Opinion ID: 1129291
Heading Depth: 1
Heading Rank: 6

Heading: Capitalization Rate (R)

Text: The capitalization rate measures the present value of projected future benefits that a potential investor might reasonably expect from ownership of the property being evaluated. Establishing an appropriate capitalization rate is one of the principal battlegrounds in this litigation. This is not surprising, in view of the fact that a small adjustment in that decimal figure may (and in this case will) have a major impact on the ultimate figure computed for value. We turn to an examination of the way each party's expert approached this computation. Davis used one technique to derive a capitalization rate; Maude used three. Davis' technique and two of Maude's were perpetuity models, i.e., they assumed that recovered depreciation on company property would be reinvested continuously, assuring an income stream in perpetuity. [7] Evidence from both experts shows that different kinds of investment in the same company earn different rates of return. For example, the return an investor might receive on a long-term debt of a company would probably differ from the return the investor would receive through ownership of preferred stock, or of common stock. These three forms of investment are called bands of investment by both experts. Because of these different rates of return, Davis and Maude agreed that it is appropriate to establish different capitalization rates for these bands of investment, then weight each of the three bands according to the percentage of participation of each in the overall capital structure of the company, and take an average. After agreeing on this principle, however, the experts part company. Davis began by making certain assumptions with respect to this technique. As noted, he assumed constant reinvestment of depreciation to maintain plant and to produce income. He also assumed that the resulting income stream would be flat, i.e., the same from year to year. He based this last assumption on the belief that, so long as it did business in a heavily regulated industry in which the maximum return was set by law, United could at best maintain its current income level. In seeking to establish a capitalization rate using the band-of-investment technique, Davis first looked for comparable companies in order to obtain the widest possible statistical sample for his band-of-investment calculation. He found none. He therefore concluded that the only way to make a band-of-investment calculation was to utilize United's own capital structure. [8] That structure was as follows: Capital Structure '83 Percentage '84 Percentage Long-term debt 43.66% 44.15% Preferred Stock 00.54% 00.56% Common Stock 55.80% 55.29% _______ _______ 100.00% 100.00% Having selected what he believed to be reliable figures for the band-of-investment technique, Davis then determined the cost of capital of each of these three bands. For the debt and preferred stock bands, he simply obtained a standard investment service's rating for each kind of investment in United for each year (it was A, on a scale running from AAA  the most secure  to CCC  the most risky) and then employed the investment service's figures for yields to maturity on the assessment date for A -rated public utility investments of that kind. These values were: Type of Capital '83 Yields '84 Yields Debt 14.40 13.5 Preferred Stock 12.20 12.61 Davis justified this approach by noting that all similarly rated companies in the same industry grouping (A-rated public utilities, in this case) face basically the same risks. Davis encountered his greatest difficulty determining a figure for the value of the common stock. He chose to rely on what he called the risk premium technique. Under the risk premium technique, a risk free rate of return on investment is first determined. This rate is usually the current Treasury bill (T-bill) rate, because such a security is regarded as absolutely safe. The T-bill rate for 1983 was 7.98 percent; for 1984, it was 8.6 percent. Davis testified that once the risk-free rate is established, it is theoretically necessary to add a premium that reflects the relative risk of the endeavor for which the equity in question  in this case, a theoretical common stock of United  is being issued. Davis derived this risk premium from a study called Ibbotson-Sinquefield after its developers. The study traces the history of a large number of stocks over roughly the last 60 years and assigns risk premiums that should be associated with various classes of those securities. Davis determined that the appropriate risk premium attributable to stock like that of United was 8.3 percent. This premium added to the T-bill (risk free) rate gave a total of 16.28 percent as the indicated capitalization rate (R) for the year 1983. [9] The rate for 1984 would be 16.90 (8.3% + 8.6%). With the market rate of return for common stock thus calculated, Davis multiplied each capitalization rate by its percentage of the band of investment, producing the following results: 1983 CAPITAL PERCENT OF COST OF WEIGHTED COST STRUCTURE CAPITAL STRUCTURE X CAPITAL = OF CAPITAL Long-Term Debt 43.66% X 14.40% = 6.29% Preferred Stock .54% X 12.20% = .07% Common Stock 55.80% X 16.30% = 9.10% ____________ _______ ______ Total 100.00% 15.46% Davis rounded off the final figure to 15.45, which he declared to be his capitalization rate. The final calculation was then simply a matter of dividing $15,000,000 (I) by .1545 (R). The resulting value was $97,087,379, which Davis rounded off to $97,087,000. His figure for 1984, derived by the same process, was $98,726,000. Maude also used a band-of-investment technique. Unlike Davis, however, he chose three other telecommunications companies he felt were sufficiently analogous to United and took an average of their capital structures as the foundation for his computations. The companies were: COMPANY NAME CAPITAL STRUCTURE AT MARKET VALUE COMMON PREFERRED DEBT Commonwealth Tel $39,277,000 $1,439,000 $60,092,000 Lincoln Telecom 86,365,000 4,827,000 46,299,000 Rochester Tel 272,644,000 8,138,000 80,696,000 _____________ ___________ __________ ___________ TOTALS 398,286,000 14,404,000 187,087,000 GRAND TOTAL 599,777,000 CAPITAL STRUCTURE 66.4 2.4 31.2 Having derived what he deemed to be a typical capital structure by this averaging approach, Maude then turned to market information, as had Davis. Again, like Davis, he readily arrived at expected return figures for the first two types of equities, viz., long term debt and preferred stock. His figures were: Long term debt 12.82% Preferred stock 13.90% To establish the expected return on common stock, however, he was forced (as was Davis) to consider several different techniques. Maude listed four techniques for estimating