Railroad Valuation and Fair Return: A Study of the Basis, Rate, and Related Problems of Fair Return for American Railroads [Reprint 2016 ed.] 9781512809237

Table of contents :
Foreword
Preface
Contents
1. Introduction
Part I. The Basis of Return
2. Fair Value for Rate-Making Purposes
3. Original Cost and Cost of Reproduction
4. Depreciation, Intangible Values, and the Future Rate Base
Part II. The Rate of Return
5. Economic Analysis of Fair Return
6. Criteria of a Fair Rate of Return
7. The Statutory Rate of Return for Steam Railroads
Part III. Related Problems
8. Recapture of Excess Income
9. Equalization of Railroad Earnings
10. Railroad Financial Return since 1920
11. Summary and Conclusions
Appendix A: Excerpts from the O’ Fallon Decision
Appendix B: Selected statistics: railway property investment, net railway operating income and accrued depreciation
Appendix C: List of carriers which made payments of one-half of their excess income as tentatively reported for the recapture periods 1920-1928, showing the amount paid by each carrier up to October 31, 1929
Bibliography
Index

Citation preview

RAILROAD VALUATION AND FAIR RETURN

RAILROAD VALUATION AND FAIR RETURN A Study of the Basis, Rate, Related Problems of Fair for American

and

Return

Railroads

By

SHAO-TSENG WU, PH.D. Traveling Ministry

Fellow in Railway of Railways, Republic •with a Foreword

Economics of China

by

EMORY R. JOHNSON Dean of the Wharton School University of Pennsylvania

PHILADELPHIA

UNIVERSITY OF PENNSYLVANIA PRESS 1930

Copyright UNIVERSITY

OF

1930 by the

PENNSYLVANIA

PRESS

Printed in the United States of America

To

EMORY R. JOHNSON Counselor, Teacher, and Friend

FOREWORD of 1920 carried the government regulation of railroads far beyond the point that had previously been reached. The powers and duties of the Interstate Commerce Commission were greatly enlarged, and the most vital of these greater responsibilities were embodied in the "rule of rate-making." When the statute of 1920 directed the Commission to establish or adjust railroad rates so that carriers as a whole or in designated rate territories may, under honest and efficient management, earn a fair return upon the aggregate value of the property used in the service of transportation, and when the law further stipulated that "The Commission shall from time to time determine and make public what percentage of such aggregate property constitutes a fair return thereon," a new, objective test was adopted to be applied in determining the reasonableness of railroad charges. The equitable basis of rates was not changed, but a definite equitable average rate of return on railroad property was made a legal standard to be applied by the Commission in regulating the charges of American railroads as a whole. In order to establish railroad rates that will yield a fair return upon the value of property, it is obviously necessary both to ascertain the value of the property, for whose use a fair compensation is to be provided by means of service charges, and also to decide what constitutes a fair return, that being an ethical and legal question. The determination of value is clearly an economic problem, while a decision as to what is a fair return involves the consideration of such economic factors as interest and profits. These are problems not easily solved and carriers, commissions, legislators, and the public are entitled H E TRANSPORTATION ACT

[vii]

viii

FOREWORD

to receive such assistance in the solution of the problems as economists may be able to render. T h e difficulty of arriving at the value of the railroads for rate-making purposes is evidenced by the fact that it is now seventeen years since the Interstate Commerce Commission began the task of railroad valuation under the Act of 1913. T h e controversy that developed over the relative weights that should be given to "original cost" and to present "cost o f reproduction" has prolonged the task of valuation, and while the Supreme Court has definitely decided that "the law of the land" requires the Commission to consider along with other data the cost o f reproduction in determining fair present value, the Court did not, and could not, prescribe a formula to be followed in deciding how much weight to give to cost of reproduction in determining the present value of property created by investments made in the past. T h e Commission, in deciding upon the value of any particular railroad, must necessarily exercise its judgment by giving such weight to the investment cost of the existing property and such weight to the cost of reproduction as may be warranted by the present status of the property and by its prospects for the future. T h e decision that the Commission reaches in the exercise of its judgment may have its validity tested in the Courts. Its policy may be modified by future legislation. It is important that the factors influencing the valuation o f railroads should be clearly understood. Hence the importance of such an analysis as Dr. Wu, in the first part of his book, has made of fair value for rate-making purposes. He brings to the analysis a thorough understanding of economic principles, and he has, with clarity of reasoning and sanity of judgment, applied those principles to the complicated problems of railroad valuation and fair return.

FOREWORD

ix

D r . W u has no delusion of h a v i n g said the last w o r d on the subjects discussed.

T h e Interstate Commerce Commission

and the Federal C o u r t s will probably have to decide m a n y questions b e f o r e decision has been finally reached as to the f a i r valuation basis and the fair rate of return to be accorded A m e r i c a n railroads.

Doubtless there will be further legislation by C o n -

gress, particularly as regards the method to be f o l l o w e d by the Commission in keeping up to date a railroad valuation when it has once been determined.

D r . W u has not said w h a t the

Interstate C o m m e r c e Commission should have done o r h o w the Supreme C o u r t should have decided.

H e has instead ana-

lyzed the problems presented to Commission and Court.

He

has endeavored to contribute something to a clearer understanding of the questions involved and thus to a more intelligent future decision as to the wise policy to be followed. T h e author's attitude of mind concerning rate of

return,

the subject discussed in the second part of the book, is well illustrated by the f o l l o w i n g statement contained in the concluding chapter of the v o l u m e : " A fair rate of return, analyzed into its true economic elements, consists of a rate of pure interest on capital and a reasonable rate of business profits to compensate for risk and efficiency. It must be neither exorbitant nor confiscatory, and should not be higher than is necessary, yet high enough to attract capital and executive ability into the railroad industry. In determining the rate of return, equitable weight must be given to the risk of investment, both original and present, the market value of securities, financial structures, valuation methods used, the prevailing rate of interest on capital, the economy and efficiency of management and such other factors as may properly receive attention."

FOREWORD

X

T h e timeliness and practical value of Dr. W u ' s volume are increased by the fact that the Interstate Commerce Commission is charged with the duty of enforcing the so-called "recapture clause" of the rule o f rate-making in the Transportation A c t of 1920.

Each individual carrier is allowed to earn and re-

tain 6 per cent per annum upon the value of the property it devotes to the service of the public, if it is so fortunate as to have earnings that make this possible.

One half of the car-

rier's earnings in excess of 6 per cent per annum upon the value of the property must be paid to the Interstate Commerce Commission to constitute a fund to be used by the Commission in aiding the railroads in the manner specified by the Transportation Act. During the past ten years the Interstate Commerce Commission has not been in a position to enforce generally and vigorously the "recapture clause," because the Commission has not definitely determined the value of railroad property.

The

time has come, however, when the Commission is to push the collection of "excess earnings," and it is necessary f o r the Commission to press to as early a conclusion as possible the final determination of the value of railroad properties. one that cannot be quickly accomplished.

This task is

During the next few

years much consideration will be given by the Commission, the carriers, and the public to railroad valuation and related problems. T h e third part of Dr. W u ' s book deals with these "related problems" and especially with the recapture of excess income and the effect of the enforcement of this policy upon a fair return f o r American railroads.

Dr. W u believes that it will

be possible f o r American railroads generally to obtain a return upon the value o f their property that will be fair to investors and that will enable the corporations to obtain funds adequate

FOREWORD

XI

for the future development of the railroads. Moreover, the continuance and enforcement of the "recapture clause" as it now stands in the Interstate Commerce Act, will not, in the opinion of the author, prevent the railroads from securing the funds required for their prosperity and progress, although he favors balancing good years w-ith bad ones over a period of years in determining excess earnings, so that the average rate of return may be a fair one. The problems growing out of the relation of the government to the railroads and other agencies of transportation are many. New ones arise with the rapid development of the facilities of transport and communication and with the consequent increase in the dependence of society upon the services of the carriers of men, materials, and messages. Dr. W u has rendered a valuable service by turning additional light upon two transportation problems of present public importance. EMORY R .

JOHNSON

PREFACE OF T H E I R prime importance in every phase of i human activities and their close relationship with the public interest, the railroads in the United States of America found in the very beginning their raison d'etre as common carriers. They have come to be known as quasi-public industries subject to government regulation in a manner quite different from other enterprises. It has long been established that the government has the power to regulate their services and their tariffs. T o this regulation, however, there are limits. Private enterprise, if regulated, must also be protected. As was stated in the all-important case of Smyth v. Ames, their charges must be fixed high enough to yield a fair return on the fair value of their properties engaged in the public service. By Section 15a of the Transportation Act of 1920 Congress gave the Interstate Commerce Commission complete control over railroad rates and other matters and charged it with a positive duty to provide a fair return upon the aggregate value of the property of the railroads as a whole or in groups.

B

ECAUSE

Never before in the history of railroad regulation has greater importance been attached to the question of providing a fair return for railroad investors. In addressing the Sixtyeighth Congress, President Coolidge said: "Unless the Government adheres to the Rule of Rate-Making to yield a fair return, it must abandon rate-making altogether." Instead of being merely academic, the question has become a real, practical issue. An adequate railroad system, as long as it is privately owned and operated, cannot be maintained and developed without a continuous inflow of private capital and enterprise. Only the added attraction of safety and security of railroad investment, achieved through fair regulation and legal protection, [ xiii ]

PREFACE

xiv

can overcome the hidden but effective economic forces against the public limitation of railroad financial return.

Heretofore,

not much effort has been exerted to bring about a real understanding of the underlying principles, ramifications, and related problems of the statutory regulation of fair return to American railroads.

In this volume the author has attempted to discuss

concisely and systematically the various phases of the problem arising out of the statutory rule of rate-making, all his assumptions and conclusions being directed toward the insurance of justice to both parties—the railroads and the public served. While the author does not pretend to have said a final word on the subject, it is to be hoped that his humble effort may help to stimulate interest in, and further the understanding of, this important problem of the steam railroads in the United States, a complex problem about which opinions are much at variance. Acknowledgments to numerous authors, whose works have been freely drawn upon, will be found in the footnotes and in the bibliography.

Valuable assistance has been received f r o m

the Bureau of Railway Economics, the Interstate Commerce Commission, the Library of Congress, and other institutions. T o Dr. Raymond T . Bye, Professor of Economics, and Dr. Grover G. Huebner, Professor of Commerce and Transportation of the Wharton School of Finance and Commerce, University of Pennsylvania, the writer owes a real debt for their constructive criticisms and helpful suggestions.

H e is also

greatly indebted to Dr. Ralph F. Breyer, Assistant Professor of Commerce and Transportation of the Wharton School of Finance and Commerce, f o r a very careful reading of the manuscript and the proofs.

Finally, but above all, the writer desires

to record his deep gratitude to Dr. E m o r y R. Johnson, Dean of the Wharton School of Finance and Commerce and Professor of Transportation, University of Pennsylvania, without

PREFACE

xv

whose constant encouragement and unfailing help this study could not have been made. However, it would be unfair to his counselors for the writer to disavow his personal responsibility for the positions taken and the conclusions reached in the study. SHAO-TSENG

WU

C O N T E N T S F O R E W O R D BY E M O R Y R . J O H N S O N PREFACE CHAPTER

PAGE VII XIII

I.

INTRODUCTION

1

Why railroads are regulated: The part played by "fair return" in regulation: Early charter restrictions: Granger movement and restrictive legislation: The doctrine of judicial review: Fair return on fair value as the basis for judicial review: Constructive provisions of the Transportation Act of 1920: Problems of fair return: The necessity of a valuation basis: The rate of return another problem: Other related problems: Scope of this study. PART I

T H E BASIS OF R E T U R N CHAPTER II.

F A I R V A L U E FOR R A T E - M A K I N G P U R P O S E S

12

The legal doctrine of fair value in Smyth v. Ames: The railroad valuation act of 1913: The "aggregate value" in the rule of rate-making: Railroad valuation by the Interstate Commerce Commission: The Commission's valuation in the O'Fallon case: Bringing valuations down to date: What is value?: Fair value and market value: Condemnation and rate-making: Kinds of value involved in the rule of rate-making: Fair value for railroad rate-making defined. CHAPTER III.

O R I G I N A L C O S T A N D C O S T OF R E P R O D U C -

TION

28

The meaning of original cost: The meaning of cost of reproduction: Valuation of existing proper[ xvii ]

xviii

CONTENTS

ties: Valuation of subsequent investment: The effectiveness in attracting capital: Financial structure and stability: Cost of reproducing service and stabilization of real income: An ideal rate base yet to be devised: Stability v. guaranty: Inducement to efficiency: The relation of cost of reproducing substitute properties to efficiency: The relation of cost of reproducing identical properties to efficiency : The relation of original cost basis to efficiency : The argument of competitive economy: Administrative convenience. CHAPTER

IV.

DEPRECIATION,

INTANGIBLE

VALUES,

AND T H E F U T U R E R A T E B A S E

46

The nature of depreciation: The treatment of depreciation: Intangible values: Franchise, developmental expenses, and good will: Going value: The Supreme Court decisions on "fair value" : Fair value not a matter of formula: Direct legislative fixing of fair value: Résumé—the future rate base. PART I I

T H E RATE O F R E T U R N CHAPTER V .

ECONOMIC A N A L Y S I S OF FAIR R E T U R N . .

Importance of rate of return overlooked: The analysis of fair return: Interest as an element of fair return: The rate of interest: Factors affecting the rate of gross interest: A reasonable rate of interest: Business profits and railroad enterprisers: The nature of railroad profits: Economic theories of profits: The theory of imperfect competition and uncertainty : Business profits a complex product : The rate of profits difficult to determine : A reasonable rate of profits : Recapitulation of elements of fair return.

61

CONTENTS CHAPTER V I .

C R I T E R I A OF A F A I R R A T E OF R E T U R N . .

xix 81

A rate of return to attract capital: Financial structure and fair rate of return: Trading on the equity: A prudent financial structure: Cost of capital and fair return: A fair rate of return commensurate with risk: The composite character of the rate of return: Fair rate of return to stimulate efficiency: Constitutionality and rate of return: The zone of fairness: Rate of return not a constant factor: Fair rate of return defined.

CHAPTER V I I .

T H E S T A T U T O R Y R A T E O F R E T U R N FOR

STEAM RAILROADS

101

A uniform rate of return for all rate groups: The grouping device in railroad rate-making: The statutory rate of return not a cost-plus arrangement: An average rate of return over a period of years: The rate of return originally authorized under Section 15a: Additional provision for capital expenditures: The rate of return authorized in 1922: Is the present statutory rate of return for steam railroads fair ?

PART R E L A T E D CHAPTER V I I I .

III P R O B L E M S

R E C A P T U R E OF E X C E S S I N C O M E

Recapture provisions: Sources of railway excess income: Imputation a difficult problem: The Recapture Clause as a profit-sharing device: The constitutionality of the Recapture Clause: The interpretation by the Supreme Court: The effect of the Recapture Clause on efficiency and economy: The statutory

119

CONTENTS

XX

division of excess income criticized as arbitrary: Other criticisms of recapture provisions: Recovery of excess income: Present status of general railroad contingent fund: Modification of recapture period suggested: Proposed distribution of the excess recaptured among weaker railroads: Exempting short line carriers from the Recapture Clause: The proposed repeal of the Recapture Clause. CHAPTER

IX.

EQUALIZATION

OF R A I L R O A D E A R N I N G S

143

Existing inequalities in railroad earnings: Division of joint rates: Problems of divisions: Some constructive suggestions: Consolidation of railroads: Practical results and future prospects: Pooling of freight and revenues: Regrouping of rate-making territories: Financial reorganization: Control over construction: Abandonment of unprofitable lines: A constructive program of equalizing railroad earnings. CHAPTER

X.

RAILROAD

FINANCIAL

RETURN

SINCE

1920

The book investment as a temporary base of appraisal: The rates of return earned on property investment: Efficiency and economy of operation: Railroad credit and capital expenditures: The cost of railroad capital and return earned on investment compared: Comparison of yields on railroad securities with those on other securities: The future of railroad earnings: Rate increases: The growth of railroad traffic: Law of increasing returns and railroad earnings : Labor economy and tax reduction.

165

CHAPTER X I .

CONTENTS

xx i

S U M M A R Y AND CONCLUSIONS

188

A — E x c e r p t s f r o m the O'Fallon decision. . . .

197

B—Selected statistics: railway property investment, net railway operating income and accrued depreciation

207

C—List of carriers which made payments of one-half of their excess income as tentatively reported f o r the recapture periods 1920-1928, showing the amount paid by each carrier up to October 31, 1929

210

APPENDIX

APPENDIX

APPENDIX

BIBLIOGRAPHY

213

INDEX

224

ILLUSTRATIONS DIAGRAMS PAGE

I. II.

Zone of fairness Average or representative costs in relation to fair return

96 105

CHARTS

I.

II.

Trends of earnings on average property investment of Class I railroads as a whole and by groups, 1921-1929

168

Comparative trends of average yields on highgrade bonds of railroads, industries and public utilities, 1913-1929

178

TABLES

I.

II.

III.

IV.

Classified rates of return on property investment, Class I railroads, excluding switching and terminal companies, 1921-1928

144

Rates of return earned on average property investment, Class I steam roads—United States, 1921-1929

166

Rates of return earned on average property investment, Class I steam roads—by groups, 1921-1929

167

Ratios of maintenance and total operating expenses to operating revenues, all Class I railways, 1920-1929

170

[ xxiii ]

xxiv

ILLUSTRATIONS V.

VI.

VII.

VIII.

IX.

X.

Aggregate amount of railway capital expenditures, 1920-1929

173

Amounts of various railroad securities sold, 1920-1929

174

Cost of railroad capital compared with return on total investment, 1920-1929

175

Yields on 15 high-grade railroad bonds, 15 high-grade industrial bonds and 15 highgrade utility bonds, 1913-1929

177

Ton-miles and passenger-miles of steam railways, 1920-1929

181

Amount of wages and taxes and their ratios to operating revenues, all Class I railways, 1920-1929

186

CHAPTER

I

INTRODUCTION F ALL of the transportation facilities that are indispensable to modern civilization, the steam railroad stands first. This is especially true in the United States of America where we find today a railroad net of over one quarter of a million miles with a total investment that no single industry except agriculture can equal. Economic historians agree that the United States could scarcely have grown to its present commanding position as an industrial power if its railroad system had not been so developed as to bind together the vast territory of the forty-eight commonwealths into a powerful and coordinated economic empire. Indeed, the steam railroads play such a vital role in the social, economic, and political development of any civilized nation that they must be provided either by the government itself or by private companies; each nation has adopted for its policy the one deemed to be most expedient according to its own conditions. With a democratic government and with a people of energy, initiative, and genius, the United States of America has adopted a policy of private ownership and operation subject to governmental control. Why Railroads are Regulated. The American government, the champion par excellence of free competition, has seldom elsewhere interfered with private enterprise. There must have been some special reasons for singling out the railroad industry for special regulation. Legally, there are different explanations. One is the assertion that only special legal concessions, such as the granting of public aids, franchises, and permits to exercise the power of eminent domain, will give government a hold on certain industries. Another is that, with or without the granting of such special privileges, a public interest in a

O

[1]

2

RAILROAD

VALUATION

certain industry will be recognized and protected if the character of the industry is such as to give rise to the interest. From an economic point of view, there are likewise divergent theories. According to some, the basic reason for regulation is the existence of economic monopoly in certain industries, that is the so-called "consumers' disadvantage." Others contend, however, that it is not the existence of monopoly itself but rather the importance of the service furnished, whether by a monopoly or by competitive concerns. It would seem that the railroads are regulated both because of their strategic economic position and of their essentially monopolistic character. Fundamentally, the railroad service is of a public nature; it is vitally related to public dependence and national welfare, but, as history and experience have abundantly shown, the characteristics of railroad operation are such that competition easily becomes unrestrained and leads to monopoly. Under these conditions, special regulation of prices becomes necessary in order to protect both the railroads and the public they serve. The regulation of railroads, therefore, has two objectives. One is to secure for the public an adequate and efficient transportation service and to provide the railroads as a whole with a fair return for the services they render. The other is to adjust the relations between the railroads themselves, so that all of them, whether weak or strong, may be taken care of. The Part Played by "Fair Return" in Regulation. No effort is made here to trace, from the beginning, the development of the fundamental principles of railroad regulation. This has been well done by eminent authorities. It may not be amiss, however, to point out some of the salient features of the evolutionary development of the problem of "fair return," with which we are particularly concerned in the present treatise.

INTRODUCTION

3

Early Charter Restrictions. It is interesting to note that in early years railroad earnings were regulated by charter provisions, fixing either maximum rates or maximum profits. For instance, the typical legal freight rates allowed the railroads were from 6 to 8 cents per ton-mile. 1 But these legal maxima were far above the actual charges, 2 for the railroads soon realized that lower rates encouraged traffic and brought larger profits. Further, as early as 1835, one railroad charter restricted net earnings to 20 per cent on the capital, and another provided that, if the rates of toll charged enabled the railway to pay more than 15 per cent on its capital stock, the rates should be reduced so as to yield just 15 per cent but no more.® Such limitations of railroad net earnings could be easily evaded by increasing capitalization, thereby keeping the net earnings from exceeding a fixed per cent on the capital. It is said with truth that "whereas charter maxima did not work at all, limitation of profit did positive harm." 4 Granger Movement and Restrictive Legislation. Following the period of rapid and, in some instances, unwarranted railroad construction (1830-1870), came the era of wild-cat financing, speculation, ruthless competition, and discriminatory charges. However, no sooner were these evil effects felt than the public acted to demand aggressive legislation. The issues were fought out before the Supreme Court in a series of eight Granger cases, decided in 1876. In the leading case of Munn v. Illinois, 5 the legislative power was held supreme and state ' See L. H. Haney, Congressional History of American Railroads to 1850, pp. 210-215 (1908). ' S e e Johnson and Van Metre, Principles of Railroad Transportation, p. 424 (1921). * See L. H. Haney, op. cit., p. 210. 4 A. T. Hadley, "Principles and Methods of Rate Regulation," The Yale Review, April, 1927, p. 424. "94 U. S. 113.

