94-8226. Financial Reporting Requirements and Rate of Return Methodology in the Domestic Offshore Trades  

  • [Federal Register Volume 59, Number 67 (Thursday, April 7, 1994)]
    [Unknown Section]
    [Page 0]
    From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
    [FR Doc No: 94-8226]
    
    
    [[Page Unknown]]
    
    [Federal Register: April 7, 1994]
    
    
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    FEDERAL MARITIME COMMISSION
    
    46 CFR Part 552
    
    [Docket No. 94-07]
    
     
    
    Financial Reporting Requirements and Rate of Return Methodology 
    in the Domestic Offshore Trades
    
    AGENCY: Federal Maritime Commission.
    
    ACTION: Proposed rule.
    
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    SUMMARY: The Federal Maritime Commission proposes to amend its 
    regulations governing financial reporting requirements and rate of 
    return methodology applicable to vessel-operating common carriers by 
    water in the domestic offshore trades to discontinue use of the 
    comparable earnings test in determining the reasonableness of a 
    carrier's return on rate base. In its place, the Commission proposes to 
    use the weighted average cost of capital methodology. In addition, the 
    Commission proposes to amend its rules pertaining to the treatment of 
    insurance expenses, accumulated deferred taxes and the Capital 
    Construction Fund for purposes of calculating a carrier's rate base. 
    The proposed rule addresses a number of shipper and carrier concerns 
    regarding the Commission's current rate of return methodology and would 
    align the Commission's ratemaking methodologies more closely with those 
    used by numerous other regulatory agencies. The intent is to improve 
    the Commission's methodology for evaluating the reasonableness of rates 
    filed by carriers in the domestic offshore trades and for acquiring the 
    data that are essential to that evaluation.
    
    DATES: Comments due June 6, 1994.
    
    ADDRESSES: Comments (original and fifteen copies) to: Joseph C. 
    Polking, Secretary, Federal Maritime Commission, 800 North Capitol 
    Street, NW., Washington DC 20573-0001, 202-523-5725.
    
    FOR FURTHER INFORMATION CONTACT:
    
    Richard J. Kwiatkowski, Bureau of Trade Monitoring and Analysis, 
    Federal Maritime Commission, 800 North Capitol Street, NW., Washington 
    DC 20573-0001, 202-523-5790.
    C. Douglass Miller, Office of the General Counsel, Federal Maritime 
    Commission, 800 North Capitol Street, NW., Washington DC 20573-0001, 
    202-523-5740.
    
    SUPPLEMENTARY INFORMATION: On March 11, 1993, the Federal Maritime 
    Commission (``FMC'' or ``Commission'') published a final rule in Docket 
    No. 91-51, Financial Reports of Common Carriers by Water in the 
    Domestic Offshore Trades, which amended the provisions under which 
    carriers could obtain waivers of certain financial reporting 
    requirements. 58 FR 13414. (1993) (``Docket No. 91-51''). The 
    Commission stated that it intended ``* * * to turn its attention, 
    separately, to the numerous other substantive changes to 46 CFR part 
    552 that have been suggested in this proceeding.'' Id. at 13417.\1\ In 
    this regard, the Commission conducted an extensive review of part 552 
    to assess the need for changes to its financial reporting requirements 
    and rate of return methodology in the domestic offshore trades.
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        \1\In its Advance Notice of Proposed Rulemaking issued in Docket 
    No. 91-51, 56 FR 57298, the Commission had solicited comments and 
    information from the public on issues which could be addressed in a 
    proposed rule concerning substantive guidelines for determining what 
    constitutes a just and reasonable rate of return or profit for 
    common carriers by water in the domestic offshore trades.
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        Based on its review, the Commission has determined that several 
    issues regarding the adequacy and appropriateness of various aspects of 
    its present regulations should be addressed. The issues on which the 
    Commission is proposing changes to existing regulations include:
         The FMC's methodology for computing an allowable rate of 
    return on rate base.
         The treatment of deferred taxes and the Capital 
    Construction Fund for rate base purposes.
         The definition of working capital.
        Each of these issues is discussed in turn below.\2\ Also discussed 
    are the rules governing the allocation of assets and expenses, but no 
    changes are proposed.
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        \2\Copies of the proposed new schedules for collecting the data 
    required under the proposed regulations are available from the 
    Secretary, Federal Maritime Commission.
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    Computing an Allowable Rate of Return on Rate Base
    
    I. The Allowable Rate of Return Should Equal the Cost of Capital
    
        The fundamental objective when using a rate of return on rate base 
    method of regulation is to set a regulated firm's maximum allowable 
    rate of return on rate base equal to the regulated firm's cost of 
    capital. The cost of capital, sometimes referred to by economists as 
    ``the opportunity cost of capital'' or ``the required rate of return,'' 
    is the minimum rate of return necessary to attract capital to an 
    investment. It is the expected rate of return prevailing in capital 
    markets on alternative investments of equivalent risk.\3\ The bases for 
    setting the allowable rate of return equal to the cost of capital are 
    legal and economic.
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        \3\A. Lawrence Kolbe, James A. Reed, Jr., and George R. Hall, 
    The Cost of Capital, 3rd Printing, The MIT Press, Cambridge, 
    Massachusetts, 1986, p. 13.
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    A. Legal Rationale
        Two landmark Supreme Court cases defined the legal principles 
    underlying rate of return regulation and provided the notion of a fair 
    rate of return. The two cases, Bluefield Water Works & Improvement Co. 
    v. Public Service Commission of West Virginia, 262 U.S. 679 (1923) and 
    Federal Power Commission v. Hope Natural Gas Company, 320 U.S. 391 
    (1944), established that investors in companies subject to rate 
    regulation must be allowed an opportunity to earn returns sufficient to 
    attract capital and comparable to those they would expect from 
    investments in other firms for incurring the same amount of risk, and 
    that revenues must not only cover operating expenses, but capital costs 
    as well.
    B. Economic Rationale
        The economic rationale for setting the allowable rate of return of 
    a regulated enterprise equal to its cost of capital is that the 
    regulated firm's customers will thereby pay the lowest cost for service 
    in the long run.\4\ For example, if a regulator sets the allowable rate 
    of return above the cost of capital, the firm's stockholders will 
    realize earnings in excess of those they could earn on alternative 
    investments of comparable risk. Such excess earnings are paid for by 
    the firm's customers in the form of prices higher than those that they 
    would otherwise be required to pay. If, on the other hand, a regulator 
    sets the allowable rate of return below the cost of capital, 
    stockholders will realize earnings less than they could on alternative 
    investments of comparable risk. In the short run, the firm's customers 
    may benefit because they pay prices lower than those they would 
    otherwise be required to pay. In the long run, however, the firm's 
    stockholders will be unwilling to continue to invest their funds, and 
    the firm will, therefore, lack the requisite financial capital for 
    maintaining and augmenting the firm's physical plant and equipment. 
    Customers, in turn, will be supplied with a lesser quantity and/or 
    quality of service.
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        \4\Setting the allowable rate of return equal to the cost of 
    capital also ensures that society's supply of capital is used most 
    productively. Because capital markets are considered to be highly 
    competitive, the cost of new capital is an accurate gauge of that 
    capital's value in alternative uses. When the allowable rate of 
    return is greater than the cost of capital, investors will supply 
    too much capital to a regulated firm, thereby diverting capital from 
    alternative investments where it could be more productive. 
    Conversely, when the allowable rate of return is less than the cost 
    of capital, investors will supply too little capital to a regulated 
    firm, thereby allocating funds to less productive investments. Such 
    a misallocation of resources represents a welfare loss for society 
    as a whole.
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    C. Methodologies
        The Commission uses a version of the Comparable Earnings Test 
    (``CET'') to determine the reasonableness of rates of return. The 
    carrier's projected rate of return ((net income after taxes + interest 
    expense)/rate base\5\) is compared with the rate of return on total 
    capital earned by U.S. manufacturing firms over an extended period of 
    time--the benchmark rate of return. Where appropriate, adjustments are 
    made to the benchmark for current trends in rates of return, the cost 
    of money and relative risk.
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        \5\Rate base is a carrier's investment in Commission-regulated 
    activities. It consists of investments in vessels less accumulated 
    depreciation, other property and equipment less accumulated 
    depreciation, and working capital.
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        However, most regulatory agencies use the Weighted Average Cost of 
    Capital (``WACC'') methodology to set allowable rates of return, 
    including, for example the Federal Energy Regulatory Commission, the 
    Interstate Commerce Commission (``ICC''), the Federal Communications 
    Commission, and the Maryland Public Service Commission. Indeed, the 
    most recent yearbook published by the National Association of 
    Regulatory Commissioners shows that virtually every state regulatory 
    commission in the U.S. uses some variation of the WACC.6 Further, 
    current economic literature recognizes the WACC approach as the most 
    generally accepted method of setting allowable rates of return.
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        \6\See ``Table 47--Agency Authority Over Rate Of Return--All 
    Utilities,'' in Utility Regulatory Policy in the United States and 
    Canada Compilation 1992-1993, National Association of Utility 
    Regulatory Commissioners (``NARUC''), Washington D.C., 1993, pp. 
    110-111.
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        The WACC approach recognizes that there are several methods by 
    which a firm may raise capital and each has its attendant cost. 
    Typically, the total capital of a firm has come from three different 
    sources, long-term debt, preferred stock7 and common-stock equity. 
    Thus, the total capital of a firm may have a debt component, a 
    preferred stock component and a common-stock equity component. Under 
    the WACC methodology,8 the cost of each of these components is 
    calculated separately and weighted by the proportion the component is 
    to the total capital of the firm.9
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        \7\ Preference stock, also known as prior-preferred stock, is 
    preferred stock that has a higher claim than other issues of 
    preferred stock on dividends and assets in liquidation.
        \8\ Charles E. Phillips, Jr., The Regulation of Public 
    Utilities, 3rd ed., Public Utilities Reports, Inc., Arlington, 
    Virginia, 1993, p. 388.
        \9\ Short term debt that has become a permanent portion of the 
    regulated firm's financing is also included in the computation. 
    Deferred taxes are included at zero cost (unless they have been 
    deducted from rate base).
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        To illustrate the calculation of the WACC, consider a hypothetical 
    regulated company that has total invested capital of $100 million, 
    consisting of $25 million of long-term debt, $15 millon of preferred 
    stock, and $60 million of common-stock equity. Assume that the firm's 
    cost of long-term debt is 7 percent, cost of preferred stock is 9 
    percent, and cost of common-stock equity is 12 percent. Further, assume 
    that the firm operates in a world where corporate taxes do not exist. 
    The WACC for this firm is calculated as follows: 
    
                             Calculation of WACC10                          
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                             Amount                                         
                           (millions    Proportion      Cost         WACC   
     Capital component    of dollars)   (percent)    (percent)    (percent) 
                                                                            
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    Long-term debt......           25           25            7         1.75
    Preferred stock.....           15           15            9         1.35
    Common-stock equity.           60           60           12         7.20
                         ---------------------------------------------------
          Total.........          100          100  ...........       10.30 
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    10 The algebraic expression for the overall cost of capital or the WACC,
      is as follows (ignoring taxes):                                       
    
    
    TP07AP94.006
    
    
    where:
    Kd is the regulated firm's cost of long-term debt capital;
    Kp is the regulated firm's cost of preferred stock capital;
    Ke is the regulated firm's cost of common-stock equity capital;
    D is the value of the regulated firm's long-term debt outstanding;
    P is the value of the regulated firm's preferred stock outstanding; and
    E is the value of the regulated firm's common-stock equity outstanding.
    
        Thus, given the assumptions of this example, the WACC is 10.30 
    percent. The allowable rate of return for this hypothetical company 
    should, therefore, be set at 10.30 percent, which would provide the 
    firm with the opportunity to earn revenues sufficient to service the 
    company's overall cost of capital.11
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        \1\1 In reality, a regulated firm typically does pay taxes, and 
    the WACC must be adjusted to arrive at a final number for an 
    allowable rate of return. Such adjustment is made by calculating the 
    WACC on a before-tax basis (``BTWACC''). The BTWACC is described in 
    detail later.
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        The costs of long-term debt and preferred stock capital may be 
    calculated with relative precision. For the debt component, this is 
    done by computing the actual total annual fixed charges on long-term 
    debt for all issues, including any amortized discount or premium and 
    issuance expense. The total annual fixed charges are then divided by 
    the actual total value of long-term debt outstanding for all issues in 
    order to arrive at the cost of debt stated as a percentage. For 
    example, if the annual fixed charges on long-term debt are $1,750,000 
    and the total long-term debt outstanding is $25 million, the cost of 
    debt would be 7 percent ($1,750,000/$25 million=.07).
        The cost of preferred stock is calculated in similar fashion. The 
    actual total annual dividend requirements on the preferred stock for 
    all issues is divided by the actual total value of preferred stock 
    outstanding for all issues in order to arrive at the cost of preferred 
    stock stated as a percentage. For example, if the actual total annual 
    dividend requirements amounted to $1,350,000 and the total value of 
    outstanding preferred stock is $15 million, the cost of preferred stock 
    would be 9 percent ($1,350,000/$15 million=.09).
        The calculation of the cost of common stock equity capital, the 
    third component of the WACC, is more difficult. Commonly used methods 
    are the Discounted Cash Flow (``DCF''), the Capital Asset Pricing Model 
    (``CAPM'') and the Risk Premium (``RP''). Each of these models is based 
    on market variables (e.g., stock market prices and bond yields) which 
    reflect the expectations of investors in capital markets. More 
    specifically, the DCF, CAPM and RP models are constructed under the 
    generally accepted assumption that a company's stock market price at 
    any moment in time reflects completely investors' current expectations. 
    Because these market-based models are designed to reflect the 
    expectations of investors, and because a company's cost of capital is 
    defined as the rate of return expected by investors on alternative 
    investments of equivalent risk, the WACC framework implemented through 
    the use of such models will, in general, equate the allowable rate of 
    return with the cost of capital.
    
