BEFORE THE 

SURFACE TRANSPORTATION BOARD 

STB EX PARTE NO. 664 

METHODOLOGY TO BE EMPLOYED IN DETERMINING 

THE RAILROAD INDUSTRY'S COST OF CAPITAL 

PUBLIC HEARING 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: February 15,2007 
A UTHORITY AND INTi?CREST 

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. 

ZNTROD UCTZON 

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

to allow interested parties to present their views concerning the methodology used in 

calculating the railroad industry's cost of capital. USDA appreciates the willingness of 

the Board to take into consideration these views when determining the procedures to be 

employed in future annual cost of capital calculations. The outcome of this proceeding 

can have important ramifications for our nation's agricultural producers and shippers. 

USDA recommends that the Board discontinue the use of its current discounted 

cash flow (DCF) method in favor of using a multi-stage DCF model to calculate the cost 

of capital. A capital asset pricing model (CAPM) should be used to verifj the 

reasonableness of the cost of capital estimate that is obtained using the multi-stage DCF 

model. USDA also recommends that equity capital (used in cost of capital 

determinations) be calculated using net book values rather than stock prices. The 

Department's recommendations and further comments are detailed below. 
RAILROAD INDUSTRY CHANGES MERITA CHANGE IN METHODOLOGY 

Since passage of the Staggers Rail Act, the railroad industry has evolved from 

having excess rail capacity to having rail capacity constraints. The Act made it easier for 

railroads to abandon unprofitable and excess rail lines. At the same time, globalization 

resulted in increased imports and the rapid growth of intermodal movements. Increased 

reliance upon coal for generating electricity, as well as increased traffic in other 

commodities, also has resulted in increased rail traffic. Competition from the trucking 

industry has decreased due to increased fuel prices, a shortage of truck drivers, changes in 

trucking hours-of-service regulations, and highway congestion. In fact, traffic that 

normally would move by truck is now moving as intermodal traffic on railroads. 

Railroads have been able to increase rail rates as a result of constrained rail capacity and 

increased demand. Consequently, railroads are attaining or rapidly approaching revenue 

adequacy. 

IMPORTANCE OF ACCURATE COST OF CAPITAL DETERMINA TIONS 

The Interstate Commerce Commission Termination Act (ICCTA) and the 

Staggers Rail Act require the Board to balance railroads' need for an adequate return on 

investment with protecting shippers from excessive rail rates.' As such, the methods 

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

1 Rail Transportation Policy, ICC Termination Act of 1995, § 10 10 1. 
Accurate portrayal of railroad cost of capital is important for two reasons. First, 

cost of capital determinations are used to assess railroad revenue adequacy. Revenue 

adequacy can become a key issue in rail rate disputes. If cost of capital determinations 

are not accurately portrayed, railroads may be considered revenue inadequate, when 

realistically, they may actually be revenue adequate. As a result, the Board, when having 

to make a decision on excessive rail rates, may not have an accurate picture of a 

railroad's financial position and could make a decision detrimental to the shipper 

appealing the rate. 

Second, cost of capital calculations are entered into the Board's Uniform Rail 

Costing System (URCS). The URCS is used to estimate rail costs and to calculate 

revenue-to-variable cost ratios. The URCS assumes that railroad firms are entitled to a 

fair return on investment (cost of capital) and the fair return on investment is included in 

the railroads' costs. An overestimation of the cost of capital may overstate railroad total 

costs and result in a lower estimated revenue-to-variable cost ratio (R/VC)~ than would 

actually be true. In such cases, an underestimated RNC would have the potential to 

create an unfair advantage for railroads in rail rate disputes brought before the Board. 

COMPARISON OF DCFAhD CAPM MODELS 

The DCF and CAPM approaches rely on market and industry performance, 

expectations, and variability; they diverge in respect to their basis in time. The DCF 

method is focused on expected growth in dividends. Uncertainty in the DCF method is 

The Board has no regulatory authority to settle rail rate disputes in cases where RNC is less than the 

regulatory floor of 180. 
inherent because projected growth can not be ascertained with absolute certainty. Hence, 

the DCF method is based heavily on future expectations while the CAPM method relies 

primarily on pastlcurrent market performance. 

The Board currently uses a simple DCF formula, K = Do (1+ 0.5 g) 1 Po, where K 

represents the cost of equity capital, Do represents the current dividend, g represents the 

assumed dividend growth rate, and Po represents the stock price. The stock price (which 

is the estimated present value of future dividends) and current dividends are easily 

obtained. The growth rate of dividends, which is calculated based upon actual 

dividends and stock prices, is a 5-year earnings per share growth rate forecast and is 

assumed to continue at this growth rate into perpetuity. From this data, the Board infers 

the equity cost of capital. 