4

RAILROAD

VALUATION

regulation valid, binding the courts as well as the railroads. The polls and not the courts were suggested as the proper source for relief or protection. Pressed by the popular clamor for lower freight rates, the state regulating authorities gave no thought to the revenue needs o f the carriers. The laws passed were only corrective and many of them ill-considered. Unreasonable rates and discriminatory charges were declared unlawful and prohibited. But no standard of reasonableness was established. The Doctrine of Judicial Review. It was the gradual development of the doctrine of judicial review that brought to the fore the question of reasonableness of rates and with it the question o f fair return. In 1884 6 Chief Justice Waite first hinted at a modification of the Granger decisions, which acknowledged no responsibility to protect the carriers even against confiscation, and two years later, in one of the Railroad Commission cases, upholding the power of a state to regulate transportation charges, the court emphatically declared: "From what has thus been said, it is not to be inferred that this power of limitation or regulation is itself without limit. This power to regulate is not a power to destroy and limitation is not the equivalent of confiscation. Under pretense of regulating fares and freight, the State cannot require a railroad corporation to carry persons or property without reward; neither can it do that which in law amounts to taking of private property for public use without just compensation, or without due process of law.'" Upon the passage of the Interstate Commerce Act of 1887, the Federal regulating authorities likewise adopted the state 'Spring Valley Water Works v. Schottlcr, 110 U. S. 347, 354. Stone v. Farmers' Loan & Trust Co., 116 U. S. 307, 331.

7

INTRODUCTION

5

practice of declaring unreasonable and discriminatory charges unlawful without fixing a standard of reasonableness. In the year 1888, the court again expressed doubt of its power to review state-made rates. 8 However, in the first Minnesota Rate case, decided in 1890, the court definitely put restriction upon the legislative power of regulation and asserted the judicial right to review the reasonableness of rates. "The question of the reasonableness of a rate or charge for transportation by a railroad company," said the court, "is eminently a question for judicial investigation, requiring due process of law for its determination." 9 Four years later, the question of judicial review was presented in one of the Texas Commission cases, where Mr. Justice Brewer observed that "it is within the scope of judicial power, and a part of judicial duty, to restrain anything which, in the form of a regulation of rates, operates to deny to the owners of property invested in the business of transportation that equal protection which is the constitutional right of all owners of other property." 10 Fair Return the Basis for Judicial Review. Under private ownership of property and free enterprise, the very foundation of the United States of America, as an industrial nation, is, no doubt, the constitutional protection of private property. It is mainly by this supreme law that American legislatures, executives, and courts are held to conformity in the regulation of ' Dow v. Beidelman, 125 U. S. 680, 690-691. ' C. M. & St. P. Ry. Co. v. Minnesota, 134 U. S. 418, 456. 10 Reagan v. Farmers' Loan & Trust Co., 154 U. S. 362, 399. In this connection, note the language of those principal provisions of the United States Constitution, protecting all owners of private property: The Fifth Amendment (1791) provides that no person shall be "deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use without just compensation." The Fourteenth Amendment (1868) provides: "Nor shall any state deprive any person of life, liberty, or property, without due process of law; nor deny to any person within its jurisdiction the equal protection of law."

RAILROAD

6

VALUATION

public service industries. In the famous case of Smyth v. Ames, decided in 1898, the court fully established the right of the Federal judiciary to invalidate railroad rates prescribed by law. A f t e r defining the scope o f its jurisdiction, the court stated for the first time the basis for judicial review by asserting that "what the company is entitled to ask is a fair return upon the value of that which it employs for the public convenience." 11 Thus, the judicial standard o f the reasonableness of rates was established. However, since the regulation of rates was at first only corrective, the Federal authority before 1920 did not have a legislative mandate to fix rates for the future so as to yield the railroads the fair return to which they were legally entitled.

Constructive Proznsions of the Transportation

Act of 1920.

As a result of the inelastic regulation of rates by Federal authorities and the unprecedented high prices during and since the World W a r , the railroads were literally starved to a point where they could not finance their necessary additions and betterments. B y the enactment of the Transportation Act of 1920, the Federal regulation of rates was for the first time placed under a constructive rule of rate-making. The government became a guardian as well as a policeman and sought to assure railroad investors a fair return. W i t h specific recognition of the problem of the strong and weak roads, Paragraph 2 of Section 15a provides: " I n the exercise of its power to prescribe just and reasonable rates the Commission shall initiate, modify, establish or adjust such rates so that carriers as a whole (or as a whole in each of such rate groups or territories as the Commission may from time to time designate) will, under honest, efficient and ecou

169 U. S. 466, 547.

INTRODUCTION

7

nomical management and reasonable expenditures for maintenance of way, structures and equipment, earn an aggregate annual net railway operating income equal, as nearly as may be, to a fair return upon the aggregate value of the railway property of such carriers held for and used in the service of transportation." Inseparably connected with this rule of rate-making is the Recapture Clause by which one-half of the excess earnings of any individual carrier over and above 6 per cent per annum of the value of its property is to be recovered by the government and placed in a special fund for certain designated purposes. The Interstate Commerce Commission can no longer be regarded merely as a body to protect the shippers against unreasonable and discriminatory rates. It is now charged with the positive duty of providing a fair return for the railroads as a whole or in groups, though not individually. The Commission has complete control over the earnings of the railroads, the power to fix both maximum and minimum rates for interstate commerce and, in case of unreasonable discrimination, rates for intrastate commerce. To achieve this purpose, it is also authorized to supervise security issues, divisions of joint rates, routing of freight, car service, consolidations, construction, and abandonment. Problems of Fair Return. Eventually it would seem the law aims to fix a fair return as definitely as possible for each and every railroad when successfully consolidated. This is no simple problem. It is merely an effort to point out the way to solve a highly controversial and complex problem whose ramifications are numerous and whose solution is extremely difficult. Ever since the passage of the Transportation Act of 1920, the discus-

8

RAILROAD

VALUATION

sion of fair return for the railroads has been fraught with much confusion. Little or no agreement can be found even as to the meaning of the term. According to the lexicographer, "fair, in the most general terms, implies negatively, the absence of injustice, or fraud; positively, the putting of all things on an equal footing, without undue advantage to any, as fair play, fair and square, a fair statement."12 The word "return" is defined as "a giving in recompense, acknowledgment or the like, repayment, etc." 14 But, in the practical adjudication of fair return, almost countless debatable questions arise. The Necessity of a Valuation Basis. The lack of proper accounting and complete records, the constantly changing character of railroad properties, as well as the widespread belief of overcapitalization largely accounted for the early practice of basing rates on some valuation basis. While it is generally believed that a valuation basis is not essential to a determination of reasonableness of rates, we must take it as settled that, according to the judicial rule, a fair valuation basis is absolutely necessary for the regulation of fair return. Indeed, in wrestling with the problem of fair return, attention has been given primarily to the question of the valuation basis. With meticulous care, the term "fair value" and the methods of ascertaining the same have been debated and analyzed. In every rate controversy, we find both the railroads and the regulating authorities striving to validate or to invalidate certain rates on a valuation basis. For instance, in the Spokane case,14 the engineers of the Northern Pacific and Great Northern Railways estimated the cost of reproducing their properties and contended that to reduce their rates then would leave them less than a fair " Webster's New International Dictionary, p. 784 (1928). "Ibid. p. 1823. M Spokane v. Northern Pacific Ry. Co., 15 I. C. C. 376.

9

INTRODUCTION return on their properties. Commission observed:

T h u s the Interstate Commerce

"Even assuming that the valuation of our railways would be of no assistance to this commission in establishing reasonable rates, it is still necessary, if those rates are to be successfully defended when attacked by the carriers, that some means be f u r nished by which, within reasonable limits, a value can be established which shall be binding upon the courts and the commission." 15 If the rule of rate-making, as laid down in the T r a n s p o r t a tion Act of 1920, is to allow the railroads a fair return on the value of their property, the establishment of a fair valuation basis is indispensable to the calculation of the fair return to be allowed. Yet, the development of the conflicting theories of " f a i r value" has given rise to such irreconcilable differences that a satisfactory settlement looks remote, if not impossible. So long as this remains unsettled, it would be idle to talk about fair return. It is essential that a fair valuation basis be adopted. In a discussion of fair return valuation as a basis of return must be properly considered and clarified. The Rate of Return Another Problem. W h e n the problem of fair value shall have been settled, as we may hope it will be, the controversy over the rate of return will take its place as surely as sunrise follows sunset. T h e problem of rate of return is by no means simple. W h a t is a fair rate of r e t u r n ? H o w should it be determined, and, having been determined, how can it be adjusted to meet constantly changing conditions and new forces? W h a t is the practical significance of the statutory rate of return in the regulation of railroad earnings ? " Annual Report

of the Interstate

Commerce

Commission,

p. 6 (1909).

10

RAILROAD

VALUATION

Is it intended to be a minimum guaranty or a maximum limitation or something totally different ? It is difficult to overemphasize the fact that, in the regulation of financial returns, there are vital differences between steam railroads, which are national in scope and semi-competitive in character, and local, monopolistic utilities—such as, water works, light, heat and power plants, telegraph and telephone companies, rapid transit systems, etc. Unlike local utilities, the rate of return for a particular railroad cannot be fixed solely on its own valuation basis, but must, of necessity, be adjusted to the aggregate value of all the railroads, coming within the range of competition. Consequently, what an individual railroad may earn may be entirely different from the statutory rate of return allowed the railroads as a whole or in groups. It is also to be noted that much of the valuation controversy can be traced to the lack of a clear understanding of the relationship between the rate of return and the valuation basis. T o illustrate, certain elements of value, that are of a transitory character or are mainly dependent upon individual management, could be best taken care of through the rate of return rather than the valuation basis. This becomes especially evident when we come to consider the Rule of Rate-Making, together with the Recapture Clause. Since most of the discussions of rate of return are confined to local, monopolistic utilities, the rate of return for steam railroads calls for special study and thorough analysis. Other Related Problems. Furthermore, in solving the problem of weak roads, there are numerous difficulties and many conflicting forces to be encountered. How can those difficulties be remedied or minimized ? What has been the result of the much-hated Recapture Clause? H a s it worked at

INTRODUCTION

11

all? What are the measures accompanying the recapture scheme? Have they helped to lessen the difficulties? If so, to what extent? If not, what improvements should be made? These and other problems, irrelevant as they may seem, are closely related to the problem of railroad fair return and should be given appropriate consideration. Scope of this Study. In order to analyze the problem of railroad fair return adaquately and in a systematic manner, the study is divided into three parts, viz., Part I, Fair Value or the Basis of Return, Part II, the Rate of Return, and Part III, the Related Problems. Part I deals with the characteristics of fair value for rate-making purposes, the perennial controversy over "original cost" and "cost of reproduction," and such other matters as depreciation and intangibles. Part II is devoted to a detailed analysis of the economic elements, the percentage, and the statutory rate, of fair return allowed the railroads. Part I I I is concerned with the recapture of excess income, with various measures designed to effect equalization of railroad earnings, and with the railroad financial returns under the Transportation Act of 1920. A brief résumé of the conclusions thus arrived at will be found in the final chapter.

PART I T H E BASIS OF

RETURN

CHAPTER II

FAIR V A L U E FOR RATE-MAKING P U R P O S E S o EXPRESS a fair return quantitatively, two factors are indispensable. One is the basis upon which the return is to be calculated and the other is the rate of return to be allowed. It will not suffice to say that the railroads must earn 6 per cent, 8 per cent or any other per cent unless the sum or the basis upon which they are allowed to earn that per cent is stated. In all but the most general discussions, the concept of a fair return is one of a certain percentage upon a certain designated basis. Leaving the rate of return for a separate discussion, considerations may first be given, in this and the two chapters following, to the basis of railroad return. In the present chapter, an attempt will be made to set forth the judicial and legislative backgrounds of the gigantic task of railroad valuation, which the Interstate Commerce Commission has been performing since 1913, and the various constructions that have been made of the term "fair value" for ratemaking purposes. The discussion does not intend, however, to deal with details of valuation methods or to study seriatim the various court decisions on "fair value," except insofar as they may serve to illustrate the general principles of determining the basis of return. The Legal Doctrine of Fair Value in Smyth v. Ames. Since in the United States of America the basis of fair return allowed the regulated industries has largely been influenced in the past generation and is still governed by the famous but much-decried [12]

FAIR

VALUE

13

rule of fair value in Smyth v. Ames, it is helpful to look into that judicial dictum. It reads in part: "The basis of all calculations as to the reasonableness of rates to be charged by a corporation maintaining 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 improvements, the amount and market value of its bonds and stock, the present as compared with the original cost of construction, 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." 1 It would seem that the long list of elements of fair value quoted above may be consolidated into four items. The original cost plus permanent improvements equals total investment to date. The amount and market value of securities approximate the value of the property. The present as compared with the original cost of construction means the cost of reproduction new. Probable earning capacity less operating expenses would give the amount of net earnings. The amount of securities is no satisfactory criterion of " f a i r value"; there may be much watered stock, or stock without par value, or there may have been, for one reason or another, loss and deterioration of physical properties. Even if paid for at par, the amount of securities has, at best, only a 1

169 U. S. 466, 546-547.

14

RAILROAD

VALUATION

historical importance. It does not show what the property is worth and what return should be allowed for its use at the time of inquiry. 2 The market value of securities is equally unsatisfactory, for it is subject to fluctuations caused by vicissitudes and manipulations having no direct relation to the value of the property. W h a t is more, the market value of securities is usually a capitalization of the company's earnings under the existing rates which may be in dispute. Aside from some evidential importance, the amount and market value of securities have no meaning and help very little, if at all, to ascertain the fair value of the property devoted to public service.3 Moreover, it is scarcely to be doubted that the amount of net earnings cannot be used as a basis to calculate fair return. To do so would clearly involve reasoning in a vicious circle. Such being the case, there are only two items left to be particularly considered in determining a fair basis of return. They are the original cost, with subsequent additions, and the cost of reproduction new. While all other elements of value, as mentioned in the judicial dictum, should be appropriately considered, these two factors have become the main objects of valuation controversy. The Railroad Valuation Act of 1913. The purposes of early railroad valuation were many; taxation, capitalization, condemnation, consolidations, and others. Few states attempted railroad valuation merely in connection with rate control. 1 Federal valuation of railroads was largely a development from premises established, in accordance with the legal doctrine of fair value, by both the carriers® and the Interstate Commerce ' See Report of Railroad Securities Commission, p. 30 (1911). 3 Cf. J. M. Clark, Social Control of Business, p. 351 (1926). * Ibid. p. 324. 6 See, f o r instance, Spokane v. Northern Pacific Railway Company, 15 I. C. C. 376 (1909) ; Advance in Rates—Western Case, 20 I. C. C. 307, 337 (1911); etc.

FAIR

VALUE

15

Commission. 6 The need of a physical valuation of railroads was also recommended by the Railroad Securities Commission. 7 These various forces, together with an insistent public clamor alleging that some railroads were earning returns on fictitious capitalization, 8 finally resulted in the passage of the La Follette Valuation Act of 1913—Section 19a of the Interstate Commerce Act. Conforming to the judicial rule of fair value, the Valuation Act required the Commission to ascertain and report in detail as to each piece of property, other than land, owned or used by all common carriers, the original cost to date, the cost of reproduction new, the cost of reproduction less depreciation and to present a comparative analysis of the several methods used. The Commission was also required to ascertain and report separately other values or elements of value, if any, of the property of such carriers, and to state in detail and separately from improvements the original cost of all lands, right of way and terminals of such common carriers and the present value of the same. Upon the completion of primary valuation, the Commission was directed to keep itself informed of all extensions and improvements and other changes in the condition and value of the property of all common carriers and, from time to time, to revise and correct its valuations accordingly. These valuations, both original and corrected, should be "tentative" valuations. Whenever the Commission had completed the tentative valu" For the Commission's recommendation of railroad valuation, see the 23rd Annual Report of the Interstate Commerce Commission, p. 6 (1909). The same recommendation was reiterated in the 24th Annual Report, p. 35 (1910) ; and in the 25th Annual Report, p. 94 (1911). ' See Report of the Railroad Securities Commission, p. 18 (submitted to President T a f t late in 1911). 8 Senator La Follette of Wisconsin, the outstanding spokesman of the public, said that the primary purpose of the Valuation Act was to "determine the right of the railroads to capitalize the unearned increment." Congressional Records, 49th Congress, p. 3800 (1913).

16

RAILROAD

VALUATION

ation of any common carrier and had duly notified the various parties concerned, if no protest was filed within thirty days, the said valuation should become "final" as of the date thereof. It was further provided that all final valuations should be published and should be prima facie evidence of the value of the property in all proceedings under the Act to Regulate Commerce as of date of the fixing thereof, and in all judicial proceedings brought to enforce or to enjoin, set aside, annul, or suspend, in whole or in part, any order of the Commission. It is evident that, in framing the Valuation Act, Congress did not set up anything beyond the judicial rule of fair value. In order to stand the tests of the courts, it was essential that the law should conform to the judicial requirements. The "Aggregate Value" in the Rule of Rate-Making. As already stated in the introductory chapter, the Rule of RateMaking in Section 15a of the Transportation Act authorized the Commission so to adjust rates that they would yield the carriers as a whole a fair return upon the "aggregate value" of their property. And those carriers getting more than a fair return on their property value were required to submit half of the excess to the Commission for certain transportation purposes. It was by the enactment of Section 15a that Congress directed the Commission, for the first time, to make use of the "final" value ascertained under the Valuation Act. Paragraph 4 of Section 15a thus provides: "For the purpose of this section, such aggregate value of the property of the carriers shall be determined by the Commission from time to time as often as may be necessary. The Commission may utilize the results of its investigation under section 19a of this Act, in so far as deemed by it available, and shall give due consideration to all the elements of value

FAIR

VALUE

17

recognized by the law of the land for rate-making purposes, and shall give to the property investment account of the carriers only that consideration which under such law it is entitled to in establishing values for rate-making purposes. Whenever pursuant to section 19a of this Act the value of the railway property of any carrier held for and used in the service of transportation has been finally ascertained, the value as ascertained shall be deemed by the Commission as the value thereof for the purpose of determining such aggregate value." F r o m the above it may be seen that the "final" value found pursuant to Section 19a, ipso facto, becomes the value for the purposes of Section 15a. While nothing was added to define the term "final value" or the procedure to be followed in ascertaining the same, Section 15a does imply that, before the final value becomes available, the Commission may make a summary valuation when the use is to be made of it for any purpose of this section, but in making the valuation consideration shall be given to all elements of value recognized by the law of the land for rate-making purposes.

Railroad

Valuation by the Interstate

Commerce

Commis-

sion. E v e r since the passage of the valuation act, 1913, the Commission has consistently and persistently regarded the valuation of the railroads as an integral part of rate regulation. In its last annual report to the Congress, it was stated that all underlying and tentative valuation reports upon steam railroads had been served. Hearings on protests to tentative reports upon all railroad properties had been concluded, covering 2 3 4 , 8 5 9 miles of road. Final valuations had been adopted in 8 2 0 cases, representing 131,780 miles of road. 9 Thus the work *Forty-Third 1929, p. 64.

Annual Report of the Interstate

Commerce

Commission,

18

RAILROAD

VALUATION

of primary valuation under the act has practically been completed. For our own appraisal of the Commission's findings as to the final value of railroads, we may adopt the opinion of Professor Vanderblue: "The final value as reported for most roads is the sum of the cost of reproduction less depreciation, as reported by the Commission's engineers, plus the 'present value' of the carrier lands as determined by the adjacent land test, plus 5 per cent of this total then carried to the next lower or higher round figure (usually the latter) plus an allowance for working capital—cash, materials, and supplies. No allowance for intangibles, as such, appears, and there has been no apparent allowance made for any excess 'cost of reacquiring' the carrier lands, unless the bulk 5 per cent may be accepted as such."10 It would seem that the final value is a composite of heterogeneous items. Such being the case, interested parties may easily attack the figures of final value. Some contend that the Commission's final values are unjust to the railroads, while others believe that they are too liberal to them, especially in the valuation of lands. Still others have little or no confidence in the finality or usefulness of the irreconcilable figures so arrived at.11 The Commission's Valuation in the O'Fallon Case.12 In its decision of the famous O'Fallon case, the Commission reached, for the first time, a definite conclusion as to what should conw Vanderblue and Burgess, Railroads: Rates, Service, Management, p. 347. 11 The first suit to annul a final valuation order of the Commission to reach the Supreme Court was U. S. v. L. A. & S. L. Ry., 273, U. S. 299. T h e court dismissed the case for lack of finality. u Excess Income of St. L. & O'Fallon, 124 I. C. C. 3.

