47642 Federal Register / Vol. 73, No. 158 / Thursday, August 14, 2008 / Notices 

1See 49 U.S.C. 10704(a)(2),(3); Standards for 

Railroad Revenue Adequacy, 364 I.C.C. 803 (1981), 

modified, 3 I.C.C.2d 261 (1986), aff’d sub nom. 

Consolidated Rail Corp. v. United States, 855 F.2d 

78 (3d Cir. 1988). 

FTA currently allows a transit 

provider that is severely impacted by a 

natural disaster to request a waiver from 

reporting to the NTD for the current 

year. This policy is based on the NTD 

Rule (49 CFR Part 630), which provides 

for a waiver from the mandatory NTD 

reporting requirements if reporting to 

the NTD would cause ‘‘unreasonable 

expense or inconvenience.’’ When FTA 

grants such a waiver to an urbanized 

area reporter that has previously 

reported to the NTD, FTA automatically 

includes data from the last-available 

NTD report year for the reporter in the 

apportionment of formula grants for 

urbanized areas. However, FTA does not 

currently have policies or procedures 

that would allow it to use NTD data 

from a prior report year in the 

apportionment of formula grants for 

urbanized areas for a transit provider 

that is able to report for the current year. 

II. Proposed Policy Change 

If a transit provider suffers a marked 

decrease in transit service due to a 

natural disaster, FTA proposes to allow 

that transit provider to be ‘‘held 

harmless’’ in the apportionment of 

formula grants for urbanized areas. The 

affected provider may request that their 

data from the NTD report year before the 

natural disaster occurred be used in 

place of data for the current report year 

in the apportionment. FTA would 

continue to use data from the current 

NTD report year for all other transit 

providers in the apportionment. The 

designated recipient for an urbanized 

area may also make this request on 

behalf of an affected provider. This 

adjustment would not be automatic, and 

FTA will not make this adjustment 

unless requested by the affected 

provider or the designated grant 

recipient for the urbanized area. 

Under the proposed policy, FTA 

would approve or deny the request for 

the adjustment at its discretion. FTA 

will base its decision on the following 

factors: (1) Whether a Federal disaster 

declaration was in place for all or part 

of the current report year, for either all 

or part of the transit provider’s service 

area; (2) whether the adjustment request 

demonstrates that the decrease in transit 

service from the report year before the 

natural disaster is in large part due to 

the ongoing impacts of the natural 

disaster; and (3) whether the decrease in 

transit service reasonably appears to be 

temporary, and thus not reflective of the 

true transit needs of the urbanized area. 

FTA will not grant adjustment requests 

that do not address all of these factors. 

Adjustment requests should include 

sufficient documentation to allow FTA 

to evaluate the request based on these 

factors. FTA may request additional 

information from an applicant for an 

adjustment to evaluate the request based 

on these factors. If the adjustment 

request is granted, the NTD data in all 

publicly-available data sets and data 

products would remain unadjusted, and 

would reflect the actual NTD 

submission for the transit provider. The 

only adjustment would be in the data 

sets used for the apportionments of 

formula grants for urbanized areas. 

FTA proposes for this policy to take 

effect for the 2007 NTD Report Year, 

which is the data to be used in the FY 

2009 apportionment of formula grants 

for urbanized areas. This policy would 

remain in effect for the 2008 NTD 

Report Year, and will be included in the 

NTD Annual Manual for the 2009 

Report Year. 

Issued in Washington, DC, this 8th day of 

August 2008. 

James S. Simpson, 

Administrator. 

[FR Doc. E8–18939 Filed 8–12–08; 4:15 pm] 

BILLING CODE 4910–57–P 

DEPARTMENT OF TRANSPORTATION 

Surface Transportation Board 

[STB Ex Parte No. 664 (Sub-No. 1)] 

Use of a Multi-Stage Discounted Cash 

Flow Model in Determining the 

Railroad Industry’s Cost of Capital 

AGENCY: Surface Transportation Board. 

ACTION: Notice. 

SUMMARY: The Board proposes to use a 

multi-stage Discounted Cash Flow (DCF) 

model to complement its use of the 

Capital Asset Pricing Model (CAPM) in 

determining the cost-of-equity 

component of the railroad industry’s 

cost of capital. 

