CHAPTER XXVIII Appraisal of Franchise Value § 710. Cleveland street railway settlement. 711. Michigan railroad appraisal for tax purposes, 1900, 1901. 712. Proposed modification of above rule. 713. New York special franchise tax-Net earnings rule. 714. New York special franchise tax-Net earnings rule criticised. 715. Chicago Street Railway Tax Case-Net earnings rule applied. § 710. Cleveland street railway settlement. In 1908 an agreement in settlement of the street railway franchise controversies was reached between the City of Cleveland as represented by Mayor Tom L. Johnson and the Cleveland Street Railway Company. The purpose of the agreement was to secure the lease of the property of the company to a new company under the control of Mayor Johnson. A valuation of the tangible and intangible street railway properties was agreed upon and the new company leased all such property at an agreed interest on this valuation. At the time the agreement was made the company's various franchises were soon to expire but the dates of such expiration varied. In order to determine the present value of the unexpired franchises the surplus net earnings were estimated for each year of the unexpired term and capitalized at their present worth. Edward W. Bemis explains the method used in valuing unexpired franchises as follows: 1 This was done by a method that can be described by the following illustrations: One franchise on one route, known as the Euclid line, expires July 13, 1913, or 5.5315 years distant 1 Street railway settlement in Cleveland, by Edward W. Bemis, Quarterly Journal of Economics, vol. 22, pp. 543, 555, August, 1908. from January 1, 1908. This number of years multiplied into the present yearly earnings of the line, $521,984, gives total earnings during the future life of the grant, without allowance for growth, of $2,887,355. Again, the Woodland and Lorain Street franchises expired February 10, 1908, or 0.1123 years after January 1, 1908. This multiplied into the yearly earnings of the line, $828,844, gives $93,079. The total earnings of the two lines for the period of the grant, $2,980,435, divided by the sum of the yearly earnings, $1,350,828, gives 2.2 years as the average life based on earnings for those two lines. In this way the average life of all the lines and franchises was found to be 3.1929 years from January 1, 1908, making the average date of expiration March 11, 1911. Since several lines reach the heart of the city over the same tracks for the last mile or so, this method of finding the average life gives a far greater weight to the tracks in the heart of the city than elsewhere, and gives to each mile of track an importance proportionate to its traffic. The net income of the past year, less 6 per cent. assumed interest on the physical value, was considered the franchise value. The net income was increased 6 per cent. for the following year. The physical value was increased 3 per cent. to take care of the increase of traffic, and the franchise value was the net income, less 6 per cent. on the new physical value and so on until March 11, 1911. The franchise value of each year was then reduced to present worth on the basis of 6 per cent. discount. This method closely resembled that used by the writer in valuing the Detroit railway franchises for the city and company in 1899. The result was a franchise value of $4,441,564. Mr. Goff claimed that interest and discount should be figured at 5 per cent. instead of 6 per cent. and that the discount should be reckoned from the middle of each year, and the earnings computed to the end of the year. This would have added $544,276. The representative of the company also claimed a longer life on a few franchises and a little higher value on a few outside grants in later years of their franchise life. These claims would have added $1,800,188. The settlement above arranged was soon broken through the failure of the new company to meet the financial requirements of the lease and in 1909 a new agreement was entered into between the city and the Cleveland Street Railway Company which provided for operation by that company under a sliding scale of fares and provided also for purchase by the city at any time on terms fixed in the franchise. To establish the valuation for municipal purchase and to fix the basis for the sliding scale of fares a revaluation of the property and franchises was required. The parties agreed to abide by the decision of Judge R. W. Tayler of the United States Circuit Court acting as arbiter. Judge Tayler appraised the present value of the unexpired franchises of the company at $3,615,843.2 The franchise value was fixed by finding the present worths of the estimated earnings under the franchises in excess of 534% on the physical value of the property. In his decision Judge Tayler states that in appraising the franchises, he made allowance both for future growth and for competition. § 711. Michigan railroad appraisal for tax purposes, 1900, 1901. In the Michigan railroad appraisal of 1900-1901, made for purposes of taxation, the physical property was appraised by Prof. M. E. Cooley, and the nonphysical property by Prof. Henry C. Adams. In his official report Prof. Adams describes his method of valuation as follows:3 The rule submitted for the appraisal of the immaterial values of railway properties, or what I prefer to term the capitalization of corporate organization and business opportunity, is simple, as follows: 2 In the matter of the arbitration of the valuation of the property of the Cleveland Railway Company, decision and memorandum of Robert W. Tayler, U. S. District Judge, December 16, 17, 1909 (not published). 3 See U. S. Census bulletin 21, Commercial valuation of railway operating property in the United States, 1904, p. 79. 1. Begin with gross earnings from operation, deduct therefrom the aggregate of operating expenses, and the remainder may be termed the "income from operation." To this should be added "income from corporate investments," giving a sum which may be termed "total income," and which represents the amount at the disposal of the corporation for the support of its capital and for the determination of its annual surplus. 2. Deduct from the above amount, that is to say, total income, as an annuity properly chargeable to capital, a certain per cent. of the appraised value of the physical properties. 3. From this amount should be deducted taxes, rents paid for the lease of property operated, provided such property is not covered by the physical valuation made the basis of the annuity referred to under paragraph 2, and permanent improvements charged directly to income. The remainder would represent the surplus which, capitalized at a certain rate of interest, gives the value of immaterial properties. The percentage on the appraised value of the physical properties used under paragraph 2 above, was fixed by Prof. Adams at 4% which was the estimated fair return upon an assured nontaxable investment. The rate of interest for the capitalization of the surplus under paragraph 4, was fixed by Prof. Adams at 7% of which 1% was an allowance for taxes on such franchise value. Prof. Adams states that the reason for allowing 4% on the physical value, and 6% net on the franchise value is that, "the return upon the appraised value of physical elements is not exposed to the same degree of risk to which the return upon the intangible or franchise valuation is exposed. . . . These intangible values are exposed to the risk of being reduced by the legislative reduction of railway charges, a risk to which the tangible values of a railway as measured by the cost of reproduction, are not exposed, and to which, under the constitutional safeguards thrown around private property, they cannot be exposed." In order that Professor Adams's method may be more clearly understood, his estimate of the nonphysical property of the Chicago and Northwestern Railway is given below: ^ AVERAGE FOR TEN YEARS Gross earnings from operation. . . . Net income from operation... Net income from investment. Total Available Corporate Income.. Rents of Michigan Property not included in Interest on Interest-bearing Current Liabilities.. Total deductions from Corporate Income... Surplus from Operation.... $1,971,951 $727,203 46,860 $774,063 $12,000 12,000 $762,063 Mean Value of Physical Elements (Computed from Cooley Appraisal). . . . $12,239,214 Corporate Surplus from Operation... $762,063 Tax of 1% allowed on Mean Value of Physical $122,392 Annuity of 4% allowed on Mean Value of Physical 489,569 Sum of Tax and Annuity.... 611,961 Net Corporate Surplus. $150,102 Capitalization of Net Corporate Surplus at 7%, giving Value of Nonphysical Elements.. Cooley Appraisal of Physical Elements... Present Value of Property.. § 712. Proposed modification of above rule. Henry Earle Riggs in his paper on Valuation gives a 4 See Second Report Michigan Board of State Tax Commissioners, 1902, $2,144,314 13,106,048 $15,250,362 |