles underlying replacement costs which have been enunciated in the preceding sec- tions of this chapter. It may have cost the undertaking more than would be shown by the replacement cost based on mean figures, but the cost to the undertaking is indicated by the figure representing original cost. If large portions of the plant had been constructed when prices were abnormally high, the tribunal weighing the figures showing original and replacement costs may give such weight as it deems proper to that fact as revealed by the original cost figure. But the replacement cost must be evolved from prices based on mean normal costs, as of the present time, without reference in any way to what may have been done by the undertaking in the past. Moreover, if such a contention were accepted, it would be recognizing a figure based upon prices paid for only a portion of the plant, that portion built within the period of construction. In many cases this would represent only a fraction of the entire plant. 26. Piecemeal v. wholesale construction. In almost every appraisal the question arises as to whether the costs, principally of labor and transportation of men and material, should be based upon what it would cost to replace the plant in a wholesale manner or whether the plant should be considered as being rebuilt portions at a time, substantially in the same manner as the original plant was built. This difference can be made clear by a consideration of one or two practical cases. 30 PUBLIC UTILITIES In practice, underground cables in a telephone system are drawn into a conduit one at a time as the demands of the business may require. The entire underground cable system has been built in this manner, and definite knowl- edge has been obtained, as the result of large experience, as to the cost of laying and splicing cables in this man- ner. At the present time there will be found a large number of cables in a given manhole, running between that manhole and the next. It is manifest that it would be less expensive with the construction men and material at a manhole to draw in all of the cables, rather than to bring the men and material necessary for the drawing in operation to that point to draw in one cable alone. Again, there may be a thousand telephone stations in one large office building; clearly it would be a matter of less cost to install and connect all of these stations as one opera- tion rather than to place them practically one at a time, in the manner that the original system was constructed. Before entering upon a discussion of this question, it is important to emphasize a fact which has been touched upon already in section 22. In determining replacement cost the appraiser must not assume that he has definite plans and information as revealed by the inventory of the kind and position of each unit of plant. If this assumption were made there would be a usurpation of property of the undertaking which it had cost the under- taking much time and expense to obtain. Replacement assumes the rebuilding of a plant of the same size and composed of the same units placed substantially in the same positions as in the existing plant, but a knowledge of what kind of units and of their position would have to be acquired through the labor and skill of an engineer and with a public demand similar to that which had been met in the past by the existing company. The theory of replacement costs would not be complied with and there REPLACEMENT COSTS OF PHYSICAL PROPERTY 31 would be manifest injustice to the undertaking, if the in- ventory of the plant of that undertaking was turned over to a contractor and the figure, which he might give as the cost of replacing the plant, used as the replacement cost. Replacement cost is the normal present cost. Prac- tically no large utility has ever been constructed whole- sale and such a method would be clearly abnormal. It is true that assumptions have been made as to a construc- tion period much shorter than the normal period of growth of most utilities, but the period chosen has not been one which necessarily required wholesale work. There should be nothing inconsistent in an assumption of piecemeal construction and such definite and reasonable periods of construction as have been suggested. Normal costs of construction work can be obtained from reports as to the cost of work performed under usual and customary conditions. It would be difficult and many inaccuracies would probably result if an attempt were made to develop costs on a wholesale method of reconstruction. There seems to be every reason in logic and equity for the adoption of costs based on piecemeal construction in a determination of the replacement cost of a plant. The Wisconsin Commission agree in this and say that, "In appraising utilities which have been constructed on this basis, the problem seems to be to find units of cost that repre- sent a fair average of these conditions. To find such units appears to be practicable. In fact, it would seem that the extra costs of piecemeal construction can be more readily and accurately taken into account in this manner than by an arbi- trary allowance of a lump sum to be added to a cost that has originally been computed upon the basis of continuous con- struction." l The two illustrations given above represent extreme cases. As a practical matter, for a very large portion of 1 Wis. R. R. Com. Rpts., Vol. 4, pp. 548-549. 32 PUBLIC UTILITIES most public service plants, the question of piecemeal or wholesale construction does not enter as an important consideration, for the reason that it is usual to construct portions of the plant on a scale sufficiently large to make the difference between piecemeal and wholesale construc- tion negligible. 27. Piecemeal construction. Effect of changes and enlargements on cost. The above reasoning relative to piecemeal construction must not be carried too far. The existing plant may be composed of units, buildings for example, which have been enlarged to 'meet the growing demands of the business; because the total cost to the undertaking of the original building, plus the costs of enlargement, was greater than what it would cost to replace it to-day in one operation, can be no reason for an increased replacement cost on the theory of piecemeal construction. It has been contended that it requires the greatest skill of the management and of the engineer to determine for what length of time in the future a plant such as that required for a public utility should be constructed. If a plant is constructed initially of a size which will meet the demands of the public many years in the future, it is necessary for the public in the intervening years to pay, in the way of rates, the charges upon a very large idle plant. On the other hand, if the plant is constructed of insufficient size it will have to be reconstructed or enlarged at frequent intervals at a much greater cost than would be the case if it were built of its " ultimate" size at one time. In other words, the engineer is obliged to balance the additional cost of what may be called piecemeal construction against the interest charges upon an idle plant. The question is, therefore, whether, in determining the replacement costs of a plant, these increased costs which REPLACEMENT COSTS OF PHYSICAL PROPERTY 33 have been wisely incurred by building the plant no more rapidly than was consistent with the greatest economy should be considered, or whether the replacement cost should be construed strictly as originally defined, that is, the sum which would have to be expended at the present time to replace a plant identical with one already in service: whether a company which has constructed its plant as the public required it, and has so timed the periods of its enlargement that the total expense to the company, and in consequence to the public, has been kept at a minimum, should be obliged to suffer by the use of unit costs of replacement built up on what may be called wholesale construction rather than by piecemeal con- struction of the plant. There can be but one answer to this question. The replacement cost must be figured upon the plant as it now exists. If a plant unit has cost more, because it has been enlarged, than it would cost to construct it anew as it now stands, such increased cost must be due in a large measure to a virtual rejection of some material and labor which formed a part of the original construc- tion. On this question the rulings of the courts are definite. The valuation must be based upon the plant as it is. 28. Pavement over construction. Portions of the plants of many public utilities are placed under the highways. In some instances the streets have been paved after the underground construction had been installed, or a cheaper grade of pavement has been replaced by a more expensive kind. In such cases the pavement may have cost the undertaking relatively nothing but, if the underground construction had to be replaced at the pres- ent time, there would be considerable expense involved in taking up and replacing the pavement. It has been contended quite generally that the cost of 34 PUBLIC UTILITIES paving not actually paid for by the undertaking at the time of the original construction should not be made a portion of the replacement cost. Such a contention if carried out is subversive of the fundamental principles of the development of replacement costs. The cost of replacing paving found over underground structures must be made a portion of the replacement cost. The original cost will show properly what it had actu- ally cost the undertaking to construct its underground system with or without pavement. The replacement cost is what it would cost to-day to construct a new plant similar to one in existence and similarly placed. If the underground system was found under paved streets, the replacement cost should include the cost of taking up and replacing the pavement of the particular kind found. The replacement cost may be made in this way higher than the fair present cost, or it may not; it remains for the courts to determine judicially what weight shall be given to these two sets of figures, " original cost" and " replacement cost," in view of all prevailing conditions. Because those preparing the figures to show what it would cost to build a new and similar plant feel that pavement not paid for should not be made a portion of the true present value seems an insufficient reason for presenting figures which do not represent the facts, the actual replace- ment cost. CHAPTER III DETERMINATION OF REPLACEMENT COST 29. Inventory. 30. Plant elements. 31. Costs. 32. Items included in unit costs. 33. Unit costs Costs of material. 34. Unit costs Costs of labor. 35. Unit costs Losses on tools and material. 36. Unit costs Insurance. 37. Overhead charges General consideration. 38. Overhead charges Interest during construction. General con- sideration. 39. Overhead charges Interest during construction. Mean weighted time. 40. Overhead charges Interest during construction. Rate of interest. 41. Overhead charges Engineering. 42. Overhead charges Organization expense. 43. Overhead charges Legal expense. 44. Overhead charges Contingencies. 45. Overhead charges Other possible costs. 46. Promotion costs. 47. Sale of securities. 48. Contractor's profit. 49. Overhead charges Method of application. 50. Real estate. 51. Cost of land affected by cost of hypothetical buildings. 52. Cost of buildings 29. Inventory. The replacement cost has been de- fined as the " amount of money which would have to be expended at the present time to bring into existence a property substantially identical with that of the under- taking being appraised." In order, therefore, to obtain the replacement cost of the physical property of an under- taking, a knowledge of two things must be obtained, - first, a knowledge of the several classes of property of which the plant is composed and of the number of units 36 PUBLIC UTILITIES of the same kind in use in each of these classes; second, a knowledge of the cost of each unit in its final position in the plant. The first of these requisites must be obtained from an inventory of the entire plant made by an actual inspec- tion and enumeration of each unit of every class found in service or held in reserve as useful for the public in furnishing and maintaining a uniform and uninterrupted service. The second must be obtained by a determination of all costs which would be incurred in obtaining similar units of each class and placing them where existing units are now found in the plant. The methods to be employed in making the inventory, the forms to be used and the system to be employed in handling these forms, both in the field and in the office, need not be described in the present study. 1 30. Plant elements. A plant element is a definite class of property : thus, iron wire, copper wire, road bed, bridges, poles, are each elements of a plant. But in the case of most large public utility plants, the number of different articles or other character of property is so great that an inventory showing them all would be too cumbersome to be capable of use. Thus, in an inven- tory of the property of a telephone or telegraph company, a cross-arm used upon a pole to support wires has upon it a number of pins upon which the line insulators are screwed, each pin is attached to the cross-arm by a nail, the cross-arm is very generally fastened to the pole by a bolt, and it is prevented from moving in a vertical plane by the use of cross-arm braces held in place by bolts and a drive screw. Each one of the articles above enumerated could be made a plant element and recorded by those making the inventory records in the field, upon the forms 1 See H. E. Riggs, Proc. Am. Soc. of Civil Eng., Vol. XXXVI, No. 9. DETERMINATION OF REPLACEMENT COST 37 prepared for their use. On the other hand, the cross- arm complete in place with all associated apparatus could be made the plant element and all cross-arms of standard form and supported in a standard manner recorded, thereby eliminating the vast amount of field and office work which would result if each piece of associated appa- ratus were made an element and had to be recorded individually. The limitation which must be made to grouping to- gether many articles into one plant element is dependent upon whether the several articles composing the unit are brought into use simultaneously and all pass out of use simultaneously when they have served their useful life. In the case cited of a cross-arm, when the cross- arm is placed upon a pole it is associated with all of the articles above enumerated. When a cross-arm has become unserviceable due to age, it is removed and destroyed and with it the pins and nails used to attach the pins to the cross-arm. If the cross-arm braces and pole bolts and other hardware used with them can be and usually are used again with a new cross-arm, then these articles of hardware must not be included with the cross-arm and pins in order to make a plant element. This distinction is needed in order that the depreciation of the plant can be more readily figured, and this clearly will be the case when the plant element has a definite life. The plant element is, therefore, an article or group of articles used in such close association in the plant that they are normally placed in service and removed from service together. 31. Costs. It has become the custom of appraisers, in assigning costs of reproduction to the plant elements, to divide the costs of such construction into two classes, unit costs and overhead charges. 38 PUBLIC UTILITIES The cost of each unit of the plant elements in its final position is known as the unit cost. The unit cost includes all expenses to which an undertaking would be put in pur- chasing the unit and placing it in its final position in the plant. It includes, however, only such expenses as can be definitely assigned to the units of the plant elements. There are many other expenses of a more general nature which cannot be assigned readily to an individual unit, but can be spread more accurately over the cost of the plant as a whole or over certain groups of plant elements. Expenses of this character are known as over- head charges and are applied usually in the form of per- centages of that portion of the replacement cost of the physical property, obtained by the application of unit costs to the respective number of units of all elements found in the plant. 32. Items included in unit costs. The entire plant is divided, in the manner above described, into plant elements, and the inventory when made shows the num- ber of units of each element found in service. The cost of each unit of the plant elements in its final position is known as the unit cost, and is composed not only of the cost of the material employed but of all other items of expense which are necessarily involved in the purchase of the articles of which it is composed, of getting them together, assem- bling and placing them in their final position. These are all costs which can be readily assigned to each article or plant unit and combined to form the unit cost. The several items of cost which may enter to form the unit cost are, First cost of article. Purchasing cost. Transportation from factory to storehouse. Storehouse cost, rent, light, heat and clerical work at storehouse. DETERMINATION OF REPLACEMENT COST 39 Inspection. Assembling or fitting. Transportation from storehouse to town where used. Distribution from train to work. Labor of men placing the element in position. Transportation of men and tools to work. Lost time of men during travel and wet weather. Losses on tools and material. Insurance, liability and fire. Some or all of the above items of expense are present in the unit cost of each element. They can all be deter- mined or properly apportioned without difficulty for each element. 33. Units Costs Costs of material. The first cost of the unit of an element has been fully discussed and decided to be the mean of the market prices which have prevailed during the assumed period of construction. The same ruling should hold as to the several elements of cost above enumerated. The costs of labor, freight and transportation during a period in the past equal to the assumed period of construction are usually equally obtainable and, by the use of such figures, a consistent and fair present cost of the unit can be obtained. 34. Unit costs Costs of labor. In the determina- tion of unit costs, as above explained, not only is the cost of the material included, but the labor and expense involved in getting the material to its position in the plant, setting it in place, and making it ready for service. The question arises as to what labor charges should be in- cluded in these unit costs. In the construction of a plant there is always incurred the expense of purchasing the material, getting it from the factory to the stores, ship- ping from the stores into the field, the cost of the labor of the superintendent of the plant, and all foremen and sub-foremen, the time and travel of the men engaged 40 PUBLIC UTILITIES upon the field work, and the shipment of tools and mate- rial required in placing the element. It would seem that it is proper and right to charge all legitimate expenses of construction as a portion of unit costs except such charges as were of such a general nature as cannot be assigned to the special job involved in placing the unit. In view of this, it has been customary to include in the unit costs the above items and the labor charges of the plant men only up to and including the foreman of the gang espe- cially engaged on the particular work involved. The superintendent of the plant and foreman are excluded, as their time usually is so spread among several lines of work that it is difficult, if not impossible, to make a proper separation and determination of the cost of their ser- vices on a particular job. 35. Unit costs Losses on tools and material. In the normal construction of a plant, tools must be used, and these tools wear out and must be replaced. This item is, therefore, a necessary and usual expense which must be included with the other costs in finding the replacement cost of a plant. Again, there is always a certain amount of false work, necessary in certain classes of construction, which will not be found by an inven- tory but is known as being necessarily incident to the construction. The same is true of a certain amount of material which is lost or broken during the process of construction. All such losses are usual, inevitable, well known and established for each class of construction work. The tools and forms, required in the construction and pla- cing of the several plant elements, differ so greatly that a figure can be obtained, to properly cover this item of expense, more accurately for an individual element than for the plant as a whole. The same general considera- tions are equally true for the expense arising from the DETERMINATION OF REPLACEMENT COST 41 loss of material bought but not found in the plant at the time of the inventory. Losses of this character can be assigned more accurately as a portion of unit costs, therefore, than as a general expense, difficult of allocation and, in consequence, made an overhead charge. 36. Unit costs Insurance. All authorities agree that the expenditures made during the period of con- struction for insurance against fire, for the fidelity of its employees, and against losses due to injury to its em- ployees or others, should form a portion of the capital expended in the construction of the plant. This item is intended to cover only the time during the actual con- struction work, or rather until such time as the new plant is turned over to the operating forces. Clearly this item of expense will be incurred to a greater or less degree depending upon the character of the element. It seems best, therefore, to include this cost as a portion of the unit costs rather than as an overhead charge. 37. Overhead charges General: consideration. Unit costs as above described include all items of cost which can be determined and definitely attributed to the purchase of each particular unit and of getting it into its final position in the plant. There are several other items of cost which are necessarily incident to con- struction work but are of such a general nature that they cannot be definitely assigned to individual units, although they are indisputably present hi the construction of the plant as a whole. An example of this is the general supervision of the construction work. The labor costs involved in placing units, as found for the unit costs and included in them, were those up to the gang foreman, that is to say the cost of labor of all those who actually were engaged in placing the units. But, there were over the gang foremen superintendents, local, district and 42 PUBLIC UTILITIES general, all of whom gave a portion of their time to the construction of the plant and, consequently, indirectly a portion to the placing of each unit. It is impossible to determine and assign what portion of their time and, consequently, what expense should be attributed to the placing of each unit. It is, however, a simple matter to find what relation their salaries and expenses, attribut- able to construction work for the period of construction, bore to the total cost of construction. Knowing this rela- tion, the cost of construction determined by means of the unit costs can be increased by a definite percentage to cover such overhead supervision. Charges of this character in the form of percentages are known as " overhead charges." Overhead charges have been recognized and used in practically all large inventories, but have been the sub- ject of much controversy and discussion due, in a large measure, to a lack of knowledge and proper apprecia- tion, on the part of those questioning such charges, of what factors were included in the unit costs and what were omitted from such costs and applied as portions of the overhead charges. In what was said relative to unit costs, the items of expense which are to be included have been defined. The overhead charges, now under discussion, should be determined in percentages of plant cost to include all such costs of construction as are of such a general nature that they cannot be allocated to any individual or particular piece of work. 38. Overhead charges Interest during construction. General consideration. In presenting this subject, the words of a recent decision bearing on this question will be quoted: "A plant "of large size " cannot be constructed instantly. It requires time to assemble the physical properties and still a greater length of time to put these units into place where they DETERMINATION OF REPLACEMENT COST 43 may be used to render service. During this period the cap- ital invested must of necessity be idle and no income can be derived therefrom. When the construction of the plant is completed, no willing seller, who is not forced to sell, would take for his plant the cost of the physical units and the cost of the labor in the construction, because the plant has cost him in addition thereto the use of the capital or a certain part thereof invested in the physical properties during the time of construction. A willing buyer could afford to pay and would pay more than the actual cost of labor and mate- rial, assuming that the plant has been economically constructed, because such cost would not represent the total expenditures the purchaser would have to make in order to construct the plant himself. In addition to such expenditures he would have to expend the earnings of his capital during the period of construction. No case has been cited, and in our inves- tigation we have found no case involving this question where a reasonable amount has not been considered and allowed for loss of interest during construction as part of the cost of con- struction." l The loss of interest during the construction period is dependent in each special case upon what the construc- tion period has been determined to be, following the line of reasoning described in the preceding chapter. In some cases the loss of interest would extend throughout a large portion of the construction period. In most cases, however, such portions of the plant as could be made productive most quickly would be built first and extensions to the plant made with the same thought in mind. Yet even when a plant is thus con- structed in a rational and businesslike manner, there must be much time which will elapse between the incep- tion of the undertaking and the completion of the first portion of the plant. The money required to build the plant must be in hand or available from the outset up to 1 Supreme Court State of Oklahoma Pioneer Tel. & Tel. Co. v. Wes- tenhaver et al. 118 Pac. 354 (1911). 44 PUBLIC UTILITIES that time when portions of the plant are completed, paid for and turned over to the operating forces. During this period there will be a loss of adequate return upon the capital brought together for the development of the undertaking. It is to be noted that for the usual case as above de- scribed, the period is not taken as the entire construction period but the time up to that when portions of the plant can be turned over to the operating forces. For each special case, therefore, a study must be made to deter- mine when, in the entire development period, definite portions of the plant can be completed. When a large property is created, some time is required to complete the organization, both of executive and of construction forces, to make engineering plans and spec- ifications, and to order and obtain the material required for the plant. Money must be expended for this work before actual construction is undertaken. It has become usual, however, in making valuations, to date the period of construction from the time of beginning actual work upon the physical plant and to care for the loss of interest upon expenditures prior to that time as portions of other overhead charges, such as " organization/' or " engineer- ing," and to figure the loss of interest during construc- tion only on the material and labor employed in actual construction work. Again, as a practical matter, the cost of labor and of much material is paid for as the work progresses. It is now usual to assume that work of building a plant pro- gresses fairly uniformly during the construction period, so that the mean time during which the interest upon the capital expended will be lost, will be one-half of the construction period. Relative to this matter the Wisconsin Commission has said: DETERMINATION OF REPLACEMENT COST 45 "That interest " during construction . . . "is a proper item of value, is indisputable. Where the plant construction is financed by borrowing, the use of such money must be paid for in the form of interest. Where the corporation finances itself and no money is borrowed, an interest charge is neverthe- less incurred, for the money thus occupied during construc- tion is entitled to current interest for the period so engaged. The amount to be allowed for the purpose of valuation, from a theoretical standpoint at least, should be at the current rate for money from the time when financing must be arranged, directly preceding the beginning of construction, until the com- pletion of the plant. It is not difficult to conceive of condi- tions under which the interest, as so computed, would be a very large item, since organization and franchise expenses and land purchases may be long in advance of actual construction. Actual practice, however, shows that this course of financing is not generally adhered to. Since not all of the money used for construction is required during the entire period in ques- tion, it follows that the borrowing is more in the nature of fre- quent short time loans, taken out as the construction progress requires. If all the money is borrowed at once, proper econ- omy would require the re-investment of such portion as is not needed, and the interest thus earned operate to reduce the net charge on account of the loan." 1 The principles above outlined seem to have been fol- lowed in most large appraisals made in the United States. It appea'rs to have been assumed that work done in one year can be completed in most cases during that year, that financing will be made sufficient only to defray the cost of the work of that year and that money will be obtained at the legal rate of interest, 6 per cent. These assumptions have led to an extended use of 3 per cent as the figure to be assigned as the loss of interest during construction. Such a figure, based on the above assump- tions, may be a rough approximation in most cases to a proper percentage to be used for this overhead charge. Its adoption would certainly tend toward the uniform- 1 Wis. R. R. Com. Rpts., Vol. 5, p. 917. 46 PUBLIC UTILITIES ity in valuations which is so desirable. But it must be definitely recognized that a general figure, like the above, cannot be adopted for all cases without the certainty of injustice, due to the inaccuracy which may result in the valuation of the properties of many large undertakings. Nor would such inaccuracies be theoretical, but intensely practical. The question of interest during construction, which is admitted by all authorities as a proper charge to the construction cost of a plant both when originally built or theoretically replaced, is of fundamental impor- tance as it is connected intimately with the further prob- lem, yet to be solved, as to how the quickening factor, that which will transform the value of a "dead plant" into a "live one," is to be found. 39. Overhead charges Interest during construction. Mean weighted time. There are two considerations involved in a determination of the "loss of interest during construction" : first, what will be the mean time, weighted by the amounts expended, during which portions of the plant will be under construction and before they can be turned over to the operating forces to furnish service to the public; and second, at what rate of interest should it be figured that this idle money was costing the undertaking. The average time occupied in completing portions of the plant must be found by a special study of each par- ticular case in detail. If the case is the replacement of a large telephone property, land will have to be purchased, buildings and switchboards constructed, and outside plant built, before a single subscriber can be given ser- vice, that is to say, before those plant elements can be turned over to the operating departments. Clearly, therefore, at the outset and for portions of the plant con- structed later, the period of construction will be more than one year. The mean time of construction can be found only by an engineering study of the amounts of DETERMINATION OF REPLACEMENT COST 47 money to be expended each year for the several classes of plant and of the dates when the money thus expended can be considered as a part of the cost of the operating plant. Such a study may be somewhat laborious but it is a simple and usual engineering problem and one which can be solved without the probability of reasonable con- tention. Knowing the amounts expended and the time such sums are invested in an idle plant, it is a simple mat- ter to determine the weighted mean time during which there is a loss of interest. 40. Overhead charges Interest during construction. Rate of interest. The question of the proper rate of interest to be charged upon such idle plant during con- struction is more difficult of determination, as there are a number of economic problems to be solved if an attempt is made to answer this question by a detailed analysis. It will be found best to follow the usual custom and use the rate of interest which the undertaking would have to pay for the money required to build the plant on the supposition that the money required for the plant was raised by the sale of bonds. Clearly no definite rate can be established which will cover all cases, as the interest which must be paid will depend upon the location of the enterprise and the hazard or risk involved. In such rate must be included, "the legitimate charges of marketing the securities, not includ- ing, however, any discount on those securities, except so much as may be the legitimate commission to the bankers for the expense of marketing." 1 In determining what interest should be used for the replacement cost, the assumption must be made that a new undertaking is about to construct the hypothetical replacing plant. 1 Massachusetts Validation Commission Rpt., Feb. 15, 1911. 48 PUBLIC UTILITIES "The rate must not be that upon which an existing and success- ful corporation could borrow, as the credit rather than the actual hazard would be reflected in this rate; neither should the rate at which the company has borrowed money be con- trolling, though it may be confirmatory evidence. The cus- tomary rate of interest prevailing upon loans of equal security or hazard should govern." 1 The Wisconsin Commission has used quite generally a rate of 6 per cent per annum for cases that have come within its jurisdiction. A recent decision in Minnesota is: "Interest on the cost of reproduction of railway property at 4 per cent per annum during one-half the time requisite to acquire and construct it is a necessary expense of reproduction and may be lawfully allowed as such." 2 It may be contended by the public that an interest rate determined in this manner is too high for the reason that, if the undertaking had its funds in hand at the initiation of the enterprise, it could have invested such funds in such a way that they could be drawing interest, possibly at a lower rate, and at the same time be avail- able to pay for the plant as the work progressed. This could be done if the funds were placed in the bank or, if they were placed as short time loans, an even higher rate of interest might be received. On the other hand it may be contended by the under- taking that such a rate of interest as six per cent was too low; that the use of the word " interest" in this con- nection was misleading. Interest is the market rate for money under the special conditions prevailing. The undertaking is seeking a proper and ample " return," " interest" plus a " profit." The investor has placed his money in the undertaking with the expectation of a 1 Paraphrase "Water- Works Valuations, in the Light of Maine Su- preme Court Decisions," Leonard Metcalf, Trans. Am. Soc. C. E., Vol. 44. J Shepard v. Northern Pacific R. R. Co., 184 Fed. 765. DETERMINATION OF REPLACEMENT COST 49 return greater than the interest which might be obtained from the banks or from call loans. This difference be- tween the expected return and the interest that can be obtained at current rates is the profit, to which he is justly and legally entitled, due to the risk incurred in the opera- tion of the undertaking. Clearly the rate of return to which he is entitled is lost during the construction period. This loss cannot be avoided, and is as much a portion of the cost of the construction of the plant as the material and labor which is employed in building the plant. While there is ample ground upon which an undertaking can claim its right to a return over and above usual rates of interest, it must be remembered that the question now at issue is the valuation of the property on the basis of what it would cost to construct it at the present time with- out regard to the method in which the funds were obtained originally or to the return which is to be expected from the operation of the plant after it has been constructed. The question now at issue is simply to find the replace- ment cost of the physical plant and to include in such costs only such items as will be found again when the ele- ments become worn out and have to be renewed. The adoption of the current rate of interest removes all doubts or contentions. 41. Overhead charges Engineering. Another ex- pense of a general nature in the construction of the plant of an undertaking is that of the engineer and of his assist- ants. This expense has been recognized in all appraisals and has been figured, in every case, as an overhead charge. Most of the work of the engineering force is of per- manent value to the undertaking and is essential to the greatest economy and efficiency in the construction and operation of the plant. Among the expenses attributable 50 PUBLIC UTILITIES to engineering must be included the cost of the preliminary engineering necessary to present to the public at the ini- tiation of the enterprise the possibility of its success, that a plant can be constructed, what its probable cost would be, as well as what returns from the investment might be expected in successive years after its completion. Capital cannot be interested in an undertaking until such knowledge has been obtained, nor can the final and detailed plans upon which the actual construction work is to proceed be formed until preliminary and, in many cases, comprehensive plans have been made to determine upon what lines the most economical development of the plant can be made. Where such comprehensive preliminary or fundamental plans have been made, they are a legitimate portion of the cost of the development of the undertaking and, in consequence, should be included as a portion of the replacement cost. In addition to this there is the expense of the engineer and his staff in making fundamental plans which are of such a character as will permit of the construction of the plant as a whole upon well considered lines of development so that the least money will be expended consistent with service most satisfactory to the public. The engineer also makes plans and specifications showing the types of construction to be used for each plant element as well as the materials that are to be purchased and used. He also makes special detailed plans for any large new addi- tion to the plant. All of this work is of a permanent char- acter and becomes part of the property of the company which is of distinct value. Such plans and specifications may become old, out of date and possibly nominally obsolete, but actually they are never obsolete as they are fundamental in their character and upon them are based the changes which time may show as desirable. DETERMINATION OF REPLACEMENT COST 51 42. Overhead charges Organization expense. This item is a legitimate and natural overhead charge. It should be designed to cover all expenses to which the officers of the organization would be put in bringing together the men and material necessary for the creation of the undertaking and its property, as well as to cover the cost of the oversight, necessary on the part of the higher officials of the undertaking, of the actual construc- tion of the plant. It is to be remembered that in defining unit costs, the cost of labor was made to include the time and expenses of those actually engaged upon the work, thus carrying the charges up to and including the sub-foreman of the gang doing a specific piece of work. This method of figuring unit costs was adopted for the reason that, as these men are engaged upon one piece of work at a time, it is a perfectly simple matter to determine the costs of their work with accuracy. But officials of the company ranking above the sub-foreman are obliged to spend a certain portion of their time not only in supervising the actual work done in construction but, preliminary to the construction work, in planning the character of the plant to be built and the position which it must occupy. More- over, time must be spent in bringing together the con- struction force, in a general supervision of the plans of the engineer, of the purchase of material, land and build- ings and other administrative work always incident to the construction of a large plant. All of this work, to- gether with the office expenses incurred in carrying it out, must be included in this overhead charge. In addition to this cost of general supervision, an under- taking must incur, at its initiation, expense in bringing together its working forces, interesting capital and obtain- ing loans, charters and franchises. It is not intended to include under this item other amounts than those paid 52 PUBLIC UTILITIES as salaries and office expenses to those actually in the employ of the undertaking. Costs of franchise and other similar expenses will be considered later. A determina- tion of costs properly to be included in this item must rest upon the experience and judgment of those making the appraisal. It must be determined by a consideration of the conditions presented by the special case under investigation. 43. Overhead charges Legal expense. In most large appraisals, legal expenses have been cared for as a special overhead charge. In such expenses should be included the cost of the legal advice necessary at the time of the formation of the enterprise, and other legal expenses, such as inevitably arise in obtaining the charter of the undertaking, the franchise under which it is to operate, in drafting the by-laws, and in approving the forms to be used in the operation of the undertaking. Unquestionably no property, of the size and nature of that' under consideration, could be brought together, plant constructed and the company placed in an operat- ing condition, without incurring considerable expense of this character. It is a question, however, whether this overhead charge could not be omitted and the legal expenses of the undertaking included as a portion of the cost of the organization. This question is purely academic and of no special importance. The expenses for legal services are necessarily incident to the replacement of the property of the undertaking and, in consequence, must be included properly in figures derived to show replacement cost. It is simply a matter of form whether these expenses are made a special overhead charge or are included with the costs of organization. 44. Overhead charges Contingencies. A fifth overhead charge, known as " contingencies," has been used in most large appraisals. This item is intended to DETERMINATION OF REPLACEMENT COST 53 cover expenses usually encountered in the construction of a large property, which cannot be recognized in an appraisal. In many valuations this item seems to have been made omnibus in character to include not only unusual costs in the construction of the plant but omis- sions of the appraiser in his work in making the inventory. The proper weight to be given to this item will depend very greatly upon how much care has been exercised in making the inventory and upon how far the items above considered as a portion of unit costs have been included actually as a portion of such costs. Thus, losses on tools and materials as well as casualty insurance may have been considered by many appraisers as a portion of the charge for contingencies and, in consequence, the per- centage to be added for contingencies would have to be higher, naturally, than if such items had been carefully determined and made a portion of the unit costs, as un- questionably they should have been. Many large appraisals have been made in a very lim- ited time and, in consequence, without the possibility of such careful work either in the field or in the determina- tion of unit costs in the office as is to be desired. In such cases this item may be accepted as one of fairly large proportions. On the other hand, a valuation, to justify the large cost which is entailed in its preparation, should be made with such care that no question can be raised as to its accuracy, and the inventory and unit costs should be of such a character that the allowance of a large per- centage to cover omissions, under the head of " contin- gencies," should not be required. This overhead charge is not of the same character as the others already described but is one that has been established definitely by precedent. 45. Overhead charges. Other possible costs. In what has been said in the preceding sections, there have 54 PUBLIC UTILITIES been established four classes of general expense incident to the construction of most public utility properties, interest during construction, engineering, organization and legal. A fifth charge of this character has been dis- cussed, contingencies, which has been almost universally regarded as a necessary item to be included in the fig- ures to be presented by the appraisers to show the cost of reproduction of a property. There are numerous other possible items which experts and appraisers have claimed should be figured as a portion of the cost of reproduction. A few of the more important of these items will be dis- cussed as briefly as possible. In deciding what items of cost can be included properly in an appraisal, it is necessary to keep definitely in mind the fact that a determination of the replacement cost, through the medium of a valuation, has not for its object a determination of what it had cost the undertaking to construct its property, that figure is the original cost, possibly an entirely different figure, but rather, what it would cost to reproduce the property, plant and busi- ness at the time of the appraisal. Most of the addi- tional items, for which recognition is demanded, may be properly a portion of the original cost but should not be considered as forming a part of the reproduction cost. 46. Promotion costs. This item of cost must be dis- tinguished from "cost of organization," which item was considered in 42. Organization cost includes the sal- aries and legitimate expenses of those initiating a new undertaking. The salaries paid to these officials should be sufficient to reward them for their originality and skill in developing and forming a new enterprise. Organ- ization cost has been allowed and should be given as lib- eral an estimate as the conditions of each particular case seem to justify. Promotion cost, as used here, has a somewhat different DETERMINATION OF REPLACEMENT COST 55 significance. It is the reward to the promoter, the man who initiated the undertaking with the expectation of a return greater than that which would be paid him in the form of a salary, or than the usual return upon money invested in better established or less hazardous enter- prises. It must be definitely recognized that the cost of pro- motion is a very practical matter and that, without the expectation of such reward and the right to receive it in case of the success of the enterprise, it would be impos- sible to obtain the required funds or men of sufficient ability or skill to undertake such work. But the present question is whether such reward can be made properly a portion of the replacement cost of the plant. Looking at this question from the practical side, it is customary in a large majority of the cases of the initia- tion of new enterprises to give to the promoters and to those providing the funds shares of common stock as a bonus or reward. In such cases, the common stock rep- resents no money actually invested in the plant but enables the holders of such stock to participate in any surplus earnings over and above fixed charges and a reasonable return upon the preferred stock. The propri- ety of this method of financing need not be discussed. The method is a usual one and indicates the fact that there is nothing in the transaction affecting the replace- ment cost of the property, except in so far as the receipt of the common shares may decrease the losses which might obtain in the sale of securities, as those buying bonds or stock, with which a block of common stock is associated, might be willing to pay a higher price than for a bond without the speculative features presented by the com- mon stock. It would seem, therefore, that, as no money is usually directly paid for the promotion of the undertaking, there 56 PUBLIC UTILITIES was no reason whatever for including this factor as an element tending to enhance the replacement cost of the property. The above line of reasoning may appear to be contrary to some of the decisions of state commissions on this subject. But a careful reading of all the cases where this subject is discussed seems to show that what these decisions call " promoter's profit" or "cost of promotion" is more nearly covered by the overhead charge of cost of organization. 47. Sale of securities. This item is intended to in- clude the discounts or losses which an undertaking might incur in order to sell its stocks or bonds, together with such expenses as may be incurred by underwriting an issue of the securities of an undertaking to insure the disposition of its securities. In considering this item it is again necessary to call attention to the fact that it is the replacement cost of the plant as of the present time that is to be determined. It is not what the capitalization of an enterprise should have been to have constructed the plant but what amount of money would have to be spent at the time of the appraisal to rebuild it. It is probable that money could not be raised sufficient to construct the supposititious new plant except by an offer of securities below par. But such a discount is equivalent to a higher rate of interest, and this interest enters into the replacement cost only during the con- struction period. As has been already stated the rate upon which interest during construction must be based is that which would have to be paid for money for the replacing plant, such a rate including any losses which occur in the sale of securities. It will be seen, therefore, that losses in the sale of secu- rities are already fully cared for under the head of interest DETERMINATION OF REPLACEMENT COST 57 during construction and that to include such an item as a specific portion of the replacement cost would be a duplication. 48. Contractor's profit. Discussion as to the treat- ment of contractor's profits has appeared in two forms; first, as to whether the overhead charges considered above would hold in case a portion or the whole of a plant had been built by a contractor rather than by the undertak- ing; and the second, as to whether, if the plant had been built by the undertaking it would not be entitled to the profit, so called, which is usually paid to a contractor for his work. The answers to both of these questions is apparent. The answer to the first is that the unit costs and over- head charges, above derived, are representative of what it would cost an undertaking to acquire a property identical with that already in existence. Whether the existing plant was constructed by a contractor or not is imma- terial. And second, replacement cost is the sum of money which would have to be expended to replace the existing plant and is based upon fair present costs of labor and material. The contractor's profit, so called, is really not a profit, if the fair market prices of labor and material are used, but a sum sufficient to reimburse the contractor for his own time and skill and for the expenses which he has incurred in building up an organization capable of carrying out the work, in acquiring the tools needed in the work, in caring for the contingencies inherent in the work and obtaining the credit or means required to meet the expenses incurred between payments for his work. All of these items are properly and fairly cared for in the unit costs obtained as above described and by the over- head charges. 