BEFORE THE 

SURFACE TRANSPORTATION BOARD 

STB EX PARTE NO. 664 

METHODOLOGY TO BE EMPLOYED IN DETERMINING 

THE RAILROAD INDUSTRY'S COST OF CAPITAL 

COMMENTS OF THE 

U.S. DEPARTMENT OF AGRICULTURE 

Bruce I. Knight 

Under Secretary 

Marketing and Regulatory Programs 

U.S. Department of Agriculture 

Washington, D.C. 20250 

Date: September 13,2007 
AUTHORITY AND INIEREST 

The Secretary of Agriculture is charged with the responsibility under the 

Agricultural Adiustment Act of 1938 and the Agricultural Marketing Act of 1946 to 

represent the interests of agricultural producers and shippers in improving transportation 

services and facilities by, among other things, initiating and participating in Surface 

Transportation Board (Board) proceedings involving rates, charges, tariffs, practices, and 

services. 

The Department of Agriculture (USDA) commends the Board for its proposed use 

of a capital asset pricing model (CAPM) when estimating the railroad industry's cost of 

equity capital. The record of this proceeding presents compelling evidence that the 

Board's current discounted cash flow (DCF) methodology overestimates the cost of 

equity. The Board carefully considered the record developed in this proceeding and 

chose a more modem and accurate method to estimate cost of equity. USDA supports the 

Board's proposed CAPM' model subject to several recommendations. 

An accurate estimate of the railroad industry's cost of capital is important because 

the Interstate Commerce Commission Termination Act (ICCTA) and the Staggers Rail 

Act require the Board to balance the railroad industry's need for an adequate return on 

CAPM calculates a firm's cost of equity by comparing a company's risk profile to that of the market as a 

whole using the formula: k = rf + B(&, where k equals the cost of equity; rf is the rate of return available 

on a risk-free security; fl is the measure of the systematic risk of a stock, relative to the market as a whole; 

and rp, is the equity risk premium for the market as a whole. 
investment with protecting shippers from excessive rail rates.2 As such, the methods 

used to determine railroad cost of capital should be fair to both railroads and shippers. 

The accuracy of the cost of capital estimates can have important ramifications for 

our nation's agricultural producers and shippers because it plays an important role in the 

regulation of railroads. The Board uses the cost of capital to evaluate the adequacy of 

individual railroads' revenue each year. In addition, cost of capital plays an important 

role when shippers appeal rail rates and oppose rail line abandonment proposals. 

USDA RECOWENDATIONS 

USDA supports the use of a levered b3 when using CAPM to calculate the cost of 

equity. Besides giving a more realistic estimation of the cost of capital: USDA believes 

that CAPM estimates of the cost of equity will be less affected by volatility in railroad 

stock prices. One major shortcoming of the Board's present DCF methodology is that it 

results in a sharply rising cost of equity in response to rising railroad profitability and 

stock prices. Thus, the present calculations of cost of equity appear to reflect the 

profitability of the railroad industry rather than increased risk or the cost of equity capital. 

2 Rail Transportation Policy, ICC Termination Act of 1995, 5 10 10 1. 

3 An unlevered P is equal to the covariance between a company's stock and the market as a whole (P = o 

(- -) + 4 An unlevered f3, because it assumes that the firm is financed with 100 percent equity 

does not reflect risk associated with the relative proportions of debt and equity in the h. A levered f3 is 

adjusted for the fioancial leverage of a firm and is equal to unlevered f3 * [ 1 + (1 - Corporate Tax Rate) * 

(Debt capital + Equity capital)], Since the Board does not account for and does not consider the taxshielding effects of a company's tax rate in its cost of capital determination, the equation for a levered f3 

simplifies to: Levered P = Unlevered P * [ 1 + (Debt capital + Equity capital)]. Western Coal 

Transportation League reply comments in Ex Parte 558 (Sub. No. lo), July 25,2007, VS Crowley/Fapp, 

pg. 7- 

An unlevered P assumes that a firm uses 100 percent equity financing, which can result in an 

unrealistically low estimate for the cost of equity. In contrast, a levered P takes into account the 

incremental risk associated with a company's debt. 
The relative insensitivity of the levered P CAPM model to changes in the capital 

structure of a fm is expected to break the circularity between railroad freight rates, the 

level of railroad profitability, and the cost of capital. As railroad stock prices increase, 

the ratio of debt capital to equity capital will decrease, resulting in a smaller adjustment 

to the unlevered f3, assuming all other factors are kept constant (see footnote 3 above). 

In addition, whether the Board decides to use either a levered or unlevered f3, 

USDA opposes the use of an assumption that P equals 1. The record of this proceeding 

clearly shows that the P for the railroad industry is substantially below 1. USDA notes 

that in the Western Coal Traffic League's (WCTL) reply comments to Ex Parte No. 558, 

the unlevered P estimates for individual railroads range from 0.37 to 0.64 and the levered 

f3 estimates range from 0.65 to 0.82 (VS CrowleyFapp, pg. 10-1 1). In addition, the 

Ibbotson estimates for individual railroad unlevered f3 range from 0.27 to 0.69 and the 

estimates for levered P range from 0.37 to 0.97 (WCTL, reply comments, Ex Parte No. 

558, July 25,2007, appendix). Based upon the record in this proceeding, USDA supports 

using actual levered betas because the estimated cost of equity is likely to be substantially 

overstated by assuming that P is equal to 1. 

The record in this proceeding indicates that reliable estimates of f3 are readily 

available from a number of reputable firms. Thus, USDA questions whether it is costeffective and necessary for the Board to use its limited resources to calculate its own P 

estimates for calculating the cost of equity capital. 
CONCL USZON 

USDA supports the Board's proposed CAPM model subject to several 

recommendations: 

The Board use a levered P. 

The Board use an actual estimate of P in the calculation of the cost of equity 

capital rather than the use of an assumption that P is equal to 1. 

The Board consider using levered P estimates developed by respected 

financial services firms rather than calculating its own estimates of b. 

Respectively submitted, I 

Bruce I. Knight 

Under Secretary 

Marketing and Regulatory Programs 

U.S. Department of Agriculture 

Washington, D.C. 20250 
CERTIFICATE OF SERVICE 

I, Bruce Blanton, certify that on this 27th day of September, 2007, I caused a copy of the 

foregoing document to be served by first-class mail, postage prepaid, on all parties of 

record in STB Ex Parte No. 664. 

Bruce Blanton 

Associate Deputy Administrator 

Transportation and Marketing Programs 

U. S. Department of Agriculture 

Washington, D.C. 20250