[Federal Register Volume 60, Number 171 (Tuesday, September 5, 1995)]
[Rules and Regulations]
[Pages 46047-46063]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-21845]
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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: Final rule.
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SUMMARY: The Federal Maritime Commission is amending 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 will use the weighted
average cost of capital methodology. The Commission is modifying the
calculation of the rate of return on rate base to a before-tax basis.
In addition, the Commission is amending its rules pertaining to the
computation of working capital. The 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.
EFFECTIVE DATE: October 5, 1995.
FOR FURTHER INFORMATION CONTACT:
Richard R. Speigel or Anne M. McAloon, Bureau of Economics and
Agreement Analysis, Federal Maritime Commission, 800 North Capitol
Street, NW., Washington, DC 20573-0001, 202-523-5845 or 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 April 7, 1994, the Federal Maritime
Commission (``FMC'' or ``Commission'') published a Notice of Proposed
Rulemaking (``NPR'' or ``proposed rule'') (59 FR 16592) which proposed
to amend the regulations governing financial reporting requirements and
rate of return methodology applicable to vessel-operating common
carriers by water in the domestic offshore trades. The Commission
proposed to change the method of determining the reasonableness of a
carrier's return on rate base from the comparable earnings test
(``CET'') to the weighted average cost of capital (``WACC'')
methodology. At the request of Matson Navigation Company (``Matson''),
the Commission extended the comment period for interested parties to
file until July 20, 1994 (59 FR 27002). The following seven parties
filed comments on the NPR: American President Lines (``APL''), Crowley
Maritime Corporation (``Crowley''), Matson, Puerto Rico Maritime
Shipping Authority (``PRMSA''), the Department of Transportation
(``DOT''), Marsoft Incorporated (``Marsoft''), and the State of Hawaii
(``Hawaii'').
By notice published November 4, 1994, 59 FR 55232 (``Request for
Reply Comments''), the Commission invited reply comments on four
specific issues--the calculation of the cost of capital, working
capital, the selection of proxy groups, and the deletion of alternative
methodologies. The Commission extended the time for reply comments
until January 6, 1995, partially granting a request of NPR, Inc. (59 FR
62372). Reply comments were received from APL, Crowley, Matson, PRMSA,
Hawaii, and Tobias E. Seaman (``Seaman''), president of the National
Association of Shippers, Consignees, and Consumers for Maritime
Affairs. With the exception of Seaman, all reply commenters had
submitted initial comments on the proposed rule.
PRMSA and NPR filed a motion for an evidentiary hearing on December
2, 1994. The Commission does not believe that there is a need to hold
an evidentiary hearing as suggested by PRMSA and NPR. There have been
two rounds of comments which have given
[[Page 46048]]
all interested parties, including PRMSA and NPR, adequate opportunity
to comment on the proposed rule.
The commenters raised concerns with many provisions of the proposed
rule. The Commission has addressed all relevant comments. Any comment
not specifically addressed has nevertheless been considered.
The Weighted Average Cost of Capital Approach
Comments: The commenters generally support the adoption of the WACC
methodology for determining the allowable rate of return on rate base.
Crowley does not support, however, the change to the WACC methodology
for the following reasons. Crowley argues that the WACC methodology
contained in the NPR does not correct the alleged shortcomings of the
CET, because the WACC methodology will also rely on a proxy group to
determine the regulated carrier's cost of capital. Crowley further
urges caution in the Commission's deliberations because of the
uncertainty over the Interstate Commerce Commission's (``ICC'')
continued jurisdiction over intermodal services and the Government of
Puerto Rico's continued attempts to sell PRMSA. Crowley also contends
that the rule would raise the cost of regulatory compliance
substantially. Crowley disputes, as being too low, the Commission's
estimate of the additional regulatory burden of the proposed rule
(i.e., 1.5 weeks), because substantially more effort would be required
in the first years as the carriers learn the new system. In his
comments, Seaman echoes Crowley's opposition to the proposed rule.
In its initial comments, PRMSA urged the Commission to require
carriers initially to provide parallel testimony and information which
would permit analysis under both the CET and the WACC methodologies. In
its reply comments, however, PRMSA states that no need exists for the
parallel CET analysis should the FMC decide to be less restrictive in
specifying the permissible evidence in rate-of-return proceedings, and
instead, permit carriers to submit evidence as to their demonstrated
risk and, hence, their required rate of return.
Both PRMSA and Matson argue that setting the maximum allowable rate
of return on rate base equal to the carrier's weighted average cost of
capital would not provide the regulated carriers with sufficient
earnings to fund their operations and attract capital. PRMSA urges the
Commission to adopt provisions which would allow an earnings
``cushion'' above the before-tax weighted average cost of capital
(``BTWACC'').1 PRMSA states that its required rate of return was
less than that of the CET reference group, because it is 100 percent
debt-financed and tax-exempt. Thus, it is said that PRMSA gained a tax
advantage over the CET reference group. The earnings which the
reference group devoted to tax payments was allegedly the ``cushion''
for PRMSA. The result, PRMSA states, is that the CET allows earnings
levels which, when achieved, provide PRMSA with the ability to remain
in business.
\1\The BTWACC is a before-tax version of the WACC.
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However, PRMSA maintains that the proposed BTWACC yields an
untenable result for PRMSA, because it would strip away the earnings
cushion which provides the ability to service debt which was acquired
to finance past losses. PRMSA argues that this lack of an earnings
``cushion'' would be potentially harmful to any company with
substantial debt in its capital structure. PRMSA contends that the
allowable rate of return must provide a sufficient cushion above the
cost of overall debt to permit the carrier to weather a downturn in its
business.
Matson states that the Commission's definition of the cost of
capital is the minimum rate of return necessary to attract capital to
an investment. Matson also notes that in the proposed rule the maximum
allowable return on rate base is the weighted average cost of capital.
Matson claims that using the cost of capital to determine the allowable
return on rate base sets the Commission's BTWACC as both the minimum
and the maximum rate of return for the regulated carrier. Matson claims
that for this to be correct, capital markets must be perfectly
efficient. Matson claims that since it is recognized that capital
markets are not perfectly efficient, by itself the BTWACC is not an
adequate measure of the return on capital necessary to attract capital
to the regulated carrier.
Matson claims that since the cost of capital is a minimum rate of
return necessary to attract capital to the regulated firm, the
Commission should allow carriers to earn returns equal to their cost of
capital plus a specified margin in excess. Matson states that the extra
earnings above the cost of capital that carriers in the domestic trades
would be given the opportunity to earn would not be ``gouging'' the
public. Matson states that the carriers in the domestic offshore trades
face competitive market conditions, and thus the carrier's ability to
meet customer needs will determine what return the carrier will earn
from its operations. Matson claims that modifying the proposed rule to
allow for a cushion above the BTWACC would permit Matson to attract
capital to finance the assets necessary to continue and to enhance its
operations.
Discussion: Crowley is correct that both the CET and BTWACC
methodologies generally need to use some form of proxy group. However,
for the following reasons, the Commission is convinced that the types
of information used to calculate the BTWACC provide a better estimate
than the CET of the allowable rate of return for each individual
carrier. First, the BTWACC uses information specific to the regulated
carrier's capital structure to calculate the carrier's required rate of
return. Second, the BTWACC uses either the regulated carrier's cost of
common-stock equity or a related proxy group's cost of common-stock
equity to determine the required rate of return on equity, rather than
the averages derived from all manufacturing firms that are used under
the CET. Similarly, the BTWACC calculates the actual coupon payments
for debt paid by the regulated carrier, rather than a proxy derived
from a rolling average of Baa-rated corporate bonds. Therefore, the
specificity that the BTWACC gives in determining the cost of capital of
the individual regulated carrier is a vast improvement over the CET.
Crowley's claims of additional regulatory burden appear to be
overstated. Under the proposed rule, if a carrier filed a general rate
increase, the extra regulatory burden is estimated to be 24 staff-
hours. An additional 41 staff-hours would have been required for the
annual filing of the proxy group. Thus, the proposed rule estimated the
increase in regulatory burden to be 41 to 65 staff-hours. The
additional regulatory burden under the proposed rule, then, was quite
modest. The Commission believes these estimates to be accurate
approximations of the additional time necessary to comply with the
final rule. Some firms may take more time while other firms may take
less time, but on average the Commission believes that the estimates
are accurate for the typical firm.