    II. The Commission's Comparable Earnings Test Compared to the WACC
    
    A. Theoretical Issues
        The Commission has used its variation of the CET in a number of 
    rate investigations. Commission orders adjudicating the reasonableness 
    of rate increases under the CET have been repeatedly upheld by the 
    courts. E.g., Matson Navigation Company, Inc. v. FMC, 959 F.2d 1039 
    (D.C. Cir. 1992); and Puerto Rico Maritime Shipping Authority v. FMC, 
    678 F.2d 327 (D.C. Cir.), cert. denied, 459 U.S. 906 (1982). However, 
    the Commission's CET does present a theoretical shortcoming compared to 
    the WACC method, in that it is unlikely to equate the allowable rate of 
    return with the cost of capital, because it uses historical accounting 
    data to calculate an average book value12 rate of return that the 
    regulated carrier should be allowed.
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        \1\2 Book value means the value at which an asset is carried on 
    a balance sheet.
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        The accounting rate of return for a company is not equivalent to 
    the firm's true economic rate of return because accounting and economic 
    concepts of income and value are substantially different. Accounting 
    numbers are derived on the basis of generally accepted accounting 
    principles while economics specifies the use of opportunity costs. This 
    difference is particularly acute when the economy is characterized by 
    high and variable rates of inflation. For example, accountants define 
    asset values in terms of acquisition or historical costs while 
    economists define asset values on the basis of market values or 
    replacement costs. This distinction effects both the income statement 
    as well as the balance sheet. Consequently, an accounting-based rate of 
    return methodology such as the Commission's CET does not adequately 
    measure a regulated carrier's true cost of capital. In Docket No. 91-
    51, the State of Hawaii noted the problems associated with using 
    accounting data and criticized the Commission's CET for being 
    accounting-based and not market-based.
        Several empirical tests have demonstrated that there is a large 
    discrepancy between accounting rate of return and true economic 
    return.13 These studies also demonstrate that biases inherent in 
    book returns are systematic, and that these biases do not cancel out by 
    averaging across companies. Furthermore, the type and magnitude of bias 
    for regulated firms are different than those of unregulated firms 
    contained in the comparable risk group of firms selected in applying 
    the Commission's CET method.14
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        \1\3 See, for example, Franklin M. Fisher and John J. McGowan, 
    ``On the Misuse of Accounting Rates of Return to Infer Monopoly 
    Profits,'' 73 Am. Econ. Rev. 82-97, March 1983; and Richard Brealy 
    and Stewart C. Myers, Principles of Corporate Finance, New York: 
    McGraw-Hill, Chapter 12, 1981.
        \1\4 Regulators (including the FMC) commonly set rates on the 
    basis of a book value rate base. In such instances, the economic 
    (i.e., market) value of a regulated firm will tend to be closer to 
    its book value in comparison to the economic values and book values 
    of the unregulated firms contained in the proxy group. The book 
    returns of the unregulated firms are, therefore, likely to be 
    substantially more biased than those of the regulated firm under 
    consideration.
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    B. Practical Issues
        The WACC approach also presents some important technical 
    advantages. First, the WACC uses the actual long-term interest expense 
    currently provided by a regulated carrier to compute the company's cost 
    of long-term debt capital, while the Commission's CET uses an estimate 
    of a carrier's long-term interest expense based on moving averages of 
    Baa-rated corporate bond yields in computing an allowable rate of 
    return on rate base. By definition, a firm's actual long-term interest 
    expense is more accurate than an estimate of that expense. In its 
    comments in Docket No. 91-51, the State of Hawaii stated that the 
    Commission's CET introduces imprecision into the calculation by 
    requiring that parties substitute a proxy for carrier interest expense 
    as a component of the carrier's rate of return, although this component 
    is known and subject to verification.
        Second, the WACC, when implemented properly, ensures that the 
    regulated carrier will be allowed a return on rate base that is large 
    enough to ensure that the carrier will have the opportunity to earn, at 
    a minimum, revenues that are sufficient to cover its embedded (actual 
    historical) cost of debt. Assuming that debt capital financing is less 
    expensive than preferred stock and common-stock equity capital 
    financing, when the known cost of long-term debt is weighted by the 
    regulated company's proportion of long-term debt capital outstanding, 
    and then added to the firm's cost of preferred stock weighted by the 
    firm's proportion of preferred stock capital outstanding and the firm's 
    cost of common-stock equity capital weighted by the firm's proportion 
    of common-stock equity capital outstanding, the resulting sum (i.e., 
    the WACC) can be no less than the cost of the firm's embedded cost of 
    debt. Such a guarantee is not available under the Commission's CET, as 
    Matson Navigation Company, Inc. (``Matson''), has pointed out. For 
    example, if the long-term interest expense estimate, derived on the 
    basis of a moving average of historical Baa corporate bond yields, is 
    not representative of the actual long-term interest expense of the 
    regulated carrier, or if the historical financial data reflecting the 
    financial picture of the benchmark group of firms are not 
    representative of the regulated carrier's financial position, then the 
    regulated carrier's calculated allowable rate of return on rate base 
    could fall short of its embedded cost of debt.
        Third, the Commission's CET has proved difficult to apply in the 
    case of the Puerto Rico Maritime Shipping Authority (``PRMSA''), which 
    has a capital structure composed entirely of long-term debt and by law 
    is not required to pay taxes. On the other hand, the WACC can be used 
    effectively to establish an appropriate allowable rate of return for 
    such a carrier. The WACC is computed for such a carrier by weighting 
    the cost of long-term debt near or equal to one, the cost of preferred 
    stock near or equal to zero, and the cost of common-stock equity near 
    or equal to zero, and setting the corporate tax rate equal to zero. The 
    WACC can be used effectively to compute an accurate estimate of the 
    overall cost of capital and, in turn, to establish an appropriate 
    allowable rate of return for a regulated carrier that is financed 
    exclusively or almost completely by long-term debt15 and is tax-
    exempt, because it distinguishes between such a carrier and one that is 
    financed with substantial amounts of common-stock equity and is not 
    tax-exempt. In its comments in Docket No. 91-51, PRMSA observed that 
    the Commission's CET makes no such distinction because it uses as a 
    benchmark for every regulated carrier, regardless of actual capital 
    structure or tax status, a typical firm financed with a relatively 
    balanced mixture of long-term debt and common-stock equity capital, and 
    is not tax-exempt.
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        \1\5A profitable firm will generally have at least some amount 
    of common-stock equity capital in its capital structure because such 
    a firm will usually have an internal source of such capital in the 
    form of retained earnings.
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        Lastly, the WACC method typically uses a number of different 
    methods to calculate the regulated firm's cost of common-stock equity 
    capital. This yields several different estimates of the firm's WACC 
    providing a regulatory commission with a range of numbers from which a 
    single number representing an allowable rate of return on rate base can 
    be chosen. This minimizes the possibility that the allowable rate of 
    return will be distorted by inappropriate subjective judgements or by 
    extraordinary economic conditions existing during the time period used 
    to measure that return. By comparison, the Commission's CET produces a 
    single measure of an allowable rate of return.
        On the basis of its review, the Commission has determined to 
    propose the use of the WACC methodology to evaluate the reasonableness 
    of a carrier's rates in the domestic offshore trades. The Commission 
    believes that the WACC approach set forth in the proposed rule 
    represents a substantial improvement over the existing methodology and 
    addresses the criticisms voiced in comments in Docket No. 91-51. We now 
    turn to the proposed rule.
    
    III. Estimating the Weighted Average Cost of Capital
    
    A. Capital Structure
        The first step in calculating the WACC is to determine an 
    appropriate capital structure (i.e., the proportions of long-term debt, 
    preferred stock, and common-stock equity capital issued by a firm to 
    finance its operations) for the regulated firm. There are two important 
    issues that may have to be resolved. The first is whether to calculate 
    the WACC using a ``typical'' or ``ideal'' capital structure as some 
    regulatory commissions do, or the actual capital structure or that 
    expected in the near future, as others do. The second issue concerns 
    the situation where the regulated company is a subsidiary of a parent 
    company. The issue is whether to use the capital structure of the 
    subsidiary or that of the consolidated system (i.e., the parent company 
    and all of its subsidiaries) in computing the WACC.
        1. Hypothetical Versus Actual Capital Structure. The WACC may be 
    much lower when the proportion of debt contained in a company's capital 
    structure is relatively high compared to common-stock equity. This is 
    because the interest rate on debt is usually much lower than the cost 
    of common-stock equity.16 In addition, debt costs the firm and the 
    ratepayer less than equity because equity earnings are subject to 
    income taxes and debt is not. The revenue that a company is allowed to 
    earn on its common-stock equity is increased by amounts added to that 
    revenue for the purpose of paying income taxes. By contrast, since 
    interest is deductible for income tax purposes, earnings to cover debt 
    costs are computed before any income tax calculations, and are not 
    subject to income tax. Consequently, within limits determined by such 
    factors as the risk of a business, the WACC may be lower and ratepayers 
    may pay less when the firm employs a relatively large proportion of 
    debt than when it uses a relatively large proportion of equity. Given 
    this differential, some regulatory commissions compute the WACC using 
    what they believe to be the ``typical,'' or ``ideal,'' capital 
    structure without regard to the actual capitalization of the regulated 
    company in question. Other regulatory commissions base their WACC 
    estimates on either the actual capital structure, or that expected in 
    the near future when rates to be decided will be in effect.
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        \1\6There are two reasons for this: (1) debtholders have 
    priority over equityholders as to the remaining assets of the firm 
    in the event that the firm is liquidated; and (2) debtholders must 
    be paid their contractual level of interest (i.e., their coupon 
    payment) before equityholders receive any compensation (i.e., 
    dividend payments). A company may reduce or eliminate dividend 
    payments to equityholders in the event that it is under financial 
    strain. However, it is far less likely that coupon payments will be 
    eliminated because this could result in bankruptcy if the firm does 
    not take corrective action. Equityholders, therefore, require a 
    higher return than do debtholders. Consequently, it costs a firm 
    more to issue common-stock equity than it does to issue debt. The 
    more expensive common-stock equity financing could be borne by 
    ratepayers in the form of higher rates.
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        There are strong reasons for using a regulated carrier's actual or 
    expected capital structure rather than the alternative of a 
    hypothetical or ideal capital structure in calculating the carrier's 
    WACC. First, a regulated company's current capital structure could be 
    the product of decisions that were logical and efficient at the time 
    they were made, although a different capitalization might be consistent 
    with a lower WACC at the time of a rate investigation and hearing. 
    Although hindsight is always more accurate than foresight, a company 
    must make financial decisions based on an evaluation of the present and 
    projections of future conditions.17 Second, using a hypothetical 
    or typical capital structure substitutes an estimate of what the WACC 
    would be under conditions that do not exist for what it actually is or 
    will soon be under existing conditions.18
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        \1\7Charles E. Phillips, supra note 4, at 390.
        \1\8James C. Bonbright, Albert L. Danielsen, and David R. 
    Kamerschen, Principles of Public Utility Rates, 2nd ed., Public 
    Utilities Reports, Inc., Arlington, Virginia, 1988, p. 309.
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        Accordingly, the Commission's proposed rule specifies the use of a 
    regulated domestic offshore carrier's expected capital structure in 
    computing the carrier's WACC. The proposed rule stipulates the use of 
    the expected rather than the actual capital structure because the 
    Commission uses a future instead of a historic test year.
        2. Subsidiary Versus Consolidated Capital Structure. Where a 
    regulated company is a wholly owned subsidiary which obtains its 
    common-stock equity capital through a parent company, regulators often 
    use the capital structure of the consolidated system (i.e., the parent 
    company and all of its subsidiaries) in computing the WACC. The 
    consolidated capital structure is an appropriate capitalization to use 
    in calculating a regulated subsidiary's WACC when: (1) No substantial 
    minority interest in the subsidiary exists (i.e., the regulated 
    subsidiary is wholly-owned by a parent company or nearly so), and (2) 
    the risks are similar between the parent and subsidiary.\19\ In such a 
    situation, investors' appraisals of the parent company's common stock 
    are thought to represent the best measure of the current cost of 
    common-stock equity to the subsidiary.\20\ When the consolidated 
    capital structure is used, the consolidated system's cost of common-
    stock equity capital (issued by the parent company), the consolidated 
    system's cost of preferred stock, and the consolidated system's cost of 
    long-term debt, rather than the respective capital component costs of 
    the regulated subsidiary, are also used because the consolidated 
    capital structure directly affects the capital component costs of the 
    consolidated system and not those of the subsidiary.\21\ The use of the 
    regulated subsidiary's capital component costs is inconsistent with the 
    use of the consolidated system's capital structure and could, 
    therefore, distort the WACC estimate obtained for the regulated 
    subsidiary.
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        \19\The use of the consolidated capital structure differs from 
    the ``double leverage'' concept used by some expert witnesses. The 
    latter approach uses the parent company's WACC as a measure of the 
    subsidiary's cost of common-stock equity capital along with the 
    subsidiary's capital structure, the subsidiary's cost of preferred 
    stock, and the subsidiary's cost of debt. Those that favor the use 
    of such a method cite the advantage of using the actual data of the 
    subsidiary for which an allowable rate of return is being computed. 
    The merits of the approach are highly debatable, however, since it 
    could produce an estimate of the cost of common-stock equity capital 
    for the regulated subsidiary that is lower than the opportunity cost 
    of such capital when the subsidiary is more risky than the parent, 
    and an estimate that is higher when the subsidiary is less risky. 
    The Commission's proposed rule does not, therefore, rely on the 
    double leverage method of calculating the WACC for a regulated 
    subsidiary company.
        \20\J. Rhoads Foster, ``Fair Return Criteria and Estimation,'' 
    28 Baylor L. Rev. 889 (1976), in Charles E. Phillips, supra note 4, 
    at 392.
        \21\To see how a company's capital structure could affect its 
    component capital costs, consider, for example, the case of a 
    heavily-leveraged company (i.e., one that has a relatively large 
    proportion of debt in its capital structure). Such a company could 
    be perceived by current and potential debtholders and equityholders 
    as having a relatively high probability of bankruptcy (in which case 
    coupon and dividend payments would be discontinued and the 
    possibility that principal could also be lost would be heightened) 
    and, therefore, as being a relatively high risk investment. 
    Debtholders and equityholders would require a return on their 
    investment funds that is commensurate with the relatively high risk 
    of such a company in order for them to be willing to purchase and 
    hold the company's debt and common stock. A heavily leveraged firm 
    could, therefore, have relatively high costs of debt and common-
    stock equity capital.
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        The use of the consolidated capital structure is not correct, 
    however, when a substantial minority interest in the regulated 
    subsidiary exists, or when the regulated subsidiary's risk differs 
    substantially from that of the parent company. The appropriate approach 
    in this situation is to ignore the parent-subsidiary relationship and 
    to estimate the subsidiary's WACC using the subsidiary's own capital 
    structure and capital component costs. This method, referred to as the 
    ``stand alone'' or ``subsidiary approach,'' recognizes the subsidiary 
    as an independent operating company, and its cost of common-stock 
    equity capital is inferred as the cost of common-stock equity of firms 
    having risk comparable to that of the subsidiary.\22\ The basis for 
    this method is that the required return on an investment depends on its 
    risk (i.e., the subsidiary's risk) rather than on the parent's 
    financing costs. In short, this method emphasizes the use, rather than 
    the source, of the subsidiary's capital funds.
    ---------------------------------------------------------------------------
    
        \22\The issue of selecting an appropriate sample of firms having 
    risk similar to that of the regulated company under consideration is 
    explored in detail below.
    ---------------------------------------------------------------------------
    
        The Commission's proposed rule specifies that a subsidiary 
    carrier's capital structure is to be used in computing the WACC unless, 
    after notice and opportunity for comment, the Commission determines 
    that: (1) The subsidiary carrier's parent company issues publicly 
    traded common-stock equity; (2) no substantial minority interest in the 
    subsidiary carrier exists; and (3) risks are similar between the 
    subsidiary carrier and the parent company. Under the proposed rule, no 
    substantial minority interest in a subsidiary carrier exists when a 
    parent company owns 90 percent or more of the subsidiary's voting 
    shares of stock. It also must be demonstrated that both the business 
    and the financial risks facing the parent and subsidiary are 
    similar.\23\
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        \23\Business risk is the variability that a company's internal 
    (e.g., the skill levels and salaries of employees) and external 
    (e.g., the number of competitors) operating variables impart to the 
    earnings available to investors because of the fundamental nature of 
    the company's business.
        Financial risk is the additional variability that debt and 
    preferred stock financing impart to the earnings available to 
    common-stock equityholders.
    ---------------------------------------------------------------------------
    