FAIR

VALUE

19

stitute a fair value for rate-making purposes. On February 15, 1927, the Commission, pursuant to the requirements of paragraphs (6) and (9) of Section 15a, decided to recover from the St. Louis and O'Fallon Railway Company excess earnings of some $226,000, covering the period from March 1, 1920, to December 31, 1923. In a 6 to 4 decision, the majority opinion explicitly held that the fair value for rate-making purposes approached more nearly the reasonable investment than the present cost of reproduction at a particular time.13 But the minority contended that under the law of the land as laid down by the courts effective weight should be given to the greatly enhanced costs." What the Commission approved was a synthetic valuation, consisting of present land values, of reproduction costs at 1914 unit prices for old structures installed prior to June 30, 1914, and of both the estimated and recorded actual investments of the new structures installed thereafter. 15 Thus the Commission's valuation was viewed by the minority as illegal, since no consideration was given to "the present as compared with the original cost of construction" of the major part of the property installed before 1914. To the minority, the duty of the Commission was "to apply the law as it stands." 16 The majority thought, however, that the Commission would be derelict in its duty should it try to do so.17 It was this issue that presented anew the perennial discussion of fair value and provoked active debate.18 "Ibid. p. 41. " Ibid. p. 62. "Ibid. p. 60. "Ibid. p. 64. "Ibid. p. 51. 18 See, for instance, the article entitled "Price Fluctuations in RateMaking Valuation," Vale Law Journal, June, 1927, pp. 1151-1155; John G. Buchanan, "The Ohio Valley Water Company Case and the Valuation of Railroads," 40 Harvard Law Review, June, 1927, pp. 1033-1069; M. G. Glaeser, "The Valuation Doctrine at Crossroads," The Journal of Land and Public Utility Economics, August, 1927, pp. 241-251; H. P. Gillette,

20

RAILROAD

VALUATION

On the ground that the Commission's method of valuation was invalid and unconstitutional, the O'Fallon Railroad appealed to the District Court, Eastern Missouri. The court, three judges sitting, unanimously refused to pass upon the Commission's valuation, holding that even on the valuation basis claimed by the O'Fallon itself the net earnings left would still be about 8 per cent and therefore no confiscation was involved. The O'Fallon Railway Company lost no time in appealing to the Supreme Court which, by a 5 to 3 decision, reversed the judgment of the District Court. Speaking through Mr. Justice McReynolds, the Court held that according to the law of the land the cost of reproduction must be given equitable consideration in determining the value of the railroads. Inasmuch as the Commission disregarded the approved rule in valuing the O'Fallon Railroad, it further asserted, the duty imposed by Congress had not been properly discharged. Hence, the action taken was invalid. 19 Justice Butler did not take part in the decision. Justice Brandeis wrote a long dissenting opinion, concurred in by both Justice Holmes and Justice Stone, holding that the Commission had given sufficient consideration to reproduction cost in accordance with the law, which did not require any specific weight to be given. Bringing Valuations Down to Date. The valuation work does not stop after the finding of a single sum value as of a fixed date. The Commission's duty, as provided in paragraph "A Proper Basis for Railway Rates: Sophisms in the O'Fallon Case," Annalist, January 27, 1928, pp. 205-206; G. G. Tunell, "Value for RateMaking and Recapture of Excess Income," Journal of Political Economy, December, 1927, pp. 725-775; and February, 1928, pp. 100-140; J. C. Bonbright, "Railroad Valuation with Special Reference to the O'Fallon Decision," American Economic Review, Supplement, 1928, pp. 181-205 (with discussions by I. L. Sharfman and H. G. Brown) ; Edwin C. Goddard, "The Evolution of Cost of Reproduction as the Rate Base," 41 Harvard Law Review, March, 1928, pp. 564-592; H. Evans, "The O'Fallon Railway Recapture Case," American Federationists, April, 1928, pp. 410-417; etc., etc. See St. L. & O'Fallon R. Co. v. U. S., 279 U. S. 461, 488.

FAIR

VALUE

21

( f ) of Section 19a, is to keep the valuation up to date in like manner, in other words, in any valuation as of the present, the cost of reproduction new of the property including subsequent additions and improvements since the original valuation date, must be re-estimated on the basis of present-day prices. Being aware of the difficulty of so bringing valuations down to date and in view of the practical situation resulting from the Supreme Court's decision in the O'Fallon case, the Commission again repeated in its last annual report recommendations made in successive previous reports regarding methods for bringing valuations to date.20 According to the Commission's suggestions, future valuation would in effect be the sum of "final value" as of the designated valuation date and of amounts subsequently added to property account under correct accounting. Whether this method of bringing valuation to date could be held by the courts to be present value is a matter of doubt. What is Value? Many and varied are the meanings of the word value. There are value in use and value in exchange; the former is the intrinsic value or the utility of a thing, while the latter is the price a thing will bring, measured in money or in commodities. Furthermore, we must distinguish the concept of value based on what the buyer is willing and able to pay for an article from that based on what the article has cost in the way of toil and sacrifice.21 Another concept of value is that it is determined not only by individual motives in terms of pleasures and pains but by super-individual or social forces.22 In fact, we may have as many concepts of value as there are divergent views of business ethics. 20 See Forty-Third Annual Report of the Interstate Commerce mission, 1929, pp. 89-90. 21 Cf. A. T. Hadley, Economics, p. 92. 22 See B. M. Anderson, Social Value, pp. 198-199 (1911).

Com-

22

RAILROAD

VALUATION

In contrast with the foregoing are the legal values for various purposes, such as condemnation, capitalization, reorganization, taxation, and rate-making. They are the result of authoritative determination and, for this reason, are usually called the bases of some sort, that is, the condemnation base, the base for capitalization, the base for taxation, and the rate base.23 Evidently, legal values cannot and should not be the same for all purposes." In some cases only limited private interest is involved, while in others the public interest is predominant. A certain method of valuation, which may be just and equitable in one case, may be unjust and inequitable in another. It was in view of this that A. T. Hadley suggested that assessment rather than valuation should be used in the process of determining a fair base for rate-making purposes.28 The suggested .terminology is no doubt appropriate and has much to commend it. If the need and underlying purposes of railroad valuation are clearly understood, the terminology adopted seems relatively unimportant. Moreover, since the terms fair value and valuation have long been adopted in rate regulation, a The term "rate base" was judicially used in Galveston Electric Co. v. Galveston, 42 U. S. 351. " F o r an analysis of their differences, see J. C. Bonbright, " T h e Problem of Judicial Valuation," Columbia Law Review, May, 1927, pp. 493522. * "Assessment is the fixing of a price by government authority. It differs radically f r o m value in the fact that it depends on public authority— not on public demand. It is essentially a political term—not a scientific one. W e fix an assessment; we ascertain a value. W e ascertain the value of a piece of property by the same process of observation and calculation that we use in ascertaining the weight of a mass of metal or the size of a piece of land. Value in the accredited sense of the term—to come back to Walker's excellent definition—is the power which an object confers on its possessor independent of political authority or personal sentiments to command the labor or products of labor of others. It is what an article is worth, sometimes in meeting an individual demand, more often in meeting a public demand, but it depends on demand in either case. Cost of production only enters into value indirectly by limiting the supply. A cost assessment neither produces value nor measures it." A. T. Hadley, "The Meaning of Valuation," American Economic Review, Supplement, 1928, pp. 179-180.

FAIR

VALUE

23

our effort can be directed, with more terms adopted than to questioning the adopting them. 29 We shall, therefore, meaning of fair value for rate-making

profit, to clarifying the wisdom or propriety of attempt to ascertain the purposes.

Fair Value and Market Value. In the discussion of fair value for rate-making purposes, there are striking and persistent differences of opinion. With equal finality it is urged that fair value and market value should be one and the same, and that fair value when qualified by the phrase "for rate-making purposes" should not be so regarded, for to regard fair value as market value would at once estop rate-regulation. This conflict of opinion results from the belief that there is a single pecuniary value for all purposes, valid under all conditions. As a matter of fact, an adequate theory of value must include all the problems of pecuniary valuation, which the modern industrial system presents and which cannot be settled by the higgling and bargaining of commercial or competitive forces in the market. All values are purposive and fair value for rate-making purposes must be interpreted in terms of the situations arising from rate-regulation and the policies adopted to meet them. 27 Fair value for rate-making purposes is a new and different kind of value. 28 It possesses a different literature, a special " "The term 'fair value,' however regrettable, has been irrevocably incorporated in our vocabulary and must be accepted." H. H. Hartman, Fair Value, p. 78. ** "Since all values are relative to and mediated by some purpose, it is entirely natural that value should have become a term of many meanings Once we recognize that all valuation is purposive we have a test for the validity and sufficiency of any institution of pecuniary valuation like the market or the court sitting in a rate case." David Friday, "An Extension of Value Theory," 36 Quarterly Journal of Economics, pp. 215, 219 (1922). " "This kind of value was never before John Stuart Mill or Stanley Jevons. The idea has never occurred to John Ruskin when he undertook to draw a sharp distinction between exchange value, which is what a thing will sell for, and inherent value, which is what that thing is worth, looking to its possible uses It has never been defined by any economist or any

24

RAILROAD

VALUATION

technique and a definite set of rules and principles. It is not commercial value, i.e., what the property may be actually sold for in the market. In the words of Mr. Prouty, "it has been described by the courts and is that sum upon zvkich under all circumstances and upon a fair consideration of all the facts and elements to be taken into account a fair return should be permitted."29 Briefly stated, it is a rate base on which all relations between the service and the public rest. 30 In order to secure the continuous flow of service, the value adopted as a rate base may be larger or smaller than the market value of the property. A "fair value" for rate-making purposes may become synonymous with the actual market value of the property, only if and when a fair return equivalent to the current rate of capitalization is allowed to be earned thereon and is actually earned, no more no less. But this seldom occurs except by accident. Furthermore, it should also be remembered that the actual market value of a property is not necessarily the capitalized net worth of its actual earnings. Sentiment or speculation as to prospective earnings may influence the market value of the property. Condemnation and Rate-Making. The notion of market value constantly creeps into valuation and rate controversies, when it is argued that value for rate-making is fundamentally analogous to value for condemnation. This argument is not without an element of truth and has its origin in the Reagan case, where Mr. Justice Brewer said: "If the States were to condemn the railroads, is there any doubt that constitutional provisions would require the payment to the corporation of just comdictionary maker." C. A. Prouty, Memorandum on the Valuation of the Texas Midland Railroad Company, pp. 3-4. (1917). " Ibid. p. 4. " Cf. Edwin C. Goddard, "Public Utility Valuation," IS Michigan Law Review, pp. 223-224.

FAIR

VALUE

25

pensation—that compensation being the value of the property as it stood in the market of the world and not as prescribed by an act of the legislature? Is it any less a departure from the obligations of justice to seek to take not the title, but the use for the public benefit at less than its market value ?" 3 1 However, there are some differences that should be noted. First, the two types of proceedings are not exactly the same. Condemnation proceedings are under the power of eminent domain, whereas rate-regulation is an exercise of police power. The power of eminent domain cannot take private property for public use, except on the payment of just compensation which may be assumed to mean its market value. 32 But rate-regulation under the police power often does reduce the market value of private property and it is not necessary to pay a compensation exactly proportionate thereto. Secondly, in condemnation cases, the title, the use and indeed the rights of the property generally are totally denied, while, in rate cases, nothing but the service of the property is taken; the rights of possession, of disposition, and of other private uses are untouched. In other words, condemnation takes the entire value of the property. T h e State receives it and must pay for the same. Valuation for condemnation proceedings constitutes an attempted estimate of the market value of the property to be condemned. Rate-making valuation is merely a process of determining a fair basis upon which a fair return should be paid for the service the property helps to render. Thus, valuation for condemnation and for rate-making cannot with fairness be said to be exactly the same. 33 Reagan v. the Farmers' Loan & Trust Co., 154 U. S. 362, 410. " C f . J. C. Bonbright, "The Problem of Judicial Valuation," 27 Columbia Law Review, p. 506. " C f . H. H. Hartman, Fair Value, p. 71. 11

26

RAILROAD

VALUATION

Finally, it should not be supposed that the value for condemnation is necessarily any higher than that for rate-making purposes or vice versa. While value for condemnation may be interpreted as an estimate of the market value of the property, a fair value for rate-making purposes should not be judged by the same standard. Consistent with the public interest, it may be either higher or lower than the market value of the property under particular rates. It is a common knowledge that many railroads, especially in the Western district, have never been worth in the market as much as their original investment, because adverse operating conditions and limited or undeveloped traffic have prevented them from earning a fair return. But it would be irrational to value their property for rate-making purposes exactly at their commercial worth or market value. On the other hand, if market value should be adopted as a standard of rate-regulation, there could be but little validity in the regulation of rates and far less in the limitation of excess profits. Kinds of Value Involved in the Rule of Rate-Making. It remains to be considered how fair value is related to rate-making. Many kinds of value are involved in the Rule of RateMaking under the Transportation Act. There is an "individual value" of the property of each and every carrier. It constitutes only a part of the basis upon which a fair return is allowed the railroads as a whole, but furnishes the sole criterion for the recapture of excess income when earned. The "aggregate value" of the property of all the carriers serves as the starting point for the whole process of rate-making. After the general level of rates is established, then there is the "commercial value" of each individual carrier as a going concern, or, as Professor J. M. Clark put it, the going-concern value under regulated rates.34 ** Cf. his article, "Railroad Valuation As a Working Tool," of Political Economy, April, 1920, p. 274.

Journal

FAIR

VALUE

27

The "commercial value" of each individual railroad may be larger or smaller than its "individual value" allowed for rate-making purposes, depending upon whether it is a strong or weak railroad. In case of a strong railroad, getting more than 6 per cent upon the value of its property, its actual "commercial value" would be the capitalized worth of its total net railway operating income less the amount subject to recapture. Thus, we have for every carrier a fair value for rate-making purposes and a commercial or market value under regulated rates; the former starts the process of rate-making, while the latter is the result of rates established. Fair Value for Railroad Rate-Making Defined. In view of the foregoing discussion, it may be asserted that a fair value for railroad rate-making is merely an impartial estimate of what the value ought to be under normal conditions and reasonable rates as distinct from what it is or was. It may be defined as a reasonable sum or an equitable base, upon which a fair return should be allowed, due consideration being given to all the facts and elements of value recognized by the law of the land for rate-making purposes. So far as individual railroads are concerned, a fair value for rate-making purposes is a value that would be considered as fair if reasonable rates could be independently fixed for every individual railroad without regard to the necessity of group rate-making or competitive conditions. The following chapter will be devoted to a discussion of the various purposes to be served by such a rate base and the pros and cons of "original cost" and "cost of reproduction"— the two rival bases that have the largest number of supporters.

CHAPTER I I I ORIGINAL COST AND COST OF REPRODUCTION

o DISCUSS the relative merits of original cost and cost of reproduction as a valuation basis, it is necessary, at the outset, to explain briefly the meanings of the two terms. The Meaning of Original Cost. In valuation literature, the connotation original cost seems plain. It is usually understood to be what the investor originally put into the property, with a view to getting a fair return. Additions and betterments, under fair conditions and proper accounting, are simply further investments with the same intent. Thus, original cost plus net additions should constitute original cost to date. Under correct accounting and good management, original cost might be taken to mean the actual cost or book value. In practice, however, due to the lack of proper or uniform accounting system and because of the constantly changing character of railroad properties, it is quite impossible to ascertain the original cost. The early records may never have been kept; or, if kept, they may be either incomplete or undependable. For this reason, the estimated "historical cost" as supplemented by the history of the properties—both physical and non-physical— is generally taken as original cost. Furthermore, parts of the property may have been acquired either extravagantly or uneconomically, and, in order to rule out wasteful or inflated costs, the original cost is further qualified by the familiar phrase, "honestly and prudently made." It should also be remembered that the original cost to date, now the universal construction of original cost,1 excludes all expenditures made ne1 "A careful consideration of the literature of valuation, the briefs of attorneys, the reports of engineers, and court opinions lead to the conclusion that original cost is now universally construed as original cost to date." H. H. Hartman, Fair Value, pp. 97-98.

[28]

ORIGINAL

COST

29

cessary by depreciation, obsolescence, or inadequacy, taking into account all the equities in a particular case. Abandoned property is not included, 2 except f o r a limited time or by special arrangement between the company and the public. 3 In confiscation cases, therefore, the term "used and u s e f u l " has been commonly employed in making the valuation of the properties. So, as a matter of fact, the term "original cost" or rather "original cost to date" corresponds neither t o actual cost nor to book value. 4 Unless otherwise stated, the term "original cost" throughout our discussion will be taken to mean the cost at which the existing property used and useful f o r the public convenience has been honestly and prudently acquired. Indeed, this is the theory of "prudent investment." The Meaning of "Cost of Reproduction." A s regards the term "cost of reproduction," interpretations are many. It has been construed as the cost of reproducing the identical property being valued : ( 1 ) under present conditions and at present prices; ( 2 ) under original conditions but at present prices; ( 3 ) under original conditions and at historical prices; 5 or ( 4 ) under present conditions and at average prices during a reasonable period. 6 Oftentimes, "cost of reproduction less depreciation" is spoken of as another f o r m of "cost of reproduction," although it is merely an application of the depreciation rule to the reproduction method. According to economic theory, however, the term "cost of 2 F o r a detailed discussion see W h i t t e n ' s Valuation, pp. 190-5. " C f . J. M. Clark, Social Control of Business, p. 369. 4 S e e H a r t m a n , op. cit., p. 98. * It is to be noted that, under f a i r conditions, the result obtained w o u l d be practically the same as original or historical cost of the property being valued. ' " I n d e t e r m i n i n g present value, consideration must be g i v e n to prices and w a g e s prevailing at the time of the i n v e s t i g a t i o n ; and, in the light of all the circumstances, there must be an honest and intelligent f o r e c a s t as to probable price and w a g e levels during a reasonable period in the immediate future." McCardle v. Indianapolis Co., 272 U . S. 400, 408.

30

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VALUATION

reproduction" is generally considered to be the cost of reproducing not an identical, but a substitute property, representing the up-to-date construction capable of rendering the same service. For this is the cost of production toward which competitive prices would tend to conform. If normal price is to be maintained in the regulation of rates, the cost of reproducing the service under the present as well as near-future conditions is, theoretically, the most logical interpretation of "cost of reproduction" as a rate base. However, the kind of reproduction cost that has had the largest number of supporters and to which the Supreme Court seems to have given its approval is the cost of reproducing a substantially identical property used to give the service and not the estimated cost of a different or substitute property. This is the difference between the economic and legal interpretation of "cost of reproduction" and should be clearly understood. Valuation -of Existing Properties. Following the procedure emphasized by Dr. John Bauer, we will discuss the valuation of existing properties and the valuation of future investment separately. In dealing with the valuation of existing properties, one of the paramount considerations is the protection of vested interests. "While vested interests may not have been justly, or even honestly, derived in the first instance, they may be held in all good faith by their present owners, and therefore properly entitled to respect and protection."7 As we have already noted, the Supreme Court did not say, in Smyth v. Ames, nor did the Congress specify in the valuation act, that the basis of all calculations as to the reasonableness of rates or more exactly the rate base should be a clear-cut original cost or cost of reproduction. The present fair value of existing properties must be determined by a balanced consideration of all these and * I. L. Sharfman, The American Railroad Problem, p. 305.

ORIGINAL

COST

31

other relevant factors of value in accordance with the law of the land. As a statement of principle, this is true. But it does not lend itself to a precise measurement of what the present fair value should be. The Supreme Court, the original source of the definition of what constitutes fair value, has shown a tendency to give more consideration to reproduction cost in valuation cases, including the Indianapolis water case, the O'Fallon railroad case, and the very recent Baltimore street railway case.8 It has not dictated, however, the exact weight to be accorded in all cases. Consequently, there are two schools of thought in the interpretation of the legal doctrine of present fair value. One is that current reproduction cost must be considered along with all other elements of value and must find its genuine reflection in the ultimate valuation ascertained. Another viewpoint is that current reproduction cost as well as other elements of value should be considered by the fact-finding tribunal which must determine for itself what, if any, weight shall be given to either reproduction cost or any other element of value recognized by the law of the land. These two schools of thought were well represented by the majority and minority opinions in the O'Fallon case; the majority emphasized the former view while the minority led by Mr. Justice Brandeis stressed the latter.* In the absence of legislative action, it now becomes the task of the Interstate Commerce Commission to determine how much weight it must give to the factor of reproduction cost in valuing a railroad property for rate-making purposes. As the law stands at present, it is incumbent upon the Commission to modify its method of valuation, especially the valuation of the carriers' properties installed prior to 1914. Following the • 280 U. S. 234. •Excerpts from both majority and minority opinions in the O'Fallon case will be found in Appendix A.

32

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O'Fallon decision, the Commission has made it clear that, in subsequent valuation cases, it will give current reproduction cost such consideration as may be required by the law of the land.10 The reproduction cost cannot, however, be the sole measure of fair value. Nor can the Commission follow any uniform plan as between different carriers, for there are circumstances under which the value of certain carriers' property should be placed far below the cost of reproduction. Compromises and inconsistencies are inevitable, the predominant principle being that both the vested rights of the carriers and the public interest are matters to be considered. On February 28, 1930, the Commission, pursuant to the decision of the Supreme Court in the O'Fallon case, handed down its recapture order on the Brimstone Railroad and Canal Company, requesting the payment of $260,435 as one-half of the excess income for the years 1920-1925. In arriving at the final values for recapture, the Commission made no mention of the exact weight accorded the reproduction cost or any other factor. 11 Probably no exact figures will be known until the Brimstone case has been settled. Further and prolonged litigation may be necessary to clarify the law. Valuation of Subsequent Investment. As regards the valuation of investments made subsequent to present or initial valuations, many believe that the rules for the future may be different from those in the past, that within constitutional limits the legislature is practically free to adopt any measure as it sees fit, and that any measure adopted may be considered as just and reasonable so far as the future investor is concerned. For if free capital chooses to come into the regulated field, the terms offered must be viewed as satisfactory. Assuming that w See Valuation Docket No. 1017, N e w York Connecting R. R. Co. " See Finance Docket No. 3643, Excess Income of Brimstone Railroad and Canal Company, February 28, 1930.

ORIGINAL

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33

this is true, which makes a better or more satisfactory rate base for the future-original cost or current cost of reproduction, each having its enthusiastic advocates? Disregarding f o r the moment the constitutional question involved, we shall sketch in the remainder of this chapter both sides of the argument without attempting to establish the soundness of either. The Effectiveness in Attracting Capital. Inasmuch as the crux of the whole program of railroad rate regulation is whether needed capital is attracted into the railroad field, the point that is most frequently emphasized by advocates of original cost and cost of reproduction alike is the alleged effectiveness in attracting capital. The argument f o r the basis of original cost rests largely upon the stability of income that is supposed to result. Most investors, it is argued, prefer a definite return on their contributed capital under all conditions rather than a speculative return, changing as the level of prices changes; 1 2 this argument seems to have been amply supported, in the past at least, by the preference of the majority of investors for bonds and other fixed interest-bearing securities. It should not be overlooked, however, that the basis of original cost in its generally accepted form of prudent investment also contains some formidable uncertainties as to what constitutes "prudence" in each case. An instrument of transportation, although originally well conceived, may later prove unremunerative. It may be abandoned when it becomes unprofitable. One of the arguments for cost of reproduction is that the reproduction basis offers a special attraction by permitting the investors to take advantage of the unearned increment in land values. W i t h o u t this lure, the reproductionists believe, capital would tend to keep away f r o m the railroad industry. Others argue that railroad investment could be made just as attractive " C f . J o h n B a u e r , Effective

Regulation

of Public

Utilities,

p. 120.

