[Federal Register Volume 59, Number 67 (Thursday, April 7, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-8226]


[[Page Unknown]]

[Federal Register: April 7, 1994]


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FEDERAL MARITIME COMMISSION

46 CFR Part 552

[Docket No. 94-07]

 

Financial Reporting Requirements and Rate of Return Methodology 
in the Domestic Offshore Trades

AGENCY: Federal Maritime Commission.

ACTION: Proposed rule.

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SUMMARY: The Federal Maritime Commission proposes to amend its 
regulations governing financial reporting requirements and rate of 
return methodology applicable to vessel-operating common carriers by 
water in the domestic offshore trades to discontinue use of the 
comparable earnings test in determining the reasonableness of a 
carrier's return on rate base. In its place, the Commission proposes to 
use the weighted average cost of capital methodology. In addition, the 
Commission proposes to amend its rules pertaining to the treatment of 
insurance expenses, accumulated deferred taxes and the Capital 
Construction Fund for purposes of calculating a carrier's rate base. 
The proposed rule addresses a number of shipper and carrier concerns 
regarding the Commission's current rate of return methodology and would 
align the Commission's ratemaking methodologies more closely with those 
used by numerous other regulatory agencies. The intent is to improve 
the Commission's methodology for evaluating the reasonableness of rates 
filed by carriers in the domestic offshore trades and for acquiring the 
data that are essential to that evaluation.

DATES: Comments due June 6, 1994.

ADDRESSES: Comments (original and fifteen copies) to: Joseph C. 
Polking, Secretary, Federal Maritime Commission, 800 North Capitol 
Street, NW., Washington DC 20573-0001, 202-523-5725.

FOR FURTHER INFORMATION CONTACT:

Richard J. Kwiatkowski, Bureau of Trade Monitoring and Analysis, 
Federal Maritime Commission, 800 North Capitol Street, NW., Washington 
DC 20573-0001, 202-523-5790.
C. Douglass Miller, Office of the General Counsel, Federal Maritime 
Commission, 800 North Capitol Street, NW., Washington DC 20573-0001, 
202-523-5740.

SUPPLEMENTARY INFORMATION: On March 11, 1993, the Federal Maritime 
Commission (``FMC'' or ``Commission'') published a final rule in Docket 
No. 91-51, Financial Reports of Common Carriers by Water in the 
Domestic Offshore Trades, which amended the provisions under which 
carriers could obtain waivers of certain financial reporting 
requirements. 58 FR 13414. (1993) (``Docket No. 91-51''). The 
Commission stated that it intended ``* * * to turn its attention, 
separately, to the numerous other substantive changes to 46 CFR part 
552 that have been suggested in this proceeding.'' Id. at 13417.\1\ In 
this regard, the Commission conducted an extensive review of part 552 
to assess the need for changes to its financial reporting requirements 
and rate of return methodology in the domestic offshore trades.
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    \1\In its Advance Notice of Proposed Rulemaking issued in Docket 
No. 91-51, 56 FR 57298, the Commission had solicited comments and 
information from the public on issues which could be addressed in a 
proposed rule concerning substantive guidelines for determining what 
constitutes a just and reasonable rate of return or profit for 
common carriers by water in the domestic offshore trades.
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    Based on its review, the Commission has determined that several 
issues regarding the adequacy and appropriateness of various aspects of 
its present regulations should be addressed. The issues on which the 
Commission is proposing changes to existing regulations include:
     The FMC's methodology for computing an allowable rate of 
return on rate base.
     The treatment of deferred taxes and the Capital 
Construction Fund for rate base purposes.
     The definition of working capital.
    Each of these issues is discussed in turn below.\2\ Also discussed 
are the rules governing the allocation of assets and expenses, but no 
changes are proposed.
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    \2\Copies of the proposed new schedules for collecting the data 
required under the proposed regulations are available from the 
Secretary, Federal Maritime Commission.
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Computing an Allowable Rate of Return on Rate Base