        Such an evaluation may involve a comparison of such financial risk 
    measures as total capitalization and debt-to-equity ratios, investment 
    quality ratings on short-and long-term debt instruments, and coverage 
    ratios such as the times interest earned and fixed charges coverage 
    ratios.\24\ There must also be an assessment of the degree to which the 
    regulated subsidiary comprises the parent's holdings. To the extent 
    that a subsidiary accounts for a substantial majority of the 
    consolidated system's revenues, expenses, and profits, the business 
    risks of the parent and subsidiary would, in general, be the same. 
    However, where a parent's holdings are diversified into areas of 
    business unrelated to the regulated subsidiary, the business risks of 
    the parent and of the subsidiary are more likely to differ.
    ---------------------------------------------------------------------------
    
        \24\Times interest earned ratios (``TIER'') measure the extent 
    to which operating income can decline before a firm is unable to 
    meet its annual interest costs. TIER is computed by dividing a 
    firm's earnings before interest and taxes by the firms' annual 
    interest expense.
        The fixed charges coverage ratio (``FCCR'') measures the ability 
    of a firm to satisfy all of its fixed obligations. FCCR is computed 
    by dividing the total of net income, interest expense, depreciation 
    and amortization expense, and the provision for income taxes, by 
    fixed charges. Fixed charges are the total of interest expense, 
    principal payments, and capital lease obligations.
    ---------------------------------------------------------------------------
    
        Accordingly, the Commission's proposed rule states that the 
    Commission shall consider some or all of the aforementioned business 
    and financial risk criteria in determining whether to approve the use 
    of a consolidated system's capital structure and component costs in 
    computing the subsidiary's WACC.
        Other measures of business and financial risks may also be used in 
    comparing the risk of a parent with the risk of a subsidiary. These 
    could include those discussed later for selecting an appropriate proxy 
    group of firms.
        3. Book Value Versus Market Value Capitalization Ratios. Another 
    capital structure issue is whether to use market or book values in 
    computing the capitalization ratios (i.e., the weights) in the WACC 
    formula. Technically, capitalization ratios should be computed on the 
    basis of market value. A capital structure computed on the basis of 
    historical (i.e., book values) as opposed to current market values 
    misrepresents the true capital structure over time, since price levels 
    fluctuate. The common practice is, nevertheless, to compute 
    capitalization ratios on the basis of book values. This is defended on 
    grounds that a regulated firm supposedly raises capital in such a 
    fashion that a target capitalization ratio expressed on the basis of 
    book values is maintained by the company. Consequently, regulators must 
    compute the firm's overall cost of capital on the same basis in order 
    to ensure that the company's capital costs are adequately covered. In 
    addition, book value capitalization ratios are stable and the regulator 
    is, therefore, not required to deal with the uncertainties associated 
    with volatile market weights. Further, effective regulation is said to 
    force book and market values toward equality. Accordingly, the 
    Commission's proposed rule requires the use of book value 
    capitalization ratios in computing the WACC.
        4. Average Versus Year-End Capital Structure. Finally, there is the 
    issue of whether a year-end or average capital structure should be used 
    in computing the WACC. The fact that financial variables and ratios are 
    commonly stated on an average basis argues in favor of using an 
    expected average capital structure projected over a future test year, 
    rather than a year-end capital structure. Earnings per share, for 
    example, are typically expressed on the basis of average number of 
    shares outstanding. Equity returns are also frequently expressed on the 
    basis of average common-stock equity. In addition, an average capital 
    structure computed over a future test year is likely to represent the 
    company's capital structure during the time interval in which a 
    proposed general rate increase will be in effect better than a year-end 
    capital structure, because the company could acquire new capital from, 
    or return existing capital to, investors during that period of time. 
    The use of an average capital structure rather than a year-end capital 
    structure is, therefore, more likely to enable a regulated firm to 
    actually earn its allowable rate of return. Accordingly, the 
    Commission's proposed rule specifies the use of test-year 
    average25 book value capitalization ratios in computing the WACC.
    ---------------------------------------------------------------------------
    
        \2\5Such average ratios are computed using the average amount of 
    each capital component (expected to be) outstanding during the test 
    year. The average test year amount outstanding for any class of 
    capital is computed by adding the amount of a particular type of 
    capital (expected to be) outstanding at the beginning of the test 
    year to the amount of that same type of capital (expected to be) 
    outstanding at the end of the test year, and dividing the sum of the 
    two amounts outstanding by two.
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    B. Annual Cost of the Capital Components
        Determining the cost of the regulated firm's senior capital (i.e., 
    debt and preferred stock) and common-stock equity is the second step in 
    estimating the WACC. The costs of each of these components are then 
    applied to the capital structure (i.e., each is weighted on the basis 
    of the proportion of the value of the total capital outstanding that 
    each represents) in order to determine the WACC.
        1. Cost of Senior Capital. There are usually few problems 
    encountered in computing the cost of senior capital with precision. 
    Regulatory commissions traditionally compute cost of senior capital on 
    the basis of embedded (actual historical) cost. This is done by first 
    computing the actual total annual fixed charges on long-term debt, 
    including any amortized discount or premium and issuance expense, and 
    the actual total annual dividend requirements on the preferred (and 
    preference) stock for all issues on a dollar basis. These dollar 
    figures are then converted to a percentage by dividing the actual total 
    annual fixed charges on long-term debt by the actual total value of 
    long-term debt outstanding, and the actual total annual preferred stock 
    dividend requirements by the actual total value of preferred stock 
    outstanding for all issues. If a future (rather than a historical) test 
    year is used (as the FMC does), the cost of senior capital is 
    calculated on the basis of: (1) The embedded cost for the existing 
    long-term debt and preferred stock, and (2) the current cost for any 
    new long-term debt and preferred stock that the regulated firm 
    anticipates issuing on or before the final day of the projected test 
    year.
        The embedded cost is used to calculate the cost of existing senior 
    capital in order to determine what the senior capital will cost the 
    firm today, in view of the fact that the majority of it was issued at 
    prior points in time, and under bond and stock market conditions that 
    could have differed substantially compared to those prevailing today. 
    The objective is not to determine what the existing senior capital 
    would cost if issued today. Rather, the embedded debt cost measures 
    precisely what the regulated firm needs to satisfy its contractually 
    required interest payments to those holding existing long-term debt, 
    and preferred-dividend payments to those holding existing preferred 
    stock. The current cost of bonds and preferred stock is, therefore, 
    estimated only to measure the cost to the regulated firm when such 
    senior securities are to be issued in the near future.
        2. Cost of Common-Stock Equity Capital. The most critical problem 
    in determining the WACC is that of estimating the cost of common-stock 
    equity capital. The objective is to determine how much the regulated 
    firm is required to earn in order to be able to entice investors into 
    purchasing and holding its common-stock equity. A precise answer to 
    this question is difficult to arrive at due to the absence of any 
    expressed or fixed agreement as to the level of dividends that are to 
    be paid by the regulated firm to its common-stock equityholders. 
    Dividend payments, on the one hand, depend upon the profits of the 
    regulated company. The allowable amount of profits, on the other hand, 
    is the object of a rate investigation and hearing. A regulator, in 
    allowing a fair rate of return, does not, therefore, have any 
    predetermined gauge as to the level of profit and common-stock equity 
    dividends required by investors.
        There are five major methods used to estimate the cost of common-
    stock equity capital: DCF, RP, CAPM,26 Market-to-Book Ratio 
    (``MBR''), and Comparable Earnings (``CE'').27 The DCF, CAPM, RP, 
    and MBR methods are market-based approaches that emphasize the standard 
    of capital attraction articulated in Hope and Bluefield by examining 
    investors' expectations of the regulated firm's profits, dividends, and 
    market prices. The CE method emphasizes the comparable earnings 
    standard specified by those cases by estimating the return on book 
    common-stock equity of firms having risk similar to that of the 
    regulated firm under consideration. The five methods are reviewed in 
    turn.
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        \2\6The CAPM is actually a specific type of RP model.
        \2\7The CE method is used by regulatory commissions 
    traditionally to calculate the regulated firm's cost of common-stock 
    equity capital. This approach differs significantly from the 
    comparable earnings test currently used by the FMC, which estimates 
    the rate of return on total invested capital (i.e., on long-term 
    debt and common-stock equity) of the regulated carrier under 
    consideration.
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        a. Discounted Cash Flow Method. The DCF method of estimating the 
    cost of common-stock equity is the technique that is used with the 
    greatest frequency by state and federal regulatory commissions and 
    agencies. Its popularity reflects the intuitive appeal of the DCF model 
    with its basis in valuation theory. That theory holds that the current 
    market price of a common stock is equal to the present value of its 
    expected future dividend payments plus the proceeds that an investor 
    would expect to receive when the common stock is finally sold. Because 
    the value of an amount of money to be received in the future is less 
    than the value of the same amount of money received today,28 the 
    expected value of the future dividends and ultimate proceeds must be 
    discounted back to the present at the investor's required rate of 
    return in computing the present value of a common stock. The most basic 
    mathematical representation of this concept assumes that: (1) Dividends 
    grow at a constant annual rate, and (2) that an investor will hold the 
    common stock forever. The latter assumption implies that the value of 
    the stock depends solely on the dividends that are expected to be paid. 
    The basic DCF model is expressed algebraically as follows:
    
        \2\8 The value of a dollar received today is greater than that 
    of a dollar received a year from today, for example, because today's 
    dollar can be invested and begin to earn a rate of return 
    immediately.
    
    TP07AP94.007
    
    ---------------------------------------------------------------------------
    where:
    
    Po is the current market price per share of the regulated 
    company's common stock;
    D1 is the dividend to be received at the end of year 1 
    (mathematically D1=Do(1+g), where D0 is the current 
    dividend);
    Ke is the required or expected return on the regulated firm's 
    common-stock equity capital (i.e., the cost of common-stock equity 
    capital); and
    
    g is the constant expected annual rate of growth in dividends per 
    share.
    
        The equation is solved for Ke in rate of return testimony in 
    order to determine the cost of the common-stock equity of the regulated 
    firm under consideration. Solving the equation for Ke yields the 
    following expression:
    
    
    TP07AP94.008
    
    
    Hence, the basic or standard DCF model states that the cost of common-
    stock equity is equal to the expected (first-year) dividend yield plus 
    the rate at which investors expect dividends to grow in the future.
    
        To illustrate the basic DCF model, assume that the current market 
    price of a hypothetical regulated company's common stock is $30.00 per 
    share, and that a single common stock share currently pays a $2.00 
    dividend, which is expected to grow at a rate of 5 percent per year. 
    The cost of common-stock equity capital for such a company is:
    
    TP07AP94.009
    
    
    i. Practical Issues
    
        (a) Expected Growth Rate of Dividends. The major practical issue 
    involves determining ``g,'' the constant expected annual rate of growth 
    in dividends per share. There are three techniques that are commonly 
    used to estimate ``g'': (1) Historical growth rates; (2) professional 
    investment services' projections; and (3) sustainable growth or 
    retention growth. An average of the growth rates arrived at separately 
    using each of the three methods is often used to produce a final growth 
    estimate. This averaging procedure is the one reflected in the proposed 
    rule.
    
        (i) Historical Growth Rate. The historical growth rate in dividends 
    over some period, frequently five or ten years, is one method used to 
    estimate ``g.'' Historical data are used because investors' 
    expectations of future growth are based in part on growth rates 
    experienced in the past. The historical growth in earnings per share, 
    or book value per share, is sometimes used as a proxy for the growth in 
    dividends, because dividends are often increased at discrete intervals, 
    so that their estimated growth rate can differ considerably depending 
    upon the precise beginning and ending points of the selected data 
    series. The proposed rule, therefore, requires averaging the historical 
    growth rate of dividends per share, earnings per share, and book value 
    per share in arriving at an estimate of ``g.''
        The period over which ``g'' is to be measured must be sufficiently 
    long to avoid distortions in the data resulting from short-term 
    conditions and aberrational years, but sufficiently short to capture 
    foreseeable influences relevant for investors' evaluation of the 
    future. The most recent five- and ten-year periods are commonly used to 
    calculate the growth rate. The proposed rule uses an average of the 
    five- and ten-year growth rates on the basis that the average 
    represents a reasonable trade-off between the incongruous requirements 
    of representativity and statistical adequacy.
        (ii) Professional Investment Services' Projections. The expected 
    growth rate of dividends is also commonly based upon the growth rates 
    published by professional investment services, since investor 
    expectations are the desired quantities in the DCF model, and 
    investors' growth anticipations are based in part upon the projections 
    of such services. Growth forecasts of dividends per share, earnings per 
    share, and book value per share are published by several services, 
    including Value Line Publishing, Inc. (``Value Line''), and the 
    Institutional Brokers Estimation Service (``IBES''). Such growth rates 
    are published on a regular basis, usually for five-year periods, and 
    are readily available to investors. Expert witnesses usually develop a 
    consensus forecast by averaging the forecasts of the professional 
    analysts, and use this average in calculating ``g.'' The Commission's 
    proposed rule similarly specifies that ``g'' will be measured by using 
    the average of: (1) The five-year dividend, earnings, and book value 
    forecasts published by Value Line, and of (2) the five-year earnings 
    forecast published by IBES.29
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        \2\9IBES produces a consensus forecast of earnings based on the 
    individual predictions of virtually every major brokerage house.
    ---------------------------------------------------------------------------
    
        (iii) The Sustainable Growth Rate. The third technique used to 
    estimate ``g,'' known alternately as the ``sustainable growth,'' 
    ``retention ratio,'' or ``plowback'' method, is to multiply the 
    proportion of earnings expected to be retained by the company, ``b,'' 
    by the expected return on book equity, ROE. The relationship is 
    expressed algebraically as g=(b)(ROE). The theoretical underpinning for 
    the method is that future growth in dividends for existing equity can 
    only occur if a portion of the overall return to investors is plowed 
    back into the firm rather than being paid out as dividends.
    
        To illustrate the sustainable growth rate method, assume that a 
    hypothetical regulated company is expected to retain 75 percent of its 
    earnings, and is expected to earn a 10 percent return on book equity. 
    The company's sustainable growth rate estimate of ``g'' is:
    
    g=.75(.10)
    =.075 or 7.5 percent.
    
        Both historical and projected values of ``b'' and ROE are used to 
    estimate ``g.'' Projected values are regarded as superior, however, 
    since forecasted values incorporate current and predicted changes into 
    the values. In addition, the use of historical realized book returns on 
    equity in estimating ROE has been criticized because the realized 
    returns are the product of the regulatory process itself, and are also 
    subject to tests of reasonableness. Therefore, the Commission's 
    proposed rule requires that the forecasted values of ``b'' and ROE 
    published by Value Line be used in implementing the sustainable growth 
    method.
    
        (iv) Final Estimate of ``g''. The final estimate of ``g'' for the 
    DCF model is commonly based on an average of the separate estimates 
    arrived at using the historical data, the professional investment 
    services' projections, and the sustainable growth model. Thus, the 
    Commission's proposed rule reflects such an averaging procedure.
    
        (b) Dividend Yield. Two methods are commonly used to calculate 
    dividend yields in DCF analyses. The standard DCF model uses the annual 
    dividend expected to be paid 12 months following the purchase of the 
    security. This method assumes that dividends are paid annually. The 
    other method uses the current dividend to compute the yield portion of 
    the annual return. This method assumes that dividends are paid 
    continuously. However, the assumption of annual payments results in an 
    overstatement of the required return (i.e., the regulated firm's cost 
    of common-stock equity capital), and the assumption of continuous 
    payments results in an understatement of the required return. Since 
    most firms pay dividends on a quarterly basis, however, it is proper to 
    use a method that recognizes such quarterly installments. Such a method 
    applies an adjustment factor to the current dividend yield to account 
    for quarterly payment of dividends. The dividend yield, assuming 
    quarterly payment of dividends, is calculated on the basis of the 
    following formula:
    
    
    TP07AP94.010
    
    where:
    
    D0 is the current annualized dividend (defined as four times the 
    current quarterly installment) per share;
    P0 is the current market price per share of the common stock; and
    g is the constant expected annual rate of growth in dividends per 
    share.
    