49. Overhead charges. Method of application. It will be assumed, in the discussion contained in this sec- 58 PUBLIC UTILITIES tion, that definite percentages have been obtained to cover with accuracy the five items of cost which have been described above as properly represented by over- head charges. It is important that these percentages should be applied to the costs of the several plant ele- ments as obtained by multiplying the number of units of each element found in the plant by the unit costs, in such a way as to obtain properly the replacement cost. Before studying this question in detail, a general con- sideration is necessary as to whether one or all of these overhead charges should be presented as independent items in the valuation, or should be added directly to the cost of the elements as derived by the use of unit costs so as to make one cost for each of the elements. Thus, if the replacement cost of an element is found to be $100,000.00, using unit costs alone, and one of the over- head charges, let us say engineering, is found to be ten per cent of such cost, the question is whether the replace- ment cost of the element shall be presented as $110,000.00 or as $100,000.00. In the latter case it would be neces- sary to make engineering a special item of the inventory and, as far as this item alone is concerned in such a case as is cited, given a value of $10,000. The necessity for this consideration is twofold; first, as affecting the question of depreciation; and second, as to whether the application of the percentages for over- head charges shall be compounded. Relative to the first of these considerations, it must be appreciated that, after the replacement cost has been found, it will be necessary to find another figure to show by how much the value of each element has been reduced by the time that each element has been, on the average, in service. This depreciation value is obtained from figures based upon the replacement cost of the element and upon the relation of the years of service to the years DETERMINATION OF REPLACEMENT COST 59 of probable usefulness of the element. If the amounts represented by the overhead charges are made a portion of the replacement cost of the element, then the expenses, which they represent, are made to depreciate with the element. If they are made separate items, then they can be cared for in any manner that seems proper, independ- ently of the elements to which they may be applied. This question might be made the subject of an extended discussion, particularly with regard to one or more of the overhead charges. No attempt will be made to present the various arguments which may be made as to what method should be employed. 1 It will be stated, more or less arbitrarily, that each overhead charge should be pre- sented as an individual item exactly as if it were in itself an independent element of the plant. Thus, organiza- tion, engineering, and iegal expenses, although obtained by an application of percentages to the costs of certain elements, will not be made a portion of the cost of those elements, but the sum of the amounts, derived by the application of these percentages to the several elements affected, will be presented as a definite sum for engineer- ing, another for organization, and others for the other overhead charges. Clearly, such a method of valua- tion will not affect, in any way, the total replacement cost, but it will affect the replacement cost, as presented, of the individual elements. This method is unquestionably proper for the reason that, although the expenses incurred under the heads of engineering, and organization, may include a certain amount of supervision which will have to be reincurred when the plant is replaced, still the cost of the super- vision that will have to be reincurred is relatively so small as to be entirely negligible. It is difficult to see how legal expense will be reincurred when units become 1 See In re Met. St. Ry. Co. N. Y. P. S. C., 1st Dist., Vol. Ill, p. 155. 60 PUBLIC UTILITIES worn out and have to be replaced. The item of contin- gencies is of such a doubtful character that it had best be segregated, if it is used at all. At first sight it would seem that interest during construction was an item of expense that would have to be reincurred and, in conse- quence, that it should be made a part of the cost of each element and, consequently, depreciated with it. But a consideration of the practical conditions existing at the time of renewal shows that but an extremely small por- tion, so small as to be practically negligible, of the orig- inal charge for interest during construction will have to be reincurred. Interest during construction is the loss of return on money tied up in plant under construction and, in consequence, not earning. In most cases, at the time of replacement, the plant is earning, and even the material required to replace that no longer serviceable forms a part of the working capital and, consequently, can be figured as a portion of the assets upon which a return can be obtained. From general considerations and for the reasons above briefly stated, it would seem best to include the amounts derived through overhead charges as individual elements of plant costs. Relative to the second consideration as to whether overhead charges should be applied in such a way as to be compounded, it must be admitted that there has been such a wide variation in the methods employed in large valuations made in the past as to have established no definite precedent. Theoretically, engineering should be made an inde- pendent item and included with the others to which the percentage representative of loss of interest during con- struction should be applied. This seems logical when it is remembered that most, if not all, engineering expense is incurred prior to the completion of the construction DETERMINATION OF REPLACEMENT COST 61 work and, in consequence, the interest on the money required for such engineering is lost during the construc- tion period. This practice has been followed in many of the largest appraisals. It is difficult to see why interest during construction should not be applied to organization and legal expenses, following the same line of reasoning, but there is sub- stantially no precedent for such a practice. 50. Real estate. The valuation of land is one of the most difficult elements of an appraisal, due to the fact that the value of such property is looked at ordina- rily from many points of view. A real estate investor or speculator may give land one value, whereas bank officers or others lending money upon real estate are naturally inclined to place the value of the property at a consider- ably lower figure. What is required for the replacement cost is the fair market value of the land at the time of the appraisal, or in other words such a sum of money as would be paid by a willing buyer to a willing seller. Fair values for real estate can be given by the engi- neers making the appraisal of the physical property of undertakings in but few cases. The engineers must depend largely upon the personal opinions of men familiar with the prices paid for similar property in that local- ity, upon whose judgment as to local values reliance can be placed. The appraiser must establish what, in his opinion, the proper value should be, after properly weighing all the evidence and figures obtained from local real estate experts. In presenting the final figure as to the value of the property, the engineer will find it best, in most cases, to present the figures obtained from the real estate experts, giving his own reasons for adopting the final figure. Frequently it will be of advantage, simply as corroborative evidence, to obtain the prices paid in recent sales for surrounding or similarly situated land and 62 PUBLIC UTILITIES determine the ratio which such sales bear to the assessed valuation. Such a ratio applied to the assessed value of the land in question would throw some light upon the correctness of the value obtained for the appraisal. The value of land determined by comparison with current sales of similarly situated real estate and by the best expert opinion will give as good figures as probably can be obtained for most cases where the uses to which the land is put may not result in a change in its value. Thus land used by telephone companies is developed usually by the construction of buildings conforming in outward appearance to the character of those in the vicinity, nor are there any special features introduced by its use to influence the value of surrounding property more than would be caused by the construction of a similar high grade building for business or residential purposes. For the land used by railroads as a right-of-way or for terminals, the conditions are very different. The right- of-way, being a relatively narrow and continuous strip of land, frequently cuts up the property of an owner so as to seriously damage that which is not sold : it makes access in some cases from one part of the remaining prop- erty to the other more difficult, and in most cases it is claimed that the railroad itself tends to damage the prop- erty contiguous to the railroad. Whether or not all of these reasons should hold as good against the general enhancement in the value of land due to the increased ease of communication incident to the operation of the railroad and the encouragement thereby afforded to the construction of manufacturing establishments or for the disposal in more distant markets of the products of the farms, the fact remains that the railroads have had to pay more for the land which they occupy than is usually paid for land similarly situated and used for farming, residence, or business purposes. DETERMINATION OF REPLACEMENT COST 63 In view of these facts, it has been the custom, in the appraisal of railway property to determine with the greatest care based upon as many individual cases" as possible for land in thickly settled, sparsely settled and in farming or wild country, the ratio of the prices paid by railroads for their land to the fair present usual prices as given by real estate experts after the manner of valuation described above. Their figures, based on current prices for ordinary sales, have been raised by the ratios properly applicable to the land under appraisal. In many cases, particularly in appraisals of the lands forming the right-of-way and terminals of railroads, it may be found best to eliminate expert opinion and derive the present value entirely from the records of the prices paid by railroads for land as compared with those paid by others for contiguous or similarly situated property. The difficulty in obtaining satisfactory expert opinion is that such personal judgment is influenced almost in vari- ably by the present uses of the property. Theoretically, the value that is desired is what the fundamental fair market value is without any regard whatever as to the purposes for which the land is to be used. If the value of land is increased by the ratio of such price to the mean advanced price which railroads usually have to pay for their land, and if this value is advanced still further as a portion of the entire property of the company, when recognition is made of the value inherent in the property as a whole as a "live" operat- ing entity, and, still further, by the percentages repre- sentative of overhead charges, such as engineering, legal and contingencies, it is apparent that the value of land will become abnormally inflated. Manifestly it is unfair to base the fundamental value of the land upon the estimates of men who cannot but be influenced by its use for a par- 64 PUBLIC UTILITIES ticular purpose. Such a method would be somewhat analogous to enhancing the replacement cost by the presence of the plant being replaced, which, as has just been shown, is inequitable. A somewhat similar question enters in the valuation of the land occupied by a telephone central office building. Such a building must be at the centre of distribution of all lines radiating from the central office. In the cases of large offices, the difference in the first cost of plant at the centre and one fifty or one hundred feet away would amount to many thousands of dollars. A telephone company in acquiring the land originally would be justified in paying more for land at the centre of distribution of its system of wires than the usual or current market value of similar property, and in many cases it may have paid such enhanced price. But in making the appraisal, such special value due to strategic position cannot be made a portion of the replacement cost. The advantages or disadvantages of location are properly cared for by considerations of the value inherent in the live property. In addition to the value of the land, the expenses usually incurred in buying the land, in abstracting titles, recording the deeds and other similar expenses should be added. 61. Cost of land affected by cost of hypothetical build- ings. Further, it is usually difficult, if not impossible, to acquire land properly situated, upon which there is not already a building of a kind unsuited to the purposes of the undertaking. The undertaking, when it acquired the land originally, had to purchase the buildings found upon it and to incur some expense in their removal. Thus the original cost of the land included not only the land itself but the buildings found upon it and with such cost should have been included the amount paid for their removal. In determining the replacement cost, it is not DETERMINATION OF REPLACEMENT COST 65 proper to assume that the figures, obtained from experts to show the market value of the naked land at the pres- ent time, show the entire present value of the land. Nor would it be proper to add to such value what had been paid originally for the buildings found upon the land and for removing the buildings. The entire character of the buildings in that locality may have changed between the time of the original purchase and the time of the appraisal. The replacement cost being what it would cost at the present time to build a similar plant must be based, in this instance, upon what it would cost for the land encumbered by such a building as would in all prob- ability have been found upon the land at the present time, if it had not been utilized by the undertaking. The determination of such a figure is not a difficult matter in most cases. It must not be based necessarily upon what it would cost to purchase and remove the existing structure nor must it be based upon the cost of such a structure as would be likely to be built upon land similarly situated at the present time. The best method to pur- sue is to determine the mean cost of buildings in that locality, that is to say, within the same or adjacent blocks, and use this mean figure, plus the probable cost of their removal, as the sum which must be added to the cost of the land as previously determined, in order to show what it would cost at the present time to acquire the land needed for a utility of the character of that under appraisal, i.e., the replacement cost of the land. It should be noted that the above method cannot be rigidly followed in all valuations, but must be modified to meet the special conditions presented by each special case. The method above outlined could be followed safely in the case of most telephone buildings, as the econ- omies produced in the operation of a large telephone system demand that the central office building shall be 66 PUBLIC UTILITIES situated at a point as nearly at the centre of distribution of its system of wires as possible. Moreover, the sav- ing to the telephone company would be, in most cases, of such an order as would exceed the assumed cost of buildings which might have been found upon that site, or at least be commensurate with such cost. Conditions will be found, however, in the valuation of public util- ities wherein a rigid adherence to such a method would lead to absurdities. Thus, a gas plant may still exist upon a site which has become surrounded with buildings of the highest grade. Every condition of the business may indicate that it would have been wiser to have util- ized land situated elsewhere. The value of the naked land will be its fair market value, but it would be mani- festly absurd to contend that such a value should be increased still further by the cost of assumed high grade buildings which might be found upon the land, and would have to be destroyed to make way for the gas plant. Probably the best possible illustration of such an extreme case is found in a recent case before a Public Service Commission. The Metropolitan Company (a street railway company) owned a whole block upon which it had built a one-story car barn employed in large part for the storage of cars not in use. This property was surrounded by land which had been greatly improved by the erection of large and valuable buildings. The Com- pany, following the principles of valuation above enun- ciated, claimed that the value of the naked land should be enhanced by the value of such higher grade buildings as would probably have been found upon the land if the same property, as now existed, had to be replaced to-day. In answer to this claim, the Commission said, "If this theory be sound, then when the block comes to be entirely surrounded with buildings of fifteen or twenty stories (that is the tendency in that district), the capitalizable DETERMINATION OF REPLACEMENT COST 67 value of that land will be not only the fair market value of the land itself, but that value plus the cost of these ten, fifteen or twenty story buildings, upon the assump- tion that ' such buildings would be cleared off.' . . . The Commission does not accept any such theory as proper or as affording the basis for determining the reasonable value of the land, and no precedents or court decisions have been cited to support it. ... Even from the standpoint of a new company which would undertake to reproduce a system like the Metropolitan, it is incon- ceivable that a thrifty company would recommend the purchase of a whole block and the removal of fine, expen- sive buildings in order that it may be used in large part to store cars not in use." l It may be contended that, as the prices of land have increased in most places in the United States very greatly, the cost of land as determined by the method described above will not bear any relation to its original cost, particularly if the cost of the naked land is enhanced by the cost of buildings, possibly of a high grade of construc- tion, which may be characteristic of the development of real estate in that locality. This argument was presented in the report of the Rail- road Commission of Minnesota, wherein it was said: "Another important work in connection with valuing the properties, to be undertaken by the Commission, is to establish the original cost of the lands to the railway companies. It must be apparent to all that if the constantly increasing value of railroad properties is to be taken as the basis for computing proper returns, without regard to the original cost of the same, it is only a matter of time when transportation companies will, by absorption, own a disproportionate share of the wealth of the country." 2 1 In re Metropolitan St. Ry. Co., N. Y. P. S. C. Rpts., 1st Dist., Vol. Ill, p. 139. (1912). 2 Report Railroad Commission of Minnesota, 1908. Supplement, p. v. 68 PUBLIC UTILITIES It is true that there may be a great enhancement in value in some cases but, because this higher value is made a part of the replacement cost, it does not mean that this is the figure which is to be used ultimately as the true present value of the plant. The court will be furnished with the original cost and the undertaking is entitled to the normal increment which has arisen from the increas- ing values such as have just been discussed " within reason." The replacement cost must represent what it would actually cost the undertaking or the public to-day to acquire this same land, if it had to do so at the present time, and this replacement cost is the figure to be pre- sented to the court for what, in the opinion of the court, it may be worth as evidence toward the final true present value. 52. Cost of buildings. The value of buildings should be determined by experts familiar with costs of construct- ing similar buildings in that locality and should be de- termined by an inspection and detailed inventory and appraisal of all the material and labor which would be required to construct a new building identical with that in existence. CHAPTER IV VALUE AS GOING CONCERN 53. Value inherent in an operating plant. 54. Value of plant in use dependent upon purpose of appraisal. 55. Fundamental conception of value inherent in "live plant." 56. Capitalization of present net earnings. 57. Capitalization of present and anticipated net earnings. 58. Value not dependent upon cost alone. 59. Capitalization of profits. 60. Analytical methods of determining value inherent in a live plant. 61. Wisconsin method. 62. Reproduction of net earnings method. 63. Doubt as to inclusion of going value in rate cases. 64. General consideration of value inherent in a live plant. 65. Practical usefulness of methods of determining value in live plant. 53. Value inherent in an operating plant. The replacement cost, as derived by the methods which have just been described, shows simply the cost of the physical plant new as of the present time, that is to say, the pres- ent cost of reproducing the "bare bones" of the plant. That the value of the property of an undertaking is greater than this has become generally recognized, as was shown by the decision of Judge Lurton already quoted. There have been many decisions of the same tenor, a few of the more important of which will be quoted : Mr. Justice Brewer said: "The original cost of the construction cannot control, for ' original cost' and ' present value ' are not equivalent terms. Nor would the mere cost of reproducing the waterworks plant be a fair test, because that does not take into account the value which flows from the established connections between the pipes and the buildings of the city. It is obvious that the mere cost of purchasing the land, constructing the buildings, putting in the machinery, and laying the pipes in the streets in other 70 PUBLIC UTILITIES words, the cost of reproduction does not give the value of the property as it is to-day. A completed system of water- works, such as the company has, without a single connection between the pipes in the streets and the buildings of the city, would be a property of much less value than that system con- nected, as it is, with so many buildings, and earning, in con- sequence thereof, the money which it does earn. The fact that it is a system in operation, not only with a capacity to supply the city, but actually supplying many buildings in the city, not only with a capacity to earn, but actually earning, makes it true that ' the fair and equitable value ' is something in excess of the cost of reproduction. . . . The city, by this purchase, steps into possession of a waterworks plant, not merely a completed system for bringing water to the city, and distributing it through pipes placed in the streets, but a system already earning a large income by virtue of having secured connections between the pipes in the streets and a multitude of private buildings. It steps into pos- session of a property which not only has the ability to earn, but is in fact earning. It should pay therefor not merely the value of a system which might be made to earn, but that of a system which does earn." 1 "It is plain that the real, commercial, market value of the property of the water company is, or may be, in fact, greater than 'the cost of duplication, less depreciation, of the differ- ent features of the physical plant.' Take, for example, a manufacturing plant : Suppose a manufacturing plant has been established for some ten years and is doing a good business and is sold as a going concern; it will sell for more on the market than a similar plant reproduced physically would sell for immediately on its completion, before it had acquired any business." 2 "The defendants, in request 9, ask that in determining the amount to be added to structure value, in consideration of the fact that the system is a going concern, the appraisers should consider, among other things, the present efficiency of the sys- tem, the length of time necessary to construct the same de novo, the time and cost needed after construction to develop such new system to the level of the present one in respect to 1 National Water Works Co. v. Kansas City, 62 Fed. 865 (1894). 8 Gloucester Water Supply Co. v. City of Gloucester, 179 Mass. 382 (1901) . VALUE AS GOING CONCERN 71 business and income, and the added net incomes and profits, if any, which, by its acquirement as such going concern, would accrue to a purchaser during the time required for such new construction, and for such development of business and income. We think this instruction should be given. These are all proper matters for consideration 'among other things/ They are not controlling. Their weight and value depend upon the varying circumstances of each particular case. Of course a plant, as such, already equipped for business, is worth more, if the business be a profitable one, than the mere cost of con- struction." l These decisions clearly indicate that there is inherent in a plant a value over and above its replacement cost. "It is the value of the structure as being used" that must be sought rather than the value of the physical plant ready to be used but not productive. 54. Value of plant in use dependent upon purpose of appraisal. Thus far in the present discussion of valua- tion of public utilities, no distinction has been made as to the purpose for which the appraisal was designed. The replacement cost will be unchanged whatever the object of the investigation as to value and the methods, which have been outlined for the purpose of determining replace- ment costs, can be used for all cases. This general treatment cannot be followed when the value inherent in a plant in service is to be determined. This distinction arises from the necessity of determining this value by considerations of the returns which arise from the opera- tion of the plant, and the fact that it is within the power of the State to exercise such a control over the rates charged by a public utility as to make the return an uncer- tain quantity. Thus, this value inherent in a plant in use may be one thing where the appraisal is for the purpose of determining a basis for taxation, another where a con- sideration of a statutory rate is involved and another 1 Kennebec Water District v. City of Waterville, 54 Atl. 19 (1902). 72 PUBLIC UTILITIES when the object is the determination of a fair selling price. 55. Fundamental conception of value inherent in "live plant." The fundamental conception of the value inherent in a "live" plant is contained in the fol- lowing ruling: "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 pecu- niary value outside of that which results from such use." 1 This quotation voices the spirit of the business man and the investor. The replacement cost is but one element in his consideration of an operating property and, usually, it is of secondary importance as compared with the return present and prospective that can be obtained from the property. Should the net return capitalized at a fair market rate show a value greater than the present value of the physical plant, this enhancement in value is the value of the " livening f actor. " It matters not what it arises from, the value is there and the plant is worth more by that amount than the cost of its bare bones. A method based on this line of reasoning can be used whenever there is no possibility of action on the part of the community toward reducing rates, or where the value is desired at the present time under an existing schedule. It is a method which can be used for this reason where the value of the property is desired as a basis for taxa- tion. It is one which has been extensively used in the past in valuations where the replacement cost was not determined. This method has been elaborated and used in some of the most important valuations of the prop- erties of public utilities in the United States. It may be briefly described as follows. 1 Cleveland, Cincinnati, Chicago and St. Louis R. R. Co. v. Backus, 154 U. S. 445 (1894). VALUE AS GOING CONCERN 73 56. Capitalization of present net earnings. The method about to be described was employed in the val- uation of the railroad properties in the State of Michigan in 1900. 1 The replacement cost of the physical plant was found in substantially the manner already described, including in this figure the cost of land and material together with all overhead charges. The depreciation, which the plant had suffered, was found also with great care, and the difference between the replacement cost and the depreciation was called the " present value of the physical property." The value inherent in the plant over and above the present value of the physical property thus derived was found by first determining the total available corporate income. This was done by subtract- ing from the gross income the operating expenses and the depreciation reserves. From the available corporate income thus found was subtracted a sum equal to "4 per cent of the mean value of the physical elements." This last sum represents the interest upon the present plant investments, i.e., interest upon the present value of the "bare bones" of the plant as derived by means of the replacement cost. The remainder, after subtract- ing this interest charge, was capitalized at 6 per cent and added to the present value of the physical plant as the value inherent in the plant over and above its pres- ent physical value. The question of taxes upon the property as an annual expense, has been eliminated from the above description for the sake of clearness.] It is of interest to note that this method shows the value of the physical plant with as near an approach to accuracy as is possible. The value of the plant as an operating organization depends upon the profitableness of its use, " present and actual." It makes no recogni- tion of the value attaching to its use, " prospective and 1 Bulletin 21, 1905, U. S. Dept. of Commerce and Labor, p. 76. 74 PUBLIC UTILITIES anticipated." Thus if there is, for the period taken as a measure of profitableness, no remainder after subtract- ing the interest upon the present value, there is no value inherent in the property over and above the present plant value. Theoretically, if there is shown a deficit the value of the plant should be reduced by a capitaliza- tion of the losses. As a practical matter in the partic- ular investigation described above this was not done, the minimum value of the property being taken as the value of the physical plant. By this method no attempt is made to analyze the rea- sons why there may be a special value inherent in the operating property. The plant is there. It is earning more than its legitimate fixed charges and, consequently, has an enlivening value. This enhancement in value may come from good management, strategical position, from the development arising from years of service, from special grant or franchises. It matters not. By reason of one or all of these conditions, the property is successful and, consequently, has inherent value as an operating organization. But the above method does not cover all of the condi- tions which would be considered by a business man look- ing into the value of a property, assuming for the moment the probable continuance of existing rates. The under- taking may be at its inception and have special strategic value which would make it of prospective value. The method just described cares only for the existing operat- ing conditions and as such may be useful as a basis for taxation but would not represent the value naturally inherent in the enterprise and thus be considered fair and just for a case of sale. Another method will be described wherein an attempt has been made to recognize not only the present, but " prospective and anticipated" value of the property. VALUE AS GOING CONCERN 75 57. Capitalization of present and anticipated net earnings. By this method the present value of the physical plant is determined in the manner described above, and the value inherent in the plant as an operat- ing concern is determined by finding what has been called the market value of the property wherein recognition of all of the special conditions surrounding the plant are considered which will tend to affect the value of the property as a producer of income. The exact value to be thus assigned to the property due to its strategic posi- tion is arrived at by a more or less arbitrary exercise of judgment after a careful consideration of all favorable and unfavorable conditions affecting the property. 1 Such a method is reasonable and fair for a valuation for taxation or sale provided it is possible to arrive at a proper figure which will be just to the community and to the undertaking by a simple exercise of judgment and without a formulated procedure, whereby results can be obtained for all cases with accuracy and without contro- versy. It does not seem as if it was one that could be of general use owing to the fact that it requires values to be assigned on the basis of the judgment of the ap- praiser rather than of the court. It is probable that there would be many different values assigned depending upon the personal bias of the appraiser. This method is introduced simply to show the recog- nition, which has been held in some of the most impor- tant appraisals which have been made in this country, of definite values inherent in property, both present and anticipated. This method tacitly accepts the continu- ance of the prevailing rates. 58. Value not dependent upon cost alone. The above two methods illustrate the real value, the market value, 1 Valuation of Railways in Washington, Railway Age Gazette, Vol. 48, p. 359. 76 PUBLIC UTILITIES of a property in active operation. If the undertaking is successfully earning a return, the owners feel that they are entitled to such return and that it is due to natural value inherent in the property which they have created. They incurred the hazard of starting in upon a new enter- prise, in many cases in a community or with a utility more or less unknown. The community itself had the right to provide the same utility, but did not dare or care to undertake the risk. The owners had to borrow or obtain money to finance the enterprise. In most cases it was necessary to issue common stock as a bonus, upon which dividends were to be paid when the return became sufficient. They argue that no progress can be made if an ample reward is not afforded to the men who have the means, skill and courage to enter upon such pioneer work and make it successful. To them this value in a "live" plant, either present or prospective, is their reward and should be made a distinct element in the value of their property. This line of reasoning has been used in the determina- tion of the value of several water companies in cases of condemnation, and is of great interest as exemplifying the recognition of this inherent value in a successfully operating property. 59. Capitalization of profits. The fact that the undertaking is furnishing the service presupposes that the community preferred to grant the privilege to operate to others rather than itself incur the financial risks in- volved. At some time prior to the date of the appraisal, the undertaking had raised the money required to build the plant and to operate it, had constructed the plant and taken the risk involved by investing its money in a new enterprise. The money which has thus been tied up in the new utility could have been expected to earn a nor- mal rate of interest if invested in some manner involv- VALUE AS GOING CONCERN 77 ing less hazard. The undertaking can expect properly and is entitled legally to a profit over and above the normal interest charges on the money which had beerr expended in the new enterprise. The question which is involved in any special case, therefore, is what should be the proper ratio of profit to the interest normally required on bonds or loans on the property of enterprises of this character. Probably in most cases, the answer to this question must be given by the court. The appraiser can present figures for inter- est and profit, determined by the methods described in another chapter. If, for any particular case, it has been found that the interest rate upon the bonds of this undertaking or a similar undertaking is properly 5 per cent and that a return of 7 per cent is justifiable for an enterprise of this character in the locality where it is sit- uated, then the ratio of profit is 40 per cent. Following out this line of reasoning, it would appear that, in a case where the enterprise itself has provided all of the money required, the value of the property when completed was greater than the actual cost by an amount equivalent to the capitalization of the profits. Thus, for the above case, if the property had cost $100,000.00, its value could be considered to be $140,000.00. At the time of an appraisal it will not be the original cost which will be taken as the basis of the profit incre- ment, but rather what it would cost at the present time to reproduce the property of the undertaking; in other words, it would be the replacement cost from which no depreciation is deducted, as it is the value of the property new as of the present time. Thus the replacement cost plus the profit increment may be considered as showing the maximum value that can be given to the property of an undertaking as it fur- 78 PUBLIC UTILITIES nishes a value equal to the cost at the present time of the same plant new and to such value is added an amount which can be considered as the maximum which it is fair and right to award to an undertaking for its skill and enterprise in providing the utility for the community. As just stated, the figure thus derived is a maximum; it must be reduced by amounts representing the diminu- tion in value of the plant arising from its depreciation and from its inefficiency. This reduced value is presented as a tentative present value of the "live" property of the undertaking. 60. Analytical methods of determining value inherent in a live plant. In the methods thus far discussed, the value inherent in a live plant has been derived without any attempt being made to assign definite values to the characteristics of the plant which operate to make the operating organization successful and capable of pro- ducing an adequate return. The operating organiza- tion is there and has been developed, is furnishing service to the public and the live plant is of more value than it would be if it were not furnishing service. But in many cases appraisers have attempted to analyze the value inherent in the life-giving character- istics of an operating property, and by such dissection to assign definite values not only to the dead plant but to the organism which may be claimed to give it life. Thus the physical plant, called the tangible property, is dis- tinguished from the vitalizing factor, called intangible property, and intangible property, when dissected, is claimed by many to be composed of special life-giving attributes, such as good will, franchise rights and going value. Good will and franchise values will be considered more in detail later. It is sufficient here to say that the courts have ruled that for a public utility no value can be as- VALUE AS GOING CONCERN 79 signed to good will, and that except where there is a defi- nite agreement, beyond the right to operate, franchises have no value that can be capitalized except what may" have been paid for them or may have been allowed for them by some prior decree of the court. Going value or value as a going concern has been re- garded by many experts simply as what it had cost the undertaking to establish a profitable business or what it would cost to-day to reproduce its present business. It is seen that as a result of this analytical treatment there can be presented a figure representative of the value exist- ing in but one enlivening attribute of a successfully oper- ating property, that of value as a going concern. Two methods have been evolved for finding this value and will be briefly described. 61. Wisconsin method. The method about to be described is called the Wisconsin method for the reason that it is the one which has been used by the Wisconsin Commission in all valuations made by it for all purposes. In explanation of this method, a portion of one of the decisions of the Wisconsin Commission may be quoted: "If property is devoted to the public use, and reasonable care has been exercised in all the phases of its management, but the owners have not received a fair return during the earlier years of the operation of the plant in which the property is used for the convenience of the public, the deficit thus incurred must be made up out of later earnings, in so far as this is com- mercially possible and expedient. In other words, every effort honestly put forth, every dollar properly expended, and every obligation legitimately incurred in the establishment of an effi- cient public utility business must be taken into consideration in the making of rates for such business. Collectively the ele- ments just referred to may be designated by the term going value, and in this sense there can be no question regarding the propriety and justice of admitting going value as a considera- tion in the determination of rates. Whether this going value should be made a part of the permanent capitalization of the 80 PUBLIC UTILITIES plant, or provided for by means of a sinking or other fund, is a matter to be decided on the facts in each particular case." 1 Authority is given to this method by a recent decision of the Supreme Court of Oklahoma. "Few industries, if any, involving an investment of $90,000 or more, can be made self-sustaining from the first day of their operation. The uncontradicted evidence in this case discloses that appellant's plant for the years preceding the first hearing, failed to produce revenue sufficient for operating expenses, current repair, and lay aside an amount for depreciation. During the time of development there is a loss of money actu- ally expended and of dividends upon the property invested. How shall this be taken care of? Must it be borne by the owner of the plant? Or by the initial customers? Or shall it be treated as part of the investment or value of the plant con- stituting the basis upon which charges shall be made to all customers who receive the benefits from the increased service rendering power of the plant by reason of these expenditures? It seems that the last solution is the logical, just and correct one. If rates were to be charged from the beginning so as to cover these expenditures and earn a dividend from the time a plant is first operated, the rate to the first customers would be in many instances, if not in all, so exorbitant as to be pro- hibitive and would be so at the time when the plant could be of least service to them. On the other hand, the public can- not expect as a business proposition or demand as a legal right that this loss shall be borne by him who furnishes the service; for, investors in public service property make such investments for the return they will yield; and, if the law required that a portion of the investments shall never yield any return, but shall be a total loss to the investor, capital would unwillingly be placed into such class of investments; but the law, in our opinion, does not so require. Private property can no more be taken in this method for public use without compensation, than by any other method. When the use of the property and the expenditures made during the nonexpense-paying and nondividend-paying period of the plant are treated as an ele- ment of the value of the property upon which fair returns shall 1 Wis. R. R. Com. Rpts., Vol. 4, p. 61. VALUE AS GOING CONCERN 81 be allowed, then the burden is distributed among those who receive the benefits of the expenditures and the use of the property in its enhanced value." i Practically no undertaking begins earning a warrant- able return upon its investment from its inception. There must be inevitably money expended not only in the admin- istration and the operation of the business but in adver- tising, canvassing and similar work required to attract users of the utility. In most cases these expenses will be considerable, for the reason that the public will be unfamiliar with the service and must be educated to its use. In this respect, in many cases, the original cost will be greater than similar expenses figured under the repro- duction value of a replacing plant. The Wisconsin Commission evidently has felt that the value imparted to the dead plant by making it actively in operation was to be measured by what it had cost the company to acquire a successful and remunerative busi- ness. In other words, this increment of value over and above the replacement cost is the original cost of making the concern productive of a fair return. There are two doubts which arise as to whether this method is one which is free from such difficulties in its practical operation as to commend it for general use. The first is that pointed out by the Court in the Spring Valley Case, wherein this method was employed by one or more experts to derive the increment in value in a live plant, in which it was said: "This estimate is open to the objection that the deficiency of revenue may have been due to extravagant or wasteful management. The company may have purchased a plant larger and more expensive than necessary; current rates of interest may have been abnormally high; many causes which 1 Supreme Court of Oklahoma Pioneer Tel. & Tel. Co. v. E. H. Westenhaver, 29 Oklahoma, p. 447, (1911). 82 PUBLIC UTILITIES have absolutely no relation to the value of the company's business now as a going concern may have increased or dimin- ished the deficiency in revenue. Furthermore, if it be con- ceded that early deficiency of revenue is the proper measure of value for the present going business, then it follows that, the greater the deficiency and the more unprofitable the business, the greater the present value of the going concern; and, if the business had yielded large profits from its very inception, the going business to-day would be worthless." 1 The Court refused in this case to use figures derived in this manner. The Wisconsin Commission has fully appreciated the above mentioned difficulties which are present in this plan, and in its later decisions has indicated not only the factors which may tend to distort results but has said: "When, however, conditions, which may be unusual or abnor- mal for any reason, are encountered in any particular investi- gation, they must be first eliminated or disregarded before a reliable result can be reached." 2 The second doubt lies in the fact that, what is needed by the Court is the value of the entire property of the company at the present time, and, to aid him in forming a decision as to what that value may be, he requires the original cost and the replacement cost. Logically the increment in value derived by the Wisconsin method is the original cost of obtaining a successful business and is a proper increment of the original cost of the property. It is not a figure representative in any way of what it would cost to-day to reproduce the business. In a case of sale, where the buyer had the option of either building up a new enterprise or of acquiring an existing one, he would not be concerned at all with what it had cost the present 1 Spring Valley Water Co. 0. City and County of San Francisco, 165 Fed. 697, 1908. 2 Wis. R. R. Com. Rpts., Vol. 5, p. 277. See N. Y. P. S. C. 1st Dist. Case 1398, Feb. 13, 1912. VALUE AS GOING CONCERN 83 owners for their property but rather with what it would cost him to-day to acquire a similar property, plant and business. 62. Reproduction of net earnings method. This method was designed evidently to correct the difficulty inherent in that just described and is designed to show what it would cost to reproduce the business at the pres- ent time. It was first used in determining the value of the property of the Dubuque Water Works in a case of sale, and has been employed frequently since that time in the valuation of waterworks in cases of condemnation. 1 This method has been elaborated and described in detail by Messrs. Leonard Metcalf and John W. Alvord, whose original papers should be studied for a full understanding of the figuring involved. 2 Briefly stated, this method consists in a determination of the cost of reproducing the business of the undertak- ing. All of the assumptions above made as to period of construction and sums invested yearly in plant, as well as probable dates when completed portions of the plant are turned over to operating departments, hold. The development of the business is assumed to cover not only the period of the construction of the plant but some period of time, after the date of the completion of the construction work, which, it is estimated, will be sufficient for the new hypothetical replacing plant to be able to have acquired a business equal to that of the undertaking using the existing going plant. The amount of business which the imaginary or comparative plant can obtain during each year of the assumed development period of the business is estimated and computed. It is usual to assume that the comparative plant starts 1 See Proceedings American Water Works Association, 1909, p. 184. 2 See Transactions American Society of Civil Engineers, 1911, Vol. 73, p. 326. 84 PUBLIC UTILITIES at the date of valuation and assumptions must be made as to the probable business of both the existing and comparative plants. "The sum of the present worths of the_ annual excess in net return of the existing plant over the hypothetical or com- parative plant, in the period of years from the date of taking to the time when the earnings of the comparative plant are assumed to become identical with those of the existing plant, represents the going value of the existing plant." The above method has been criticised as depending very largely upon the assumptions of the appraisers as to the length of time required by a hypothetical plant to reproduce the present earning power of the existing plant. There can be no question that this assump- tion must be based upon the judgment of an appraiser especially familiar with the business and business condi- tions affecting the utility under valuation. But, it can be seriously questioned whether an opinion of a compe- tent expert on this matter involves any greater possibil- ity of errors than are present in making the assumptions needed in determining the replacement cost and depre- ciation of the distinctly physical portion of the plant. The appraiser has at his command figures showing the earnings and operating expenses of the undertaking for as many years in the past as may be necessary. No assumption is made as to the familiarity of the public with the use of the utility sold. Thus it may have taken many years for the existing undertaking to have brought the public to an appreciation of the value or convenience of the utility and, in consequence, the development of the existing service may have been slow. For a deter- mination of the development of the hypothetical busi- ness, the present conditions are assumed and no more time assumed than would be necessary to attract users than would be the case if the present undertaking ceased VALUE AS GOING CONCERN 85 to exist and a new one continued in its stead. The exist- ing undertaking is in no way considered as a competitor of the hypothetical replacing undertaking. From what has been said above, this method of deter- mining going concern value is simply an extension, to the business of the undertaking, of the same general methods and of many of the same assumptions as were used in a determination of the replacement cost of the physical plant, and can be employed, in most cases, with approxi- mately the same degree of accuracy. 63. Doubt as to inclusion of going value in rate cases. - The above two methods assign a value, as a going concern, equivalent to the cost of building up the busi- ness of the undertaking. But some doubt has been cast upon even this value when the valuation is made for the purpose of determining the equity of a statutory rate. This doubt is clearly manifested in Judge Lurton's deci- sion which has been quoted already, in which he said: "No such question," value as going concern, "was consid- ered in either Knoxville v. Knoxville Water Company (212 U. S. 1) or in Willcox v. Consolidated Gas Company (212 U. S. 19). Both cases were rate cases, and did not concern the ascertain- ment of value under contracts of sale." 1 Mr. Justice Weaver said in another case: "By 'going value' we understand is meant that value which arises from having an established 'going' business. While not the exact equivalent of 'good will/ as applied in ordinary business, it is of a somewhat similar nature, and attaches to the business, rather than to the property employed in such business. The fact that the business is established is, of course, a material fact in ascertaining the value of the plant, and espe- cially is this true where the property is being estimated for the purposes of sale or condemnation; but as a basis for estimating profits its significance is less apparent." 2 1 City of Omaha v. Omaha Water Company, 218 U. S. 180 (1909). * Cedar Rapids Water Co. v. Cedar Rapids, 118 Iowa, 262. 