34

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VALUATION

by adopting a rate base that would guard the investors against the risk of unearned decrement in the value of their property. However, since the Valuation Act provides special treatment for railroad land which is to be valued by the present adjacent land test, this argument has little importance. Especially since the World War, cost-of-reproductionists have relied more and more, for defense of their doctrine, upon its effectiveness in stabilizing the real, instead of money, return to the investors, the theory being that the reproduction basis, though changing as prices change in number of dollars and cents, is believed to be stable in terms of purchasing power. If prices go up, the purchasing power of the dollar will decline, representing less real goods than before. If prices go down, instead, the situation is reversed. But, in either case, it is urged, the cost of reproduction at current prices would automatically, from time to time, adjust the rate base and the rate of return to the purchasing power of the dollar. Theoretically, the above argument is sound and has much economic merit. However, the cost of reproducing railroad property at current prices does not necessarily correspond to the purchasing power of the dollar in terms of real goods. Prices do not move in union. Coal may be dear when bread and butter are cheap. The cost of railroad construction may be going up when clothing prices are coming down. Even an average increase in the general level of prices may be easily offset by improved construction methods.18 Financial Structure and Stability. Perhaps, the most forceful argument against the stability of reproduction cost is the structure of railroad finance. Thus it is said: " S e e Texas Midland Railroad, 75 I. C. C. 1, 140; also Paul Jtrome Raver, "Index Numbers of Public Utility Construction Costs," The Journal of Land and Public Utility Economics, III, 343, 359, where signal discrepancies between changes in general price level and changes in constriction costs are found.

ORIGINAL

COST

35

"Reproduction, in such a case, though changing in number of dollars, is stable in terms of value—but it is a kind of stability which people do not expect or fully understand, and hence it cannot give them the benefits which stability ought to bring. They will srtill issue bonds calling for a fixed number of dollars, and so long as this is done uncertainty, miscalculation, and injustice are bound to remain." 14 Nearly two-thirds of the investments of common carriers are financed by bonds or preferred stocks, bearing a fixed or a maximum rate of return on the number of dollars originally invested. W i t h a financial structure such as this, not only would all the benefit from a rise o f price level accrue three-fold to the common stockholders, but they would also suffer corresponding losses if the general price level should go down. Theoretically, of course, the losses may be urged as a justification of the benefits. T h e Supreme Court has said that "it is well established that if the values of utilities fluctuate, owners must bear the decline and are entitled to the increase." 1 6 The objection, however, does not lie so much in the opportunity for gains as in the risk of losses. T h e public might perhaps be unmindful of such gains as the railroad stockholders may occasionally enjoy, inasmuch as the same state of affairs prevails in competitive industries. But, as a matter of fact, the public could hardly permit them to suffer the corresponding losses which would endanger the maintenance of adequate transportation, and would, in effect, react disastrously upon all industries. 18 Professor Irving Fisher, the most distinguished advocate of the stabilization of the dollar by adjusting it to the constantly fluctuating commodity prices, finds difficulties in the strict and " J . M. Clark, Social Control of Business, p. 372. " McCardle v. Indianapolis Water Co., 272 U. S. 400, 410. * Cf. Excess Income of O'Fallon Ry., 124 I. C. C. 3, 35.

36

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VALUATION

consistent application of the theory of reproduction cost to the railroads. Thus he writes: "If there were no bondholders, only stockholders, it would be proper to apply rigorously and naively the simple rule of adjusting the rate base, in direct proportion to the rise in the price level, i. e., inversely to the purchasing power of money But there are bondholders, and there is the public."17 Cost of Reproducing Scrvicc and Stabilization of Real Income. Thus far we have tacitly assumed that cost of reproduction means the cost of reproducing substantially identical properties. But, if the reproduction basis is taken to mean, as most economists seem to mean, the cost of reproducing, not an identical, but a substitute property, it would be harder still to give the investors the real-income stability which it is supposed to bring about. A single innovation in the process of railroad construction may cause profound shrinkage in the cost of reproducing a substitute property. Furthermore, the effects of improved methods of operation, competitive means of transportation and external changes in the localities served, may more than offset the increase in the value of the property which would otherwise result from the rise in the price level. To quote Whitten: "In the case of a railroad, there might be a radical relocation and realignment of roadbed and important changes in the method of construction, leading to great economies in operating cost. It has been stated that 'if our railways were to be built anew, in the light of our present knowledge and with our present traffic offerings and financial resources, " Irving Fisher, "Rail Valuation Still a Problem: Question of Fair Return to Owners Yet to be Adjudicated," a copyrighted article dated June 27, 1927.

ORIGINAL

COST

37

vast changes would be made in the character of construction !"18 A n d such changes, according the theory of the cost of reproducing the service, may require a railroad property to submit to a reduction in its rate base that would wipe out a considerable portion of the stockholder's equity. An Ideal Rate Base Yet to be Devised. It is obvious, then, that neither the original cost nor the cost of reproduction, whether of a substantially "identical property" or of some "substitute property," can give the investor the real stability that might be desired. It is equally obvious that, in order to make the railroad investment attractive, somewhere and somehow the investors must be given some allowance f o r the depreciated purchasing power of the dollar. If a rate base to be ideal must be an income stabilizer, the ideal base has not yet been found. P r o f e s s o r Bonbright has suggested the adoption of the investment standing, using as the measure of the investment, not the money cost but the real cost. " I n other w o r d s , " he explains, "the rate base might be made to vary, not with changes in the cost of railway construction but rather with changes in an index of the cost of living." 1 6 This rate base, however, should not be used, according to P r o f e s s o r Bonbright, unless all railroad bonds and preferred stocks can be totally replaced by common stocks, or, if not replaced, the incomes fixed thereon can be made payable, not in number of dollars and cents, but in terms of purchasing power. While this proposed change is too radical to put into effect, as P r o f e s s o r Bonbright himself believes, it is, nevertheless, interesting to those whose interest lies in the stabilization of the real income of railroad investors. 18 R. H. Whitten, "Fair Value for Rate Purposes," Harvard Law Review, X X V I I , 419. "J. C. Bonbright, "Railroad Valuation with Special Reference to the O'Fallon Decision," American Economic Review, supplement, 1928, p. 187.

RAILROAD

38

VALUATION

Stability v. Guaranty. As a matter of practice, stability, at its best, could not be taken as guaranty; whichever rate base is adopted, some uncertainties are always to be expected. If the investment or original cost basis is adopted, it is conceivable that the public may require, in periods of unusually low prices, a shift to the basis of reproduction cost in order to disallow a return on the high basis of original investment. If this is true it also follows that if the basis of reproduction cost is adopted there is a similar uncertainty as to whether the original investment may not be insisted upon by the public when the cost of reproduction proves to be exceptionally high. If human nature continues unchanged, and the dynamic world such as ours is ever changing, no definite return on any designated basis can be absolutely guaranteed. It has been well stated that "rates should be made not only in accordance with what the traffic will bear, but also in accordance with what public sentiment will stand." 20 To be sure, however, other things being equal, higher rates can be borne by the public more easily in a period of high prices than in periods of low prices. Thus, considering the effectiveness to attract capital, the stability argument in favor of reproduction cost basis is, in this respect, somewhat strengthened. Inducement to Efficiency. Another consideration that is usually taken into account in the discussion of a valuation basis is the proper inducement to efficiency. The question remains whether the investment basis or reproduction cost basis may better serve this purpose. The Relation of Cost of Reproducing Substitute Properties to Efficiency. So far as the inducement to efficiency is concerned, the argument for the cost of reproducing service or substitute property is most convincing and deserves far more atM

Railway Age, December 10, 1927, p. 1147.

ORIGINAL

COST

39

tention than it has usually received. It is argued that if the railroads knew that their financial return would be calculated on the basis of the cost of reproducing a substitute up-to-date property, there would be a strong incentive to keep their operating expenses down by introducing into the property the most improved appliances and latest scientific devices. This would not be true, of course, if their return were computed on the original cost as long as the property remains. Indeed, had this argument been more clearly understood, the reproduction cost theory might not have so often been rejected merely because it has meant or may have meant a higher valuation basis in a period of high prices. In practice, however, the replacement theory lacks the very definiteness that both the railroads and the public most naturally desire. Not only is it difficult to ascertain what it would cost to build an up-to-date railroad under present conditions, but such a rate base, even if ascertained, would no doubt fluctuate with changes in prices as well as in the arts of construction and operation. Once the replacement cost basis is adopted, "the door is opened to a speculative risk which it is the primary aim of regulation to eliminate." 21 Though economically sound, the theory of replacement cost is difficult to apply. For instance, how could we proceed to calculate the return of the Pennsylvania Railroad on the basis of its replacement costs according to up-to-date methods and present knowledge? Any such attempt must necessarily result in uncertainty and conjecture and is not serviceable. 22 The Relation of Cost of Reproducing Identical Properties * M. G. Glaeser, Outlines of Public Utility Economics, p. 469. " " T h e cost-of-reproduction method is of service in ascertaining the present value of the plant, when it is reasonably applied and when the cost o f reproducing the property may be ascertained with a proper degree of certainty. But it does not justify the acceptance of results which depend upon mere conjecture." Minnesota Rate Cases, 230 U. S. 352, 452 (1913).

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to Efficiency. In support of the reproduction of an identical property, advocates of the basis of reproduction cost argue that the adoption of the basis of cost of reproduction would tend to encourage the construction of railroads when prices are low, whereas the investment or original cost basis would cause construction in periods of high prices for the purpose of taking advantage of a high valuation basis. It is socially desirable, it is further argued, to encourage railroad construction during low price periods, thus reducing the severity of the business cycle. This argument is plausible but not convincing for reasons we shall briefly state. The construction of a railroad is generally intended to meet a demand; if the demand is urgent, the construction will not be held back. On the other hand, if there is no demand in prospect, an unwarranted project will not be put forward simply to get a high valuation basis. It must be admitted that some railroads, especially in the West, were built far in advance of their demands, although we know that they were not built to take advantage of a high valuation basis, which was totally undreamed of in those days. Even assuming that some of the promoters or financiers were so inclined, it would be difficult to predict price changes with such confidence as to shift their construction programs. Furthermore, the construction of railroads during a low-price period does not necessarily help reduce the severity of the business cycle, if the low price level is due, not to cyclical trend, but to secular trend, such as, for instance, a changing ratio between the volume of money and that of business. 23 However that may be, it is, at least, doubtful whether the public should place a premium on what might be an unwarranted construction " C f . J. C. Bonbright, Railroad Valuation the O'Failon Decision, op. cit., p. 192.

with

Special

Reference

to

ORIGINAL

COST

41

at low-price intervals and place a check on a much needed project during periods of high prices. From the standpoint of efficiency, it would not appear to be desirable to have the railroads constructed chiefly for the purpose of speculating in rails, ties, lands, labor, and other materials. The Relation of Original Cost Basis to Efficiency. Opponents of the original-cost or investment basis contend, among other things, that if the return is computed on original cost of the property rather than on the efficiency and usefulness of the property, there would be no extra inducement to improve the property and the service any further than to make possible the maximum return allowed. It is for this reason that some leading economists strongly object to the regulation of return on the basis of original or historical cost.24 In answer to the above, however, champions of original cost argue that under the basis of original cost, the investors would know exactly what they can expect and the public would know just what they have to pay. Every dollar prudently invested in the property whether at high prices or low prices would be recognized and protected. Then the way lies open for stimulating efficiency. The reasons are twofold. One is that the incentive to efficiency that appears as a part of the theory of prudent investment is at least a negative one; for no return is to be allowed on expenditures made unwisely, extravagantly, or dishonestly. 25 Moreover, the reward for unusual efficiency and economy will be easily found in the return actually earned under the rule of rate-making, the "aggregate value" of the railroads being used as the rate base. Another reason is the alleged favorable effect on operating effi" See, for instance, A. T. Hadley, "Principles and Methods of Rate Regulation," The Yale Review, April, 1927, 417. * Cf. J. M. Clark, "Railroad Valuation as a Working Tool," Journal of Political Economy, April, 1920, p. 300.

42

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VALUATION

ciency. Since, according to the investment basis, the rights of the railroads and the public are definitely determinable at all times, the incessant and perennial conflict over the rate base would be avoided. Consequently, there would be time, energy, and a disposition of all concerned to co-operate on matters of efficiency in operation and management. Thus, it has been asserted that "the elimination of the continuous friction between the public authorities and the companies would be in itself a potent factor of greater efficiency."28 While this view may appear to be too optimistic, it merits attention. The Argument of Competitive Economy. Turning to the argument of competitive economy and justice, the theoretical superiority of the basis of replacement cost is unchallengeable. It is generally agreed that "the aim of public regulation is to accomplish what in other industries is assumed to be accomplished automatically by free competition, that is, to limit the price charged to the normal cost of production." 27 Many economists, therefore, are inclined to believe that the cost of reproducing the service or the substitute property is the only rate base that will cause the rates charged to correspond to the "normal price" under free competition. Professor H. G. Brown28 and Dr. F. G. Dorety 29 have argued that the basis of original cost is unworkable and is likely to result in waste and economic injustice. When cost of reproduction is higher, the new railroad construction would be stifled, if the new road were to charge the same rates as would yield a fair return only " J o h n Bauer, Effective Regulation of Public Utilities, p. 331. * Whittcn, "Fair Value for Rate Purpose," 27 Harvard Law Review, 422. " See, for instance, his "Transportation Rates and Their Regulation" (1916) ; "Railroad Valuation and Rate Regulation," Journal of Political Economy (1925), pp. 505-530; "Rate Base for Railroad Regulation," Journal of Political Economy (1926), pp. 479-513; etc. " S e e especially his article, "The Function of Reproduction Cost," 37 Harvard Law Review, 173-200 (1924).

ORIGINAL

43

COST

on the original cost of the old railroad. If different rates were permitted, some shippers would pay high rates and others low rates, thus leading to economic injustice and abnormal development of industries. On the other hand, if the present cost of reproduction is lower, to insist on rates based on the original cost of the old railroad is to make rates higher than they are economically justified. Similarly, should separate rates be allowed on two different bases for two railroads built at different times, injustice and waste would also be inevitable. The basis of cost replacement, it is further contended, would not only induce, at any given time, the construction and operation of the road needed but would also do full justice to the existing road according to the competitive principle. In the words of Professor H. G. Brown, "however much it may have cost me, say in 1920, to construct a plant for the manufacture of a competitive product, the fact that competitors can construct such a plant now at a lower cost compels me to accept a lower price. And, vice versa, if cost of plant construction has risen, this fact, by influencing new competition, influences my price as well." 30 There can be no doubt that the price of general merchandise that is easily reproducible by competitors and is movable and quickly used up conforms in a relatively short time pretty closely to current reproduction cost. But, in case of a railroad, which is fixed, permanent, and not easily duplicable, there can hardly be such correspondence between the price of its service and its reproduction cost at any particular time. The fact is that the railroads sell their services in a market where competition is either absent or regulated. It is only when and where free competition prevails that cost of reproduction influences price indirectly by limiting the supply. 30 H. G. Brown, "Discussion on Valuation," American view, Supplement, 1928, p. 211.

Economic

Re-

44

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VALUATION

That gross injustice and economic waste are inevitable unless the basis of replacement cost is adopted, is theoretically true but may be greatly exaggerated. In view of the presentday tendency toward merger and consolidation, few, if any, railroads will be built independently, in direct competition with existing roads. Even if they are built independently, the rates charged by the railroads can hardly be said to depend entirely upon the costs of construction, the capital cost—both fixed charges and dividends—constituting only about one-fifth of the total operating revenues. New railroad construction will not necessarily be discouraged or prevented if rates are so held down as to yield a fair return only on the original investment of existing roads—a basis materially lower than the current cost of reproduction. A new road could take full advantage of modern appliances and up-to-date methods and secure a fair return on a higher basis by reducing operating expenses. Administrative Convenience. The easiest way is not necessarily the right way. Nor is a thing undesirable simply because it is difficult. Yet, administrative convenience constitutes one of the most important considerations in the discussion of valuation basis or the rate base. Despite the economic merits of the reproduction theory, it is generally conceded that its determination and administration would result in speculation, and would vary with the conjecture and whim of appraisers and public administrators. The basis of replacement cost becomes obsolete not only with price changes but with improvement in the arts of construction and operation. The kind of reproduction cost, to which the Supreme Court has given its approval in ascertaining the present fair value of a property, is thus interpreted to be the cost of reproducing, not an entirely different property, but a substantially identical one. To wit: "There is to be ascertained the value of the plant

ORIGINAL

COST

45

used to give the service and not the estimated cost of a different plant. Save under exceptional circumstances, the Court is not required to enter upon a comparison of the merits of different systems. Such inquiry would lead to collateral issues and investigations having only remote bearing on the fact to be found, viz., the value of the property devoted to the service of the public." 31 This gives the cost of reproducing the service or a substitute property no place in valuation, even if it is most economically sound. Indeed, a great number of economists have in recent years vigorously advocated an uncompromising basis of prudent investment, believing that a f t e r the basic valuation of existing properties has been fixed and agreed upon, the determination of the rate base in the f u t u r e would simply be a matter of proper accounting and bookkeeping. T o these thinkers, the basis of prudent investment would offer a definite return to every dollar actually and prudently invested and an easy method of administration. Attention may, however, be called to the frequent fluctuation in the value of properties which might render such a rate base the means of confiscation at one time and the instrument of losses to the public at another, even if some adjustment may be made through the rate of return. The reproductionists claim, on the other hand, that once the basic value is fixed the future rate base can be easily ascertained by the use of index numbers, assuming that changes in reproduction costs correspond to changes in prices. If changes in construction methods enter into the valuation estimate, this assumption is, of course, not tenable. Furthermore, there are numerous other matters which cannot be brought up to date by the use of index numbers. " McCardle v. Indianapolis Water Co., 272 U. S. 400, 417-8.

CHAPTER

IV

DEPRECIATION, INTANGIBLE VALUES, AND T H E F U T U R E RATE BASE matters two important problems stand out. One is the treatment of depreciation, which may affect the railroad rate base to the extent of several billion dollars. The other is the problem of intangible values, notably, f r a n chise, going concern values, good will, and the like. Each of these items deserves separate and detailed treatment; but, on account of the limit of space and purpose, we shall consider briefly the problems'of m a j o r importance. The Nature of Depreciation. W h a t e v e r valuation basis may be adopted, the problem of depreciation will certainly arise, and it is a complicated one. U n d e r the Valuation Act of 1913 and Section 15a, there must be a determination, among other items, of the cost of reproduction less depreciation. Further, the Commission is directed, under the amended Section 20 of the Interstate Commerce Act, to prescribe the keeping of a depreciation account by all carriers subject to the Act, although no definite system of depreciation accounting has as yet been evolved. 1 A s to the nature and definition of depreciation, there are striking differences of opinion among economists, accountants, engineers, and traffic managers. In general, there are two kinds of depreciation, physical and functional. The f o r m e r is due to wear and tear, to use as well as age. All properties are undergoing physical deterioration. The owners of the proper10NG OTHER

1 For a good summary of the Commission's Depreciation Accounting, see D. P. Locklin, Railroad Regulation Since 1920, pp. 171-181; and for a critique see Perry Mason, "The Treatment of Depreciation in the Interstate Commerce Commission Valuation Cases," The Accounting Review, June, 1928, pp. 141-148.

[46]

DEPRECIATION

47

ties are entitled to reimbursement by charging the loss to operating expenses; for such depreciation allowances are regarded as one of the elements of costs. 2 Regarding functional depreciation, it is urged that to the extent that depreciation occurs due to inadequacy, obsolescence, and other causes, properties suffer a functional deterioration. 3 The determination of the extent of such functional depreciation, however, is not only difficult but is irrelevant as regards the present value of the property being used, unless the basis of reproducing a substitute property is applied. So, the Commission has made it clear that it does not intend by the term depreciation to include such functional depreciation of railroad properties. 4 The Treatment of Depreciation. Confining our discussion to the problem of physical depreciation, it may be said that properties no longer used and useful should not be included in the valuation basis. But it is difficult to deal uniformly with old properties. The railroads in the past may or may not have earned enough to permit the charging of depreciation to operating expenses. If not, it would be unfair to force them to accept a depreciated rate base.-11 If the past earnings were ample enough to cover such depreciation charges, it would be unfair to the public to adopt a rate base undepreciated. In valuation cases, therefore, it becomes necessary to look into the past history of earnings as well as the past depreciation policies of the individual carriers concerned. Equity and expediency seem to dictate that, if upon investigation it is found that due and ample allowance for accrued J See R. T. Bye, "The Nature and Fundamental Elements of Costs," Quarterly Journal of Economics, vol. 41, p. 47. ' F o r detailed discussion of functional depreciation of railroad properties due to various causes, see Mr. Justice Brandeis's dissenting opinion in St. L. & O'Fallon R. Co. v. U. S., 279 U. S. 461, 516-534. • C f . Texas Midland R. R„ 75 I. C. C. 1, 47-52, 124-130; also Depreciation Charges on Steam Railroads, 118 I. C. C. 295, 362. * Cf. Perry Mason, op. cit., p. 147.