        To illustrate the quarterly dividend formula, assume that the 
    current market price of a hypothetical regulated company's common stock 
    is $30.00 per share, and that a single common stock share currently 
    pays quarterly a 50 cent dividend ($2.00 annually), which is expected 
    to grow at a rate of 5 percent per year. The dividend yield for such a 
    company is:
    
    
    TP07AP94.011
    
        The Commission proposes to use this formula in calculating the 
    dividend yield in DCF analyses.
        In calculating the current price per share found in the denominator 
    of the expression for the dividend yield, an average price over a 
    period of time, rather than a price on a particular day, is often used 
    in order to remove aberrations from the calculation. Such aberrations 
    could be the result of events internal to the company (e.g., the stock 
    may go ex-dividend30) or external factors (e.g., political events 
    that affect the price of a firm's stock). The period over which to 
    average the price of the common stock should be sufficiently long to 
    remove the aberration, but sufficiently short so as not to obscure any 
    real trends in the stock market. The Commission believes that the use 
    of an average of the monthly high and low prices for a six-month period 
    in computing the dividend yield meets these criteria, and such an 
    average is, therefore, reflected in the proposed rule.
    ---------------------------------------------------------------------------
    
        \3\0Ex-dividend is the interval between the announcement and the 
    payment of the next dividend. An investor who buys shares during 
    that interval is not entitled to that dividend. Typically, a stock's 
    price moves up by the dollar amount of the dividend as the ex-
    dividend date approaches, then falls by the amount of the dividend 
    after that date.
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        (c) Company-Specific Versus Comparable Group DCF Approach. The DCF 
    model can be applied directly to a regulated company which issues 
    publicly-traded common-stock equity (so that the requisite stock market 
    price data for doing so exist), to a group of companies comparable in 
    risk to the subject carrier which issue publicly-traded common-stock 
    equity, or, where possible, both. The company-specific DCF approach 
    provides the stock market's most direct and meaningful measure of a 
    company's cost of common-stock equity capital. Accordingly, the 
    Commission's proposed rule requires that the DCF model be applied 
    directly to the subject carrier where the carrier issues common-stock 
    equity which trades publicly.31 Only where a carrier issues no 
    publicly-traded common-stock equity is the DCF model to be applied to a 
    comparable group of firms under the proposed rule. Some expert 
    witnesses do, however, apply the DCF model to a comparable group of 
    firms, even where direct stock market data are available, either in 
    place of, or in addition to, the company-specific DCF approach. The 
    Commission's proposed rule does not prescribe the comparable group DCF 
    approach where direct stock market price data are available because it 
    is not certain that this approach would improve upon the accuracy of 
    the cost of common-stock equity capital estimate obtained using the 
    carrier-specific DCF approach.
    ---------------------------------------------------------------------------
    
        \3\1Alternatively, under the proposed rule, the DCF model is to 
    be applied directly to the parent company of a subsidiary carrier 
    where a consolidated capital structure and consolidated system 
    capital component costs are to be used to calculate the WACC, 
    assuming that the parent company issues common-stock equity which 
    trades publicly.
    ---------------------------------------------------------------------------
    
        b. Capital Asset Pricing Model. The conceptual basis of the CAPM is 
    that investors hold diversified portfolios consisting of individual 
    common stocks to minimize risk. Diversification reduces the risk of the 
    portfolio because individual common stock rates of return32 are 
    not perfectly correlated. The rate of return on some common stocks 
    tends to be high while on others it tends to be low so that the average 
    risk or variability of the return of the portfolio is less than the 
    average risk of the returns of the common stocks contained in that 
    portfolio. Diversification does not completely eliminate risk, however, 
    since individual common stock returns are correlated to a certain 
    degree due to the influence of pervasive forces not specific to a 
    particular security that affect the overall market.
    ---------------------------------------------------------------------------
    
        \3\2The annual rate of return on a common stock is the sum of 
    two components: (1) The annual dividend yield, which is annual 
    dividend income divided by the price of the common stock at the 
    beginning of a given year; and (2) the annual capital appreciation 
    or depreciation, which is the annual increase or decrease in the 
    price of the common stock, divided by the price at the beginning of 
    the given year.
    ---------------------------------------------------------------------------
    
        The total risk of a common stock is partitioned into two 
    components: (1) The ``specific'' or ``unsystematic'' risk unique to a 
    company that can be diversified away in a well-constructed portfolio, 
    and (2) the ``market'' or ``systematic'' risk that cannot be 
    diversified away. The core idea of the CAPM is that because investors 
    can diversify away company-specific risk, they should not be rewarded 
    for bearing this superfluous risk. Diversified risk-averse investors 
    are exposed solely to market risk and are, therefore, rewarded with 
    higher expected returns for bearing higher market risk.
        The CAPM provides a measure of market risk, known as ``beta,'' 
    which gauges the degree to which an individual common stock's return 
    moves with the overall market's return. Specifically, the common 
    stock's historical returns are compared with the overall market's 
    historical returns (commonly measured as the returns on a broad market 
    index such as the Standard and Poor's 500). A common stock is 
    considered to be of above average risk if the stock's return is more 
    volatile than that of the market,33 and of below average risk if 
    the stock's return is less volatile than that of the market.34 
    ``Beta'' is used in the CAPM model to adjust the market premium 
    expected by investors in comparison to debt for the riskiness of an 
    individual common stock.
    ---------------------------------------------------------------------------
    
        \3\3The ``beta'' for such an above-average risk common stock is 
    greater than one.
        \3\4The ``beta'' for such a below-average risk common stock is 
    less than one.
    ---------------------------------------------------------------------------
    
        The CAPM holds that the return on a common stock expected by an 
    investor is equivalent to that which could be earned on a riskless 
    investment, plus a premium for assuming risk that is proportional to 
    the common stock's market risk (i.e., ``beta''), and the market price 
    of risk (i.e., the difference between the overall expected stock market 
    return and the expected return on a risk-free investment). The CAPM is 
    represented algebraically as follows:
    
    Ke=Rf+B(Rm-Rf)
    
    where:
    
    Ke is the expected return on the regulated firm's common stock 
    (i.e., its cost of common-stock equity capital;
    Rf is the expected risk-free return;
    B is the relevant expected market risk ``beta'' of the regulated firm's 
    common stock; and
    Rm is the expected overall stock market return.
    
        To illustrate the CAPM, assume that a hypothetical regulated 
    company's expected ``beta'' is .95, the expected risk-free rate is 7 
    percent, and the expected overall stock market return is 12 percent. 
    The company's cost of common-stock equity capital is:
    
    Ke=.07+.95(.12-.07)
        =.07+.0475
        =.1175 or 11.75 percent.
    
        i. Practical Issues. The practical application of the CAPM requires 
    estimates of the expected ``beta'' of the regulated firm, the expected 
    risk-free rate, and the expected return on the stock market. Each of 
    these inputs is discussed in turn.
        (a) Risk-Free Rate. The yield on a 90-day Treasury Bill is 
    theoretically risk-free. It is devoid of default risk and is subject to 
    little interest rate risk. Treasury Bill rates vary widely, however, 
    resulting in volatile and unreliable common-stock equity return 
    estimates. In addition, 90-day Treasury Bill rates generally do not 
    match investors' planning horizons, which typically are far in excess 
    of 90 days. Short-term government obligations may also reflect the 
    impact of factors (e.g., inflation) differently than long-term 
    securities such as common stocks, or may reflect different factors than 
    those influencing the long term securities. Long-term Treasury bonds 
    (e.g., 30-year bonds) may more closely approximate investors' planning 
    horizons, and their yields usually match more closely with common stock 
    returns. The yields on long-term bonds are subject to substantial 
    interest rate risk, however, and so are not truly risk-free. A 
    compromise is to use the yields on Treasury securities of intermediate 
    maturities as proxies for the risk-free rate. Accordingly, the 
    Commission's proposed rule implements the CAPM using a six-month 
    average of five-year Treasury Note yields.
        (b) ``Beta.'' The value of ``beta'' used in applying the CAPM 
    should, in principle, be that which is expected in the future. The 
    ``beta'' actually used in the practical application of the model is, 
    however, more commonly calculated on the basis of historical data. 
    ``Beta'' could be calculated by applying regression analysis, using 
    historical price and dividend data for the regulated firm under 
    consideration, in order to measure the variability of the return on the 
    regulated firm's common stock relative to that of the market. The usual 
    practice, however, is to use the ``betas'' published by an investment 
    firm such as Value Line. Value Line ``betas'' are derived from a 
    regression analysis between weekly percent changes in the price of a 
    company's common stock and the weekly percent changes in the New York 
    Stock Exchange Composite Indices over a period of five years.35 
    Provided that the regulated firm's market risk is not expected to 
    change appreciably in the future, ``betas'' based on historical data 
    are appropriate for estimating the cost of common-stock equity. 
    Therefore, the Commission's proposed rule specifies the use of Value 
    Line's most current ``betas'' in implementing the CAPM.
    ---------------------------------------------------------------------------
    
        \3\5Value Line publishes adjusted ``betas.'' The adjustment 
    recognizes the tendency of ``betas'' to move toward one. (The market 
    index by definition has a value identically equal to one.) There are 
    two justifications for making such an adjustment: (1) Empirical 
    studies demonstrate that ``betas'' tend to move toward one over 
    time, and (2) the average ``beta'' is known to be one, and adjusting 
    an estimated ``beta'' toward one is, therefore, an appropriate use 
    of existing information.
    ---------------------------------------------------------------------------
    
        (c) Market Return. The third input required by the CAPM is an 
    estimate of the expected return on the stock market. One broad approach 
    is to estimate the expected return on the market directly. One such 
    technique is to apply a DCF analysis to a broad market index such as 
    the Standard & Poor's 500. A second broad approach is the historically 
    derived risk premium method, which involves two steps: (1) The 
    arithmetic average difference between the actual annual returns 
    realized in the past on the overall stock market and the risk-free rate 
    is calculated,36 and (2) this historical differential is added to 
    the currently prevailing yield on the risk-free security. The resulting 
    sum is a measure of the return on the market. The rationale for this 
    method is that investors anticipate that common stocks will yield a 
    higher return than the return on lower risk, fixed income securities, 
    and the additional return on the common stocks is expected to be 
    approximately equal to what it was in the past. The Commission's 
    proposed rule stipulates the use of the historically derived risk 
    premium method because it is relatively easy to apply, and its data 
    requirements are relatively light compared to methods designed to 
    measure the expected market return directly.
    ---------------------------------------------------------------------------
    
        \3\6The arithmetic mean, not the geometric mean, should be used, 
    since the quantity desired is the rate of return investors expect 
    over the next year for the random annual rate of return on the 
    market. The arithmetic mean is the unbiased measure of the expected 
    value of repeated observations of a random variable.
    ---------------------------------------------------------------------------
    
        The historical risk differential is commonly based on the 
    historical return series published annually by Ibbotson Associates in 
    the Stocks, Bonds, Bills, and Inflation Yearbook (``SBBI Yearbook''). 
    The SBBI Yearbook provides averages of the historical risk 
    differentials relative to various government securities for the period 
    1926 to the present, using Standard and Poor's 500 Index to compute the 
    overall market rate of return. The Commission's proposed rule specifies 
    the same source for measuring the arithmetic average risk premium 
    relative to the required risk-free rate proxy (i.e., the five-year 
    Treasury Note).
        The choice of a time period for measuring the historical 
    differential sometimes differs, but frequently it matches the entire 
    period over which Ibbotson Associates provides the data. Returns 
    calculated over a substantially shorter horizon (e.g., five or ten 
    years) are sometimes used to calculate the risk premium. This is not 
    appropriate, however, due to the extreme volatility of the return on 
    the overall stock market.37 Accordingly, the Commission's proposed 
    rule stipulates that the entire length of the data series be used as 
    the time horizon.
    ---------------------------------------------------------------------------
    
        \3\7In statistical terms, this extreme variability implies an 
    extremely large standard deviation over any short period of time. 
    Estimates of the overall market return calculated over such a short 
    period of time are, therefore, unreliable.
    ---------------------------------------------------------------------------
    
        In summary, the proposed rule requires that the market return used 
    in CAPM calculations be computed using a risk premium defined as the 
    arithmetic average historical risk differential relative to the five-
    year Treasury Note using the data published in the most current SBBI 
    Yearbook for the period 1926 through the most recent date for which the 
    data are available.
        c. Risk Premium Method. The RP method, alternately referred to as 
    the ``risk positioning method'' or the ``stock-bond yield spread 
    method,'' is based upon the premise that common-stock equity capital is 
    riskier than debt from an investors' perspective and that investors, 
    therefore, require a larger rate of return on investments in common 
    stocks than on bonds to compensate them for bearing the extra risk. 
    Common stock equity is riskier than debt because the payment of 
    interest and principal to debtholders has priority over the payment of 
    dividends and return of capital to common-stock equityholders. The RP 
    method, therefore, estimates the cost of capital by adding an explicit 
    premium for risk to a current interest rate, frequently an interest 
    rate on a particular government security. The general mathematical 
    expression for the RP model is as follows:
    
    Ke=Kd+RP
    
    where:
    
    Ke is the regulated firm's cost of common-stock equity capital;
    Kd is the incremental (i.e., current) cost of debt; and
    RP is the risk premium.
    
