~"~"~~"~,,_L,,,,,,.o.~ _ 

BEFORE THE
 

SURFACE TRANSPORTATION BOARD
 

sm EX PARTE NO. 664 

MElliODOLOGY TO BE EMPLOYED IN DETERMINlNG
 

THE RAILROAD INDUSTRY'S COST OF CAPITAL
 

PUBLIC HEARING COMMENTS OF THE 

U.S. DEPARTMENT OF AGRICULTURE 

BruCI~ 1. Knight 

Under Secretary 

Marketing and Regulatory Programs 

U.S. Department ofAgriculture 

Washington, D.C. 20250 

Date: November 27,2007 
AUTHORITYAND INTEREST 

The Secretary ofAgriculture is charged with the responsibility under the 

Agricultural Adjustment 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. 

INTRODUCTION 

The Department ofAgriculture (USDA) thanks the Board for holding this hearing 

which allows interested parties the opportunity to more fully debate the Board's proposed 

methodology to calculate the railroad industry's cost of capital. The issues involved in 

estimating the railroad industry's cost of capital merits the Board's careful deliberation of 

the record and careful consideration ofthe basic inputs and assumptions ofits proposed 

methodology. 

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

the Board is required to balance the railroad industry's need for an adequate return on 

investment with protecting shippers from excessive rail rates.! The accuracy and fairness 

ofmany ofthe Board's regulatory decisions depend upon an accurate and unbiased 

estimation of cost ofcapital, particularly in regard to thf: cost of equity which, unlike the 

cost ofdebt, can only be estimated. 

Among other things, the estimation ofthe cost olf capital is important in: (l) 

determining whether railroads are revenue adequate; (2) which rail tariffrates are deemed 

I Rail Transportation Policy, ICC Termination Act of1995, §10101. 

2
 
=r
 

to be excessive; (3) revenue-to-variable cost ratios; and (4) whetherthe Board should 

allow abandonment of a rail line. Consequently, the outcome ofthis proceeding can have 

important ramifications for our nation's agricultural producers, shippers, and rail carriers. 

The methodology and data used to estimate the railroad industry's cost ofcapital 

should be reasonably accurate, fair to both shippers and railroads, transparent to all 

stakeholders, and provide estimates that are relatively stable from year to year. USDA 

contends that the Board's proposed methodology more closely fulfills these criteria than 

the rail industry has stated, but recognizes that some adjustments to the methodology may 

be appropriate. The record ofthis proceeding has provided numerous comments and 

verified statements that could help guide the Board in determining the best methodology. 

USDA recommends that the Board use the Capital Asset Pricing Model (CAPM) 

as its primary method ofestimating the cost of equity allld has no objection to the use of a 

properly designed and unbiased 3-stage Discounted Cash Flow model to check the 

reasonableness ofthe CAPM estimate. In addition, USDA strongly urges that the Board 

reject the railroads' recommendation to choose a cost ofequity toward the upper end of 

the range ofmultiple estimates. Finally, USDA recommends that the Board reject the use 

ofan inflation adjusted asset base when estimating the railroad industry cost of capital. 

3
 
ESTIMATE OFCOST OFEQUITYMUSTBE UNBIASED
 

The Association ofAmerican Railroads (AAR) states that the Board has derived 

an unreasonably low estimated cost ofequity. To corred this, the AAR suggests that the 

Board consider multiple estimates ofthe cost ofequity and choose a value toward the 

upper end ofthe range when anticipated growth in demand from shippers is expected to 

require large new capital investments in property (AAR Reply Comments, pg. 2-3, 21­

22). 

USDA strongly opposes the use ofany methodology which would provide a 

biased estimation ofthe railroad industry's cost of equity in order to encourage 

investment in rail infrastructure. Such a biased estimat(~ would be expected to result in 

the misallocation ofresources and reduced economic efficiency. USDA believes it is far 

more important to develop a methodology that is as accurate as possible rather than to 

arbitrarily choose a pre-determined level at the upper elJld of a range. The development of 

accurate cost of capital estimates will be far more fair to all parties. 

The estimation ofthe cost ofcapital is important in determining which rail tariff 

rates are deemed to be excessive, revenue-to-variable cost ratios, and whether the Board 

should allow abandonment of a rail line. Consequently, USDA contends that a policy 

decision to encourage investment in rail infrastructure should be implemented in ways 

that do not impact the fairness ofthe Board's basic decisions in these areas. 