However, the Commission is concerned that any additional regulatory
burden required under the final rule be minimized. Therefore, as will
be discussed later, the requirement that carriers annually file a proxy
group has been dropped in the final rule and the procedure for
estimating the cost of equity has been changed. Under the final rule, a
carrier that does not file a general rate increase will incur no extra
regulatory burden because it need not
[[Page 46049]]
file a proxy group. In addition, one of the three methods used to
estimate the cost of equity, the Capital Asset Pricing Model, will no
longer be required. These modifications to the proposed rule will
result in a significant lessening of the regulatory burden. If the
carrier does file a general rate increase, the extra regulatory burden
remains 65 staff-hours. The Commission believes that the improvement in
rate-of-return regulation which will occur under the BTWACC methodology
more than compensates for the extra staff-hours of regulatory burden
which will be incurred by those carriers which file a general rate
increase. Therefore, the Commission rejects the suggestion by Crowley
and Seaman that the Commission abandon its proposal to implement a
BTWACC approach to determine the allowable rate of return in the
domestic trades.
As will be discussed in the following sections, the Commission is
modifying its proposed rule to allow for greater flexibility in the
determination of the cost of common-stock equity. This modification
should eliminate the need perceived by PRMSA in its initial comments
that both the BTWACC and CET be utilized initially to determine an
appropriate rate of return.
The NPR explained the legal and economic rationale for setting the
allowable rate of return equal to the regulated carrier's cost of
capital. Two landmark Supreme Court cases2 established that
investors in companies subject to rate regulation must be allowed an
opportunity to earn returns sufficient to attract capital comparable to
investments in other firms having the same amount of risk, and that
revenues must not only cover operating expenses, but capital costs as
well. The economic rationale for setting the allowable rate of return
of a regulated company equal to its cost of capital is that in the long
run the regulated firm's customers will pay the lowest cost for service
while at the same time the company's earnings will be sufficient to
attract capital so that the company is able to provide the customers'
desired level of service. Based on the legal decisions and economic
rationale, the Commission considers the BTWACC an appropriate measure
of the allowable rate of return for regulated carriers. The Commission
believes that the BTWACC methodology will allow carriers to attract
adequate capital, thereby negating the concerns expressed by Matson.
However, as PRMSA noted, a carrier with only debt financing would be
allowed only to earn the cost of its long-term debt under the
BTWACC.3 It appears that such a capital structure is highly
unusual and unlikely to occur without substantial government backing of
the carrier (as has been the case with PRMSA).
\2\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).
\3\If a carrier is 100% debt-financed, the equity portion of the
BTWACC equation equals 0.
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PRMSA is unique among ocean carriers in the domestic offshore
trades in that, until its recent sale to NPR in January 1995, it was
government owned and 100 percent debt-financed. PRMSA contends that it
lost money year after year and part of its debt was used to finance
past losses.4 While a regulatory commission should minimize
regulatory risk by ensuring that regulated firms are given the
opportunity to earn a reasonable return on capital, it is the
responsibility of the firm to achieve a viable capital structure and
operate the business efficiently. The BTWACC is an appropriate measure
of the cost of capital for carriers having a broad range of capital
structures. The Commission cannot prevent a carrier from departing from
the broad range of capital structures that are generally used. However,
the Commission must assure that ratepayers do not pay a premium for
such a decision by the carrier. Therefore, the Commission believes that
ratepayers should not be required to pay for an additional ``cushion''
due to PRMSA's unique capital structure.
\4\Similar to Crowley, PRMSA has filed many of its rates in ICC-
regulated or exempt tariffs since 1981, the last year in which that
carrier's rates were subject to an FMC investigation.
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Lastly, as a further clarification the Commission will state in its
rule that the BTWACC is the ``allowable'' rate of return rather than
the ``maximum allowable'' rate of return.
Accessibility of Carrier Financial Data
Hawaii argues that the adoption of the BTWACC methodology will
require that all parties have access to information regarding the
carrier's financing and capitalization. Such information is company
specific and can be obtained only through the carriers' annual
financial reports filed with the Commission. Hawaii recommends that the
Commission reverse its present policy of not requiring the carriers'
annual reports to be made available to all parties.5 However, the
issue was not raised in the NPR and there has been no opportunity for
the other parties to comment on Hawaii's recommendation. Accordingly,
it would not be proper for the Commission to rule on the merits of
Hawaii's recommendation here.
\5\Section 552.4(c) of the Commission's regulations protects the
carrier's annual reports from public disclosure and treats them as
confidential information in the files of the Commission.
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Hawaii also requests the right of discovery by all parties, so that
any questions which may arise concerning the carrier's financial
situation may be pursued. Rule 67 of the Commission's rules of practice
and procedure (46 CFR 502.67) currently provides for discovery in
proceedings under section 3(a) of the Intercoastal Shipping Act, 1933
(``1933 Act'') 46 U.S.C. app. 845 (a). Hawaii's request fails to
explain why Rule 67 is deficient. In any event, an amendment to Rule 67
is outside the scope of this proceeding and cannot be properly
addressed here.
Deletion of Alternative Methodologies
The proposed rule revised paragraph (b) of Sec. 552.1 by deleting
the provision that the methodology employed in each case will depend on
the nature of the relevant carrier's operations and financial
structure. Also, the proposed rule added language to the paragraph that
specifies the extent of possible alternative methodologies. Paragraph
(b) reads:
(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.
Paragraph (d) of the same section has been deleted. That paragraph
provided that the Commission may use some other basis for allocation
and calculation and may consider other operational factors in any
instance where it is deemed necessary to achieve a fair and reasonable
result.
APL advised, in its initial comments, that these provisions are at
the heart of a major dispute in FMC Docket No. 89-26, The Government of
the Territory of Guam, et al. v. Sea-Land Service, Inc. and American
President Lines, Ltd. It pointed out that the NPR does not give any
reasons for the proposed changes to Sec. 552.1 and argued that the
changes cannot be legally adopted unless and until the FMC identifies
its reasons for such a change and allows opportunity for comment.
Further, APL pointed out that the proposed changes could have no effect
on a pending complaint docket focused on a prior time period.
In the Request for Reply Comments, the Commission explained that
the Guam trade is unique in that the trade is a very small portion of
the carriers' overall service. Whether the current
[[Page 46050]]
method of allocation is appropriate in such a case need not be decided
in this proceeding because the two carriers serving Guam, APL and Sea-
Land Service, Inc., currently file most of their rates with the ICC.
Neither carrier files full financial reports under 46 CFR part 552. If
in the future a carrier serves Guam under FMC regulation, the
Commission could address the need for any change in 46 CFR part 552 in
a separate rulemaking proceeding. Paragraph (d) of Sec. 552.1 was
eliminated because the Commission did not want such determinations to
be made on an ad hoc basis during a rate investigation. It is essential
that significant issues relating to the underlying methodology to be
employed in determining the reasonableness of rates be settled prior to
any rate investigation. The 180-day limit specified by section 3 of the
1933 Act cannot be met if parties are permitted to change methodologies
during the course of a rate investigation. Moreover, the Commission
stated in its Request for Reply Comments that parties to a rate
proceeding are entitled to rely on the Commission's rules. They should
not have to respond to ever-changing methodologies proposed by other
parties. The Commission also explained that any changes that may be
made to part 552 as a result of this proceeding will only be applied
prospectively and will have no application in pending cases such as
Docket No. 89-26.
Both APL and Matson support the proposed changes to Sec. 552.1. APL
urges the FMC, in discussing the reply comments in this proceeding, to
``avoid overbroad statements that might be argued to have application
to pre-existing complaint dockets as opposed to GRI proceedings.'' (APL
Reply at 3.) Matson concurs with the Commission that it is essential
that significant issues relating to the underlying methodology to be
used in determining the reasonableness of rates be settled prior to any
investigation.
Crowley argues that it is not clear that the Commission has
adequately preserved its option of using other rate-of-return
methodologies ``in order to achieve a fair and reasonable result.'' The
carrier suggests that, while certainty in predicting the Commission's
reaction to a proposed rate increase is important, it should not be
achieved at the expense of the Commission's flexibility to consider
legitimate alternatives for measuring a carrier's rate of return.
Seaman does not comment on the merits of the proposed changes to
this section, but rather repeats his opinion that the alternative
methodologies should be applied to Matson's operations in the Hawaii
trade. He further claims, as APL did in its initial comments, that
because the NPR did not give any explanation for the proposed changes,
the due process rights of those affected are violated.