86 PUBLIC UTILITIES While these decisions appear to afford some reason for doubt upon this matter, a review of the facts relative to the above cited cases will throw much light as to present practice. In the Knoxville case the Master allowed a valuation of $608,000.00 made up of an appraisement in minute detail of the tangible property with an added amount $10,000 for " organization, promotion, etc.," and $60,000 for " going concern." The court refused to pass upon the propriety of these two items, leaving that ques- tion to be considered " when it necessarily arises." It assumed without deciding that they were properly added. The decision of the Supreme Court of the State of Okla- homa in the Enid case, a case involving the equity of a statutory rate, which was quoted above, definitely in- cluded going value. " Whatever discoverable value may attach to the concern as a going business is proper to be considered in determining the value of complainant's plant for rate-fixing purposes." 1 To the engineer and to those familiar with the cost which must be inevitably incurred in bringing the busi- ness of an undertaking up to a paying basis, it seems that "in equity it cannot be doubted that going value should be included in the base on which the returns are predi- cated, if, as contended, it involves real cost to the com- pany; for the company must be permitted to earn a fair return on this cost, or to liquidate it in some way, as otherwise the corporation would suffer substantial prop- erty loss from 10 to 20 per cent, more or less, of the reproduction cost of its property. This would be con- trary to public policy, for, with such an outlook, capital would not enter this field of enterprise, except at increased rates of return, commensurate with this added hazard." 2 1 Spring Valley Water Co. v. City and County of San Francisco, 165 Fed. 693, (1908). 2 Mr. Leonard Metcalf, Trans. Am. Soc. Civil Engineers, Vol. LXXII, p. 256. VALUE AS GOING CONCERN 87 64. General consideration of value inherent in a live plant. Probably no question involved in the appraisal of the property of a public utility is less understood by appraisers and the public at large at the present time, than this of the value of a live plant as distinguished from the value of the bare bones of the plant. This is indicated by the widely different methods above described which have been employed by different experts to derive such values. That there may be such an inherent value has been definitely recognized by the courts, as has been shown in the above quoted decisions. The insistence upon this value and the fear that it may not be sufficiently recog- nized are the bases of most of the opposition on the part of the management and owners of public utilities to apprai- sals designed to determine the present value of their prop- erties, particularly when questions of rates are involved. Moreover, it must be admitted that errors have been made by appraisers in attempting to find and assign definite values to possible life giving or earning factors which may be characteristic of a successful operating undertaking. As has been shown, such definite values have been given little or no consideration by the courts although they fully recognize the value inherent in the live plant. Thus good will, and franchise value, for a public service corporation have been ruled to be incapable of being capitalized in the case of public service corpora- tions and, in some cases, the attempts made to find a so-called going value have not been accepted by the courts as definitely established figures. But while it may seem that the exclusion of these values has been definitely ruled by the courts, still we have the reiterated authority of the Supreme Court of the United States, that the value inherent in the live plant, its value as a going concern, is a definite asset of a public utility undertaking. 88 PUBLIC UTILITIES As will be shown there can be no value definitely assign- able to good will per se nor, with possible exceptions in special cases, to franchises per se. But it will be claimed, and claimed upon reasonably good grounds, that for an undertaking, even if it has no competitor, its ability to earn money is enhanced by the possession of both of these attributes. An undertaking that is furnishing the best possible service, is prompt and courteous in its dealings with the public, that has adjusted its rates voluntarily when it could afford to do so and has been liberal and fair in the treatment of its employees, has what may be called the "good will" of the community. Such good will in reality may amount to nothing more than a free- dom from an imposition by the public authorities of rates productive of a loss of revenue. Although such good will cannot be given a value by experts nor by the courts, yet such good will is unquestionably an attribute which enables the undertaking to earn a fair return over and above a return on the value of its purely physical property. It is the same with franchises. The plant of the undertak- ing "is not only a structure, and a structure being used, but it is a structure built, maintained, and used by authority expressly granted to the company by the state; that is, it was built and is maintained and used by virtue of a franchise or franchises. The structure is lawfully in existence, and may rightfully con- tinue to be used as a going concern structure, until the state determines otherwise. This also makes the structure in use more valuable. It is the difference between a structure exist- ing by sufferance and one maintained by right. The franchise, however, is a limited one. It is not perpetual. It may be recalled by the state. It is not exclusive. Other and com- peting franchises may be granted. It is not absolute." l The above decision clearly and definitely rules that a property, operating under a franchise, is more valuable 1 Brunswick and Topsham Water Dist. v. Maine Water Co., 59 Atl 539 (1905). VALUE AS GOING CONCERN 89 than if it did not possess this attribute. But the fran- chise per se, separated from the plant, cannot be given a value by the experts nor by the courts, except, as will be seen later, when money has been actually paid for the rights under which the undertaking is operating. This reasoning is fully borne out by the following ruling: "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 upon the faith thereof, and that, considered alone and apart from the property which 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." 1 This decision, that a franchise "considered alone and apart from the property which it renders fruitful" cannot be given a definite value, brings out definitely the point that an analytical discussion of the attributes of a live plant is fruitless. This point is accentuated by another ruling on this matter. "It were better ... to have proceeded along the lines of . . . the doctrine of this court, that there can be no such sep- aration of tangible and intangible elements which will furnish any legitimate basis for the valuation of one or the other. As neither, strictly speaking, is required to be valued, but only the thing which the two in combination make, why attempt to do what lays the very basis for claims which are illegitimate though embarrassing? The departure from the needful, try- ing to do the impracticable, would seem to be worse than use- less. One might as well try to value the life-blood of a horse, or his capacity to breathe, as try to place a value upon the visible part of railroad property separate from its rights, fran- chises and privileges." 2 Yet, while it must be admitted by all that, although such factors cannot be analytically separated from the 1 Consolidated Gas Co. v. City of New York, 157 Fed. 874. 2 Chicago and Northwestern Railway Co. v. The State (1906) 128 Wise. 621. 90 PUBLIC UTILITIES property as a whole, each is a factor in making the suc- cess of the undertaking to an extent not measurable by definite figures. Thus, - "The property to be taken, both plant and franchises, are to be appraised, having in view their value as property in itself, and their value as a source of income. The physical property has value irrespective of the franchise, and the franchise with- out reference to the physical property. But these two kinds of value practically shade into each other." 1 "The value of the physical elements of corporations, or bus- iness property, is made up largely of those which are invisible. Sometimes the value of the latter exceeds that of the former in that, were the two separated, the visible things in the disor- ganized condition would be worth less than half the value of the property in use as an organized enterprise." 2 The present misunderstanding of this question is fur- ther increased by the attempts made by appraisers them- selves to find the present value of the property; in other words, to usurp the functions of the court or commis- sion. Experts are to present to the court or commission certain figures, which were recapitulated in Chapter I, and that tribunal and that tribunal alone is to determine "with sound and well informed judgment/' the true present value, and, in the true present value, they have ruled that they will include what seems to them to be the value inherent in the plant as a live plant furnishing service and earning money. They will not attempt to attribute values to definite factors analytically deter- mined but to the operating plant as a whole, to the plant as a going concern. For the sake of clearness in presentation we have spoken of " going value" as one of the factors tending to give life to the plant and have shown how this factor is in 1 Kennebec Water District v. City of Waterville, 54 Atl. 20, (1902). 2 Chicago and Northwestern Railway Co. v. The State (1906) 128 Wise. 617. VALUE AS GOING CONCERN 91 reality the cost of producing or reproducing the business as distinguished from the plant. This "going value " is but one element of the value inherent in the plant, of its value "as a going concern." As just defined the "going value" is capable of definite determination by the expert and must be made by him a figure to be presented both with the original cost and with the replacement cost. The "value as a going concern" or, as it has been termed throughout the present study, "the value of the live plant," in order to avoid the ambiguity liable to arise from the use of such similar expressions, "going value" and "value as a going concern," is to be determined by the Court upon well informed judgment based upon the varied sets of figures presented by the appraisers. 65. Practical usefulness of methods of determining value in live plant. In the first portion of the present chapter a number of methods were described which have been used in important appraisals. It is to be noted that they varied widely from each other and would have pro- duced divergent figures. It is of interest to note that, while each method has had its advocates, still each method has been held by other experts, and in some instances by the courts, to be unreliable. It now remains to be shown that each method is productive of figures which have their own logical and proper value as evidence when taken in connection with the figures which Mr. Justice Harlan has ruled are essential for the information of the court in making a decision as to the true present value of a property. Original cost was one of the figures to be presented by the experts. This figure should not be the original cost of the plant alone but the cost of the plant plus what it had cost the undertaking to acquire its business. This latter cost, carefully determined and from which all improper expenses have been excluded, is as much a 92 PUBLIC UTILITIES part of the original cost of the property as the original cost of the physical plant itself. This cost, the capitali- zation of losses, as determined by the method employed by the Wisconsin Commission, when added to the original cost of the plant is one figure to be presented. It is not the true value inherent in the live plant any more than the replacement cost is the true value of the physical prop- erty. It is simply evidence, presented to the tribunal for what that tribunal may consider it to be worth. Another figure to be presented is the present cost of reproducing the property. The cost of a new plant would be the replacement cost of the existing plant. But the replacement cost of the physical plant represents in most cases but a portion of the reproduction cost of the prop- erty. It would take time and money to bring a new plant into the productive condition of the existing prop- erty. The cost of reproducing the business must be added to the replacement cost of the plant to give the reproduc- tion cost of the property. This cost of reproducing the business must be determined by the method described above under the heading " Reproduction of Net Earn- ings." The reproduction cost of the property, as thus formed, does not show the true present value nor is the figure, designed to show the cost of reproducing the net earnings, a criterion or even a measure of the value inher- ent in the live plant. These three figures, replacement cost, reproduction of net earnings and their sum are simply further evidences for the use of the court or commission in forming its judgment as to the fair present value of the property. Another figure to be presented is the commercial value as shown by the capitalization of net earnings. This is the figure which appeals most to the business man and is offered with the others, as evidence of value, for the consideration of the court. Thus, VALUE AS GOING CONCERN 93 " Capitalization of income, even at reasonable rates, cannot be adopted as a sufficient or satisfactory test of present value. But while not a test, present and probable future earnings at reasonable rates are properly to be considered in determining the present value of the system." Another figure to be presented is the par value of stocks and bonds. Some of these securities may not be repre- sentative of a dollar actually paid into the capital of the undertaking. Some of them may be common stock issued to assure the sale of other securities. It matters not why or how the securities were issued. The court or commission must have these figures to add to its infor- mation concerning the case. Another figure is the worth of the service to the user. As will be shown later, the value of the service to the com- munity is based largely upon what it would cost the public to construct a new plant and acquire the business of the original undertaking. The cost of reproducing the plant and business is the reproduction cost of the property described above. In addition to this the pub- lic has been relieved by the undertaking from the risk originally incident to the development of the enterprise. Some additional value should be given to the property for this reason and the method termed above " Capital- ization of Profits" offers the means of determining what this increment may be. This figure is presented with the others for the consideration of the court, as evi- dence of the true present value of the property. CHAPTER V VALUES OF GOOD WILL AND FRANCHISES 66. Good will and franchise values attributes of value inherent in live plant. 67. Goodwill. 68. Franchise General consideration. 69. Value of franchise in case of sale. 70. Value of franchise in cases involving the equity of a statutory rate. 71. Value of franchise in valuations for taxation. 66. Good will and franchise values attributes of value inherent in live plant. In the last chapter it was ex- plained that, while there was admittedly a value in many operating undertakings over and above the value of the physical plant alone, difficulties were met when an attempt was made to consider such value analytically and assign values to supposed constituent attributes. The full sig- nificance of this was seen from the fact that doubt was expressed whether even value as a "going concern/ ' the most unquestioned attribute of a live property, - could be included in a valuation made for the purpose of determining the equity of a statutory rate. As will be shown presently, this possible value has been reduced still further by the definite exclusion of the values possibly attributable to good will and franchise rights. In view of the impossibility of experts assigning definite figures to values inherent in a live plant, it is not neces- sary to enter into an extended discussion as to the reasons why the factors, good will and franchises, considered alone, have been excluded as incapable of being assigned definite values. A few only of the rulings bearing upon these so-called intangible assets will be presented. VALUES OF GOOD WILL AND FRANCHISES 95 67. Good will. Good will may be defined as "the advantage or benefit which is acquired by an establishment beyond the mere value of the capital stock, funds or property employed therein, in consequence of the general public patronage, and encouragement which it receives from constant or habitual customers, on account of its local position or common celebrity or reputation for skill, affluence, punctuality, or from other existing cir- cumstances or necessities, or even from ancient partial- ities or prejudices." It will be seen from this definition that good will implies the exercise of choice on the part of the customer as to which of several establishments offers the best inducements for his patronage. It would seem, therefore, as if while there might be "an element of good will in the business of a public service corporation where competition exists, and the public may resort to more than one public utility for the desired service, yet when the public is confined to a single public utility for the service the latter undertakes there would seem to be no ground upon which good will could be predicated." The above quotations seem to have been taken as a basis for the decisions which have been given in most cases in- volving valuations of the properties of public utility undertakings. No case has been found where courts or public service commissions in this country have allowed any increase in the value of the property of such an enter- prise for good will per se. In the case of Consolidated Gas Company v. City of New York, 1 the lower court disallowed the item of "good will" and was sustained by the Supreme Court. It ruled that "good will" can have no existence as apart from or detached from the franchise conferring the nec- essary privilege. Such "good will " is not capable of being capitalized. 1 Consolidated Gas Company v. City of New York, 157 Fed. 849. 96 PUBLIC UTILITIES In the Cleveland Railway arbitration, Judge Taylor said : "Nor do I find anything properly allowable for good will, as that term is generally defined. A street railway company which has a monopoly, and especially if it has a franchise value remaining, can have no good will value." Both of the above decisions indicate the futility of an analytical determination of the value inherent in a live plant. Mr. Justice Lurton said: "That kind of good will, as suggested in Willcox v. Consol- idated Gas Co., (212 U. S. 19), is of little or no commercial value when the business is, as here, a natural monopoly, with which the customer must deal, whether he will or no." 1 Judge -Savage said : "But the term 'good will' may be misleading. Lord Eldon said that good will is nothing more than the probability that the old customers will resort to the old place. Crutw r ell v. Lye, 17 Ves. Jr. 335. ... See Flagg Mfg. Co. v. Holway, 178 Mass. 83. Under any possible definition, it involves an element of personal choice. This phrase is inappropriate where there can be no choice. So far as the defendants' system is 'prac- tically exclusive/ the element of good will should not be con- sidered. Bristol v. Bristol and Warren Water Works, 34 Atl. 359." 2 It is to be noted that, in all of the above decisions, the idea of good will arises from the preference, in trade rela- tions, which is possessed by a long established and success- ful private competitive business. With a public utility, good will, if it exists at all, has a value which " shades into " franchise value in such a way that it cannot be recognized in a valuation as a definite attribute of the property. 68. Franchise. General consideration. The fun- damental difficulty in assigning a value to the franchise of a public utility lies in the fact that the undertaking, 1 City of Omaha v. Omaha Water Co., 218 U. S. 180. 2 Kennebec Water District v. City of Waterville, 54 Atl. 19. VALUES OF GOOD WILL AND FRANCHISES 97 in accepting the franchise and devoting its property to public use, must submit to the right of the public to reg- ulate its compensation for such use. Thus, except when a special term of years is specified, the franchise can be kept, changed or recalled, at the pleasure of the State or of such bodies as may represent the State. The under- taking must submit to such regulation, unless it can satisfy the Courts that the action of the State is confisca- tory of its property and, in consequence, in violation of the laws of the United States. The value of a franchise, generally speaking, must be based on the capacity of the undertaking to earn a profit. "If its earning power be reduced by regulation, the value of the property is pro tanto reduced, and, since the franchise is property, the value of the franchise is also reduced.." l The value of the franchise will be different depending upon the purpose for which the appraisal is made. 69. Value of franchise in case of sale. If a property is earning a profit and is taken from its owners by condemnation, then the franchise must be paid for, and consequently has a definite value. "When property used under a franchise is condemned, the whole property is taken. The franchise is paid for as well as the physical property. The idea that a valuable franchise could be taken in condemnation proceedings, without compensa- tion, would not be tolerated for an instant; and to per- mit such a franchise to be taken without consideration, indirectly, by means of rate regulation, is equally obnox- ious to the federal Constitution." 2 That franchises of this nature are property and cannot be taken or used by others without compensation has been fully established by the Supreme Court. 3 1 Consolidated Gas Co. v. City of New York (1907) 157 Fed. 876. 2 Spring Valley Water Co. v. City and County of San Francisco (1908) 165 Fed. 693. 3 See Monongaheja Navigation Co. v. United States (1893) 148 U.S. 312. 98 PUBLIC UTILITIES From these general statements it will be seen that for a case of condemnation or sale, "the value of the prop- erty, generally speaking, is determined by its productive- ness, the profits which its use brings the owners," and that such productiveness cannot be reduced prior to a sale by means of rate regulation. These facts do not alter in any way the nature of the appraisal nor the figures that must be prepared by the experts and pre- sented to the court. It means simply that, in finding the true present value of the property, the value of the physical property and the capitalized net earnings become figures of special importance to the Court in forming his judgment as to what that value should be decided by him to be. 70. Value of franchise in cases involving the equity of a statutory rate. The difficulty which arises in cases of this character lies in the fact that, as "The value of the franchise is itself based on the capacity of the company to earn profits; and it becomes greater when the earnings of the company are increased. If, therefore, a high rate of income could be justified on account of the great value of the franchise, this fact would in turn enhance the value of the franchise itself and so justify a still higher charge; and there would be no limit to the legal charge of the company which could be enforced should such franchise value be per- mitted to increase in this way the capital charges." 1 The above reasons and the fact that the rates and, consequently, the return upon the property of the under- taking, are dependent upon regulation, based upon the will of the people, that is to say of the State, have led to the exclusion of franchise values per se as elements of value in the property of a public utility corporation, except for such cases as definite payments have been made for the franchise or that some special condition is 1 Wyman on Public Service Corporations, Vol. II, 1104. VALUES OF GOOD WILL AND FRANCHISES 99 present in a particular case to work exception to the general rule. The Wisconsin Commission has consistently held that no franchise values could be considered for rate making purposes other than those which are represented by a reasonable cost to the investor. "Franchises are not always obtained without cost. Many of them include provisions which entail outlays that may be charged either to the capital account or the operating expenses. The former may consist of considerations in the form of stip- ulated payments to the municipality, license fees, a certain amount of free service upon which values can be placed, and other items of this character. The latter may include the up-keep of streets and other property, extra services of various kinds, and other items of a similar nature. The former, again, would seem to be as much a part of the investment in the plant and in its business as the cost of the physical plant, and there would appear to be the best of reasons why such costs should be included in the value of the plant for rate making purposes." l And again: "It is difficult, if not impossible, to discover any justice in the practice of including in the valuation of a plant, for rate making purposes, such values of its franchise as are based upon surplus earnings only, or which have not cost the plant any- thing." 2 An exception to the above practice, of not allowing a value to a franchise except when actual payment has been made, occurred in one recent case wherein a value which had been agreed to by the stockholders and was provided for in the act which was followed by the com- panies, had been previously assigned to the franchise at the time of a consolidation. The judge in the lower court "stated his own views as opposed to including these franchises in the property upon the value of which a return is to be cal- 1 Wis. R. R. Com. Rpts., Vol. 3, p. 727. 2 Ibid., p. 729. 100 PUBLIC UTILITIES culated in fixing the amount of rates, but held that he was bound by decided cases to hold against his personal views." l He said "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 detri- ment of those who had securely rested upon the decisions sought to be invalidated." 2 In the decision of this case by the Supreme Court the value allowed originally by act of the State was included but no increase in value was permitted. The Supreme Court said: "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 thereon 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." 3 It is seen from the above that, although no value can be assigned definitely by the expert as a value to be pre- sented in an appraisal, it does not affect the figures to be prepared by him and presented to the Court. The Court will give only such weight to the capitalized net earnings as in his judgment may seem proper. The past earnings of a company may not be evidence of the fair value of the property but it is testimony which will be considered by the Court. 71. Value of franchise in valuations for taxation. Valuations in cases of this character are different from the above, as no question is involved as to the continu- ance of the rates. The valuation is based simply upon the present earning capacity of the property, If there is a value in the property over and above the value of the physical plant, it has value in what may be called 1 Willcox v. Consolidated Gas Co., 212 U. S. 45. 2 Consolidated Gas v. City of New York, 157 Fed. 849. 8 Willcox v. Consolidated Gas, 212 U. S. 19 (1909). VALUES OF GOOD WILL AND FRANCHISES 101 its intangible property, be it good will, going value, or franchise value. This intangible value arises from the rights given to the company to operate and may be of definite value due to its fruitfulness at the date of the investigation. No inconsistency is introduced by the fact that a diminution may later arise as a result of legis- lative action. 1 1 See Beale and Wyman, Railroad Rate Regulation, Sees. 362-363. CHAPTER VI ORIGINAL COST 72. Necessity of an unbiased determination of original cost. 73. Original cost required by court decisions. 74. Neglect in past of figures showing original cost. 75. Abandoned or destroyed plant cannot be given value. 76. Difficulty in obtaining original cost. 77. Unit costs. 78. Piecemeal construction. 79. Pavement over construction. 80. Overhead charges. 81. Sale of securities. 82. Cost of developing business. 72. Necessity of an unbiased determination of orig- inal cost. As with all other figures presented by the engineer, the original cost must be determined without any regard whatever as to the effect that such a figure may have upon the fair present value. It seems perfectly right to assume that the tribunals, whose duty it is to ascertain the fair present values of the properties of public utilities, will be just to the present holders of the securities of such companies by not penal- izing them for errors and extravagancies committed in the past, possibly by former owners and under different man- agements. It must be recognized that it is only within a relatively short time that the full duty of public ser- vice corporations to the public has been understood or appreciated either by the undertakings or by the public. It seems reasonable to expect that the tribunal, either Court or State, will give full weight to the fact, if proved, that the undertaking has property of a present value, based on present prices, at least equal to the capital upon ORIGINAL COST 103 which returns have been paid, even though the original cost of that property, the money contributed by the stockholders to buy and construct that property, may" have been less. There is no question of the fact that very many undertakings have issued stock to their shareholders without payment, and that, as a result of this practice, the capital assets are greater than the original or actual cost of their property. Such a practice has been a com- mon and usual plan of rewarding stockholders for the risks which they have taken in initiating a new enter- prise which has proved remunerative. It must be recognized that, as far as public utility undertakings are concerned, this method of financing belongs to the past. It seems right to assume that the tribunal will recog- nize that a new era in the management of public util- ities has begun, that the past must be obliterated as far as may be possible without injury to the public and that it is its duty to establish as of to-day a value upon which returns in the future can be based, which will be fair both to the undertaking and to the public. 73. Original cost required by court decisions. The rulings which have been given by the courts have de- manded figures showing original cost in order that present value may be properly determined. Two decisions only need be quoted to emphasize this demand. "So that the right of the public to use the defendant's turn- pike upon payment of such tolls as in view of the nature and value of the service rendered by the company are reasonable, is an element in the general inquiry whether the rates estab- lished by law are unjust and unreasonable. That inquiry also involves other considerations, such, for instance, as the reasonable cost of maintaining the road in good condition for public use, and the amount that may have been really and necessarily invested in the enterprise. In short, each case must depend upon its special facts." 1 1 Covington & Lexington Turnpike Co. v. Sandford, 164 U. S. 578, 597. 104 PUBLIC UTILITIES "The actual cost of the plant and property, together with proper allowance for depreciation ... is competent evidence, but it is not conclusive. It is not a controlling criterion of value, but it is evidence." 1 The original cost may have been abnormally high or abnormally low, but whatever it may have been, it is a figure of prime importance, in theory at least, to the tribunal as a guide to its decision as to what the fair present value of a property should be. 74. Neglect in past of figures showing original cost. In but few valuations have original costs been pre- pared and presented to rate regulating tribunals, prob- ably largely for the reason that the original cost shows in no way the increased value which has accrued to most undertakings in this country from increased values principally of land and of labor. The replacement cost is designed to show the cost-new at the present time and, in most cases, the value derived from the replacement cost would be considerably greater than could be derived from the original cost alone. In consequence of this, and probably also of a lack of appreciation of what is meant by original cost, fig- ures showing this cost have been omitted from most valuations, so that there is little or no precedent to guide the engineer as to what original cost really is nor how, as a practical matter, figures to show it are to be obtained. It will be necessary, therefore, to study such decisions as are available to determine what the Court meant when it said that "the original cost of construction" should be ascertained. 75. Abandoned or destroyed plant cannot be given value. Much of the present existing physical property 1 Kennebec Water District v. City of Waterville, 54 Atl. p. 15. See also Cotting v. Kansas City Stock Yard Co., 183 U. S. 79. Westchester Turnpike v. Westchester County, 37 Atl. 905. Griffen v. Goldsboro Water Co., 122 N. C. 206. ORIGINAL COST 105 of an undertaking, which has been in operation for a num- ber of years, has replaced plant which has been aban- doned or destroyed for the reason that it was no longer useful to the public. There is no question or doubt about the fact thatfthe cost of such abandoned plant cannot be included in ascertaining the replacement cost of the prop- erty. It is the plant as it is that must be valued, the plant then in existence and useful to the public at the time of the appraisal. 1 The question to be settled relative to original cost is whether the cost of such abandoned, destroyed or unser- viceable plant is to be made a portion of the original cost. The best decision bearing upon this point was given in the Knoxville case. The defendants contended that amounts representing " complete depreciation" should be added to the present value of the surviving parts of the plant to reach the sum upon which the com- pany should be entitled to earn a return. ''Complete depreciation" was denned by the company as that part of the original plant which had entirely disappeared through destruction and obsolescence. The Court ruled, "The court refused to approve this method, and we think properly refused." 2 Again, in Switzerland, in cases involving the purchase of the railroads by the Government, it was ruled that property constructed and destroyed or abandoned could not be given any value. 3 The logic of these rulings is apparent when it is remem- bered that an undertaking is entitled to such rates as will enable it to make annual reserves from income suffi- cient in amount to cover all losses occurring from the replacement of old or obsolete units of plant. If an 1 Wis. R. R. Com. Rpts., Vol. 5, p. 397. 2 Knoxville v. Knoxville Water Co., 212JJ..3..1. 3 U. S. Bureau of Census Bulletin 21, (1905), p. 72. 106 PUBLIC UTILITIES undertaking has made such reserves, the cost of the dis- carded plant has been paid for practically by the public in the form of the higher rates that such a practice has necessitated. What the Court requires is the " original cost" of the plant now found in existence. But there is confusion as to what " original cost" really means: does it mean the amount of money that was paid originally for the first unit brought into service, a unit which, probably, has been replaced many times in the past; or does it mean the actual cost of the unit now found in service, the unit now performing the same functions as the original unit? Logically, there seems to be but one answer to this question. The /'original cost" must be the cost of the unit now in existence. The logic of this reasoning will be apparent when practical cases are considered. If a valuation of a street railway was being made, it would be quite absurd to furnish the court with the original costs of the cars drawn by horses, cars which had been replaced by cable cars and later by the electric cars now found in a portion of the property being valued. Or if a telephone, telegraph or electric light company was being appraised, there would be no assistance afforded the tribunal by presenting to it the prices paid for a pole at the time the plant was first constructed. Such a figure could furnish no indication of the value of a pres- ent pole, which possibly is the fourth pole that has been placed by the undertaking in that spot, each pole having replaced one that had had to be abandoned owing to its lack of physical strength arising from its years of service. It would seem, therefore, as if the .original cost must mean actual cost, that is to say the price actually paid for the identical unit now found in the plant in use and useful to the service offered to the public. ORIGINAL COST 107 76. Difficulty in obtaining original cost. The reason given for the absence of original costs in most valuations is the difficulty in ascertaining what the costs actually- had been in the past. It is a very serious question whether this difficulty has not arisen from attempts to find the first cost of the original units. It is a fact that, for most electrical enterprises using units of plant of rel- atively low mean life, there should be no greater diffi- culty in finding the actual cost within as great a degree of accuracy as the replacement cost can be obtained. There can be no doubt that, if the officers or accountants of an undertaking were approached and asked for the actual cost of their plant, it would be impossible, in the case of older undertakings, for them to give it with such accuracy as they would desire. But, if an inventory, the same or similar in every way to that required and used in determining the replacement cost, was in hand with the probable age attributable to each unit, a requirement for the determination of depreciation as will be described later, most or all of the accountant's difficulties would be removed. The difficulty in obtaining actual cost has been stated at some length in the following decision: "the court . . . directed an inquiry into the actual cost of the company's property in this city. The lapse of many years, the multitude of items making up the total, the wide diversity of present views as to what expenditures should have been or should now be included in the cost of construction, etc., the manner of keeping the company's accounts (though no dis- honesty is attributable, inasmuch as no motive is conceivable which at that time tempted to deliberate wrong), and other considerations have so obscured the question of cost of the plant as to greatly weaken the value of this inquiry, laborious and painstaking as it appears to have been." L 1 Cumberland Telephone and Telegraph Co. v. City of Louisville, 187 Fed. 637 (1911). 108 PUBLIC UTILITIES This decision shows the error which, evidently, has been made by those attempting to obtain the actual cost. The actual cost need not accord with the books of the undertaking as far as classification is concerned; in fact it is probable that it could accord in but few cases and then only of properties that had been in existence for a short tune only. The cost of some of the present plant may have been charged to replacements or current repair and not entered directly as a portion of the plant cost. By far the larger part of these difficulties is removed if the original cost is determined in substantially the same manner as was the replacement cost. An inven- tory is prepared showing all plant units now in useful service. Such an inventory is identical with that required for ascertaining replacement cost. The age of each unit is ascertained and entered in the inventory. As will be explained later, this figure for age is necessary for a determination of the loss in value of the investment aris- ing from depreciation. From this age figure it is possible to find how many units of each class of elements were constructed in each year in the past. The engineer and an accountant familiar with the company's records can ascertain the unit costs of all elements for each year in the past. The sum of the products of the numbers of units constructed each year by the unit costs for that year will give the original cost. Overhead charges can be found for each year and applied to the cost of construc- tion each year in a manner similar in all respects to that described under replacement cost. Thus it is seen that the method of determining original cost is practically the same as replacement cost except that in the case of the original cost there are several unit costs, one for each year in the past, for each element, whereas for replace- ment cost there is but one unit cost applicable to all units of the same kind. ORIGINAL COST 109 There can be no wider " diversity of present views" relative to original costs than to replacement costs if the above reasoning is correct. It is not at all improbable that some of the costs which should have been made properly a portion of original costs, some of the over- head charges most frequently, may have been included on the books of the undertaking as a portion of the oper- ating expenses, but a determination of original cost is not an investigation of the capital cost as shown by the company's books but rather what has been actually spent in the construction of the property now in use for the convenience of the public. 77. Unit costs. The unit costs developed for use in ascertaining replacement costs were obtained by taking the prices for labor and material which had prevailed in the past during a period of time assumed as that which would be required to reconstruct the property. For use in obtaining actual cost, unit prices must be obtained in which are included all of the items of cost noted in section 32, for each year in the past in which the units now in existence were installed. Clearly this period will depend upon the life of each element. The number of units of each element, introduced into the plant during each year, must be multiplied by the unit costs determined for that year. 78. Piecemeal construction. The first point rela- tive to piecemeal construction, the point discussed in section 26, cannot be questioned in any way whatever in a determination of the original cost. The original cost must be the actual cost to the undertaking of the work as it was actually done by it. The second point, discussed in section 27, requires very careful consideration, particularly for the reason that no decisions have been found bearing upon this question nor is there any precedent to establish an authority or 110 PUBLIC UTILITIES guide. This point is whether the greater cost naturally incident to a plant, built at first smaller than that now found in existence and later enlarged, should be taken as the actual original cost; or whether the reasoning em- ployed in section 27 relative to replacement cost, i.e., that the increased cost must be due to work or material that has been abandoned, should hold good when applied to original cost. There can be no doubt whatever that, if a unit had been too small and had to be completely removed and a new and larger one substituted, the cost of the original smaller unit of plant could not be made a portion of the original cost. But taking as an example of a more doubtful nature the case of an underground conduit originally composed of, say, ten ducts, which had been increased at some later time by ten more ducts: to place the second group of ducts, the pavement would have to be reopened, the trench redug and refilled and the street repaved. If the conduit had been constructed originally with twenty ducts, the cost of paving, excavating and filling would not have been much greater than it was for ten ducts. There is but little doubt that most undertakings have charged the cost of each group of ducts, when laid, to plant cost and, naturally, they would desire to have the original cost figured as the sum of the two operations. The undertaking can argue with perfect justice that it had been wise in thus constructing in a piecemeal manner and that it might have placed the second line of ducts possibly equally well somewhat away from the first for substantially the same cost and have had recognition made in the valuation of their proper and legitimate expense. This line of argument is based on very prac- tical considerations and any objection to it must be largely of a theoretical character. But the fact remains ORIGINAL COST 111 that there is at the time of valuation a twenty duct con- duit and that to place the second section of ducts the pave- ment placed over the first section of ducts was destroyed: and abandoned and the same is true of the labor entailed in the first excavation. It was the right and duty of the undertaking to charge off from its construction account the cost of the labor and material thus abandoned. There seems to be no more reason for including the cost of abandoned work in the original cost than there was reason for including it in replacement cost. 79. Pavement over construction. This question has been conspicuous in most appraisals of public service undertakings where there is property in large cities, and in most decisions the actual cost to the undertaking has been the figure which has been required by the court or commission for its consideration. It is probably one of the most difficult portions of original cost to be found with the desired accuracy but its importance demands special effort. It is true that the undertaking may have laid its under- ground system originally in unpaved streets somewhat before it was needed in order to avoid the cost of the high grade pavement to be laid somewhat later by the city; or, what amounts to the same thing, that the city had obliged the undertaking to lay its underground pipes much before they were required in order that a new high grade pavement might not be broken into later when the pipes were actually required for the service of the public. There can be no doubt that the undertaking was involved in some expense for interest and maintenance upon a plant somewhat larger than the actual requirements of the service at that time, but such expense cannot be made properly a portion of the plant cost. Such expense is a portion of the annual cost of operation and should not be capitalized. The public pays a fair return upon the 112 PUBLIC UTILITIES plant in use and useful to it. Plant, wisely prematurely built or placed on the demand of the public authorities, must be considered as virtually useful to the public. The courts have held invariably that the public service corporation "is under obligation to the public to keep in advance of the present demand and take liberal account of the probable increase of demand due to increase of population. " 80. Overhead charges. The overhead charges, ruled as proper in a determination of replacement cost, viz., interest during construction, engineering, organization and legal expenses, are to be determined from the books of the company and made a portion of the original cost, following the general principles enunciated when the sub- jects were discussed as a portion of replacement cost. It is not at all improbable that some of the overhead charges will be different for different years, depending upon the amount of construction work of each year. Figures representative of overhead costs, however, can be obtained in every case without inordinate difficulty, provided the engineer and accountant have a definite knowledge and appreciation of the expenses which should be made a part of these charges. The item of contingencies should be given special consideration in each particular case. If the books and records are in such form that the actual costs can be determined and the inventory of the plant and the ages of the units have been prepared with proper care and skill, it is difficult to see good reason for making this item one of any importance. 81. Sale of securities. In the discussion of the replacement cost of a plant, it was stated that "the discounts or losses which an undertaking might incur in order to sell its stocks or bonds, together with such expenses as may be incurred by underwriting an issue of ORIGINAL COST 113 the securities" should not be made a portion of the replace- ment cost of a plant. It has been contended, however, that no new undertaking can obtain money for the con^ struction of a plant and the development of a new busi- ness without some expense and that such expense should be included as a legitimate portion of the original cost of its property. It has been argued, further, that, if the money required for the construction and operation of the plant had been obtained as cheaply and economically as possible, and if all the money thus obtained had been used in the construction of the plant and in its operation during the development period of the business, the cost of obtaining funds, the discounts between par value and the price obtained, was properly a portion of the original cost. Here again the instructions of Mr. Justice Harlan must be recalled. He ruled that the original cost of the prop- erty should be found and presented to the Court as well as figures showing the amount of the bonds and stocks of the undertaking. The Court has, thus, before it informa- tion which will show by how much the capitalization ex- ceeds the original cost. Any attempt on the part of the engineer or expert to add, to the original cost of the prop- erty, figures representing what in his opinion the cost of obtaining money originally may have been and including such cost in the original cost of the property is unneces- sary and an assumption of the functions of the Court. Thus the economic arguments which have been made so often, that the management of the undertaking showed good business judgment in the sale of securities at a larger discount at a low rate of interest rather than at a higher price at a higher rate, need no special pres- entation on the part of the appraiser. The facts are presented to the Court in the statement prepared by the appraiser showing the character of the securities and the rate of interest which they bear. 114 PUBLIC UTILITIES Moreover the interest during the construction period is based upon the rate of interest the undertaking had to pay for the money required in the construction of the plant and this rate should be made to cover the losses practically applicable to that period. 82. Cost of developing business. The cost of the physical property is but a portion of the original cost of the entire property, as has been fully explained in the chapter dealing with "the value inherent in a live plant." The original cost of developing the business must be determined and added to the original cost of the physical plant in order that a complete comparison can be made between the original cost of the property and its replace- ment cost at the present time. The original cost of devel- oping the business should be determined by the method employed by the Wisconsin Commission and briefly described in section 61. In ascertaining this cost, care should be taken to see that only such figures are included as can be considered reasonable and proper expenses in the conduct and development of a utility of the kind under appraisal. It must be appreciated by those whose duty it is to determine this cost that the results of their work will be scrutinized by the tribunal to ascertain whether the character of the plant was suited to the needs of the community, whether its cost as related to similar plants elsewhere was too high, whether the operating expenses in the past had been usual and reasonable, and whether undue charges, in the way of salaries or as cost of replace- ment of faulty construction, had been made to operating expenses. In order to enable such a scrutiny to be made, the figures should be presented in such a manner and in such detail that there can remain no doubt in the minds of the court or commission as to the propriety of their admission as a portion of the cost of developing the busi- ness of the undertaking. CHAPTER VII COMMERCIAL VALUE 83. Three figures to be presented under head of commercial value. 84. Relative importance of figures representing the market value of stocks and bonds. 85. Method to be used in ascertaining the market value of stocks and bonds. 86. Method of ascertaining value based on capitalization of net earnings. 87. Liabilities. 83. Three figures to be presented under head of com- mercial value. What is here called the commercial value of an undertaking is distinctly different from the values derived by the methods which have just been described, in that the values are determined in no way analytically but are based upon market values deter- mined either by the prices which the public is paying for the securities of the undertaking or by a capitalization of its earnings. There are thus two distinct commercial values, one the market values of the stocks and bonds, and the other the capitalization of the net earnings. In addition to these two figures is a third, the liabilities of the undertaking. This last figure should be presented in detail and in such form as will show the figure definitely demanded by the court, viz., the amount and par value of the stocks, bonds, or other securities which the under- taking has issued. 