A multi-stage DCF model could give a more accurate estimation of the dividend 

growth rate because it allows the Board to use a different dividend growth rate for each 

discreet period of time. For instance, the growth rate may be estimated at 10 percent for 

the first five years, but then converge to the estimated economic growth rate for the entire 

economy for all subsequent years. This would be an example of a Zstage DCF model. 

In contrast, a CAPM model, K = RRF + P (ERM - RRF), is based upon the risk of a 

stock in relation to that of the individual firm and the entire stock market. K represents 

the cost of equity capital, RRF represents the rate of return for a risk fiee investment, 

represents the risk level of a firm or industry relative to that of the entire stock market, 

and ERM represents the rate of return for the entire market. The CAPM model, unlike the 

In finance and economic theory, stock prices are actually the sum of the discounted cash value hm 

expected dividends and the discounted cash value due to expected growth in stock value. 
DCF model, directly calculates the cost of equity capital. In addition, the CAPM model 

may also include other risk factors. 

Each method, DCF and CAPM, has its own advantages and disadvantages 

because of differing assumptions. The estimated cost of equity capital, however, should 

not vary markedly between the two methods. By using CAPM to check the results 

obtained by using a multi-stage DCF model, the Board can re-examine the assumptions 

of the models should the results differ substantially and choose the model that provides 

the most realistic estimate of the cost of capital. 

DRAWBACKS OF CURRENT COST OF CAPITAL METHOD 

The Board's current DCF methodology may have major sources of circularity in 

that the Board's rulings on revenue adequacy may influence its cost of capital calculation. 

The first major source of circularity is the assumption that the growth rate of dividends 

will continue at a constant rate into perpetuity. Given the relatively recent and rapid 

growth in the railroad industry relative to that of the economy as a whole, the assumption 

that this rate of growth will continue into perpetuity is an error that greatly impacts the 

calculation of the industry's cost of capital and determination of revenue adequacy. 

Consequently, even though railroads are achieving record levels of profitability, 

the cost of equity capital continues to increase, often resulting in the Board ruling that a 

railroad is revenue inadequate while railroad industry analysts believe otherwise. A 

ruling of revenue inadequacy allows the railroad to increase rail rates, resulting in higher 

estimates of industry earnings and higher stock prices. As a result of increased railroad 
stock prices, which are part of the DCF formula, the cost of equity capital and weighted 

average cost of capital are increased, starting the cycle over again. 

The second source of circularity could be due to the Board's use of stock values 

rather than the net book value of assets (cost less depreciation) when calculating the cost 

of equity capital with the current DCF method. Railroad stock prices are influenced by 

the level of railroad profits and have risen rapidly as railroad profits have increased. As a 

result, railroad stock prices are now substantially higher than the net book value of assets 

and are much more volatile. Consequently, when the Board calculates the weighted 

average cost of capital, the proportion of equity to debt capital may be inflated as well as 

the weighted average cost of capital because equity capital is more expensive than debt 

capital. In contrast, net book value is not influenced by a railroad's profitability and is a 

much more stable value that is based upon the actual investment. 

The methodology used in future cost of capital determinations should not allow 

the level of railroad profitability to iduence the railroad's cost of capital. USDA is 

concerned that such drawbacks in the current DCF method may adversely affect the 

accuracy of the current cost of capital determination method employed by the Board. 

These drawbacks warrant the Board's adoption of a new methodology or methodologies. 

USDA RECOMMEmA TIONS 

USDA recommends that the Board discontinue the use of its current discounted 

cash flow (DCF) method in favor of using a multi-stage DCF model to calculate the cost 

of capital. A capital asset pricing model (CAPM) should be used to verify the 
reasonableness of the cost of capital estimate that is obtained using the multi-stage DCF 

model. USDA also recommends that equity capital (used in cost of capital 

determinations) be calculated using net book values rather than stock prices. 

CONCL USZON 

USDA appreciates the efforts of the Board to seek comments and 

recommendations on its current methodologies. USDA hopes that its comments will aid 

the Board in reaching a decision that is hir to railroads and their customers. The 

outcome of this proceeding could have important ramifications for railroads and our 

nation's producers and shippers. 

Under Secretary 

Marketing and Regulatory Programs 

U.S. Department of Agriculture 

Washington, D.C. 20250 
CERTIFICATE OF SERVICE 

I, Brian M. McGregor, certify that on this 15th day of February, 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. 

Brian M. McGregor 

Acting Associate Deputy Administrator 

Transportation and Marketing Programs 

U.S. Department of Agriculture 

Washington, D.C. 20250