Crowley's and Seaman's concerns that methodologies other than rate
of return on rate base be available appear to be overstated. The
Commission believes that the proposed methodology should be appropriate
for almost any conceivable situation. Moreover, neither Crowley nor
Seaman provide sufficient reasons for altering the proposed changes to
Sec. 552.1. The flexibility they appear to seek simply cannot be
accommodated within the 180-day limit specified by section 3 of the
1933 Act. Further, neither Crowley nor Seaman have addressed the fact
that it is not fair to require parties to respond to ever-changing
methodologies proposed by other parties. Therefore, unless the
Commission prescribes an alternative methodology in its order
commencing a rate investigation, all parties will be limited to the use
of rate of return on rate base throughout the proceeding. The changes
to Sec. 552.1 will be adopted as proposed.
Capital Structure
The Proposed Rule
The proposed rule provided that a regulated domestic offshore
carrier's expected capital structure is to be used in calculating that
carrier's BTWACC. In the case of a regulated carrier that is a
subsidiary of a larger parent company, the proposed rule provided that
a subsidiary carrier's capital structure be used in computing the
BTWACC unless, after notice and opportunity for comment, the Commission
determines that the carrier may use the capital structure of the parent
company (i.e., the consolidated system). Such a determination would
require that: (1) The subsidiary carrier's parent company issues
publicly traded common stock equity; (2) no substantial minority
interest in the subsidiary exists;6 and (3) the risks are similar
between the subsidiary carrier and the parent company.7 The NPR
also proposed that the capitalization ratios (i.e., the weights) used
in calculating the BTWACC be based on the test-year average book value.
\6\Under the proposed rule, no substantial minority interest in
a subsidiary carrier would exist when a parent company owns 90
percent or more of the subsidiary's voting shares of stock.
\7\In considering the similarity of both business and financial
risks facing the parent and subsidiary, the following will be
considered: Financial risk measures, such as total capitalization
and debt/equity ratios, investment quality ratings on short and long
term debt instruments; and coverage ratios, such as times interest
earned and fixed charges coverage ratios, and the degree to which
the regulated subsidiary comprises the parents' holding.
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Comments: Hawaii agrees that the expected capital structure should
be used when a company is an independent company. In the case of wholly
owned subsidiaries,8 however, Hawaii recommends that the FMC allow
greater flexibility in adopting the appropriate capital structure.
Hawaii suggests that the Commission not declare a preference for either
the subsidiary or consolidated financial data but avail itself of the
option to decide, on a case-by-case basis, whether to use the
subsidiary, consolidated system,9 or a hypothetical capital
structure. By deciding on a case-by-case basis, Hawaii contends that
the FMC will avoid prejudging which method will allow the most accurate
estimation of the carrier's cost of capital.
\8\Hawaii couched its comments on a wholly owned subsidiary in
terms of Matson Navigation Co., Inc., which is a subsidiary of
Alexander & Baldwin, Inc.
\9\Hawaii requested clarification on the issue of whether all
parties have the option to apply for the use of the consolidated
system. The Commission anticipates that only the regulated carrier
will be able to apply for use of the consolidated system's capital
structure. In addition, the Commission's staff may also recommend
the use of the consolidated system. Such application or
recommendation will be subject, however, to notice and comment prior
to Commission approval. It appears that interested parties will be
provided with ample opportunity to comment on this issue.
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Hawaii points out two potential drawbacks of using subsidiary data.
The first drawback would be the need for a portfolio of comparable
companies. Hawaii contends that finding a comparable group may be
problematic or impossible within the framework of the proposed rule.
The second drawback would be the possible artificiality of the
capital structure of a subsidiary. Hawaii points out a situation it has
encountered in which the capital structure of a subsidiary is reported
to consist of all equity. The parent company holds and sells all debt,
but the proceeds of the debt are used by the subsidiary. Hawaii states
that it has
no a priori reason to believe that data from a portfolio of
comparable companies is a better base from which to estimate a
carrier's cost of capital than data from the consolidated system of
which a carrier is a part. There are necessarily pros and cons in a
choice between the characteristics of a consolidated company, within
which the characteristics of the relevant company are hidden, and a
portfolio of proxy companies which may bear little resemblance to
the relevant company.
(Hawaii at 7). Hawaii suggests that the choice between two
inappropriate
[[Page 46051]]
capital structures could be avoided by using a hypothetical capital
structure.
Hawaii also points out the interrelationship between the capital
structure and the required rate of return on equity. As the share of
equity increases in the capital structure, financial risk and total
risk are lessened. Thus, the required rate of return on equity declines
as the proportion of equity increases, all other things being equal.
With respect to the NPR's provision for basing the capitalization
ratios and amounts on average book values, PRMSA asserts that the
capital structure using historic book valuation may differ
significantly from a capital structure computed using market
valuation.10 Depending on how the book value of equity deviates
from its market value, the Commission may be allowing a rate of return
that is either too high or too low.
\10\PRMSA's initial comments on this issue continued its
characterization of the Commission's reasons for proposing a change
from the CET to the BTWACC as resulting from a desire to eschew the
use of accounting data in favor of the use of market data. PRMSA
contends that because the proposed rule relies extensively on
historic accounting data, the shortcomings of the CET are
perpetuated in the proposed rule.
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Discussion: The Commission is not persuaded by Hawaii's argument to
decide the capital structure on a case-by-case basis. The Commission
believes the capital structure of the subsidiary will generally be the
most direct measure of the regulated carrier's capital structure.
However, where the regulated carrier can show that the business and
financial risk of the parent company and the subsidiary are similar,
the Commission may allow the use of the consolidated system's capital
structure because its cost of capital will likely be the same as the
subsidiary's cost of capital. Moreover, the calculation of the
consolidated system's cost of capital will be more direct because there
will be no need to select a proxy group to estimate the cost of common-
stock equity. Thus, in some cases, the use of the consolidated system's
capital structure will likely give the best measure of the regulated
carrier's capital structure.
With respect to hypothetical capital structures, some regulatory
commissions do use a hypothetical capital structure. However, the
Commission believes that good reasons exist for using the actual
capital structure rather than a hypothetical capital structure. First,
capital structures are the products of decisions, which may be assumed
to be logical and efficient at the time they are made, although a
different capitalization might be consistent with a lower BTWACC at the
time of investigation and hearing. Second, the hypothetical capital
structure substitutes the judgment of the regulator for the judgment of
those operating the business as to the best mix of debt and equity for
the company. The initial decision as to the best debt/equity mix should
be left to the company management, with regulatory oversight by the
Commission.
A review of regulatory commission practice indicates that, in
general, the actual capital structure is used, unless that structure is
wasteful or not otherwise in the long-term public interest. In cases
where the Commission might find evidence of wasteful or imprudent
investment, it is permitted to deduct such investment from the
carrier's rate base.11 Therefore, the Commission believes that it
has ample authority to deal with imprudent or wasteful investment
without employing a hypothetical capital structure.
\11\ Likewise, the Commission may disallow questionable expense
items for a carrier's income statement.
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In situations in which the Commission determines that the capital
structure of a subsidiary does not represent the true capitalization of
a carrier (e.g., debt ``hidden'' in a parent company's capital
structure), the Commission believes that it has adequate options for
ensuring that the subsidiary's capital structure reflects its
financing. First, the Commission can order that the capital structure
of the consolidated system be used. If the consolidated system consists
of a number of subsidiaries or its capital structure is very complex,
the Commission can fashion an appropriate proceeding to determine the
appropriate capital structure. At the conclusion of the proceeding, the
Commission would weigh all the information it had collected to
determine the most realistic and meaningful capital structure possible
for the regulated carrier. The Commission does not believe, however,
that such proceedings will be necessary in most cases.
The NPR recognized that valid theoretical reasons exist for
measuring the capital structure on the basis of the market value of its
components. However, the common practice of regulatory commissions is
to compute capitalization ratios on the basis of book values for a
number of practical considerations. First, a regulated firm is believed
to raise capital in such a fashion that a target capitalization ratio
expressed on the basis of book values is maintained by the company over
time. Consequently, regulators must compute the firm's overall cost of
capital on the same basis to ensure that the company's capital costs
are adequately covered. Second, effective regulation is said to result
in book and market values approaching equality. Last, and most
importantly, book-value capitalization ratios are stable, removing the
problems that volatile market prices can present when determining the
appropriate capitalization ratio. The Commission remains convinced that
the practical considerations outweigh the theoretical issues involved
in using book-value capitalization ratios. Therefore, the process of
determining the regulated carrier's capital structure is adopted
without change from the proposed rule.