84. Relative importance of figures representing the market value of stocks and bonds. As indicated in section 9, when this subject was presented, there have been many who have felt that this figure, if developed with care and with proper precautions, was more reliable 116 PUBLIC UTILITIES than those obtained by the more artificial methods required in a determination of the replacement cost or of the original cost. It has been claimed that the market value " represents the crystallization of the best judg- ment respecting the value of property"; that it repre- sents the potential value of the property more nearly than can be derived in any possible way from such methods as involve the capitalization of past losses or a reproduction of a hypothetical new property; and that it recognizes any favorable peculiarities of location or of operating conditions which cannot be valued by any arbi- trary, theoretical or analytical determination of value. On the other hand the Maine Courts have said: "It may be true that if we were to-day valuing an ordinary corporation like a manufacturing corporation, a mercantile cor- poration, any corporation not engaged in the public service, public utility corporation, it might be that one way of measur- ing its value over and above the physical value would be to get at the value of its stock sold in the market. The people who bought and sold such stock may be fairly supposed to know what they are buying and selling, and what the rights, what the limitations upon such corporations are. There is no lim- itation to the amount of money which such corporation is entitled to earn if it can get it; no limitation outside of the char- ter as to the lines of business in which men engage. All the things which seem to establish the value of such stock may be fairly known, may be fairly presumed to be in the considera- tion of the men who bought and who sold. But when you come to the matter of a public service corporation, we are met at the very outset with this great difference; that the rights of the corporation to earn money are limited, that is to say, to earn money, to make a charge to its customers. They are limited by rules of law which are not easy, always, of applica- tion, they are limited by rules of law which we think are not and cannot be deemed to be within the knowledge and contempla- tion of investors in its stock. It would be rather a far reach to say that investors even contemplated the physical plant, the most of which is out of sight. Of course this is a matter COMMERCIAL VALUE 117 which would rather go to the weight of the evidence. There are elements in it of law, the application of legal principles which in our judgment remove it from the rule which might perhaps properly be applied to a business corporation; and it is because of this unknown and unknowable element of the legal application of rules to the rate question that we think the testimony is beyond the limit of admissibility." 1 Three other decisions only need be quoted to show the tenor of court rulings on this matter: " Again, when property has been capitalized by issuing stock, neither the market value nor the par value of the stock can be accepted in all cases as a proper criterion of value, because the stock may not represent the money actually invested, and, furthermore, because the property may have been capitalized mainly with reference to its income-producing capacity, on the assumption that it is ordinary private property, which the owner may use as he thinks proper, without being subject to legisla- tive control." 2 "The aggregate value of bonds and issued capital stock of the company at present market prices is not a reliable index of the value of the plant, because such prices often rise and fall from the operation of causes which have little or nothing to do with the real intrinsic value of the property, and the bonded or other indebtedness of the Company may exceed the actual value of its property." 3 "It is well known from experience that public utilities are mostly over-capitalized, and that the par value of their out- standing securities usually exceeds the actual investment in the property that is used and useful in connection with the serv- ices they render to the public. In fact, the bonds alone often amount to more than the cost-value of this property. The reasons for this are easily explained. They are found in the fact that in capitalizing the plants, whether for the purposes of consolidation or otherwise, securities are often issued not only against actual and other costs, but against estimated 1 Ruling of Supreme Court in Portland Water Works Valuation. See Trans. Amer. Soc. Civil Engs., Vol. LX1V, p. 60, 1909. 2 Cotting v. Kansas City Stock Yards Co. et al., 82 Fed. 854 (1897). 3 Spring Valley Water Works v. San Francisco et al., 192 Fed. 145 (1911). 118 PUBLIC UTILITIES monopoly profits, future increases in the business, estimated savings in expenses and many other elements of this nature. Not only this, but investigators of such matters feel that the greater proportions of the consolidation of business interests during the past three decades have had their sources in the opportunities for private gains that were offered to insiders in connection therewith, through unlimited security issues and the rigging of the markets by which these securities were un- loaded upon the public at prices that netted such insiders large profits. In the public utility field, where monopolistic conditions largely obtain, the opportunities for such practices have been relatively large. That security issues, based on such conditions, cannot often fairly measure either actual investments in, or fair value of, the property they represent, is rather obvious. It is equally clear that excessive capital issues of this sort can- not ordinarily constitute a fair and equitable basis for the valuation upon which the rates charged for the services rendered to the public should be fixed." " Operators in public utilities who fail to use ordinary business judgment, either in the location, construction, or management of the same, or who incur unnecessary and excessive obligations in other ways, should not be permitted to shift such extra costs upon the public. It is, in fact, to prevent such shifting and other unfair practices of this kind, which are possible under monopolistic conditions, that public utilities have been placed under government regulation." 1 While the above decisions indicate that, although for a private enterprise the market value of its securities may be a satisfactory way of measuring the value of the prop- erty over and above the value of the physical plant, still for a public utility the figures representing market value must be used with caution and possibly be of relatively little value. Notwithstanding such cautionary rulings, there can be no question that such a figure is of great assistance to a tribunal in forming a decision as to what the value in- herent in the property as a going concern really is. i Wis. R. R. Com. Rpts., Vol. XI, pp. 84 and 85 (1912). COMMERCIAL VALUE 119 The method to be used in deriving this figure will be very briefly described. 85. Method to be used in ascertaining the market value of stocks and bonds. The problem of ascertaining the true market value of stocks and bonds would be an extremely simple one if the market quotations as of the date of the appraisal could be accepted. This cannot be done, however, owing to the market fluctuations produced largely by speculative interests. Iii the long run it is the investing interest rather than the speculative inter- est which controls and determines the prices of securities. "With the view of arriving at a price which shall fairly rep- resent the value of the property, the course of the movement of prices must be examined over a sufficiently long period of time to warrant the assumption that the fluctuations caused by the manipulations of trader and speculator are neutralized. How long such a period should be must be determined by prac- tical judgment in each specific case. A cursory examination of the course of prices over a considerable period of time should be made in all cases. Should such an examination show the changes to have been comparatively slight and the course uni- form, the conclusion would be warranted that a comparatively short period prior to the date as of which the valuation is to be made is sufficient. If the changes are violent and appar- ently capricious, a greater period of time should be chosen." * What it is desired to obtain is a figure representative of the true present market value of the stocks and bonds of the undertaking freed from the fluctuations produced by speculative interests, freed from daily fluctuations, and from changes in prices due to the anticipation of dividend or interest payments. As has been stated, the elimination of fluctuations from speculative buyers can be accomplished by the use of prices for sales extending over a sufficient time in the past. 1 Bulletin 21, (1905), United States Department of Commerce and Labor, p. 22. 120 PUBLIC UTILITIES Daily fluctuations can be cared for most accurately, probably, by finding the weighted mean value of all sales during the period chosen for examination. This can be found by dividing the total amount paid for the secu- rities during the period of examination by the number actually sold. It is probable that in most cases the third cause of variation would not be the source of appreciable error if neglected, particularly if the period chosen for exam- ination was sufficiently long. This fluctuation would not be present in the case of a bond sold "flat," and, if sales are quoted with accrued interest, the amount of accrued interest to the date of sale should be subtracted from such quoted price in order to obtain the true value of the bond itself for the sale. In the case of stock, it can be cared for, particularly if the stock is one which pays dividends with a fair degree of regularity, by reduc- ing the market price for each sale by an amount equal to the expected accrued return, analogous to the accrued interest on bonds. The figures thus determined furnish one value based on commercial considerations to be used in an investi- gation as to fair present value. (For complete de- scription of this method reference should be made to Bulletin 21, United States Department of Commerce and Labor.) 86. Method of ascertaining value based on capitaliza- tion of net earnings. This item is designed to meet Mr. Justice Harlan's requirement for figures showing "the probable earning capacity of the property under particular rates established by the statute, and the sum required to meet operating expenses." This item was summarized in section 5, as "Figures showing the com- mercial or capitalized value of the business of the under- taking based upon present as well as possible future COMMERCIAL VALUE 121 earnings, i.e., the probable gross earnings less present or possible future operating expenses." Thus two sets of figures are to be presented in cases where a statutory rate has been imposed, one as of the earnings and operating expenses under prevailing rates, the other under the proposed statutory rate. For the present it will be necessary only to describe the first of these two sets of figures. There are two figures which require careful study in a determination of the capitalization of net earnings, one operating expenses, and the other the proper rate upon which the capitalization should be based. The net earnings are the gross earnings less operating expenses, taxes and reserves for depreciation. In any de- termination of the gross earnings for the purposes of valua- tion, both of these items should be examined with care to see that there have been included in them only such pay- ments as should legitimately be charged as expenses. Thus many undertakings have charged extensions of the plant to operating expenses and, thereby, reduced the net earnings by amounts which should have been charged di- rectly to the cost of the plant. In other cases insufficient amounts have been laid aside as depreciation reserves. It will be seen that it will usually be an extremely diffi- cult question to determine what the proper depreciation re- serve should be unless this method of valuation is pursued in connection with an appraisal which shows the replace- ment cost and depreciation of the physical property of the undertaking. In such a case, the depreciation reserves can be estimated with a reasonable degree of accuracy. The proper rate of return upon which the capitaliza- tion of net earnings should be based is the rate of return which the investing public is willing to receive for that particular security. Thus if the market value of the stock of the undertaking under appraisal has been found 122 PUBLIC UTILITIES by the method described in the last section to be 50 per cent above par value and the return paid stockholders is 6 per cent on the par value, then clearly the stockholder figures 4 per cent as the fair rate of return on his invest- ment. The proper net return capitalized on a 4 per cent basis would give therefore the commercial value of the undertaking. If the stock stood below par and paid no dividends, then clearly it would have speculative value only and could be given no commercial value on this basis, and reliance would have to be placed largely upon the prices of the securities as sold on the market. It should be noted that the rate upon which capitaliza- tion is to be based should be determined with the greatest possible accuracy, for the reason that a slight variation in the rate may cause an enormous variation in the capitalized value. It is necessary, therefore, that the present market value, one of the quantities essential to the determination of the rate for capitalization, should be found freed from all fluctuations and should be deter- mined to as many significant figures as may be necessary to secure the required accuracy. 87. Liabilities. The usual form of a corporation balance sheet is shown below. Figures have been intro- duced for ease of explanation. Assets Plant Apparatus, Etc Real Estate Working Capital Cash Bills and Accounts Receivable . . Supplies Stocks and Bonds (outside securities) Liabilities Capital Stock Funded Debt Bills and Accounts Payable Reserves Depreciation of Plant . . $1,000,000 500,000 200,000 200,000 100,000 $1,500,000 500,000 500,000 $2,500,000 $1,300,000 500,000 200,000 500,000 $2,500,000 COMMERCIAL VALUE 123 It will be noticed that the figures derived to show orig- inal cost and replacement cost were designed to be used as checks upon the plant account, the principal item in the assets of the undertaking. Working capital con- sists of cash and supplies plus " Bills and Accounts Re- ceivable." This sum in a valuation must be reduced by " Bills and Accounts Payable" which is carried on the books as a liability. Working capital can be obtained directly from the books of the undertaking and is pre- sented with the other figures as an asset. The only ques- tion involved in working capital is whether or not it is of proper amount for the successful conduct of the busi- ness of the undertaking. Securities of outside organiza- tions or quick assets of any kind are also entered with the other property but are properly securities held to make good the losses in value of the plant investment in perish- able property. The tribunal has, therefore, two figures to test the trial balance of the undertaking, original cost plus two constants, working capital and outside securities; and replacement cost plus the same two constants. The demand of the court for figures to show the par value of the stocks and bonds is for the purpose of com- paring the actual liabilities of the undertaking with its assets as given not only by the company's books but by the original cost and replacement cost plus the constants above described. The item of " Reserves Deprecia- tion of Plant," which is shown as a liability, is always difficult for one who is not an accountant to understand. In order to eliminate this difficulty, the above supposi- titious trial balance can be shown in a form which would present the financial condition in a manner suitable in an appraisal. 124 PUBLIC UTILITIES Assets Plant Apparatus, Etc $1,000,000 Real Estate 500,000 Cost-new 1,500,000 Loss due to Depreciation 500,000 Plant Value $1,000,000 Working Capital 300,000 Stocks and Bonds (outside securities) 500,000 $1,800,000 Liabilities Capital Stock : $1,300,000 Funded Debt 500,000 $1,800,000 The above statement shows the present value of the assets balanced against the liabilities, and it is this figure of the liabilities of the undertaking which the tribunal must have as one of the guides toward the true present value. CHAPTER VIII THE WORTH OF SERVICE TO THE CONSUMER 88. Decisions as to worth of service. 89. Rates based on different substituting plant not a criterion of worth. 90. Rates in other communities not a criterion of worth. 91. Profit inherent in worth. 92. Worth of service to be measured by what it would cost the public to furnish the same service. 93. Overbuilt plant. 88. Decisions as to worth of service. "It cannot be said that a corporation is entitled, as of right, and without reference to the interests of the public, to realize a given per cent upon its capital stock. When the question arises whether the legislature has exceeded its constitutional power in prescribing rates to be charged by a corporation controlling a public highway, stockholders are not the only persons whose rights or interests are to be considered. The rights of the public are not to be ignored. It is alleged here that the rates prescribed are unreasonable and unjust to the company and its stockholders. But that involves an inquiry as to what is rea- sonable and just for the public. . . . The public cannot prop- erly be subjected to unreasonable rates in order simply that stockholders may earn dividends. The legislature has the authority, in every case, where its power has not been restrained by contract, to proceed upon the ground that the public may not rightfully be required to submit to unreasonable exactions for the use of a public highway established and maintained under legislative authority. If a corporation cannot maintain such a highway and earn dividends for stockholders, it is a misfortune for it and them which the Constitution does not require to be remedied by imposing unjust burdens upon the public." * "The contention of the appellant in the present case is that in ascertaining what are just rates the court shall take into 1 Covington & Lexington Turnpike Road Co. v. Sandford, 164 U. S. 597 (1896). 126 PUBLIC UTILITIES consideration the cost of its plant; the cost per annum of oper- ating the plant, including interest paid on money borrowed and reasonably necessary to be used in constructing the same; the annual depreciation of the plant from natural causes result- ing from its use; and a fair profit to the company over and above such charges for its services in supplying the water to consumers, either by way of interest on the money it has ex- pended for the public use, or upon some other fair and equitable basis. Undoubtedly, all these matters ought to be taken into consideration, and such weight be given them, when rates are being fixed, as under all the circumstances will be just to the company and to the public. The basis of calculation sug- gested by the appellant is, however, defective in not requiring the real value of the property and the fair value in themselves of the services rendered to be taken into consideration." J The fair value of the services rendered are here ruled as a figure to be presented in a determination of fair present value. The same figure was ruled as necessary by Judge Harlan in the decision already quoted. "What the public is entitled to demand is that no more be exacted from it for the use of a public highway than the ser- vices rendered by it are reasonably worth." Similar rulings were made in the Maine Water cases: At the same time, the public have the right to "demand that the rates shall be no higher than the services are worth to them, not in the aggregate, but as individuals." "No more shall be exacted from the public than the services in themselves are worth to the public as individuals." 2 The worth of a water service in such connection "is the worth to the customers as individuals, but as individuals mak- ing up a community of water takers." 3 The question at issue is probably most clearly defined by Judge Savage : 1 San Diego Land Company v. National City, 174 U. S. 757. 2 Kennebec Water District v. City of Waterville (1902), 97 Maine 185. 3 Brunswick and Topsham Water Dist. v. Maine Water Co. (1905), 59 Atl. 537. WORTH OF SERVICE TO THE CONSUMER 127 "The elemental principles as thus far noted may be summa- rized as, on the one hand, the right of the company to derive a fair income, based upon' the fair value of the property at the_ time it is being used for the public, taking into account the cost of maintenance or depreciation, and current operating expenses; and on the other hand, the right of the public to have no more exacted than the services in themselves are worth." l This ruling is based on the decisions of the United States Courts in a number of cases. 2 89. Rates based on different substituting plant not a criterion of worth. The utility under investigation may have availed itself of such strategic position that it is able to furnish service more cheaply than would be pos- sible from a substituting plant in another location. The cost of this less favorably situated substituting plant can- not be made the measure of worth to the community of the service that it is enjoying at the date of the appraisal. The measure of the worth must be based upon the value of the plant under investigation. "But when he devotes his property to public use, he must submit to the right of the public to regulate his compensation for such use down to what is just both to himself and to the pub- lic, and that compensation is to be based, not on the cost of the next available substitute, but on a fair, reasonable value of the property at the time it is used for public convenience." 3 90. Rates in other communities not a criterion of worth. The courts have excluded evidence tending to prove the worth of the service to the users by a compari- son of the existing rates with the charges for similar 1 Kennebec Water District v. City of Waterville, 54 Atl. p. 14 (1902). 2 See Smyth v. Ames, 169 U. S. 466. San Diego Land and Town Co. v. Nat. City, 174 U. S. 739. Covington and Lexington Turnpike Road Co. v. Sandford, 164 U. S. 579. Cotting v. Kansas City Stockyards Co. 183 U. S. 79. Reagan v. Farmers' Loan & Trust Co. 154 U. S. 362. 3 Spring Valley Water Co. v. City and County of San Francisco, 165 Fed. 691 (1908). 128 PUBLIC UTILITIES service in other communities. This has been based on the fact that identical plants rarely exist in two places and weight cannot be given readily nor intelligently to the different causes which might tend to make the cost of the service or worth of the service more in one place than in another. Evidently with the object of finding some method by which the value of the service to the pub- lic could be determined, Judge Savage, in the Brunswick water case, ruled : In estimating the value of a public service "to the public or customers, one of the elements necessary to be considered is the expense at which the public or customers, as a com- munity, might serve themselves, were they free to do so, and were it not for the existence of the practically exclusive fran- chises of the supplying company. Water is to be regarded as a product, and the cost at which it can be produced or dis- tributed is an important element of its worth." 1 91. Profit inherent in worth. But this decision must not be construed literally. The community granted to the undertaking the right or franchise to supply the util- ity, preferring to do so rather than raise the money and incur the risk incident to the construction and operation of a service which, in most cases, was new and untried. By the granting of these rights it seems but reasonable to assume that the community was willing to pay some- what higher rates than would have been the case if it had undertaken the construction and operation of the business itself. In the Maine cases the courts have held that this excess must be a matter of judgment in the light of all existing facts, due recognition being given to the fact that the undertaking, in accepting its franchise, tacitly accepted whatever hazards there might be in the busi- ness. Thus, 1 Brunswick and Topsham Water Dist. v. Maine Water Co. (1905), 59 Atl. 543. WORTH OF SERVICE TO THE CONSUMER 129 " Injustice is done by anything that fails to deal equitably with the private as well as the public interests involved. It (a fair profit) is not necessarily regulated by what others would- now make the venture for under the present circumstances and with present knowledge.' 7 1 92. Worth of service to be measured by what it would cost the public to furnish the same service. It will be seen from the above quoted decisions, that the worth of the service of a public utility to the users must be based upon what it would cost the public to itself provide the same service that is being obtained at the present time from the undertaking. It would be measured, there- fore, by the rates which would have to be paid by the users to produce a gross income sufficient to maintain the plant, pay fixed charges and operating expenses, and provide an adequate annual reserve for depreciation. The investment which would have to be made by the public to enable it to furnish the service would equal the replacement cost of the existing plant, but from which no depreciation value had been deducted except such lack of value as might exist from the presence of inefficient elements in the existing plant. It must be remembered that the figure thus derived is simply one of the many which are presented to provide the Court with ample data upon which to base his deci- sion as to the present value. It may seem as if this figure was simply a repetition of those which have been already discussed but presented under a different name. In a measure this is true, but it must be recognized that the only measure of the worth of a service to the users must be what it would cost them to provide the same utility them- selves. It must be measured by the cost, at the date of investigation, of a new plant and a new organization. It cannot be measured by the present value of the exist- 1 Pennsylvania Ry. Co. v. Philadelphia County, 68 Atl. 679 (1908). 130 PUBLIC UTILITIES ing physical plant nor by the cost of the property of the existing undertaking. It is a value when derived as above described which is unfair to the undertaking which in good faith has created and maintained its plant and business in that it takes no cognizance of the profit which the undertaking is justly and legally entitled to receive. A proper increment must be added by the Court to this figure in forming his decision as to the fair present value. 93. Overbuilt plant. There is one point in this con- nection which must be carefully considered. If the plant has been overbuilt, so that its capacity exceeds the present demands for the utility, the worth of the serv- ice to the users cannot be based upon the reproduction value of the abnormally large plant, as the rates, which would have to be paid by the relatively few subscribers in order to provide a gross return ample to pay fixed charges, maintenance and depreciation, would be more than the service was worth. In such a case the worth of the service would be such rates as would have to be paid by the larger number of users for which the plant has been designed. The worth of the service, the fair rate, would be that which will yield a fair return upon the property then in use or useful to the "then" takers of the service or utility. The determination of whether a plant has been over- built or not is a simple and common engineering prob- lem. Every plant should be and usually is designed to meet an expected reasonable growth in the number of users. It would be an extravagant and foolish policy to build a plant of such size as will meet only the present needs of the public, and to make repeated enlargements to care for an increasing number of users. The above rulings cannot and must not penalize both the under- taking and the public by any such short-sighted and WORTH OF SERVICE TO THE CONSUMER 131 unbusinesslike policy. For all well-engineered plants, forecasts are made by those most competent to foretell the growth of the community and the probable percent- age of the population that will be takers or users of the utility. With these forecasts before him the engineer, on the basis of present worths and known costs of con- struction, can design the plant which will meet these pres- ent and future demands of the public with the least total expenditure. A plant thus designed and constructed would be a normal, not an overbuilt plant, although there would be at all times spare plant to meet emergencies and reasonable normal growth, and it is upon such a normal plant that the value of the service to the users must be based. A good illustration of an overbuilt plant is that afforded by the plant of the Tin turn Manor Water Company. 1 This company had constructed portions of its plant of a size that would not be required for fifty years. In the findings in this case, it was held that it was the right of the company, if not its duty to the public, to provide for a reasonable normal growth, but, as it could be shown that a smaller initial plant with later enlargements was that which would conform to the best engineering and greatest economy, the company could not expect a return upon the fair present value of such an abnormally large plant as was then in existence. This case is of further interest as the ultimate value upon which rates were based was found by discarding practically entirely the original and replacement costs and finding, as far as the physical plant was concerned, what the cost of a plant would have been to provide service for the present users and for such reasonable growth as good engineering and the development of the community indicated. 1 Long Branch Commission v. Tinturn Manor Water Co. (1905), 62 Atl. 474. 132 PUBLIC UTILITIES "The lots or others may be required some time, but no man can determine the contingencies of the future, and it will not do to burden the patrons of to-day in order to provide for pos- sible needs of those of five or ten years hence, at least when this is conceded not to be necessary in order to provide for equal facilities when demanded. This property should not be in- cluded." J 1 Cedar Rapids Gas-Light Co. v. City of Cedar Rapids. 120 N. W. 969 (1909). See also San Diego Land and Town Co. v. Jasper, 189 U. S. 446 (1903). CHAPTER IX RESERVES FOR DEPRECIATION 94. Investment in perishable property a wasting asset 95. Authority for depreciation reserves. 96. Current repair and maintenance. 97. Salvage value. 98. Wearing value. 99. Importance of accurate determination of probable life of units. 100. Creation of depreciation reserves. 101. Creation of reserve fund by "sinking fund" method. 102. Creation of reserve fund by "straight line" method. 103. Creation of reserve fund Authority for use of "sinking fund " or "straight line" method. 104. Mean life of plant. 105. Danger of misconception of mean life. 106. Adoption of " sinking fund " or "straight line" method of making reserves in practical cases. 107. Straight line method. 108. Sinking fund method. 109. Reserves invested in plant. 110. Reserves for depreciation. 94. Investment in perishable property a wasting asset. - A public utility invests its money in a plant, usually consisting of land, buildings and machinery of various kinds, for the purpose of providing the public with a service or utility of which the public has need. The money is not invested for the purpose of gaining profit by sale of the plant, as might be the case with mines or with raw material to be manufactured, but for the pur- pose of providing a utility which can be sold at such a price as will give the undertaking a reasonable return and profit upon the investment. But in the operation of the plant used to produce the utility sold, portions wear out or become obsolete, inefficient or of inadequate size, and, consequently, have to be replaced in the course of time 134 PUBLIC UTILITIES by new, more efficient or larger units. The investment in the older units has been gradually wasting away and, when the units can be used no longer, the investment represented by them ceases to be a portion of the cap- ital used for the benefit of the public. When a unit of plant has become unserviceable for any reason, it must be replaced by a new one. The cost of the new unit cannot be added to the cost of the orig- inal unit as, by such a method, the capital of the under- taking would not represent properly the money invested in plant in use and useful for the public. The original investment in the unit no longer serviceable must be removed from the capital account and the cost of the new unit entered in that account. Thus it is seen that after a time, in most public utility plants, the original invest- ment in many units has wasted, and that this loss in capital, arising from time of use or service, is a real cost of the production of the utility or service furnished to the public, and must be charged as a portion of the cost of service and paid for by the public in return for the service which it obtains. With this understanding it is apparent that the gross in- come of the undertaking must be sufficiently large to pay the operating expenses and taxes of the organization own- ing the plant, to pay the annual sums required for an amortization of the cost of the plant and pay to the stock- holders not less than a fair return upon their property. 95. Authority for depreciation reserves. The right of an undertaking thus to reserve each year considerable sums of money to be used in the reconstruction of plant in addition to the payment of dividends to stockholders, has been the subject of serious contention in the past and some of the earlier decisions of state courts have been against such a practice. 1 The Supreme Court of 1 See 118 Iowa 234 (1902) , 118 Cal, 556. RESERVES FOR DEPRECIATION 135 the United States, in a recent decision, has ruled definitely the necessity of public service corporations safeguarding their stockholders and the public by making ample reserves to prevent the waste of the investment in the property required for the use of the public. A portion of this decision and a few others bearing on this subject are given below. "A water plant, with all its additions, begins to depreciate in value from the moment of its use. Before coming to the question of profit at all the company is entitled to earn a suffi- cient sum annually to provide not only for current repairs but for making good the depreciation and replacing the parts of the property when they come to the end of their life. The company is not bound to see its property gradually waste, without making provision out of earnings for its replacement. It is entitled to see that from earnings the value of the prop- erty invested is kept unimpaired, so that at the end of any given term of years the original investment remains as it was at the beginning. It is not only the right of the company to make such a provision, but it is its duty to its bond and stock- holders, and, in the case of a public service corporation at least, its plain duty to the public. If a different course were pursued, the only method of providing for replacement of property which has ceased to be useful would be the investment of new capital and the issue of new bonds or stocks. This course would lead to a constantly increasing variance between present value and bond and stock capitalization a tendency which would inev- itably lead to disaster either to the stockholders or to the pub- lic, or both. If, however, a company fails to perform this plain duty and to exact sufficient returns to keep the investment unimpaired, whether this is the result of unwarranted divi- dends upon over-issues of securities, or of omission to exact proper prices for the output, the fault is its own. When, therefore, a public regulation of its prices comes under ques- tion, the true value of the property then employed for the purpose of earning a return cannot be enhanced by a consider- ation of the errors in management which have been committed in the past." l 1 Knoxville v. Knoxville Water Co., 212 U. S. p. 13 (1909). 136 PUBLIC UTILITIES "A tramway company lay down a new tramway. Of course the ordinary wear and tear of the rails and sleepers, and so on, causes a sum of money to be required from year to year in re- pairs. It may or may not be desirable to do the repairs all at once, but if at the end of the first year the line of tramway is still in so good a state of repair that it requires nothing to be laid out on it for repairs in that year, still, before you can ascertain the net profits, a sum of money ought to be set aside as representing the amount in which the wear and tear of the line has, I may say, so far depreciated it in value as that sum will be required for the next year or next two years. It appears to me that you can have no net profits unless this sum has been set aside. When you come to the next year, or the third or fourth year, what happens is this: As the line gets older the amount required for repairs increases. If you had done what you ought to have done, that is, set aside every year the sum necessary to make good the wear and tear in that year, then in the following years you would have fund sufficient to meet the extra cost." l " Depreciation should be met out of the earnings and should be charged to operating expenses. In no case should it be charged to the construction account, or be met by the proceeds of the sale of stocks or bonds, or other forms of fixed capital liabilities. This, at least, is the general rule and holds good except perhaps as a temporary expedient under abnormal conditions." 2 " Depreciation is, properly speaking, an operating expense and should be charged or treated as other operating expenses. A plant, that is not earning enough to meet depreciation, is a losing proposition." 3 96. Current repair and maintenance. An under- taking is entitled to a return sufficient to pay a fair return upon the tnie value of its investment in property useful to the public after paying reserves for depreciation and proper operating expenses. Operating expenses include not only the salaries and wages of all employees and other well established costs involved in the production of the 1 16, Ch. D. 347n (1879). 2 Wisconsin Commission, Vol. II, p. 154. 3 Ibid., p. 406. RESERVES FOR DEPRECIATION 137 utility sold, but also the costs of the material and labor required to maintain all plant units in efficient and suc- cessful operation. This expense for maintenance must be distinguished from the cost of renewals, although for certain classes of repair work the actual dividing line is frequently difficult to draw except by a more or less arbitrary ruling. A general rule which can be safely followed is that, whefe^ plant is in any way renewed or replaced, the cost of labor and material consumed in such work must be defrayed from the reserves for depreciation. Where there are no such renewals or renewals are of a trifling nature, the cost should be considered a portion of the operating expense under the head of maintenance. In reality the distinction between cost of renewals and cost of maintenance, or, as they are frequently called, the "cost of current repair," is more or less theoret- ical rather than practical. This distinction has been the cause of many misunderstandings and controversies. The explanation of these controversies probably lies in the fact that, in many of the older plants of large under- takings, there are many short-lived elements of relatively small value, the replacement of which, on account of wear and tear, obsolescence or inadequacy, is of almost uniform yearly occurrence. The uniformity and regularity with which such renewals are made, it is argued, places the cost of renewals in the same category as current repairs, and a distinction between the cost of renewals to be paid from depreciation reserves and the cost of current repair and maintenance to be treated as an operating expense, is unnecessary. But the facts are that plants contain some units of considerable cost and of a life greater than the average lives of most of the other units. When the renewal of these expensive units becomes necessary, there will be required sums of money much greater than would 138 PUBLIC UTILITIES be needed for the up-keep and normal renewals of other years. Such abnormal drains upon the treasury of the undertaking can be avoided, if, during the life of the unit, there had been set aside each year a sufficient sum to aggregate, at the time of the renewal, the original cost of the unit. In this way the abnormal demands of some years for means to make the necessary renewals of the plant are met by the contributions to the depreciation reserve fund made during a number of preceding years. Possibly another way of looking at this question may make this clearer. An undertaking, upon the best judg- ment of its experts, finds that, for the up-keep of its plant and for the renewals of unserviceable units, there is need each year of contributions from income of, let us say, 12| per cent of the plant cost. The costs of small repairs and renewals, which it finds necessary to make during this year, are charged against this reserve fund, as well as the costs of units that have to be replaced that year. It is possible that during that year 10 per cent of the cost of the plant is spent for these two purposes, thus leaving 2 J per cent of the 12 \ per cent reserved remaining unex- pended. This 2 1 per cent remaining this year is held in funds or otherwise as a depreciation reserve to help defray the costs of renewals which in some later years may be greater than could be met by the 12 J per cent usually reserved each year. Further, the necessity of treating the costs of renewals as a definite item of expense and making reserves to defray such costs is very conspicu- ous in the case of a new plant which may not reach, for many years, such a condition as was cited above where the sum of the costs of maintenance and renewals was substantially uniform year by year. During a term of years until renewals have to be made with a fair degree of regularity, current repairs and maintenance will be necessary, but as there is no actual immediate demand RESERVES FOR DEPRECIATION 139 for money for renewals, appropriations for that purpose from the yearly income might not be made as they should. It is with the object of emphasizing the necessity of pro- viding for future rather than possible present demands, that the distinction between current repair, an annual operating expense, and renewals, a charge against a fund designed to make such cost a uniform annual expense in operating the undertaking, is made. 97. Salvage value. From what has been said above it will be understood that the investment of an under- taking in many units of plant is wasting; that, when a renewal is required, the cost of the original unit must be removed from the plant account as an asset and the cost of the replacing unit entered as a portion of the cost of the plant. Moreover, it has been explained that the cost of the original unit must be recovered by an amortiza- tion, in the form of reserves made annually, in such a way that the original cost of the unit will be on hand in the reserve funds when the renewal has to be made. The above statement is not strictly accurate, for the reason that expense may be incurred in removing the old unit from the plant and, in many cases, the old unit may have some value as scrap or second-hand material. The difference between the scrap value of the unit and its cost of removal is the salvage value of the unit. Salvage may be positive or negative depending upon whether the scrap value exceeds the cost of removal or not. Clearly it is the difference between the original cost and the scrap value of the unit that is the wasting asset of the undertaking represented by the unit. This figure represents the sum of money which must be acquired, through the depreciation reserves, to make good this loss in the value of the investment resulting from the removal of the unit at the time when it has to be replaced. 98. Wearing value. This loss of capital represented 140 PUBLIC UTILITIES by the difference between the original cost and the sal- vage value is frequently called the " wearing value" of the plant or plant unit. 99. Importance of accurate determination of probable life of units. As the reserves required to meet the cost of renewals must be obtained by increments derived from income each year during the life of the plant, it is necessary for the management to forecast, with care and skill, the number of years that it is probable that each unit of plant can be retained in service, and from these figures derive the composite life of the plant as a whole. This problem is one requiring engineering knowledge and familiarity with the art upon which the service of the utility depends. It is of such importance that it will be fully discussed in the following chapter. But there is a second problem involved in the creation of reserves for renewals which, when the probable life has been determined, is one of accountancy. This sec- ond problem is, with a known " wearing value" and an estimated probable life for a unit, how large increments should be set aside each year in order that the capital cost of the unit, as represented by its wearing value, may be in hand at the time when a renewal must be made. This accounting problem is that of the creation of reserves for renewals. 100. Creation of depreciation reserves. In what has been said above it has been attempted to show that the investment in perishable property is a wasting one and that to offset such waste the loss in capital must be made good by an amortization of such capital loss during the period of probable usefulness of the property affected; that the capital loss is the difference between the cost and the salvage value, frequently called the " wearing value" of the property; that this amortization is cared for by sums of money set aside from income each year RESERVES FOR DEPRECIATION 141 of such an amount that at the end of the period of service- ability there will be in hand and available for the replace- ment of the unserviceable property a sum equal to the wearing value of that property; that the sums, thus set aside as an amortization fund, are usually termed reserves for depreciation. Thus, with a wearing value and a period of serviceability established by the exercise of the best expert judgment, the economic question arises as to the treatment of the amortization or depreciation reserve funds. As a practical matter the treatment of this fund will differ depending upon the conditions under which the undertaking may be operating. For a well-established, successful and growing undertaking, it may be found best, from a business point of view, to invest the amor- tization reserves, set aside each year from income, in needed extensions of the plant. In another case, sim- ilar to the above but where there is not the necessity for such a great extension of plant as will require all of the reserve funds, a portion may be invested in plant and a portion placed at interest in readily convertible securities. In still other cases, particularly where undertakings are not so well established that new funds can be easily secured or are not expanding, the entire reserves for depre- ciation may be invested most properly in safe and read- ily convertible securities upon which some return can be obtained. In each one of these cases, the capital invested in the property is made good and held good, but in each case the contributions to the reserve fund, made from income each year, may be different. 101. Creation of reserve fund by "sinking fund" method. If the reserves for. depreciation are to be drawing interest, as they should be if invested in secu- rities of other undertakings, the amount to be laid aside from the income of the undertaking under consideration 142 PUBLIC UTILITIES would be less than if no interest were obtained, as the fund would have the benefit of the interest accumulations. The amount to be set aside each year, therefore, is an annuity, which, at the obtainable rate of interest, will equal in the aggregate the "wearing value" of the prop- erty at the end of its Me. This method of creating depre- ciation reserves is known as the " sinking fund " method. 102. Creation of reserve fund by "straight line" method. In case depreciation reserves cannot obtain the benefit of interest accretions, the amount to be laid aside each year would be the amount represented by the wearing value divided by the years of serviceable life. This method of amortization is known as the "straight line " method, for the reason that, if the growth of the amortization fund were plotted, it would be shown as a straight line, owing to the equal annual increments. A similar curve for the sinking fund method would not be straight, for, although the annuity paid each year into the fund by the undertaking would be equal, yet the interest accretions would be larger and larger each year. It must be noted that at the end of the life of each element of perishable property, whichever method is followed either "straight line" or "sinking fund," there will be an equal amount on hand, i.e., the wearing value of the element, but that, during the intervening years, there will be a smaller amount in the reserves for de- preciation if the sinking fund method is employed and interest is obtained on the amounts held in reserve. 103. Creation of reserve fund Authority for use of "sinking fund" or "straight line" method. There has been and probably should be no arbitrary ruling, applicable to all cases, as to which method of forming depreciation reserves should be followed by undertak- ings. In the case of some undertakings, the "straight line" method may be the wiser, with others the "sinking RESERVES FOR DEPRECIATION 143 fund" method and with still others a combination of the two methods. The method to be employed in making depreciation reserves must be adopted after all the con- ditions affecting the economic conditions of the under- taking have been carefully considered. Thus in the case of many undertakings which have not made sufficient reserves in the past, there is a desire to be permitted by the courts and commissions to make as large a reserve for depreciation each year as possible, and, in conse- quence, the straight line method has had many advo- cates. Commissions have also ordered the use of the straight line method in cases where an amortization of overcapitalization of an undertaking was desired. 1 On the other hand, commissions have favored repeatedly the sinking fund method. In one case it was said: "the facts obtained tend to show that the sinking fund method of computing depreciation is, on the whole, fairer than the straight line method, and that the advantages of the sinking fund method tend to increase with increases in the average life of the utilities/ 7 2 "The expense of this substitution," i.e., replacement of old plant by new, "which does not increase the gross earning capac- ity cannot be fairly charged to capital account, but should be defrayed out of a suitably supported depreciation fund which has been gradually accumulated out of the earnings during the life of the equipment, and which, at the end of the life period, has become equal to the first cost of the original equipment diminished by the amount of any ' scrap ' value or salvage which may be obtained from the discarded equipment. Interest accretions will add to the amount as the fund grows, and the annual sum set aside out of the earnings should be adjusted with this in view. Three per cent is a conservative rate of interest to set as the minimum which ought to be accepted on the moneys of a trust fund, within which category this depre- ciation fund belongs." 3 1 See P. S. C., N. Y., 1st Dist., Vol. Ill, p. 156. 2 Wis. R. R. Com. Rpts., Vol. IV, p. 502. 3 Rept. Special Tel. Comm., Chicago, Apr., 1907, p. 71. 