CHAPTER XXIX

The Theory of Franchise Value

§ 720. The economic function of the franchise. 721. Franchise value in rate cases.

722. Franchise value in condemnation cases.

§ 720. The economic function of the franchise.

There can be no doubt that a franchise is property and as such has a value. This principle has the best legal authority and a sound economic basis. There are two distinct functions of a franchise: One is to guarantee the integrity of the investment and the other is to make it possible for the investor to secure a reasonable reward for his enterprise in establishing the plant or railroad.

1. The function of the franchise in guaranteeing the integrity of the investment. The franchise gives and guarantees the right to use the tangible property in its existing location. The ownership of street railway tracks with no right to use them as located and the duty of taking them up and restoring the street would be of negative value. The franchise, however, gives the right to use the tracks as located and to charge reasonable rates for such / service. The possession of a franchise gives the plant a value as a going, operating plant rather than the mere salvage value that it would have if its parts could not be used in their existing location. The construction of a street railway requires a large fixed investment that will be practically destroyed unless the enterprise can continue with substantial permanency. The first function of the franchise therefore is to assure to the investor for a stated period or permanently that the fixed capital he invests

and which can not be withdrawn without great loss can be used for the purpose intended, i. e., the service of the public at reasonable rates of charge. So far as this function of the franchise is concerned it is scrupulously recognized and provided for if in a valuation for rate purposes or public purchase the tangible property is recognized as being rightfully in the streets or public places and each part is valued with reference to its use in the existing operating system and not simply at its value as scrap. Here the franchise is simply a characteristic of the structure. It gives the structure its full operative value and not a mere salvage value. As to this there can be no question of two values-a franchise value and a structural value. There is but one value and that is the value of the structure in use.

People ex rel. Brooklyn Heights Railroad Company v. Tax Commissioners, 69 Misc. (N. Y.) 646, 661, decided December, 1910, is a special franchise tax case. In this case the net earnings rule was applied in order to determine the value of a special franchise and it was found that under the rule there were no surplus net earnings to be capitalized as representing the value of the special franchise. Judge La Boeuf, however, states that although the franchises are thus found to have no value for the purposes of the franchise tax assessment, they nevertheless have a certain value to the company, as without the franchise the property would have only a scrap value. Judge La Boeuf says (at page 661):

While this deficit results in a finding that the intangible property of the relator has no value for the purpose of franchise tax assessment, it does not mean that the franchises are absolutely valueless. . . . That the franchises are not valueless is apparent from the value which is placed upon the tangibles used in connection therewith. If the franchises were absolutely valueless, the tangibles in the streets would only have a junk

value. People ex rel. Metropolitan Railway Company v. State Board of Tax Commissioners, 174 N. Y. 417.

The franchise in such case would only serve to give the property a value as a property capable of use in its existing position and therefore a value in excess of that which it would bring if it were dismantled and the parts sold as scrap. It could not however have a value in excess of cost-of-reproduction-less-depreciation. The franchise is here merely a characteristic of the structure.

2. The function of the franchise in assuring to the investor the opportunity to secure if possible a reasonable reward for his enterprise and risk in establishing the public utility. The investor in a new enterprise assumes certain risks. He determines the existence of an economic demand sufficient to warrant the enterprise and backs up his opinion with cash. In order that he may be induced to do this it is necessary that he should be assured the chance of earning a return on his investment commensurate with the risk he has taken. But not only must he have a chance to earn a fair return but that opportunity must have some permanency. There must be some guarantee that after the success of the enterprise has been in fact attained he will not be deprived of all fruits of success through municipal purchase. If such purchase or condemnation does in fact take place it should compensate the investor for the actual value from an investment standpoint of the entire property operating under reasonable rates of charge. Let us assume that a probable rate return of 7% will attract investment in an electric enterprise. The investor puts his money into the venture and after a few years its success is demonstrated and the state commission adjusts the rates so as to limit the company to a 7% return on its tangible property. The question of condemnation or purchase now comes up. If the property is taken over at the value of the tangible

property the opportunity of earning a 7% return for which the risks of the enterprise were originally undertaken is destroyed. This opportunity may be worth considerable if the prospects for a continuance of a 7% return are considered favorable. Assume that under

the conditions other investors are now willing to buy the securities of the enterprise on a 6% return basis. If the tangible property on which the 7% return was based amounted to $1,000,000, the annual return would be $70,000. $70,000 capitalized on a 6% basis gives $1,116, 666 as the investment value of the enterprise. The amount by which such investment value exceeds the value of the tangible property represents a capitalization of the investor's reward for risking his capital and establishing a successful business operated at reasonable rates. This amount may properly be attributed to franchise value in a valuation for condemnation or purchase.

§ 721. Franchise value in rate cases.

The actual and necessary cost of obtaining a franchise should of course be included in a valuation for rate purposes. Other than this the weight of practice and authority is distinctly against the inclusion of an allowance for franchise value in a valuation for rate purposes. This position seems to be economically sound. From our consideration of the economic function of the franchise in the conservation of the integrity of the investment and the chance of a reward for risk incurred, all just requirements are seen to be fulfilled if the franchise secures for the investor a chance to realize a return on the actual necessary investment commensurate with the risk assumed. If the rate of return is fair and is based on the entire actual investment nothing further can in reason be expected.

A great deal of confusion has arisen in the consideration of this subject owing to a failure to see the fundamental

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distinction between valuation for rate making and valuation for public purchase. It is recognized that in a condemnation case the value of the franchise must be included. From this it is argued that unless the franchise is included also in the valuation for rate making the value of the franchise is in effect confiscated. If it is wrong and illegal to confiscate the value of the franchise in a condemnation case it is just as wrong and presumably just as illegal to confiscate such value indirectly through the rate making process. Deprivation of compensation for the use of property is no less confiscation than the actual taking of the property. The fallacy arises in a failure to realize that though in a condemnation case the valuation is the all important factor, in the determination of reasonable rates the essential thing is the total net income; and that this net income is not measured by the valuation alone but by the product of the valuation and the rate of return. If the capitalized value of the total net income allowed in a rate case is the same as the valuation for purchase purposes, due consideration will have been given to the franchise in both cases, even though in the valuation for purchase there has been a specific allowance for the franchise and in the valuation for rate purposes there has been no such allowance.

In a rate case due consideration is given to the franchise rights in the determination of the fair rate of return. The fact that the rate of return is fixed on the basis of a return adequate to induce investment in a new enterprise although now that the enterprise in question has been successfully established persons will invest on a lower return basis, is a substantial recognition of the rights that it is the function of the franchise to protect. The franchise having thus been allowed for in the rate of return, it would be duplication to allow for it again in the valuation on which the rates are based.