DATES: Comments are due on or before 

September 15, 2008. Reply comments 

are due on or before October 14, 2008. 

ADDRESSES: Comments may be 

submitted either via the Board’s e-filing 

format or in traditional paper format. 

Any person using e-filing should attach 

a document and otherwise comply with 

the instructions at the E-FILING link on 

the Board’s Web site at http:// 

www.stb.dot.gov. Any person submitting 

a filing in the traditional paper format 

should send an original and 10 copies 

referring to STB Ex Parte No. 664 (SubNo. 1) to: Surface Transportation Board, 

395 E Street, SW., Washington, DC 

20423–0001. 

FOR FURTHER INFORMATION CONTACT: Paul 

Aguiar, (202) 245–0323. [Assistance for 

the hearing impaired is available 

through the Federal Information Relay 

Service (FIRS) at 1–800–877–8339.] 

SUPPLEMENTARY INFORMATION: Each year 

the Board measures the cost of capital 

for the railroad industry in the prior 

year. The Board then uses this cost-ofcapital figure for a variety of regulatory 

purposes. It is used to evaluate the 

adequacy of individual railroads’

revenues for that year.1 It is also 

employed in cases involving rail rate 

review, feeder line applications, rail line 

abandonment proposals, trackage rights 

compensation cases, and rail merger 

review, as well as in our Uniform Rail 

Costing System (URCS). 

The Board calculates the cost of 

capital as the weighted average of the 

cost of debt and the cost of equity, with 

the weights determined by the capital 

structure of the railroad industry (i.e., 

the proportion of capital from debt or 

equity on a market-value basis). While 

the cost of debt is observable and 

readily available, the cost of equity (the 

expected return that equity investors 

require) can only be estimated. How 

best to calculate the cost of equity is the 

subject of a vast amount of literature. 

Because the cost of equity cannot be 

directly observed, estimating the cost of 

equity requires adopting a finance 

model and making a variety of 

simplifying assumptions. 

In Methodology to be Employed in 

Determining the Railroad Industry’s 

Cost of Capital, STB Ex Parte No. 664 

(STB served Jan. 17, 2008), the Board 

changed the methodology that it uses to 

calculate the railroad industry’s cost of 

equity. We concluded that the time had 

come to modernize our regulatory 

process and replace the aging singlestage DCF model that had been 

employed since 1981. After a thorough 

rulemaking process, we decided to 

calculate the cost of equity using CAPM. 

During that process, several parties 

urged the Board to use a multi-stage 

DCF in conjunction with CAPM. We 

elected to adopt a stand-alone CAPM 

approach because the record in that 

proceeding did not support adopting 

any particular DCF model. But, we did 

not want to foreclose the possibility of 

augmenting CAPM with a DCF 

approach. As we explained in the 

January 2008 decision (footnotes 

omitted): 

There may be merit to the idea of using 

both models to estimate the cost of equity. 

While CAPM is a widely accepted tool for 

estimating the cost of equity, it has certain 


sroberts on PROD1PC70 with NOTICES
Federal Register / Vol. 73, No. 158 / Thursday, August 14, 2008 / Notices 47643 

2February 2007 Hearing Tr. at 18. 

3See generally David F. Hendry & Michael P. 

Clements, Pooling of Forecasts, VII Econometrics 

Journal 1 (2004); J.M. Bates & C.W.J. Granger, The 

Combination of Forecasts in Essays in 

Econometrics: Collected Papers of Clive W.J. 

Granger. Vol. I: Spectral Analysis, Seasonality, 

Nonlinearity, Methodology, and Forecasting 391–

410 (Eric Ghysels, Norman R. Swanson, & Mark W. 

Watson, eds., 2001); Spyros Makridakis and Robert 

L. Windler, Averages of Forecasts: Some Empirical 

Results, XXIX Management Science 987 (1983). 