144 PUBLIC UTILITIES 104. Mean life of plant. The full significance of reserves for renewals is most clearly understood when the case of each individual unit of plant is considered. In such a case it is known that certain relatively small sums will have to be paid yearly for the current maintenance of the unit but that the capital invested will be active in earning its portion of the annual charges throughout the life of the unit. If one unit only is considered, it would seem as if no misunderstanding could occur as to the importance of reserves for renewals and that a choice between the sinking fund method or the straight line method was of no material importance, except so far as the financial question of new money was concerned, so long as the fund for the renewal of the unit had reached its wearing value at the time when it had to be replaced. But in practice the problem is not so simple. The plants of most large public service corporations are made up of a large number of elements, such as poles, rails, wire, generators and switchboards, the useful life of each of which will vary greatly, so that it is necessary, in order to find the total amount to be set aside in the reserves for renewals, to find the mean life of the entire plant. It will be well to keep clearly in mind the fact that the present discussion relates wholly to the question of the necessary reserves for renewals and, consequently, the life of the plant and its wearing value are the only figures involved. Units or elements may have been installed at different dates in the past and, consequently, have entirely different ageSj but the age of the several units has no bearing whatever upon the amount required for the reserves for renewals. The amount set aside each year for each unit is the same for each year of its life, that is, it is the same for an old as for a new unit, and, as a consequence, the increment to the reserve fund for all portions of the plant of the same life is the quotient RESERVES FOR DEPRECIATION 145 obtained by dividing the sum of the wearing values of all such portions of the plant by the number of years of their life. Or, in the case of a large plant with elements each of different life, the mean We is found by dividing the sum of such quotients into the sum of the wearing values of all plant elements, i.e., the wearing value of the entire plant. This can be illustrated best by a concrete case. Let the wearing value of all plant elements that can be useful for 5 years be $50,000; for 10 years be $100,000; for 15 years, $75,000; for 20 years be $100,000. Then, $50,000 -r 5 = $10,000 100,000 -T- 10 = 10,000 75,000 -r- 15 = 5,000 100,000 -T- 20 = 5,000 $325,000 $30,000 This shows that the annual reserves should be $30,000, which would be the same as if it had been said that the entire plant, having a wearing value of $325,000, had a mean life of approximately 10.8 years (325,000-^30,000). 105. Danger of misconception of mean life. In the preceding section an example is given illustrating the correct method of determining the mean life of a prop- erty. When thus determined the mean life becomes a figure by the use of which the property of a utility in one place may be compared with a similar property in another place. Naturally local conditions may have an important effect in causing a variation, but, generally speaking, it is possible to say that the mean life of a water plant is x years, of a gas plant y years, or of a telephone plant z years. But when we speak of the mean life of such a property as was considered in the preceding example as 10.8 years, it is not meant that $30,000 is set aside each year for 10.8 years and that the renewals required during that period are not made when required. The mean life is simply 146 PUBLIC UTILITIES a practical figure derived by a careful study of each unit and is to be used in determining the annual reserve for the plant as a whole. The reserve for each particular unit is made each year and is held for that unit in the funds until its life has been exhausted, at which time the wearing value of that unit is taken from the reserve to pay the cost of renewal of that particular unit. Possibly the idea of mean life will be clearer if the following thought is kept in mind. Take the case used in the preceding section and suppose that the plant does not grow and that the plant cost does not change, then, so long as the utility is in existence, using units which have been worn out and replaced time and again, there will have to be set aside as a yearly reserve for depreciation $30,000. Mean Me is, therefore, simply the number of years which will elapse before an amount equal to the total cost of the perishable property will have been paid from revenue for reserves for renewals. The mean life is not a Me dating from the original construction of the plant. It is true of a given plant at any time, now or in the future, provided the plant does not change in character or in cost. The failure to appreciate that the reserves for each unit accumulate for the benefit of that unit throughout that unit's life, and that mean life is simply a composite figure useful for determining what proportion of the total cost of the plant shall be set aside as the annual reserve for the entire perishable property, is the cause of most of the existing misunderstanding relative to the sinking fund method of accumulating reserves for renewals and the cause of many of the arbitrary rulings in favor of the straight line method. 1 106. Adoption of "sinking fund" or "straight line" 1 See Manhattan Railway Co. v. Woodbury, 203 N. Y. 231, (Oct. 17, 1911). RESERVES FOR DEPRECIATION 147 method of making reserves in practical cases. The discussion in the preceding sections of this chapter has been very largely theoretical and has been intended to present the fundamental principles involved in maintain- ing the capital value of the undertaking. When the practical case is presented to the management of a pub- lic utility as to which basis shall be adopted in making reserves for depreciation, the question must be answered very largely by a decision as to whether the reserves for depreciation are to be invested in extensions to the plant or not. If the reserves are to be invested in plant enlargements, then the straight line method must be employed. On the other hand, if the reserves for depre- ciation are invested in outside securities, then, as such funds have the benefit of interest accumulations, the use of a straight line method would result in abnormally large sums being set aside, and, in consequence, the sinking fund method is to be preferred. 107. Straight line method. The reason why the straight line method should be employed, when the reserves for renewals are invested in plant, is apparent when the operation of the sinking fund method is con- sidered. This can be understood most readily by a consideration of a practical example. Let it be assumed that the plant of an undertaking had cost $100,000 (assuming zero salvage value) and that it had a mean life of 10 years. Let it also be assumed that the undertaking operating the plant is entitled to a return of eight per cent. Then, during each of the ten years, the gross income must be sufficient to pay taxes, to pay the operating expenses, to pay eight per cent on the investment of $100,000.00 and to pay to a reserve fund such an amount as will aggregate at the end of ten years the original investment. For the present example, let it be assumed that each increment to this fund has 148 PUBLIC UTILITIES been invested each year in new plant needed and required by the public. If the sinking fund method is employed in figuring reserves for renewals, the undertaking must pay not only the annuity but the interest on the sinking fund. If the straight line method is employed, the incre- ments to the reserve fund will be the original cost divided by the years of life, or $10,000. The operation of this fund for each year of life by each of the above methods of accumulation is shown hi the following table: TABLE I YEARLY INCREMENT TO DEPRECIATION RESERVES TO COVER ORIGINAL INVESTMENT ANNUITY + INTEREST YEAKLY PAYMENTS Year Annuity Interest Sinking Fund Method Straight Line Method End of 1st $6903 $6903 $10000 2nd 6903 $552 7455 10000 3rd 6903 1149 8052 10000 4th 6903 1793 8696 10000 5th 6903 2488 9391 10000 6th 6903 3240 10143 10000 7th 6903 4051 10954 10000 8th 6903 4927 11830 10000 9th 6903 5874 12777 10000 10th 6903 6896 13799 10000 $100000 $100000 From this it is seen that, by the sinking fund method, the sums of the payments to the reserves, for annuity and interest, during the early years of the life of the plant are less than they would be if the straight line method was used, but, later on, the annual payments to the sink- ing fund become very much larger, in the 10th year $13,799 and $10,000 respectively. The results of the two methods, however, are the same, in that, at the end RESERVES FOR DEPRECIATION 149 of the life of the plant, there has been accumulated $100,000 by both methods. In other words, there has been contributed by the public for the purpose of reserves $100,000 by either method during the ten years that the plant has been useful. When it is remembered that the plant is made up of a large number of units, which have been brought into service at different dates, and is composed of units of different lives, it will be appreciated that the sum of the increments for the reserves for each unit would be not the amounts shown as the yearly total of the sinking fund column but rather figures approaching those shown in the straight line column. But even supposing that we were dealing only with a single plant unit; as the $100,000, the entire original cost, must be recovered by the under- taking from the public, clearly it is simpler and more rational to make the payments uniform for each year than to set up an artificial method such as that of the sink- ing fund, wherein different amounts must be set aside each year. It is true that, in some cases, it is desirable to make the burden upon the public as light in the early years of the operation of an undertaking as possible, but, for most public utilities, such an argument has no force. Moreover, the inequality of the demands for deprecia- tion reserves each year would indicate, at least theoret- ically, a necessity for an increasing or variable charge for the service or utility furnished. For the above reasons there seems to be no question but that, when reserves are used for needed and useful extensions of plant, the straight line method of making reserves for depreciation should be employed. 108. Sinking fund method. For practical reasons there seems to be no doubt as to the desirability of mak- ing uniform increments each year to the reserves for depreciation. By "uniform" it is not meant that the 150 PUBLIC UTILITIES same total amount should be placed in reserve each year, but that there should be set aside a uniform percentage of the wearing value of the plant as it is found to be after additions to the plant or removals of abandoned plant have been properly entered as positive or negative fac- tors in the plant account. If the depreciation reserves are invested in outside securities, the interest on the reserve funds is paid not by the public but by those having the use of the money. Moreover, the amount paid by the public as an annuity to the reserves would be uniform and (if 8 per cent could be obtained for such money) would be the amount shown as the annuity in the above table. Thus it is seen that, provided the straight line method is used when reserves are invested in plant and the sinking fund method when reserves are invested in outside secu- rities, the percentage of the wearing value of the plant to be set aside each year is uniform in each method but that the annual payments to the fund for renewals are larger when the straight line method is used than when the sinking fund method is employed. 109. Reserves invested in plant. It must not be inferred that, because the amount paid annually as a reserve for depreciation is less with the sinking fund method, when such funds are invested in outside secu- rities, than with the straight line method, the sinking fund method is, consequently, more favorable to the public and that it is therefore the proper method to be adopted generally. A careful consideration of this ques- tion will show that the burden upon the public is less when the straight line method is employed than it would be with the sinking fund method, in all cases where the undertaking is in successful operation, is growing and, consequently, requires new money with which to carry out needed enlargements or extensions of the plant. RESERVES FOR DEPRECIATION 151 This economic question is of such fundamental impor- tance that it will be discussed somewhat at length. The use of reserve funds for plant extensions necessarily indicates that the business is growing. If the plant is of sufficient size for all immediate needs, then, clearly, the sinking fund method is the only plan that should be used. But for a growing property the management has two alternatives, either to use the reserves to defray the cost of plant extensions, or to obtain new money from the stockholders for that purpose. In the latter case, the public will have to pay the full return upon the stock- holders' investment ; in the former case, the new plant would be provided from funds upon which the stock- holders can obtain no return. Where reserves are in- vested in plant, the undertaking is not using its own money for such extensions, but money in which the pub- lic has an interest, and, consequently, the public be- comes to a certain extent a partner in the operations of the undertaking. As a consequence of this the burden upon the public is somewhat less when the reserves are invested in plant than would be the case if the stock- holders' money was used. This point can be illustrated quantitatively by a numerical example. Let the cost of the plant be taken as $100,000, and let it be supposed that the plant has no salvage ^value. Let the rate of return to the stockholders of the undertaking owning the plant be 8 per cent and the life of the plant be ten years. Let us take the case first of the yearly requirements when the reserves are invested in plant. At the end of the first year $10,000 will be required as a reserve for depreciation. With this $10,000 let it be supposed that new plant is immediately purchased. The new plant will have a life of ten years. At the end of the first year of its use, i.e., at the end of the second year of the exist- 152 PUBLIC UTILITIES ence of the plant, a reserve must be set aside to cover the depreciation of the plant a year old as well as the second installment toward the depreciation reserve of the orig- inal plant. So that at the end of the second year $11,000 must be set aside, i.e., $100,000 -+ 10 and $10,000 -v- 10. This has been set out in the following table : TABLE II ILLUSTRATING ACCUMULATION OF DEPRECIATION RESERVES End of' Year Amount set aside each Year 1 $10000 $10000 2 10000 + 1000 11000 3 10000 + 1000+ 1100 12100 4 10000'+ 1000+ 1100 + 1210 13310 5 10000 + 1000+ 1100 + 1210 + 1331 14641 6 7 10000 + 1000+ 1100 + 1210 + 1331 + 1464 10000 + 1000+ 1100 + 1210 + 1331 + 1464 + 1610 16105 17715 It must be remembered that, in accordance with the assumptions of this example, the amounts set aside each year as depreciation reserves are invested in plant and, in consequence, the cost of the plant is constantly in- creasing by the increments given in the last column of Table II. The stockholders' original investment is only SI 00,000, but the cost of the property is constantly increasing with yearly increments of increasing size. This growth in cost .of the plant is shown in column 2 of Table III, page 153. Column 3 shows the condition of the investment of the stockholders in the undertaking. The original investment made by them in the plant unit remains unchanged during the first ten years, but the total amount that has been invested increases rapidly owing to the reserves that must be made to maintain the investment intact. At the end of the ninth year ^here has been expended to make good the original invest- RESERVES FOR DEPRECIATION 153 TABLE III ILLUSTRATING RELATIVE INVESTMENTS OF STOCKHOLDERS AND OF DEPRE- CIATION RESERVES IN A RAPIDLY EXPANDING ENTERPRISE End of Year Plant Cost Stockholders' Investment Investment of Reserves Mean Age (1) (2) (3) (4) (5) $100,000 $100,000 1 110,000 100,000 $10,000 .909 2 121,000 100,000 21,000 1.735 3 133,100 100,000 33,100 2.486 4 146,410 100,000 46,410 3.169 5 161,051 100,000 61,051 3.790 6 177,156 100,000 77,156 4.355 7 194,872 100,000 94,872 4.868 8 214,359 100,000 114,359 5.335 9 235,795 100,000 135,795 5.759 10 259,374 200,000 59,374 2.289 11 285,311 210,000 75,311 2.640 12 313,842 221,000 92,842 2.958 13 345,227 233,100 112,127 3.247 14 379,750 246,410 133,340 3.511 15 417,725 261,051 156,674 3.750 16 459,497 277,156 182,341 3.968 17 505,447 294,872 210,575 4.166 18 555,992 314,359 241,633 4.346 19 611,591 335,795 275,796 4.509 20 672,750 459,374 213,376 3.171 21 740,025 495,311 244,714 3.306 22 814,027 534,842 279,185 3.429 23 895,430 578,326 317,104 3.541 24 984,973 626,159 358,814 3.642 25 1,083,470 678,775 404,695 3.735 26 1,191,818 736,652 455,166 3.819 27 1,310,999 800,317 510,682 3.895 28 1,442,099 870,348 571,751 3.964 29 1,586,309 947,382 638,927 4.027 30 1,744,940 1,132,120 612,820 3.511 ment, as well as the wasting investment in plant built with reserves, a total sum of approximately $235,795.00. In other words, the cost of plant built with the reserve funds exceeds the cost of the original plant built with stockholders' money by approximately $135,795.00. The 154 PUBLIC UTILITIES plant as a whole still has a depreciated value of $100,- 000.00, as there has been invested from reserves approximately $135,795.00 in plant which has itself de- preciated about $35,795.00 at the end of the tenth year, the plant representing the original investment has become worn out. At this time the stockholders must invest $100,000.00 of new money to make good the original plant which has passed out of existence and each year there- after money must be paid in to replace portions of the plant, originally built with reserves, which become yearly unserviceable. At the beginning of the nineteenth year the stockholders' investment has become about $314,- 359.00, while there has been invested in plant approxi- mately $555,992.00. This shows that at this particular time the reserves for renewals are $241,633.00, approx- imately three-quarters of the stockholders' investment. This study illustrates the principle of the operation of depreciation reserves when invested in plant and brings out clearly the important fact that very large reserves, under certain conditions, are essential to the security of the investment in wasting property. The above table has been presented in an extended form in order to illustrate the fact already suggested in section 105, that, for every additional investment in per- ishable property, there is required each year in perpetuity a sum of money equal to a certain fraction of that invest- ment to be set aside from income for the purpose of renewals. Clearly the same results can be obtained more simply by making a reserve each year equal to the cost-new of the property divided by the life. The above table is useful also to show how the succeeding table has been prepared, wherein it is shown by how much greater the burden is upon the public when extensions to plant are constructed by the use of new money, subscribed by the stockholders, than is the case when the money RESERVES FOR DEPRECIATION 155 reserved for renewals is used for that purpose. It must be remembered that, to make this comparison possible, it is necessary to assume that all of the reserves invested" in plant were for needed extensions and that, if the reserves had not been used for this purpose, money would have had to be obtained in some other way. Moreover, it can be assumed that operating expenses and taxes are propor- tional to the size of the plant and, in consequence, need not be introduced with the other figures presented in this study. Reserves for renewals must be first taken from gross income and stockholders can obtain 8 per cent on the money invested by them in the property. Table IV, page 156, shows the gross income which must be obtained from the public when the reserves are in- vested in plant and when they are invested in outside securities. Column 3 shows the gross income required when reserves for renewals are invested in plant, and column 7 when the reserves are invested in outside securities. It will be seen that, although somewhat greater in the first few years, in later years the amount required to be paid by the public to create this gross income is con- siderably less when the reserves are invested in needed extensions of plant than is the case when these extensions are paid for by stockholders 7 money upon which the full rate of return must be paid. 110. Reserves for depreciation. It will be noted that throughout this chapter the reserves set aside each year to make good the losses in the capital invested in perishable property have been spoken of as "reserves for renewals." This term is not that usually used. These reserves are commonly called "reserves for depreciation." and will be so designated hereafter in the present work. The expression " reserves for renewals" has been used to avoid the ambiguity which at present exists in the use 156 PUBLIC UTILITIES TABLE IV GROSS INCOME REQUIRED TO PAY RESERVES FOR RENEWALS AND DIVIDENDS (Taxes and Operating Expenses Omitted) Reserves for Renewals Reserves for Renewals Invested in Plant Invested in Outside Securities 00 Cost of a t> Required "C*.2 5 a * 8 Plant S"c3 tn W | {I 1 "3 it If 1 "5 1 II 3 i loll 5 1 (1) (2) (3) (4) (5) (6) (7) Year $100,000 End of 1st $10,000 $8,000 $18,000 110,000 $ 8,724 $ 8,000 $16,724 2nd 11,000 8,000 19,000 121,000 9,596 8,800 18,396 3rd 12,100 8,000 20,100 133,100 10,556 9,680 20,236 4th 13,310 8,000 21,310 146,410 11,612 10,648 22,260 5th 14,641 8,000 22,641 161,051 12,773 11,713 24,486 6th 16,105 8,000 24,105 177,156 14,050 12,884 26,934 7th 17,715 8,000 25,715 194,872 15,455 14,172 29,627 8th 19,486 8,000 27,486 214,359 17,001 15,590 32,591 9th 21,435 8,000 29,435 235,795 18,701 17,149 35,850 10th 23,579 8,000 31,579 259,374 20,571 18,864 39,435 llth 25,937 8,800 34,737 285,311 22,628 20,750 43,378 12th 28,531 9,680 38,211 313,842 24,890 22,825 47,715 of the word " depreciation/' Reserves thus set aside are for the purpose of amortizing the loss of the invest- ment in property of limited life. As far as reserves for depreciation are concerned, there is no question involved of the physical condition of the unit at any intermediate date in its well defined life. A unit may deteriorate in effi- ciency or it may deteriorate in such a way as to require greater expenditures for maintenance, but, as will be shown in the next chapter, such "deterioration" may affect the life of the unit but can affect in no other way the reserves for renewals which must equal the wearing value of that unit at the end of its life only. RESERVES FOR DEPRECIATION 157 The term, " reserves for renewals, " conveys this impres- sion more clearly to most minds than " reserves for depreciation," for two reasons, first, depreciation to be figured in cases of valuation for a date interme- diate in the life of the plant, hence there is always a ques- tion whether or not reserves for depreciation, i.e., reserves for renewals at the end of life, are a measure of the loss of value at an intermediate date; and, second, whether " depreciation " and " deterioration " should not be made synonymous terms. These two questions will be discussed at length in suc- ceeding chapters, but what we have been concerned with up to the present time has been the " reserves" required for renewals, usually called " reserves for depreciation," which reserves, so far as they are made carefully and intel- ligently along the lines which have been suggested above, have nothing to do with deterioration but simply insure the undertaking and the public of a continuation of the operation of the undertaking with best service at the least possible expense. CHAPTER X LIFE OF PLANT 111. Life of plant. 112. Continuation of undertaking. 113. Interest of public in operation of public utility. 114. Interest of public in depreciation reserves. 115. Maintenance and depreciation reserves. 116. Importance of "life" in a determination of depreciation. 117. Life of a plant unit. 118. Physical life. 119. Factors affecting life of plant. 120. Inefficiency. 121. Wear and tear of plant. 122. Obsolescence. 123. Inadequacy Definition. 124. Inadequacy Changes in financial policy. 125. Inadequacy Engineering economy. 126. Inadequacy Unexpected development. 127. Operation of factors affecting useful life of plant units. 128. Probable life of various plant elements. 129. Limited tenure of holding. 111. Life of plant. Before entering upon a discus- sion of the loss in value of a plant on account of age, which is the problem of depreciation in a valuation, it will be necessary to consider the question of the determina- tion of the life of each unit in the plant as well as the composite life of the plant as a whole. The life of each unit and of the whole plant must be known in order to make proper depreciation reserves, i.e., reserves for renewals, and the same figure is needed for use in con- nection with a figure showing "age" when the loss of value must be determined in an appraisal. The life in these two cases should be the same but, clearly, there is a possibility of a somewhat greater degree of accuracy when life is determined at the time of an LIFE OF PLANT 159 appraisal, for the reason that many units are nearer the ends of their lives so that a shorter forecast into the future is necessary. 112. Continuation of undertaking. One or two fun- damental considerations must be appreciated before it is possible to discuss the subject of the life of a plant as it must be determined by the engineer. The first and possibly the most important is a definite recognition of the fact that, in the case of most valuations, an appraisal is made of a continuing service. The present undertaking, or possibly its successor, will continue to give service to the public for many years in the future, using the same plant or the same plant renewed when portions have become unserviceable. A valuation per se imposes no limit to the life of the undertaking. At first sight this consideration seems to be unneces- sary but, as a matter of fact, the lack of a full apprecia- tion of this point has been, in most valuations, the source of much controversy. There is a tendency for all men to feel that apparatus and plant which has been for some time in use is " second-hand" and that, being-second hand, such apparatus and plant, even though it may have been in use but a short time, must be of greatly reduced value. Plant units, in the intermediate years of their lives, would unquestionably bring much lower prices if they had to be removed from the plant of the undertaking and sold. This loss in value would arise not only from the expense incident to their removal but from the smaller market which exists for a partly worn article. But, at the time of an appraisal at an intermediate time in the life of most units, there is no question but that the units will be retained in the plant throughout their serviceable life, whatever that life may have been determined to be. The units are partially worn but are not second-hand in the ordinary acceptance of that term. This is equally 160 PUBLIC UTILITIES true if the appraisal is made for a case of sale. The pur- chaser is buying a partially worn plant, a plant which he may argue is second-hand, but it is an assemblage of units furnishing a service to the public which the pur- chaser undertakes to continue to give. Buyer and seller agree upon the present age of the several plant elements as well as upon the number of years the units can be retained in service, i.e., the life less the age. It is thus seen that there have been removed all of the attributes usually attaching to second-hand plant or material. The plant units are to be retained in their present position until the end of an agreed period. There is no expense of removal or adaptation to new conditions, and, as far as may be humanly possible, all uncertainty as to the usefulness of second-hand apparatus has been removed by the agreement of experts of necessarily differing views as to the length of time it is wise and proper to retain the units of the plant in service. Thus the engineer's problem is reduced largely to a determination of the years of remaining serviceable life in the several units of which the plant is composed. Usu- ally the age of the units can be determined without diffi- culty or controversy. With the age known and with an agreement as to the years of remaining life, the total life of each unit of plant has been found and the engineer's portion of the problem of determining depreciation has been solved. 113. Interest of public in operation of public utility. A second consideration, which is usually lost sight of in the valuation of a public utility, needs to be fully appre- ciated, and that is that a public service undertaking has been given certain special rights and privileges and, in return, the undertaking must conduct its business in such a way that the best service or product is afforded with the least expense to the public. It is the question LIFE OF PLANT 161 of least expense to the public which requires special con- sideration in this connection. For the utility furnished by the public service under taking, the public must pay a proper rate of interest upon the invested capital, the salaries and wages properly attaching to the operation of the enterprise, a fair and reasonable profit as well as the cost of current mainte- nance and repairs and proper sums to be set aside each year to defray the cost of the replacement of the plant or portions of the plant when they can be retained no longer in service. The first three of the above sources of expense need not be discussed in the present connection. The last two items of expense, current maintenance and repairs and depreciation, are the two directly involved in a determination of the depreciation of a property. These expenses are direct contributions made by the public to enable the undertaking to give it the best ser- vice not only at the present time but in the future. The rights of the public demand that the sum of these two items should be kept as low as possible consistent with a modern and high grade product. The demand for mak- ing the sum of these two items a minimum has an impor- tant influence in the work of the engineer in determining the life which should be assigned to the different units of plant. 114. Interest of public in depreciation reserves. As a corollary to the question discussed in the last section is the fact that the public has a direct interest and right in the reserves which are contributed by them for the special purpose of renewing the plant when it becomes unser- viceable and are held by the undertaking for that specific purpose. It will be found, frequently, that officers of undertakings are in the habit of considering reserves for depreciation as money earned through their own good management and, as such, a portion of the property of 162 PUBLIC UTILITIES the undertaking. Reserves, thus set aside, are unques- tionably a portion of the property of the undertaking, but the fact must not be lost sight of that the money thus set aside came from the public in the form of higher rates than would have been required otherwise, and that the public has paid such higher rates for the sole purpose of guaranteeing for themselves a continuation of the ser- vice of the utility with high grade apparatus and plant. The reserve fund, therefore, while belonging to the under- taking, belongs also to the public which actually has con- tributed it. The undertaking must hold such funds for the benefit of the public as well as for itself, and the reserves for depreciation can be used properly and legiti- mately only for one purpose, for maintaining the value of the investment in perishable property unimpaired. The truth of the above contention has become so well understood and established that it would be unnecessary to emphasize it in this connection were it not for the fact that its full significance has not been appreciated suffi- ciently by the officers of undertakings or by experts. They fully recognize that the reserves for depreciation should not be distributed as dividends to the stock- holders, but, when a question of value for rates or for sale arises, they are in doubt as to the proper treatment of this fund or of the plant which may have been acquired with this fund. The reserves for depreciation, being, virtually, funds of the public, held in escrow for plant renewals, cannot be considered as a part of the prop- erty of the undertaking upon which the undertaking can demand a return nor, in the case of a sale, can such reserves be held back by the seller as his property; the reserves must be transferred to the buyer, who then becomes responsible to the public for the proper expend- iture of such reserves in replacing plant which has become unserviceable. LIFE OF PLANT 163 115. Maintenance and depreciation reserves. - There is another feature which requires definition in order that the subject of depreciation may be fully under- stood. It is the distinction which must be carefully made between the cost of maintenance and the cost of renewals. The expenses to which an undertaking is put in making the small repairs necessary to keep a plant in a high state of efficiency has nothing to do with the depreciation reserves. It is a current expense incident to the operation of the plant and as such may and should be taken from income. The cost of maintenance for each class of property may not be uniform throughout its life; in fact, in some cases, it is greatest when a plant element is new and, in a large proportion of cases, it is of increasing magnitude for each year of increasing age. This question of cost of maintenance, the cost of keep- ing up the efficiency of a plant or a plant element may have an effect upon the life of the unit, as it may be shown that the increased cost of maintenance would justify the renewal of the unit, but it can thus have only an indirect effect upon the depreciation. The reserves for depreciation are designed only to keep the " capital" of the undertaking unimpaired, and, as a consequence, are to be used only to defray that por- tion of the expense of renewal as was represented by the original capital cost of the unit. 116. Importance of "life" in a determination of depre-" ciation. It is seen from the above considerations that the "life" of each unit of plant is of fundamental importance in a determination of its deterioration or deprecia- tion. Its life may depend upon a number of considera- tions which will be fully discussed later but, in whatever manner it may be decided eventually that a plant depre- ciates in value between the time it was put into service and the time of its renewal, the life, the years of useful 164 PUBLIC UTILITIES service, is the same and is the one and most important controlling factor. 117. Life of a plant unit. Some clearness in the pres- entation of this subject can be obtained by making a dis- tinction between the actual physical life of the unit and its serviceable or useful life. The physical life of a plant unit is the number of years that it could be retained in service and furnish substan- tially the same character of service as it was designed to afford. The serviceable or useful life is the number of years during which, for economic or public considerations, it may be considered wise to retain the unit in service. In very many cases the physical life and the useful life may be the same. In others, the useful life will be less than the physical life. Clearly in no case will the useful life be greater than the physical life. 118. Physical life. The physical life of a plant unit is the number of years that the unit can be retained safely Jin service without introducing any hazard to the uni- formity of the service which the unit is called upon to perform. Such hazards, as may occur, arise from a loss of strength in the unit due to wear and tear or to decay resulting from the years of service. Thus the strength of a pole, used to support overhead wires, diminishes as time goes on by the decay of the wood, of which the pole may be made. The pole has a physical life from the time it was set up to the day when the pole becomes so weakened by decay that it must be replaced in order to remove the hazard to the continuity of service which arises from the possibility of the pole falling in case of high wind or an overload of snow or sleet. Or in the case of an electric car upon a tramway, the car may require occasional repairs but the physical life of the car will LIFE OF PLANT 165 be the length of time that it can be retained in use and furnish good, safe and satisfactory service to the public. In other words, the physical life of a plant unit is deter- mined largely by what is usually spoken of as the "wear and tear" upon the unit arising from its position and the service which it is called upon to perform. 119. Factors affecting life of plant. The years of remaining serviceable or useful life of plant elements must be determined by a careful consideration of all factors or conditions which may tend to lengthen or shorten the period of serviceability. The following factors have been admitted as the most important to be considered in the determination of this figure. 1. Wear and tear of plant. 2. Obsolescence. 3. Inadequacy. 4. Tenure of holding. 120. Inefficiency. Before entering upon a considera- tion of the above factors influencing the life of plant units, it will be well to discuss somewhat at length how far the value of a plant is affected by the relative ineffi- ciency of the older units which may be found in service as compared with a plant composed entirely of new or newer units. This question is introduced thus early in the consideration of depreciation for the reason that the relative inefficiency of an older plant, as compared with a newer, is one of the most frequent arguments raised to substantiate the claim in a valuation that the existing plant, being more or less inefficient, is really second-hand and, therefore, of an abnormally low value. Moreover, the inefficiency of a unit may arise from the wear and tear of use, from the antiquation of the method of its operation as compared with a substitute of later and 166 PUBLIC UTILITIES improved design, or from the fact that the business has grown to such an extent as to render the unit too small for present demands. Thus inefficiency enters as a fac- tor affecting the three principal factors, to be discussed later, which have a dominating influence in the decision of the engineer as to the probable life of the unit. In what follows it will be shown that inefficiency can- not be made a factor distinct from "wear and tear," "obsolesence," and " inadequacy," which are the three main causes of the limits imposed upon the life of plant units, but rather that inefficiency is an important con- sideration or factor entering into the determination of the life period assigned from a study of these three main factors affecting the "life" of perishable property. It must be recognized, however, that, for a large num- ber of classes of units, inefficiency does not enter at all for the reason that the units of such classes are equally efficient throughout their life. Clearly in such cases the physical life is limited only by the wear and tear which, in time, renders them so untrustworthy as to intro- duce a hazard to the continuity of a high grade of ser- vice. Thus in the case of poles, wires, conduits and many other elements of a similar character, there is no diminu- tion in the efficiency of the units of the several elements throughout their physical life. When they become so weak that there is danger of their failing to give good service, they are removed and replaced by new units. But during their entire life there is little or no expense of maintenance incurred to keep them in a high state of effi- ciency. Their efficiency remains practically uniform. But with other classes of property, especially such as have moving parts, there is an increasing need of repairs with increasing life, so that the cost of maintenance becomes, in time, a matter of serious importance in deter- mining the useful life of the unit. It is true that, by con- LIFE OF PLANT 167 stant and frequent repairs, the useful life of a unit might be greatly prolonged, but such increased useful life could be obtained only by an excessive cost of maintenance? As this cost of maintenance is a charge which must be borne by the public, no public service undertaking would have performed its proper duty to the public if it had not seen that the useful life of each plant unit was made no longer than could be justified by a full consideration of the economic conditions arising from the cost and annual charges of a new unit as balanced by the annual charges arising from the retention of an older unit in service. The same is true in the case of such elements as grad- ually become less efficient and must be subjected to fre- quent repairs in order to maintain a required standard of operation. The problem, in all such cases, becomes one of determining the life of a unit by a consideration of cost and annual charge upon a new unit, and the cost of main- tenance which may be expected to arise during succeed- ing years if the existing unit is retained in service. This problem is one which is familiar to all engineers and is still one of determining the life of a unit but, for units of this class, the estimate of probable life is not based upon general knowledge and experience as to the usual life of units of the same character under similar conditions but upon figures gained from experience as to costs of new units and the annual charges upon such units during succeeding years of service. Again, a plant unit may become inefficient as compared with a new form of later design or in which some new invention has been incorporated. In such a case the inefficiency will become apparent in a larger cost for the production of the service sold than would be the case if the newer form were used. The problem is, again, a simple and usual one for the engineer to solve, having 168 PUBLIC UTILITIES due regard for all of the annual charges which affect the cost of the service to the public. In this case the engineer must determine when the renewal should be made and produce a minimum charge over a term of years for inter- est on the investment, depreciation reserves, mainte- nance and cost of operation. If the figures representing these annual charges have been determined with care, the life to be given to the unit can be readily assigned. Again, a plant unit which has become too small may have its life determined largely by engineering reasoning based upon the above items of annual expense which must be borne by the public. It is thus seen that inefficiency is a result produced in many cases by the "wear and tear," " obsolescence," or " inadequacy" of the plant unit. It is the measure usually of the limit imposed upon the life of the units by each one of the above three factors. It cannot be considered in any way as an independent factor pro- ducing depreciation nor, in the usual interpretation of its effect, of transforming existing plant into second-hand plant even though such plant is retained in service. Ineffi- ciency may be the final factor imposing the limit to be assigned to the life of a unit under each one of the factors, "wear and tear," "obsolescence" and "inade- quacy," but one of these three factors alone is instru- mental in determining the life of a unit and, when that life has been determined and assigned definitely, and not until after that life has been exhausted, does the plant become second-hand. 121. Wear and tear of plant. As has been stated already in speaking of physical depreciation, the first and usually the most important factor tending to limit the life of a plant unit of an undertaking is that which arises simply from time of service, exposure to the elements and decay, and has been termed "wear and tear." LIFE OF PLANT 169 All elements and units in a plant begin to deteriorate with more or less rapidity from the moment they are intro- duced into the plant, even though, in many cases, the- actual use of the units may not be great. Thus, poles, insulation of outside rubber-covered wire, switchboard plugs and cords all begin to deteriorate with more or less rapidity from the time they are put into place, and will continue to deteriorate until such time as the units are unable to meet the requirements of service and must be replaced. Deterioration as here considered has no effect upon the service or utility furnished, as the plant is kept up to a standard of operating efficiency by the repair of individ- ual units and by the time and money expended for the up-keep of the plant, usually termed the " maintenance and current repair" of the plant. But despite such maintenance and current repair, a time comes when either the expenses of this character become so great that, for engineering and coinmercial reasons, the unit of plant has to be replaced, or the unit becomes so weak as to ren- der its retention a hazard to the service and makes* its replacement desirable. It must be clearly remembered that the above figures for the life of elements will be greatly affected by the condition in which they have been maintained by current repair. In consequence of this, the effects of wear and tear upon the elements, of which the plant is composed, cannot be determined by theoretical considerations but only by actual observation and inspection made by ex- perts familiar with the operation of similar plants. 122. Obsolescence. The physical life of a unit of plant may be shortened by changes or improvements in the art, which development will be productive of a better product or of a similar product at a lower cost, or pos- sibly of both. 170 PUBLIC UTILITIES A public service undertaking is bound, in virtue of the franchises it has received, to give to the public the best service that can be offered and at as low a cost as may be consistent with the public needs. The development of the art, upon which most utilities are dependent, has been gradual in the past and it is probable to continue into the future. Under such conditions it is frequently necessary to replace an existing unit before the number of years, assigned to it on the basis of its physical life, has been attained. Thus there are two considerations involved in obsoles- cence, improved character of service fl/n rl inf^rpg^pH efficiency. Both of these considerations must be ever in the mind of the engineer when making his estimate as to how far this factor of obsolescence may enter to affect the life of any plant unit. Unquestionably there will be always some uncertainty attaching to the estimate made by the engineer as to the limit of the life of a unit to be expected by the oper- ation of the factor of obsolescence. Moreover, there can be no question but that the accuracy of the forecast will depend very largely upon the familiarity of the engineer not only with the developments, which have taken place in the past in the special art involved, but with the weak- nesses of the present plant equipment and the probability of such defects being overcome within the physical life of each unit by improvements and inventions. But these uncertainties should cast no doubt upon the importance x of a careful and expert forecast of the effects of obsoles- cence upon the lives of the several plant units. It can- not be denied that obsolescence, in the past, has entered in a very large number of cases to limit the serviceable life of many units of plant and there is no reason to suppose that similar conditions may not arise in the future. No undertaking would be wise in assuming that LIFE OF PLANT 171 all of the plant could be retained in service until it had been worn out completely. However, with each succeed- ing year of the life of the unit, this uncertainty becomes less, so that, in most cases, at the time of an appraisal, usually some years after the plant units have been in service, there is sufficient information at hand to be able to tell with reasonable accuracy whether or not the limit of life due to obsolescence will be less than the physical life and to assign some definite figure with this considera- tion in mind. In the case of most public utilities, the problem of obso- lescence is not as difficult of solution as it may seem to those who are not specially expert in the art. With by far the larger number of classes of units, those most famil- iar with the art know the units which will be able to serve their entire physical life, and what classes are so uneconomical or otherwise defective that some improve- ment must be expected. But, even for this latter class, there is always the question of the economical time when the change should be made and still further there is the probability, especially with the larger utility undertak- ings, of some time elapsing before it is wise or possible to make a replacement of all units of the plant. It is not usual that such changes can be made in a wholesale manner. Thus, taking the case of a telephone switch- board, a new form may be developed to-day but it would require many years before a general change could be made of all switchboards in the system. Changes of this character must be made slowly and carefully in order that no interference with the service should take place and, in any wise replacement of older switchboards by newer forms, it is probable that obsolescence would have only a small effect as a limitation upon the physical life of apparatus of this character. 123. Inadequacy. Definition. A third factor tend- 172 PUBLIC UTILITIES ing to shorten the lives of plant units is " inadequacy/ ' which, as the term implies, is the condition arising from the growth of the business and from the consequent neces- sity of replacing smaller units by larger ones. While this factor is unquestionably one which has been the reason for shortening the lives of many units, par- ticularly in communities where the increase in activities has been rapid, and although it has been recognized by the courts as one of the factors which should be consid- ered in determining the probable lives of plant units, yet in some respects it seems to be somewhat different in character from either "wear and tear" or " obsolescence." There appear to be three main classes of conditions which tend to introduce this factor of inadequacy, - first, a change in financial policy; second, engineering jgonomy: and thirb!. unexpected development. 124. Inadequacy. Changes in financial policy. - That changes in financial policy have been the cause of the rejection of many plant units as too small, will be apparent if the past history of many of our public utility undertakings is reviewed with this thought in mind. It will be surprising to note in what a la^ge proportion of the cases where units have been replaced for the reason that they were of inadequate size, the cause can be attributed directly to a lowering of the rates for service or to the introduction of some special rates to attract new classes of customers. It is here contended that inadequacy based on such a reason is not the inadequacy recognized by the courts as justification for the assignment of a shorter life to units and the consequent imposition of larger reserves to be contributed by the earlier subscribers to the service afforded by the utility. The burden, which such a change in policy necessarily imposes, should be borne largely, if not wholly, by those who are to be benefited directly by the change. Thus, if a gas company, LIFE OF PLANT 173 with mains of sufficient size for the usual supply of gas, should offer new and lower rates for some particular purpose which necessitated the replacement of the half worn existing mains by larger ones, the inadequacy thus produced and the decreased life of the older mains is not a legitimate limit to be imposed by inadequacy to the life of the original mains. It is, on the contrary, a special case, in which the loss in the otherwise remaining value in the original mains forms a portion of the cost incident to the new service, the rates for which should be made sufficiently high to amortize this loss. This feature of inadequacy becomes of special impor- tance in cases of the sale of the property of public utility undertakings. The buyer may have in mind to take ad- vantage of conditions not available to the original owner or to form a combination with some other similar enter- prise. The buyer, in such cases, would contend that many of the units in the plant which he wishes to acquire are of inadequate size for his new purposes and, as a consequence, should be considered as having completed their years of serviceable life. The seller, on the contrary, would con- tend that the units were adequate for the successful op- eration of the plant on the lines originally contemplated for a number of years to come and, therefore, could not be considered as unserviceable. These two contentions would be reasonable and logical were the present value to be determined for the property of a private undertaking. An owner of a private undertaking may endeavor, as far as may be possible, to write down the value of his plant, through large reserves for depreciation, so that at all times the existing value may be what could be obtained for the plant primarily as scrap, should he be forced to sell. But the case is entirely different when the value of the property of a public utility is involved. The con- ditions are entirely altered by the fact that the interests 174 PUBLIC UTILITIES of the public are involved. Thus, in the sale of a public utility, there are the interests of three parties at stake, - the buyer, the seller and the public. If the officers of a public utility undertaking had reason to expect even a remote probability that their property might be taken by condemnation and that it might be considered as inadequate due to a change in conditions beyond their control, clearly it would be their duty to make " inade- quacy" a controlling factor in shortening the life of the plant and by so doing oblige the public to pay such higher rates as would amortize, through the annual reserves for depreciation, the entire cost of their plant within the years that the plant -remained under their control. But such a condition should not arise. A public utility under- taking has obtained special rights and in return it must give to the public the best service with a minimum total cost to the public for such service. When such an under- taking has performed its duty faithfully, the public is bound to respect the fact that the undertaking has in- curred certain hazards and risks for its benefit in extending the number of years of useful life as far as was safe in order that the cost of the service to the public might be made as low as possible. In a case of sale, therefore, if it can be shown that inadequacy as of the date of transfer could not have been proved, if the original undertaking had been per- mitted to continue along the lines of development origi- nally wisely and properly planned, the change in policy contemplated by the buyer cannot be given as a reason for a reduction in useful life due to inadequacy. The buyer must pay the value which still exists in each unit, arising from the years of serviceable life which each unit would possess had no change in policy or management arisen. Should the buyer, having paid more than scrap value for units which he deems inadequate for his new LIFE OF PLANT 175 purpose, decide that a change is desirable, the burden is upon him to show that the cost of new units plus the price paid for existing units, when properly combined with the annual charges, would result in such economies that the cost of service to the public would be reduced. The above consideration is most important, as, on any other basis, the public might be very heavily burdened. Public utilities, on the one hand, must be given such a guarantee of a continuity of service or of such fair treat- ment, in case of condemnation or sale, that nothing abnor- mal in amount can be added as a burden upon the public in the way of needlessly high rates arising from the neces- sity of making large reserves for depreciation. On the other hand, nothing should be done to prevent the pub- lic from obtaining the advantages which may result from economies due to combinations or enlargements of the undertakings furnishing the service. Thus, if it can be shown that the public can obtain the highest grade of service at less cost by the combina- tion of two competing undertakings furnishing the same or similar service within the same territory, no impedi- ment should be introduced which would deprive the pub- lic of such saving. If, in such a combination, it is ruled that such of the acquired plant, as is too small for the enlarged undertaking, has only value as scrap, then a legitimate objection can be made by the seller on the ground that he is deprived of property which, to the public and to the company which he represents, has more than scrap value. On the other hand, if a fair pres- ent value is given for such units, the public should be willing to give up a portion of the savings, which such a combination would afford, by contributing somewhat larger sums to the annual reserves in order to provide funds to amortize the assigned present value of plant which would not be used for as long a period of time as 176 PUBLIC UTILITIES might have been possible had the combination not taken place. 