Opinion ID: 2604259
Heading Depth: 1
Heading Rank: 12

Heading: UP's Approach to the Capitalization Rate

Text: UP's expert, Schoenwald, approached the problem by placing emphasis from the outset on the difficult financial circumstances confronting railroads, particularly with respect to their ability to compete for capital. We are satisfied, from the abundance of evidence that Schoenwald amassed on this subject, that he is correct in asserting that, during the years in question, capital was not easy for UP (or other railroads) to obtain. Railroads, as already discussed, were struggling (and commonly failing) to obtain a return equal to their cost of capital. Inflation also was elevating requirements for investment returns. Thus, investment in a railroad would not be one that a potential investor would have regarded as particularly safe when compared with other potential investments. Investors therefore would have demanded a higher return on any investment in a railroad. One other overall observation must be made. Beginning with the 1983 assessment period, Schoenwald chose to use, for the purposes of assessing the weighted average cost of capital, an average or idealized equity/debt distribution (which he referred to as being that of a high-quality railroad operation), rather than the actual equity/debt distribution found in UP. This distribution Schoenwald determined to be 66 per cent equity, 20 per cent equipment trust certificates, and 14 per cent funded debt (mortgage bonds). Thus, he projected an idealized ratio of 66 per cent equity to 34 per cent debt. (UP's actual capital structure differed.) Ultimately, the Department agreed that, in establishing a capitalization rate for an income figure derived by DCF methodology, using that idealized approach was appropriate. Schoenwald made another pivotal decision in identifying the data on which he relied: He chose to use yearly averages of the various figures that he selected, rather than to use figures as of (or as close as possible to) the assessment dates. Goodwin and Ifflander purported to derive their values from figures near the end of each tax year (and, therefore, closer to the precise value applicable on January 1). We find some significance in the difference, as we shall explain later. We turn now to an examination of Schoenwald's derivation of the various capitalization rates that, in combination, go to make up his weighted average cost of capital. (1) Equity capitalization rates. Schoenwald's equity capitalization rate studies considered economic conditions, the capital markets, and the costs of capital for many securities of varying degrees of risk. He examined common stock price/earnings (P/E) ratiosa tool commonly used in valuing companies that issue publicly traded securitiesand determined that, for the assessment periods in question, the P/E ratios in the railroad industry were not representative because of the recession that was occurring at the time. Because he believed that P/E ratios would not produce representative results, he sought other means to develop capitalization rates. Schoenwald examined the spreads [12] between railroad costs of capital and returns on other, safer investments. Taking 17 per cent as a representative figure for historic railroad equity costs (based on his analysis of capital costs over time), Schoenwald then compared that figure to the rates of safer securities. He determined that the yearly average rate of return for railroad bonds for the 1984 assessment year had been 12.51 per cent, and opined that the additional 4.49 per cent (17.00 per cent minus 12.51 per cent) would be an inadequate differential compared with historic standards. That suggested that a rate even higher than 17 per cent was appropriate. The 17 per cent rate would result in a 5.73 per cent spread between railroad bonds and the safest investments (United States government securities). Schoenwald opined that this spread might be too conservative. History, in his opinion, suggested a spread closer to 7 per cent. Nonetheless, after further comparing his proposed 17 per cent figure with other types of utility companies (electric and telephone), Schoenwald selected 17 per cent as the appropriate cost of equity capital for the 1984 assessment. For 1983, he found the equity rate to be higher18 per cent. Schoenwald was able to demonstrate that his figures were reasonable when compared with figures derived from other sources, including the ICC, UP itself, a consulting firm, and (from another case involving a similar railroad, Southern Pacific) Goodwin and Ifflander. [13] (2) Debt capitalization rates. As a representative form of debt of a high-quality railroad operation, Schoenwald chose an equipment trust certificate. (He testified that some other forms of debt instruments commonly issued by railroads carried higher interest rates, but he settled for the trust certificates.) Schoenwald was able to determine from various sources and publications that the average expected return for such instruments during 1982 (the year preceding the January 1, 1983, assessment date) was 13.62 per cent. The average expected return for funded debt (mortgage bonds) of similar railroads during 1982 was 13.63 per cent. Schoenwald used those two figures as his costs of capital for those segments of the ideal high-quality railroad operation as of the 1983 assessment date. After performing essentially the same analysis, using the same approach, in identifying the various parts of the overall capitalization rate for the 1984 assessment, Schoenwald selected figures of 11.86 per cent for railroad trust certificates and 12.51 per cent for funded debt. The following table summarizes Schoenwald's proposed weighted capitalization rates for the tax years in question, including his calculation of the weighted average capitalization rate for all the bands of investment: Summary of UP Discount Rate Calculations 1983 1984 % of % of Capital Weighted Capital Weighted Rate Structure Rate Rate Structure Rate Equity 18% 66% 11.88 17% 67% 11.39 Debt: Equipment Trust 13.62% 20% 2.72 11.86% 20% 2.37 Funded 13.63% 14% 1.91 12.51% 13% 1.63 _____ ____ 16.51 15.39 b. The Department's Approaches to the Capitalization Rate In attempting to make use of the Department's alternative methods of establishing an appropriate capitalization rate, we are met at the outset with a problem: Not only do the Goodwin/Ifflander capitalization rates assume growth, they also are not (according to their authors) of any use unless the cash flows with which they are compared share the same assumption. Goodwin and Ifflander wrote with respect to their capitalization rate under the DCF method: It is important to re-emphasize that a discount rate which includes a growth component must be applied to a cash flow stream which is also growing. One cannot