Opinion ID: 2604259
Heading Depth: 1
Heading Rank: 6

Heading: The Department's Alternative Income Approaches

Text: The Department's experts were Michael Goodwin and Dr. James Ifflander. Goodwin, a private consultant in the field of valuation, had worked for several years as a staff appraiser for the Kansas Department of Revenue. Ifflander, an assistant professor of finance at Arizona State University, had appeared as an expert witness in railroad utility valuation cases on other occasions. The Department's experts utilized two different income models, the discounted cash flow model and the direct capitalization model. We shall discuss each model briefly. (1) The Department's discounted cash flow (DCF) model. We previously have set out the algebraic formula for calculating income under the Department's DCF model, which basically attempts to do the same thing that Schoenwald attempted to do, but assumes that there is a growth component (the g in the equation) in the railroad's future income stream that must be factored in. The parties argue at some length over whether the Tax Court did, in fact, give any weight to the Department's DCF method of valuation. We need not resolve this controversy. It is enough for our purposes to state that, because we are not persuaded by the evidence in this record that the method was applied properly in valuing UP, we do not give the Department's DCF method of valuation any weight. There are several flaws identified in the testimony concerning the Department's DCF model, not the least of which is the Department's reliance (in part), during its preparation of its DCF valuation, on UP's internal strategic plans. We do not find those plans to be sufficiently reliable to be used as source data for projections of the kind made from them in connection with the Department's DCF model, especially when the plans are viewed in the light of the plans' own historic record of unjustified optimism and in the light of all the evidence in the record concerning the state of the railroad industry. Even if we were not dissuaded from using the Department's DCF model by the Department's choice of sources for its data, we would have a further difficulty with the model. The Department attempted to massage its income projection data through a computer program called PRISM in order to obtain its final income figure. The Tax Court was unimpressed by PRISM, and we share that court's misgivings. In addition to the fact that a witness for UP raised serious questions concerning the efficacy of the program, neither of the Department's principal witnesses, Ifflander and Goodwin, seemed sufficiently conversant with the program, its assumptions or its limitations, to persuade us, any more than either persuaded the Tax Court, that the simulation produced by the program can be relied on here. Without prejudice to the Department's right to persuade us in some future case that we should accept conclusions based on PRISM, [10] we decline to utilize the Department's valuation approach that depended on that program here. Defending its use of PRISM, the Department argues that [UP's] evidence criticizing [the Department's] computer-generated DCF results does not meet its burden of proof. There is a profound misunderstanding here on the part of the Department. It is the Department that is offering in evidence a particular approach for identifying the taxpayer's cash flow. As to that particular approach, acceptance of which would change the Tax Court's decision, it is the Department's burden to persuade us that the approach correctly identifies the pertinent cash flow and that we therefore should utilize the approach. (2) The Department's direct capitalization (DCAP) model. With respect to the Department's DCAP method, our problem is a more general one. We find the testimony about this method and the various arguments made for and against it by the parties (and by the Tax Court) confusing and, ultimately, unsatisfying. The model requires the use of P/E (price/earnings) ratios, i.e., mathematical ratios derived from comparing the price at which particular companies' stock sold with the earnings of those companies. If an appraiser uses P/E ratios, it is vital that the ratios be for comparable companies, i.e., be derived from companies sufficiently similar to the company being evaluated to make use of the ratios analytically meaningful. We find, as did the Tax Court, that some of the comparable railroads used by the Department to calculate its P/E ratios were not comparable. [11] Moreover, what the Tax Court characterized as [t]he apparent lack of in-depth analysis by [the Department's] appraisers before the trial, a problem that the Tax Court said raises concerns about the reliability of their conclusions, troubles us as well. Too much went unexplained in the testimony and in the exhibits to permit us to believe that we can rely on the Department's evidence under this method. Furthermore, and as the Department itself acknowledged in its post-trial brief, its DCAP method takes on many of the same characteristics as its separate, stock and debt approach to value. We will consider the Department's stock and debt approach later. Finally, the Department itself attempted in its post-trial brief to establish different assumptions for, and in effect to amend, its DCAP approach. (The Department's amendments would increase the valuation of UP.) The problem here is that the Department attempts to accomplish these amendments by impeaching its own experts. The net effect of all this is thoroughly to defeat the court's ability to rely on the Department's trial evidence concerning the DCAP method. We do not accept or give any weight to the Department's valuation achieved through that method. (3) The Department's alternative argument. The Department makes one other point concerning the income stream. It argues that, even if we disregard the Department's income stream projections as unpersuasive, we must use some income stream, and that income stream has two partsdebt flow and equity cash flow. The Department argues that those flows, generated as they are by different market forces, should be discounted separately. The Tax Court disagreed, taking the view that what the Department was attempting to do, in essence, was to amalgamate the income approach and the stock and debt approach. It would seem preferable, the court stated, to obtain an indication of value wholly by the income approach and an indication of value wholly by the stock and debt approach and then [to] correlate those two indications of value rather than [to] mix the methods and obtain a diluted result. Union Pacific Railroad v. Dept. of Rev., supra, 11 OTR at 184. We agree.