        To illustrate the RP model, assume that the incremental cost of 
    debt is 7 percent, and the risk premium is 5 percent. The regulated 
    company's cost of common-stock equity capital is:
    
    Ke=07+.05
        =.12 or 12 percent.
    
    i. Practical Issues
        (a) Risk Premium. There are several procedures for estimating the 
    risk premium. One common approach is to use the historical arithmetic 
    average return differential between rates of return actually earned on 
    investments in common-stock equities and bonds. This approach is 
    expressed mathematically as follows:
    
    Ke=Kd+Historical bond-equity spread
    
        The historical bond-equity spread, in turn, is often based on the 
    data series published annually in the SBBI Yearbook. The portfolio of 
    common stocks used as the benchmark for estimating the risk premium 
    should be one that is composed of a broad array of firms and is well 
    diversified, in order to minimize the potential for it to be 
    contaminated by the peculiarities of a particular group of common 
    stocks. The SBBI Yearbook database is based upon the Standard & Poor's 
    500 Index, which meets these criteria. The range of companies in such a 
    broad group as the Standard & Poor's 500 Index covers the broad 
    dimensions of investor perceptions of the trade-off between risk and 
    return, and serves as a benchmark for investor-required returns. The 
    Commission's proposed rule stipulates the use of the historical bond-
    equity spread based on the data published in the SBBI Yearbook.
        Risk premiums based on the historical differential can be extremely 
    volatile and may fluctuate as macroeconomic and microeconomic 
    conditions change. The time period over which the risk premium is 
    selected should, therefore, be sufficiently long that short-term 
    aberrations are smoothed out. Such a time period must encompass at 
    least several business and interest rate cycles. The Commission's 
    proposed rule requires the use of the entire data series (1926-present) 
    published annually in the SBBI Yearbook in estimating the risk premium.
        (b) Debt Security. The particular debt security used to implement 
    the RP model should be one which is, at least in theory, risk-free and 
    embodies a premium for inflation similar in magnitude to that reflected 
    in common stocks. Satisfying these criteria would isolate the spread 
    component of the return and obviate the need to make any type of 
    adjustment to the debt yield to account for default risk, which can 
    vary over time, and obscure the long-term relationship between returns 
    on common stocks and debt. These criteria are the same as those 
    identified for selecting a debt security to measure the risk-free rate 
    in implementing the CAPM.
        Accordingly, the Commission's proposed rule stipulates the use of 
    the six-month average five-year Treasury Note yield in implementing the 
    RP model, for the reasons identified for selecting this same yield as 
    the risk-free rate in implementing the CAPM.
        (c) Risk Adjustment. The risk premium estimate derived from a 
    composite market index is sometimes adjusted if there are differences 
    in the risk of the firms represented in the common-stock equity index 
    and that of the regulated firm under consideration. The CAPM (which is 
    actually the company-specific form of the general RP model), for 
    example, adjusts for such risk differences by multiplying the risk 
    premium by ``beta,'' which serves as the measure of relative risk in 
    the CAPM model. The Commission's proposed rule specifies that the RP 
    model be used in its general form without making any adjustment for 
    risk, because the generic form provides a useful benchmark for the 
    range of companies contained in the Standard & Poor's 500 Stock Index 
    on which it is based and, therefore, measures the broad dimensions of 
    investor perceptions of the trade-off between risk and return. The cost 
    of capital estimate produced using the RP model is not to be used as 
    the estimate, but instead is to be used as a check on, and in 
    combination with, the cost of capital company-specific estimates 
    produced using the DCF and CAPM models.
        d. Market-to-Book Ratio Method. The MBR method is based on the 
    notion that the market value of a regulated firm's common-stock equity 
    should be equal to its book value (plus some allowance for 
    underpricing), and will be so if the firm's allowable rate of return on 
    common-stock equity capital is equal to the firm's cost of common-stock 
    equity capital. The MBR approach is considered solid conceptually, but 
    is criticized widely for being impractical or even impossible to 
    implement. In order to apply the MBR, a regulator must be able to 
    accurately predict the effect that its rate order will have on the 
    common stock price of a regulated firm in attempting to maintain the 
    equality between the market value and book value of the firm's common 
    stock. Critics argue that regulators are unable to produce such 
    accurate forecasts even when sophisticated econometric models are used. 
    In addition, a regulator may influence, but cannot control completely, 
    the market price of the regulated firm's stock. Even if it could, the 
    exercise of such control would produce violent swings in rate levels 
    which would be uneconomical to both the ratepayer and the regulated 
    firm alike. Finally, diversification by the regulated firm into 
    unregulated activities could result in a market price that differs from 
    book value, although the earnings of the regulated segment are 
    restrained.
        The severe practical problems involved with implementing the MBR 
    method of computing an allowable rate of return on common-stock equity 
    capital sharply reduces the utility of the approach. Accordingly, the 
    Commission does not propose the MBR method of computing an allowable 
    rate of return on common-stock equity capital.
        e. Comparable Earnings Method. The CE method is based upon the 
    fundamental economic concept of opportunity cost. This concept states 
    that the cost of using any resource (i.e., land, labor, or capital) in 
    a particular activity is what that resource could have earned in its 
    next best alternative use. Thus, the opportunity cost of an investment 
    in a regulated firm's common stock is what the invested funds could 
    have earned in their next best alternative investment (e.g., in another 
    company's common stock, in a government or corporate bond, in real 
    estate, in gold, etc.). In brief, the CE method infers a regulated 
    company's cost of common-stock equity capital from the average 
    (sometimes the adjusted average) book value rate of return on common-
    stock equity of a group of firms comparable in risk to the regulated 
    company.
        As already discussed above, the CE method is not thought to be well 
    grounded in economic theory, primarily because the method is 
    implemented using accounting data rather than market information, and 
    does not accurately reflect the regulated carrier's cost of common-
    stock equity capital. Accordingly, the proposed rule does not specify 
    the CE method for computing the regulated firm's cost of common-stock 
    equity capital.
        f. Final Cost of Common-Stock Equity Capital Estimate. Rather than 
    choosing between the DCF, CAPM, and RP methods, the Commission believes 
    that all three methods should be used to produce separate estimates in 
    arriving at a final estimate of a regulated carrier's cost of common-
    stock equity capital, in order to avoid any inappropriate judgments 
    that could be embodied in any one of the individual estimates. 
    Accordingly, the proposed rule states that the Commission shall 
    consider the cost of common-stock equity capital estimates obtained 
    using the DCF, CAPM, and RP methods in arriving at a final cost of 
    common-stock equity capital estimate.
    C. Other Cost of Capital Issues
        1. Comparable-Risk Companies. a. Comparable-Risk Cost of Common-
    Stock Equity Capital Estimates. When a regulated firm finances assets 
    with common-stock equity that does not trade publicly, it is necessary 
    to use a surrogate to impute the firm's cost of common-stock equity 
    capital. The cost must be imputed because the regulated firm's equity 
    position is not explicitly recognized in the capital market and, 
    consequently, the necessary data for directly estimating the regulated 
    firm's cost of common-stock equity do not exist. This occurs when: (1) 
    The regulated firm is an independent company (i.e., one which has no 
    corporate parent) which issues no publicly traded common-stock equity, 
    or (2) the regulated firm is a subsidiary of a parent company, and the 
    subsidiary issues no publicly traded common stock of its own.
        In the case of the independent regulated company which issues no 
    publicly-traded common stock, the cost of common-stock equity capital 
    must be imputed from a sample of firms having risk similar to that of 
    the regulated company. Once an appropriate sample is selected, the cost 
    of common-stock equity capital is calculated using the methods 
    described earlier (i.e., DCF, CAPM, and RP) to produce a range of 
    estimates for the independent regulated company. In the case of the 
    regulated subsidiary, as discussed above, it may be appropriate to use 
    the consolidated system's capital structure and component costs to 
    estimate the subsidiary's WACC. If so, the consolidated system's cost 
    of common-stock equity is obtained by applying the DCF, CAPM, and RP 
    methods directly to the parent company, provided that the parent issues 
    publicly-traded common-stock equity so that the stock market price data 
    required for such an application exist. Otherwise, the regulated 
    subsidiary's capital structure and component costs are used, and it is 
    necessary to impute the subsidiary's cost of common-stock equity from a 
    sample of firms having risk similar to that of the subsidiary.
        b. Selecting a Proxy Group. The proxy group must be composed of 
    companies whose business and financial risks are substantially 
    comparable to the risk of the regulated firm. Since no two companies 
    are identical in risk characteristics, and because a company's risk 
    profile may not be perfectly stable over time, at least several 
    companies must be chosen to maximize the reliability of the estimated 
    cost of common-stock equity capital computed for the regulated company.
        The criteria for selecting the proxy companies should evaluate the 
    comparability of each company's business risk and financial risk with 
    those of the regulated firm. Comparability with regard to business risk 
    is most readily and directly accomplished by selecting companies in the 
    same line of business as the regulated firm. The comparability of 
    financial risk can be established by analyzing various financial 
    statistics and investment quality ratings which are commonly used as 
    measures of risk by investors. The Commission's proposed rule sets 
    forth a set of risk criteria for selecting proxy companies.
        The proposed rule further directs carriers that must rely on proxy 
    companies to impute their cost of common-stock equity capital to use 
    the prescribed risk criteria in selecting proxy companies, and to 
    annually submit their selection of proxy companies along with their 
    annually filed statement of financial and operating data, as required 
    in Sec. 552.2. After notice and opportunity for comment, the Commission 
    shall annually designate the respective proxy group of companies for 
    each applicable carrier in accordance with its prescribed risk 
    criteria. The sequence of steps for selecting the proxy companies and 
    the prescribed risk criteria are discussed in detail below.
    i. Risk Criteria
        (a) Step 1: U.S. Companies Listed in Value Line. The Commission's 
    proposed rule stipulates that the proxy companies must be U.S.-based, 
    and must be those for which The Value Line Investment Survey (``Value 
    Line'') provides financial data. The proxy companies are to be based in 
    the U.S. so as to maintain consistent accounting and tax requirements. 
    Value Line contains financial information on 1,700 companies that 
    publicly issue common stock for over 95 industries, including the 
    transportation sector. The use of Value Line as a resource for 
    selecting proxy companies is particularly suitable since it contains 
    the requisite historical and projected financial data for estimating 
    the cost of common-stock equity.
        (b) Step 2: Companies that Operate as Common Carriers. Consistent 
    with the concept of selecting firms of comparable business risk, the 
    proxy companies should be those which are in the same line of business 
    as the regulated firm. The proxy companies should operate and derive a 
    major portion of their gross revenues primarily as common carriers in 
    the business of freight transportation. The proxy group, for example, 
    could be comprised of common carriers that transport freight by air, 
    truck, water, and/or rail. The companies should also own or operate 
    transportation vehicles or vessels. Excluded from this group are 
    companies with gross revenues equal to or less than the $25,000,000 
    waiver level for vessel operating common carriers in the domestic 
    offshore trades, as described in 46 CFR Sec. 552.2(e).
        (c) Step 3: Financial Analysis of Comparable Risk. The proposed 
    rule further states that the Commission may also consider a company's 
    financial strength in evaluating the degree of financial risk faced by 
    each of the selected companies. This may include an examination of 
    some, but not necessarily all, of the factors listed below.
        (i) Total Capitalization Ratios and/or Debt/Equity Ratios. Total 
    capitalization ratios and debt/equity ratios measure the proportional 
    mix of financing in a company's capital structure. They are useful 
    measures of financial risk because they indicate the extent of leverage 
    or fixed-cost financing in a company (i.e., the degree to which the 
    company's assets are financed by long-term debt and/or preferred 
    stock). A low percentage of fixed-cost financing generally denotes a 
    low level of financial risk.
        (ii) Debt Ratings. Investment analysis services, such as Standard & 
    Poor's and Moody's, provide investment quality ratings of companies' 
    long-term debt instruments. These include ratings on corporate bonds 
    and commercial paper. The ratings reflect a company's risk of default 
    on debt obligations and the possible risk of bankruptcy. The primary 
    basis of the debt ratings is interest coverage. This represents the 
    number of times a company's earnings are greater than its fixed 
    contractual charges or interest costs.
        (iii) Stock Safety Rankings. Both Value Line and Standard & Poor's 
    provide common-stock equity rankings for each company listed in their 
    respective publications. While the basis of their ranking systems 
    differ, they both measure the degree of risk associated with each 
    company's common-stock equity. Value Line bases its ranking system on 
    the stability of the common stock's price adjusted for trends, as 
    measured by the standard deviation of weekly percent changes in the 
    stock's market prices over a five-year period, and partially on the 
    subjective analysis of its financial experts. Value Line's safety scale 
    ranges from 1, the highest, to 5.
        (iv) Financial Strength Ratings. Value Line rates the financial 
    strength of each of the 1,700 companies listed in its publication 
    relative to all the others. The ratings are based on key variables that 
    determine financial leverage, business risk, and company size. The 
    ratings range from A++, the highest, to C.
        (v) Standard Deviation. The standard deviation is a common 
    statistical measure which can be used to determine the variability of a 
    company's common-stock price changes, or returns on common-stock 
    equity. A high standard deviation indicates a high variability in the 
    range of price changes or returns relative to the average price change 
    or return. Thus, a high standard deviation implies a greater degree of 
    risk associated with a particular company's common stock. Value Line 
    provides a price stability index which ranks the standard deviation of 
    the weekly percentage changes in the market price of each company's 
    common stock over a five-year period.
        (vi) The Beta Coefficient. Beta is a regression coefficient that 
    measures the volatility of a company's common-stock price changes, or 
    returns on common-stock equity, relative to the stock market as a 
    whole. Where beta for the stock market equals one, common stocks with 
    beta values of less than one are said to be less risky than the market, 
    while stocks with beta values greater than one are said to be riskier 
    than the market. Value Line and Standard & Poor's provide the beta 
    values associated with the common stock of each company listed in their 
    respective publications.
        The Commission may also consider other information commonly 
    accepted by investors as measures of risk in a company. In this regard, 
    commenters may wish to address whether an accurate measure of 
    comparable risk should include some consideration of the regulated 
    firm's status as a subsidiary of a larger organization and, if so, 
    whether the criteria for inclusion in the proxy group should include 
    position in a larger corporate structure.
        2. The Before-Tax Weighted Average Cost of Capital. The WACC was 
    defined above as the composite of the cost of the various classes of 
    capital used by the regulated firm weighted on the basis of the 
    proportions of the total which each class represents. Corporate taxes 
    were excluded. In reality, a regulated firm typically does pay taxes, 
    and the WACC must be adjusted accordingly in arriving at a final 
    allowable rate of return. The use of the WACC to determine an allowable 
    rate of return without making such an adjustment would result in an 
    understatement of the total cost of servicing capital to ratepayers. 
    Assuming a 40 percent corporate income tax rate, for example, a company 
    requires only $1.00 of revenue to provide a $1.00 return to bondholders 
    because interest payments are tax deductible for corporate income tax 
    purposes. The same company requires $1.67 of revenue, however, to 
    provide a $1.00 return to preferred stock and common-stock equity 
    shareholders because the firm must pay corporate income taxes, and 
    dividend payments to such shareholders are not tax deductible.
        The following before-tax expression of the WACC (``BTWACC'') 
    recognizes explicitly the existence of income taxes and is, therefore, 
    the appropriate formula to use in computing an allowable rate of 
    return:
    
    
    TP07AP94.012
    
    where:
    
    Kd is the regulated firm's cost of long-term debt capital;
    Kp is the regulated firm's cost of preferred stock capital;
    Ke is the regulated firm's cost of common-stock equity capital;
    D is the value of the regulated firm's long-term debt outstanding;
    P is the value of the regulated firm's preferred stock outstanding;
    E is the value of the regulated firm's common-stock equity outstanding; 
    and
    T is the corporate income tax rate.
    