imply growth in the discount rate and zero growth in the cash flow stream. There may be some debate as to what the total growth rate would be in any particular time period, but at the very least, cash flows should be adjusted by the projected inflation rate. To argue that earnings do not change over time is to argue that inflation is zero. Clearly, there is not a shred of evidence to support this contention. Inflation is a fact of life in the U.S. economy; consequently, the discount rate which investors demand is based on inflation and, therefore inflation must be factored into the income stream. (Exhibit D-3, at p 108.) We already have indicated why we reject the Department's theories justifying projected growth and instead accept (for the purposes of this case) Schoenwald's model. One way to read that cautionary note from Goodwin and Ifflander is that, because we have rejected their income projections, we cannot make any use of their capitalization rates. Upon careful consideration, however, we conclude that there is some utility to the Goodwin/Ifflander projections. Our acceptance of Schoenwald's testimony does not mean that we believe that UP's cash flows cannot go up, at least as raw numbers. We understand Schoenwald to acknowledge that the cash flows may go up. His point (which we accept based on the evidence offered in this case, including some of the Department's admissions concerning the economic climate) is that UP does not appear to have any chance of obtaining returns in excess of its cost of capital, i.e., it has no present prospects of real growth, which we have identified as being growth of a kind that would increase the present value of UP. Inflation, by itself, may produce higher cash flows, but that is not growth. Nevertheless, we conclude that, at least in theory, Goodwin and Ifflander's capitalization rate calculations may have some utility with respect to the cash flows projected by Schoenwald. We turn to a closer examination of those capitalization rates. (1) Debt capitalization rates. As will be explained below, the Department does not make an issue of UP's debt capitalization rates for the purpose of this calculation. (2) Equity capitalization rates. Goodwin and Ifflander used two methods to estimate the equity capitalization rate: the dividend growth model and the capital asset pricing model. Unfortunately, neither their appraisal report (Exhibit D-3) nor their testimony fully explains either the sources for their data or the mathematics that produced their conclusions under these models. This omission diminishes the weight to be given to the estimates involved. However, they still have significant value. (a) The Dividend Growth Model. The dividend growth model recognizes that the return to an investor in common stock will be comprised of the current dividends that the investor is receiving on that stock plus future growth (if any) in those dividends. Accordingly, the model attempts to estimate the dividend yield, i.e., the expected dividends in relation to the current price, and adds the expected growth in dividends. [14] The total represents the discount rate as it is calculated under this model. Goodwin and Ifflander explained the derivation of their dividend growth figures as follows: The dividend yield was based on average dividend yields for rail equities. These can be found in Value Line[, a generally-available periodic market study,] or in various ICC cost of capital studies. The growth rate was based on growth rates contained in the same ICC studies. The difficulty with the appraisers' explanation is that, when one consults the same data that Goodwin and Ifflander indicated that they had used, one cannot reproduce their reported results. Application of the method to the figures to which Goodwin and Ifflander refer would, by our calculations, produce a lower discount rate for each of the tax years than the rates that Schoenwald projected, but the figures would be higher than those selected by Goodwin and Ifflander. (b) The Capital Asset Pricing Model. The idea behind this model is straightforward. First, one determines the return that an investor would be willing to accept on a risk-free investment. Then, one attempts to identify the additional return (the risk premium) that an investor would require in order to justify investing in the kind of company under consideration. Once that risk premium has been quantified, its value is added to the risk-free rate of return in order to obtain an estimate of the total return that equity investors would require in order to invest in the kind of company under consideration. The Department's use of this method is subject to problems similar to those that affected the dividend growth model. Goodwin and Ifflander claim to have utilized data that was based on current interest rates and risk premiums taken from [a well-known publication specializing in identifying risk premiums]. The data is not more precisely identified. We have difficulty making use of the method under these circumstances. Ifflander and Goodwin combined the results of their two methods of calculating the cost of equity capital. They concluded that the cost of equity capital for the 1983 assessment year should be 15.5 per cent in 1983 and 15.0 per cent in 1984. As the Department observed in its post-trial brief to the Tax Court: [T]he 2.5 and 2.0 percent difference in the equity cost comprise, essentially, the only issue in regard to discount rate and capital structure issues. Taking the Department at its word, the following table summarizes the Department's proposed capitalization rates for the tax years in question, including its calculation of the weighted average capitalization rate for all the bands of investment: Summary of Department's Discount Rate Calculations 1983 1984 % of % of Capital Weighted Capital Weighted Rate Structure Rate Rate Structure Rate Equity 15.5% 66% 10.23% 15.0% 67% 10.05% Debt: Equipment Trusts 13.62% 20% 2.72% 11.86% 20% 2.37% Funded 13.63% 14% 1.91% 12.51 13% 1.63% ____ ______ 14.86% 14.05% c. The Tax Court's resolution of the capitalization rate The Tax Court professed some difficulties with the approaches taken by each side. UP's figures, the court opined, were not particularly persuasive. 11 OTR at 177. The Department's calculations did not fare much better: The court expressed the same dissatisfaction that we have expressed concerning the sources of Goodwin and Ifflander's data and the mathematics that had been applied to that data. Ultimately, however, the court concluded that [the Department's] weighted average cost of capital for the discounted cash flow method is the most accurate. The cost of capital is primarily a function of risk. [UP] is a high quality, strong railroad with a good reputation. This should be reflected in its cost of capital. 11 OTR at 178.