Calculation of the Before-Tax Weighted Average Cost of Capital
In its initial comments, PRMSA pointed out that the formula for the
BTWACC12 is inconsistent with the Commission's formula for the
rate of return on rate base.13 This inconsistency resulted from
computing the cost of capital on a before-tax basis while the rate of
return on rate base is computed on an after-tax basis. PRMSA further
commented that the after-tax rate of return formula currently used by
the Commission and retained in the proposed rule is technically
deficient; because, in the numerator, it adds the full amount of
interest expense to income. PRMSA noted that more modern financial
analysis recognizes that only the after-tax cost of interest should be
added back to the numerator in computing after-tax rate of return.
PRMSA suggested either changing the cost of capital to an after-tax
basis so it can be compared to the after-tax return on rate base, or
retaining the BTWACC
[[Page 46052]]
and changing the rate of return on rate base to a before-tax basis.
\12\ The proposed rule states the before-tax weighted average
cost of capital will be calculated using the following equation.
BTWACC=(D/D+P+E)Kd\+(P/D+P+E)Kp(1/1-T)+(E/
D+P+E)Ke (1/1-T)
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;
T is the corporate income tax rate
\13\ Current FMC regulations (46 CFR 552.6 (d)(2)) provide that
return on rate base is computed by dividing Trade net income plus
interest expense by Trade rate base.
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In the Request for Reply Comments, the Commission proposed
retaining the BTWACC contained in the NPR and changing the calculation
of the rate of return on rate base to a before-tax basis. Comments were
sought on the following change to Sec. 552.6(d)(2):
(2) Return on Rate Base. The return on rate base will be
computed by dividing Trade net income plus interest expense plus
provision for income taxes by Trade rate base.
In its reply comments, Hawaii recognizes the basis for PRMSA's
concern that the proposed BTWACC and the rate of return on rate base
are not directly comparable. However, Hawaii prefers that the proposed
rule be changed so the weighted average cost of capital is computed on
an after-tax basis and the rate of return on rate base remain as it is
currently defined in the Commission's rule. According to Hawaii, the
Commission's current definition of return on rate base embodies the
conventional idea of payment (or return) to lenders and equity holders
who have advanced the money for capital purchases. Payments to
governments in taxes on revenue and earnings from the employment of the
purchased capital are not strictly ``returns'' and it would distort the
concept to include tax payments in the definition.
Crowley and Matson comment favorably on the proposed change to the
rate of return on rate base. Although Seaman opposes the proposed
methodology for calculating the allowable rate of return, he
acknowledges the comparability problem.
All parties have recognized that a change must be made to either
the calculation of the BTWACC or the calculation of the rate of return
on rate base to make the two terms compatible. The Commission believes
that putting the BTWACC and the rate of return on rate base on a
before-tax basis will result in the appropriate determination of the
allowable rate of return. The Commission's research indicates that most
regulatory agencies determine the allowable rate of return on a before-
tax basis. While Hawaii expresses a preference for using the after-tax
calculation, it agreed that putting the weighted average cost of
capital and the rate of return on rate base either on a before-tax
basis or after-tax basis is correct as long as the two terms are
compatible. Therefore, the Commission will adopt a BTWACC and modify
the calculation of the return on rate base as indicated in the Request
for Reply Comments.
Cost of Equity Estimation
The NPR specified that three methods of determining the cost of
common-stock equity--the discounted cash flow (``DCF''), capital asset
pricing model (``CAPM''), and risk premium (``RP'') methods--would be
used to produce separate estimates in arriving at a final estimate of a
regulated carrier's cost of common-stock equity capital. The Commission
would thereby avoid any inappropriate judgments that could be embodied
in any one of the individual estimates.
Both Matson and PRMSA contend that the DCF is unsuitable for FMC-
regulated carriers, because most of those carriers are either
subsidiaries of larger entities or privately owned firms. PRMSA avers
that choosing a proxy group for the regulated carriers is impossible,
therefore, the DCF and also the CAPM methods are not valid methods for
the FMC to use in estimating the cost of equity.
In both sets of comments, PRMSA criticizes the derivation of the
expected annual growth in dividends per share, or ``g'', as specified
in the NPR. The NPR provides that in the DCF model three methods of
estimating ``g'' would be used: (a) The average of the historical
growth rate of dividends per share, earnings per share, and book value
per share; (b) the average of (1) the five-year dividend, earnings and
book value forecasts published by Value Line Investment Survey (``Value
Line''), and (2) the five-year earnings forecast published by the
Institutional Brokers Estimation Service (``IBES''); and (c) the use of
the sustainable growth rate method, which relies on forecasted values
of the earnings retention rate. To derive a final estimate of ``g'' the
separate estimates of ``g'' would be averaged.
PRMSA states that there is no certain method to ascertain ``g''
directly. To the extent that ``g'' is wrong, the cost of capital is
incorrectly estimated. Further, PRMSA states that the proposed
averaging of the estimates has no theoretical or practical basis and
might be ``contra-indicated'' when the disparities between the
estimates are large. In its comments, PRMSA used data from one carrier,
Overseas Shipping Group, to derive an estimate of ``g'' based on the
methodology prescribed in the proposed rule. PRMSA showed that the
historic growth rate method resulted in an estimate for ``g'' of 20.4
percent, while the sustainable growth rate estimate of ``g'' was 11.2
percent. According to PRMSA, the results of its study demonstrate that
the methodology used in the proposed rule will likely result in widely
divergent results among the three estimation procedures. PRMSA asserts
that averaging these numbers results in a meaningless estimate. It
argues that since many of the numbers are derived from historical book
value, the proposed methodology offers no advantage over the CET, which
involves looking directly at history and basing judgments directly
thereon. PRMSA contends that the frailties of the methodology cannot be
remedied by averaging.
Several commenters point out deficiencies in the CAPM model. Hawaii
does not oppose its use, but notes that many regulatory analysts are
moving away from using the CAPM as a cost of equity model. Hawaii
suggests that the use of the CAPM in a regulatory rate setting removes
it from its intended purposes.14 Hawaii also states that the most
salient criticisms of CAPM lie with its central element, beta.15
Hawaii states that these criticisms include the following: (1) Beta is
a measure of variability not risk; (2) beta is not forward looking (in
keeping with a future test year); (3) betas typically have very low
correlation coefficients; and (4) recently it has been shown that there
is no statistical relationship between beta and return. PRMSA also
notes that the CAPM literature has begun to question the model's
empirical underpinnings. Matson advises that it is widely acknowledged
that the CAPM does not adequately account for firm size in determining
expected return.
\14\Hawaii states that the CAPM was developed for, and is widely
used in, the estimation of the return probabilities of a diversified
stock portfolio relative to the return of the theoretical market.
\15\Beta is the coefficient of regression of a stock's price
variability relative to the variability of the whole stock market.
It gauges the degree to which an individual stock price moves
relative to the overall stock market.
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Matson concurs with the NPR which stated that the DCF, CAPM, and RP
each have strengths and weaknesses. However, according to Matson, the
RP has an advantage that compels its use. The RP can be adjusted to
reflect the fact that the cost of common stock equity is a function of
firm size. Matson argues that the NPR's use of the RP16 is
deficient because the risk of investment in a small company, such as
Matson, is not the same as that of a Standard & Poor's 500 Stock Index
(``S&P 500'') firm.
\16\The NPR proposed that the RP method was to be used in its
generic form without any adjustments for any possible differences in
the risks of the firms contained in the Standard & Poor's 500 Stock
Index and that of the regulated carrier.
[[Page 46053]]
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In both its initial and reply comments, Matson advocates the
Commission's adoption of one method to calculate the cost of common-
stock equity and urges the adoption of the RP model adjusted for firm
size. Matson comments that neither the explanatory text nor the rule
language in the NPR indicates how the three estimation methods are to
be ``blended'' to arrive at a final cost of common-stock equity
estimate. It believes there is inefficiency and unfairness in any
system that determines a regulated company's allowable earnings by
taking the results of three separate calculations and then, using some
unexplained process, arrives at a single result. According to Matson,
this unexplained process cannot be understood by the regulated carriers
and financial markets. Further, effective judicial review would be
problematic.
The RP model advocated by Matson is the arithmetic average return
differential between rates of return actually earned on investments in
firms of the same size as the carrier, and the five-year Treasury Note.
Matson states that the risk premium in such a model should be based on
the historical data series ``Decile Portfolios of the NYSE'' published
annually in Stocks, Bonds, Bills and Inflation (``Ibbotson Yearbook''),
and should directly correspond to that decile that matches the
carrier's own size.
