[Federal Register Volume 73, Number 158 (Thursday, August 14, 2008)]
[Notices]
[Pages 47642-47644]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-18865]


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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.

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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 (Sub-No. 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-of-capital 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).
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    \1\ See 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).
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    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 single-stage 
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

[[Page 47643]]

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\
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    \2\ February 2007 Hearing Tr. at 18.
    \3\ See 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).
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    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 
multi-stage 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.
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    \4\ See, 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).
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    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 multi-stage 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-of-
capital 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

[[Page 47644]]

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 three-to-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\
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    \5\ See AAR V.S. of Stangle at 10.
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    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 multi-stage 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:

[GRAPHIC] [TIFF OMITTED] TN14AU08.010

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
gi<INF>1</INF> = earnings growth rate for firm i in stage j (j = 1, 
2, or 3).
IBEI<INF>10</INF> = IBEI<INF>0</INF> 
(1+g<INF>1</INF>)<SUP>5</SUP>(1+g<INF>2</INF>)<SUP>5</SUP>
IBEI<INF>0</INF> is determined by the same process as CF<INF>0</INF>

    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:

[GRAPHIC] [TIFF OMITTED] TN14AU08.011

    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:

[GRAPHIC] [TIFF OMITTED] TN14AU08.012

[FR Doc. E8-18865 Filed 8-13-08; 8:45 am]
BILLING CODE 4915-01-P