125. Inadequacy. Engineering economy. This con- dition of inadequacy arises from the fact that in many instances a new undertaking cannot construct, at the outset, a plant of sufficient size to meet the requirements of the business throughout the physical life of all of its plant units. The engineer figures for how long a time in the future it is safe to plan and places units of such size as will produce a maximum of economy when to such cost is added the loss incurred in the shortened life of an inade- quate but otherwise serviceable unit. It is inadequacy of this kind that can be made properly one of the factors tending to limit the life of units of plant. The engineer has had the interests of the public in mind in that he has constructed a plant of only such size as will produce a minimum of cost in annual charges and in operation. When the development of the business will warrant units of increased size, they can be obtained, but until that time arrives the greatest economy is found by the use of smaller units of smaller first cost. The problem for the engineer in this case is that dis- cussed under the head of " Inefficiency" in section 120. 126. Inadequacy. Unexpected development. It not infrequently happens, especially in the more recently settled portions of this country, that the community grows more rapidly than could have been expected at the time of the original design of the plant. Or again, when the undertaking is furnishing a new and little known utility, the demands of the public exceed the reasonable expectations of the management responsible for the origi- nal design of the plant. This condition of unexpected development, either of the population or of demands for the service offered, is a second legitimate reason for a careful estimate of the probable life of the plant units. LIFE OF PLANT 177 In growing communities or with an unknown service, it is proper and wise to place a lower estimate for the life of certain plant units as far as inadequacy is concerned than would be the case under more stable and better known conditions. 127. Operation of factors affecting useful life of plant units. It is apparent that these three factors, as they have been called, wear and tear, obsolescence and inadequacy, are not, properly speaking, factors, but are conditions affecting the life of a unit of plant and, incidentally, its scrap or salvage value. Time enters in each of these three factors and what is needed is a knowledge of the probable useful life of the plant units looked at from these three points of view. The question is simply, how long can the special plant unit under consid- eration remain in service. If the unit will become inad- equate in ten years, the fact that it is only half worn out and is of the latest design has no weight whatever as affecting that life. It will enhance the scrap value of the unit, and that is all. It is that factor or condition which produces the shortest life that is of determining importance. One or the other of these factors or con- ditions must be controlling in a determination of the probable serviceable life of a plant unit. In a deter- mination of the scrap or salvage value of a unit, all three considerations become of greater or less importance, de- pending upon the probable serviceable life assigned to the unit looked at from these three points of view. Thus, if it is estimated that the unit is entirely worn out at the end of ten years, that it would be probably obsolete in fifteen years, and inadequate in twelve, clearly the scrap value would be small. But if it was estimated that it would become inadequate in ten years, worn out in twelve years and obsolete in fifteen years, then the scrap value would be of some importance. 178 PUBLIC UTILITIES 128. Probable life of various plant elements. Much of the misunderstanding which has existed relative to the subject of depreciation has been due to a failure to appreciate the distinction which must be made as to which of the factors is controlling in deciding what may be the probable serviceable life of plant units. The period, during which the amortization of the capital invested in perishable property must take place, can be found only by a determination of which one of the three factors, "wear and tear," " obsolescence " or "inadequacy," imposes the limit as to the useful life of the plant units. A few examples will be given to illustrate the method which must be employed in determining the useful life of plant units. In a case of poles used for cross-country telegraph or telephone lines, it may be found that the probabilities are that the poles will always be adequate, arid that the factor of obsolescence will not enter during the period in which the strength of the pole will remain sufficient to perform the work for which it was intended. In such a case, the factor of wear and tear only enters, and it is possible, if the sizes of the poles and the kinds of material of which the poles are made, are known, for one, who has had experience with such a class of construction, to fore- cast the probable number of years of serviceable life of the poles with much accuracy. The salvage value of a pole at the end of its serviceable life can be deter- mined also with reasonable accuracy. If the case is taken of an aerial telephone cable, it is known that its life is practically indeterminate as long as it remains in its original position in the plant, as there is no known effect of wear and tear upon it. As a prac- tical matter there is no present indication of a change to a more efficient design, thereby eliminating any prob- LIFE OF PLANT 179 able question as to obsolescence. There remains only the factor of inadequacy to be considered. It is known that most, if not all, removals of aerial telephone cables- in the past twenty years have been made for the reason that there has been such a growth in lines that cables of larger size have been demanded, or that the aerial cables in some localities have had to be superseded by under- ground cables. The life of an aerial cable becomes, there- fore, largely a consideration of local conditions, and a forecast must be made by one most familiar with the present and future conditions of the business in that locality, to determine the length of time the cable may be retained in its original position. The salvage value will be the original cost of the cable, less the cost of taking it down, transporting it to the storehouse, interest during the time which it will probably be out of service, and possibly an allowance for the cost of some injury which may occur during the act of removal. In this case the salvage value will be relatively large. Many engineers have used and commissions have adopted years of serviceable life and salvage values for the many plant elements of public utilities, as definite figures suitable for use in valuations of similar elements in all plants and have made no record whatever as to the consideration which has led to the adoption of such fig- ures. Moreover, these figures have been quoted, gener- ally, as those equally applicable to a determination of " depreciation" and " depreciation reserves." Practi- cally all published figures of this kind are open to this objection, but naturally some are more objectionable than others. Thus, the published figures as to the serviceable life of a certain size and kind of pole would be, in all prob- ability, capable of acceptance without criticism, as there is but one factor, wear and tear, which is domi- nant in determining its serviceable life, and experi- 180 PUBLIC UTILITIES ence has been sufficient to show the probable number of years that it can remain in service. But, figures that have been published as to the life of a telephone switchboard, for example, are worthless as they now stand. If wear and tear alone were considered, the probable life of a telephone switchboard, as properly and usually maintained, would be twenty to thirty years. Most competent telephone experts would agree in such a figure. Nevertheless, a life of seven or twelve years l has been frequently given, showing that experts have taken inadequacy or obsolescence as the controlling factor in limiting the serviceable life of the switchboard. In view of the absence of definite information as to what was the controlling factor in arriving at the figures, in- tended to show the years of useful life of plant elements and their salvage values, found in papers and reports on this subject, such figures for a new and special case must be considered as of little or no value. 129. Limited tenure of holding. An undertaking, which has a limited franchise or right given it to operate, may have no agreement as to the disposition of its plant nor of its business at the end of its tenure of holding. Those who have invested their money in the undertak- ing will expect to obtain not only a proper yearly return upon their investment during the period that the busi- ness is in operation but to recover the principal invested in the undertaking at the expiration of the franchise. Such cases in this country are probably extremely rare. In such a case as there is a limited tenure of hold- ing, the life of the property as a whole is defined and the number of years specified must be considered with those above described in determining the basis for amortization of the cost of property. 1 See Wis. R. R. Com. Rpts., Vol. IV, p. 9. Also Institution of Post Office Engineers, April 4, 1910. LIFE OF PLANT 181 As a factor affecting the depreciated value of a plant, cases of limited tenure of holding are too rare to give it further consideration. When such a condition is pre- sented, there will be found, usually, some agreement as to the disposition of the plant and the business, so that this factor, being a rare and special one, must be consid- ered on the merits of each particular case as it arises. CHAPTER XI DEPRECIATION 130. Definition. 131. Physical condition not a direct measure of loss of value. 132. Determination of age. 133. Mean "life" and mean "age." 134. Determination of loss of value a problem in accountancy. 135. Shall loss in value due to age be figured by straight line or sinking fund method? 136. Return to undertaking based upon fair value of property. 137. Loss in value of plant arising from age. 138. Loss in value of property consisting of plant and reserves. 139. Justice of the rule as to use of straight line or sinking fund method. 140. "Pseudo" mean age. 141. Loss in value of property when all reserves have been held invested in outside securities. 142. Loss in value of property consisting of plant, built partly with reserves, and of reserves. 143. General consideration of loss in value due to age. 144. Question as to necessity of reserves sufficient to maintain value of original investment. / 130. Definition. Depreciation may be defined as / "the loss, arising from years of service, in the value of the ^ investment in perishable property." Depreciation is a measure of the loss in value of the in- vestment in perishable property arising from the time that such property has been in service, as related to the total number of years of serviceability. It is possible to ascer- tain with a fair degree of accuracy the time that each unit of the plant has been in service, that is to say its "age," and for experts to predict with more or less cer- tainty the length of time that each unit can be expected to be retained in service. The sum of this last figure and the age gives the. serviceable "life" of the unit. Each unit of plant, therefore, at the time of an appraisal DEPRECIATION 183 can be figured as having a certain number of years of remaining usefulness out of a total life of an estimated number of years. At the end of the period of service- ability of a unit, there will be little or nothing of value in the unit to represent the capital originally invested in it. This loss of capital value invested in plant units of lim- ited life is similar to the loss of capital invested in an undertaking with a limited franchise. Sound financiering demands that the loss in capital value, thus brought about by years of service, should be made good by reserves for depreciation obtained in a manner already fully described in the preceding chapters. 131. Physical condition not a direct measure of loss of value. Depreciation has been defined as the loss in value of an investment in perishable property arising from the years that such property has been in service. Objections to this definition have been raised on the ground that depreciation is made, thereby, to depend entirely upon financial considerations and that such a treatment would be purely theoretical in that proper regard was not given to the physical condition of the plant at the precise time of the appraisal. It is argued that, if this definition is accepted, it would make the loss in value dependent upon the same considerations as have been shown to be the basis upon which the yearly reserves for depreciation are to be figured; for, if the case of a single plant unit is taken, the reserves are designed simply to have in hand the wearing value of the unit at the end of its life. It is argued that the increment to the reserves for depreciation which is set aside from income any given year, is in no way a measure of any loss in value of the physical unit during that year, but rather, a tax upon the income of the undertaking in one year of a series of inter- mediate years, designed to meet a future condition which will demand new capital to replace the unit when it 184 PUBLIC UTILITIES becomes unserviceable. It is argued, further, that the plant unit " deteriorates " year by year and that this "deterioration" is the true measure of the " depreciation" in the value of the unit during the intermediate years of its life, and, being a physical condition of the plant, can in no way be measured by the purely financial considera- tions upon which the reserves for depreciation necessarily must be based. Such a line of reasoning is absolutely faulty. Any attempt to reconcile " deterioration " with " deprecia- tion," at any intermediate period in the life of the plant of an undertaking, is not only unnecessary but futile. The error in any such attempt arises from a failure on the part of the expert, who attempts to assign a definite loss in value to a plant unit arising from its partial deterio- ration, to recognize the fact that, if it can be proved that a plant unit can and should be retained in the service of the public for a definite number of years, in other words if definite agreement has been reached as to its service- able life, the physical " deterioration" of the unit, at any time during its life, can be a matter affecting its intrinsic value in no way whatever. Physical deterioration may enter as an important factor in affecting the serviceable life of the unit but it can affect its value in that way only indirectly, through its effect in a lessened number of years of serviceability. When it has been recognized that physical deteriora- tion affects life and, as a consequence, loss in value in- directly, it will be apparent that, if the years that a unit can and will be retained in service have been deter- mined, the undertaking has an investment in a property of a definitely limited life. The value of the investment diminishes year by year, during each year of the term of years that it is represented by perishable physical property. DEPRECIATION 185 132. Determination of age. In the last chapter the various considerations or factors necessary for an esti- mate of the probable life of a plant were fully discussed. But a valuation is made always at a date intermediate within the life of the units of which the plant is composed. At this time the several units have the probability of various years of remaining serviceableness. To obtain the loss in value that the investment in perishable prop- erty has suffered, it is necessary, therefore, to determine the age of the perishable property. With "age" and "life" known, it is possible to calculate the loss in the value of the investment, in other words to ascertain the "depreciation." It is unnecessary in the present discussion of this sub- ject to enter into any detail as to the method that should be employed in an actual appraisal to determine the age of the plant. In most cases it may be best to have an actual inspection made of some or all of the plant units by a specially qualified expert. In such an inspection the expert may be able to say that a unit can be retained in service for a number of years in the future. In other cases he may say that the unit is in a certain per cent con- dition. Whatever method he may employ, the age is derived by expert judgment, having in mind the usual life of units of that particular kind. For some classes of property detailed inspection may not be required, pro- vided the records are such that from them the age can be derived. The bases upon which losses in value must be deter- mined are, therefore, figures as definite as it may be pos- sible to obtain, showing the age and life of each unit of plant. Such figures are not theoretical, in fact they can be derived only by men most expert in the art and in a practical knowledge of the effects of the factors which influence the life of such elements of property. 186 PUBLIC UTILITIES 133. Mean " life" and mean " age." The method to be employed in ascertaining the mean life of plant for the purpose of figuring the annual reserves for deprecia- tion was described in section 104. The example given in that section was: $50,000 5 years' life $10,000 100,000 10 years' life 10,000 75,000 15 years' life 5,000 100,000 20 years' life 5,000 $325,000 $30,000 It was there shown that the mean life of such a plant would be found by dividing $325,000 by $30,000 and, consequently, would be approximately 10.8 years. The mean age must be determined in substantially the same manner. To illustrate the method of procedure it will be assumed that, with a plant such as is described by the above example, the appraisers, having in mind all factors upon which the existence of the property depends, have agreed upon the lives attributed to the dif- ferent elements. If the appraisal was made eleven years after the above plant was constructed, the experts upon viewing the several elements of which the plant was composed would say that the elements of the class having a five-year life were in 80 per cent condition or that they had four years of remaining life; that, with the second group, they were in 90 per cent condition or had nine years of remaining life; that those in the third group were in approximately 27 per cent condition or had four years of remaining life; and the fourth was in 45 per cent condition or had a life remaining of nine years. This could be represented in the following manner: $50,000 of plant 1 year old out of 5 years' life $10,000 100,000 of plant 1 year old out of 10 years' life 10,000 75,000 of plant 11 years old out of 15 years' life 55,000 100,000 of plant 11 years old out of 20 years' life 55,000 $325,000 $130,000 DEPRECIATION 187 As was seen in section 105, when once a plant has been constructed, there will have to be paid to the deprecia- tion reserves a sum equal to the cost divided by the life,~ and this sum will remain the same no matter how many times the component portions of the plant have to be renewed. Therefore in the above example, $30,000 will have to be set aside as a depreciation reserve every year regardless of the age of the several elements of which the plant is constituted. As $30,000 is set aside each year, the number of years required to aggregate $130,000 would be approximately 4.33. In other words, the plant has passed through 4.3 years of a 10.8 life, or expressed in the form of a ratio it has existed 40 per cent of its life. The mean age is, therefore, about 4.3 years. It will be interesting to notice, in this connection, the variations in the mean age of the hypothetical plant as shown in column 5 of Table III given in section 109. 134. Determination of loss of value a problem in accountancy. The figures for "mean life" and "mean age" developed along the lines above indicated supply all the information required for a determination of the loss in value that may be attributable to the perishable property of a public utility. These two figures embody the expert knowledge of the engineer as to the physical condition of the plant and as to the effect of all other conditions which impose a limit upon its usefulness. These figures are not theoretical as they are the result of a practical knowledge of the particular plant under appraisal and of the special conditions under which it may be operating. They tell the whole story as to the physical condition of the plant. The plant as a whole has been in service a certain number of years and, on the authority of the best expert knowl- edge, can be expected to give service satisfactory to the public for a certain number of years to come. 188 PUBLIC UTILITIES When these two figures have been derived by the engineer with all necessary care and skill, his work rela- tive to depreciation, or loss in value of the investment in perishable property, is completed. In a valuation of the property of a public utility, this loss in value becomes a problem for the accountant. When the accountant has been provided with a figure showing the cost-new of the perishable property and with figures showing the age and probable life of the property, he has all the data which can be given by the engineer necessary for ascer- taining the depreciation. The problem for the accountant then becomes largely one of the financial operation of the property. The prop- erty represents an investment which has been productive of a return for a definite number of years in the past and will continue to be productive for a definite number of years in the future. When the return upon the invest- ment, the return upon readily convertible securities, the demand for new money by the undertaking and the years the investment may continue to earn are consid- ered, the accountant must ascertain the remaining value in the investment at the time of the appraisal. 135. Shall loss in value due to age be figured by straight line or sinking fund method? As has been ex- plained in Chapter IX, both methods of making depre- ciation reserves are equally effective in producing the wearing value of a unit at the end of its life. But an appraisal is made at an intermediate date, within the life of the unit, and, at that time, the amount in reserve is less in the case of the sinking fund method than if the straight line method had been employed. It was shown that the choice between these two methods, when reserves for depreciation were under consideration, de- pended largely upon the demands of the business for new capital and upon the financial condition of the enter- DEPRECIATION 189 prise, that is to say upon the cost to them of obtaining new capital for needed enlargements of the plant. In the case of an appraisal, the amount that the under-" taking has charged upon its books as reserves for depre- ciation cannot be accepted as a criterion for the loss in value which should be assigned by the appraiser. The appraiser must employ that method which will be most equitable to all interested. In an appraisal to determine the equity of rates, the method should be that which is fairer to the undertaking and to the public, or, in the case of sale, that which is fairer to the owner, to the buyer and to the public. 136. Return to undertaking based upon fair value of property. Before entering upon a detailed discussion of the accountant's problem of determining the loss in value arising from the age of the plant, it will be neces- sary to reiterate what was said in section 114. This subject is introduced again as it is felt that most, if not all, of the controversy which has existed and still exists as to depreciation would be removed if the fact was defi- nitely understood that the reserves for depreciation do not belong to the undertaking but are funds held in escrow by the undertaking for the benefit of the public, arising from the use of such funds in making good the losses in the wasting assets of the undertaking. These funds, in a sense, belong to the public and the undertaking cannot use them in such a way as will in- crease the dividends paid to the stockholders. If the reserves are invested in outside securities the returns upon such securities are added to the reserves. In the same way, if the reserves are invested in needed exten- sions of plant, the earnings derived from such plant exten- sions cannot be used to swell the returns paid by the undertaking to its stockholders. Or, speaking somewhat loosely, the returns paid to the stockholders cannot be a 190 PUBLIC UTILITIES fair rate of return based upon the cost of plant paid for with the stockholders' money plus the cost of the plant paid for with the depreciation reserves. On the con- trary, the fair return to the stockholders can be based only on the legitimate cost of the plant built and paid for by the stockholders, provided the present depre- ciated value of such property equals that cost. If the enlarged plant obtained with the depreciation reserves is capable of earning more than a fair return on the stockholders' investment in plant after all proper reserves for depreciation have been made, then the benefit thus obtained should accrue to the public in the form of lower rates, as it is their money which has contributed to this condition. If the above proposition is accepted and kept con- stantly in mind, it is felt that controversy as to the proper method to be used in figuring loss in value arising from age, i.e., depreciation, will be entirely removed. 137. Loss in value of plant arising from age. In attempting to find the value of the plant alone, divested from all other forms of property of an undertaking, it can be assumed that the plant may have been enlarged by the use of some or all of the depreciation reserves or that no additions from such reserves have been made at all. It makes no difference whatever. A plant of a mean life of n years must be increased in cost each year in order that its present value may equal at all times its original cost; that is to say, depre- ciation reserves equal to the total cost of the plant must be invested in plant each year in order that the stockholders' investment in plant may be maintained unimpaired. The above statement will appear to the advocates of the sinking fund method of making reserves as an arbi- trary assumption of the straight line method. It is not DEPRECIATION 191 so. It must be remembered that the present case has reference to plant cost and value alone. Reserves, if invested in outside securities, do not form any portion of the plant, and, consequently, are*not concerned in the present discussion. As was shown in section 107, if reserves invested in plant have been set aside for each unit on the sinking fund method the public through the undertaking must pay both the annuity and interest and, consequently, the mean or average reserves for the entire plant is virtually an even increment each year of ~ of the cost. There is a second point that must be appreciated and that is that the age of the plant as given by the engineer has no bearing whatever upon how long the plant has been in existence. Cases are frequently cited, in discus- sions of this question, of the value of plants which have been in existence four, five or x years out of a life of 10, 12 or y years. Such cases always lead to confusion. A plant that had been in existence 5 years out of a ten-year life might have a mean life of less than four years if proper reserves had been made and invested in plant extensions. An undertaking that had been in existence 16 or 17 years and another similar in all respects that had been in exist- ence 25 or 26 years might have plants of the same age if renewals had been properly made in both cases. In practice the years of age and life alone are known, and these two figures with the cost-new at the present time are sufficient. But even accepting the uniformity of yearly payments to the reserves on the principle of the cost and the in- vestment of such reserves in needed plant extensions, it is difficult for many to see why, when the loss in value at the time of an appraisal is determined, the straight line rather than the sinking fund method should be used. This difficulty arises principally from a lack of apprecia- 192 PUBLIC UTILITIES tion that the compounding of the sinking fund is really cared for by the figure assigned as the mean age. This may be made clearer by a consideration of a practi- cal case. Let the case be that illustrated in Table III, page 153, of a plant, the original cost of which was $100, 000. The mean life of this plant was ten years and all of the reserves required to make good the original investment of the stockholders had been invested in plant needed to supply the public with service. Then the cost-new of the plant any number of years m from the date of the con- struction of the original plant will be $100,000 (1 + A). It is really $100,000 compounding at ten per cent annually. The plant purchased with the stockholders' money is shown in column 3. It shows that the original invest- ment, made by the stockholders, is not increased for the first ten years but, thereafter, the undertaking must sup- ply new money to pay for needed renewals. It must be remembered that the above example and the figures, representing the financial conditions relative to plant cost, have been calculated on arbitrary and theoretically correct lines in order that a test may be made of the accuracy of the straight line method for use in a determination of what portion of the plant-cost-new had been built with stockholders' money and what portion with the money contributed by the public to hold good the stockholders' investment. When the necessity of an appraisal arises, the number of years from the date of the construction of the original plant is not known and is not useful in any way. The figures represented by m were useful only in the calculations involved under column 2 of Table III, and, for the practical purposes of an ap- praisal, must be neglected. Attention must be directed to "mean age" of the plant as shown in column 5 of Table III. Each annual incre- ment to the plant tends to alter the mean age of the DEPRECIATION 193 plant. The mean age is one of the three figures deter- mined by the engineer for the use of the accountant, the other two being cost-new and the mean life. If now the engineer, in his study of the plant described in the present example, reported a mean age of the plant as it exists to-day of 3.79 years, a cost-new of $161,051, and a mean life of ten years, then the accountant can say that A/OIF of the cost-new represents the amount that has been contributed by the public as depreciation reserves, and the remainder represents the investment of the undertaking. T VA of $161,051 is $61,051. The difference between $161,051 and $61,051 is $100,000, which is the amount of the stockholders' money which has been invested in the property. One more example only need be given to test the accuracy of the straight line method in separating the stockholders' investment from the investment made with the reserves. The mean age may be given as 3.75, the cost-new as $417,725, and the mean life as 10 years. Then by the straight line method the public's contribution to the enterprise would be T Voir of $417,725, or $156,674, and the stockholders' contribution $261,051, which is the precise amount, as shown in Table III, that should have been contributed by the undertaking. There can be no question whatever of the accuracy of the statement made in the first portion of the present section, that, in order to conserve the full value of an investment in a wasting asset such as a utility plant, reserves equal to the total cost divided by the mean life of the plant must be made each year; there can be no question that, if these reserves have been invested in plant, the difference between the cost-new and the amount that should have been set aside as reserves should be the stock- holders' investment. When reserves have been made properly and the undertaking has been financed properly, 194 PUBLIC UTILITIES the straight line method accurately separates these two classes of investment, as has been illustrated in the fore- going examples. The conditions shown in Table III and illustrated by the two above examples are based upon ideal conditions. There are two classes of abnormal conditions which will be met in practice, one when inadequate reserves for depreciation had been made and the other when the under- taking had taken more from the public than was required for the plant increments necessary to make good their original investment. If the reserves had been inadequate, then by the straight line method there will be shown that portion of the cost-new which should have been represented by re- serves. When this figure is subtracted from the cost- new the difference will represent a sum less than that which had been contributed by the stockholders. In other words, the amount representative of the stockholders' share in the enterprise is less than it would have been if the reserves for depreciation had been properly made. Such a conclusion is absolutely right, as the undertaking must guarantee the public at all times a continuation of the enterprise by adequate reserves. If the reserves had been too large the difference between cost-new and reserves for depreciation would be greater than the stockholders' investment and should be treated as a surplus. 138. Loss in value of property consisting of plant and reserves. If an undertaking has reserves in outside secu- rities in addition to the plant used for giving service to the public, the first impression might be that the value of the property would be the sum of the present value of the plant, as ascertained by the method above described, and the reserve fund represented by the outside securities. Closer examination will show that this cannot be the case. DEPRECIATION 195 At the time of an appraisal the amount of money repre- sented by the securities purchased with the reserves is the accumulations of an annuity which the public pays to the undertaking. The annuity is assured to the undertaking by the public so long as a high grade of service is provided, and must be reserved by the undertaking even before any return is paid to stockholders. This annuity with its interest accretions should equal the cost-new of the perishable property at the end of its life. This must be the case in order that the public may be guaranteed a continuation of the service after the perishable property has passed away. In a valuation the reserve funds and plant are the property of the undertaking; they cannot be divorced from each other. It cannot be said that the plant is worth a certain amount and the depreciation reserve is a certain amount and the sum of the two is the value of the property. It is not right even to say, in a case where ample depreciation reserves have been made and are sufficient at the date of appraisal to insure the full cost of the property at the end of its life, that the present value of the physical property is the cost-new less the reserves for depreciation. If the undertaking has such an amount in reserve that, with it and the accumulations derived from the annuity and interest that will be received during the remaining years of the plant life, the cost of the property will be recovered, then the cost of the prop- erty is its fair present value. Or, speaking more generally, the present value of the property is the amount that will be in the reserves for depreciation at the end of the life of the property, based upon the present reserves, the pres- ent current rate of interest and a proper and reasonable annuity each year of the remaining years of life. When, therefore, at the time of an appraisal reserves are found as a portion of the property of the company, 196 PUBLIC UTILITIES the method of ascertaining the loss of value in the property as a whole must be determined by the use of calculations based on the sinking fund method. Justice to the undertaking requires that this method be employed for the reason that it may be claimed that this was the method which had been employed in the accumulations of the reserves, and that it was in conse- quence of the use of this method that the reserves were less at the time of an appraisal than would appear to be necessary for maintaining the value of the investment in perishable property. 139. Justice of the rule as to use of straight line or sinking fund method. It will be seen that a rule has been laid down in the last two sections that, when the property of a public utility consists of plant alone, the loss in value must be determined by the straight line method and, when the property consists of plant and depreciation reserves, the loss in value must be ascertained by means of what has been called the sinking fund method. There can be no question whatever as to the full justice of the straight line method when the property consists of plant alone. On the other hand, a contention might be made that the argument, which has been made so often in the presentation of this subject, as to the necessity of the public being guaranteed the continuation of the service by ample reserves, was not given its due weight in such cases as all reserves had been invested in plant, whereas it was made the controlling consideration when the sinking fund method was discussed. Such a con- tention would have little weight if viewed from a practical standpoint. An undertaking which has a plant, which at its depreciated value is equal to its investment cost and is earning a full return, would have no difficulty whatever in raising money to pay for extensions, in other words, to pay back to the reserves the money of the public which DEPRECIATION 197 had been invested in the extensions. As a matter of fact, the public is guaranteed a service, in cases of this kind, not to be sure of as great a magnitude as is represented by the enlarged plant, in which they have an interest, but of the same size as the undertaking itself had bought with its own money and upon which alone it is receiving a return. It is with the justice of the sinking fund method as above outlined that a serious doubt can be raised in such cases as the undertaking has not required all of the reserves for extension but has invested a portion only of the reserves in plant, and in such other cases as the undertaking has not been able to make needed reserves for depreciation. The above rule seems to be perfectly equitable for cases where all reserves have been made and used in a theoretically ideal manner, but such cases rarely occur in practice. It will be necessary to consider, first, normal cases where the property consists of plant and reserves, and later to prove that such cases as have just been referred to can be treated perfectly equitably by the sinking fund method. 140. "Pseudo" mean age. Before entering upon a discussion of the calculations of the loss of value of a property consisting of plant and reserves, it is necessary to call attention to a correction that must be made in the ages of plant when a sinking fund and its interest accre- tions are involved. As has been shown, the accumula- tions of annuity and interest amount to the total cost-new of the plant at the end of a life of n years. The mean of such accretions to the reserves must be, therefore, the cost-new divided by n and, in the straight line method, the annual increments are uniformly this figure, cost- new divided by n. In the sinking fund method, however, the yearly increment is affected by the compound interest upon the sums already in hand; the consequence is that 198 PUBLIC UTILITIES the mean age as derived in the manner described in section 133 must be modified somewhat to care for the variation in yearly increments. Clearly the correction will be dependent upon the rate of interest and the length of life. With plant of the same life and with the usual possible rates of interest, the correction will not be large, but for an accurate determination of losses in value this correction in age should be taken into account. It is not necessary to describe in detail the method of deriving this corrected age or, as it will be called, the "pseudo" mean age of the property. An idea of its magnitude may be derived from the mean age of a plant growing as described in section 137, with a life of ten years, and interest at the rate of three per cent. TABLE V EXAMPLE OF RELATION BETWEEN MEAN AGE AND PSEUDO MEAN AGE 10-Year Life End of Year Mean Age Pseudo Mean Age 3% Compound Interest 1 .909 .910 2 1.735 1.741 3 2.486 2.500 4 3.169 3.199 5 3.790 3.836 . 6 4.355 4.422 7 4.868 4.960 8 5.335 5.460 141. Loss in value of property when all reserves have been held invested in outside securities. The condition considered in this section is more theoretical than usual as it is assumed that reserves have been made properly, invested in outside securities and that the plant has been built entirely with money contributed by the stockholders of the undertaking. There are two classes of cases that DEPRECIATION 199 may be considered. The first typical case is that where a plant had been built originally of ample size and had not been increased by the use of money taken from the reserves for depreciation; the second is that where the plant had increased in size but the money required for extensions had been obtained from the stockholders. In both cases it is assumed that reserves of proper and adequate amounts have been made on a sinking fund basis. As an illustration of the first case, let a plant be assumed which cost originally $100,000, and has a mean life of ten years. Let it be assumed further that reserves have been made regularly on a three per cent yearly basis. Then the value of the property at different periods will be as shown in the following table. TABLE VI EXAMPLE OF CALCULATION OF VALUE OF PROPERTY CONSISTING OF PLANT AND RESERVES All Reserves Made on Sinking Fund Basis and Invested in Outside Securities Drawing 3% Interest End of Year Cost-New Mean Age Reserve Fund Years Remain- , life Compound Interest Annuity Total (1) (2) (3) (4) (5) (6) (7) (8) $100,000 10 $100,000 1 100,000 1 $8,723.06 9 $11,382 $88,618 100,000 2 100,000 2 17,707.81 8 22,432 77,568 100,000 3 100,000 3 26,962.10 7 33,160 66,840 100,000 4 100,000 4 36,494.02 6 43,576 56,424 100,000 5 100,000 5 46,311.90 5 53,688 46,312 100,000 6 100,000 6 56,424.32 4 63,506 36,494 100,000 7 100,000 7 66,840.11 3 73,038 26^962 100,000 8 100,000 8 77,568.37 2 82,292 17,708 100,000 9 100,000 9 88,618.48 1 91,277 8,723 100,000 10 100,000 10 100,000.00 11 100,000 1 8,723.06 9 11,382 88,618 100,000 12 100,000 2 17,707.81 8 22,432 77,568 100,0(50 200 PUBLIC UTILITIES Table VI on page 199 shows the financial condition of the property for each year of its life. Column 1 shows the years from the original construction of the plant, a figure unknown at the time of an appraisal and introduced here simply to show the amount that should actually be in the reserve fund to preserve the value of the investment intact. The reserve funds, which should be in hand at the end of each year, are shown in column 4. At the time of an appraisal the cost-new, the mean age and the amount in reserve would be known. From the mean age the years of remaining life, column 5, are known. The undertaking will obtain the interest compounding at 3 per cent on the reserves during each of the remaining years of life, column 6, and an annuity of $8,723.06 and interest accu- mulations during the same period, column 7. At the end of the life of the property, the amount in hand will be the sum of these two figures, column 6 plus column 7, - shown in column 8. To take an example: cost-new, $100,000, mean age 6 years, and depreciation reserves $56,424.32. There are therefore 4 years of remaining life. $56,424 at compound interest at 3 per cent for 4 years will amount to $63,506. There will be an annuity $8,723 for 4 years and with its interest accretions it will amount to $36,494. The sum of these two figures, $63,506 and $36,494, will be the present value of the property, in this case equal to the cost-new. The second typical normal case which will be considered will be that of a plant which has been growing and the additions have been paid for by the stockholders. As an example of this case, the conditions considered in section 137 will be taken. It will be assumed, therefore, that a plant originally costing $100,000 had been increased by ten per cent of the cost-new at the end of each year. Ample reserves had been made each year and held in a DEPRECIATION 201 sinking fund upon which interest at three per cent was obtained. TABLE VII EXAMPLE OP CALCULATION OF VALUE OP PROPERTY CONSISTING OP PLANT AND RESERVES All Reserves Properly Made and Held in 3% Sinking Fund End of Year Cost-New Pseudo Mean Age Reserve Fund Re- maining Life Compound Interest Annuity Total (1) (2) (3) (4) (5) (6) (7) (8) $100,000 10 $100,000 1 110,000 .91 $8,723 9.08 $11,412 $98,588 110,000 2 121,000 1.74 18,580 8.25 23,718 97,282 121,000 3 133,100 2.50 29,692 7.49 37,060 96,040 133,100 4 146,410 3.19 42,194 6.80 51,591 94,819 146,410 5 161,051 3.83 56,231 6.16 67,467 93,584 161,051 6 177,156 4.42 71,966 5.57 84,860 92,296 177,156 7 194,872 4.96 89,579 5.03 103,952 90,920 194,872 8 214,359 5.46 109,265 4.53 124,940 89,419 214,359 9 235,795 5.92 131,241 4.07 148,039 87,756 235,795 10 259,374 2.41 55,747 7.58 69,764 189,610 259,374 As will be seen froin the above table, the undertaking having made proper reserves for depreciation will have in hand, at the periods noted, the funds shown in column 4 as well as perishable property of costs-new, at the same times, of the values given in column 2. The undertaking will obtain compound interest on the reserves during the remaining years of life. The amount of the reserves, shown in column 4, when placed at compound interest for the remaining life of the plant in each case is given in column 6. Moreover, the undertaking can obtain an annuity, figured at current rates of interest, upon the cost-new of the perishable property. The aggregates of these annuities and interest for each value of the plant- new at the end of the life of the property are shown in column 7. The sum of the reserve fund in hand at the time of valuation plus interest accretions (column 6) and 202 PUBLIC UTILITIES the annuity plus interest (column 7) gives column 8, and shows that at the end of the life of the plant there will be a sufficient reserve in hand to replace the property which has become unserviceable. It follows from this that the full value of the investment in perishable property has been maintained throughout the life of the plant and, consequently, that its present value is, at all times within that period, equal to the cost-new. In other words, the investment has suffered no loss in value and, consequently, has suffered no depreciation. As an illustration the case can be taken of a property having a pseudo mean age of 4.96 years and consisting of a plant of which the cost-new is $194,872, and of deprecia- tion reserves amounting to $89,579. The remaining life of the plant is approximately 5.03 years and, in consequence, the $89, 579 will obtain compound interest during that time. $89,579 plus the compound interest will amount to $103,952. The cost-new of the plant is $194,872 and necessarily is independent of the cost of any additions or extensions that may be made at a later date. The annuity which the un- dertaking will receive during the remaining 5.03 years of life is approximately $17,000. These annuities plus the interest upon them will aggregate $90,920. $103,952 plus $90,920 equals $194,872, the cost-new of the perishable property at the time of the appraisal. 142. Loss in value of property consisting of plant, built partly with reserves, and of reserves. The case of a property consisting of plant and reserves but wherein a portion of the plant has been built with some of the reserves is more usual than the cases described in the pre- vious section. The method of calculating the present value of the property as a whole will be the same, for the reason that injustice in some cases might be done to the undertaking if this method were not employed. As the illustration given below will show, reserves which are DEPRECIATION 203 made on the sinking fund method presuppose that the amounts set aside are to obtain the benefit of interest accu- mulations. If sums are taken from the reserves, which have been obtained on the sinking fund basis and, conse- quently, are less than the cost-new divided by the life, for the purpose of paying for plant extensions, the undertaking suffers a loss. If reserves are to be used for enlargements of plant, as in many cases it is wise to do, then the reserves should be made on a straight line basis even though at the time of an appraisal it may be shown that there is a greater value in the property than its actual cost-new. This is well illustrated by the following example. For this case let it be assumed that original cost of the plant was $100,000; that it had a ten-year life; that reserves had been made on a sinking fund basis; but that at the end of two years $15,000 was taken from the reserve funds to pay for needed extensions of the. plant. The following table illustrates the changes in the value of the property under the assumed conditions : TABLE VIII EXAMPLE OP CALCULATION OF VALUE OF PROPERTY CONSISTING OF PLANT AND RESERVES Portion of Reserves, Made on Sinking Fund Basis, Invested in Plant End of Year Cost-New Mean Age Reserve Fund Remain- ing Life Compound Interest Annuity Total (1) (2) (3) (4) (5) (6) (7) (8) $100,000 10 $100,000 1 100,000 1 $8,723 9 $11,382 $88,618 100,000 2 115,000 1.74 2,708 8.25 3,456 92,400 95,856 3 115,000 2.74 12,821 7.25 15,886 79,970 95,856 4 115,000 3.74 23,237 6.25 27,955 67,901 95,856 This example need not be carried farther. It shows that, although reserves had been made in amounts suffi- 204 PUBLIC UTILITIES ciently large to recover the cost-new of the property by the end of its life on a sinking fund basis, the removal of $15,000 from the reserves for depreciation had reduced the value of the property. The present value of the prop- erty, as shown by column 8, is $95,856, which shows that the undertaking's investment of $100,000 has diminished in value by $4,144, which means that the undertaking by investing this sum in plant rather than by holding it in reserves has lost the compound interest on $15,000 for more than eight years. 