48

RAILROAD

VALUATION

depreciation has been provided, a reduction should be made in arriving at an equitable rate base. I f , on the other hand, the railroad has not enjoyed sufficient earnings to make allowances for depreciation, the accrued depreciation should not be deducted, "unless," as Professor Glaeser says, "other methods of again making depreciation reservations ample without burdening future consumers cannot under the circumstances be adopted. 6 Obviously, only by different treatment in different cases can fairness and equity be obtained. Professor J . C. Bonbright of Columbia University, in a detailed analysis of the depreciation problem, has proved conclusively that the question of deducting or not deducting depreciation in dissimilar valuation cases must be decided by considering the facts peculiar to each case. 7 A s regards the future policy, few, except some ardent antidepreciationists, question the propriety of appropriate charges to operating expenses for expired properties. But the methods of calculating such allowances are subject to debate. First, there is a question whether depreciation allowances should be based upon present fair value or on original cost of the properties—a question on which the Supreme Court recently divided in United Railways v. West, 8 where the majority held that the allowances for annual depreciation must be based, not upon cost, but upon present fair value of the property of a utility. Indeed much that was said in the last chapter about valuation basis applies to the depreciation charges. There is another question as to the amount of depreciation allowances. Numerous methods of calculation are advocated. Most commonly used are the straight line method and the sink* M. G. Glaeser, Outlines of Public Utility Economics, p. 504. * See J. C. Bonbright, "Depreciation and Valuation for Rate Control," 41 Quarterly Journal of Economics, pp. 210-211. ' See 280 U. S. 234-291.

DEPRECIATION ing fund method.

49

U n d e r the former method, the aggregate

charges equal the net property expense for the entire service life and the annual allowance is the same f o r all years, while, under the latter, both the aggregate and annual charges are different, because the proceeds o f each year's charge are required to be continuously invested at compound interest the whole period of service life.

for

It is not within the scope of

this treatise to discuss the relative merits of the various methods o f making depreciation allowances. Intangible

Values.

Another point o f conflict in valuation

cases is the so-called intangibles or "other values" as implied in the Valuation Act.

In arriving at the final value o f railroad

properties, the Commission has found no other elements of value to which specific amounts can be assigned, although a bulk 5 per cent is usually added to the physical value ascertained presumably for some intangible items.

T h e following may

be noted.

Franchise,

Developmental

Expenses,

and Good Will.

Many

contend that no allowance is necessary for franchise, when it was originally a gift from the public, although in the United Railway case the Supreme Court sanctioned $ 5 , 0 0 0 , 0 0 0 easements.®

Justice

and equity may

require the

for

inclusion

in the valuation basis of such amount as may be reasonable and necessary f o r promotion and developmental purposes.

While

good will, the capitalized worth o f excess earning power, constitutes an important item in determining the commercial or market value of a property, it is generally held unnecessary to recognize it in valuation f o r rate-making purposes, especially when a carrier is allowed to earn more than a fair statutory rate of return upon value f o r rate-making purposes. Going

Value.

O f going value or going concern value, only

' See Ibid., 248-249.

50

RAILROAD

VALUATION

two items have logical significance. The first is the differential between either original or reproduction cost of a successful operating property and the bare or bone value of its separate physical units. All necessary and reasonable overheads, it is agreed, should be included in the appraised value of the various physical units which constitute the operating entity. 10 As a matter of fact, in fixing railway valuation this item would be automatically taken care of, if the Commission had in mind, not a heap of miscellaneous junk-units, but a railroad entity doing business. 11 The second item of going value is the amount representing the necessary and uncompensated deficits below a fair return in early years. In other words, it is the capitalization of early deficits. Since most of the railroads have already gone through their leanest years, some equitable allowance on this score may with justice be made, but writers on this subject differ widely as to how such allowance can best be made. Some advocate the inclusion, in the rate base, of the legitimate cost of waiting for a fair return. 12 It is urged by others that the early deficit should be compensated through rate of return rather than through valuation basis.13 Still others are of the opinion that, if early losses be compensated for either one way or the other, 10 Cf. John D. Sumner, "Going V a l u e : Its Various Interpretations and Their Validity," The Journal of Land and Public Utility Economics, February, 1928, p. 69. " "In making up the inventory we apply prices to the different parts of the property in the light of the fact that it is a railroad and doing business; otherwise the prices which would be applied would be scrap prices." Texas Midland Railroad, 75 I. C. C. 1, 70. For a similar expression of the above, see also Elgin, Joliet and Eastern Ry. Co. et. al., 84 I. C. C. 587, 617. " J o h n D. Sumner, op. cit., The Journal of Land and Public Utility Economics, May, 1928, p. 117. M Cf. J. M. Clark, "Social Control of Business," p. 375n; and Ben W. Lewis, "Going Value and Rate Regulation," 26 Michigan Law Review, May, 1928, p. 746.

DEPRECIATION

51

the surplus earnings in the past should also be deducted from the rate base.14 Obviously, the treatment of uncompensated losses depends largely upon expediency. It is not a question of pure logic but of reconciliations. Since what actually governs the general level of rates is the aggregate value of the railroads as a whole or in groups, the problem of deliberately making allowance for going concern value of any individual railroad is of no great importance. As we have stated, the ultimate value of a railroad under the statutory rule of rate-making may be said to contain an element of going concern value if and when its net railway operating income after recapture is larger than a fair statutory rate of return on its value for rate-making purposes. Concerning early losses, opinions are at variance. Despite the Indianapolis decision which seems to have lent color to the judicial sanction of the capitalization of early losses, it remains an open question whether allowances when justified should be made through valuation basis.16 In the recapture of railroad excess income, as will be shown later, past deficits may, however, require due consideration.18 The Supreme Court Decisions on "Fair Value." Under American Jurisprudence, the final judge of the valuation basis is the United States Supreme Court. What are the highlights of the Supreme Court's decisions on "fair value for ratemaking purposes?" It will be remembered that neither original cost nor current cost of reproduction was the only item named in the judicial doctrine of fair value in Smyth v. Ames. In the Con" See H. B. Vanderblue, Railroad Valuation, p. 171. " For a careful analysis of 12 Supreme Court decisions relating to going value, see E. W . Bemis, "Going Value in Rate Cases in the Supreme Court," 27 Columbia Law Review, p. 546. " See pp. 174-175 infra.

52

RAILROAD

VALUATION

solidated Gas case," the first important decision a f t e r Ames, the Court held that the value of a property was to be determined as of the time of inquiry, with the exception of abnormal conditions. A few years later, feeling the effects of price changes, the Supreme Court further emphasized, in the Minnesota rate cases, 18 that it was not the original cost but the property that should be protected. In 1922 the Court sustained the lower court decision in the Galveston case 19 in which 33 1/3 per cent increase was made in the valuation basis although prices had risen about 110 per cent over those of pre-war years. While in the so-called second Consolidated Gas case 20 the Supreme Court did not discuss the theory of reproduction cost, it was in agreement with the lower court that rates based on original costs were confiscatory particularly because they did not yield thereon a return of more than 2 or 3 per cent. Three important cases were decided by the Supreme Court in 1923. In the first case, the Southwestern Bell case, 21 the cost of reproduction was given recognition in the valuation found but only 25 per cent was added to the actual investment which would have been doubled by applying then prevailing prices. N e x t came the Bluefield W a t e r case 22 which was decided in a similar fashion. The third was the Atlanta case 23 in which the Court made no allowance for current cost of reproduction because the rates charged yield a fair return on the investment basis. It was in the McCardle case,24 decided in 1926, that the Supreme Court practically declared that current " Wilcox v. Consolidated Gas Co., 212 U. S. 19 (1909). "Minnesota Rate Cases, 230 U. S. 3S2 (1913). " Galveston Etect. Co. v. City of Galveston, 258 U. S. 388 (1922). "Newton v. Consolidated Gas Co., 258 U. S. 165 (1922). " Southwestern Bell Tel. Co. v. Pub. Serv. Comm. of Missouri, 262 U. S. 276 (1923). * Bluefield Water Co. v. Pub. Serv. Comm., 262 U. S. 679. ™ Georgia Ry. & Power Co. v. R. R. Comm., 262 U. S. 625. M McCardle v. Indianapolis Water Co., 272 U. S. 400.

DEPRECIATION

53

reproduction cost constituted a dominating element of present fair value. T h e latest pronouncement in the O ' F a l l o n case 25 and in the Baltimore street railway case 26 simply reiterated the established rule that, in valuing a property f o r rate-making purposes, current reproduction cost must be considered along with other factors. Fair Value not a Matter of Formula. It may be observed that, in substantially every case f r o m Smyth v. A m e s to the very recent Baltimore street railway case in which fair value or fair return has been an issue, the judicial doctrine of fair value established in the Ames case has been cited. But acceptable of the f a i r value doctrine of Smyth v. A m e s does not require that either original cost or cost of reproduction or any other element of value be the sole measure of fair value f o r rate-making purposes. In early cases, the Court considered more or less the factor of reproduction cost as a check on original investment which in most if not all cases w-as difficult to ascertain. O n account of the marked disparity between original investment and current cost of reproduction of utilities' property a f t e r the W o r l d W a r , the Court has doubtless shown a tendency to accord more and more consideration to the latter estimate. But close observers should not fail to see that the Supreme Court has persistently declared that f a i r value is not a m a t t e r of f o r m u l a ; it must be determined in the light of all relevant facts and circumstances. On numerous occasions the Court has declined to substitute its j u d g m e n t f o r that of a fact-finding commission informed by actual experience and appointed by law to deal with an intricate subject. 27 T h e judicial power has in the main been invoked as a means of preventing confiscation and *St. L. & O'Fallon R. Co. v. U. S„ 279 U. S. 461. United RailTmys & E. Co. v. West, 280 U. S. 234. * Cf., for instance, Illinois Central R. R. Co. v. Interstate Commission, 206 U. S. 441, 454. M

Commerce

54

RAILROAD

VALUATION

what constitutes confiscation in each case must of necessity be a flexible matter. T h e decisions of the Court, taken together, lay the ground for methods of ascertaining fair value that permit of different interpretations and emphasis. W h a t the Court emphasizes in one case to be a controlling factor may, with further lights and under different conditions, be modified in other cases. Thus, after declaring in the O'Fallon case that current reproduction costs must be given equitable consideration in valuing a railroad property, the Supreme Court was careful to point out: " N o doubt there are some, perhaps many, railroads the ultimate value of which should be placed far below the sum necessary for reproduction." 2 8 Furthermore, there are striking differences of opinion as to what should be the legal basis of fair value for rate-making purposes even among the Justices of the Supreme Court as now constituted. F o r instance, Mr. Justice Brandeis is strongly in favor of the adoption of the prudent investment basis, 29 whereas Mr. Justice McReynolds, who delivered the opinion of the Court both in the Southwestern Bell case and in the O'Fallon Railway case, has persistently maintained that current cost of reproduction constitutes an important element of fair value. Mr. Justice Butler, because of his experience as a former railroad attorney, naturally prefers some basis which can easily be identified with judicial definitions. T h e rest of the Justices, it would seem, are not so marked in their alignments, sometimes joining the one side and sometimes the other. Moreover, it should be remembered that even those J u s " 2 7 9 U. S. 461, 487. M Following his famous minority opinion in the Southwestern Bell case, Mr. Justice Brandeis has consistently maintained his position in several later cases: see, for example, his opinion in Georgia Ry. & Power Co. v. R. R. Comm., 262 U. S. 625; his dissenting opinion in McCardle v. Indianapolis Water Co., 272 U. S. 400, 421-425; also his dissenting opinion in the O'Fallon Railway case, 279 U. S. 461, 488-548, and in the more recent Baltimore street railway case, 280 U. S. 234, 255-288.

DEPRECIATION

55

tices who hold different opinions are not always opposed to one another. In support of this assertion, it may be pointed out that Mr. Justice Brandeis, while advocating the prudent investment basis in a separate opinion in the Southwestern Bell case, was able to concur in the result reached in that case by the majority, and also in the result reached in the Bluefield W a t e r case. The Justices who supported Justice Butler in the Bluefield case in rejecting the proposed rate reduction as confiscatory were also able to join Justice Brandeis in sustaining a rate reduction in the Atlanta case. Similarly, Mr. Justice Holmes, who concurred in the dissenting opinion of Mr. Justice Brandeis in the Southwestern Bell case, felt free to cast his vote with the m a j o r ity in the McCardle case while Mr. Justice Brandeis again dissented. W h a t is more, both Mr. Justice Holmes and Mr. Justice Stone joined Mr. Justice Brandeis in taking sharp issue with the majority opinion in the O'Fallon case and in the Baltimore street railway case. Contradictory and inconsistent as it may seem, the Supreme Court, as a whole, wisely avoided a crystallization of the law in ascertaining fair value for ratemaking purposes; each case seems to have been decided in the light of its peculiar circumstances.

Direct Legislative Fixing of Fair Value.

As was shown in

Chapter II, 3 0 in f r a m i n g the railroad valuation act of 1913, the Congress did not set up anything beyond the established judicial rule of fair value described above. There can be no dispute that the doctrine of fair value enunciated by the Supreme Court, however soundly conceived, has made the task of the Interstate Commerce Commission anything but easy. It has been noted that the Commission sought to determine fair value in the O'Fallon case on the basis of reproduction new as of 1914, plus actual investments since then, minus depreciation, " S e e p. IS supra.

56

RAILROAD

VALUATION

but the Supreme Court said that the Commission had not given proper consideration to current reproduction costs as was directed by the Congress. Question was raised by the minority of the Court that Congress did not intend by the Valuation Act or Section 15a to deny the Commission discretion in giving "all relevant evidence such probative force as, in its judgment, the evidence inherently possesses." 31 Following this counsel, it has been suggested that existing laws be clarified by an amendment providing that the Commission in determining fair value for rate-making and recapture purposes shall give such weight as it may deem proper or expedient to any factor or element of value that is pertinent to the issue at hand. 32 In order to bring certainty into a more or less uncertain situation, Professor Bonbright has proposed that valuations of existing properties be made in accordance with the "law of the land," and such initial valuations when once determined shall remain unchanged regardless of price changes or reproduction costs. Added to the initial valuation shall be the actual and reasonable cost of new properties subject to the Commission's accounting control. 33 This proposal would require positive legislation and a relaxing of the policy of judicial direction on the part of the Commission. But would such a legislative act, if enacted, be constitutional? It is a matter of record that values of properties fluctuate. The Supreme Court has consistently held that if the value of the property increases the company is entitled to the benefit, and if it decreases the company must bear the loss,34 and that what " 2 7 9 U. S. 491, 496. " See J. F. Christ, "The Supreme Court Decision in the O'Fallon Case," The Journal of Business of the University of Chicago, July, 1929, p. 247. " For his able discussion see American Economic Review, Supplement, 1928, pp. 181-205. ** See p. 35 suf>ra.

DEPRECIATION

57

a company is entitled to ask for is a fair return upon the fair value of the property devoted to the public service at the time the inquiry is made. The Supreme Court of the United States does not often or lightly change its approved policy. Those who have invested their money in existing properties might look upon the permanent fixation of values as ex post facto legislation and hence unconstitutional. With regard to future investments made subsequent to the adoption of the prudent investment basis, the same constitutional objection as to the treatment of past investments might not apply, because future investors would be fully aware that there was to be no adjustment in values whatever might happen to current reproduction costs. Thus it is asserted: "All the decisions requiring the 'consideration' of reproduction cost have been in cases where it has been proposed to cut down the value which the company's property has already attained ; the court has never indicated that it will hold 'confiscatory' regulations which prevent the value of a company's property from increasing in the future." 35 Résumé—the Future Rate Base. In summing up the discussion of "fair value," it may first be noted that, in the duel between original cost and current cost of reproduction, many have sought to pursue the niceties of their favorite doctrines without attempting to link them with the pressing and everchanging problems which confront industrial society. One group, in stressing competitive theory and free enterprise, tend to overlook the peculiar nature and paramount importance of properties devoted to the public service. Another group, in in" R. American Goddard, Harvard

L. Hale, "Recent Decisions on Valuation and Rate-Making," Economic Review, June, 1924, p. 267 ; also compare Edwin C. "The Evolution of Cost of Reproduction as the Rate Base," Law Review, March, 1928, pp. 588-589.

58

RAILROAD

VALUATION

sisting upon a rigid mathematical formula of valuation fixed once for all, seem to reverse the thesis by sacrificing the end to the means. In fact, the regulatory authorities have to deal with a multitude of cases and problems affected by a vast variety of considerations. T h i s is especially true in the field of semicompetitive industries like steam railroads as compared with local, monopolistic utilities. It is often argued that the merit of the original cost basis lies in its simplicity and definiteness and in the resulting stability of rates, whereas current reproduction cost changing as prices change requires incessant rate adjustments and makes effective regulation well-nigh impossible. The truth is that any price revolution such as occurred after the war makes it necessary to adjust rates to an entirely new level of operating expenses and of "wages of capital," even if the return is based strictly on original investment. A reasonable theory of using current reproduction cost as one of the factors of fair value contemplates nothing more than such infrequent and reasonable rate adjustments as may be required from time to time by violent price changes. This is so because ordinarily both the railroads and the public are in favor of a reasonable stability of rates and charges. There has been, furthermore, an unwarranted fear, or rather a misconception, especially among the anti-reproductionists, about the possible effect of an increased valuation basis upon rates. Even if, a f t e r equitable consideration of the enhanced costs of reproduction, the aggregate value of the railroads as a whole should amount to a sum, let us say, higher by 25 per cent or 50 per cent than the Commission's tentative valuation used in E x Parte 74 plus additional investments since then, the theoretical increase in rates, assuming that the traffic would bear it, would not be anything like 25 per cent or 50

DEPRECIATION

59

per cent above the present rate level as is commonly supposed. Railroad operating expenses and taxes now take about 75 per cent of total operating revenues, leaving only about 25 per cent as the return on the value of railroad property. Therefore, a 6}4 P e r c e n t increase in rates would provide a 25 per cent increase in net railway operating income, and a 1 2 ^ per cent increase in rates would provide a 50 per cent increase in net railway operating income, although the competitive situation probably would preclude even such moderate increases in rates. Moreover, it should be remembered that the advocates of the two rival valuation bases, the original cost and cost of reproduction, have changed places since the 90's. A generation ago, the railroads, hit by declining prices, favored original cost, while the defenders of popular rights argued for current cost of reproduction. Mounting prices since the war have caused the adversaries to change their swords. Will they change back again in an era of declining prices? It is interesting to note that the theory of original investment which the railroads once espoused is already enlisting the favor of certain utilities whose properties have been largely constructed at post-war prices. It is this human inconsistency and the constantly recurring conflict of interest in valuation and rate-making that lead many to advocate the establishment of a fixed rate base. E f f o r t has been made in the Congress to sustain by legislation the Commission's valuation formula in the O'Fallon case which represents a liberalized estimate of original investment. 36 It is questionable, however, whether such legislation or any other mandatory fixed rate base could be sustained against constitutional attacks a f t e r a substantial shift in prices. Another brand of thought is to " S e e S. J. Res. 104, introduced by Senator Howell, 71st Congress, 2nd Session; also the Howell bill (S. 4005), 71 Cong., 2nd Sess.

60

RAILROAD

VALUATION

establish a fixed rate base through mutual agreement for a limited number of years, thus leaving the way open f o r such periodical revision as may be required by rising or falling prices. 37 Even in this respect, there is a dispute as to its practical expediency. Meanwhile, it may be observed that "present value" is the established doctrine of a fair rate base which must be determined in accordance with the law of the land, with fairness to both the railroads and the public they serve. ** Such legislation as applied to local utilities has been suggested by the majority of the Special Legislative Commission on the Revision of the Public Service Commission Law of N e w York.

PART I I T H E

R A T E

O F

CHAPTER

R E T U R N

V

ECONOMIC ANALYSIS OF FAIR R E T U R N

I

M P O R T A N C E OF R A T E OF R E T U R N

OVERLOOKED.

Valuation

or the ascertainment of an equitable rate base is only one of the perplexities arising out of the present statutory rule of rate-making. The regulating authorities or the Commission must also determine f r o m time to time what rate of return should be allowed the railroads. The rate of return means a certain per centum upon a certain designated valuation basis; it is the amount (per hundred per a n n u m ) of "net railway operating income" in relation to the rate base. T h e justice of return regulation or the adequacy of railroad earnings depends upon not only the rate base determined but also the rate of return allowed thereon. It is a joint product. So, these two factors must be considered together; else what may be gained through valuation basis may be easily vitiated by the offhand manner in which the rate of return is determined and vice versa. Heretofore, however, the problem of what constitutes a fair rate of return has been relegated to a place of secondary importance. F o r example, an inclusion or a deduction of $100,000 to or f r o m a valuation basis, let us say, $24,000,000, may be considered by a railroad highly important, whereas an item such as of 1 per cent in the rate of return receives little or no attention. Yet, as a matter of fact, an increase of J4 1 per cent in a rate of return of 6 per cent per annum on a valuation basis of $24,000,000 would be equivalent to an increase of exactly $1,000,000 [ 6in1 ] the rate base. W h e n this is

62

RAILROAD

VALUATION

realized, the importance of the problem of rate of return becomes at once evident. The Analysis of Fair Return. T o arrive at a clear understanding of the fundamental forces, governing the ascertainment of rate of return, it is necessary first to analyze fair return into its component parts and then to consider the economic characteristics peculiar to each. Chemists can tell us accurately the exact composition of water, iron, gold, and other substances. But no such scientific analysis can be made of a fair return to the railroads. The best we could do is to draw only conceptual lines separating its economic elements. According to strict economic analysis, a fair return is composed of pure interest on capital and some profits for risk-taking and efficient management. One writer has analyzed it into the four elements of pure interest, compensation for risk, compensation for attention, and prospects for extra profits. 1 Others, however, have seldom troubled themselves with such minute classifications. They simply say that a fair return is a lump sum allowance for interest charges as well as for profits; after paying interest charges, whatever is left constitutes the profits of the corporation in a legal and accounting sense.2 As a business concept, this is believed to be a correct interpretation. But, because of the loose usage of the terms, interest and profits, there has been a great deal of confusion between them. Quite in line with this general analysis of fair return, the courts and commissions have also held or implied that interest and profits are the principal elements involved in a fair return. Thus the Wisconsin Railroad Commission said: "The courts hold, in substance, that the investor is entitled to a reasonable return or reward for his 1 1

H. Barker, Public Utility Rates, pp. 96-106. Cf. M. G. Glaeser, Outlines of Public Utility

Economics,

p. 408.

