Opinion ID: 456159
Heading Depth: 3
Heading Rank: 1

Heading: The Financial Impacts Model

Text: 293 DOE used the FIM to predict changes that two different levels of standards might cause in business risk, profitability, debt/equity ratio, and quick ratio 59 for small, medium, and large manufacturers of covered products 60 over the period 1980-1981. The FIM results were then used to gauge the economic impact of standards on manufacturers, which is one of the statutory criteria bearing on economic justification. 294 One of the analysts working on the FIM described that model as follows: 295 Our analysis clearly presupposes an absolutely worst case. We have assumed that there will be no price increase, no abandonment of low efficiency models, and no capital investment outside of the scenario specifications. Under these conditions, the impacts appear to be minimal. 296 Memorandum from David P. Ross to Steven Lee at 4 (Sept. 14, 1981), J.A. at 2314. DOE describes the model-builders as having made every attempt to use conservative assumptions, 1982 Economic Analysis at 209, J.A. at 1146, [t]he most conservative of [which was] that the appliance industry has, as of this point in time, made no major investment in products with efficiencies approaching those of the final standard, id. 61 This assumption supposed that nearly all of the investment needed to achieve standard-mandated efficiencies resulted from standards, and thus tended to increase the burdens predicted for standards. 297 Petitioners suggest that the FIM produced unstable results. For example, the FIM predicted that the debt/equity ratio for freezer manufacturers under level 2 standards would deteriorate 6 percent for small firms, would improve for large firms, but would plummet by 183 percent for medium firms. For water-heater manufacturers, the debt/equity ratio of large firms declined 280 percent, as against reductions of 32 percent and 26 percent for medium and small firms. We agree with petitioners that these and other FIM results 62 are surprisingly counterintuitive; and DOE's mild reply that [t]he predictions of the FIM ... were well within a reasonable range, DOE Br. at 68, is not completely reassuring, because we do not know what DOE considers a reasonable range. 298 We rest our decision, however, not on these surprising results, but on a specific assumption in the model. The FIM assumes that all appliance manufacturers will finance the increased investment required by standards with debt. This assumption molds at least one important projected consequence of standards, changes in a firm's debt/equity ratio, in a way that could substantially affect the dollar cost of that burden. Petitioners assert that the assumption rests on no evidence that appliance manufacturers in fact always employ debt rather than equity financing, and was thus arbitrary. 63 More specifically, petitioners charge that the all-debt assumption made it virtually inevitable that the model would overestimate deteriorations in debt/equity ratios under standards. Here is DOE's account of the assumption: 299 As developed for this program, the FIM does not allow for equity financing. The only kind of financing allowed is debt financing. This assumption was made because the analysis was performed at the manufacturing division level. No manufacturing division, if it is not itself a corporate entity, can issue equity. The meaning of debt as used herein includes debt issued to the parent company in return for an intrafirm transfer of cash in the form of a loan. 300 The effect of this assumption is to overstate the indebtedness of the prototypical firm if it could obtain equity financing either directly or through a parent. Normally, equity financing of a division is not done, however. Conversations with industry experts indicate that normal practice requires the division to forward its budget requests to higher corporate authority where they are reviewed, revised and budgeted. These loans are then repaid out of funds from operations over some term of years. 301 On the basis of industry practice, while indebtedness is to a certain extent overstated, the assumption captures industry practice more fully than would be the case if equity financing were allowed. Thus, it was felt that this assumption was neutral with respect to analysis of impacts on manufacturers. 302 1982 Economic Analysis Document Sec. A.2.5.1 at 251, J.A. at 1188. 303 DOE has not explained how this analysis at the manufacturing division level could produce a meaningful prediction about the effect of standards on debt/equity ratio, which is necessarily a characteristic of an entire firm. We assume arguendo that, as DOE asserts, parent corporations normally finance capital improvements in manufacturing divisions through loans, which the division eventually repays. As DOE states, this conclusion breaks down for manufacturing divisions that are themselves corporations, and DOE does not tell us whether such corporations exist in significant numbers. In addition, DOE's argument relies entirely an accounting procedures within a corporation. The only loan necessarily involved is one from the parent to the division, and DOE offers no opinion at all about how the parent raised the money to make the loan. It is, in fact, perfectly consistent with everything DOE says--though not very likely--to suppose that parent corporations always raise the funds for capital improvements in appliance manufacturing divisions through equity financing, and then lend the money thus raised to the divisions. Thus, the debt of a division to a parent might correspond to equity financing or debt financing by the parent corporation, depending on how the parent obtained the money lent. 304 One of the FIM's four outputs is the effect of standards on the debt/equity ratio of a firm. As DOE comments, a manufacturing division that is not a corporation has no stock. It consequently has no real debt/equity ratio, which is a characteristic of the entire firm. Of course, DOE will want to isolate changes in the debt/equity ratio of manufacturers resulting from efficiency standards. But we do not understand how DOE can do that without making some assumption about the way the parent raises the money that it then lends to the manufacturing division. It is not enough, so far as we can see, to call the money owed by the division to the parent debt and therefore exclude from the model's assumptions any possibility of equity financing. This is so because such debt may not represent any money owed by the corporation at all, which is the sense of debt relevant to a firm's debt/equity ratio. Petitioners argue that by defining debt in such a way that all capital investments required by standards are debt-financed, DOE virtually guaranteed that standards would worsen the debt/equity ratios of manufacturers. Our review of DOE's explanation does not enable us to say that petitioners are wrong. 305 Nor can we tell what effect the all-debt assumption may have had on the model's other outputs. While the debt/equity ratio is the output that on its face is most likely to have been affected by that assumption, all four outputs measure the financial impact of standards on manufacturers, and all four may have been affected by the costs of the debt financing DOE assumed. In any event, DOE's discussion of the FIM results does not enable us to decide how much any particular output influenced DOE's generally negative view of the financial impact standards would have on appliance manufacturers. 64 For these reasons, we cannot assume that the challenged assumption did not affect DOE's overall view of the FIM results; and we cannot assume that the FIM results, which DOE interpreted as weighing against standards, did not affect the final rules. 306 We wish to emphasize that we do not invalidate DOE's use of the FIM. We conclude only that this record does not contain an adequate explanation of the all-debt assumption, and the model is therefore not supported by substantial evidence. There may be a straightforward answer to the objection we have sketched. 65 But the agency did not explain how the assumption we have questioned corresponds to the real world, and we cannot gauge with any confidence what effect that assumption had on the final rules. DOE must provide such an explanation if it is to use this assumption in the FIM to measure the burdens of standards. 307