Furthermore, USDA contends that it is just as important for the Board to protect 

and encourage shipper and producer investment as to do so for railroad carriers. Ifthe 

estimated cost of equity is too low, it would be expected to hinder railroad investment 

4
 
and ifthe estimate is too high, it would be expected to hinder shipper and producer 

investment. 

Thus, USDA agrees with DOT that the "difficuU task ofbalancing the Staggers 

Act's sometimes inharmonious goals is best met in this proceeding by adopting the 

methodology that produces the most realistic estimate ofthe cost of capital" (DOT Reply 

Comments, October 29, 2007, pg. 7). The various options for estimating the risk free rate 

ofreturn, 13, the market risk premium, and the appropriate time period from which to 

draw historical data should be closely evaluated against their effects upon the desired 

characteristics ofbeing reasonably accurate, fair to both shippers and railroads, 

transparent to all stakeholders, and provide estimates that are relatively stable from year 

to year. To meet the requirements for being unbiased and fair, the chosen methodology 

must have a sound theoretical basis but reflect marketpllace realities. 

REPLACEMENT COSTASSETBASEIS INAPPROPRIATE 

Some parties have recommended the use of a relplacement cost asset base (Reply 

Comments ofThe Children's Fund, pp. 1-6; BNSF, pg. 4). USDA recommends that the 

Board not approve the use of a replacement cost asset blase when calculating the railroad 

industry cost ofcapital. 

A replacement cost asset base has serious deficitmcies when used to estimate the 

cost of capital. The first deficiency is that it could provide windfall profits for raj]. 

carriers at the expense ofshippers. The cost ofdebt aln::ady includes a risk premium for 

expected inflation and financial theory implies that the cost of equity also would include 

5
 
-_.~-~-~..~. . ..~ .~'"".. j 

""
 

such a risk premium. Thus, a replacement cost asset base would allow railroads to 

double dip on the costs ofinflation. 

A second deficiency is the difficulty determining reliable replacement costs and 

implementing these values in a regulatory situation. hi particular, the table in Appendix 1 

values all locomotives, :freight cars, and track miles at the replacement value (Reply 

Comments ofThe Children's Fund, pg. 6). USDA notes that all ofthese items have had , 

considerable usage and all have a life span that provid(;ls a certain level ofuse over the 

lifetime ofthe assets. It is incongruous that the propos'ed replacement valuation ignores 

this wear and does not provide lower values for outdatt::d technologies. None ofthe sane 

parties in this proceeding would purchase used equipment at the same price as new 

equipment ofthe same model. Thus, it seems inappropriate and unfair to expect shippers 

to pay new prices (through higher rail rates) for partially depreciated, old, or worn out 

railroad assets. 

CONCLUSION 

The issues involved in estimating the railroad industry's cost ofcapital merits the 

Board's careful deliberation ofthe record and careful consideration ofthe basic inputs 

and assumptions ofits proposed methodology. The accuracy and fairness ofmany ofthe 

Board's regulatory decisions depend upon an accurate and unbiased estimation ofcost of 

capital, particularly in regard to the cost ofequity which, unlike the cost ofdebt, can only 

be estimated.. 

The estimation ofthe railroad industry's cost of<:apital should be reasonably 

accurate, fair to both shippers and railroads, transparent to all stakeholders, and provide 

6 
, . 

estimates that are relatively stable from one year to tht: next. USDA contends that the 

Board's proposed methodology more closely fulfills these criteria than the rail industry 

has stated, but recognizes that some adjustments to the methodology may be appropriate. 

Therefore, USDA recommends that the Board: 

•	 Use the Capital Asset Pricing Model (CAPM) as its PrimarY method of 

determining the cost ofequity and has no objection to the use ofa properly 

designed and unbiased 3-stage Discounted Cash Flow model to check the 

reasonableness ofthe CAPM estimate. 

•	 Reject the railroads' recommendation that the Board choose a cost ofequity 

toward the upper end ofthe range ofmultiple estimates. 

•	 Reject the use of an inflation adjusted asset baS(~ in the estimate ofrailroad 

industry cost of capital. 

Respectively submitted, 

Bruce I. Knight 

Under Secretary 

Marketing and Regulatory Programs 

U.S. Department ofAgriculture 

Washington, D.C. 20250 

7
 
CERTIFICATE OF SERVICE 

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

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