Likewise, in its reply comments, PRMSA urges the Commission to use
only the RP method to estimate the cost of common-stock equity. PRMSA
recommends that the proposed RP method be modified to allow for several
adjustments for risk. One such adjustment would be for firm size,
similar to that suggested by Matson. It also recommends adjustments for
illiquidity (in the case of privately-owned carriers), industry risk,
and individual carrier risk (as compared to the industry average for
publicly traded firms).
Marsoft comments that the RP model is designed to reflect the
return on equity of the large, diverse range of companies included in
the S&P 500. Marsoft, therefore, contends that the NPR puts a heavy
weight on the assumption that all regulated companies are identical and
are no more or less risky than companies included in the S&P 500. In
contrast to the suggestions of Matson and PRMSA, Marsoft recommends
that the Commission give lower weight to non-specific standards such as
the RP model.
In addition to commenting on the specific provisions of the cost of
equity estimation models, several commenters contend that the process
of estimating the cost of equity is too rigidly prescribed in the NPR.
Most commenters point out the importance of allowing judgment to enter
into the estimation process.
Marsoft states that the proposed cost of equity methodology is
excessively restrictive and is likely to result in biased estimates of
the appropriate rate of return on equity. Under the BTWACC methodology,
it believes that the Commission will need to exercise considerable
judgment in determining the appropriate estimate for the cost of
common-stock equity. Marsoft suggests the Commission use information
from security analysts, management reports, and other industry-based
sources in determining the appropriate rate of return on equity.
Hawaii points out that the NPR's specification of using a six-month
average stock price as a base for calculating dividend yield may limit
appropriate subjective judgments and preclude Commission consideration
of valid information.17 It suggests that in addition to
prescribing that the average stock prices be used in the DCF (and
interest rates in the CAPM and RP models), the Commission should also
allow parties to use the most recent stock price in calculating the DCF
model. Hawaii contends that some financial analysts argue that the use
of average stock prices and interest rates may lead to greater forecast
error in determining the test year stock price and interest rate than
will occur when the most recent stock price and interest rate are used.
According to Hawaii, allowing parties to calculate these models using
both a six-month average stock price and interest rate, as well as the
most recent stock price and interest rate, would add flexibility to the
proposed rule and increase the information upon which the Commission
could base its judgment.
\17\Hawaii commented similarly on the CAPM and RP models. In
those models, the NPR specified the use of a six-month average of
five-year Treasury note yields.
---------------------------------------------------------------------------
Hawaii also states in its initial comments that access to several
data sources is required to determine the cost of common-stock equity
under the proposed rule. One of the required data sources used to
compute the DCF model is published by IBES. In addition, data from
Ibbotson Associates must be used to compute the CAPM and RP models.
Hawaii requests that, depending on the cost of acquiring the necessary
data, the Commission consider making both the IBES and Ibbotson
Associates data available to non-subscribing parties.
In drafting the proposed rule, the Commission attempted to specify
in detail the calculation of the cost of common-stock equity in order
to prevent prolonged debate that would accompany more subjective and
flexible methodologies. Under section 3 of the 1933 Act not only must
the FMC rule within 180 days, but also carriers and protestants have
similar time limits in that hearings must be completed within 60 days.
The commenters have taken issue with the NPR's specification of the
estimation methods and have suggested that the proposed rule would
unduly limit the amount of information that the Commission could
consider in the course of a proceeding, to the detriment of obtaining a
just and reasonable result. The Commission believes that these comments
have merit. If a party to a proceeding follows a predetermined formula
in preparing testimony, the resultant testimony may not contain the
necessary judgment required in using these estimating techniques. There
are many different applications of these methodologies, and an
important part of the estimating procedure is the skill with which the
practitioner implements the methodology. As a consequence, the
Commission, as decision maker, would not be making the fullest use of
the expertise that the testimony could provide in arriving at an
appropriate determination of the cost of common-stock equity for the
regulated carrier.
The Commission has decided, therefore, to modify the cost of equity
estimation procedures contained in Sec. 552.6 of the proposed rule.
Carriers will still be required to use the DCF and RP methods to
determine the cost of common-stock equity. However, they will not be
required to follow the proposed rule's detailed specifications in
implementing the techniques.
The Commission has decided to strike the requirement to use the
CAPM method. As the NPR explained, the CAPM is actually the company-
specific form of the general RP model. The central feature of the CAPM
model, beta, has been commented upon disparagingly not only by the
instant commenters, but also by an increasing number of academicians.
The major criticisms of Beta are that: beta measures variability not
risk; beta is not forward looking; and no statistical relationship
exists between a firm's beta and its return. Given that the merits of
beta and, therefore, the CAPM are increasingly suspect, the Commission
does not believe that this deletion will negatively impact upon the
FMC's responsibilities under the 1933 Act.
[[Page 46054]]
The Commission is not persuaded that the selection of the proxy
group is so problematic that the requirement to use the DCF model
should be eliminated. The DCF method remains a standard tool used by
regulatory agencies to determine cost of common-stock equity in rate
cases. The Commission acknowledges that selecting a proxy group may be
an extremely controversial matter, given that no two companies have
exactly the same risk characteristics. Nevertheless, any alleged
arbitrariness should be able to be overcome by a judicious
determination of the business and financial risk factors of the
regulated carrier. Further, with the requirement to use the CAPM being
eliminated, the Commission does not believe that it should limit itself
to only one method of estimating the cost of common-stock equity.
The proposed rule provided that the estimate produced by the RP
method was to be used as a check on, and in combination with, the
company-specific estimates produced using the DCF and CAPM models. With
the CAPM being deleted, however, the RP will become more prominent in
the determination of the cost of equity. In order to produce a more
representative estimate of the risk premium required by investors for a
particular carrier, the final rule will permit, but not require,
carriers to argue for a risk adjustment for firm size. The final rule
also allows for an RP model in its generic form.
In contrast to most commenters, Matson states that the Commission's
process of determining the cost of capital is not spelled out clearly
enough. The Commission does not agree with Matson on this point. The
Commission requires the flexibility to consider all issues relevant to
estimating the regulated carrier's cost of capital. The Commission
recognizes that each of the methodologies are estimates only and that
reasoned judgment is necessary in the process of determining the final
estimate of the regulated company's cost of capital. Therefore, the
process of combining the estimates of the cost of equity in the final
rule will remain as it is in the proposed rule, though only the DCF and
RP estimates of the cost of equity will be used to reach a final
determination.
If a proceeding is initiated, the Commission will evaluate the
testimony of the carrier, the FMC staff, and all protesters in arriving
at its decision on the allowable rate of return. The Commission will
then issue a ruling that spells out its reasoning so that the parties
can see how the Commission arrived at its decision. Therefore, the
Commission does not accept Matson's assertion that the process of
combining the two estimates of common-stock equity is unfair. The
combining process will be arrived at openly and will take into account
the vagaries of cost of capital estimation.
With regard to the use of average prices, the Commission stated in
the proposed rule that regulatory agencies often use average prices
over time rather than a price on a particular day to remove aberrations
in stock price movements. Such aberrations could be the result of
events internal to the company (e.g., the stock may go ex-dividend) or
due to factors external to the company (e.g., political events that
affect the price of a firm's stock). The Commission continues to
believe that the use of an average will be appropriate in most
instances to filter out potential aberrations in stock prices and
interest rates. However, to avoid the possibility that use of an
average may serve to blind the Commission to significant changes or
trends, the rule will permit, but not require, parties to calculate
these models using both a six month average stock price and interest
rate as well as the most recent stock price and interest rate as
suggested by Hawaii.
With respect to the suggestion that the FMC consider providing
access to the required data, the Commission has considered this, but
has decided that the costs of such information are not prohibitive.
Under the final rule no particular data source is required for the DCF
analysis. IBES data can be obtained inexpensively from Compuserve, an
on-line information provider. The Ibbotson Yearbook and Value Line are
available at many libraries or through subscription at nominal cost.
Proxy Group
If a carrier is an independent company which issues no publicly-
traded common-stock equity or is a subsidiary that obtains its common-
stock equity capital through a parent company, a proxy group of
companies must be selected to impute the carrier's cost of common-stock
equity. Under the proposed rule, the proxy group is selected from
companies listed in Value Line that operate and derive a major portion
of their gross revenues primarily as common carriers in the business of
freight transportation, and own and operate transportation vehicles or
vessels. Further, under the proposed rule, carriers relying on proxy
companies are to use the prescribed risk criteria in selecting proxy
companies and are to submit their selection of proxy companies, along
with their annual report of financial and operating data, as required
in Sec. 552.2.