        To illustrate the calculation of the BTWACC, consider a 
    hypothetical regulated company that has total invested capital of $100 
    million, consisting of $25 million of long-term debt, $15 million of 
    preferred stock, and $60 million of common-stock equity. Assume that 
    the firm's cost of long-term debt is 7 percent, cost of preferred stock 
    is 9 percent and cost of common-stock equity is 12 percent, and that 
    the corporate income tax rate is 40 percent. The BTWACC for this firm 
    is calculated as follows: 
    
                                                 Calculation of BTWACC                                              
    ----------------------------------------------------------------------------------------------------------------
                                           Amount                                                                   
                                         (millions    Proportion      Cost         WACC      Tax factor             
            Capital component           of dollars)   (percent)    (percent)    (percent)     (1/1-T)       BTWACC  
                                                                                                                    
    ----------------------------------------------------------------------------------------------------------------
    Long-term debt....................           25           25            7         1.75         1.00         1.75
    Preferred stock...................           15           15            9         1.35         1.67         2.25
    Common-stock equity...............           60           60           12         7.20         1.67        12.02
                                       -----------------------------------------------------------------------------
          Total.......................          100          100  ...........        10.30  ...........       16.02 
    ----------------------------------------------------------------------------------------------------------------
    
        The allowable rate of return for this hypothetical company should, 
    therefore, be set at 16.02 percent, which would provide the firm with 
    the opportunity to earn revenues sufficient to service the total cost 
    of capital and taxes.
        The Commission's proposed rule specifies that the allowable rate of 
    return on rate base for a regulated carrier in the domestic offshore 
    trades shall be set equal to the carrier's WACC calculated on a before-
    tax basis. The proposed rule also stipulates the use of the regulated 
    carrier's normalized corporate income tax rate (i.e., the statutory 
    corporate income tax rate, not the actual or effective corporate income 
    tax rate) in computing the BTWACC. This is consistent with the approach 
    the Commission uses currently in calculating the rate of return on rate 
    base. Furthermore, the large majority of regulatory commissions in the 
    U.S. use the normalized income tax rate for ratemaking and accounting 
    purposes.38
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        \3\8See NARUC, ``Table 40--Accounting Treatment Of Tax 
    Reductions--All Utilities,'' supra note 4, at 95-96.
    ---------------------------------------------------------------------------
    
        3. Flotation Costs. Three factors could theoretically result in a 
    firm receiving as net proceeds from the issuance of common stock an 
    amount less than the pre-announcement common stock price: (1) The cost 
    of floating new issues (e.g., the fee paid to the underwriter) and 
    other administrative expenses (e.g., printing, legal, and accounting 
    expenses); (2) the downward market pressure resulting from the 
    increased supply of the common stock (i.e., the ``market pressure'' 
    effect); and (3) the potential market price decline related to external 
    market variables (i.e., the ``market break'' effect).
        The Commission's proposed rule specifies that an allowance for the 
    cost of common-stock equity capital financing be made for those 
    flotation costs that are actually incurred (i.e., those that are 
    identifiable and directly attributable to underwriting, printing, 
    legal, and accounting expenses), but only in the event that the 
    regulated carrier under consideration plans on issuing new common stock 
    to the general public during the test year in question.
        No allowance would be made for any hypothetical costs such as those 
    associated with market pressure and market break effects. The proposed 
    rule also specifies that the allowance is to be applied solely to the 
    new common-stock equity and not to the existing common-stock equity 
    balance.39 The regulated carrier would be required to supply the 
    requisite information for computing the allowance.
    ---------------------------------------------------------------------------
    
        \3\9The appropriate formula for computing such as allowance is 
    as follows:
    
        k=Fs/(1+s)
    
        where:
    
        k is the required increment to the cost of the regulated firm's 
    common-stock equity capital that will allow the company to recover 
    its flotation costs;
        F is the flotation costs expressed as a decimal fraction of the 
    dollar value of new common-stock equity sales; and
        s is the new common-stock equity sales expressed as a decimal 
    fraction of the dollar value of existing common equity.
    ---------------------------------------------------------------------------
    
    Deferred Taxes and The Capital Construction Fund
    
        Under its current rules, the Commission does not address the issue 
    of deferred taxes for calculating rate base. The Commission proposes to 
    amend its rules to provide for the treatment of deferred taxes, 
    including the Capital Construction Fund (``Fund'').
        The Fund is comprised of three components: (1) The capital account, 
    which results from contributions, (2) capital gains on investment 
    transactions, and (3) ordinary income, representing the earnings of 
    Fund assets. Section 607 of the Merchant Marine Act, 1936, 46 U.S.C. 
    app. Sec. 1177, which governs the Fund, provides for different tax 
    treatment for withdrawals from the various components of the Fund. 
    Section 607 requires that the basis of vessels, barges or containers 
    purchased with monies from the Fund be reduced by the amount of funds 
    withdrawn from the ordinary income and capital gains components of the 
    Fund. The proposed rule takes a similar approach, and would require 
    carriers to reduce the cost of an asset as shown in rate base by the 
    amount of funds withdrawn from the ordinary income and capital gains 
    components of the Fund which are used in acquiring the asset.
        A certain portion of a carrier's physical capital (rate base) is 
    financed by deferred taxes. Unlike the debt, preferred stock, and 
    common-stock equity components of financial capital, deferred taxes 
    cost the carrier nothing. Deferred taxes are in the nature of an 
    interest-free loan from the government. Given that these funds are 
    obtained at zero cost, we believe that the carrier should not be 
    allowed a return on that portion of rate base which results from 
    deferred taxes, except on that portion that results from deferred taxes 
    that may arise from the Fund or the expired Investment Tax Credit, and 
    that rate base be reduced accordingly.
        This treatment comports with the treatment of deferred taxes by 
    other federal agencies, as well as a majority of state regulatory 
    agencies.40 When it is necessary to allocate such accumulated 
    deferred taxes between Commission and non-Commission regulated 
    activities, such allocation shall be on the ratio of vessels and other 
    property and equipment included in rate base, less accumulated 
    depreciation, to total company vessels and other property and 
    equipment, less accumulated depreciation.
    ---------------------------------------------------------------------------
    
        \4\0See NARUC, ``Table 39--Treatment Of Accumulated Deferred 
    Income Taxes In Rate Base--All Utilities,'' supra note 4, at 93-94.
    ---------------------------------------------------------------------------
    
    Working Capital
    
        The inclusion of working capital in rate base is intended to 
    recognize the necessity for the carrier to maintain an adequate supply 
    of cash for the purpose of meeting expenditure requirements during the 
    period between the payment of expenses and the collection of revenue. 
    Average voyage expense is used as the measure of working capital for a 
    self-propelled vessel operator under the Commission's existing rule.
        With regard to the treatment of insurance expense in the 
    computation of average voyage expense, the Commission's current 
    regulations provide for the inclusion of 90 days' hull and machinery 
    insurance and protection and indemnity insurance. Hawaii suggests that 
    insurance expense be treated in the same manner as other operating 
    expenses, i.e., include that amount applicable to the duration of an 
    average voyage. The proposed rule adopts that approach.
    
    Allocation of Assets and Expenses
    
        In 1980, the Commission amended its rules governing the allocation 
    of assets and expenses. As a result of these changes, cargo cube or 
    space occupied replaced weight or revenue ton as the basis for 
    allocations. The rationale for this decision was that in a 
    containership operation, the cost of providing service is the cost of 
    providing space. The Commission concluded that the carrier's cost per 
    container remains the same regardless of the amount of cargo in the 
    container or revenue generated by the container.
        Accordingly, part 552 currently prescribes that vessels, 
    accumulated depreciation and vessel expense shall be allocated on the 
    cargo-cube-mile relationship as defined in 46 CFR 552.5(n), while those 
    expenses related to cargo handling are allocated on the basis of cargo 
    cube loaded and discharged. Other property and equipment, and 
    administrative and general expenses are required to be allocated on the 
    voyage expense relationship, as defined in 46 CFR 552.5(p).
        Commenters in Docket No. 91-51 suggested several alternative 
    allocation methods, including a method based on cargo carried on the 
    outbound portion of the voyage or based on revenue generated by 
    Commission and non-Commission regulated cargo. These proposals stemmed 
    from the bifurcation of regulatory authority in the domestic offshore 
    trades between the Commission and the Interstate Commerce Commission. 
    However, that split in jurisdiction has no direct connection with the 
    costs a carrier incurs in providing service. The Commission shall not 
    attempt to contrive an allocation methodology as a solution to an issue 
    that can best be remedied by legislative action.
        The Federal Maritime Commission certifies pursuant to section 
    605(b) of the Regulatory Flexibility Act, 5 U.S.C. 605(n), that this 
    rule will not have a significant economic impact on a substantial 
    number of small entities, including small businesses, small 
    organizational units and small government jurisdictions. The Commission 
    grants a waiver of the detailed reporting requirements to carriers 
    which earn gross revenues of $25 million or less in a particular trade 
    in accordance with 46 CFR 552.2(e).
        The collection of information requirements contained in this 
    proposed rule have been submitted to the Office of Management and 
    Budget for review under the provisions of the Paperwork Reduction Act 
    of 1980 (Pub. L. 96-511), as amended. The incremental public reporting 
    burden for this collection of information is estimated to range from an 
    average of 41 hours to 65 hours per response, including the time for 
    reviewing instructions, searching existing data sources, gathering and 
    maintaining the data needed, and completing and reviewing the 
    collection of information. Send comments regarding this burden 
    estimate, including suggestions for reducing this burden, to Sandra L. 
    Kusumoto, Director, Bureau of Administration, Federal Maritime 
    Commission, Washington, DC 20573 and to the Office of Information and 
    Regulatory Affairs, Office of Management and Budget, Washington, DC 
    20503.
    
    List of Subjects in 46 CFR Part 552
    
        Maritime carriers, Reporting and recordkeeping requirements, 
    Uniform system of accounts.
    
        Therefore, pursuant to 5 U.S.C. 553, sections 18 and 43 of the 
    Shipping Act, 1916, 46 U.S.C. app. 817 and 841a, and sections 2 and 3 
    of the Intercoastal Shipping Act, 1933, 46 U.S.C. app. 844 and 845, 
    Part 552 of Title 46, Code of Federal Regulations, is proposed to be 
    amended as follows:
    
    PART 552--FINANCIAL REPORTS OF VESSEL OPERATING COMMON CARRIERS BY 
    WATER IN THE DOMESTIC OFFSHORE TRADES
    
        1. The authority citation for part 552 continues to read as 
    follows:
    
        Authority: 5 U.S.C. 553; 46 U.S.C. app. 817(a), 820, 841a, 843, 
    844, 845, 845a and 847.
    
        2. In Sec. 552.1, paragraph (b) is revised to read as follows and 
    paragraph (d) is removed:
    
    
    Sec. 552.1  Purpose.
    
    * * * * *
        (b) In evaluating the reasonableness of a VOCC's overall level of 
    rates, the Commission will use return on rate base as its primary 
    standard. A carrier's allowable rate of return on rate base will be set 
    equal to its before-tax weighted average cost of capital. However, the 
    Commission may also employ the other financial methodologies set forth 
    in Sec. 552.6(f) in order to achieve a fair and reasonable result.
    * * * * *
        3. In Sec. 552.2, paragraph (a) is amended by revising the filing 
    address contained therein, paragraph (b) is redesignated as paragraph 
    (b)(1) and revised, a new paragraph (b)(2) is added, paragraph 
    (f)(1)(iv) is amended by removing ``and,'' from the end thereof, 
    paragraph (f)(1)(v) is amended by changing the period at the end 
    thereof to a semicolon and adding ``and,'' to the end of the paragraph, 
    and a new paragraph (f)(1)(vi) is added reading as follows:
    
    
    Sec. 552.2  General requirements.
    
        (a) * * *
    
    Federal Maritime Commission, Bureau of Tariffs, Certification and 
    Licensing, 800 North Capitol Street, NW., Washington, DC 20573-0001
    
        (b)(1) Annual statements under this part shall consist of Exhibits 
    A, B, and C, as described in Sec. 552.6, and shall be filed within 150 
    days after the close of the carrier's fiscal year and be accompanied by 
    a company-wide balance sheet and income statement having a time period 
    coinciding with that of the annual statements. A specific format is not 
    prescribed for the company-wide statements.
        (2) Concurrently with the filing of the carrier's annual financial 
    statements required under this section, a carrier that issues no 
    publicly traded common-stock equity must submit for Commission approval 
    annually:
        (i) A proxy group of companies to impute the carrier's cost of 
    common-stock equity capital in accordance with the requirements set 
    forth in Sec. 552.6(e)(3); or
        (ii) An application to use a consolidated capital structure in 
    accordance with the requirements set forth in Sec. 552.6(e)(4).
    * * * * *
        (f) * * *
        (1) * * *
        (vi) Projected schedules for capitalization amounts and ratios 
    (Schedule F-I); cost of long-term debt capital calculation (Schedules 
    F-II and F-III); cost of preferred (and preference) stock capital 
    calculation (Schedules F-IV and F-V); corporate income tax rate 
    (Schedule F-VI); and flotation costs (Schedule F-VII) for the 12-month 
    period used to compute projected midyear rate base in paragraph 
    (f)(1)(ii) of this section.
    * * * * *
        4. In Sec. 552.5, paragraphs (b) and (c) are revised, and 
    paragraphs (v), (w), (x), (y), (z), (aa), and (bb) are added to read as 
    follows:
    
    
    Sec. 552.5  Definitions.
    
    * * * * *
        (b) The service means those voyages and/or terminal facilities in 
    which cargo subject to the Commission's regulation under 46 CFR 
    514.1(c)(2) is either carried or handled.
        (c) The trade means that part of the Service subject to the 
    Commission's regulation under 46 CFR 514.1(c)(2), more extensively 
    defined in this section under Domestic Offshore Trade.
    * * * * *
        (v) Book value means the value at which an asset is carried on a 
    balance sheet.
        (w) Capital structure means a company's financial framework, which 
    is composed of long-term debt, preferred (and preference) stock, and 
    common-stock equity capital (par value plus earned and capital 
    surplus).
        (x) Capitalization ratio means the percentage of a company's 
    capital structure that is long-term debt, preferred (and preference) 
    stock, and common stock-equity capital.
        (y) Consolidated system means a parent company and all of its 
    subsidiaries.
        (z) Subsidiary company means a company of which more than 50 
    percent of the voting shares of stock are owned by another corporation, 
    called the parent company.
        (aa) Long-term debt means a liability due in a year or more.
        (bb) Times-interest-earned ratio means the measure of the extent to 
    which operating income can decline before a firm is unable to meet its 
    annual interest costs. It is computed by dividing a firm's earnings 
    before interest and taxes by the firm's annual interest expense.
        5. In Sec. 552.6, paragraph (a)(1), the first sentence of paragraph 
    (a)(2), the introductory text of paragraph (b)(1), paragraphs (b)(4)(i) 
    and (b)(5), and the heading of paragraph (b)(9) are revised; paragraph 
    (b)(10) is added; paragraphs (c)(5) and (c)(10) are revised; paragraphs 
    (d)(1) and (d)(2) are revised; paragraphs (e) and (f) are redesignated 
    (g) and (h); a new paragraph (e) is added and paragraphs (d)(3) and 
    (d)(4) are redesignated (f)(1) and (f)(2) and the paragraph headings 
    thereof revised reading as follows:
    
    
    Sec. 552.6  Forms.
    
        (a) General. (1) The submission required by this part shall be 
    submitted in the prescribed format and shall include General 
    Information regarding the carrier, as well as the following schedules 
    as applicable:
    
    Exhibit A--Rate Base and supporting schedules;
    Exhibit B--Income Account and supporting schedules;
    Exhibit C--Rate of Return and supporting schedules;
    Exhibit D--Application for Waiver;
    Exhibit E--Initial Tariff Filing Supporting Data; and
    Exhibit F--Allowable Rate of Return schedules.
    