4See, e.g., Franco Modigliani & Merton H. Miller, 

The Cost of Capital, Corporation Finance, and the 

Theory of Investment, 48 Am. Econ. Rev., 261–97 

(1958). By integrating tax—and information-related 

considerations on capital structure and dividend 

policy choices, Modigliani and Miller greatly 

influenced subsequent developments in the field of 

finance. See Sudipto Bhattacharya, Corporate 

Finance and the Legacy of Miller and Modigliani, 

2 J. Econ. Perspectives 135–47 (1988). 

strengths and weaknesses, and it may be 

complemented by a DCF model. In theory, 

both approaches seek to estimate the true 

cost of equity for a firm, and if applied 

correctly should produce the same expected 

result. The two approaches simply take 

different paths towards the same objective. 

Therefore, by taking an average of the results 

from the two approaches, we might be able 

to obtain a more reliable, less volatile, and 

ultimately superior estimate than by relying 

on either model standing alone. 

Ultimately, both CAPM and DCF are 

economic models that seek to measure 

the same thing. CAPM seeks to do so by 

estimating the level of expected returns 

that investors would demand given the 

perceived risks associated with the 

company. By contrast, DCF models 

estimate the expected rate of return 

based on the present value of the cash 

flows that the company is expected to 

generate. Both approaches are plausible 

and intuitive, but are merely models. 

The Federal Reserve Board noted in 

its testimony in STB Ex Parte No. 664 

that ‘‘academic studies had 

demonstrated that using multiple 

models will improve estimation 

techniques when each model provides 

new information * * *’’ 2 There is, in 

fact, robust economic literature 

confirming that, in many cases, 

combining forecasts from different 

models is more accurate than relying on 

a single model.3

The record before us in STB Ex Parte 

No. 664 was insufficient for us to adopt 

a particular DCF model. But, it did 

illuminate a number of criteria to guide 

us in that effort. We issued an Advance 

Notice of Proposed Rulemaking, Use of 

a Multi-Stage Discounted Cash Flow 

Model in Determining the Railroad 

Industry’s Cost of Capital, STB Ex Parte 

No. 664 (Sub-No. 1) (STB served Feb. 

11, 2008) (ANPRM) in which we 

requested comments on the use of a 

multi-stage DCF model to complement 

the use of CAPM in determining the 

railroad industry’s cost-of-capital. 

Specifically, we invited interested 

parties to submit comments on an 

appropriate multi-stage DCF for use in 

the Board’s cost-of-equity 

determination. In the ANPRM, we 

identified the requirements that a multistage DCF model should satisfy. 

First, and foremost, the proposed DCF 

model should be a multi-stage model. 

For cost-of-capital determinations for 

years 1981 through 2005, the agency 

relied on a single-stage DCF. That model 

required few inputs and few judgment 

calls, permitting the agency to promptly 

develop an estimate of the cost-of-equity 

component of the cost of capital. But its 

simplicity was due in part to an 

assumption that the 5-year growth rate 

would remain constant thereafter. That 

assumption proved problematic. In 

recent years, railroad earnings have 

grown at a very rapid pace, exceeding 

the long-run growth rate of the economy 

as a whole. While it is certainly possible 

that railroad earnings will continue to 

grow rapidly for many years, they 

cannot do so forever as the single-stage 

DCF model assumes. Thus, in years 

when the 5-year growth rate is very 

high, this model may overstate the cost 

of equity. Similarly, in years when the 

railroads experience a downturn and the 

predicted 5-year growth rate is very low, 

the model may understate the cost of 

equity. 

Second, we noted in the ANPRM that 

the DCF model should not focus on 

dividend payments only. Finance theory 

suggests that the value of a firm should 

be independent of its dividend policy.4

Although changes in dividends do 

influence stock prices, it is because 

these changes are ‘‘news’’ to the market. 

The market then responds in valuing the 

stock. It is the news, not the dividend 

distribution, that drives the change in 

prices. In addition, companies return 

profits to their shareholders in ways 

other than increasing dividends, 

including buying back shares. As a 

result, we no longer think that a simple 

dividend distribution model is an 

acceptable framework for valuing firms. 

Rather, broader measures of cash flow or 

shareholder returns should be 

incorporated. 