In its initial comments, Hawaii was concerned that the companies in
Value Line which satisfy the Commission's criteria for the proxy group
do not have business risks similar to those of Matson. Hawaii claimed
that these companies are generally consolidated companies; are not
dominant in their markets; and do not operate in industries with
statutory barriers to entry.
Marsoft stated that according to its research only three marine
transportation companies and four trucking companies meet the proposed
guidelines for the proxy group. Marsoft did not believe that airlines,
railroads, or full-load trucking companies should be included in the
proxy group, because they do not provide comparable services. Marsoft
also stated that in many cases large, geographically and operationally
diverse companies will be compared to small, highly specialized private
carriers. Marsoft contends that the comparison may not be credible in
some cases. Further, Marsoft urged the Commission to allow non-U.S.
based firms to be included in the proxy group.
PRMSA commented that the proxy group should not be restricted to
the freight transportation business. PRMSA asserted that equity capital
in the regulated carrier competes against the broad spectrum of
companies in the economy, not just against companies involved in
freight transportation. PRMSA stated that the nature of a company's
business is only one ingredient of business risk, not the sole
determinant. PRMSA noted that as of June 1994, there were a total of 39
companies listed in Value Line involved in transport by air, truck,
water, and railroad. Allegedly, not all of these companies were
involved in freight transportation as required by the proposed rule.
PRMSA concluded from this that the potential list of comparable
companies is highly limited.
In its Request for Reply Comments, the Commission sought specific
suggestions on industries other than freight transportation to be added
to the current proxy group criteria. In its reply comments, Hawaii
concurs with the parties who have suggested that dependence on data for
proxy groups reported in Value Line and IBES imposes a limitation on
finding appropriate proxy group members. Hawaii is unable to suggest
other sources from which the required financial data would be
available. However, Hawaii urges the Commission not to unduly limit the
data that may be used to present evidence, especially
[[Page 46055]]
with respect to the proxy group. Hawaii also points out that undue
limitation of the companies that may be used as proxies might introduce
the statistical problems inherent in small samples.
Hawaii states that the Commission should not expect to be able to
apply the results of estimations based on proxy groups directly to the
regulated carrier. It urges the Commission to allow the introduction of
information which relates to the comparability of the proxy group and
the applicant company. In addition, Hawaii states that if each expert
witness is allowed to provide estimates based on different proxy
groups, the Commission would gain valuable insight into the impact of
various risk characteristics on the cost of common-stock equity.
Matson argues that the Commission should retain the proxy group
identified in the NPR and not add other industries. According to
Matson, business risk is dependent on the diversification of a
business, the cyclicality of its operations, and the operating leverage
employed in its business. It suggests that transportation companies
generally have similar levels of cyclicality and degrees of operating
leverage. Matson claims that it would be extremely difficult to
identify companies outside of the transportation industry that have the
same amount of cyclicality and degree of leverage as transportation
companies.
In its reply comments, PRMSA notes that the most serious deficiency
of the proposed rule is the use of the proxy groups to compensate for
the lack of market data for non-publicly traded companies. PRMSA points
out that most domestic offshore carriers are either privately owned or
subsidiaries of larger consolidated systems for which no market data
exists. PRMSA asserts that the Commission has embarked on an impossible
task in attempting to enumerate specific companies and/or industries to
serve as a proxy for the regulated company. PRMSA says that the
selection of proxy companies will necessarily be arbitrary, negating
the mathematical exactitude that can be achieved under the DCF model.
With respect to the annual submission of proxy groups, PRMSA
contends that this proposal would actually require a greater use of
agency resources than are currently devoted to rate-of-return analysis
in the domestic offshore trades. PRMSA argues that the proposed
selection process raises serious due process issues, because it
attempts to bar members of the public from challenge at a time when
their interests are at stake, because of their failure to have made a
challenge when no injury could be alleged.
Crowley advocates opening up the proxy group to companies outside
the freight transportation business because, it contends, the key
comparison is not the line of business. Crowley notes that companies
within the same industry may have different business characteristics,
and different attractions to investors. Crowley would, however,
restrict the selection to any company listed in Value Line. Crowley
also states that other suitable industries would be those characterized
by large initial capital investments, seasonal markets, and common
carrier operations. Crowley proposes that passenger transportation and
certain telecommunications industries might be possible sources of
proxy groups.
In Seaman's comments, he notes that the commenting parties have
given ample reason why the selection of a proxy group is flawed. Seaman
contends that without a comparable portfolio of companies, estimates of
the cost of common-stock equity are meaningless. He concludes,
therefore, that the Commission will not be able to determine a fair
rate of return under the BTWACC methodology.
The Commission does not agree with the contention that the proxy
group selection is unworkable. The use of proxy groups is a common
regulatory practice, especially in conjunction with the DCF model in
estimating cost of common-stock equity. Selecting a proxy group will
require, however, an assessment of the regulated carrier's operations
and financial status in order to determine the appropriate business and
financial risk. The results of this assessment will be used to select
companies to be included in the proxy group. Because no two companies
will be identical in all aspects of risk, the proposed rule specified a
number of risk indicators that might be used in selecting a proxy
group.
After carefully reviewing all of the comments on comparable risk
companies, the Commission has determined to drop three proposals.
First, the Commission has decided that requiring the annual submission
of a proxy group of companies which would be subject to notice and
approval would expend considerable resources. Little benefit would be
gained from the exercise if the regulated carrier were not to file any
rate increases during its fiscal year. Thus, the final rule allows for
the submission of the proxy group of companies at the same time as the
submission of direct testimony in support of a proposed general rate
increase.
Second, the Commission has decided not to limit the selection of
the proxy group only to companies followed by Value Line. The proposed
rule required Value Line to be used because it contains all the data
necessary to complete the cost of equity calculations specified in the
proposed rule. Since the final rule will not be as specific as the
proposed rule in delineating the methods and data sources to be used in
estimating the cost of common-stock equity, the Commission believes the
need to use only Value Line data is lessened. Therefore, in addition to
Value Line, other data sources will be permitted for proxy group
selection.
Nevertheless, the Commission believes that Value Line provides the
best overall data available for determining a proxy group. It provides
analysis of many factors necessary for the selection of comparable risk
companies. While Value Line does not cover every company that issues
stock, the Commission expects that most proxy group companies will be
found in it. The Commission does not want to proscribe the use of
companies not followed by Value Line that would make good proxy group
members. However, if a party selects proxy group members based on data
from sources other than Value Line, the burden is on that party to
prove that the data source is reliable and the data are sufficiently
detailed to calculate the BTWACC.
Finally, the Commission has decided not to limit the allowable
proxy group members only to companies which operate in the
transportation industry. The final rule will require that the majority
of the proxy companies be companies which operate in the transportation
industry. This will allow those giving testimony some latitude in
selecting proxy group members from outside the transportation industry.
Crowley is the only commenter suggesting other industries that
might be included as candidates for the proxy group. Crowley suggests
that proxy group members could be selected from the passenger
transportation and telecommunications industries. Crowley offered very
little analysis as to why these industries should be included. A
thorough analysis would be required to persuade the Commission that
companies in these industries would make acceptable proxy group
members.
The Commission is concerned that the difficulty commenters had in
suggesting alternative industries from which proxy group members might
be selected is illustrative of the difficulties that may be found in
attempting to find proxy group members outside the transportation
industry. Most
[[Page 46056]]
commenters, however, were quite concerned that in some cases it may be
difficult to select an adequate list of proxy group members within the
confines of the transportation industry. To balance these two concerns,
some of the proxy group members will be permitted to come from outside
the transportation industry. However, a majority of the proxy group
members will be required to come from the transportation industry.
Those seeking to include companies outside the transportation industry
in the proxy group shall have the burden of establishing that the firms
selected have business risks comparable to the regulated carrier.
The final rule will continue to require that the proxy group be
limited to U.S. companies. In many instances foreign accounting
procedures are different from U.S. accounting practices. In order to
ensure that accurate estimates of the cost of common-stock equity can
be made from the proxy group, the exclusion of foreign companies will
continue. Lastly, based on the prior discussion of the concerns
regarding the use of beta, two of the risk indicators specified in the
proposed rule to be used in selecting the proxy group will be
eliminated, the volatility of a company's common-stock price changes as
measured by both beta and standard deviation.
