§ 590. New York Public Service Commission, First District, disapproves comparative plant method.

Commissioner Maltbie in delivering the opinion of the Commission in a rate case which involved a valuation of the property of the Kings County Lighting Co., says:

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Mr. Baehr, the other witness for the company upon this point, in his estimate of going value, included a valuation of part of the profits of the street lighting contract, and claims the proper amount to be $781,916. He defined "going value" or "going-concern value" as "the enhancement in the value of the physical property of any concern, due to the business that concern has and is doing." While calling it also the "cost of developing the business," he did not base his estimate on any cost or expenditures that have actually been made by the existing company. It is rather an estimate or capitalization of the profits that an existing concern enjoys or would enjoy in excess of the profits that might accrue to an investor who set out to build a duplicate plant and to develop for it a business that would overtake in volume the business that the existing plant may be presumed to have attained at some future date. An elaborate calculation is involved resting on various assumptions and hypotheses. An estimate was made of the length of time it would take to construct a plant similar to the existing plant, and of the number of years it would take to develop the business until it would be the exact equivalent of the old plant. The new investor was assumed to have on hand from the outset a sum equal to the valuation of the existing plant, including its going value. The capital which such investor could not use is supposed to earn interest at a low rate, while interest during construction is charged to capital at a high rate. Indeed, the whole structure does not rest upon a foundation of recorded facts, but upon uncertain hypotheses as to a supposititious future. Naturally, the results will vary according to the hypotheses. If the assumptions were changed, quite different results would follow.

11 Mayhew v. Kings Co. Lighting Co., 2 P. S. C. 1st D. (N. Y.) —, decided October 20, 1911.

Mr. Baehr makes important use of two factors-rates now charged and earnings and the amount computed as "going value" is determined very largely by them. But the fundamental purpose of the present case is to determine what the rates should be, and obviously earnings are determined by the rates charged. Hence the process is reasoning in a circle. If present earnings are capitalized and if the fair rates must yield a fair return upon such capitalized value, it is apparent that the fair rates found by such a process will not be lower than the present rates. Lower rates would not yield sufficient earnings to pay a fair return upon the capitalized value of such earnings. The value of a "going business" in current use of the term is determined by the expected net income, regardless of cost of property, capitalization of company, etc. But such a method cannot logically be used to determine what that net income should be. This is one important reason why acquisition proceedings through purchase or condemnation have been differentiated from rate cases. (See City of Omaha v. Omaha Water Co., 218 U. S. 203, and cases cited therein.)

§ 591. United States District Court in San Francisco Water Rate Case rejects comparative plant method.

In Spring Valley Water Works v. San Francisco, 192 Fed. 137, decided October 21, 1911, District Judge Farrington rejects the comparative plant method of estimating going value. He says (at page 167):

Counsel for complainant suggest that "an economically sound appraisement" of this element is found by ascertaining the total probable net income of the Spring Valley Water Company during such period as would be required to construct the Tuolumne system, and adding thereto interest during the period of construction covering the same time.

Of this method of valuation it may be said that the length of the period of construction depends on the efficiency and celerity of the contractors. The earnings of the company depend on the Board of Supervisors. And among all the many factors

which would enter into such a computation, probably not a single one can be fixed with any degree of certainty.

§ 592. Value of created income bears no direct relation to cost.

Frank F. Fowle, in a paper on going value before the Western Society of Civil Engineers, November 22, 1911, considers the various methods that have been advocated for estimating going value. He rejects the theory that going value is to be measured by the value of a created income or the cost of producing a given income. He says:

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It can be said in the first place that it measures no element of direct cost in building up a going business, and it bears no relation to the past profits, or the losses; and in fact there may be a going value, under this theory, in an unprofitable business. What the method really does determine seems to be this: It estimates the loss of income which would result if the present service contracts and connections were suddenly wiped out, along with the physical plant, and then reëstablished as fast as possible after the completion of the duplicate plant, assuming that the public appreciation of and demand for the service proceeds as though there had been no change. But such a loss of income tells us neither the actual outlay or investment for building up the original business, or the reproduced business, and hence it seems to be not in keeping with the cost of service theory.

It is still a fair question, at least under the value of service theory, whether this method establishes a parcel of value which is quite independent of all the other elements of value which are ordinarily present. Granting now that a physical property has a value equal to its reproduction cost, what establishes that value? Surely not the mere act of appraisal or the statement of a theory of rates. It seems very evident that the value exists by virtue of the fact that the property as a going business will earn a fair rate of return on the cost. This is supported by

12 Going value by Frank F. Fowle published in Journal Western Jociety of Engineers, February, 1912, vol. 17, pp. 147-190, 160.

the fact that appraisals are usually made under the assumption that the component parts of the plant are useful in their existing locations, in coördinate relations with each other, for an indefinite future period or until they wear out. Were this not so, the physical property could not be assigned a value equal to its structural cost, but instead it would have to be considered as a group of separate parts which would be thrown on the market and sold for what they would bring; this value, especially in the case of machinery and equipment, would be much less than the present value found by deducting depreciation from the reproduction cost.

Thus a new plant with no business has a value much less than its structural cost, except as regards the expectancy of future earnings. Undeniably a plant with connected consumers and a going business is worth more than one without business, but the one without business is worth less than its present physical value, or reproduction cost minus depreciation. It seems perfectly clear that the cost value is established by an amount of net earnings equal to a fair return. If then the net earnings give rise to a physical value equal to the cost, is it equitable to consider them a second time as having a reproduction value, quite apart from the physical plant? That is to say, do the earnings have an intrinsic value over and above the value which they confer on the tangible property, where such property value does not exceed the cost? It would seem not, and yet the reproduction of net earnings theory seeks to establish this very proposition. Apparently this is like trying to eat your cake and have it, at the same time, because earnings which establish a value on the tangible property equal to the cost, and no more, can not equitably be considered to establish simultaneously some additional value. Of course if any intangible or going value is admitted at the start, it will appear in the final result, but that proves nothing..

The author's conclusion in regard to this method, after much study of it, is that it measures no element of value which can be considered under the cost of service theory of rates. It might be admissible, however, under the value of service theory, where cost is not a primary consideration.

593. Summary.

The comparative plant method of estimating going value is specifically rejected in each of the three above mentioned cases. It has doubtless been used by the appraisers in various water plant purchase cases but the court opinions in such cases have not discussed the methods of appraising going value. For the most part the courts have merely approved of the inclusion of an allowance for going value and have not concerned themselves with methods of computation. In the first of the Maine water plant condemnation cases, Judge Savage in laying down rules to govern appraisers did consent to an instruction that the appraisers should, among other methods, consider the results under the comparative plant method (see § 533). The determination of the value of a created income by the comparative plant method is a process of very great practical difficulty. It involves the making of assumptions that necessarily lead to a wide divergence in results. It is an involved hypothetical process. The theory itself seems to have been developed prior to the modern recognition of the mutual relations of justice and equity subsisting between the public service corporation and the public. In general this relation implies that service shall be based on cost plus a reasonable profit. The fundamental criticism of the comparative plant method is that the value found bears no possible relation to actual investment or actual sacrifice. It is neither the amount that the company has actually invested in the establishment of its business nor is it the amount that it would spend if it were actually starting at the present time. It is therefore neither actual cost nor cost of reproduction, but the capitalization of a certain monopoly value due to the fact that it takes time to construct a plant and time to develop business and that during such time possible profits are lost to the new enterprise. Its basis is value to