ANALYSIS

OF FAIR

RETURN

63

enterprise, his risk, and the devotion of his capital to the service of the public. The return for profit, under this definition, appears to include interest, or the share of the investor, as well as profits, or the share of the entrepreneur. Those who carry on the business may be investors as well as the organizers and directors of the factors of production, but this does not necessarily imply that interest and profits should not be kept separate . . . . it is the duty of the commission, in passing upon matters in which interest and profits are involved, to determine in each particular case how much is to be allowed for each of these elements."3 This analysis of fair return was repeated in several later cases by the same commission. It may be noted that the elements of a fair return, though not fixed by law, must necessarily be influenced by general economic forces as well as by the conditions in each particular case. It seems best that we should make a more detailed analysis of these economic elements in an effort to show how and to what extent such an approach to the problem can be actually applied to the determination of a fair rate of return for railroad investors. We begin with interest. Interest as an Element of Fair Return. Interest may be explicit or implicit; the former is the type of interest explicitly stated in definite contractual relations, such as, promissory notes, mortgages, bonds, etc., while the latter refers to the interest element of the total financial return to an enterpriser who furnishes some capital of his own and assumes the responsibility of directing the business. In the long run, an implicit interest is just as important and necessary as an explicit one, for, other'Hill

et. al v. Antigo

Water

Co., 3 W . R. C. R . 623, 751, 764.

64

RAILROAD

VALUATION

wise, no one would be willing to continue to devote his capital to his own business. Instead, he would lend it out and get an explicit interest elsewhere. Inasmuch as capital is indispensable to the roundabout method of production and since savings are scarce as compared with the demand for them, capital commands a price which must be paid.4 Whether it should be treated as an item of operating expenses or as an element of return is simply a matter of convenience in accounting, which in no way changes the burden of the rate-payers in the long run. N o matter which way it is provided it must be provided. Since the angle from which the problem is approached is not the same in rate regulation and in industrial cost accounting, "interest," in the words of Hartman, "has been uniformly excluded from operating expenses and treated as a part of the return by commissions and courts." 8 The Rate of Interest. It is easier to assert that an element of interest should be included in a fair return to railroad investors than to decide how much or what rate of interest should be included. Considerable confusion exists as to what constitutes a fair rate of interest. Indeed, there are several rates of interest that may be discerned. In a strictly economic sense, when we say that a fair return to railroad investors should include a fair rate of interest on capital, it is, of course, the rate of pure interest or the payment for the use of capital per se that we really mean or that we should mean. Pure interest excludes all payments for risk and management. When and where perfect competition exists the 4 "Interest is justifiable and necessary, because of the importance of capital in production, and because capital cannot be had for such purposes unless something is paid for its use." Hill et. al. v. Antigo Water Co., 3 W. R. C. R. 623, 751. • H. H. Hartman, Fair Value, p. 224.

ANALYSIS

OF FAIR

RETURN

65

rate of pure interest as such would tend to be the same on all investments. But, in a highly dynamic industrial society such as ours, there is no investment that is absolutely free from risk, attention and other burdens accompanying investment. Hence, the rate of pure interest, if it exists at all, is most difficult to ascertain. The rate of interest usually offered by savings banks represents perhaps the nearest approach to the rate of pure interest that is practically ascertainable. Like other industries, the railroads must be allowed in their return at least a prevailing rate of pure interest for the use of their capital devoted to public service. It is frequently asserted that the capital invested in the railroad industry should be allowed a going or competitive rate of interest, speaking as though there were only one uniform or general rate of interest. This statement may be true but not convincing if by that rate of interest is meant the rate actually paid in the market. There are different rates of interest in different markets—such as, the call loan market, the commercial paper market, the market for short-term notes, the market for long term bonds, the farm mortgage loan market, and the like. Each market has its own rate of interest, according to the demand for and supply of its particular type of investment, the risk being involved, and the amount of work required in placing and looking a f t e r the investment. It should be particularly noted, therefore, that the rate of interest actually paid in the markets includes not only pure interest for the use of capital per se but also payments for the risk of loss and f o r the administrative expenses in the lending of such capital. F o r example, a mortgage may bear interest at 5 per cent and may be sold at par. But its rate of pure interest is probably about 3 or per cent, while 2 per cent or \ y 2 per cent may cover management and risks. The total

66

RAILROAD

VALUATION

amount of interest paid is called gross interest as distinguished from pure interest. Factors Affecting the Rate of Gross Interest. W h a t is a necessary rate of interest, that is, gross interest, in each particular industry depends upon numerous factors. So far as pure interest is concerned, it is bound to be influenced by the total supply of and the total demand for the loanable capital in the general market; when demand is greater than supply the rate tends to be high, while the rate tends to be low if supply is greater than demand. Risk is another factor affecting the rate of interest. Take the railroad industry. Generally stated, there are three kinds of risks, industrial, regulatory, and managerial. Industrial risks relate to the character of the traffic, stable or speculative, and all external changes, such as, changes in the arts of transportation affecting the supply of and the demand for the service rendered and the changes of the community served. Among the regulatory risks are the uncertainties of regulation itself, whether strict or liberal, unreasonable methods of valuation, heavy taxes, rigid requirements for non-productive investment, and other burdensome measures. Managerial risks may be due to bad judgment, poor location, improper construction, unsound financial structure, inefficient management and other factors which are more or less confined to individual managements. As a rule, the rate of interest required in bidding for capital in the open market varies directly as the degree or amount of risks involved. In determining the rate of interest we should also consider certain administrative costs of obtaining the capital. They are principally the difference between the price received by the corporation and the price at which the investment banker offers the securities to the investor, and other incidental expenses,

ANALYSIS

OF FAIR

RETURN

67

such as costs of preparing, printing and issuing securities, etc. A Reasonable Rate of Interest. In some early rate cases, the legal rate of interest figured prominently. 6 The reason was that so long as the investor was permitted to earn at least the usual and legal rate of interest where he was situated, the issue of confiscation was not involved. However, it would be more correct to say that, for lack of a definite standard of reasonableness, the legal rate of interest was merely considered as a minimum rate of return which was necessary to escape confiscation. In fact, the legal rate of interest varies from state to state and is of significance only as a maximum limit against usury. It is obvious that, in determining a reasonable rate of interest for the railroad capital, neither the highest rate of interest that may be sanctioned by law nor the rate of pure interest which excludes all payments for risk and management can be adopted as a practical standard. A reasonable rate of interest on railroad capital, it would seem, lies somewhere between them. Nor is it the rate paid on government bonds or offered by government enterprises, because governments can borrow funds at much lower rates than the railroads, and government enterprises are not sufficiently numerous to provide a safe standard. Bearing this in mind, it may be asserted that a reasonable rate of interest to be allowed on railroad capital should be a rate such as the capital would bring from its possible alternative employments with the same risks, attention, and administrative expenses involved in making railroad investment. Business Profits and Railroad Enterprisers. Turning to the profit element involved in a fair return, it is necessary first to ascertain the function of railroad enterprisers. According to economists, the function of a business enterpriser, whether ' F o r detailed discussion see R. H. Whitten, Valuation of Public Corf orations, 656ff.

Service

68

RAILROAD

VALUATION

individual or corporate, must be found in something, which no one else but himself can perform. 7 As an enterpriser, he does not furnish either the capital or the labor himself, but simply brings them together, assuming responsibility and determining the general policies of the enterprise thus established. 8 In other words, he employs other factors of production simply as his auxiliaries; he is alone responsible for the ultimate product produced or service rendered and subjects himself to whatever consequences may result from the enterprise as a whole. Since the advent of regulation, the railroad enterprisers may have become less important than those in competitive or unregulated industries, but the ultimate control and risk-bearing must, nevertheless, fall on the enterprisers, that is, those railroad stockholders who choose the board of directors and delegate to it the power of selecting active managing officials and formulating general policies. It is because of this function that the railroad enterprisers are entitled to some profits to be included in a fair return. The Nature of Railroad Profits. As a matter of practice, it is to be noted, a business enterpriser usually and, perhaps, of necessity, puts some capital and labor of his own into his business. His incomes, therefore, are of a composite character. In railroad industry, as in most corporate enterprises, the stockholders are enterpriser-capitalists, although the work of active management is generally rewarded by wages and salaries. Thus, the total income to the stockholders consists of interest on their capital and some profits for their assuming responsibilities and risks, including no wages or salaries of active management; 8 all payments made to executive officers are treated ' F. M. Taylor, Principles of Economics, p. 493 (192S). * R. T. Bye, Principles of Economics, p. 436 (1924). ' I n practical adjudication of fair return or more particularly profit element in the return, the following quotation may be noted : "The high salaries usually paid to executive officers of our

the

ANALYSIS

OF FAIR

RETURN

69

as operating expenses which, according to law, must be deducted before arriving at a net railway operating income. Further, a distinction must be made between gross profits and pure profits to an enterpriser-capitalist. T h e former includes both the share of interest and the share of profits, whereas the latter excludes the share of interest. However, since the share of interest on his capital is inseparably connected with his short-run profits, no such separation can be made in practice. Railroad enterprisers usually take as their profits or gross profits the excess of the credits over the debits to income, as reflected in the operating revenues, operating expenses, tax accruals, uncollectable revenues, equipment rents, joint facilities rents, and fixed charges on funded debts. Stockholders in a given railroad, paying a 7 per cent dividend, would ordinarily think of the road as yielding that much profits rather than 5 per cent interest on their capital and 2 per cent profits. In the long run, however, they are not unmindful of their separate influences ; over longer periods, the railroad's income must make the stockholders a return at least equal to, if not more than, a reasonable rate of interest. Concerning this reasonable rate of interest, what we have said of the borrowed capital will equally apply to the capital owned and invested by the enterprisers themselves. Such being the case, it would seem that the problem left now is to explain and ascertain the element of pure profits to which the railroad enterprisers are entitled. So many theories of profits have been put forward that even a hurried discussion can be given only to some of the main divisions, which, to be sure, large public service companies o f t e n include an element of income which might properly be considered a portion of the fair return. On this account, when dividends or pure profits to the principal risk-taking elements—the stockholders—are considered, commissions must carefully look into the salary situation because a lack in the one is sometimes made up by a surplus in the other." M. G. Glaeser, "Outlines of Public Utility Economics," p. 412.

70

RAILROAD

VALUATION

are not mutually exclusive but represent differences of emphasis rather than different theories. Economic Theories of Profits. Before the industrial revolution when the enterpriser in a modern sense was unknown, business profits as embodied in the customary price of a commodity, were generally regarded as a reward for the labor and effort spent in production. Classical economists, though vague and different in their explanations, seldom failed to agree that minimum profits entered into long-run supply prices. Stressing this classical view of a minimum profits, many are of the opinion that an enterpriser's reward resembles very closely a laborer's income. While recognizing the difference between business profits and wages, some economists have suggested that the simplest way is to regard them all as returns for labor. 10 Profits are needed to induce an enterpriser to continue his production. 11 So long as some men have better organizing ability and better judgment than others, profits will continue to emerge. 12 Thus profits are regarded as service or efficiency income; they enter into the cost of production in the long run and indirectly determine the price by limiting the supply. No doubt, some relation exists between an enterpriser's profits and his service or efficiency, but this does not seem adequate to ascertain the share of profits to be allowed the railroads managed entirely by salaried officials and employees. In contrast to the efficiency theory is the surplus or dynamic theory of profits. As in the case of land rent, business profits are regarded by some as surpluses measured from the pricedetermining margin of production.13 They are the result of dynamic changes or frictions of industrial society. In a static F. R. "F. " F. 10

11

W. Taussig, Principles of Economics, II, 185. T. Ely, Outlines of Economics, p. 441. A. Fetter, Principles of Economics, p. 291. A. Walker, Political Economy, p. 205.

ANALYSIS

OF FAIR

RETURN

71

state when perfect competition prevails, each factor of production would simply get what it produces and "pure business profit," in the words of Professor J. B. Clark, "would be annihilated as soon as it could be created." 14 Business profits have variously been described as the result of fluctuations in market values, 15 of monopoly and improvements, 16 or of lower costs attained by improved process of production. 17 The surplus theory of profits rightly emphasizes the existence of enormous profits which are more or less due to chance, luck or natural conditions and which the labor or efficiency theory of profits seems to ignore. But it does not seem justifiable to regard as surpluses the differential profits resulting from individual efficiency and honest economic effort, although the surplus theory of profits may lend plausibility to the regulation of railroad excess income—a subject which will be discussed later. Somewhat similar and somewhat opposed to the dynamic theory of profits is the version that profit is a necessary reward for risks undergone by the enterprisers. 18 In an ever-changing dynamic society, an enterpriser is, of necessity, a speculator, a risk bearer; he advances wages to his laborers, pays interests on his borrowed capital and subjects himself to whatever losses or profits may result. Unless some reward be paid on this score, it is believed that no one would be willing or could be induced to bear such risks. Like the surplus or dynamic theory, the "reward-for-risk" theory of profits regards the business profit as a residual income, but attempts to identify it as a direct reward for risks actually taken by the enterprisers. Thus, in a way it tries to establish a direct connection between the 14

J. B. Clark, The Distribution of Wealth, p. 410. " E. R. A. Seligman, Principles of Economics, p. 354. * H. R. Seager, Introduction to Economics, 3rd ed.( p. 182. " S. N. Patten, The Theory of Prosperity, p. 126. " S e e especially F. B. Hawley, "The Risk Theory of Profit," 15 Quarterly Journal of Economics, p. 610.

72

RAILROAD

VALUATION

degree of risk in a given industry and the average profits prevailing in that industry. In other words, the greater the risk in any particular industry, the larger the profits must be in that industry, for otherwise the enterprisers would not assume the risks. The "reward-for-risk" theory of profits is not free from defects as a complete explanation of pure business profits, but it merits consideration because it connects business profits with the uncertainties of an enterpriser's position and sheds some light upon the general proposition that the profit element included in a fair return to the railroads must equal that earned by other industries having the same degree or amount of risk. The Theory of Imperfect Competition and Uncertainty. It is true that some reward is necessary for risk-taking as explained by the "reward-for-risk" theory. It is doubtful if there is any close relation between the profits of an enterpriser or a group of enterprisers and the risks actually undergone. However risky a given industry may be, the average profits would be quite moderate if the total profits were balanced against the total losses in that industry. Hence, a more satisfactory theory of profits is that of imperfect-competition and uncertainty. While assigning an important place to risk as a determinant of pure business profits, this theory introduces imperfect-competition as an equally important factor. Thus Professor Knight says: "On the one hand, profit is in fact bound up in economic changes (but because change is the condition of uncertainty), and on the other, it is clearly the result of risk, or what good usage calls such, but only of a unique kind of risk, which is not susceptible of measurement." 18 " F. H. Knight, Risk, Uncertainty and Profits, p. 458.

ANALYSIS

OF FAIR

RETURN

73

In other words, business profits are merely prizes or bonuses which are obtainable only in the event of success or good luck. It is the hope of getting a prize that draws the contestants to a contest. Business profits being very irregular and unpredictable, the theory of imperfect-competition and uncertainty focusses attention on individual profits rather than average profits in a given industry or group of industries. 20 Business Profits a Complex Product. Business risks, economic changes and uncertainties being many and varied, business profits are not a homogeneous, but a very complex product. A one-sided explanation of how profits may arise furnishes no safe criterion to ascertain or to regulate railroad profits. Like other forms of income, profits may be earned or unearned. Profits may be earned by individual efforts or dynamic efficiency in production, buying, selling and finance. They appear either in the reduction of costs of production or in the improvement of products or services. Unearned profits, on the other hand, may be due to luck, chance or illegitimate activities; they appear more in increased prices at which the products or services are sold than in reduced costs of production. Earned profits may be justified by either the efficiency theory or the "reward-for-risk" theory as we have explained, whereas unearned profits should be interpreted in the light of the surplus theory or the theory of imperfect competition and uncertainty. Similarly, there are business losses as well as business profits, having their common origin in business risks, changes and uncertainties. Business losses are sometimes regarded as negative profits; indeed, profits and losses are but two phases of one fact. Losses or negative profits, too, may be earned or

" Cf. R. T . Bye, Principles

of Economics,

p. 445.

74

RAILROAD

VALUATION

unearned.21 Earned losses are the result of inefficiency or inability to control risks which are controllable, while unearned losses are chiefly due to forces over which an enterpriser has no control. It would seem that the ideal system of return regulation would be one which seeks to eliminate both unearned profits and unearned losses and would leave them where they belong if earned. This question will be of importance when we come to discuss the recapture of excess income and the equalization of railroad earnings. The Rate of Profits Difficult to Determine. With this general examination of current theories of profits we return to the problem of ascertaining the share of profits to be allowed in a fair return to railroad investors. In view of the various theories examined and particularly the theory of imperfectcompetition and uncertainties, it seems extremely difficult to ascertain the rate of profits. It is a matter of common observation not only that different industries cannot expect the same rate of profits, but that different companies within the same industry may yield entirely different rates of profits in different places. Thus it is asserted: "The rate of profits depends upon the supply of business capacity and initiative, the risks involved, the nature of the undertakings, and many other conditions. These rates therefore vary as between the different industries and the different classes of service. They even vary as between the various public utilities in the same place, as well as often also between like utilities in different localities."22 In the railroad field, as in other industries, profits are ever present but most uncertain. They are enjoyed by some " C f . R. T. Bye and W. W. Hewett, Applied Economics, p. 532. "Superior Commercial Club v. Superior Water, Light and Power 11 W. R. C. R. 704, 759.

Co.,

ANALYSIS

OF FAIR

RETURN

75

fortunate roads always, by some quite often, by others only once in a while, and by still others not at all. Furthermore, the diversity and uncertainty of railroad profits year in and year out must be explained in terms of business cycles, a subject too complicated for us to enter upon here at length. Suffice it to say that, during periods of prosperity, prices rise, traffic increase and profits grow surprisingly, while wages and interest (except on new loans) remain about the same. When business depression comes, prices fall, traffic decrease, wages and interest will not decrease as rapidly but profits shrink more rapidly and may be reduced even to a negative quantity—that is, to losses. While it is generally believed that because of competitive biddings for the enterprisers' service, the rates of business profits in different industries are constantly tending toward equality, thus resulting in an ordinary rate of profits in the long run, there can be no such perfect equality in a highly dynamic society such as ours. At any given time we will find that some business concerns are reaping enormous profits and others are kept going simply by the prospects of making profits or not losing the capital already invested in the business. T o quote Professor David Friday: "The most that can be said for normality of profit is that the amount of capital that earns the average of profit will remain a constant percentage of all capital, also that the amount of capital that earns less than or more than the average remains about the same one year with the other." 23 A Reasonable Rate of Profits. This brings us to a consideration of a reasonable rate of profits to be included in a fair return for the railroads as a whole. Doubt may arise as " David Friday, Profits, Wages and Prices, p. 45.

76

RAILROAD

VALUATION

to the existence or size of a pure business profits, after all losses are balanced against all profits of the enterpriser class." But there seems to be little warrant for the contention that net business profits tend to be reduced to nothing in the modern industrial society.2® So long as the system of private ownership and operation continues, a reasonable rate of profits must be allowed in a fair return for the railroads. It may be, as many would argue, that in the fields of regulated industries, such as railroads, where the risks are usually moderate, an enormously high rate of profits is not necessary. But it should be remembered that it is the enterpriser function of railroad investors that has brought into being and maintained for the public the gigantic American railway net. Their services and accomplishment are worthy of recognition and should be given appropriate reward in order to promote efficiency, economy and progressiveness; so that energy, enterprise, and executive ability may not disappear from this field. However, we are again on controversial ground, when we consider the rate of profits to be allowed. It will be recalled that a fair return, according to pure economic analysis, consists of pure interest on capital and some profits to reward for risk and efficiency. But, as we have previously shown,26 part of the reward for risk has already been included in a reasonable rate of interest on railroad capital, that is, gross interest as distinguished from pure interest or interest per se. So, a reasonable rate of profits in a fair rate of return allowed the railroads, should constitute a reward for efficiency and a part of the reward for the risks of the railroad * "Our statistical data are not sufficient to permit of anything approaching an exact balancing of total profits against total losses. But we may at least hazard the guess that on the whole business losses are not far short of business profit." Fairchild, Elementary Economics, II, 275. " Cf. David Friday, op. cit., p. 98. " See p. 67 supra.

ANALYSIS

OF FAIR

RETURN

77

enterprise. As to how a reasonable rate of profits should be determined, writers seldom agree. One has asserted: "It (the rate of profit) cannot be strictly a percentage on capital, since it is remuneration for services other than those involved in the supply of capital. Still it is true that an enterpriser's activity is to a large extent proportional to the amount of capital that he handles." 27 Another writer has observed: "The proper earning should be the cost of service, including a going interest charge on the entire investment plus a reasonable profit on the total cost." 28 According to the same author, 2 9 a reasonable rate of profit in a fair return to all utilities may be expressed as " 1 0 r C 7 / 8 " ; r representing the borrowing interest rate and C the annual operating cost excluding fixed charges but including depreciation allowance. 30 However, according to the same authority, both coefficient 10 and exponent in the equation are given with diffidence and gross income may be substituted f o r operating cost, the implication being that a profit rate, conditioned by the actual borrowing interest rate, should grow less with the increase of business done, while the actual money profits grow larger as a quantum, and that if operating cost is used in the calculation the regulating authorities should see to it that operating costs are not inflated. 17 R. A. Lehfeldt, "Analysis of Profit," Journal of Political Economy, X X X I I I 291 28 W.' G. Raymond, The Public and Its Utilities, p. 288. M W . G. Raymond, What Is Fair, pp. 116-118. " Illustrations of the equation may be found in a separate article by Dr. Raymond, contributed to Railway Age, L X I V , 506.