Deferred Taxes and the Capital Construction Fund
The proposed rule provided for two amendments to allow for the
treatment of deferred taxes in the calculation of rate base. First, the
cost of an asset included in the rate base would be reduced by the
amount of funds withdrawn from the ordinary income and capital gains
components of the Capital Construction Fund (``CCF'').\18\ Second, the
rate base would be reduced by the amount of deferred taxes, except that
portion resulting from the CCF or the expired Investment Tax Credit.
\18\The Capital Construction Fund is comprised of three
components: the capital account, the capital gains account, and the
ordinary income account.
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Capital Construction Fund
Matson, Crowley and DOT oppose the Commission's proposal to exclude
CCF withdrawals from the rate base. Hawaii's comments appear to support
the proposal, although most of its comments address deferred taxes.
The opposition to the proposed treatment of the CCF falls into two
main areas. First, several commenters contend that the proposed changes
are contrary to the Congressional intent behind the Merchant Marine
Act, 1936, 46 U.S.C. app. section 1100, et seq., as amended, which
governs the CCF. Matson points out that the Commission recognized the
Congressional intent in Docket No. 78-46, Part 512. Financial Reports
of Common Carriers by Water in the Domestic Offshore Trades. In that
proceeding, Matson states that the Commission gave the reasons for its
complete rejection of methodologies which penalized the carrier for
using the financing benefits provided by the Merchant Marine Act, 1970.
That legislation amended the 1936 Act and, inter alia, extended the CCF
provisions to include the domestic offshore carriers. Matson points out
that, in Docket No. 78-46, the Commission stated that:
The Commission is persuaded that the Congress, in enacting the
Merchant Marine Act, 1970 sought to provide carriers with tax
incentives in order to encourage investment aimed at modernizing and
expanding the fleet serving the domestic offshore trades. As MARAD
indicated [in its comments], the adoption of the flow-through
methodology would not be in accordance with the Congressional
intent. Docket No. 78-46, 19 SRR at 1305. (Matson at 8).
Crowley adds that it ``makes no sense for the FMC to take away the
benefit of the CCF program, or to steer CCF funds away from the
domestic trades, when the program is a part of the basic U.S.
government policy to support the U.S. Merchant Marine.'' (Crowley at
8). DOT asserts that the proposed rule would frustrate Congress' intent
in establishing the CCF program by directly penalizing companies that
participate in the program, which would in turn impede DOT's efforts to
maintain and expand the U.S.-flag fleet.
Second, the carriers and DOT contend that the proposed changes in
the accounting treatment of the CCF and accumulated deferred taxes are
based on a misunderstanding of the actual financial and tax
consequences of the CCF and deferred taxes. Crowley argues that the
Commission has misconstrued the character of the contributions to the
three components of the CCF. In its comments, DOT explained that under
the CCF program both deposits from taxable income and any subsequent
investment earnings are temporarily sheltered from federal income
taxes. These tax benefits are assured only if the deposits and earnings
thereon are withdrawn to meet the company's CCF program objectives,
principally vessel construction or reconstruction. Any unauthorized
withdrawals are fully taxable. The recovery of the tax benefit of CCF
deposits is accomplished by reducing the income tax basis of a vessel
built with CCF monies. The reduction of the taxable basis of the CCF
vessel reduces otherwise allowable depreciation over time which, in
turn, increases taxable income, thereby recovering the initial benefits
of the CCF deposit. DOT points out that this tax deferral has no
connection to the cost of a vessel and therefore, should have no impact
on the FMC's determination of a carrier's rate base for setting an
allowable rate of return.
Matson contends that the Commission has grossly overstated the
benefit of the CCF investment. According to Matson, the sole economic
benefit which flows from the use of a CCF is the interest-free use of
the deferred tax monies until the taxes are paid through the loss of
tax-depreciation on the CCF investment. Matson points out that the tax
repayment period is 10 years for vessels, and 5 years for containers.
According to Matson, not only has the FMC overstated the benefit but
also, the duration of the benefit because its proposal would ``exclude
forever 100% of the CCF investment.''
Based on the comments received, the Commission is abandoning the
proposed treatment of the CCF. The NPR indicated that of the three
accounts comprising the CCF (capital account, capital gains account,
and ordinary income account) the capital account is the only account
containing carrier contributions to the CCF. The NPR likewise indicated
that the capital gains and ordinary income accounts were comprised
solely of the carriers' earnings on money contributed to the CCF.
Several commenters clarified that the capital gains account consists of
capital gains from the sale of CCF vessels as well as earnings from
that account, and the ordinary income account consists of CCF vessel
income plus earnings from that account. Only the capital gains and
ordinary income accounts are tax deferred. Given the commenters'
clarifications that the capital gains and ordinary income accounts are
comprised of carrier contributions along with earnings, it appears that
to require carriers to reduce the cost of the vessel by the amount of
funds withdrawn from these two components of the CCF would indeed
penalize CCF carriers and serve as a disincentive to carrier
participation in the CCF. Such disincentive would appear to be contrary
to the Congressional intent in establishing the CCF program.
Deferred Taxes
Hawaii supports the changes to the treatment of deferred taxes in
the proposed rule. The State points out that
[[Page 46057]]
the Commission appropriately decided in Docket No. 78-46 to require
carriers to calculate their income tax expense at the applicable
statutory rate. Before issuing the final rule in Docket No. 78-46, the
Commission had ordered deferred income taxes deducted from rate base in
two rate investigations.19 However, in Docket No. 78-46, the
Commission reversed its prior rulings and decided not to require
carriers to deduct accumulated deferred income taxes from rate base.
Hawaii also notes that the proposed treatment of deferred taxes
conforms with the policy of a majority of state regulatory commissions,
as well as the Federal Communications Commission and the Federal Energy
Regulatory Commission.
\19\See FMC Docket No. 75-57, Matson Navigation Co.--Proposed
Rate Increase in the United States Pacific Coast/Hawaii Domestic
Offshore Trade and FMC Docket No. 76-43, Matson Navigation Company--
Proposed Rate Increase in the United States Pacific Coast/Hawaii
Domestic Offshore Trade.
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In its initial comments, Matson asserts that the deferred taxes
account arises only due to the different treatment of depreciation for
tax purposes than for expense purposes. According to Matson, when an
asset is allowed to depreciate faster for tax accounting purposes than
for book accounting purposes, a timing difference occurs and is
reflected in deferred taxes. The differences in taxes booked versus
taxes paid is recorded as a ``book'' liability. Matson claims that this
is not a real liability but only the recognition that more taxes have
been expensed than have yet to be paid. If the generally accepted
accounting principles (``GAAP'') allowed for recording as an expense
only the amount of taxes paid, no book liability for deferred taxes
would occur. Matson argues that the value of deferred taxes is only in
the time value of money, and this value reverses over a relatively few
years. Matson claims that the benefit that the Commission refers to in
the proposed rule does not exist. It is merely a philosophical
difference between GAAP and the Internal Revenue Service code.
In its reply comments, Matson addresses Hawaii's statement that the
majority of regulatory agencies surveyed by the National Association of
Regulatory Utility Commissioners treat deferred taxes similarly to the
Commission's proposed treatment. Matson argues that such treatment of
deferred taxes by state regulatory agencies resulted from the
requirements of the Tax Reform Act of 1969 that required utilities to
deduct deferred taxes from the rate base, if the utilities planned to
use accelerated depreciation.
PRMSA argues that the proposed rule would negate the stimulating
effect on investment that was intended by public policy. It further
argues that prohibiting returns on shipping assets financed by funds
generated through the tax treatment of accelerated depreciation creates
a disincentive to investment in the regulated shipping trades. PRMSA
suggests that it is clear that a firm's decision to invest funds
provided by deferred taxes is a decision that puts its investor-
provided equity at risk. Therefore, PRMSA contends that the FMC should
focus on providing a rate of return on deferred taxes more akin to that
provided by equity. Nevertheless, PRMSA suggests that the return could
be adjusted downward to recognize the fact that the initial funds are
not investor provided, although once the firm uses those funds its own
equity is at risk and some reward is required.
