Opinion ID: 1129291
Heading Depth: 1
Heading Rank: 7

Heading: The Cost Approach to Valuation

Text: The experts agree that historical cost less depreciation (HCLD) properly establishes the cost indicator of value for a closely regulated utility like United. HCLD is an item periodically reported by United to both the state Public Utility Commission and the Federal Communications Commission, and is the basis upon which United is allowed to earn a return. Both Davis and Maude used HCLD. Davis, however, made an adjustment for obsolescence that substantially reduced the value he reported under this indicator. Davis began with a figure for United's net telephone plant plus material and supplies (also called net operating plant in service), $139,704,371, which both parties accepted. From this figure, however, he subtracted the amount of $42,616,990, which he described as an appropriate deduction from net plant for obsolescence. This left a net of $97,087,381 which, rounded off, exactly equalled Davis' final figure under the income indicator, viz., $97,087,000. Davis rationalized the deduction by explaining that when actual earnings of a company are less than its authorized rate of return, the difference between the two, when capitalized, will reflect obsolescence in the property. His calculation for this was interesting: (1) HCLD X discount rate (R) = required earnings (2) $139,704,371 X .1545 = $21,584,325 (3) Projected earnings for the period are $15,000,000. (4) The shortfall between required earnings at the discount rate and the projected earnings ($21,584,325  $15,000,000 = $6,584,325) is a reflection of obsolescence, i.e., an inability to earn full return on the rate base. (5) Capitalizing the shortfall at 15.45, the present value of the shortfall is $42,616,990. Therefore, Davis reasoned, the accurate figure for the value of United is $139,704,000  $42,617,000, or $97,087,000, when rounded off to the nearest thousand. Maude's approach, on the other hand, was simplicity itself: He reported net operating plant in service, $139,704,000, as the cost indicator. He rejected the idea that obsolescence played a role in calculating the cost indicator. The Tax Court rejected Davis' theory of obsolescence on two bases: First,    the mathematical logic of Dr. Davis' approach essentially converts the cost approach to an income approach. Where the income and the rate are given, Dr. Davis' method will always result in a value exactly the same as the income approach because it shoves the cost out the back door. Algebraically, the method cancels all cost in excess of the value indicated by the income approach as obsolescence.         In theory, each approach [to valuation] views the concept of value from a different perspective, with the intent of considering all facts and perspectives relevant in the result in the marketplace. Adjusting one approach to make it rely on the result in the same indication of value as another approach effectively eliminates a relevant perspective from consideration. `Where data for use of the three approaches to value are available, the overwhelming weight of authority on the part of writers and qualified experts is that each of the three approaches to value should be utilized.' Pacific Power & Light Co. v. Dept. of Rev., 7 OTR 203, 217 (1977) [1977 WL 1615]. The second error of Dr. Davis is his assumption that failure to earn a market rate of interest on HCLD is an indication of obsolescence. The fact that other investments may produce a greater return is no indication of obsolescence. The evidence in this case established that regulated utilities are viewed as bearing less risk than other companies and therefore can obtain investor capital at less cost. Hence, it is to be expected that their earnings would be less than companies which bear a greater risk. If there is obsolescence in [United's] property, it can only be disclosed in this context by comparing companies. 10 OTR at 337-38. Having rejected Davis' theory for reduction of HCLD, the Tax Court adopted Maude's figure of $139,704,400. We agree entirely with the explanation and rationale of the Tax Court. It may be that there is obsolescence in United's plant and that a cogent theory could be developed for identifying that obsolescence and subtracting it from HCLD. [12] But Davis' argument, based on circumstances not comparable to those presented in this case, is not that theory. We find that the cost indicator for valuation of United for ad valorem tax purposes in 1983 was $139,704,000.