of most plants is represented by both bonds and stocks. The bonds have prior claims on the earnings, while the stockholders take what is left after all other claims have been met. The amount set aside in case the cost is written off would, therefore, have to come out of the share of the stockholders alone instead of being distributed over the entire valuation, as it should be. There is something to be said in favor of the method under which the cost of building up the business is written off, but in so far as this case is concerned it would hardly seem that anything that could be brought out in favor of this method could be as important or of greater importance than the facts. just given.

It seems probable that the above is not an accurate statement of the Commission's real position. It seems improbable that the Commission would really approve the issue of new securities to pay dividends-that is, to make up the amount by which net income failed to equal a fair return on the investment. In a number of states railroad officials are subject to fine and imprisonment for paying dividends except out of surplus profits. This is a salutary regulation and conforms to elementary principles of sound finance. If it were legitimate to capitalize each year the amount by which a company should fail to earn a fair return, the door to fraud and wild-cat financiering would be opened wide.

§ 641. Cost of subsequent promotion of business-Rate Case. But after an enterprise is established on a paying basis there are still expenditures for the further promotion of the business. The management seeks by advertising, soliciting, and demonstration of new uses to hold the former business and to develop and extend it in every possible way. Expenditures of this kind are normally charged to operation and not to capital account. This is the approved method and the method contemplated in

the uniform systems of accounts prescribed by governmental authority. Large scale production reduces the per unit cost. The development of new business renders large scale production possible and temporarily at least increases the profits of the owner. Its effects upon the business and profits of the enterprise are the same as any improvement as a result of which the per unit cost of production is reduced. The company is in duty bound to manage as efficiently as possible, and expenditures for advertising, soliciting, demonstration, etc., would seem to be essential to such management and to be properly chargeable to operation. To charge such expenditures to capital is fraught with danger and is seldom considered proper or wise in a public utility enterprise. This being the standard practice it is probably well to follow it in a rate case and to assume that all costs of developing the business subsequent to the time when the business began to earn a fair return have been and will continue to be paid out of operating expenses. In this case there will be no capitalization of this cost of development, but the estimate of operating expenses for the future will include an allowance for normal expenditures for this purpose. Some estimators, while allowing in the valuation for a capitalization of the cost of promoting business, nevertheless treat the current expenditures for this purpose as an operating expense in estimating future income requirements for rate purposes. Of course this is wrong, for this item can not be charged both to operation and to capital.

§ 642. Going concern value-Rate Case.

The above discussion seems to prove that if in a rate case the rate of return is adequate to induce investment in a new enterprise of similar character subject to the probability of a low return for the first years, the so-called cost of putting the business on a paying basis is fully pro

vided for, and provided for in the way that conforms most closely to actual conditions and the actual equities of the investor and the consumer. It also appears that the cost of promoting additional business subsequent to the time when the business began to earn a fair return is, according to approved practice and theory, treated as an operating expense. The consumer pays for the increased business that makes possible a reduced per unit cost out of the current earnings and this being the case it is not proper to also capitalize it and thus require the consumer to pay twice for the same thing.

§ 643. Going concern value-Public purchase.

The above reasoning is applicable to a valuation for rate purposes. In a valuation for public purchase the same fundamental principles will apply but the result is modified by a difference in the meaning of value for these two purposes. Value in a rate case is the amount on which the fair return should be allowed in order to adequately compensate the investor. The essential thing is not the value alone or the rate of return alone but the net income which is the product of the two. So long as the net income remains unchanged it is immaterial so far as the justice of the result is concerned whether cost of creating a paying business is taken care of by increasing fair value and reducing fair rate of return or by increasing fair rate of return and reducing fair value. A reasonable net income is the fundamental requirement. In public purchase, however, it is value or price that is fundamental. Existing relations are terminated and the price paid cancels all rights to the property and the profits thereof. If the company is operating under a perpetual franchise but subject to regulation as to service and rates of charge the value of the property and rights transferred should be based on the estimated present and future net income

under reasonable rates of charge. In determining purchase price the first thing to be determined therefore is the reasonable rate of charge. This should be determined in exactly the same way as if it were a rate case. The same consideration will be given to cost of establishing the business as in a rate case, i. e., it may be treated as affecting primarily either fair value or fair rate of return. Whichever way treated its effect will be represented in the net income allowed. Having in this way arrived at the probable net income under reasonable rates it remains simply to capitalize this income at such rate as may be deemed most reasonable in order to arrive at the price that will adequately compensate the investor for parting with this source of interest and profit. If the rate of capitalization chosen is the same as the fair rate of return used in determining a reasonable rate of charge the purchase price and the fair value for rate purposes will be identical. But ordinarily the fair rate of return will be higher than the capitalization rate and therefore the fair value for rate purposes will be lower than the purchase price. This is true because the fair rate of return is based on the hazards of a new enterprise while the capitalization rate is determined by the lessened hazards of an established business. The difference between fair value for rate purposes found by this method and the purchase price for of public purchase may therefore be attributed to the established business and the right to a continued enjoyment of the profits therefrom. It therefore includes both going concern value and franchise value. In the above case it was assumed that there was a perpetual franchise. If the company were operating under a fixed term franchise the fair rate of return would be determined with a view to permitting the amortization of the cost of establishing the business within such franchise term so that at the end of the franchise term there should be neither

purposes

going value nor franchise value. If the company were operating under an indeterminate franchise the fair rate of return at any time should be adequate to amortize any uncompensated losses incurred in the establishment of the business. After such losses have in fact been amortized there will be no going value in a valuation for purchase but there may remain some franchise value (see $$ 720-722).

§ 644. Cost of service theory of determining going value as set forth by Frank F. Fowle.

In an article on Going Value published in the Journal of the Western Society of Engineers, February, 1912, pages 147-190, Frank F. Fowle discusses various theories of going value. He holds that rates should be based on the actual cost of the service and that any theory of going value should conform to this more fundamental theory. He rejects the value of a created income method as based on the value of the service rather than on the cost of the service. Under the cost of service theory, going value may be measured according to the Wisconsin method or may be allowed for in fixing the rate of return. Mr. Fowle says (at pages 154, 168):

The cost of service theory measures value by actual cost or investment in the tangible property, as being the lowest value which is equitable. The rate of return which is regarded as reasonable depends upon local circumstances, but in the main it covers both the ordinary interest rate on secure investments and a margin of speculative profit; this is necessary to attract capital and stimulate development. The total return generally allowed is 7% to 8%. This makes it possible, with certain forms of financing, to show a margin of going value. Under the rule of conservative banking that a property should not be bonded beyond the point where the interest exceeds one-half of the net earnings, the stock can be made to show more than the rate of return allowed on the whole property. Consider,