        (2) Statements containing the required exhibits and schedules are 
    described in paragraphs (b), (c), (d), (e), (g), and (h) of this 
    section and are available upon request from the Commission. * * *
        (b) Rate base (Exhibits A and A(A))-(1) Investment in Vessels 
    (Schedules A-I and A-I(A)). Each cargo vessel (excluding vessels 
    chartered under leases which are not capitalized in accordance with 
    Sec. 552.6(b)(10)) employed in the Service for which a statement is 
    filed shall be listed by name, showing the original cost to the carrier 
    or to any related company, reduced to reflect the use of funds from the 
    Capital Construction Fund's capital gains account or ordinary income 
    account, plus the cost of improvements, conversions, and alterations, 
    reduced to reflect the use of funds from the Capital Construction 
    Fund's capital gains account or ordinary income account, less the cost 
    of any deductions. All additions and deductions made during the period 
    shall be shown on a pro rata basis, reflecting the number of days they 
    were applicable during the period. The result of these computations 
    shall be called the Adjusted Cost.
    * * * * *
        (4) Investment in other property and equipment; accumulated 
    depreciation other property and equipment (Schedule A-IV and A-IV(A)). 
    (i) Actual investment, representing original cost to the carrier or to 
    any related company, reduced to reflect the use of funds from the 
    Capital Construction Fund's capital gains account or ordinary income 
    account, in other fixed assets employed in the Service, shall be 
    reported as of the beginning of the year. Accumulated depreciation for 
    these assets shall be reported both as of the beginning and as of the 
    end of the year. The arithmetic average of the two amounts shall also 
    be shown and shall be the amount deducted from original cost in 
    determining rate base. The cost of additions and deductions during the 
    period, adjusted to reflect the use of the Capital Construction Fund, 
    shall also be reported. The carrier shall report as though all such 
    changes took place at midyear, except those involving substantial sums, 
    which shall be prorated on a daily basis. Allocation to the Trade shall 
    be based upon the actual use of the specific asset or group of assets 
    within the Trade. For those assets employed in a general capacity, such 
    as office furniture and fixtures, the voyage expense relationship shall 
    be employed for allocation purposes. The basis of allocation to the 
    Trade shall be set forth and fully explained.
        (ii) * * *
        (5) Working Capital (Schedule A-V). Working capital for vessel 
    operators shall be determined as average voyage expense. Average voyage 
    expense shall be calculated on the basis of the actual expenses of 
    operating and maintaining the vessel(s) employed in the Service 
    (excluding lay-up expenses) during the average length of time of all 
    voyages (excluding lay-up periods) during the period in which any cargo 
    was carried in the Trade. Expenses for operating and maintaining 
    vessels employed in the Trade shall include: Vessel Operating Expense, 
    Vessel Port Call Expense, Cargo Handling Expense, Administrative and 
    General Expense and Interest Expense allocated to the Trade as provided 
    in paragraphs (c) (2), (4) and (5) of this section.
    * * * * *
        (9) Capitalization of leases (Schedules A-VII and A-VII(A)). * * *
         (10) Accumulated Deferred Taxes (Schedules A-VIII and A-VIII(A)). 
    Accumulated deferred taxes, excluding deferred taxes that may arise 
    from the Capital Construction Fund or the expired Investment Tax 
    Credit, shall be reported both as of the beginning and the end of the 
    year and the arithmetic average of the two amounts shall be shown. 
    Allocation to the Trade shall be based upon the ratio of Trade 
    Investment in Vessels (Schedules A-I and A-I(A)) less Accumulated 
    Depreciation (Schedules A-II and A-II(A)) plus Other Property and 
    Equipment less Accumulated Depreciation (Schedules A-IV and A-IV(A)) to 
    total company investment in vessels and other property and equipment 
    less accumulated depreciation.
        (c) * * *
    * * * * *
        (5) Interest expense and debt payments (Schedules B-IV and B-
    IV(A)). This schedule shall set forth the total interest and debt 
    payments, apportioned between principal and interest, short and long-
    term, on debt and lease obligations. Payments on long-term debt are to 
    be calculated consistent with the method set forth in Sec. 552.6(e)(7) 
    for computing the cost of long-term debt capital. Principal and 
    interest shall be allocated to the Trade in the ratio that Trade rate 
    base less working capital bears to company-wide assets less current 
    assets. Where related company assets are employed by the filing 
    company, the balance sheet figures on the related company's books for 
    such assets shall be added to the company-wide total in computing the 
    ratio. In those instances where interest expenses are capitalized in 
    accordance with paragraph (b)(9) of this section, a deduction shall be 
    made for the amount so capitalized.
    * * * * *
        (10) Provision for income tax. Federal, State, and other income 
    taxes shall be listed separately. If the company is organized outside 
    the United States, it shall indicate the entity to which it pays income 
    taxes and the rate of tax applicable to its taxable income for the 
    subject year. Federal, State and other income taxes shall be calculated 
    at the statutory rate. Such tax rates are to be identical to those set 
    forth in Schedules F-VI or F-VI(A) used in determining the carrier's 
    allowable rate of return unless the carrier is a subsidiary of a parent 
    company and a consolidated capital structure is to be used in that 
    determination.
    * * * * *
        (d) Rate of Return (Exhibits C and C(A))--(1) General. All carriers 
    are required to calculate rate of return on rate base. However, the 
    Commission or individual carriers, at the Commission's discretion, may 
    also employ fixed charges coverage and/or operating ratios as provided 
    for in paragraph (f) of this section.
        (2) Return on rate base. The return on rate base will be computed 
    by dividing Trade net income plus interest expense by Trade rate base.
        (e) Maximum allowable rate of return on rate base (Exhibits F and 
    F(A))--(1) General. A carrier's maximum allowable rate of return on 
    rate base shall be set equal to the carrier's weighted average cost of 
    capital calculated on a before-tax basis (``BTWACC''). The BTWACC is 
    defined mathematically by the following expression:
    
    
    TP07AP94.013
    
    where:
    
    Kd is the carrier's cost of long-term debt capital;
    Kp is the carrier's cost of preferred (and preference) stock 
    capital;
    Ke is the carrier's cost of common-stock equity capital;
    D is the average book value of the carrier's long-term debt capital 
    outstanding;
    P is the average book value of the carrier's preferred (and preference) 
    stock capital outstanding;
    E is the average book value of the carrier's common-stock equity 
    capital (par value plus earned and capital surplus) outstanding; and
    T is the carrier's composite statutory corporate income tax rate.
    
        A carrier's BTWACC shall be calculated in precise accordance with 
    the rules set forth in this section.
        (2) Subsidiary carrier's capital structure. Where a carrier is a 
    subsidiary that obtains its common-stock equity capital through a 
    parent company, the capital structure of the subsidiary shall be used 
    in computing the BTWACC. The subsidiary carrier's cost of common-stock 
    equity capital, the subsidiary carrier's cost of long-term debt 
    capital, the subsidiary carrier's cost of preferred stock capital, and 
    the subsidiary carrier's composite statutory corporate income tax rate 
    shall also be used in computing the BTWACC. The subsidiary carrier's 
    cost of common-stock equity capital shall be inferred as the cost of 
    common-stock equity capital estimated for a sample of firms having 
    business and financial risk comparable to the subsidiary carrier when 
    the subsidiary carrier's capital structure is used in calculating the 
    BTWACC.
        (3) Comparable risk companies. (i) Concurrently with the filing of 
    the annual financial statements required under Sec. 552.2, a carrier 
    must submit for Commission approval a proxy group of companies to 
    impute the carrier's cost of common-stock equity capital where:
        (A) The carrier is an independent company (i.e., it has no 
    corporate parent) which issues no publicly-traded common-stock equity, 
    or
        (B) The carrier is a subsidiary that obtains its common-stock 
    equity capital through a parent company.
        (ii) After notice and opportunity for comment, the Commission will 
    approve a proxy group of companies based on the following criteria:
        (A) The proxy companies shall be based in the United States and 
    shall be listed in The Value Line Investment Survey.
        (B) The proxy companies shall operate and derive a major portion of 
    their gross revenues primarily as common carriers in the business of 
    freight transportation, and shall own or operate transportation 
    vehicles or vessels. Companies with gross annual revenues equal to or 
    less than the $25,000,000 shall be excluded from the proxy group.
        (C) In addition, comparable risk companies shall be selected by 
    examining some, but not necessarily all, of the following risk 
    indicators:
        (1) A company's total capitalization ratio and/or debt-to-equity 
    ratio;
        (2) The investment quality ratings of a company's long-term debt 
    instruments;
        (3) The investment safety ranking of a company's common-stock 
    equity;
        (4) The rating of a company's financial strength, as provided by 
    Value Line;
        (5) The variability of a company's common-stock price changes or 
    returns on common-stock equity (i.e., the standard deviation);
        (6) The volatility of a company's common-stock price changes or 
    returns on common-stock equity relative to the stock market as a whole 
    (i.e., the beta coefficient); or
        (7) Other such valid indicators deemed appropriate by the 
    Commission.
        (iii) Any proxy group of companies that has received Commission 
    approval will not be subject to challenge in a subsequent rate 
    investigation brought under section (3) of the Intercoastal Act, 1933.
        (4) Consolidated capital structure. (i) Upon application, after 
    notice and opportunity for comment, the Commission may authorize use of 
    the capital structure of the consolidated system (i.e., the parent 
    company and all of its subsidiaries) in computing the BTWACC. The 
    application must show that:
        (A) The subsidiary carrier's parent company issues publicly traded 
    common-stock equity;
        (B) The subsidiary carrier's parent company owns 90 percent or more 
    of the subsidiary's voting shares of stock; and
        (C) The business and the financial risks of the subsidiary carrier 
    and the parent company are similar.
        (ii) The similarity of the parent company's and subsidiary 
    carrier's business risk shall be evaluated by examining the degree to 
    which the consolidated system's profits, revenues, and expenses are 
    composed of those of the subsidiary carrier, and the extent to which 
    the parent's holdings are diversified into lines of business unrelated 
    to those of the subsidiary carrier, and/or other indicators of business 
    risk deemed appropriate by the Commission. The similarity of the parent 
    company's and subsidiary carrier's financial risk shall be evaluated by 
    examining the consolidated system's and the subsidiary's total 
    capitalization ratios, debt-to-equity ratios, investment quality 
    rankings on short- and long-term debt instruments, times-interest-
    earned ratios, fixed charges coverage ratios (calculated to include 
    both FMC and non-FMC regulated operations), and/or other measures of 
    financial risk deemed appropriate by the Commission.
        (iii) When the consolidated capital structure is used, the 
    consolidated system's cost of common-stock equity capital (issued by 
    the parent company), the consolidated system's cost of long-term debt 
    capital, the consolidated system's cost of preferred (and preference) 
    stock capital, and the consolidated system's composite statutory 
    corporate income tax rate shall also be used in estimating the 
    subsidiary's BTWACC.
        (iv) Where the Commission has approved the use of a consolidated 
    capital structure, such use will not be subject to challenge in a 
    subsequent rate investigation brought under section (3) of the 
    Intercoastal Act, 1933.
        (5) Book-value, average capitalization ratios. Capitalization 
    ratios representing the capital structure used in deriving a carrier's 
    BTWACC shall be computed on the basis of average projected book value 
    outstanding over the 12-month period used to calculate projected 
    midyear rate base in Sec. 552.2 (f)(1)(ii). The average amount of any 
    class of capital outstanding used in determining the capitalization 
    ratios is computed by adding the amount of a particular type of capital 
    expected to be outstanding as of the beginning of the 12-month period 
    to the amount of that same type of capital expected to be outstanding 
    as of the end of the 12-month period, and dividing the sum of the two 
    amounts outstanding by two.
        (6) Capitalization amounts and ratios (Schedules F-I and F-I(A)). A 
    carrier shall show its long-term debt, preferred stock, and common-
    stock equity capitalization amounts outstanding, stated in book value 
    terms, as of the beginning and as of the end of the 12-month period 
    used to calculate projected midyear rate base, and the average amounts 
    and average ratios for that 12-month period. Where a carrier is a 
    subsidiary of a parent company, the carrier shall show its own 
    capitalization amounts and ratios unless the carrier applies for and 
    receives permission from the Commission to use a consolidated capital 
    structure in computing the BTWACC. Where such permission is granted, 
    the carrier shall show instead the consolidated system's capitalization 
    amounts and ratios.
        (7) Cost of long-term debt capital (Schedules F-II, F-II(A), F-III, 
    and F-III(A)). (i) The cost of long-term debt capital1 shall be 
    calculated by the carrier for the 12-month period used to compute 
    projected mid-year rate base on the basis of:
    ---------------------------------------------------------------------------
    
        \1\The cost of sinking fund preferred stock shall be computed in 
    accordance with the regulations in this section for calculating the 
    cost of long-term debt.
    ---------------------------------------------------------------------------
    