78

RAILROAD

VALUATION

It seems clear that a reasonable rate of profits to be allowed the railroads can hardly be so determined, especially in view of the fact that a railway fair return is to be computed on the aggregate value of the property of all carriers as a whole or in groups. It is again a matter of sound judgment and observation. A reasonable rate of profits in a fair return for the railroads can be determined only by a consideration of the risks involved and the standard of efficiency to be expected in the railroad field, and by a careful study of the normal rate of profits usually anticipated and realized in other industries incurring approximately the same risk and operating under substantially similar circumstances. In short, a reasonable rate of profits should be high enough to attract business enterprise and executive abilities into the railroad field in fair rivalry with other industries. Recapitulation of Elements of Fair Return. T o sum up: a fair return in an economic sense includes pure interest on capital and profits to compensate for risk and efficiency. Pure interest or interest proper is paid for the use of capital per se. The rate of pure interest is probably not far from 3 per cent, a rate usually paid on savings bank deposits. In practice, however, no interest paid on capital is free f r o m admixture of some payments for risks and administrative costs in connection with making and attending to investments. F o r fairly good industrial securities, the average rate of interest paid is probably somewhere between 4 and 5 per cent which is to cover pure interest and at the same time to compensate f o r risks and administrative costs in connection therewith. So, a reasonable rate of interest in a fair return allowed the investors in railroad properties should be the prevailing rate f r o m other investments where the risks and administrative costs are found to be about the same as those accompanying railroad investments.

ANALYSIS

OF FAIR

RETURN

79

Profits are paid primarily for the enterpriser function of the investors, viz., the taking of risk and responsibilities. All railroad enterprises are also capitalists and their profits and interest are inseparably connected. Hence, we must distinguish pure profits from gross profits. Pure profits should include only the reward for their enterpriser function, while gross profits consist of pure profits as well as interest on capital employed. In the long run, the gross profits to railroad enterprisers should at least equal a reasonable rate of interest on their capital, else, they will withdraw their capital and lend it out if possible. As to the share of pure profits, one is less certain and is often confused by its peculiar, complex and uncertain characteristics. Many doubt whether pure profits exist as a positive quantity, the assumption being that profit-makers simply get what others lose. Beside, there is a confusion between the part of "reward-for-risk" included in gross interest and that part of "reward-for-risk" which should be included in pure profits. For these reasons, the share of pure profits is either totally omitted or counted twice. However that may be, a reasonable rate of profits should be allowed in a fair return for the railroads as a whole, considering especially the strategic importance of railroad service in commerce and industry. The rate to be allowed should not be higher than is necessary but must be high enough to attract business enterprise, executive ability, genius and initiative to the railroads and to hold them there. It follows that a fair return to railroad investors should include the element of pure interest, payments for risks and administrative costs in connection with making and looking after the investment and some profits to compensate for the enterpriser function of railroad investors. But, so far as individual railroads are concerned, their share of profits may be a

80

RAILROAD

VALUATION

positive or a negative quantity, may be large or small, depending upon the risk-bearing ability and efficiency of their management. It is a contingent reward. Under ordinary conditions, fixed-income investors, such as bondholders, who cannot participate in increased profits or excess earnings when earned, should receive every year a reasonable rate of interest on their capital. On the other hand, the railroad enterprisers, that is the stockholders, may receive more or less than that reasonable rate of interest on their investment, their income being conditioned by the quantity of pure profits, either large or small, whether positive or negative, as the case may be. At any particular time, the interest element on an enterpriser's capital is inseparably connected with his short-run business profits, but the interest and profits proper should not be confused in an analysis of a fair return to be allowed the railroads in the long run.

CHAPTER

VI

CRITERIA OF A FAIR RATE OF RETURN of the economic elements of fair return has included a theoretical discussion. A s we shall later see, such an analysis is of great importance and connects itself closely with practical considerations in determining the rate of return f o r public service industries. In practice, of course, no separation is made between interest on capital and profits to cover risks and to compensate f o r efficiency. It is a total rate of return sufficiently high to cover all these elements combined that must be determined by the regulating authorities. It is the purpose of this chapter to study the rate of return as a whole and the various criteria or considerations affecting the same. H E FOREGOING A N A L Y S I S

In one of the earliest and most important cases since the decision of S m y t h v. Ames, the United States Supreme Court enunciated the following doctrine on the rate of r e t u r n : "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 compensation 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 business 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 matters which in some cases might also be properly taken into account in determining the rate which an investor might propyl]

82

RAILROAD

VALUATION

erly expect or hope to receive and which he would be entitled to without legislative interference." 1 It appears that the determination of rate of return is a specific problem in each particular case; it depends upon circumstances, locality and time. A m o n g other considerations are the methods of valuation used; the extent to which the cost of promotion and financing has been capitalized, the extent to which the elements of going value have been included in the rate base, the extent to which changes in the purchasing power of money have been taken into account and reflected in valuation, the extent to which the amortization of capital exhausted through depreciation or due to the limited life of service is taken care of. A Rate of Return to Attract Capital. A s we have previously shown, one of the most important considerations is that a rate of return must be high enough to attract capital. In this connection, it is significant to note the pronouncement of Mr. Justice Butler in the Bluefield case: "The return should be reasonably sufficient to assure confidence in the financial soundness of the utility and should be adequate, under efficient and economical management, to maintain and support its credit and enable it to raise the money necessary for the proper discharge of its public duties." 8 Negatively stated, a fair rate of return must not be so meager as to repel investment in the industry. Indeed, the procurement of new capital is the crux of the whole problem of the regulation of railroad financial return. Railroads, like all other industries, always need capital and must have capital for 1 Wilcox v. Consolidated Gas Co., 212 U. S. 19, 48-49 (1909). •262 U. S. 679, 693.

A FAIR RATE

OF

83

RETURN

upkeep and expansion. It is a matter of record that the railroads in the United States have during the last t w o decades spent an average of more than $500,000,000 a year f o r betterments and additions. 3 In general, there are two sources where the railroads can get needed capital: one is their surplus earnings and the other the investment market. They can get the capital from the latter source only if and when their earnings are so satisfactory as to inspire confidence of prospective investors. Financial Structure and Fair Rate of Return. In order to support their credit, the rate of return allowed to the railroads must be high enough to provide interest charges and reasonable dividends. But interest and dividends are necessarily related to a financial structure, that is, the proportion of bonds and stocks as related to the sum total of securities outstanding. So, the rate of return tends to vary not only with interest and dividend Interest Rate on Bonds

Ratio of Stocks

Case

Ratio of Bonds

1

è

6%

è

10%

8%

2

i

5à

è

10

71

3

i

S

è

9

7

4

1

5

è

8

61

S

\

6

ì

10

7*

6

§

5*

*

10

7

7

i

S

*

9

6*

8

\

5

\

8

6

Dividend Rate Needed

Average Rate of Return

* Cf. the address by Mr. Daniel Willard, President of the Baltimore and Ohio Railway Company, before the Illinois Chamber of Commerce, October 13, 1927.

84

RAILROAD

VALUATION

rates but also with the proportion of various securities. T o illustrate the effects of various financial structures on the total rate of return, the following table is presented. 4 Assuming, for the sake of argument, that the total capital outstanding in each case is $3,000,000 and assuming also that the capitalization and valuation basis are exactly the same, let us compare case 3 with case 7 and note the rate of return and the amount of earnings that would be required to pay both interest charges and dividends in each case. (Case 3) Financial Structure Bonds $1,500,000 Stocks $1,500,000 Total

$3,000,000

(Case 7) Financial Structure Bonds $2,000,000 Stocks $1,000,000 Total

$3,000,000

Rate 5% 9%

Earnings $ 75,000 $135,000

7%

$210,000

Rate 5% 9%

Earnings $100,000 $ 90,000

6

$190,000

In both cases, the rate of interest and the rate of dividend are identical, but the average rate of return to be allowed on the total capitalization would be 7 per cent with a financial structure of case 3 and 6 1/3 per cent with a financial structure of case 7. The total amount of earnings required would be $210,000 in case 3 as against $190,000 in case 7—a difference of $20,000. From this illustration, it appears that the adequacy of a certain rate of return on a certain valuation or capitalization basis must, of necessity, depend upon the financial structure of the companies. Trading on the Equity. Another aspect of the problem to * See Mayhew v. Kings County Lighting Company, 2 P. S. C. 1st D. N. Y., decided 1911, cited in Whitten's Valuation of Public Service Corporations, p. 701.

A FAIR

RATE

OF

RETURN

85

be brought out here is of even greater importance in the o f a f a i r rate o f return. " t r a d i n g on the equity." 5

fixing

It is known in corporation finance as W h e n a public service corporation

uses b o r r o w e d capital as well as owned capital, it is usually able to b o r r o w at an interest rate l o w e r than the average rate o f return earned on the total investment.

T h e modern system

o f dividing the furnishing of capital between stockholders and bondholders and other creditors, which has been carried so far by the railroads, is doubtless one o f the most important sources o f corporate profits.

B y virtue o f the statutory rule of rate-

making, permitting a f a i r rate o f return on the value of the entire property, there has been an added inducement on the part o f the railroads t o raise capital by selling bonds at a lower rate of interest in order to enhance the profits on the equity o f their capital stock.

T o make this clearer, let us assume that

a certain railroad has a total capitalization of

$300,000,000,

consisting of $200,000,000 bonds with 5 per cent interest and $100,000,000 capital stock and assume also that by coincidence its fair value f o r rate-making purposes is o f the same amount. I f a statutory rate of 7 per cent is allowed on its valuation basis, the amount of earnings, when actually earned,

would

enable the railroad to reap a return o f 11 per cent on its stock. To-wit: Valuation Basis ..$300,000,000 Bonds $200,000,000 Capital Stock . .$100,000,000

7 % 5 % 11%

$21,000,000 $10,000,000 $11,000,000

B y taking a residual position and by assuming the m a j o r element of risk and responsibility, the railroad enterpriser finds 5 "Its origin is f r o m the expression 'equity of redemption,' which describes a m o r t g a g o r ' s right in the property he has mortgaged, that is the right to get back the title he has pledged to m o r t g a g e e as security f o r the capital advanced." W . H . L y o n , Capitalization, p. 50.

86

RAILROAD

VALUATION

it profitable to trade on a thinner equity especially when interest rates are low. A Prudent Financial Structure. Many have contended that the public or the rate payers should take advantage of borrowed capital as far as possible. Dr. W. G. Raymond, one of the leading authorities on utility problems, has graphically demonstrated that a financial structure made up of two-thirds borrowed capital and one-third equity would be most economical.6 While not generally accepted, the principles involved are worthy of further examination. Let us assume that the total amount of capital to be raised by a railroad company is $120,000,000 and that a 4 per cent rate of interest is necessary to raise funds by bond issues. Following the reasoning of Dr. Raymond, it is also assumed that the lender requires a net earning capacity of the borrower twice as large as the interest charges, while the borrower or the owner of the railroad demands for his own capital a rate Case

Ratio of Borrowed Capital

Earnings Demanded by the Lender

Earnings Demanded by the Owner

Total Earnings that Would Satisfy Them All

Rate of Return Needed

1

1

$2,400,000

$7,200,000

$8,400,000

7%

2

i

3,200,000

6,400,000

8,000,000

6?%

3

\

4,800,000

4,800,000

7,200,000

6%

4

I

6,400,000

3,200,000

6,400,000

51%

5

i

7,200,000

2,400,000

7,200,000

6%

NOTE: Earnings to the lender means earnings over and above operating expenses, while, to the owner, earnings should mean net earnings after deducting operating expenses and fixed charges. * For detailed discussion see his The Public and Its Utilities, pp. 283285 inclusive; also L. R. Nash, Economics of Public Utilities, pp. 209-211, where a somewhat similar contention may be found.

A FAIR

RATE

OF

RETURN

87

of compensation of about two times the lender's rate of interest. The following table is complied to show the possible results of the various ratios of borrowed capital, ranging f r o m one-quarter to three-quarters of the amount of $120,000,000. 7 It would seem that the most economical borrowing ratio is two-thirds of the total capital of $120,000,000, for in that event a total earning of $6,400,000 would satisfy both the lender and owner. The leader would receive as his interest an amount of $3,200,000 or exactly 4 per cent of $80,000,000 and would be secured by earnings equivalent to twice the interest charges. And, at the same time, the owner of the railroad would receive two times the lender's interest rate on his own capital, amounting to $3,200,000 or exactly 8 per cent of $40,000,000. But when the borrowing ratio becomes either larger or smaller than two-thirds of the total capital, the total earnings required or the average rate of return needed would invariably be larger. Unfortunately, however, no such rigid borrowing ratio can be assumed or set up as a standard for the railroads. In the absence of absolute guarantee of earnings, fixed charges must be kept within reasonable limits, consistent with the public interest. However economical a certain borrowing ratio may be in theory, the amount of borrowed capital should not be so great as to impose upon the railroad a burden of interest charges that is above, or even equal to, a conservative estimate of the earning power of the railroad under the worst conditions it is likely to meet. A financial structure consisting mainly of borrowed capital is imprudent, because the railroad having such a financial structure is likely to be thrown into receivership by even a slight business depression. Indeed, the proportion of * Compare carefully with the diagram given by Dr. Raymond, op. cit., p. 283.

88

RAILROAD

VALUATION

bonds in railroad capitalization has already grown f a r beyond the 50 per cent which had formerly been considered a prudent and safe ratio in view of the nature of railroad business. The present ratio of funded debt t o railroad capital is about 56 per cent. A n d this is in part due to the fact that a few companies have been able to market stocks on account of the low return and other obstacles. It cannot be overemphasized that in fixing the rate of return a prudent financial structure, not necessarily the most theoretically economical one as has just been described, must be assumed and it is important that the financing of American railroads in the future should not be so largely by the sale of bonds as it has been recently. Cost of Capital and Fair Return. It has long been recognized that the cost of capital is an important point of reference f o r the determination of fair return. Several meanings, however, are attached to the phrase "cost of capital," depending upon which element in the total cost of capital is being emphasized. In a very limited sense, the term "cost of capital" may mean merely the cost of financing, including principally the difference between the price received by the company f o r the securities and the price at which the investment banker offers them to the investors and the expenses incidental to the financing absorbed directly by the company. The total cost of capital ought to mean the cost of financing plus payments in the f o r m of current yields and amortization of discount, if any. T h i s total cost of capital depends upon many factors. Of particular importance are the current rate of interest on capital, the type of securities offered, the volume of financing, the earning capacity and the financial structure of the company, the law and the regulations concerning financing and issuance of securities, and the customary rate of underwriters' profits. In estimating the cost of capital, it cannot be assumed that the cost of borrowed and secured capital is the same as that

A FAIR RATE OF

RETURN

89

of owned and unsecured capital, and it is necessary to recognize the greater uncertainties of the latter class of investment. Nor is a fair rate of return to be allowed on the value of the entire property necessarily the same as the cost of securing capital under present conditions. Furthermore, the rate of return as fixed by the Commission does not apply to individual railroads but only to the railroads as a whole or in groups. Evidently, the cost of obtaining capital by any individual railroad cannot be taken as a criterion of the rate of return allowed the railroads as a whole. The disparity between railroad capitalization and valuation for rate-making purposes, divergencies of financial structures, differences in earning power, complex intercorporate relations, and various speculative factors—these add many difficulties to the problem of ascertaining the cost of railroad capital and make it evident that the market rates at which various railroad securities are bought and sold can be of help only after scrupulous and detailed analysis. At any rate, one should not be led to believe that the fair rate of return is the rate at which the railroad industry can borrow capital. Railroad capital consists of not only borrowed capital but owned capital as well. In order to compensate the owned capital, the average rate of return upon railroad investment must be fixed appreciably above the cost of borrowed capital.

A Fair Rate of Return Commensurate

with Risk.

An-

other important criterion which is frequently submitted for determining fair return is that a fair rate of return must equal that earned by other enterprises having the same risk. So long as capital can secure a higher rate of return from competitive employments incurring about the same risk it will not come to the railroad industry. A s a principle, this is true, but it does not lend itself to a precise measurement of what the fair rate of return should be for a particular industry like railroads. There are various kinds of risks; some peculiar to the railroad

90

RAILROAD

VALUATION

industry as a w h o l e , some confined t o individual

companies,

some in c o m m o n w i t h other regulated utilities, a n d still others in c o m m o n w i t h competitive industries. 8

T h e kind o f risk that

particularly concerns the investor is, in the final analysis, the security o f his principal and the security o f his income.

The

security o f his income, in turn, is a question o f the stability as w e l l as the amount o f earnings.

R a i l r o a d earnings are pro-

duced b y rates w h i c h are subject t o r e g u l a t i o n ; and the prim a r y purpose o f regulation is t o control, alter, and t o reduce, if possible, the v a r i o u s risks that are uncontrollable in c o m p e t i t i v e industries.

T h u s , f o r purposes o f comparison, it is difficult

t o k n o w h o w an industry o r a g r o u p o f

industries is t o be

selected as h a v i n g the same risks as the railroads.

Professor

B o n b r i g h t has w r i t t e n : " I t is true that some kind of a balance o f advantages must be preserved between the market

for

railway securities and the market f o r other securities, but it by no means f o l l o w s that these advantages need to be of the same nature in both cases." 9 S e l d o m d o those, w h o t e s t i f y on f a i r return f r o m the standpoint o f risk, present any exhibits s h o w i n g the actual earnings of

other industries subject t o the same risks.

I n d e e d , it is

difficult to learn the actual earnings o f other industries, even if selected, unless w e k n o w :

w h a t valuation bases they

adopt;

w h e t h e r their earnings are computed b e f o r e or a f t e r deducting depreciation

charges;

what

w h e t h e r taxes, especially their actual

financial

and

depreciation

are; what

structures a r e ; w h a t the nature o f

their

economically

taxes, are

policies

deducted;

business and their o p e r a t i n g efficiently

their

income

ratios a r e ; their

and h o w

enterprises

' See p. 66 supra. • Harvard Law Review, March, 1928, 596, 597.

are

honestly, managed.

A FAIR

RATE

OF

91

RETURN

These and other factors of equal importance must be given detailed and scrupulous study before attempting to arrive at a comparable basis. What standard should be adopted to compare the earnings of different industries on the basis of risk? The original risk standard or the present risk standard? In most industries including railroads, there are wide discrepancies in the treatment of different investors who have invested their capital at different times under different conditions. Obviously, it can hardly be assumed that whatever rate of return was considered fair to past investors, in view of original risks, must also be fair to present or prospective investors. Nor is it necessarily true that the rate of return needed to attract capital under present conditions and risks will make unnecessary the consideration of original risks. In general, it should be remembered that unless the original risks were well compensated in past earnings or duly considered in fixing the valuation basis, they must be given equitable consideration for a reasonable period in determining the rate of return. 10 For this reason, the present risk standard is not necessarily controlling as applied to the old capital. From time to time, there should be an adjustment of the rate of return on the entire property so as to attract new capital into the industry under present conditions. It seems probable that in determining the fair rate of return both the initial risks and the present risks should be jointly considered. The Composite Character of the Rate of Return. The rate of return thus determined is necessarily of a composite nature. It was Dr. John Bauer who first separated the discussion of rate of return, as also the rate base, into an initial rate of return 10

708-9.

Compare Whitten, Valuation

for

Public

Service

Corporations,

pp.

92

RAILROAD

VALUATION

on old properties and a rate of return for subsequent investment. 1 1 In substance, he advocates the fixing of a definite rate of return f o r the old properties with regard to past conditions and other considerations so f a r as may be necessary to secure justice to the investors. Once fixed or agreed upon, this initial rate of return would not be changed so long as the properties remained in the valuation basis. The rate of return for future investment should depend upon the actual costs incurred and should correspond to the market conditions at the time. The cost of capital, like the cost of materials and supplies, can be easily determined under the Commission's accounting control and the regulation of security issues. F u n d s secured through bond or note issues would receive a rate of return equal to the cost to the company, while preferred stockholders would be paid a return equal to the rate named in the certificates. In case of successive bond issues, it is f u r ther suggested, the difference between the market rate of interest and the nominal rate of interest would be automatically adjusted through the accumulation of discount or the amortization of premium as the case may be. If common stock is sold, it would be preferable to fix, either by legislation or by an administrative order, a definite rate of dividend thereon. T h i s would be possible because, under the suggested scheme of rate regulation, the income would be virtually assured and risks would vanish. Dr. Bauer's proposal, it seems, would resemble very much service-at-cost plan under which a number of local utilities are operating. It is difficult to evaluate his proposals when practically applied to steam railroads to which he did not refer. While the Transportation Act of 1920 did as far as practicable 11 For a detailed discussion see his Effective Utilities, Chapter X, pp. 253-274 inclusive.

Regulation

of

Public

A FAIR

RATE

OF

RETURN

93

assure the railroads as a whole a fair rate of return, his ingenious scheme is perhaps far in advance of the present possibilities. However that may be, it is not suggested here that two entirely different rates of return should be established separately, one f o r past investors and another for the n e w ; it is only through such mental processes that a fair rate of return can be equitably established. The most important point to be borne in mind is this: The rule that fixes the rate of return on the entire valuation basis in accordance with the past conditions or the present conditions alone would have the same defects that are inherent in the rule that determines the value of a property exclusively by its original cost or by its present cost of reproduction. Fair Rate of Return to Stimulate Efficiency. The incentive to efficiency and progress is another m a j o r force with which the regulating authorities will need to reckon in determining the rate of return. While in the field of public service industries the speculative elements and risks should be eliminated as much as possible, an adequate incentive to economy and efficiency is none the less important. So it is suggested: "The ideal system would be one which would eliminate risks of a purely speculative character or those due to forces over which the investor has no control, and would leave a differential return which would measure the worth of his performance." 12 T h e incentive which a fair return gives to efficiency is twofold. It depends on the rate of return and on its differentials as well. An inadequate rate of return would make it impossible f o r the companies to render adequate and efficient service "J.

M. Clark, Social

Control

of Business,

pp. 369-370.