DOT avers that the proposed treatment of deferred taxes is unfair
to CCF companies. DOT states that a consequence of participation in the
CCF program is that companies tend to have large deferred tax
liabilities. Therefore, the Commission's proposal would penalize CCF
vessels, which are all U.S. flag, by reducing the rate base by the
amount of the tax benefit, which would directly devalue the CCF
incentive conferred by Congress. DOT takes issue with the statement in
the NPR that accumulated deferred taxes should be eliminated from the
rate base, because ``unlike debt, preferred stock, and common-stock
equity, deferred taxes cost the carrier nothing.'' (NPR at 52). In its
discussion of the CCF, DOT argues that deferred taxes are not cost free
to the carrier, because over the life of a vessel, CCF companies will
tend to pay higher taxes in later years than those carriers not
participating in the CCF program.
The Commission views the issue of deducting deferred taxes arising
from accelerated depreciation from the rate base as being similar to
that of deducting CCF withdrawals from the cost of a vessel or
equipment. The Commission believes that carriers should not be
penalized for using accelerated depreciation by deducting accumulated
deferred taxes from the rate base and that such a deduction would
likely serve to reduce the incentive of carriers to invest in the
industry. Congress clearly intended companies to benefit from the use
of accelerated depreciation and the Commission does not believe it
should take any action which would minimize that benefit. Therefore,
the Commission will not require carriers to deduct accumulated deferred
taxes arising from accelerated depreciation from the rate base as was
proposed. This is in conformance with current Commission policy
determined in Docket 78-46, Financial Reports of Common Carriers by
Water in the Domestic Offshore Trades.
Working Capital
In the NPR, the Commission proposed to amend its regulations
governing the computation of working capital to remove the
extraordinary treatment of insurance expense. Only Hawaii commented on
the proposed change. In addition to supporting the proposed change,
Hawaii proposed two additional changes. First, Hawaii suggested that,
in determining the amount of working capital to be included in rate
base, the Commission adopt what it termed a ``modified lead-lag
approach''. Hawaii's second proposal is to exclude interest expense
from the calculation of working capital.
In Docket No. 78-46, and Docket No. 91-51, Financial Reports of
Common Carriers by Water in the Domestic Offshore Trades, Hawaii
recommended the use of a ``lead-lag study'' in calculating the amount
of working capital to be included in rate base. Taking into account the
complexities inherent in adopting such an approach, the Commission
declined to abandon average voyage expense as the basis for calculating
working capital.20
\20\ In Docket No. 78-46, the Commission wrote, ``There is no
persuasive evidence in this proceeding or otherwise available which
would indicate that average voyage expense incurred by a carrier
utilizing self-propelled vessels is not a fair measure of that
carrier's working capital requirements.''
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Hawaii stated that ``the modified lead-lag approach compares the
lag in paying for major operating expenses (excluding depreciation and
amortization, and interest expense) with the lag in receiving the
revenues to pay for these expenses.'' (Hawaii at 19) Although Hawaii
downplays the complexity of this method, its very description of the
process belies this conclusion. The Commission can envision carriers
spending inordinate amounts of time analyzing various accounts to
develop the working capital component of rate base. On the other hand,
the Commission believes that the average voyage expense calculation is
straightforward and uniquely suited for the maritime industry.
Hawaii also proposed removing interest expense from the calculation
of working capital. In its initial comments, Hawaii stated:
Interest expenses should also be excluded from the working
capital computation because they represent a source of working
[[Page 46058]]
capital funds. Interest is not paid to bondholders until after the
related revenue is received by the carrier. Thus, interest expense
does not create a need for working capital.
(Hawaii at 20).
Crowley and Seaman comment on this proposal. Crowley opposes
Hawaii's suggested treatment of interest. Crowley argues that interest
expense is a cost of doing business not unlike any other liability for
which working capital is required, such as employee costs, equipment
acquisition and maintenance and repair, and similarly accrues on the
carrier's books. Seaman merely endorses Hawaii's position.
The Commission agrees with Crowley that interest expense is no
different from a carrier's other liabilities for which working capital
is required. The Commission believes that the working capital component
of the rate base is intended to provide for a return on the cash
required for the carrier's day-to-day operations and that interest
expense meets this criteria. Therefore, the final rule eliminates only
the extraordinary treatment of insurance expense from the calculation
of the working capital component of rate base.
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 rule
have been approved by the Office of Management and Budget under the
provisions of the Paperwork Reduction Act of 1980, as amended, and have
been assigned OMB control number 3072-0008. Under the proposed rule the
incremental public reporting burden for this collection of information
was 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. The annual
filing of a proxy group was estimated to require 41 man-hours while
Schedule F was estimated to require 24 man-hours to complete. Since the
final rule no longer requires that a proxy group of companies be filed
annually, carriers which do not file a general rate increase as
described in 46 CFR 552.2(f) will incur no additional regulatory
burden. To be conservative, the estimated regulatory burden for
carriers which file a general rate increase is still estimated to be 65
man-hours. However, the cost of equity estimation has been simplified
by eliminating the requirement that a capital asset pricing model be
used in deriving the final estimate of the cost of equity. Thus, an
extra cushion of time within the 65 man-hours has been created for
carriers which file a general rate increase. Send comments regarding
this burden estimate, including suggestions for reducing this burden,
to Bruce Dombrowski, Deputy Managing Director, 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 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 revised, 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 Economics and Agreement
Analysis, 800 North Capitol Street, NW, Washington, DC 20573-0001
(b) 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.
* * * * *
(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 below 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).
[[Page 46059]]
(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), (b)(5), and the heading of paragraph (b)(9) are revised;
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) * * *
(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) for a period represented by 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)). * * *
(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.
* * * * *
(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 plus provision for
income taxes by Trade rate base.
(e) Allowable rate of return on rate base (Exhibits F and F(A))--
(1) General. A carrier's 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:
[GRAPHIC][TIFF OMITTED]TR05SE95.000
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 unless the carrier has received prior approval
by the Commission to use the consolidated capital structure. 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
[[Page 46060]]
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) A proxy group of companies shall
be selected 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) The selection of the proxy group of companies shall be based
on the following criteria:
(A) The proxy companies shall be based in the United States.
(B) The proxy companies shall be listed in The Value Line
Investment Survey or equivalent data source. If a party uses data from
sources other than The Value Line Investment Survey, the burden is on
that party to prove that the data source is reliable and the data are
sufficiently detailed to calculate the BTWACC.
(C) A majority of 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 $25,000,000 shall be excluded from the
proxy group. Proxy group companies whose businesses are not in the
transportation industry must clearly be demonstrated to have business
risk equivalent to the regulated carrier's business risk.
(D) 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;
(5) Other such valid indicators deemed appropriate by the
Commission.
(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 Shipping 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(b)(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 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 has applied for
and has been granted permission from the Commission to use a
consolidated capital structure in computing the BTWACC. Where such
permission has been 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 for calculating the cost of long-
term debt.
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(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
[[Page 46061]]
(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 for its own cost of long-term
debt unless the carrier has applied for and received prior permission
from the Commission to use a consolidated capital structure in
computing the BTWACC. Where such permission has been 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 paragraph
(e)(7)(v)(A) (1) through (13) of this section.
(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
[[Page 46062]]
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 for its own
preferred (and preference) stock unless the carrier has applied for and
been granted permission from the Commission to use a consolidated
capital structure in computing the BTWACC. Where such permission has
been 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) of this section.
(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'') and the Risk Premium (``RP'') methods. A final
estimate of that cost shall be derived from the separate estimates
obtained using each of the 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:
[GRAPHIC][TIFF OMITTED]TR05SE95.001
where:
Ke is the carrier's cost of common-stock equity capital;
Do is the carrier's current annualized dividend (defined as
four times the current quarterly installment) per share;
Po 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. A DCF analysis
in which the current market price per share of the carrier's common
stock is 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 is required. Supplemental DCF
analysis using the most recent stock price as a basis for the current
market price per share of common stock may also be used.
(iii) Additional Studies. Other analysis or forms of the DCF model
may be included in the computation and determination of the DCF
estimate of the cost of common-stock equity.
(11) 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 and Poor's 500
Stock Index and the five-year Treasury note. A risk adjustment specific
to the carrier for firm size may be included in the computation and
determination of the risk premium. The 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 commencing 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.
Supplemental RP analysis using the most recent five-year Treasury Note
yield as a basis for the incremental cost of debt may also be used.
(12) 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 has applied for and been granted permission
from the Commission to use a consolidated capital structure in
computing the BTWACC. Where such permission has been granted, the
carrier shall show instead the consolidated system's statutory
corporate income tax rates.
(13) 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
[[Page 46063]]
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 has applied for and been granted
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. 95-21845 Filed 9-1-95; 8:45 am]
BILLING CODE 6730-01-W