Third, the DCF model responsive to 

the ANPRM should be limited to those 

firms that pass the screening criteria set 

forth in Railroad Cost of Capital—1984, 

1 I.C.C.2d 989 (1985) (Railroad Cost of 

Capital—1984). Under those criteria, we 

include in the analysis only those Class 

I carriers that: (1) Had rail assets greater 

than 50% of their total assets; (2) had a 

debt rating of at least BBB (Standard & 

Poors) and Baa (Moody’s); (3) are listed 

on either the New York or American 

Stock Exchange; and (4) paid dividends 

throughout the year. A Class I railroad 

is one having annual carrier operating 

revenues of at least $250 million in 1991 

dollars. 49 CFR 1201.1–1. Those criteria 

tend to result in establishing the cost of 

capital for an efficiently run railroad 

firm, on which data are readily and 

transparently available. 

Fourth, we sought a multi-stage DCF 

model that, when used in combination 

with CAPM, would enhance the 

precision of the resulting cost-of-equity 

estimate, one that over a sufficiently 

lengthy historical analysis period would 

result in a combined forecast with a 

lower variance than a forecast relying on 

the CAPM approach alone. 

In response to the ANPRM, the Board 

received comments from Arkansas 

Electric Cooperative Corporation 

(AECC); the Association of American 

Railroads (AAR) and the Western Coal 

Traffic League (WCTL). 

AAR and WCTL each proposed multistage DCF models. AAR’s proposed 

model satisfied all of the four 

fundamental requirements identified by 

the Board in the ANPRM. AAR’s model 

is a multi-stage DCF. Its cash flow 

component is broader than models 

using only dividends. It is limited to the 

four carriers that meet the Board’s 

screening criteria, and it reduces 

variance in estimating the cost of equity 

as compared to using the CAPM 

approach alone. 

WCTL submitted a multi-stage DCF 

model and asserted that such a model 

could provide further validation of the 

CAPM results. However, WCTL asserted 

that it did not believe the Board should 

receive and consider evidence 

concerning multi-stage DCF calculations 

along with CAPM calculations as part of 

our annual railroad industry cost-ofcapital determinations at this time. 

WCTL suggested that we revisit this 

matter in five years. 

AECC did not submit a model in 

response to the ANPRM, but deferred to 

the WCTL. AECC did express the 

opinion that the use of a multi-stage 

DCF model in conjunction with CAPM 

could enhance the precision of the 

resulting cost-of-equity estimate. 

Proposed Rule 

For the reasons set forth below, the 

Board proposes to determine the cost of 

equity of the railroad industry by using 

the average of the estimate produced by 

the CAPM model and the Morningstar/ 

Ibbotson multi-stage DCF model 

identified by AAR. 

The Morningstar/Ibbotson model 

meets the four requirements we 

established in the ANPRM. It employs 


sroberts on PROD1PC70 with NOTICES
47644 Federal Register / Vol. 73, No. 158 / Thursday, August 14, 2008 / Notices 

5See AAR V.S. of Stangle at 10. 

three different growth rates of the 

railroads meeting the Board’s criteria. 

Stage 1 represents the first 5 years. In 

each year of Stage 1, the growth rate 

used is the median value of the threeto-five-year growth estimates for the 

qualifying railroads as provided to 

Morningstar by railroad industry 

analysts. Stage 2 represents years 6 

through 10. In Stage 2, the growth rate 

is the average of the earnings growth for 

the qualifying railroads taken as a 

whole. Stage 3 begins with year 11 and 

continues thereafter. The growth rate in 

Stage 3 is assumed to be the long-run 

nominal growth rate of the aggregate 

U.S. economy. This three-tier approach 

eliminates the problem posed by a 

single-stage DCF model which could 

overstate the cost of equity by assuming 

a constant growth rate. The precise 

equation that describes the Morningstar/ 

Ibbotson multi-stage DCF model is set 

forth in the submission by the AAR.5

The model also meets the second 

requirement that it not limit future cash 

flows to dividend payments alone. 

Rather, the model incorporates a wider 

array of cash flows for equity investors 

by applying expectations of earnings 

growth to the firms’ cash flows, not just 

actual dividends. Thus, it accounts for 

all of the relevant cash flows a 

reasonable investor is likely to 

anticipate, including share repurchases 

and earnings’ reinvestments to obtain 

greater future cash flows, along with 

dividends. The Morningstar/Ibbotson 

model includes the impact of capital 

expenditures on a firm’s cash flow. 