a return on common equity: the discounted-cash-flow (DCF) technique, the earnings-to-price ratio (E/P, also commonly reversed as P/E) technique, the earnings-to-book ratio (E/B) technique, and the risk-premium technique. [10] While Davis had professed to be unable to use any of the first three, Maude used them all. He derived the following expected rates of return on common stock: DCF approach 17.9% E/P ratio 14.4% E/B ratio 13.0% Risk premium 16.2% The average of the four approaches was 15.375. Maude, however, considered the DCF approach and the risk premium approach more reliable and therefore used the average of those two  17.1  as his multiplier. Maude's final calculations produced the following result: 1983 CAPITAL STRUCTURE RATE OF RETURN WEIGHTED PERCENT Long term debt 31.2% 12.8% 3.99% Preferred stock 2.4% 13.9% 0.33% Common stock 66.4% 17.1% 11.35% ____________ ______ TOTAL 15.67% Maude's discount rate  his R  under the band-of-investment technique was thus 15.67. Maude also utilized one further technique, a perpetuity model. As Maude explained it, the perpetuity model assumes that the annual capital recovery (depreciation) by a company will be reinvested in capital assets continuously into the future in a manner consistent with historic practices of the company. Davis' model, which made the same assumption, is a perpetuity model. A second assumption of the model is that income from the property will continue indefinitely into the future. Davis postulated that this continued income would be at a flat rate, i.e., income from year to year would not vary. Maude specifically rejected this assumption because historical experience would not validate it  United's income had continued to rise over the years  and because he believed that external forces such as inflation would also dictate that income would increase rather than remain static. Therefore, any calculation under the formula V = I/R would seriously undervalue the company unless it included some allowance for growth. This growth factor is illustrated by the way Maude made his calculations. His original income figure (I) was $14,432,000. His original capitalization rate (R) was .1567. Carrying out the calculation produces a V of $92,099,553, rounded up to $92,100,000. But, as noted, Maude objected that this figure was too low because it made no allowance for growth. The problem, he explained, was that the I figure was an historical, no-growth figure while the R, derived as it was from market information, had the market's own expectation of growth as a built-in factor. Dividing a no-growth I by a growth-influenced R would, in Maude's opinion, seriously understate the value of the company. Whether the assumption was growth or no growth, he testified, the numerator and denominator in the fraction I/R needed to be derived on the same assumption. Maude therefore sought a figure for R that would be approximately no-growth. As a surrogate for this figure, he adopted the rate of return United actually was allowed by the Public Utility Commission to earn at the time  12.3. This led to the following calculation: 14,432,000 V = .123 = 117,333,000 This calculation did not depend for its validity on Maude's utilization of the three outside telephone companies to generate a capital structure model. Maude then made a second computation in which, instead of taking growth out of R, he attempted to factor growth into I. For this computation, Maude assumed a modest growth in income of 2.5 per year. The computation was: 14,432,000 + 2.5% per year V = .1567 = $108,551,000 Maude criticized the resulting figure as probably being too low, because growth would probably come much closer to 3.0 per year. In summary, Maude's two perpetuity model valuation figures were $117,333,000 (a figure generated by taking growth out of both numerator and denominator in the equation V = I/R) and $108,551,000 (a figure generated by attempting to put growth into both parts of the fraction). The Tax Court rejected Maude's attempt to postulate an average capital structure by the use of the three outside telephone companies. Only one of the three, the court noted, closely resembled United's own capital structure. The court concluded that [w]ith this range in such a small sample, any average would be meaningless. [United's] actual capital structure is far more relevant and meaningful. United Telephone Co. v. Dept. of Rev., supra, 10 OTR at 339. The court next reviewed the capitalization rates (Rs) proposed by both sides. It purported to accept Davis' rate, probably because Maude's rate was derived from assumptions about the three outside telephone companies. However, the Tax Court ultimately seems to have abandoned Davis' capitalization rate as well. Concerning the other half of the fraction (the income figure, I), the court noted that the two sides were not far apart, but did not identify specifically which calculation (if either) it accepted. The court then turned to the pivotal issue of growth. As noted, the Davis approach assumed no growth in income. Both of Maude's techniques assumed growth. Although the Tax Court considered some of Maude's specific figures (by implication, those used in generating a value using enhanced income) flawed because of Maude's original hypothesis that a capital structure could be postulated based on the average of the structures of the three outside telephone companies, the court nonetheless found his argument for some element of growth persuasive. It did not further explain its choice of growth models. Instead, it simply announced the result of its calculation  a valuation of $117,500,000 based on the income approach. This valuation is almost precisely that determined by Maude based on his modified, no growth perpetuity model. We conclude that the Tax Court accepted Maude's theory that United's permitted rate of return was a rational surrogate for R. Thus, the Tax Court apparently calculated the income valuation as follows: 14,432,000 V = .123 = 117,333,000 SAY 117,500,000 We agree with this analysis. With the smoke cleared away, the only technique that persuades us as the triers of fact is Maude's simple no growth formulation. All the techniques that attempted, either explicitly or implicitly, to include growth as a factor make assumptions we do not find persuasive. Thus, we conclude that the appropriate capitalization rate (R) to be used in a no growth formulation is 12.3. [11] For the reasons already stated, however, we are more persuaded by Davis' income figure (I) than by that offered by Maude. Thus, we select $14,679,000 as the appropriate income figure. This produces the following calculation of value by the income method: 14,679,000 V = .123 = 119,341,000 We find that the value for United for 1983 calculated by the income method is $119,341,000.