Opinion ID: 1362962
Heading Depth: 1
Heading Rank: 8

Heading: Annuity Method of Capitalization Treatment of Depreciation.

Text: The capitalization of income involves taking into account the hypothetical purchaser's recovery of his capital which was invested in depreciable property. Plaintiff's approach was to capitalize net operating income, or to deduct depreciation as an expense before capitalization, which is the method the company actually follows. In computing its straight-line method of depreciation plaintiff used the estimates of depreciation which it reports to the Federal Power Commission. Defendant's approach was to capitalize income before depreciation, and to then include a depreciation component within the capitalization (CAP) rate. In its computations defendant used the Inwood factor, which is merely a reciprocal of the CAP rate to which one has added the depreciation rate. Rather than use dollar amounts of depreciation, this annuity method requires use of a sinking fund rate of depreciation. The formula is: income divided by CAP rate, plus sinking fund factor (determined from CAP rate of 9 percent and 37 year remaining life), plus residual value, equals system value: 157,529,700 + .04123 (44,180,000) = 1,679,990,300, ___________ .090 + .00387 which x (times) .3369 allocation factor = 569,988,700, defendant's January 1, 1975 valuation. Dr. Ring gave this description of the alternative methods of capitalization: There are, in fact, a number of sinking funds, some that are acceptable for use in one instance and some that may be accepted for regulated industry and, of course, there are some that are unacceptable in the application. To illustrate, all methods described in most valuation textbooks are sinking funds. There is a sinking fund that bears no interest. The sums needed for plant retirement are placed in a reserve or fund for depreciation to be available for instant use for both regular and emergency retirement of plant. This sinking fund is known as the straight-line method. This fund or method is used almost exclusively by all interstate public utilities in this country. Another method of modification of the straight line provision for depreciation is to place periodic or annual provisions for plant retirement in an interest-bearing fund at what we call a safe rate. This sinking fund is known as the safe interest-bearing sinking fund. A third method of a sinking fund applicable only where funds are to be set aside or can immediately be reinvested instantaneously at a risk-bearing interest rate is known as the annuity method of depreciation. This method should only be applied where income stream is level and under firm contract. It is this third method, through its reciprocal the Inwood factor, which defendant utilized here. Plaintiff contends and the tax court agreed that defendant's method essentially involved double counting in that defendant was assuming that the income stream to be capitalized would remain constant, which required reinvestment in plant to keep the rate base and thus income from declining, and that at the same time the depreciation would be invested in a sinking fund at the risk rate. Defendant argues in its briefs to this court that the tax court's interpretation of the annuity method of capitalization is incorrect because the Inwood method does not necessarily assume reinvestment. It is not clear whether defendant is asserting that reinvestment in plant is unnecessary to maintain the income stream, or that the depreciation may be invested in a sinking fund from which reinvestment in plant may be made, or just that reinvestment in plant may be made which will earn at the same rate as a sinking fund. Even assuming that defendant's method of capitalization only involves reinvestment in plant, plaintiff criticizes defendant's use of the Inwood factor because the rate of return on the depreciation is assumed to be the same as the CAP rate. Since the utility is required to invest its depreciation in plant to keep its income stream constant, and since the utility did not earn at the defendant's CAP rates of 9 percent and 9.5 percent for the assessment years in question, the annuity method is inapplicable here. In fact the utility was not allowed to earn a rate of 9 percent or 9.5 percent on its rate base for those years. In its briefs to this court defendant states that if the Inwood factor should not be applied here, then the Hoskold factor should be used. This factor also involves capitalization before depreciation, but applies a riskless rate of return to the sinking fund. While Dr. Ring testified that this factor would be more applicable than the Inwood factor to a utility company, he still disagreed with its use. First of all, he asserted it required, along with Inwood, a detailed depreciation study of each of the major plant units involving eight to nine months work, to figure the depreciation component of the CAP rate. The sinking fund requirements of the individual categories of plant would be added and set aside to provide for replacements and retirements as they fall due. Defendant, though, used the 37 year life of the plant as a whole as a reasonable approximation in lieu of an actual life study. Dr. Ring also asserted that defendant's 37 year remaining life of the whole plant was excessive, considering the increasing number of steam plants being built as opposed to hydro plants in the past. Further, he disagreed with the 7 percent risk rate applied by defendant, mentioning instead the possibility of a 3 percent rate. In rebuttal defendant quoted from Def. Ex. D, Appraisal of Railroad and Other Public Utility Property for Ad Valorem Tax Purposes, Report of the Committee on Unit Valuation, National Association of Tax Administrators (1954), which states, at page 5, that proponents of the procedure of capitalizing before depreciation claim that even crude estimates of remaining life will give superior results to those derived from capitalization after depreciation. Not only is this reasoning not explained in the record but another authority cited by defendant in support of its capitalization before depreciation appraisal method, Report of Committee on Railroad and Utility Valuation, Western States Association of Tax Administrators (1971), states at page 15, that in closely regulated companies there is possibly a persuasive argument that the book depreciation expense is a proper allowance rather than providing for depreciation in the capitalization rate. While from the record it does appear that the Hoskold method could be used here, the validity of the appraisal presented by defendant utilizing that method is too unclear to be used instead of plaintiff's straight-line method. It may be that the straight-line method of depreciation is too conservative, but the proper determination of remaining life of the property and of the riskless rate of return to be used in the Hoskold method were insufficiently explained.