The Morningstar/Ibbotson model 

meets our third requirement, as it can be 

modified to use only those firms that 

pass the screening criteria set forth in 

Railroad Cost of Capital—1984. 

And AAR has demonstrated that the 

model satisfies our fourth requirement. 

When combined with CAPM and 

applied over a sufficiently lengthy 

historical analysis period, the 

Morningstar/Ibbotson multi-stage DCF 

model enhances the precision of the 

resulting cost-of-equity estimate with a 

lower variance than a forecast relying on 

the CAPM approach alone. For the 

period 1998 through 2006, for the four 

Class I railroads meeting the Railroad 

Cost of Capital—1984 standards, the 

Morningstar/Ibbotson model produces a 

cost of equity ranging from 11.6% to 

14.6%, while the CAPM yields 

estimates between 9.7% and 12.7%. 

Averaging the estimates from the two 

models yields estimates in the range 

between 11.1% and 13.4%. The 

standard deviation for both the 

Morningstar/Ibbotson model and the 

CAPM model is 0.92 while the standard 

deviation of the average of the two 

models is only 0.75. As such, using the 

average of both CAPM and the multistage DCF model produces a more stable 

and more precise cost-of-equity 

estimate. 

Finally, the Morningstar/Ibbotson 

model is a commercially accepted 

multi-stage DCF model. It was 

developed by disinterested, respected 

third parties and created for use by the 

financial community in evaluating 

publicly traded equities and in making 

real-world investment decisions. It was 

not developed as a tool for litigation or 

advocacy, and the same model is used 

by Morningstar to estimate the cost of 

equity for hundreds of different 

industries. The model’s variables can be 

estimated from publicly available data, 

and here can be applied to those 

railroads that meet the Board’s selection 

criteria. While there may well be a 

variety of other multi-stage DCF 

models—each with different 

assumptions and inputs—that might 

satisfy the four requirements set forth in 

our notice, we believe it is prudent to 

use an approach that was not developed 

simply as a tool for litigation before the 

Board, but rather to use an approach 

that has been tested in the marketplace 

and is used to estimate the cost of equity 

for different industries, not just the rail 

industry. For this reason, we are 

proposing to use the Morningstar/ 

Ibbotson model, rather than the model 

developed and proposed by WTCL. 

Interested parties are invited to 

comment on the proposed use of the 

Morningstar/Ibbotson model in 

conjunction with CAPM. Parties should 

also comment on the best way to 

integrate the two approaches and 

whether a simple average is the best 

approach. 

This action will not significantly 

affect either the quality of the human 

environment or the conservation of 

energy resources. 

Board decisions and notices are 

available on our Web site at http:// 

www.stb.dot.gov. 

Decided: August 7, 2008. 

By the Board, Chairman Nottingham, Vice 

Chairman Mulvey, and Commissioner 

Buttrey. 

Anne K. Quinlan, 

Acting Secretary. 

Appendix 

The cost of equity for each firm (ri) in 

the Morningstar/Ibbotson three-stage 

DCF model is the solution to the 

following equation: 

MV i

i i

t

i

t

i i

t

i

t

t t

CF g

r

CF g

r 0

01 52

5

6

10

1

5 1

1

1

1 = ( ) +

( ) +

+ ( ) +

( ) +

( ) −

=

∑=∑ +

( ) +

−

( ) +

IBEIi i

i i

i

g

r g

r

10 3

3

10

1

1

Where, 

MVi0 = market value of firm i in year 0 (i.e., 

the year for which the cost of equity is 

being estimated) 

CFit = average cash flow for firm i at the end 

of year t 

gi1 = earnings growth rate for firm i in stage 

j (j = 1, 2, or 3). 

IBEI10 = IBEI0 (1+g1)5(1+g2)5

IBEI0 is determined by the same process as 

CF0

The industry cost of equity (R) for the 

three-stage DCF model is computed as 

the market value weighted average of 

the individual firm cost of equity 

estimates: 

R = =

∑S ri i

t

N

, 1

Where, si is firm i’s share of the total 

industry market value and N is the number 

of firms in the industry composite, such that: 

S MV ii i

t

N

= ( ) MV

=

0 0 ∑1

/

[FR Doc. E8–18865 Filed 8–13–08; 8:45 am] 

BILLING CODE 4915–01–P 


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