143. General consideration of loss in value due to age. -The above cases sufficiently illustrate the methods to be used in calculations of the loss in value of investments in perishable property or, as it is more frequently called, of the depreciation in the value of property. In the last case it was assumed that a portion of the reserve funds had been used for the purchase of new plant. The method of treatment would have been the same if the reserves in the earlier years had been inadequate or if the $15,000 had been paid outright to the stockholders. The loss in the value of the property would have been, however, much greater. In such a case the cost-new would have been found to be only $100,000 and, in consequence, the annuity on a sinking fund basis could have been only $8,723. The mean life at the period chosen would have been two years. The $2,708 at compound interest for eight years would have been $3,430, and the amount of the annuity and interest at the end of eight years would have been $77,568. The sum of these two figures is $80,998, which shows a depreciation of $19,002. The above consideration of depreciation presents methods which, as far as general rules are concerned, are fair and equitable to both the undertaking and the public in questions concerning rates and to both buyer and seller as well as to the public in cases of condemnation or sale. DEPRECIATION 205 General rules of this kind cannot be followed rigidly in all cases. Special conditions require special treatment. 144. Question as to necessity of reserves sufficient to maintain value of original investment. Attention has been called to the fact that the mean age of most large properties, especially those which have been for some time in service and are composed of many different classes of elements of varying lives, approaches a figure approxi- mately one-half of the mean life of the entire perishable property. It is argued that this mean age will rarely, if ever, be less than twenty per cent of the total mean life and, consequently, that in all such large older properties there is always at least a 25 per cent loss in value. This item has been called the normal wear. It is argued further that this loss in value " represents the necessary shrinkage of the property at the start from the original investment. This shrinkage is something that cannot and need not ever be restored. It should be taken care of not by a depreciation fund but by an amortization of a portion of the capital." It is apparent that the idea presented by the above argu- ment is that a part of the depreciation reserve funds, if they have been accumulated in the manner above described, will never be required for renewals particularly in large, old and growing undertakings. In consequence of this a portion of the depreciation reserve fund serves no useful purpose other than that of maintaining the value of the original investment of the stockholders in the enterprise, and, as a consequence, it maintains an unnecessarily high value upon which the public must pay a return in the form of rates higher than would be required if this value were reduced by an amortization of a portion of the original cost to the undertaking. This idea is interesting theoretically but is probably of little practical value owing to the nature of most large 206 PUBLIC UTILITIES public utilities in this country. Most public utilities in this country are growing and there is a constant demand for new money to pay for the required extensions of plant to meet the needs of growing communities or of larger uses of the utility. This new plant, if purchased with money taken from the depreciation reserves acquired on a straight line basis, will reduce by that amount the money which would have had to be provided otherwise by the stock- holders of the undertaking. If a portion of these reserves had been used to amortize a portion of the stockholders' original investment, then, as these funds would not be available to pay for extensions, new money would have to be obtained from the stockholders. It will be seen from this that, in all cases where the property of an under- taking is growing as fast or faster each year than the plant cost divided by the mean life, nothing whatever is gained by any such plan, for by as much as the capital cost is reduced, by so much must it be restored. The idea is interesting, as a study of the working of this plan brings out very forcibly the association of the public in the financial operation of a public utility. Every dollar of the reserves for depreciation invested wisely in needed extensions results in a reduced cost of service to the public, provided the public pays such a reasonable rate of return that new money, when required for renewals or for other pur- poses, can be obtained without undue difficulty or expense. If this plan of amortizing a portion of the original investment of the stockholders is restricted to such under- takings only as do not require all of the reserves for extensions, it is a question whether a reserve fund would not be a wise provision to safeguard the public interests. 1 1 See Frederick A. Delano, " The Application of a Depreciation Charge in Railway Accounting," The Journal of Political Economy, November, 1908. Report of the United Railways Company by the St. Louis Public Ser- vice Commission, Appendix A, by James E. Allison, p. 75. The Tramway and Railway World, November 9, 1911. CHAPTER XII FAIR PRESENT VALUE RATES 145. Fair present value determined by "well-informed" judgment. 146. Two kinds of rate cases, state and court. 147. Fair present value dependent upon purpose of valuation. 148. Fair present value. Valuation for state regulation. 149. Fair present value. Valuation for court investigation. 150. Cost-new of property. State investigation of rates. 151. Increased value of real estate. 152. Paving. 153. Property acquired by gift. ^ 154. Cost-new of property. Investigation by court of statutory rates. 155. Increased value of real estate. 156. Cost of repaving. 157. Property acquired by gift. 158. Value inherent in live plant. 159. Brokerage Discounts. 160. Tendency of later decisions to establish a fair cost-new. 161. Depreciation. 162. Method of figuring depreciation in cases involving rates. 163. Returns based upon capital investment. 164. Investment in property, not plant, ruled by courts as basis of fair return. 165. Dangers resulting from making present value of plant alone the basis of fair rates. 166. Valuation of new properties. 167. Working capital. 168. Fair return. 169. Fair rate based upon stock only or upon stock and bonds. 145. Fair present value determined by " well-informed " judgment. The fair present value of the property of a public utility is a mixed question of fact, judgment and law and the court or commission is competent only to assign such value by a judicial consideration of the facts, figures and law involved in each particular case. The facts and figures required in each case can be obtained in accordance with the methods which have been 208 PUBLIC UTILITIES described in the preceding pages. It is futile to attempt to formulate the decisions which have been rendered by courts and commissions as to fair present value, with any expectation of finding hard and fast rules upon which such decisions have been reached. The decisions have been made by the tribunal upon well-informed judgment based upon the facts peculiar to each individual case. Full justice can be accorded only in this way. The purpose of the present work has been accomplished if the methods of obtaining and presenting all essential facts and figures have been described and formulated so distinctly and correctly that controversy as to the accu- racy of the experts' figures may be removed entirely or be capable of adjustment by conference, out of court, between those representing the two sides of the controversy. A full understanding of the subject of valuation cannot be obtained, however, without some knowledge of the general trend of decisions as to true present value. Many decisions have been given without the full knowledge which is afforded by such figures as have been described above as necessary for the use of the tribunal. In many cases it is extremely difficult, if not impossible, to obtain all of the facts which influenced the decision in any special case. Despite a lack of sufficient information relative to many of the cases cited, but in order that some knowledge of the general trend of recent decisions may be associated with the present study, a brief resume* of the court and commission decisions is presented in the following pages. 1 146. Two kinds of rate cases, state and court. - In approaching a discussion of this portion of the subject of the valuation of the properties of public utilities, attention should be called again to the fact that rates, for the service offered by a utility, are regulated by the 1 For fuller information on this subject, see Public Service Corporations by Bruce Wyman, 191 1 ; Valuation of Public Utilities by R. H. Whitten, 1912, FAIR PRESENT VALUE RATES 209 state and that the court does not enter upon a considera-^ tion of the rates imposed until a claim has been made by the undertaking affected that the rates are so low as to prevent it from earning a proper return upon its property. \ Thus it is seen that there are two authorities which may enter into a consideration of the schedule of rates of a utility, the State which has the power of regulation and the Court to which appeal may be made in case a rate imposed by the State appears to be illegal. The State, in its regulation of rates, is obliged to see that the schedule of charges for the utility furnished or for the service rendered is reasonable and productive of no more than a fair return upon the " capital invested in good faith and with reasonable judgment" by the undertaking in the property in use and useful to the public. On the other hand, the Court is concerned simply with the question as to whether the earnings of the undertaking, based upon the statutory rate, are or will be so small as to be virtually confiscatory of the property of the undertaking. Each authority, State or Court, in all investigations as to rates has two things, therefore, to decide, a rate of return and a value upon which such return can be earned. But in each case both figures may be widely different. In the case of the State the rate of return will be that which is a fair reward for the hazard and risk of those investing in the enterprise. In the case of the Court the rate of return may be only that which could be held as not so low as to be confiscatory. Again, the value upon which the undertaking may be entitled by the State to earn a return may be only the capital invested by the undertaking for the use of the public, whereas the value of the property assigned by the Court will be based upon the actual present cost of reproduction of the entire prop- erty useful for the public. 147. Fair present value dependent upon purpose of 210 PUBLIC UTILITIES valuation. It is thus seen that there are two different fair present values for the same property, one value to be determined and used by the State in the regulation of rates and another to be determined and used by the Courts when a question arises as to whether an imposed rate is equivalent to a confiscation of the property of the undertaking. 148. Fair present value. Valuation for state regula- tion. Strictly speaking, the state legislature, a public utility commission or even the undertaking itself should consider the fair present value, upon which the schedule of rates is to be made so as to yield a fair return, as the money which has been expended in good faith and with reasonable judgment in the construction of the property in use and serviceable for the public at the time of the investigation provided that value has been maintained by proper reserves for renewals. The plant may have cost the undertaking more at the time of construction than it would cost to build the plant anew at the present time; nevertheless, the rates should be based, theoretically at least, upon the money legitimately expended upon the property now in existence. Likewise the present value of the property may have been greatly enhanced by the increased cost of labor and material or of real estate. Such changed conditions can have no effect. It is the money which has been expended for the property in use and useful, and its value maintained by proper reserves, that must be the basis upon which the schedule of rates should be based by the rate regulating authorities. 149. Fair present value. Valuation for court investiga- tion. On the other hand, when a question comes before the court as to whether a rate or schedule of rates, imposed upon the undertaking by the state rate regulating author- \ ity, is confiscatory or not, the question before the court is, jwhat is the fair present value of the property? Not FAIR PRESENT VALUE RATES 211 what money was expended by the undertaking for its property, but rather what that property then in use and useful is actually worth at the present time. If the plank had cost more than it would cost to-day, it makes no difference. It is its present value that must be con- sidered. In a decision, Judge Walter H. Sanborn, United States Circuit Court, St. Paul, Minn., April 8, 1911, said: "The just compensation secured by the 14th amendment entitles the defendant railroad companies to a fair return upon the reasonable value of their property in Minnesota devoted to the public use of transportation. Such a return is just to the public as well as to the carriers." "Under the evidence in these cases the cost of reproduction new of the Minnesota properties of the defendant companies devoted to the public use of transportation is more persuasive evidence of their values than the market value of their stocks and bonds, or the original cost of their acquisition and con- struction." l If the property has depreciated in value due to time of service, such depreciation must be subtracted from the replacement cost. If the schedule of rates yields a return to the undertaking upon such a fair present value so low as to be confiscatory, then the court will find the imposed rate illegal. On the other hand, if the court finds the present value so small that the imposed rate will yield a return much greater than the usual return obtained upon similar property, the case will be dismissed, as the question before the court is not one of rate making but as to whether the Constitution of the United States had been violated by the imposition of rates which deprive the undertaking of its property. 150. Cost-new of property. State investigation of rates. From what was said above it is apparent that 1 Shepard v. Northern Pacific Railway Co., 184 Fed. 765. 212 PUBLIC UTILITIES the main difference between the fair value of property to be determined in a rate investigation by state author- ities and that to be ascertained by a court will be found in the cost-new of the property. The effect of the loss in value due to age will be considered in a later section. Fundamentally, the cost-new to be determined in the case of an investigation by the state must be "the capital invested in good faith and with reasonable judgment " by the undertaking, found represented at the time of the valuation in plant in use and useful to the public plus working capital and what are frequently termed the intangible assets, i.e., value inherent in the plant as a part of a well established business. Considering for the moment only that portion of the property represented by plant, the cost-new will be, as nearly as can be determined, the original cost of that plant now found in use and useful. 151. Increased value of real estate. If the principle above outlined is correct, then the increased value of the ! real estate owned by the undertaking, the unearned j increment which in most cases is found to exist in this ( country, cannot properly be included as a portion of the original cost. The truth of this assertion will be ques- tioned and various arguments will be raised to show that the unearned increment must be included in any fair value whether ascertained by court or commission in a rate case. Many court decisions may be cited to substantiate the claim that such increase in value is a definite asset of a public utility upon which it is entitled to a fair return. Two cases only need be cited bearing upon this question. "And we concur with the court below in holding that the value of the property is to be determined as of the time when the inquiry is made regarding the rates. If the property, which legally enters into the consideration of the question of rates, has increased in value since it was acquired, the com- V- FAIR PRESENT VALUE RATES 213 pany is entitled to the benefit of such increase. This is, at any rate, the general rule. We do not say there may not possibly be an exception to it, where the property may have increased so enormously in value as to render a rate permitting a reason- able return upon such increased value unjust to the public. How such facts should be treated is not a question now before us, as this case does not present it. We refer to the matter only for the purpose of stating that the decision herein does not prevent an inquiry into the question when, if ever, it should be necessarily presented." 1 Another ruling on this point is, " On the other hand, however, when property is valued for the purpose last stated" (legis- lative control), "it is clear that the owner thereof is entitled to the benefit of any appreciation in value above the original cost and the cost of improvements, which is due to what may be termed natural causes. If improvements made in the vicinity of the property, the growth of the city or town where it is located, the building of railroads, the development of the surrounding country, and other like causes, give property an increased value, the owner cannot be deprived of such increase by legislative action which prevents him from realiz- ing an income commensurate with the enhanced value of his property." 2 Another argument in favor of the inclusion of the unearned increment in the value of land has been that taxes are paid by the undertaking on this enhanced value, and that, having to incur this increased expense, the undertaking should be entitled to a higher basic value for its property. Or again, it has been claimed that the undertaking should be entitled to some offset, in the way of appreciation in the value of its property, to com- pensate the losses which may have been incurred in the early days of its operation possibly with an art but little known. The answers to the last two contentions are simple. Taxes are a portion of the operating expenses of the com- 1 Willcox v. Consolidated Gas Company, 212 U. S. 52 (1909). 8 Getting v. Kansas City Stock- Yards Co., 82 Fed. 854. 214 PUBLIC UTILITIES pany and, as such, are paid by the users of the utility through the rates. This being the case, the imposition of taxes, based upon a higher valuation of land, imposes no burden upon the undertaking, provided such taxes are con- sidered properly by the rate regulating authorities when ascertaining the current expenses of the enterprise. In answer to the last claim, it may be said that early losses should have been cared for through depreciation reserves or, if the earnings had been insufficient to make such reserves possible, the early losses should have been in- cluded in the figure representing the value inherent in the plant. The answer to the first contention is more difficult. A strict adherence to the theory, which has been set forth above, demands that the unearned increment should not be included as a portion of the fair present value upon which rates can be based by state authorities. It is, moreover, a legal question as to how far the cases above cited are intended to control the state regulating author- ities and whether these and similar decisions have not been made rather from the point of view of a court passing upon a question of whether statutory rates were con- fiscatory or not. It is best to assume that the theory is correct only so far as justice is afforded by a strict adherence to it. The fair present value can be determined only by "well informed judgment," and the theory above presented is simply a guide as to the direction which a decision should take provided it would result in a figure equitable to the undertaking and to the public. It would seem as if the Massachusetts Gas and Electric Light Commission had followed the theory that the unearned increment in land values should not be included in cases of rate regulation as a portion of the true present value of public utilities coming within its control. FAIR PRESENT VALUE RATES 215 The Interstate Commerce Commission has indicated its doubt as to how far such values should be included, as is instanced by the following decision. "Whatever the true economic or legal view may be as to the right of a carrier to consider the increase in value of its land as a part of the value upon which it is entitled to a reasonable return, such increase in value does not of itself establish the right of a carrier to increase rates upon a given service. . . . It is a conservative statement of the law to hold that a railroad may not increase the rates upon a number of commodities solely because its real estate has risen in value." 1 On the other hand the Wisconsin Commission has used quite generally the present value of land as a portion of the true present value upon which rates should be based. "In view of these facts there would seem to be good ground, from both a legal and economic viewpoint, for giving such appreciations in value consideration in appraising public utilities. At any rate, we can not now see good reasons upon which to exclude these elements from the appraisal of utility properties." 2 It is unnecessary to quote at greater length decisions upon this point. A few references bearing upon this subject are given below. 3 In reading these cases it is important to bear in mind that the present value of land, in which necessarily is included the unearned increment, must be used where the case is one of court investigation as to whether a rate imposed by state authorities is con- fiscatory or not. If the decisions are studied with this thought in mind, it will be seen that the logic of the theory 1 Interstate Commerce Commission Rpts., Vol. XX, p. 344. 2 Wis. R. R. Com. Rpts., Vol. IV, p. 579. 3 Consolidated Gas Co. v. City of New York, 157 Fed. 854; Willcox v. Consolidated Gas Co., 212 U. S. 52; Shepard v. Northern Pac. R. R., 184 Fed. 806; St. Louis Pub. Serv. Com. on United Railways Co. of St! Louis, Nov. 19, 1912, p. 23; New York Pub. Serv. Com., 1st Dist., Deci- sions June 23, 1911, Aug. 18, 1911, Oct. 20, 1911, Nov. 17, 1911. 216 PUBLIC UTILITIES as to value used by the state authorities demands that cost must be the basis. I 152. Paving. The cost of paving over that portion of the undertaking's property placed in a paved street or under it, which cost was not actually incurred by the undertaking, should not be included as a portion of the cost-new in such cases as are being now considered. All authorities are agreed upon this matter. This question has been discussed already in section 28 and will be treated later in section 156. Its exclusion is clearly called for by the theory upon which this study of present value is based. 153. Property acquired by gift. Following strictly the theory that an undertaking can earn only upon the money invested in property now useful to the public, the value of all property, which has been acquired by gift or by contribution from outside sources, should be excluded > from the cost-new used in determining the value upon which rates should be based. Conditions of this kind are found very frequently in the case of railroads where, in many instances, grants of land were made by the Government or State to assist in the construction of a needed railroad in new country. Some- what the same condition is present in the aid given in re- cent years by the state or towns to railroads for the elimi- nation of grade crossings. Likewise with other classes of utilities, portions of the plant may have been paid for by the users in order to obtain service under special or unusual conditions. On the other hand, utilities may have had to incur large expense upon property the title to which they do not possess, in order to meet the requirements of the public or public authorities. Such instances may be found where approaches to stations or changes in the grade of streets have been made at the expense of the undertaking. FAIR PRESENT VALUE RATES 217 Clearly such costs are a portion of capital invested in the undertaking and must be included in the value upon which rates can be earned. A careful reading of all later decisions of courts and commissions on this subject seems to show a general recognition of the principle above laid down. Thus, "It is well understood that, as a matter of equity, the Com- mission does not include services paid for by consumers in the valuation of public service property for the purpose of estab- lishing rates." 1 "If services," water service pipes, "are installed by the util- ity, they constitute a part of the plant upon which the utility should be allowed to earn a return to provide for depreciation and interest; if put in by property owners, the cost of such services should not be included in the value upon which the utility is entitled to a return." 2 154. Cost-new of property. Investigation by court of statutory rates. Rate cases come before the court for a determination as to whether rates, imposed by the rate regulating authorities of the state upon the undertaking, are confiscatory of the property of the undertaking and, consequently, in violation of the 14th amendment of the Constitution of the United States. In such cases the cost-new must be the replacement cost; and the actual present value must be the replacement cost of the property less depreciation. In considering the figures derived to indicate the basis of present value, the court may use original cost, capi- tal value of stocks and bonds, and even their market value as checks, however, only as to the probable accu- 1 City of Washburn v. Washburn Water Works Co., 6 Wis. R. R. Com. Rpts., p. 92 (1910); See City of Beloit v. Beloit Water, Gas & Elec. Co., 7 Wis. R. R. Com. Rpts., 215 (1911); Monheimer v. Brooklyn Union Elevated R. R. Co., 2 P. S. C. 1st Dist., N. Y. (1910). 2 Oscar A. Alter et al. v. Ed. Water Com. Manitowoc, 11 Wis. R. R., p. 387 (1912). 218 PUBLIC UTILITIES racy of the figure derived to show the cost of reproduction- new. In cases of this kind it must be value-new of the prop- erty, as of the time of the investigation, in use and useful to the public and not at all the original cost, which is of importance. With this view it is clear that many of the items of value which may have been excluded by the state authorities will be included by the court. The reasoning followed in sections 151 to 153 relative to the value of real estate, of paving, and of donated property, no longer holds good. This difference in the theory of present value is so important that it will be well to recon- sider these subjects in some detail. 155. Increased value of real estate. It is the pres- ent value of the real estate, which belongs to the under- taking, that should be accepted as a definite asset. It is the value of the land "as it is" that the courts will accept as the correct value. This has been established by a long line of court decisions which need not be quoted in detail. 1 156. Cost of repaying. Carrying out the theory of value above outlined it is clear that what it would cost to replace the pavement over or about the structures of an undertaking, whether such pavement had been paid for by the undertaking or not, should be the present value to the undertaking of its property. It is what it would cost at the present time to replace or reproduce that portion of its plant. 157. Property acquired by gift. Here again it is the value of the property owned by the undertaking, no matter how acquired, that should be given its full present value. 1 Smyth v. Ames, 169 U. S., p. 546; San Diego Land Co. v. Nat. City, 174 U. S., p. 757; San Diego Land Co. v. Jasper, 110 Fed. 714; Shepard v. Northern Pacific R. R., 184 Fed. 806. FAIR PRESENT VALUE RATES 219 "The Special Master takes it to be a sound principle of law that where property is given to a railway company for a right of way, such property becomes as much a part of the property of the railway company devoted to the public use- as does property purchased or condemned by it, and its value is just as much to be considered for rate purposes as is the value of any other property devoted by the railway company to the use of the public." 1 158. Value inherent in live plant. In cases before a court it would seem as if logic demanded that it should be the cost of developing the business anew as of the present time that should be regarded as the " going value' 7 of the undertaking. It cannot be past costs as determined by the Wisconsin method (section 61), but that method described in section 62. 159. Brokerage. Discounts. --In the consideration of replacement cost in section 47, it was stated that the cost of raising capital, including cost of brokerage,! underwriting or discounts, should not be included ex- { cept in so far as such items might be effective in in- creasing the rate used in figuring the loss of interest during construction. This reasoning was based on the assumption that expenses of this character would not be capitalized but would be amortized through higher rates of return. This subject was discussed further in connection with original cost in section 81, wherein it was stated that expenses of this character should not be included, for the reason that the par value of securities was another figure to be presented to the tribunal and with that figure and the original cost of the property a full knowledge of the difference between the cost of the property and par value of the securities could be obtained. Whether or not these losses or expenses should be 1 Central of Georgia Railway Co. v. Railway Com. of Alabama, No. 261, in equity, U. S. Middle Dist., Ala. 220 PUBLIC UTILITIES included in the fair value upon which rates should be based may depend somewhat upon the conditions affecting special cases but, speaking generally, it would seem as if the tendency of courts and commissions was to eliminate them from the fair value, and rule that all legitimate expenses of this character should be amortized. This does not mean that the cost of getting money is not a legitimate portion of the cost of the property, but that it is wiser to allow a rate of return higher than would other- wise have been assigned, and to require that a portion of such return be turned into a fund to amortize such losses. Thus the expenses of this character are made a charge against revenue rather than a portion of the fair present value of the property. 1 This treatment as far as the undertaking and the public are concerned is fair and just. It makes no difference to either whether a higher rate on a lower capitalization or a lower rate on a higher capitalization is allowed. This treatment avoids the more or less theoretical controversy as to whether the cost of raising money is a portion of the cost of construction and, in consequence, increases the value of the property in use and useful to the public. That money, in such quantities as are required for most public utilities, cannot be obtained without some expense, in many cases, must be admitted and, if the cost of such money is reasonable, clearly it is only just to the under- taking that it should recover the legitimate expenses to which it has been put in providing the public with a needed service. But that the cost of obtaining money with which to construct a property increases the value of that property appears to be considered by most rate making bodies in this country as questionable. Thus, "If rate-making is to be based upon actual cost, it would seem that such cost must be measured by the money necessa- i See N. Y. P. S. C., 1st Disk, Case No. 1305 (Dec. 10, 1912). FAIR PRESENT VALUE RATES 221 rily expended in producing the construction without regard to whether those undertaking the enterprise have the same or must borrow for the purpose a matter in which the public has no concern. If allowed interest during construction on the money- invested, more should not be asked; otherwise, the rate would be directly affected by the good credit or otherwise of those undertaking the work." 1 On the other hand, in the decision in the case of sale of National Telephone Company to the Postmaster General of England, Mr. Justice Lawrence said : " Whoever raises the money necessary to pay for the materials, labour, &c., &c., is put to the expense of raising that money. Every necessary cost must appear in value, otherwise no sane person would ever knowingly construct; for, if it does not appear in value, it must result in loss, and to say it should be relegated to loss is to deny the principle upon which we are agreed, that value should be ascertained by finding what it would cost to construct the plant. Unless, then, it can be affirmed that money, unlike other commodities, can be pro- cured without expense, it is clear that this item must be included at its proper amount. In other words, we must either refuse to follow the formula approved by the House of Lords and agreed to by the parties, or find, as a fact, that money can be procured for nothing." 2 In a dissenting opinion in the same case, Sir James Woodhouse said: "The cost, therefore, of the thing constructed must, by the hypothesis, differ according to whether a man has to pay for raising the money, or is in a position to find it without incurring that expense. I fail utterly to see how this can be right, when we bear in mind that cost is only material as a step to ascertain the value of what is constructed. It is, in fact, making the 1 Report Special Master in Chancery, Sept. 21, 1910, Shepard v. No. Pacific R. R., 184 Fed. 764 (1911). 2 Decision Mr. Justice Lawrence, The Nat. Tel. Co., Ltd. v. H. M . Postmaster General (1913). 222 PUBLIC UTILITIES value of the thing constructed vary with and be dependent on the financial ability or credit of the constructor." 1 It would seem that, even in a case of sale, the exclu- sion of the cost of raising capital from the fair value was wise and just provided the rate regulating authorities recognized that rates should be maintained sufficiently high to amortize such cost within a resonable time. 2 160. Tendency of later decisions to establish a fair cost-new. In what has been said above an attempt has been made to state somewhat absolutely the fundamental principles which underlie valuations and to show what values may be expected if these fundamental principles of valuation are rigidly carried out. In early cases bearing upon rates, the courts unquestionably adhered to the doctrine that the province of the court was simply to determine whether statutory rates were confiscatory or not. In later years state commissions have been formed, composed of men capable of careful analysis of all factors affecting value. These commissions, in most cases, have determined value not along the lines of a rigid or arbi- trary theory, such as has been outlined above, but "with the well informed judgment" with which the courts have said the determination of present value should be made. The result has been that the figures derived by commis- sions have not been strictly original cost but figures which under all of the special conditions of each particular case seemed to them to be fair. They have taken the several sets of figures which have been described in the preceding pages and determined what in their judgment might be considered a figure which would be fair to the undertaking 1 Dissenting opinion Sir James Woodhouse, The Nat. Tel. Co., Ltd. v. H. M. Postmaster General (1913). 2 For possible exceptions to this doctrine see reports Wisconsin Com- mission. FAIR PRESENT VALUE RATES 223 and to the public. Some commissions have gone still further than this and have used cost of reproduction-new rather than original cost as the basis. Thus in a recemV decision a commission said, "We do not think that the original cost of construction, whatever that may have been, ... is a proper standard to determine the value of the plant and equipment for which the company is entitled to receive a fair income, but that the cost of reproduction at the present time in this particular case is a more accurate standard." 1 Likewise the tendency of the courts has been to depart from the strict question as to what the value of the prop- erty was and what rate would be confiscatory but, re- cognizing the work of the commissions, to review their decisions as to a figure fair to both parties affected. Courts have given of late decisions defining fair rates of return. If this practice is to be continued, clearly the basis of fair value will be changed and courts and commissions will adopt a basis of fair value in many cases probably somewhere between the original cost and cost-new as of the present time. Thus in course of time conventions or rules may grow up as to what may or may not be included in the fair present value. Thus the cost of repaving seems to be almost universally excluded. The present value of land rather than original cost seems to be recognized in cases where the unearned increment is not so large as to affect rates unduly. 161. Depreciation. The courts have held that "what the company is entitled to demand in order that it may have just compensation is a fair return upon the reasonable value of the property at the time it is being used by the public/' 1 Conn. Pub. Utilities Com., Pet. H. O. Bowers et al., March 7, 1912. 224 PUBLIC UTILITIES The investment in a portion or the whole of the physical property of the undertaking will have depreciated in value due to its years of service and consequently, at the time of the appraisal, have a value less than the fair value-new whatever that figure may have been found to be. The depreciation which the plant has suffered must be presented in such form that the court, having deter- mined the reasonable value of the plant new, can find the reasonable value of the property as it exists at the time of the appraisal. 162. Method of figuring depreciation in cases involving rates. In the last chapter, two methods of figuring the loss in the value of a property were described. One, the so-called straight line method, was held to be applicable to such cases as plant alone formed the property of the undertaking, and the second, the sinking fund method, when the property consisted both of plant and of reserves invested in outside securities. As stated in the last section, the undertaking is entitled to a fair return upon the reasonable value of the property at the time it is being used by the public. It is necessary now to see whether these two methods of determining loss of value will operate equitably in all cases. As was demonstrated in section 137, if there is plant alone as representative of the property of the undertaking, the straight line method when age and life have been determined with accuracy will show the absolute loss in value and, consequently, this loss in value gives the true depreciation of the property. If the property of the undertaking consists of plant and reserves, the sinking fund method will likewise show the loss in value if properly applied. But the equity of this method has been the subject of much doubt. It has been argued that, if the straight line method is proper for use when applied to property consisting of plant alone, it FAIR PRESENT VALUE RATES 225 should always be applied to the valuation of plant even when associated with reserves. Thus, if a plant having a fan* cost-new of $100,000, was being valued at the endr of 5 years of a 10-year life, and the property of the under- taking was found to consist of the plant and outside secu- rities to the amount of $46,312, drawing 3 per cent interest, it would be argued that the plant by the straight line method would be worth $50,000, and the securities $46,312, so that the present value of the property was $96,312, and upon that sum alone the undertaking was entitled to base its return. Such a line of reasoning is manifestly unfair to the undertaking. The company has done all that its duty to the public demands, in that it has made reserves sufficient to ensure to the public the con- tinuation of the service; it has exacted from the public as small payments to the reserves as could be made and, at the same time, guarantee a continuation of the operation of the property. If the undertaking is to be thus penal- ized by a reduction of its assets below what it has actually invested, recourse would have to be made to larger reserves for depreciation at the early years of the operation of the plant, and gradually reduced annual payments, in order thus artificially to make the reserves conform to the loss in value produced by the straight line method applied to the plant. Rates cannot be changed each year. By the use of the sinking fund method as thus outlined the rates would remain unchanged throughout the life of the plant and even after it was renewed, as the capitalization, i.e., the value of the property, would remain unchanged. But in the case of depreciation as in all other matters relating to valuations, arbitrary rules cannot be applied. The choice of which method should be used to ascertain depreciation will depend upon the good judgment of those whose duty it is to make the decision. Thus cases can be conceived wherein a rigid adherence to the rule of using 226 PUBLIC UTILITIES the straight line method for property consisting of plant alone, and the sinking fund method for plant associated with reserves, would prove inequitable to the undertaking. Thus if, in the case cited above, the reserves had been $100 instead of being $46,312, then, since there are re- serves in hand, if this rule is followed the loss in value must be ascertained by the sinking fund method. $100 at compound interest for five years would be approximately $116. The accumulations of the annuity and interest at the end of five years on $100,000 at a three per cent rate is $46,312. Thus, by a strict adherence to the above rule, the loss in value would be $53,572; whereas it would have been fairer to the undertaking in such a case to have used the straight line method. 163. Returns based upon capital investment. The theory of depreciation, which has been outlined in the preceding pages, is founded on the belief that justice to the public and to the undertaking can be obtained only when the fair value upon which rates can be based is ruled to be, as nearly as may be capable of determination, the proper investment of shareholders in the enterprise (neglecting for the present any question of the unearned increment), provided there is always maintained that value by adequate reserves to make good the loss in the value of the investment arising from the years of service. But, it has been contended, the courts have held that rates shall be based on "the present value of the property of the undertaking in use and useful to the public" and not the cost of the property. The answer to this conten- tion is that it is a question of property, not plant alone, and of property maintained through adequate reserves at that value. But again it is argued, if that theory is correct the plant value may be a fraction of the cost, and the full cost be attained only by adding to the plant value the reserves FAIR PRESENT VALUE RATES 227 for depreciation. On such a basis the public would have to pay a return not only on the plant value but upon the depreciation reserves which possibly may be drawing interest from some outside source. The plant is in use and useful to the public ; the reserves are not. It cannot be right to make the public pay a return upon depreciation reserves which it has contributed to the undertaking. These arguments cannot be held to be sound. If all reserves are invested in plant, the method which has been described clearly determines a value upon which rates are to be based, which does not include the plant purchased with such reserves. If the property consists of plant and money properly invested, the value of the property is that sum which can be proved to be capable of use for the benefit of the public. The very fact that the plant is to be used only as long as it affords good service and will be renewed with funds held specially for that purpose main- tains the full value of the investment in perishable prop- erty. Nor does the public pay a return upon the reserves; it pays a return upon the property as a whole which is held and used for the benefit of the public. The interest on the reserve funds does not go to swell the returns to the stockholders but is used to reduce the aniount which the public has to pay toward the depreciation reserves. 164. Investment in property, not plant, ruled by courts as basis of fair return. The Supreme Court has said, "It" (an undertaking) "is entitled, it is its duty, to see that from its earnings the value of the property invested is kept unimpaired, so that, at the end of any given term of years, the original investment remains as it was at the be- ginning." It must be noted that the court says that it is the value of the property, not value of the plant. This ruling of the Supreme Court states as clearly and defi- nitely as words can express, that the sums set aside from earnings keep the property invested unimpaired. Another 228 PUBLIC UTILITIES ruling of the Supreme Court is that it is "the fair value of the property being used by it for the convenience of the public/ 7 that must be the basis of all calculations as to the reasonableness of rates. In the light of these rulings, it must be property, the property invested and kept unimpaired by depreciation reserves, property invested by the stockholders in the undertaking and held by the un- dertaking for the perpetuation of the service to the public, that must be the basis for all calculations as to the reason- ableness of rates. It is illogical and unreasonable to ex- pect that the court will hold that, if the value of the plant diminishes year by year, the return to the stockholders must diminish correspondingly, and be increased when the reserves for depreciation properly set aside bring back to the plant its original cost. It is the investment in prop- erty that is the basis of fair rates and the depreciation re- serves hold the value of the investment unchanged. In other words, the depreciation reserves are a part of the property of the undertaking, as much as is the plant itself. In another case the court has said : "It was obligatory upon the complainant to show that no part of the money raised to pay for depreciation was added to cap- ital, upon which a return was to be made to stockholders in the way of dividends for the future. It cannot be left to con- jecture, but the burden rests with the complainant to show it. It certainly was not proper for the complainant to take the money, or any portion of it, which it received as a result of the rates under which it was operating, and so to use it, or any part of it, as to permit the company to add it to its capital account, upon which it was paying dividends to shareholders. If that were allowable, it would be collecting money to pay for depreciation of the property, and, having collected it, to use it in another way, upon which the complainant would obtain a return and distribute it to its stockholders. That it was right to raise more money to pay for depreciation than was actually disbursed for the particular year there can be no doubt, for a reserve is necessary in any business of this kind, and so FAIR PRESENT VALUE RATES 229 it might accumulate, but to raise more than money enough for the purpose and place the balance to the credit of capital upon which to pay dividends cannot be proper treatment." 1 This decision seems to establish the principle that it is the value of the property in which the stockholders of the undertaking have invested their money, which prop- erty has been kept unimpaired, that is the basis of fair rates. 165. Dangers resulting from making present value of plant alone the basis of fair rates. One more point only will be cited to show that the depreciation reserves not invested in plant must be included as a portion of the value of the property of an undertaking upon which rates should be based. If the depreciation reserves are to be excluded from the property of an undertaking, it would be necessary for all undertakings to invest all their reserves in extensions to their property whether there was a need of such extensions or not. In very many cases where the growth of a community is slow or the financial success of the undertaking is doubtful, it may be wiser to safeguard the reserves by holding them in good, readily convertible securities. 166. Valuation of new properties. In some cases it may be necessary to make a valuation of a property before it has been in operation long enough to have ob- tained a sufficient income to pay its operating expenses, to make proper and sufficient contributions to its depre- ciation reserves and to contribute a proper return to its stockholders. In such a case, in one state at least, the Public Service Commission has authority to permit a tem- porary abandonment of depreciation reserves, and the loss properly sustained may be considered as a part of the value of the property incident to making it a going con- 1 Louisiana R. R. Com. v. Cumberland Tel. & Teleg. Co. 212 U. S. 424 (1909). 230 PUBLIC UTILITIES cern. In such a case the present value will be something more than the original cost or the replacement cost plus other proper intangible assets and must be found by a study somewhat similar to that of the artificial de- termination of going value as a part of the cost of developing the business. 167. Working capital. Nothing has been said up to the present time relative to working capital, which is naturally an asset of any large undertaking and is essen- tial to the successful and economical operation of its business. This item has been omitted for the reason that it does not enter naturally as a portion of the ap- praisal but is a sum which must be obtained directly from the books of the undertaking. The items to be included in working capital are supplies of all kinds, cash for current use in sufficient amounts to insure economical and safe operation of the plant, and the balance between bills and accounts receivable and accounts payable. " Plants which are running, or in actual operation, must have working capital as well as fixed capital. In this case the latter, or the fixed capital, is largely represented by the cost of reproducing the plants, while the working capital is, in part, represented by the figures given in that table for ' stores and supplies/ The stores and supplies there given, however, do not represent all the working capital the plants require. Plants of this kind, the same as practically all other business enter- prises, must have on hand a reasonable cash balance and other current resources in order to operate economically and effec- tively. That this is the case, is almost self-evident. Just what sum represents a fair amount for working capital, is nearly always a matter of judgment, and to this there is no exception in this case." l The proper amount to be allowed for working capital must be decided for each particular case as it arises, by * Wis. R. R. Com. Rpts., Vol. 5, p. 316. FAIR PRESENT VALUE RATES 231 a consideration of the character and extent of the opera- tions of the undertaking, the working capital ordinarily carried by it in the past, and the amounts usually car- ried by similar undertakings of the same size and activity. Probably the best citation of a court ruling on this item will be a portion of the opinion of the Court in the case of the Consolidated Gas Company v. City of New York. "The amount of cash necessary for the safe and convenient transaction of a business, having regard to the owner's ordi- nary outstandings both payable and receivable, the ordinary condition of his stock, or supplies in hand, the natural risk of his business, and the condition of his credit; and unless these matters, and perhaps others, be looked into, no comparison can be drawn between one business and another, or even be- tween those of the same general nature." 1 168. Fair return. There may be two figures which may be assigned as the return which a public utility can earn upon the fair present value of its property, one a rate assigned by the state authorities as a fair return, when the hazards and risks incurred by the undertaking are considered, as well as the rate of return to similar enterprises in the same or similar localities; the other, a rate assigned by the court as productive of such a return as would not be considered confiscatory of the property. Authority for fair rate of return allowed by the state can be summed up best by the following decisions. "It therefore does not seem that rates producing no more than a reasonable return on their fair value could be unjust to any one. In fixing the measure of return upon property devoted to public use regard should be had to the character of the business, the locality and the risk ; whether the return will be uniform and secure; whether the patronage is steady or 1 Consolidated Gas Co. v. City of N. Y., 157 Fed. 859 (1907). 