        (A) Embedded cost for existing long-term debt; and
        (B) Current cost for any new long-term debt expected to be issued 
    on or before the final day of the 12-month period.
        (ii) The arithmetic average annual percentage rate cost of long-
    term debt capital calculated on the basis of all issues of long-term 
    debt expected to be outstanding as of the beginning and as of the end 
    of the 12-month period used to compute projected mid-year rate base 
    shall be the cost of long-term debt capital used in computing the 
    BTWACC.
        (iii) The annual percentage rate cost of long-term debt capital for 
    all issues of long-term debt expected to be outstanding as of the 
    beginning and as of the end of the 12-month period used to compute 
    projected mid-year rate base shall be calculated separately for the two 
    dates by:
        (A) Multiplying the cost of money for each issue under paragraph 
    (e)(7)(v)(A)(10) of this section by the principal amount outstanding 
    for each issue, which yields the annual dollar cost for each issue; and
        (B) Adding the annual dollar cost of each issue to obtain the total 
    dollar cost for all issues, which is divided by the total principal 
    amount outstanding for all issues to obtain the annual percentage rate 
    cost of long-term debt capital for all issues.
        (iv) The arithmetic average annual percentage rate cost of long-
    term debt capital for all issues to be used as the cost of long-term 
    debt capital in computing the BTWACC shall be calculated by:
        (A) Adding the total annual dollar cost for all issues of long-term 
    debt capital expected to be outstanding as of the beginning of the 12-
    month period used to compute projected mid-year rate base to the total 
    annual dollar cost for all issues of long-term debt capital expected to 
    be outstanding as of the end of the 12-month period, and dividing the 
    resulting sum by two, which yields the average total annual dollar cost 
    of long-term debt for all issues for the 12-month period;
        (B) Adding the total principal amount outstanding for all long-term 
    debt issues expected to be outstanding as of the beginning of the 12-
    month period used to compute projected mid-year rate base to the total 
    principal amount outstanding for all long-term debt issues expected to 
    be outstanding as of the end of the 12-month period, and dividing the 
    resulting sum by two, which yields the average total principal amount 
    expected to be outstanding for all issues for the 12-month period; and
        (C) Dividing the average total annual dollar cost of long term debt 
    for all issues for the 12-month period by the average total principal 
    amount expected to be outstanding for all issues for the 12-month 
    period, which yields the average annual percentage rate cost of long-
    term debt capital for all issues to be used in computing the BTWACC.
        (v)(A) Cost of long-term debt capital calculation (Schedules F-II, 
    F-II(A), F-III and F-III(A)). The carrier shall calculate the annual 
    percentage rate cost of long-term debt capital for all issues of long-
    term debt expected to be outstanding as of the beginning and as of the 
    end of the 12-month period used to compute projected mid-year rate base 
    separately for the two dates, and shall also calculate the average 
    annual percentage rate cost of long-term debt for all issues for the 
    12-month period. The carrier shall support these calculations by 
    showing in tabular form the following for each class and series of 
    long-term debt expected to be outstanding as of the beginning and as of 
    the end of the 12-month period separately for the two dates:
        (1) Title;
        (2) Date of issuance;
        (3) Date of maturity;
        (4) Coupon rate (%);
        (5) Principal amount issued ($);
        (6) Discount or premium ($);
        (7) Issuance expense ($);
        (8) Net proceeds to the carrier ($);
        (9) Net proceeds ratio (%), which is the net proceeds to the 
    carrier divided by the principal amount issued;
        (10) Cost of money (%), which, for existing long-term debt issues, 
    shall be the yield-to-maturity at issuance based on the coupon rate, 
    term of issue, and net proceeds ratio determined by reference to any 
    generally accepted table of bond yields; and, for long-term debt issues 
    to be newly issued on or before the final day of the 12-month period, 
    shall be based on the average current yield (published in such a 
    publication as Moody's Bond Survey) on long-term debt instruments 
    similar in maturity and investment quality as the long-term debt 
    security that is to be issued;
        (11) Principal amount outstanding (%);
        (12) Annual cost ($); and
        (13) Name and relationship of issuer to carrier.
        (B) Where a carrier is a subsidiary of a parent company, the 
    carrier shall show the cost of long-term debt calculations and 
    information required in this paragraph (e)(7)(v) for its own cost of 
    long-term debt unless the carrier applies for and receives permission 
    from the Commission to use a consolidated capital structure in 
    computing the BTWACC. Where such permission is granted, the subsidiary 
    carrier shall show the required cost of long-term debt calculations and 
    information for the consolidated system's long-term debt.
        (vi) In the event that new long-term debt is to be issued on or 
    before the final day of the 12-month period used to compute projected 
    mid-year rate base, the carrier shall submit a statement explaining the 
    methods used to estimate information required under paragraphs 
    (e)(7)(v)(A) (1) through (13).
        (8) Cost of preferred (and preference) stock capital Schedules F-
    IV, F-IV(A), F-V, and F-V(A)). (i) The cost of preferred (and 
    preference) stock capital shall be calculated by the carrier for the 
    12-month period used to compute projected mid-year rate base on the 
    basis of:
        (A) Embedded cost for existing preferred (and preference stock); 
    and
        (B) Current cost for any new preferred (and preference) stock to be 
    issued on or before the final day of the 12-month period.
        (ii) The arithmetic average annual percentage rate cost of 
    preferred (and preference) stock capital calculated on the basis of all 
    issues of preferred (and preference) stock expected to be outstanding 
    as of the beginning and as of the end of the 12-month period used to 
    calculate projected mid-year rate base shall be the cost of preferred 
    (and preference) stock capital used in computing the BTWACC.
        (iii) The annual percentage rate cost of preferred (and preference) 
    stock capital for all issues of preferred (and preference) stock 
    expected to be outstanding as of the beginning and as of the end of the 
    12-month period used to compute projected mid-year rate base shall be 
    calculated separately for the two dates by:
        (A) Multiplying the cost of money for each issue under paragraph 
    (e)(8)(v)(A)(9) of this section by the par or stated amount outstanding 
    for each issue, which yields the annual dollar cost for each issue; and
        (B) Adding the annual dollar cost of each issue to obtain the total 
    for all issues, which is divided by the total par or stated amount 
    outstanding for all issues to obtain the annual percentage rate cost of 
    preferred (and preference) stock capital for all issues.
        (iv) The arithmetic average annual percentage rate cost of 
    preferred (and preference) stock capital for all issues to be used as 
    the cost of preferred (and preference) stock capital in computing the 
    BTWACC shall be calculated by:
        (A) Adding the total annual dollar cost for all issues of preferred 
    (and preference) stock capital expected to be outstanding as of the 
    beginning of the 12-month period used to compute projected mid-year 
    rate base to the total annual dollar cost for all issues of preferred 
    (and preference) stock capital expected to be outstanding as of the end 
    of the 12-month period, and dividing the resulting sum by two, which 
    yields the average total annual dollar cost of preferred (and 
    preference) stock for all issues for the 12-month period;
        (B) Adding the total par or stated amount outstanding for all 
    preferred (and preference) stock issues expected to be outstanding as 
    of the beginning of the 12-month period used to compute projected mid-
    year rate base to the total par or stated amount outstanding for all 
    issues expected to be outstanding as of the end of the 12-month period, 
    and dividing the resulting sum by two, which yields the average total 
    par or stated amount expected to be outstanding for all issues for the 
    12-month period;
        (C) Dividing the average total annual dollar cost of preferred (and 
    preference) stock for all issues for the 12-month period by the average 
    total par or stated amount expected to be outstanding for all issues 
    for the 12-month period, which yields the average annual percentage 
    rate cost of preferred (and preference) stock capital for all issues to 
    be used in computing the BTWACC.
        (v)(A) Cost of preferred (and preference) stock capital calculation 
    (Schedules F-IV, F-IV(A), F-V, and F-V(A)). The carrier shall calculate 
    the annual percentage rate cost of preferred (and preference) stock 
    capital for all issues of preferred (and preference) stock expected to 
    be outstanding as of the beginning and as of the end of the 12-month 
    period used to compute projected mid-year rate base separately for the 
    two dates, and shall also calculate the average annual percentage rate 
    cost of preferred (and preference) stock for all issues for the 12-
    month period. The carrier shall support these calculations by showing 
    in tabular form the following for each issue of preferred (and 
    preference) stock as of the beginning and as of the end of the 12-month 
    period separately for the two dates:
        (1) Title;
        (2) Date of issuance;
        (3) Dividend rate (%);
        (4) Par or stated amount of issue ($);
        (5) Discount or premium ($);
        (6) Issuance expense ($);
        (7) Net proceeds to the carrier ($);
        (8) Net proceeds ratio (%), which is the net proceeds to the 
    carrier divided by the par or stated amount issued;
        (9) Cost of money (%), which, for existing preferred (and 
    preference) stock issues, shall be the dividend rate divided by the net 
    proceeds ratio; and, for preferred (and preference) stock issues to be 
    newly issued on or before the final day of the 12-month period, shall 
    be the estimated dividend rate divided by the estimated net proceeds 
    ratio;
        (10) Par or stated amount outstanding ($);
        (11) Annual cost ($); and
        (12) If issue is owned by an affiliate, name and relationship of 
    owner.
        (B) Where a carrier is a subsidiary of a parent company, the 
    carrier shall show the cost of preferred (and preference) stock 
    calculations and information required in this paragraph (e)(8)(v) for 
    its own preferred (and preference) stock unless the carrier applies for 
    and receives permission from the Commission to use a consolidated 
    capital structure in computing the BTWACC. Where such permission is 
    granted, the subsidiary carrier shall show the required cost of 
    preferred (and preference) stock calculations and information for the 
    consolidated system's preferred (and preference) stock.
        (vi) In the event that new preferred (and preference) stock is to 
    be issued on or before the final day of the 12-month period used to 
    compute projected mid-year rate base, the carrier shall submit a 
    statement explaining the methods used to estimate information required 
    under paragraph (e)(8)(v)(A) (1) through (12).
        (9) Cost of common-stock equity capital. A carrier's cost of 
    common-stock equity capital shall be calculated using the Discounted 
    Cash Flow (``DCF''), Capital Asset Pricing Model (``CAPM''), and Risk 
    Premium (``RP'') methods. A final estimate of that cost shall be 
    derived from the separate estimates obtained using each of the three 
    methods.
        (10) DCF method. (i) The DCF model that shall be used in 
    calculating a carrier's cost of common-stock equity is defined 
    algebraically as follows:
    
    
    TP07AP94.014
    
    where:
    
    Ke is the carrier's cost of common-stock equity capital;
    D0 is the carrier's current annualized dividend (defined as four 
    times the current quarterly installment) per share;
    P0 is the current market price per share of the carrier's common 
    stock; and
    g is the constant expected annual rate of growth in the carrier's 
    dividends per share.
    
        (ii) Current market price per share of common stock. The current 
    market price per share of the carrier's common stock used in the DCF 
    model shall be an average of the monthly high and low market prices 
    during a six-month period commencing not more than nine months prior to 
    the date on which the proposed rates are filed.
        (iii) Estimated growth rate of dividends. The estimate of g used in 
    the DCF model shall be an average of three separate estimates obtained 
    using historical growth rate data, professional investment services' 
    projections, and the sustainable growth rate model.
        (iv) Historical growth rate estimate of g. The historical growth 
    rate estimate of g shall be an average of the carrier's most recent 
    five- and ten-year historical growth rate averages of dividends per 
    share, earnings per share, and book value per share.
        (v) Professional investment services' projections estimate of g. 
    The professional investment services' projections estimate of g shall 
    be an average of Value Line's five-year forecasted growth rate of 
    dividends per share, earnings per share, book value per share, and the 
    Institutional Brokers Estimation Service's five-year forecasted growth 
    rate in earnings per share for the carrier.
        (vi) Sustainable growth rate estimate of g. The sustainable growth 
    rate estimate of g shall be obtained by multiplying the proportion of 
    earnings expected to be retained by the carrier by the expected return 
    on book equity. Value Line's forecasted values for expected retained 
    earnings and expected return on book equity shall be used in arriving 
    at the sustainable growth rate estimate of g.
        (11) CAPM. (i) The CAPM that shall be used in calculating a 
    carrier's cost of common-stock equity is represented algebraically as 
    follows:
    
    Ke = Rf + B(Rm - Rf)
    
    where:
    
    Ke is the carrier's cost of common-stock equity capital;
    Rf is the expected risk-free rate of return;
    B is the relevant market risk beta of the carrier's common stock; and
    Rm is the expected overall stock market return.
    
        (ii) Expected risk-free rate of return. A six-month average of 
    five-year Treasury Note yields computed over a period not more than 
    nine months prior to the date on which the proposed rates are filed 
    shall be used as the estimate of the expected risk-free rate of return 
    in the CAPM.
        (iii) Expected beta. Value Line's most current market risk beta of 
    the carrier's common-stock shall be used as the estimate of the 
    expected beta in the CAPM.
        (iv) Expected overall market return. The expected overall return on 
    the stock market shall be estimated by adding the six-month average of 
    five-year Treasury Note yields used as the estimate of the expected 
    risk-free rate to the arithmetic average difference between the actual 
    annual returns realized historically by the Standard & Poor's 500 Stock 
    Index and the five-year Treasury Note. The arithmetic average 
    differential shall be based on the complete historical series published 
    annually by Ibbotson Associates in the most recent Stocks, Bonds, Bills 
    and Inflation Yearbook, for the period 1926 through the most recent 
    date for which the specified data are available.
        (12) RP method. (i) The RP model that shall be used in calculating 
    a carrier's cost of common-stock equity is defined mathematically as 
    follows:
    
    Ke = Kd + RP
    
    where:
    
    Ke is the regulated carrier's cost of common-stock equity capital;
    Kd is the incremental cost of debt; and RP is the risk premium.
    
        (ii) Risk premium. The risk premium used in the RP model shall be 
    the historical arithmetic average return differential between rates of 
    return actually earned on investments in the Standard & Poor's 500 
    Stock Index and the five-year Treasury Note. This risk premium shall be 
    based on the complete historical data series published annually in the 
    Stocks, Bonds, Bills and Inflation Yearbook, for the period 1926 
    through the most recent date for which the specified data are 
    available.
        (iii) Incremental cost of debt. A six-month average of five-year 
    Treasury Note yields computed over a period not more than nine months 
    prior to the date on which the proposed rates are filed shall be the 
    estimate of the incremental cost of debt in the RP model.
        (iv) Risk adjustment. The RP model shall be used in its generic 
    form and the risk premium specified herein shall not be adjusted for 
    any possible differences in the risk of the firms represented in the 
    Standard & Poor's 500 Stock Index and that of the carrier under 
    consideration. The generic RP model shall be used as a benchmark for 
    the range of companies contained in the Standard & Poor's 500 Stock 
    Index on which it is based, and, therefore, shall be used to measure 
    the broad dimensions of investor perceptions of the trade-off between 
    risk and return.
        (13) Corporate income tax rate (Schedules F-VI and F-VI(A)). The 
    corporate income tax rate used in computing the BTWACC shall be the 
    carrier's composite statutory corporate income tax rate for the 12-
    month period used to compute projected midyear rate base. Such rate 
    shall be a composite of the carrier's Federal and State income tax 
    rates, and of any other income tax rate to be applied to the carrier's 
    income by any other entity to which the carrier is to pay income taxes. 
    The carrier shall calculate and show its composite statutory corporate 
    income tax rate as well as its Federal, State, and any other applicable 
    statutory income tax rates separately for the 12-month period used to 
    compute projected midyear rate base. The carrier shall also state the 
    name of any entity other than the Federal and State governments to 
    which it is to pay taxes. Where a carrier is a subsidiary of a parent 
    company, the carrier shall show its own statutory corporate income tax 
    rates unless the carrier applies for and receives permission from the 
    Commission to use a consolidated capital structure in computing the 
    BTWACC. Where such permission is granted, the carrier shall show 
    instead the consolidated system's statutory corporate income tax rates.
        (14) Flotation costs (Schedules F-VII and F-VII(A)). (i) A 
    carrier's cost of common-stock equity capital shall be adjusted to 
    reflect those costs of floating new issues that are actually incurred, 
    but only in the event that new common stock is to be issued to the 
    general public during the 12-month period used to compute projected 
    midyear rate base. Those flotation costs for which an allowance shall 
    be made must be identifiable, and must be directly attributable to 
    underwriting fees, and printing, legal, accounting, and/or other 
    administrative expenses. No allowance shall be made for any 
    hypothetical costs such as those associated with market pressure and 
    market break effects. The allowance shall be applied solely to the new 
    common-stock equity and shall not be applied to the existing common-
    stock equity balance. The formula that shall be used to compute such an 
    allowance is as follows:
    
    k = Fs/(1+s)
    
    where:
    
    k is the required increment to the cost of the carrier's common stock 
    equity capital that will allow the company to recover its flotation 
    costs;
    F is the flotation costs expressed as a decimal fraction of the dollar 
    value of new common-stock equity sales; and
    s is the new common-stock equity sales expressed as a decimal fraction 
    of the dollar value of existing common-stock equity capital.
    
        (ii) Flotation costs data (Schedules F-VII and F-VII(A)). (A) In 
    the event that new common-stock equity is to be issued during the 12-
    month period used to compute projected midyear rate base, the carrier 
    shall show separately by category the estimated costs of floating the 
    new issues to the extent that such costs are identifiable and are 
    directly attributable to actual underwriting fees, and to printing, 
    legal, accounting, and/or other administrative expenses that must be 
    paid by the carrier. The carrier shall submit a statement explaining 
    the method used in estimating the flotation costs. The carrier shall 
    also show estimates of the date of issuance; number of shares to be 
    issued; gross proceeds at issuance price; and net proceeds to the 
    carrier.
        (B) Where a carrier is a subsidiary that obtains its common-stock 
    equity capital through a parent company, and the parent company intends 
    to issue new common-stock equity during the 12-month period, the 
    carrier shall show separately by category the estimated costs to the 
    parent company of floating the new issues, and estimates of the above 
    items relative to the parent company's issuance of new common-stock 
    equity, provided that such carrier applies for and receives permission 
    from the Commission to use a consolidated capital structure in 
    computing the BTWACC.
        (f) Financial ratio methods--(1) Fixed charges coverage ratio. * * 
    *
        (2) Operating ratio. * * *
    
        By the Commission.
    Joseph C. Polking,
    Secretary.
    [FR Doc. 94-8226 Filed 4-6-94; 8:45 am]
    BILLING CODE 6730-01-W
    
    
    

Document Information

Published:
04/07/1994
Department:
Federal Maritime Commission
Entry Type:
Uncategorized Document
Action:
Proposed rule.
Document Number:
94-8226
Dates:
Comments due June 6, 1994.
Pages:
0-0 (1 pages)
Docket Numbers:
Federal Register: April 7, 1994, Docket No. 94-07
CFR: (5)
46 CFR 552.6(b)(10))
46 CFR 552.1
46 CFR 552.2
46 CFR 552.5
46 CFR 552.6