94

RAILROAD

VALUATION

for they could not attract and secure the capital needed. An adequate rate of return may attract the needed capital but will not in itself afford an automatic incentive to extraordinary economy and efficiency, while a lavish rate of return will surely encourage inefficiency and invite extravagance. A fair rate of return, therefore, must be a rate which is graded according to efficiency, enabling an individual company to earn more for marked efficiency, while running the risk of getting less if inefficient. In the case of steam railroads, however, some difficulties are encountered. According to the rule of rate-making, a fair rate of return is to be allowed on the aggregate value of the railroads as a whole or in groups. While the incentive to extraordinary efficiency and economy can easily be found in the actual rate of return earned by each individual railroad, the persistence of a differential return may or may not measure accurately the worth of a carrier's performance. The carriers having the best situated routes or greatest natural advantages will earn a large differential return which may have very little to do with real efficiency and economy, whereas the most unfortunate or the least developed railroads can hardly get a living return even if they try to be efficient and economical. It is because of this unique situation that the differentials when earned must somehow be adjusted or equalized, although, as we will see later, there are serious problems as regards the promotion of efficiency and economy. Constitutionality and Rate of Return. In addition to the various economic considerations affecting the rate of return, there is the constitutional criterion of "just compensation." The constitution does not define "just compensation." The courts do. As was stated at the beginning of this chapter, whether a certain rate of return to the public service companies

A FAIR

RATE

OF

RETURN

95

is constitutionally just or compensatory must depend upon all relevant facts and circumstances in each case. The constitutional standard of fair return is determined after the rate of return has been fixed by a legislature or its administrative agent. The court is not concerned with ratemaking, which is a legislative power. Ordinarily, the court will not interfere with or set aside a legislative act or an administrative order fixing a rate of return unless it is clearly beyond a doubt that it is unfair and unconstitutional. When a case arises, the court inquires whether a given rate of return is sufficient to escape being confiscatory. In early confiscation cases, it may be observed, the constitutional interpretation of a fair rate of return was more or less a minimum or nonconfiscatory return. The court was chiefly concerned with the investment already made and seldom considered the possible effect of a given rate of return on future investors. More recently, however, the judicial interpretation of a fair return has somewhat been changed. Especially since the pronouncement in the Bluefield case, which we have already referred to, the tendency seems to have been, in the main, to move the confiscation point upward. This change may be partly attributed to the high level of prices since the World W a r and partly to the fact that strong political pressure has often been brought upon commissions to fix rates as low as possible— sometimes so low that the utilities could not finance their necessary additions and sustain themselves. By a rigid interpretation, the constitutional and economic concepts of a fair return have become one and the same. This is not necessarily wrong in principle, for, strictly speaking, there should be no distinction between a constitutional or non-confiscatory rate of return and a fair rate of return in an economic sense. But such a rigid interpretation may be hampering in practical rate-

96

RAILROAD

VALUATION

making. Should the courts definitely consider as identical a non-confiscatory return and a fair return in an economic sense, they will virtually substitute their judgment for that of legislatures and commissions, and the tendency will be to wipe out entirely the free field of action on the part of regulating or legislative authorities. The Zone of Fairness. The word " f a i r " being a relative concept, the conception of a fair rate of return must have been derived from an assumption of the existence of a confiscatory rate of return on the one hand and of an extortionate or exorbitant rate of return on the other. It seems logical to assume that somewhere between these two extremes lies a zone of fairness or a field of discretion. This may be illustrated by the accompanying diagram.

E E'

E E1 F I

F

I C

l

C DIAGRAM

Zone of

I

Fairness

Here, it is assumed that the line E E indicates the line of extortion; F F , the line of fairness; and CC, the line of confiscation. Above the line of fairness and below the line of extortion lies the zone of unfairness or excessiveness, while the line E ' E ' represents the line of excessiveness. Below the line of fairness and above the line of confiscation lies another zone of unfairness or inadequacy, the line of inadequacy being

A FAIR

RATE

OF

RETURN

97

represented by the line II. Thus, above the line of inadequacy II and below the line of excessiveness E ' E ' , we will find a broad shaded zone of fairness—a free field of discretion— which ought to exist. By virtue of the common law, the courts, on petition of the public, are competent to prohibit an extortionate rate of return to common carriers. Under the F i f t h and the Fourteenth Amendments of the Constitution of the United States, they are also competent to declare a confiscatory rate of return unconstitutional, if imposed by a legislature. Independently of statute, the courts may disallow an excessive rate of return to the carriers. If so authorized by statute, they may declare an inadequate or non-compensatory rate of return unlawful. But unless a rate of return allowed is so manifestly inadequate or excessive as to exceed the discretion properly allowable to a legislature or its administrative agent, the courts should maintain the distinction between the reasonableness, a legislative question, and constitutionality, a judicial one. Indeed, within the zone of fairness, as indicated in the diagram, the legislative discretion may be exercised in determining the rate of return, or may be delegated to its administrative agent who may select such point of fairness within that zone as may be justified by administrative expediency and prudence and be within the scope of due process of law. Rate of Return not a Constant Factor. Thus, in the words of Holmes, "rate of return is not a constant, definite factor." 1 3 There are, for instance, three rates of return, viz., the nonconfiscatory rate of return, the fair rate of return, and the expedient rate of r e t u r n . " The rate of return which is non" F r e d L. Holmes, Regulation of Railroads and Public Utilities in Wisconsin, p. 45. " Cf. L a m a r Lyndon, Rate-Making for Public Utilities, pp. 119-122.

98

RAILROAD

VALUATION

confiscatory is generally interpreted as a rate just high enough to escape confiscation. The duty of a regulatory body is to establish reasonable rates, and reasonableness demands something more than non-confiscatory rates. Within the zone of fairness, there is considerable latitude between a rate of return that is fair and one that is not. Sometimes, because of necessity or exceptional conditions an expedient rate of return may be established which may be higher or lower than an ordinary, fair rate of return. In case of war or on account of a limited life of the service, conditions may be such as to make it impossible for a utility to secure the needed capital and business ability if only what would ordinarily be considered a fair rate of return is allowed. During a period of prosperity, a company must be permitted to earn a very large rate of return in order to accumulate enough surplus to maintain its credit in lean years. On the other hand, during periods of business depression or bad crops it may be impracticable for a regulatory body to maintain rates high enough to yield a utility a fair rate of return upon the value of its property devoted to the public service. Furthermore, in determining the rate of return within the zone of fairness, the process is more than a mathematical calculation. It may be described as subjective, objective or both; the former is the exercise of discretion while the latter, the ascertainment of a fact." But in the ascertainment of a fact, fairminded men may widely differ. Judges and commissioners often write divergent opinions based on the same facts. There is no clear-cut dividing line between facts and opinions. They are mutually determined. They both decide. The point of fairness within its flexible zone is usually found by the exer" For a discussion of this dual concept of the process of rate-making, see M. St. P. S. S. M. Ry. Co. v. Railroad Commission, 146 Wisconsin, 146 (1908).

A FAIR

RATE

OF

RETURNS

99

cise of a reasonable judgment of ascertainable facts instead of being fixed solely by considering the facts presented. The word " f a i r " is a relative term. T h u s it is said: "Reasonable return may be thought of as a point moving in a plane. The path of this moving point lies between two other variables, confiscation and exorbitance moving in the same plane."1® If this be true, it follows that the ascertainment of the points of exorbitance and confiscation also involves the exercise of discretion or judgment, as well as the consideration of facts. Fair Rate of Return Defined. It is only in the long run that the objective point of fairness in each particular case may be discerned. Under competitive and fully developed industrial and commercial conditions according to orthodox economists, the investments in different industries having the same risk and burden tend to earn the same amount of interest. The size of business profits, they likewise contend, also tends toward equality. While, as was pointed out in the last chapter, this uniformity or equality, especially with regard t o the share of business profits, is very imperfectly realized in the business world, it may nevertheless be asserted that there is always a tendency toward it. W h a t the regulatory authorities are trying to do, as many economists believe, is to establish and maintain railroad rates which, in a way, correspond with the normal prices of economic theory. W h a t the railroads should be allowed to earn must presumably be something like a normal return in competitive industries. This, then, is perhaps the real criterion by which our concept of a fair rate of return must be tested. " H. D. Dozier, "Present Reasonable Rate of Return of Public Utilities," The Journal of Land and Public Utility Economics, August, 1928, 235, 242.

100

RAILROAD

VALUATION

Bringing together the essential points of the discussion thus far, it may be stated that a fair rate of return for the railroads must be neither confiscatory nor exorbitant, but should be high enough to attract capital and business ability into the railroad field and to hold them there; more than this is an unnecessary public burden and less than this is a check to efficiency, progressiveness, and f u r t h e r development of the railroad service.

CHAPTER

VII

T H E STATUTORY RATE OF RETURN STEAM RAILROADS

FOR

U N I F O R M R A T E O F R E T U R N FOR A L L R A T E G R O U P S .

Fol-

lowing the provision that the Commission shall so adjust rates as to yield a fair return upon the aggregate value of the railway property engaged in the service of transportation, P a r a g r a p h 3 of Section 15a provides: "The Commission shall from time to time determine and make public what percentage of such aggregate property value constitutes a fair return thereon, and such percentage shall be uniform for all rate groups or territories which may be designated by the Commission. In making such determination it shall give due consideration, among other things, to the transportation needs of the country and the necessity (under honest, efficient and economical management of existing transportation facilities) of

enlarging such facilities in order to provide the people of the United States with adequate transportation." It is evident that the relationship between the problem of attracting capital and enterprise to the industry and the rate of return is duly recognized. Despite, however, the notion that there is a particular rate of return applicable to each individual company according to locality and circumstances, the determination of the rate of return for steam railroads can hardly be said to be a strictly local or individual affair. On account of their physical connections and financial affiliations with one another, the steam railroads are financed, in the ma[101]

102

RAILROAD

VALUATION

jority of cases, as a national enterprise. The rate of payment for their capital is generally influenced by the same conditions in the general market. But this is not all. Even if varying rates of return be established in accordance with local and individual conditions of various railroads, little can be added to the justice of the result. Railroads are semi-competitive industries. Where competition exists, directly or indirectly, charges must be the same for all roads, notwithstanding their individual conditions. In the absence of direct competition, the railroads must so maintain their rates as to keep their producers in a position to compete in a common market with the producers served by other railroads. To a large extent, railroad rates can be adjusted only by concerted action and a grouping device. The Grouping Device in Railroad Rate-Making. To many, the Rule of Rate-Making seems revolutionary. 1 For many years before the passage of the Transportation Act of 1920, the groupingof railroads in rate-making had been a practice of the Interstate Commerce Commission.2 The problem was fully presented in the well-known Spokane Case where the city of Spokane sought the cheapest practicable rates from St. Paul and asked the Commission to take the Great Northern Railway, the least expensive route, as the basis, while the defendant lines insisted that the most unfavorably situated route should also be considered. In finding a way out of the dilemma, the Commission declared: "The city of Spokane could not develop if served by the Great Northern Railway alone; nor can we 1 For an interesting debate against the provisions of group rate-making under Section 15a, see Congressional Record, vol. 59 (1920), Part 4, p. 3342. ' Cf. New England Division Case, 261 U . S. 1845, 197-198.

STATUTORY

RATE

OF RETURN

103

look wholly to the interest of Spokane. The whole territory served by these defendant lines must be considered and the existence of all these railroads to that territory is absolutely essential. These railroads cannot exist unless rates are established which will yield a fair return upon their property. We must, therefore, in fixing these rates, have regard not altogether to any one particular railroad, but to the whole situation, and must consider the effect of whatever order we make upon all these defendants."3 In Advance in Rates, Eastern Case, the Commission grouped the Pennsylvania, the New York Central and the Baltimore and Ohio together as typical in order to judge the reasonableness of rates in the trunk line territory and said: "We do not mean that other lines should not be considered, but that these systems may be taken as typical. Under rates reasonable for these three systems there may be lines whose earnings will be extravagant, but that is their good fortune. There may be lines which cannot make sufficient earnings, but that is their misfortune. We ought not to impose upon this territory, for the purpose of allowing these defendants additional revenues, higher rates than are adequate to these three systems considered as a whole."4 Thus, the grouping device did not have its origin in the Rule of Rate-Making under Section 15a. It acquired, however, a new and an extended application therein. The wartime experiences demonstrated conclusively that all railroads, whether weak or strong, were absolutely essential to provide •15 I. C. C. 376, 393-394 (1909). 4 20 I. C. C. 243, 274 (1911).

104

RAILROAD

VALUATION

the people with an adequate transportation system. After the W a r was over, the railroads were found impaired both physically and financially. A constructive rule of rate-making was considered indispensable to the rehabilitation of railroad credit. In order that the railroads as a whole might have a chance to earn a fair rate of return, the grouping device was so widely extended under Section 15a as to throw together all the carriers, small and large, whether in direct competition or not. The Statutory Rate of Return not a Cost-plus Arrangement. According to what standard, then, should a uniform statutory rate of return be determined? Considering the necessity of preserving the most expensive but equally important roads, it would seem rational to assume that the statutory rate of return might be determined solely in the light of the most expensive or poorly situated roads. While this may perhaps be true in case of real emergency or under exceptional conditions, peculiarities of the railroad industry lead one to doubt whether such an interpretation is justified. If the object of rate regulation is to make and adjust rates in accordance with long-period normal prices, it does not seem reasonable to establish rates so as to guarantee a fair rate of return to the most expensive or least efficient roads. In an ever-changing economic world, there are always some producers with very high costs and others with very low costs. High-cost producers must be either improved or eliminated, while low-cost producers are bound to lose their temporary advantage, thus tending to wipe out the differences. At any particular time, therefore, the long-period costs must lie somewhere between the lowest and the highest costs prevailing in a given industry. This is the well-known theory of Professor Marshall's "representative firm," whose average costs over a period of time are said to be representative costs typical of an industry as a whole.8 According to this theory, what really ' See Alfred Marshall, Principles

of Economics,

4th ed. p. 397.

STATUTORY

RATE

OF RETURN

105

determines the statutory rate of fair return should be the costs of average roads which are neither the most nor the least expensive roads in the industry. We can imagine a railroad constructed and managed with average efficiency and economy under fairly favorable conditions and take it as a standard to determine the statutory rate of return for the railroads as a whole or in groups. That this is an application of the doctrine of averages can be made clearer by the following diagram. 6 In this diagram, the carriers are shown horizontally upon the base line O X ; their costs, including a fair rate of return on

DIAGRAM

II

Average or Representative Costs Relation to Fair Return

in

' It may be profitable to compare this diagram with that given by Professor F. W. Taussig in his article, "Price-Fixing as Seen by a PriceFixer," Quarterly Journal of Economics, February, 1919, p. 218.

106

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the value of their property, are measured off on the vertical line O Y ; and the curve line CC' portrays the varied costs of the carriers. The general level of rates, as indicated by the line LR, would be fixed just high enough to yield the average or representative roads, such as at a, a fair rate of return after paying operating expenses. Consequently, one group of strong or fortunate roads with lower than average costs such as at s and s' would earn more than a fair rate of return, while another group of weak or unfortunate roads with higher than average costs such as at w and w' would earn less. The carriers getting less than a fair rate of return would not cease their operation, however: some are willing to forego part of their profits for the time being, such as w ; some temporarily will consent to have just enough to pay their fixed charges, such as w ' ; and some still weaker carriers would probably be in a process of transformation whether through consolidation or otherwise. Only the hopelessly weak roads are ready to be abandoned. It thus appears that when we speak of a fair rate of return allowed the railroads as a whole we mean a fair rate of return to the average or representative roads. The statutory rule of rate-making under Section 15a does not operate as a sort of cost-plus arrangement insuring each railroad a fair return in addition to its operating expenses. All the statute guarantees is a fair prospect for all; every road must take its chances of getting more or less according to its operating efficiency and economic conditions. An Average Rate of Return over a Period of Years. Furthermore, constant confusion arises because of failure to understand the function of the statutory rate of return in rate-making. In general, there are two functions of the rate of return; one is to be used with the rate-base as of a given date in calculating reasonable rates and the other as a criterion of

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reasonable rates over a period of years. When used in the former capacity, the product of the valuation basis as of a given date and the rate of return as of the same date is the amount of the net operating income which reasonable rates are supposed to produce under efficient management. By distributing the amount of the net operating income so determined and the reasonable cost of operation over the estimated number of units of service to be rendered during the year, a tentative schedule of reasonable rates may be established. However, this process of rate-making is applicable only in those local utilities whose rate schedules are simple, although in no case will the rates so established turn out exactly the rate of return aimed at. Railroad services and railroad tariffs are so complex and heterogenous that it is impossible to apply this method of computing rates. The volume of railroad traffic, unlike that of local utilities, responds sensibly to changing conditions of business and to the competition of other means of transportation. There are bound to be substantial fluctuations in railroad earnings f r o m year to year. On account of the prime importance of commercial and industrial stability, rates can not be frequently changed in order to enable the railroads to earn a fixed rate of return for each and every year. In many cases, it would be undesirable, even if possible, to advance rates during a period of business depression when higher rates would be most burdensome to the shippers. Nor would it be wise to lower charges in prosperous times when the public can best afford to pay. Under the circumstances, it would seem only logical to allow the railroads to earn more than the statutory rate of return in prosperous years and less in times of depression, so that an average rate of statutory return may be earned by the railroads as a whole over a period of years. Rates established on the basis of rate of return used in this

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sense would seem reasonable only when the railroads as a whole happen to earn exactly the statutory rate of return in a given year. But this seldom happens. In all probability, the reasonable rates, viewed over a period of years, will appear to be too high in the peak years and too low in years of curtailed traffic. When the statutory rate of return is interpreted as an average rate of return over a period of years, the statutory declaration that the railroads are entitled to earn that rate of return on the value of their property does not mean that the railroads are entitled to earn only that much, no more no less, in any particular year of years. It is unfortunate that during a period of temporary prosperity when the railroads earn a large rate of return the public soon forgets the lean years the railroads may have passed. Likewise, during a period of temporary depression, the railroads are likely to set up their financial difficulty as a proof of the unreasonableness of rates. Having made clear the various characteristics of the statutory rate of return for the railroads, we may next discuss the rates or percentages of return authorized under the law. The Rate of Return Originally Authorized under Section 15a. Upon the termination of Federal Control of railroads, the Transportation Act of 1920 provided various safeguards that were deemed essential to a successful transition to private management. While Paragraph 3 of Section 15a authorized the Commission to determine from time to time what percentage of the aggregate value of the railroads constitutes a fair rate of return, the following proviso was inserted therein as a transitional safeguard: ". . . That during the two years beginning March 1, 1920, the Commission shall take as such fair return a sum equal to $ l / 2 per centum of such aggregate value, but may in its discretion, add thereto a

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sum not exceeding one-half of one per centum of such aggregate value to make provision in whole or in part for improvements, betterments or equipment, which, according to the accounting system prescribed by the Commission, are chargeable to capital account." Leaving aside the provision for capital expenditures, it may be asked: "How and why was 5]/2 per cent considered as a fair rate of return? Why not 5 per cent or 7 per cent? To this question no definite answer can be given. The congressional debates and other related documents reveal only some general idea of the framers of the law. Maintaining that the rate of return adopted was not so low as to be unfair, the late Senator Cummins said: "The basis of S l / 2 per cent increases the average operating income of the three years preceding the war—I mean the test period of the three years prior to July 1, 1917—three-tenths of 1 per cent. The average rate of return upon the property investment accounts of all the railroads in the United States for the test period was 5.2 per cent, and if it were assumed that the value of the property is the amount of the property investment accounts, this increases that average by three-tenths of 1 per cent."7 In the absence of a fair aggregate value of railroad properties, the law-makers were forced to assume the property investment accounts to be an approximate measurement. Based on this assumption, it was reported that the 5^2 per cent rate of return would yield "for all the railways a net operating income of $54,000,000 in excess of the income of the test period." 8 ' Congressional Record, vol. 59, Part 1, p. 135 (1919). 'Senate Report No. 304, to accompany S. 3288, 66th Congress, 1st Session, p. 16.

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Even if the fair value of the properties, as Senator Cummins apparently believed, should prove to be less than the property investment accounts, 9 the 5 J/2 per cent rate of return thereon would at least yield the railroads as large a net operating income as was guaranteed during the period of government operation. Furthermore, the compensation provided for in the Federal-control bill, according to Senator Cummins, was a great deal more than it was needed. 10 However that may be, the contract provisions were believed by some to be quite liberal 11 or, at least, not unfavorable to the carriers. 1 2 The 5 Yi per cent, it should be remembered, was intended neither as a maximum nor a minimum but an average rate of return for the railroads as a whole. " I t means," explained Senator Cummins, "that one railroad will earn 8 per cent upon the value of its property, another railroad will earn 3 per cent or 5 per cent, some of them 2 per cent, some of them possibly as high as 10 per cent." 1 3 Moreover, the per cent upon the value of the property of the railroads as a whole would by no means limit the dividend-paying capacity of the railroads to the same percentage. It was stated that there was then outstanding more than three-fifths of railroad capitalization with a fixed rate of return of about 4 l / i per cent, so that "any railroad company," in the words of Senator Cummins, "can take what it saves between 5^2 per cent and per cent upon three-fifths of its capitalization and increase its dividends, if it earns the money necessary to do it." 1 4 While no considera* Congressional Record, op. cit., pp. 135-136. Ibid. p. 136. 11 S e e Clifford T h o r n , "Government Operation of American Railroads," Annals of the American Academy of Political and Social Science, March, 1918, pp. 87-88. 0 S e e I. L. S h a r f m a n , The American Railroad Problem, p. 103. a Congressional Record, op. cit., p. 136. "Ibid. p. 135. 10

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tion was given to reinvested earnings without being capitalized, it was assumed, though not conceded, that the value of the property and its capitalization were about equal. There were two considerations which led the law-makers to believe that the 5l/2 per cent rate of return, though apparently higher than the basis of the test period, was not only warranted but necessary. Thus it was reported: "First. The railways are being returned to their owners when everything is unsettled and abnormal; when there is suspicion and distrust everywhere. Just what rate of return will enable the carriers to finance themselves under such conditions can not, with certainty, be determined. It was, therefore, felt that some increase over