232 PUBLIC UTILITIES fluctuating and quickly responsive to financial and commer- cial changes; interest rates legal and contractual and the rates customarily sought and required in like investments in the locality; if a railroad, the character of the traffic, whether largely of a kind dependent upon uncertain conditions, or so diversified that causes affecting part will not greatly affect the whole. The return should be a fair, just, and reasonable one, and not so meager as to repel investment in the property or to embarrass the owner in operating it." 1 "There is no particular rate of compensation which must in all cases and in all parts of the country be regarded as sufficient for capital invested in business enterprises. Such compensa- tion must depend greatly upon circumstances and locality; among other things, the amount of risk in the business is a most important factor, as well as the locality where the busi- ness is conducted and the rate expected and usually realized there upon investments of a somewhat similar nature with regard to the risk attending them. There may be other mat- ters which in some cases might also be properly taken into account in determining the rate which an investor might properly expect or hope to receive and which he would be entitled to without legislative interference. The less risk, the less right to any unusual returns upon the investments." 2 A court, when a question arises as to a fair rate of return, may not " undertake to guarantee the company any fixed or certain return upon its investment" or even say what a fair return might be, but may rather say whether a certain rate is so low as to be deemed by it confiscatory of the property of the company. There seems to be no doubt that, if the principle above outlined is followed, the court might rule that the undertaking has a right to a gross revenue such that it can pay all legiti- mate operating expenses, pay interest on all valid fixed charges, so far as bonds or securities represent an expend- iture actually made in good faith, and, if the return upon the stock is equal to that which is obtained from a govern- 1 Missouri, Kansas & Texas Ry. Co. v. Love, 177 Fed. 502 (1910). 2 Willcox v. Consolidated Gas Co., 212 U. S. 48 (1909). FAIR PRESENT VALUE RATES 233 ment bond, for instance, the rates producing such gross revenue could not be considered confiscatory. That such an extremely low rate should not be consid- ered confiscatory would seem to impose an unfair burden upon the public utility, in view of the special hazards incurred by such enterprises. But on the other hand it must be recognized that such a low rate of return may be figured upon a cost-new in which there has arisen possibly an extremely large unearned increment. Attention should be called to the fact, however, that as with fair value, though possibly to a lesser degree, the courts have receded in many later decisions from the theoretical requirements above outlined and have either confirmed the fair returns assigned by state authorities or have decided what a fair return should be under the conditions peculiar to each particular case. 169. Fair rate based upon stock only or upon stock and bonds. An undertaking is entitled to a fair return upon the value of the property in use and useful to the public. A fair return has been ruled to be in many cases a percentage varying between 5 and 8 per cent. The question then arises as to whether this fair rate of return shall apply to the entire value of the property or only to the stockholders' investment. In most cases the property has been created by money received from the sale of bonds as well as from money paid in by stockholders. If equal amounts were received from these two sources and the bonds bore interest at a rate lower than the rate ruled by the rate making authorities as fair, then the stock- holders would receive a return greater than the fair rate for the property as a whole. Thus, as an example, a question may arise as to what percentage return can be paid by an undertaking to its stockholders, where the rate regulating authorities have decided that the fair present value of its property is 234 PUBLIC UTILITIES $1,000,000 and that the fair rate of return is 8 per cent. The undertaking has paid for its property by the issue of four per cent bonds to the value of $500,000 and by the sale of stock of a value of $500,000. The undertaking cannot say that it is entitled to earn $80,000 a year, so that, after paying the interest on the bonds amounting to $20,000, the remaining $60,000 can be paid as a twelve per cent dividend to the stockholders. The fair return, in this example 8 per cent, is to be figured upon the amount actually invested by the stockholders in the enterprise. CHAPTER XIII FAIR PRESENT VALUE CONDEMNATION OR SALE 170. Market value. 171. Fair cost-new. 172. Increased cost of maintenance. 173. Uncertainty as to life. 174. Value of franchise. 175. Depreciation in cases of sale. 176. Investment of buyer must be full cost-new of a public utility prop- erty. 177. Present value in case of sale. 170. Market value. The methods of determining fair present value, which have been described in the preceding pages, are those which apply in cases of rate regulation in the case of a utility which is to continue to furnish the service to the public. The question next to be discussed is whether the same methods are applicable when it is required to determine the fair present value in a case involving the condemnation or sale of the property of a public utility. The principle underlying the sale of an ordinary com- modity is that the fair price is such a sum of money as would be paid by a willing buyer, having the necessary funds, to a willing seller. In the case of the sale of a pub- lic utility undertaking, this same principle holds good, ex- cept that there is introduced the interests of a third party or group, the users of the utility or, as it will be termed, the public. The rights of the public must be conserved by such a regulation of the price paid that the amounts, which must be paid by the public in the form of rates for the use of the service and for its continuation, de- preciation reserves, must not be enhanced. The fair 236 PUBLIC UTILITIES present value of the property of a public utility under- taking in a case of sale, therefore, must be such a price as is fair to the public as well as to the seller and to the buyer. 171. Fair cost-new. In most cases, as far as the appraiser is concerned, it will be necessary to prepare and present the same figures as would be presented were the case one affecting rates. It is true that, strictly speaking, original cost in a case of sale would not seem to be of importance, for the buyer cannot be concerned with what the property had cost the original owner. This assumption arises naturally from the association in the minds of most students of this subject with the sale of a private enterprise. But in the sale of a public utility the public must be considered, and fairness to it demands that the price paid by the vendee shall not be such as will impose new higher or unfair rates. When the interests of the public are considered, there seems to be no reason to believe that the fair cost-new in the case of sale should not be the same as would be assigned to the property as fair cost-new for rates pro- vided that figure had been obtained with the well informed judgment described in the last chapter. This figure, therefore, would be not necessarily the original cost, not necessarily the cost-of-reproduction-new as of the present time, not necessarily the capital value of the assets nor of the return capitalized. It would be such a figure as would be fair to the seller and public under the special conditions affecting the property under consideration. A value based upon such a cost-new might seem to those familiar with the sale of private undertakings as imposing a burden upon the buyer. The buyer assumes the ownership and operation of a property which has been some years in existence. It is natural for him to contrast such a property with a new one and look upon FAIR PRESENT VALUE CONDEMNATION OR SALE 237 the existing plant as second-hand and that, since the plant is not new, he is entitled to a lower or bargain price. The buyer may argue that the cost of maintenance in- creases with age and that, as he is buying an older plant, some recognition should be made of the increased expense of maintenance which he will have to assume. More- over, he may demand that he should pay a lower price for the plant due to the fact that he is obliged to incur a certain amount of risk arising from the possibility that the life assigned to the plant may be wrong and, conse- quently, that he may have to incur the cost of the renewal of some portions of the plant before he has had the time necessary to accumulate the needed reserves. 172. Increased cost of maintenance. Cost of main- tenance is a burden not upon the buyer but upon the public. A regulated public utility will be entitled to such rates as will pay proper returns over and above operating expenses in which are included costs of main- tenance. As a matter of fact, in practically all cases, the property sold will possess units of widely differing ages. Under such conditions, especially if the property is increasing in size, the expense of maintenance as a percentage of the plant cost will be substantially uni- form. When these facts are considered there would seem to be no reason for diminishing the value of the plant for this reason. The buyer has the virtual promise of the public to pay the reasonable cost of maintaining the plant, whatever the cost of maintenance may be. Unreason- able cost of maintenance is cared for definitely in a proper determination of life (see section 120). The public does not suffer, as it will make no difference to it whether this expense of maintenance is paid to the new owner rather than to the original owner of the property. 173. Uncertainty as to life. Unquestionably there is 238 PUBLIC UTILITIES a certain amount of uncertainty as to whether the perish- able property will last out the full life assigned to it as the basis upon which the loss of value due to age has been figured. There is always this uncertainty in making the annual reserves for depreciation, but this uncertainty would be greater with a new plant than it would be at the time of a sale, when the plant has served already a portion of its life. Again, the probabilities are quite as great that the property can be retained in service longer than the as- signed life rather than for a shorter period. In fact the probability is that, if anything, the estimated life will be less rather than greater than the actual life. But, more than all the reasons above given, is the fact that the public pays rates sufficient to provide needed depreciation reserves, so that the risk to the purchaser of a public utility will be no greater, in most cases, than to the original owner or to any other owner of a public util- ity service. 174. Value of franchise. The commercial value, which was presented in cases involving rates as a figure of doubtful value as evidence due to the fact that it is based, necessarily, upon existing rates, the very quantity under investigation, becomes a figure of greater importance in a case of sale, as the question of rates is not directly at issue, and, in many cases, it may be a reasonable assump- tion that the rates prevailing under the management of the original owner may be continued unchanged under the new. Under certain circumstances, also, the value attaching to a franchise may be given a value which could not be included as a definite figure in a rate case. 175. Depreciation in cases of sale. The same line of reasoning holds as to depreciation in a case of sale as in that where the question of rates is involved. The public must be assured that there will be sufficient funds FAIR PRESENT VALUE CONDEMNATION OR SALE 239 in hand to make renewals of the perishable property when such renewals may be required. It is to be pre- sumed that the undertaking has been making reserves- to depreciation in the past. If it has not, it should have done so. Such reserves may have been invested in the plant or they may have been held in readily convertible securities. Probably it will make no difference, as far as the method of appraisal is concerned, as both the cash forming a portion of the working capital of the seller, and such reserves as have not been invested in the plant, will be retained by the seller. Theoretically, of course, these funds should be turned over with the remainder of the property paid for by the buyer, but as this may be only a transfer of money backward and forward between buyer and seller, it is usually not done. 176. Investment of buyer must be full cost-new of a public utility property. The condition peculiar to a sale of a public utility exists in the necessity of the buyer paying the full cost-new of the property, that is to say, the present value of the perishable property plus its intangible property to which must be added such a sum in cash or securities as will guarantee to the public a continuation of the undertaking. This requirement is so foreign to ordinary private sales that it must be explained at some length in order that its justice may be appreciated fully. A private undertaking would pay the fair present or market value of a plant and that cost would be its invested capital. Upon this capital the owner might establish rates for service as high as if the purchased plant had been new, trusting to his profits to acquire sufficient funds to replace the plant when the proper time arrived. A public service undertaking could not do this with fairness to the public, for the reason that, if a property was purchased for a fraction of its cost-new, the purchase 240 PUBLIC UTILITIES price, the money actually invested by the owner, would be the fair value upon which the rates charged the public should be based. The annual reserves would be figured on the cost-new but at the time of renewal would not be sufficient to pay for the new plant. New money would have to be contributed by the stockholders and higher rates would have to be paid by the public for the same service, a condition unfair to the public and to the vendor. On the other hand the buyer, who invests in the enter- prise the full cost-new of the property, would pay to the vendor the fair present value of the property and would hold or invest in plant needed by the public an amount of money sufficient to maintain the proper capital assets of the undertaking. The public is thus guaranteed as to the continuation of the enterprise, and the necessary uniformity of rates is maintained. 177. Present value in case of sale. The present value will be clearly the cost-new less the loss which has accrued to the investment in perishable property aris- ing from its years of service. The question that next arises is how shall this loss in value be determined. To take the simplest case first, let it be assumed that reserves for depreciation have been made by the vendor regularly in the past and have been held by him in out- side securities upon which interest has been obtained. In other words, none of the depreciation reserves have been invested in plant. Then, clearly, if at the time of the appraisal it can be shown that the amount in the reserves will equal the cost-new at the end of the life of the plant, the plant plus the reserves will equal the cost- new and the price to be paid to the vendor is the cost-new of the property. Or, if the vendor retains the securities representing the depreciation reserves, the price to be paid to the vendor is the cost-new less the value of the FAIR PRESENT VALUE CONDEMNATION OR SALE 241 securities. Thus, in either case, the vendor obtains the cost-new of his property, thereby obtaining the full value of his investment in the public utility. The vendee either obtains the depreciation reserves of the vendor or invests as a new depreciation reserve a like amount, thereby guar- anteeing to the public the perpetuation of the service. Thus it is seen that this method is fair to the seller and to the public. It is fair to the public in that the capital assets of the new undertaking remain the same as those of the older, and, consequently, there will be no changes in rates; the rates, moreover, will be based upon the fair present value of the property in use and useful to the public. The justice of this method to the buyer may be ques- tioned by those who cannot divorce from their minds the usual prices and methods of sale of private enter- prises. A public service undertaking cannot obtain any advantage from a purchase made at a bargain price. It is entitled to a fair return upon the investment. If the investment is unduly small owing to the small price paid for the property, the new owner can earn a return based upon that investment only. When this property has to be replaced, new capital must be brought in and, consequently, a new basis of rates established. This increase would go on gradually until all of the property originally purchased had been replaced. Such increases in rates are annoying and unfair to. the public. The only proper way of looking at a sale of a public utility is to consider that the sale is simply a transfer of the ownership in a continuing enterprise. The new owner takes possession of the entire property of the former owner and recognizes that the property purchased did not belong necessarily entirely to the vendor but to the public pos- sibly as well. It is, therefore, a necessary prerequisite in a case of 242 PUBLIC UTILITIES sale to have a complete examination made of the past operations of the utility in order to ascertain whether depreciation reserves had been invested in plant or whether new money had been introduced by the under- taking into its reserves for the sake possibly of inflating the value of the property. The above illustrates the principle peculiar to a sale of a public utility. In a practical case the appraiser finds plant of a certain cost-new and of a certain age and life. It is for the tribunal, whose duty it is to assign the fair selling price, to take these figures, and, with a knowledge of the past financial history of the undertaking, determine such a figure as will be fair to all three parties concerned. Justice to the public demands that the price for the property shall not produce higher rates to be paid to the vendee than were paid previously to the vendor. Justice to the vendor demands that he should obtain his original investment in the property provided that the value of the investment has been maintained. Justice to the vendee demands that he shall pay no more for the property than will make it possible for him to obtain a fair return upon his investment and be enabled to renew the perishable property when it becomes no longer serviceable. No definite rule can be formulated as to the method of ascertaining this price. It is evident that the rules, which were laid down as possibly useful in figuring fair value for rates, may not be applicable for such cases as are being now considered, as it is unusual for the vendor to turn over, with the remainder of the property, the reserves that have been accumulating during his owner- ship. If the previous rule, that the straight line method was to be followed when plant alone without reserves was to be appraised, was adopted, then in most prac- tical cases the straight line method only would be used FAIR PRESENT VALUE CONDEMNATION OR SALE 243 in ascertaining loss of value in cases of sale. As must be apparent from what has been said in the preceding pages, full justice would not be accorded by a strict adherence to such a rule. Full justice to all three parties interested is obtained only by using such method as will determine what por- tion of the present cost-new is represented by the invest- ment of the vendor and what portion by the investment of funds contributed by the public, as ascertained by a consideration of the financial conditions presented by the special case under investigation. In other words, the fair selling price can be determined only by a well-informed judgment. CHAPTER XIV GENERAL CONSIDERATION RELATIVE TO THE REGULATION OF PUBLIC UTILITY UNDERTAKINGS 178. Conduct of private undertakings. 179. Conduct of public utility undertakings. 180. Dangers involved in regulation of public utility undertakings. 181. Avoidance of dangers of regulation. 182. Obligations of public to public utility undertaking. 183. Obligation of public utility undertaking to the public. 184. Maintenance of the value of the stockholders' investment. 185. Treatment of depreciation reserves. 186. General conclusions. 178. Conduct of private undertakings. A private undertaking, usually in competition with others of a similar nature, is privileged to charge such rates for the commodity or service furnished as will be productive of as great a profit as can be obtained and, at the same time, retain the custom and good will of its customers. There is every possible incentive to a private undertaking for the establishment of a good organization, the employ- ment of the most skillful men and for the development of new methods or devices which will tend to reduce the cost of its product and thus enable it to increase its profits by means of improvements not possessed by its com- petitors. The profits made by such private undertakings can be treated in any manner that seems best to the owners; dividends may be increased or excess profits can be held in the form of a surplus designed to maintain dividends during less successful years. The reserves for deprecia- tion can be made as large or as small as may be deemed desirable. The reserves, that may be set aside, belong PUBLIC UTILITY UNDERTAKINGS 245 to the undertaking and can be used in any manner that may seem to the directors as conducive to the best inter- ests of the undertaking. Competition and the necessity of self-preservation are the means whereby the character of the product or ser- vice as well as the prices charged the users are automat- ically regulated. 179. Conduct of public utility undertakings. The- oretically, at least, the need of regulation of undertakings furnishing public utilities becomes apparent only when competition does not exist. The state or municipal- ity has recognized the wasteful duplication of property and human energy which results when the same utility is afforded by two similar undertakings in the same community. A single undertaking can furnish a utility of a certain kind with less cost to the public as a whole. But this freedom from competition has removed the stim- ulus present in usual trade relations and the states have found it necessary to supervise the conduct of such pub- lic service undertakings to see that the character and prices of the utilities sold are satisfactory for the public and reasonable for the undertaking. Thus it is seen that a public utility undertaking must consider not only its own interests but is forced to con- sider the rights of the public in all of its operations. The introduction of the considerations of the rights of the public, in the case of public utility undertakings, produces a radical difference between the conduct of such undertakings and those of a private nature. This same consideration introduces radical differences when ques- tions requiring valuations are involved. 180. Dangers involved in regulation of public utility undertakings. The fact cannot be disguised that, if there is to be exercised by the state, or by boards invested with state authority, a meticulous super- 246 PUBLIC UTILITIES vision of the operation of public utility organizations and such undertakings are to be permitted no more than a moderate return upon the money invested in the prop- erty in use or useful to the public, stimulus to improve- ments in organization, methods or devices has been removed to a very large degree. The greatest possible incentive to inventions for improving or cheapening a product comes when a reward for such labor and skill is manifested by an ability to undersell a competitor. The greatest advances in all arts have come by the employ- ment of highly specialized men whose efforts have been directed by the undertaking employing them toward im- provements in methods or machines whereby the charac- ter of a product or service may be improved or its cost reduced. The cost of this work to the undertaking is large but the reward obtained by it is in many cases enor- mous. In the case of a public utility there can be no reward, if the law is strictly enforced, for, if the product is cheapened, the rates must be lowered for the reason that no more than a certain definite rate of return can be paid upon the investment. Further than this, it is prob- able that the courts will say that the cost of such devel- opment work cannot be regarded as an expense of the undertaking to be included, properly, with the costs of operation. 1 Thus, on the mechanical side of the property and in the operation of the plant, all incentive toward improve- ments and development is removed, and all advances in the art must be sought outside the undertaking. What is true of the physical portion of the property is equally true of the organization and of the methods employed in the conduct of the business. The courts have ruled, that the costs to the user of the commodity 1 See Capital City Gas-Light Co. v. City of Des Moines, 72 Fed. 829 (1896). PUBLIC UTILITY UNDERTAKINGS 247 or service obtained in one community can be no criterion of the costs in another, owing to the fact that identical plants rarely exist in two places. While this ruling is regarded by public service commissions, when they have had occasion to investigate the operating costs of public utility undertakings within their jurisdiction, still it is not at all infrequent to find that the basis of the salaries to be paid the officials of an undertaking has been fixed by comparison with the salaries paid elsewhere. Such a practice will be productive, naturally, of the establishment of a certain uniformity in the salaries paid officials, without the possibility, as in a private under- taking, of obtaining men of exceptional executive ability, who are able to advance the interests of the undertaking employing them by better organization and better methods of conducting the business. Thus it is seen that a rigid enforcement of the powers of the state in the regulation of the operation of public utility undertakings inevitably suppresses the enterprise and initiative essential in the successful operation of a private undertaking. The same conditions are involved when the financial questions relative to a public service undertaking are considered. If the state adheres rigidly to the principle that a public utility can obtain no more than a moderate return upon the money invested in the enterprise, cap- ital will not be forthcoming and the public will be deprived of service which can be furnished more advantageously by an undertaking than by the community itself. 181. Avoidance of dangers of regulation. Most if not all of the dangers above described can be avoided by a liberal and broad-minded consideration on the part of state authorities of the needs of the undertakings as well as of the public. A public utility undertaking which is ably managed 248 PUBLIC UTILITIES and can obtain with regularity and uniformity a fair rate of return is capable of serving the public better than if it were restricted both in its expenses and in its return to its own stockholders. The undertaking and the pub- lic are mutually dependent upon each other. Each has obligations toward the other which must be fulfilled. It is necessary that these obligations should be understood fully both by the public and by the undertakings. 182. Obligations of public to public utility undertaking. It must be recognized by the public that stockholders of most public utility undertakings at the outset of their enterprise invested their money in property designed to afford the public a service which it did not possess before; that there was, in most cases, a degree of uncer- tainty or hazard involved which no municipality would be justified in encountering itself; that, as the law exists, the undertaking can expect no profit upon its invest- ment except the small and doubtful one arising from the gradual increase in costs due to the growth of the coun- try, in other words, to what is known as the unearned increment; that the only inducement for capital to enter upon an undertaking of this kind is a certainty of return and a return somewhat higher than that obtained in other classes of investment, where there is a reasonable expectation of profit; that such large and hazardous undertakings require men of exceptional skill and ability to produce a good utility at a reasonable cost. To meet these obligations the public must recognize that the rates paid by them for the service or commod- ity obtained must be sufficiently high to produce a gross return which will pay the operating expenses of the under- taking, pay a liberal contribution toward a fund to assure the continuation of the service of the utility and to pay to the stockholders, those who have invested their money in the enterprise, a liberal return. PUBLIC UTILITY UNDERTAKINGS 249 Probably no feature of the relations between the public and public utility undertakings requires more accentuation than the fact that it is just and right for the public, through the rates paid by them for the service or commod- ity obtained, to contribute toward a fund to assure the continuation of the service of the utility without obli- ging the utility to increase its investment, in other words, to create ample funds as reserves for depreciation. Until the full justice of this obligation is appreciated, the public or those representing its interest are inclined to the belief that, as depreciation reserves are used for the con- struction of the property and as the money comes from the public, it is not just to them to pay a return to the stockholders of the undertaking upon these funds. This misunderstanding of the true nature of depreciation reserves is clearly indicated in the following argument : "We see no reason why plaintiff, in addition to operating expenses, repairs, and other ordinary charges, should be allowed to reduce the apparent profits by deductions for a res- toration or rebuilding fund. The setting aside of such a fund may be good business policy, and, if the company sees fit to devote a portion of its profits to that purpose (though, as we understand the record, no such fund has yet been created), no one can complain; but it is in no just sense a charge affect- ing the net earnings of the works. To hold otherwise is to say that the public must not only pay the reasonable and fair value of the services rendered, but must, in addition, pay the company the full value of its works every 40 years the average period estimated by plaintiff for all time to come." 1 The Supreme Court of the United States in the Knox- ville Case has settled definitely this question and has explained fully the obligations of the public to safeguard the continuation of the service of the undertaking. This decision has been quoted already in the Chapter dealing 1 Cedar Rapids Co. v. Cedar Rapids, 118 Iowa, 263; 91 N. W. 1081 (1902). 250 PUBLIC UTILITIES with depreciation, but the following words may be quoted to emphasize the importance and propriety of this contri- bution from the public. "It is not only the right of the company to make such a provision, but it is its duty to its bond and stock holders, and, in the case of a public service corporation at least, its plain duty to the public. If a different course were pursued, the only method of providing for replacement of property which has ceased to be useful would be the investment of new capital and the issue of new bonds or stock. This course would lead to a constantly increasing variance between present value and bond and stock capitalization a tendency which would inev- itably lead to disaster either to the stockholders or to the pub- lic, or both. If, however, a company fails to perform this plain duty and to exact sufficient returns to keep the invest- ment unimpaired, whether this is the result of unwarranted dividends upon overissues of securities, or of omission to exact proper prices for the output, the fault is its own." This decision clearly establishes the only principle that is capable of yielding the stability of service and rates which is essential for the good of the public as well as the stockholders of the undertaking. It is manifest that if a company could obtain only a fair return upon its invest- ment and, following the former decision, was obliged to make its reserves from such return, not only would the property be ruined but no money would be invested in undertakings where such an exaction was enforced. The return allowed may be 6, 7 or 8 per cent of the value of the property invested, but the needed reserves, in many cases, would be as high as 8, 9 or 10 per cent of the same investment. 183. Obligation of public utility undertaking to the public. It must be recognized by public utility under- takings that they have been given by the public certain rights and privileges; that, instead of building and oper- ating the plant itself, the public has allowed the under- PUBLIC UTILITY UNDERTAKINGS 251 taking to take or use property and in most cases this privilege has been extended to it alone; that virtually its plant is a municipal property built and operated for the public good but with the money of private indi- viduals; that in return for these privileges the under- taking must give the public good and modern service at reasonable rates; that the rates are reasonable when they yield a gross income sufficient to pay proper and liberal operating expenses, an ample installment toward the depreciation reserve funds and a just and liberal return to those who have risked their money in the under- taking; that this return shall be based upon the value of the property in use and useful to the public; and that the reserves for depreciation shall be conserved by the under- taking for the purpose for which they were contributed, i.e., to make good portions of the property as they become no longer serviceable. There are two features only of these obligations of public utility undertakings which are not self-evident. One is that the undertaking, in order to maintain a fair rate of return upon funds originally invested in the prop- erty, must keep the value of their property unimpaired at all times. The other is that the reserves for depre- ciation, although the property of the undertaking, were contributed to it for a specific purpose and can be used only for that purpose. 184. Maintenance of the value of the stockholders' investment. An undertaking, which has invested its money wisely and properly for the purpose of supply- ing the public with a needed service, will find that the value of the property, in most cases, will depreciate, owing to the limited tenure of life of many of its elements. This gradual diminution in value can be made good by the depreciation reserves, so that there will be always in hand property of the value of the stockholders' invest- 252 PUBLIC UTILITIES ment, represented either by plant value or plant of re- duced value and depreciation reserves, equal to the amount by which the value of the plant has been reduced. So long as this total value of the property is maintained the rate of return can be based upon the original investment. Unfortunately, the fairness of the principles above outlined are not apparent in many cases, owing to ques- tions arising from the treatment of the depreciation reserves held by the undertaking. This subject is of fundamental importance and is one of the features in- volved in valuations of properties which needs most careful discussion. The depreciation reserves obtained by the undertaking from the public are not immediately needed for the replacement of plant but are held by the undertaking for this purpose. In some cases these reserves are invested in outside securities drawing interest and, in other cases, are invested in needed extensions of the plant of the undertaking. The difficulties which are frequently present in the minds of those considering this subject are: first, as to the justice to the public of an undertaking being allowed to earn a full return upon money contributed by the public, and second, if the undertaking is obtaining a return in the form of interest on the depreciation reserves which it has invested in outside securities, as to whether it is right to oblige the public again to pay to the undertak- ing a return upon this fund. The first of these difficulties is removed when it is appreciated that the public pays a full return only on the money invested in the undertaking. The value of the plant represented by that investment may diminish, but the original investment was made in good faith by the stockholders of the undertaking and they are entitled to a full return upon that investment so long as the under- PUBLIC UTILITY UNDERTAKINGS 253 taking can produce the service desired and, at the same time, show that there is sufficient property in hand to produce the same character of service indefinitely. It is_ true that a portion of the property which the undertak- ing possesses is of the nature of depreciation reserves, obtained from the public, but these reserves are not used by the undertaking to enhance the amount of their investment and so advance the rates, but rather, as directed by the courts, to maintain the value of the investment unchanged and, thus, bring about the uni- formity in rates, capital and return essential to the well-being of both the public and of the undertaking. This holds true whether the reserves for depreciation are invested in outside securities or invested in needed extensions of the plant. In each case the value of the original investment is maintained and the undertaking can obtain a return for its stockholders on that value only. When the reserves are invested in plant, the amount which has been invested in plant, its replacement cost, may exceed by a large amount the value of the orig- inal investment, but, if the reserves have been properly made, the then value of the property will be the amount invested in the property by the stockholders and it is upon that amount only that a return to the stockholders can be made. The second of these difficulties also is removed when it is appreciated that the return to the stockholders is based only upon their investment, provided there is at all times property equal to their investment in the hands of the undertaking. If the reserves are invested in outside securities drawing interest, the annuity paid by the public toward the depreciation reserves need not be as great. The return obtained from these invested reserves may not have been segregated and made a part of the deprecia- tion reserves, but shown as a portion of the gross income 254 PUBLIC UTILITIES of the undertaking. Such a practice may lead to account- ing difficulties, but can result in no unfairness to the public as the undertaking can earn only a fair return upon its "then" property and it will be necessary to trans- fer the surplus earnings to the depreciation reserves to make the then value of their property equal to the value of the original investment. 1 The same line of reasoning holds good when deprecia- tion reserves are invested in plant, provided that it is clearly recognized that, in such a case, the question of a return upon the depreciation reserves is a mere fiction, as the public in the long run contributes the entire orig- inal investment. The undertaking can pay its stock- holders only the fair return upon the original investment, provided it has property then equal in value to that amount. 185. Treatment of depreciation reserves. The sec- ond feature of the obligations of a public utility under- taking to the public is a proper recognition and treatment of the depreciation reserves. The undertaking must recognize that, fundamentally, the depreciation reserves are contributions made to the undertaking by the public for the specific purpose of maintaining the value of the investment in property in use or useful to the public. The depreciation reserves are the property of the undertak- ing, not to be disbursed, however, in any way the under- taking sees fit, but only in such a way as will insure to the public, which has contributed the money, the contin- uation of the service at unchanged rates. The full significance of the treatment of depreciation reserve funds is brought out most clearly when the pres- ent value of a property is considered in a case of con- demnation or sale. In order to obtain full justice to the 1 Under modern standard methods the above complication would not arise. PUBLIC UTILITY UNDERTAKINGS 255 public in a case of sale, the entire property of the under- taking must be acquired. This property may consist of a plant, which has served a portion of its useful life r and depreciation reserves, which have been contributed by the public to maintain the plant investment intact. The selling undertaking must turn over to the buyer, theoretically at least, its entire property, plant and depreciation reserves. The buyer, in justice to the pub- lic, assumes the ownership of these reserves, dedicated, however, to the special purpose of restoring the plant to its original condition when it has become no longer ser- viceable. The seller obtains the value of his original investment from the buyer, but the buyer assumes the responsibility of maintaining the value of the invest- ment and, as an assurance of his good faith, must hold in reserve an amount equal to the reserves held by the seller at the time of transfer of the property. 186. General conclusions. In what has been just said, the fair value of the investment in the property of an undertaking was spoken of as the basis upon which rates should be made or a just price in case of sale, pro- vided that value still existed in the property at the time of investigation. The only conclusion that can be obtained from a study of the subject of valuations of public utilities is that, apart from the appreciation in values which has been termed the unearned increment, the courts intend that the basis of return to the stockholders of public utility undertakings shall be the money properly invested by the undertaking and used by it for the benefit of the public. In most cases, the courts cannot tell whether the sums of money represented by the securities were actually invested in the property; they do not know whether the money was honestly expended in the con- struction of the property; they do not know whether a 256 PUBLIC UTILITIES large portion of the property representative of the stock- holders' investment has not already passed out of exist- ence; and lastly, they cannot tell whether the same property could not be acquired more cheaply at the present time than when it was purchased. It is for the purpose of determining what sums of money have been properly invested by the undertaking in its property and whether there is that value still remaining in the property that all of the sets of figures described in this study are required by the court. The decision as to what is a fair present value either as a basis for rates or for a price to be paid by a buyer in a case of sale is formed upon personal judgment, the opinion of the Court determined judicially with " sound and well instructed judgment." INDEX Actual cost: see Original cost Administration expenses: see Or- ganization cost Age of plant: determination of, 185 independent of age of utility, 191 mean age, 153, 186, 192 pseudo mean age, 197 Allison, James E. : amortization of normal wear, 205 Alvord, John W.: going value, 83 period of construction, 24 Amortization : bond discounts, 220 normal wear, 205 through depreciation reserves, 140 Antiquated pattern: unit cost, 20 Appreciation in land value: excluded from original cost, 212 excluded in state investigations of rates, 214 included in replacement cost, 67 included in court investigations of rates, 218 Average prices: see Unit costs B Bonds: bond discounts, 56, 112, 219 return on bonds, 233 Brokerage: see Bonds Buildings: appraisal, 68 effect upon cost of land, 22 hypothetical replacement, 64 Capital: see Working capital Capitalization : of earnings defined, 8 of earnings, method of figuring, 73 Casualties: see Insurance Cedar Rapids, Iowa: Gas rate case going value, 85 Chicago, 111.: Telephone rate in- vestigation reserves for depreciation, 143 Cleveland, Ohio: Street railway settlement good will, 96 Commercial value: capitalization of earnings, 120 defined, 115 of stocks and bonds, 119 Competition: affecting good will, 95 regulation when no competition, 245 Consolidated Gas case: good will excluded, 95 value of franchise, 89, 100 Construction: interest during construction, 42, 46 period of construction, 22 piecemeal construction, 29, 109 Contingencies: as an overhead charge, 52, 112 Contractor's profit: excluded from replacement cost, 57 Cost: compared with value, 9 transformed to value, 10 258 INDEX Cost-new: court investigation of rates, 217 fair cost-new, 222, 236 in cases of condemnation, 236 state investigation of rates, 211 Cost of money, 221 Cost of replacement: see Replace- ment cost Cost of reproduction: see Replace- ment cost Current repair and maintenance: distinguished from depreciation 36 Depreciation: allowance for, in valuation, 7, 16 annual allowance for, 134 ascertained from mean life and age, 188 defined, 7, 182 deterioration contrasted, 183 in cases of sale, 238 in rate cases, 223 old plant not second-hand, 159 overhead charges, 59 reserves invested in plant, 191 rule for use of straight line or sinking fund method, 196 sinking fund method, 198 straight line method, 188 Depreciation reserves: authority for, 134 comparison of stockholders' in- vestment with cost-new, 153 creation of, 140 invested in plant, 150 necessity for, 249 saving to public from reserves invested in plant, 156 sinking fund method, 141 straight line method, 142 treatment of reserves, 254 Deterioration: contrasted with de- preciation, 183 Development, cost of: see Organiza- tion Development of business, Cost of: see Going value Discounts on sale of securities: amortization of, 220 excluded from original cost, 112 excluded from replacement cost, 47,56 E Earnings, Capitalization of: method of figuring, 120 representative of value, 8, 73 Efficiency: see Inefficiency Element of plant: definition, 36 Engineering, Cost of: an overhead charge, 49 Enid, Oklahoma case: going value, 80 interest during construction, 42 removing obstructions, 22 Equally efficient plant, 20 Expert evidence, Limitations to, 2 Fair cost-new, 222, 236 Fair value: court investigations, 210 dependent on purpose, 14 determined by judgment, 207 new properties, 229 state regulation, 210 Franchise value: attribute of live plant, 14, 88, 94 general consideration, 96 in cases of sale, 97. 238 in cases of taxation, 100 in rate cases, 98 Gavey, Sir John: as to period of construction, 24 Gloucester, Mass.: Water plant purchase going value, 70 "Going concern, Value as: distinguished from going value, 91 INDEX 259 Going value: attribute of live plant, 14 cost of developing business, 114 doubt as to value in rate cases, 85 reproduction of earnings, 83 Wisconsin method, 79, 83 Good will: attribute of live plant, 14, 88, 94 definition, 95 H Harlan, Justice: basis of fair present value, 5 Identical reproduction of existing plant, 20 Inadequacy: due to changes in financial policy, 172 due to engineering economy, 176 due to unexpected development, 176 Income: capitalization of, 8 sufficient to pay expenses includ- ing depreciation reserves, 248 Inefficiency, 165 Insurance: included in unit cost, 39, 41 Interest during construction: an overhead charge, 42 construction period, 46 definition, 42 rate of interest, 47 Inventions : cost of inventions excluded from operating expenses, 246 Inventory: definition, 35 K Kansas City: Water plant pur- chase value as going concern, 70 Kennebec Water District: Water plant purchase reproduction of identical plant, 21 Knoxville, Tenn.: Water rate case abandoned plant excluded, 105 depreciation reserves, 135, 250 Land, valuation of: appraisal, 61 effect of cost of buildings re- moved, 22, 64 increased cost due to uses, 63 unearned increment, 212, 215 Lawrence, Justice: cost of raising capital, 221 Legal expenses: an overhead charge, 52 Liabilities: form of presentation, 122 Life of plant: depreciation dependent upon, 158 estimates of, 178 factors affecting, 165 importance of accurate deter- mination, 140 inadequacy, 165, 171 inefficiency, 165 mean life, 186 method of figuring mean life, 145 obsolescence, 165, 169 operation of factors, 177 physical life, 164 tenure of holding, 165, 180 uncertainty in case of sale, 237 useful life, 164 wear and tear, 165, 168 Losses on tools and material: a portion of unit cost, 39, 40 Louisville, Ky. : Telephone rate case difficulty in ascertaining original cost, 107 Lurton, Justice: good will, 96 value as going concern, 11, 85 260 INDEX M Maine Supreme Court: Water plant sales commercial value, 116, 117 good will, 96 original cost, 104 period of construction, 26 value as going concern, 70 worth of service to consumer, 127 Maintenance: current repair, 163 larger in older plants, 237 Market value: denned, 7, 235 method of determination, 119 relative importance, 115 Massachusetts Gas & Electric Light Commission: unearned increment, 214 Massachusetts Validation Board: discount on securities, 47 Metcalf, Leonard: going value, 83 period of construction, 24 Michigan Railroad appraisal: intangible assets, 73 unit cost, 27 Minnesota Railroad Commission: original cost of land, 67 N National Telephone Company, Limited: Sale telephone prop- erty cost of raising capital, 221 period of construction, 24 New York Public Service Commis- sion, 1st District: cost of land affected by hypo- thetical buildings, 66 Normal wear, 205 Obsolescence: a factor of depreciation, 169 Omaha, Neb. : Water plant purchase going concern value, 11 Organization, Cost of: an overhead charge, 51 Original cost: denned, 106 difficulty of ascertainment, 107 essential in a valuation, 103 general consideration, 102 overhead charges, 112 pavement, 111 piecemeal construction, 109 unit costs, 109 Overbuilt plant, Cost of: not a fair basis for rates, 130 Overhead charges: definition, 41 engineering, 49 interest during construction, 42 legal expenses, 52 method of application, 57 organization cost, 51 Partnership of public in utility, 160 Paving: in court rate cases, 218 in original cost, 111 in replacement cost, 33 in state rate cases, 216 Present value: abandoned plant excluded, 104 dependent upon purpose of appraisal, 3 determined by court or commis- sion, 4, 5, 90 figures indicative of value, 4, 5, 6 necessity of figures indicative of value, 16 Prices: see Unit costs Promotion costs: excluded from replacement cost. 54 Property acquired by gift: court rate cases, 218 state rate cases, 216 Public utilities: competitive conditions, 245 contrasted with private enter- prises, 244 INDEX 261 R Rate cases: state and court, 208 Rate of return, 231 Renewals: see Depreciation re- serves Replacement cost: cost of pavement included, 33 cost under present conditions, 19 defined, 7, 18 enhanced cost due to enlarge- ments, 32 enhanced cost due to obstruc- tions, 21 general assumptions, 19 period of construction, 23 piecemeal construction, 29 reproduction of identical plant, 20 unit costs, 25 wholesale construction, 29 Reserves: see Depreciation reserves Reserves for renewals: see Depre- ciation reserves Return: based on capital invested, 226, 233 based on fair present value of property, 227 fair return defined, 231 3 Salvage value: defined, 139 Sanborn, Judge W. H. : replacement cost, 211 San Francisco, Cal.: Water rate case commercial value, 117 fair present value, 14 franchise value, 97 going value, 81, 86 Savage, Judge: see Maine Supreme Court Second-hand plant, 159 Sinking fund method: creation of depreciation reserves, 141 used for plant and reserves, 147 Straight line method: creation of depreciation reserves, 142 used for plant alone, 147 Texas railroad appraisal: replacement cost, unit cost, 27 u Unearned increment in land: state rate investigation, 212, 218 Unit cost: average past prices, 25, 39 cost of labor, 39 definition, 38 for original cost, 109 items included in, 32 weighted mean prices, 29 Value: defined, 9 Value, as going concern: see Value inherent in live plant Value inherent in live plant: attributes, 14, 69 capitalization of cost of develop- ment, 79 capitalization of earnings, 73, 75, 76 definition, 72 general considerations, 87 means of transforming cost to value, 10 rate cases, 219 W Washington Railroad Commission: value as going concern, 75 Wear, Normal, 205 Wearing value: defined, 139 Weaver, Justice: value as going concern, 85 262 INDEX Wisconsin Railroad Commission: commercial value, 117 depreciation reserves, 136 franchise value, 99 going value, 79, 82 interest during construction, 45 piecemeal construction, 31 preference for sinking fund method, 143 property acquired by gift, 217 replacement cost based on nor- mal cost, 25, 27 replacement cost of identical plant, 20 Wisconsin Railroad Commission: unearned increment, 215 Woodhouse, Sir James: cost of raising money, 221 Working capital, 230 Worth of service to consumer: a figure indicative of value, 125 comparison with substituting plant excluded, 127 comparison with other communi- ties excluded, 127 defined, 8 measurement of, 129 profit inherent in worth, 128 THIS BOOK IS DUE ON THE LAST DATE STAMPED BELOW AN INITIAL FINE OF 25 CENTS WILL BE ASSESSED FOR FAILURE TO RETURN THIS BOOK ON THE DATE DUE. THE PENALTY WILL INCREASE TO SO CENTS ON THE FOURTH DAY AND TO $1.OO ON THE SEVENTH DAY OVERDUE. ftGV 28 ^933 JUL 19 LD 21-100m-7,'33 j 28809 HIT* UNIVERSITY OF CALIFORNIA LIBRARY