I. The Allowable Rate of Return Should Equal the Cost of Capital

    The fundamental objective when using a rate of return on rate base 
method of regulation is to set a regulated firm's maximum allowable 
rate of return on rate base equal to the regulated firm's cost of 
capital. The cost of capital, sometimes referred to by economists as 
``the opportunity cost of capital'' or ``the required rate of return,'' 
is the minimum rate of return necessary to attract capital to an 
investment. It is the expected rate of return prevailing in capital 
markets on alternative investments of equivalent risk.\3\ The bases for 
setting the allowable rate of return equal to the cost of capital are 
legal and economic.
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    \3\A. Lawrence Kolbe, James A. Reed, Jr., and George R. Hall, 
The Cost of Capital, 3rd Printing, The MIT Press, Cambridge, 
Massachusetts, 1986, p. 13.
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A. Legal Rationale
    Two landmark Supreme Court cases defined the legal principles 
underlying rate of return regulation and provided the notion of a fair 
rate of return. The two cases, Bluefield Water Works & Improvement Co. 
v. Public Service Commission of West Virginia, 262 U.S. 679 (1923) and 
Federal Power Commission v. Hope Natural Gas Company, 320 U.S. 391 
(1944), established that investors in companies subject to rate 
regulation must be allowed an opportunity to earn returns sufficient to 
attract capital and comparable to those they would expect from 
investments in other firms for incurring the same amount of risk, and 
that revenues must not only cover operating expenses, but capital costs 
as well.
B. Economic Rationale
    The economic rationale for setting the allowable rate of return of 
a regulated enterprise equal to its cost of capital is that the 
regulated firm's customers will thereby pay the lowest cost for service 
in the long run.\4\ For example, if a regulator sets the allowable rate 
of return above the cost of capital, the firm's stockholders will 
realize earnings in excess of those they could earn on alternative 
investments of comparable risk. Such excess earnings are paid for by 
the firm's customers in the form of prices higher than those that they 
would otherwise be required to pay. If, on the other hand, a regulator 
sets the allowable rate of return below the cost of capital, 
stockholders will realize earnings less than they could on alternative 
investments of comparable risk. In the short run, the firm's customers 
may benefit because they pay prices lower than those they would 
otherwise be required to pay. In the long run, however, the firm's 
stockholders will be unwilling to continue to invest their funds, and 
the firm will, therefore, lack the requisite financial capital for 
maintaining and augmenting the firm's physical plant and equipment. 
Customers, in turn, will be supplied with a lesser quantity and/or 
quality of service.
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    \4\Setting the allowable rate of return equal to the cost of 
capital also ensures that society's supply of capital is used most 
productively. Because capital markets are considered to be highly 
competitive, the cost of new capital is an accurate gauge of that 
capital's value in alternative uses. When the allowable rate of 
return is greater than the cost of capital, investors will supply 
too much capital to a regulated firm, thereby diverting capital from 
alternative investments where it could be more productive. 
Conversely, when the allowable rate of return is less than the cost 
of capital, investors will supply too little capital to a regulated 
firm, thereby allocating funds to less productive investments. Such 
a misallocation of resources represents a welfare loss for society 
as a whole.
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C. Methodologies
    The Commission uses a version of the Comparable Earnings Test 
(``CET'') to determine the reasonableness of rates of return. The 
carrier's projected rate of return ((net income after taxes + interest 
expense)/rate base\5\) is compared with the rate of return on total 
capital earned by U.S. manufacturing firms over an extended period of 
time--the benchmark rate of return. Where appropriate, adjustments are 
made to the benchmark for current trends in rates of return, the cost 
of money and relative risk.
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    \5\Rate base is a carrier's investment in Commission-regulated 
activities. It consists of investments in vessels less accumulated 
depreciation, other property and equipment less accumulated 
depreciation, and working capital.
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    However, most regulatory agencies use the Weighted Average Cost of 
Capital (``WACC'') methodology to set allowable rates of return, 
including, for example the Federal Energy Regulatory Commission, the 
Interstate Commerce Commission (``ICC''), the Federal Communications 
Commission, and the Maryland Public Service Commission. Indeed, the 
most recent yearbook published by the National Association of 
Regulatory Commissioners shows that virtually every state regulatory 
commission in the U.S. uses some variation of the WACC.6 Further, 
current economic literature recognizes the WACC approach as the most 
generally accepted method of setting allowable rates of return.
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    \6\See ``Table 47--Agency Authority Over Rate Of Return--All 
Utilities,'' in Utility Regulatory Policy in the United States and 
Canada Compilation 1992-1993, National Association of Utility 
Regulatory Commissioners (``NARUC''), Washington D.C., 1993, pp. 
110-111.
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    The WACC approach recognizes that there are several methods by 
which a firm may raise capital and each has its attendant cost. 
Typically, the total capital of a firm has come from three different 
sources, long-term debt, preferred stock7 and common-stock equity. 
Thus, the total capital of a firm may have a debt component, a 
preferred stock component and a common-stock equity component. Under 
the WACC methodology,8 the cost of each of these components is 
calculated separately and weighted by the proportion the component is 
to the total capital of the firm.9
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    \7\ Preference stock, also known as prior-preferred stock, is 
preferred stock that has a higher claim than other issues of 
preferred stock on dividends and assets in liquidation.
    \8\ Charles E. Phillips, Jr., The Regulation of Public 
Utilities, 3rd ed., Public Utilities Reports, Inc., Arlington, 
Virginia, 1993, p. 388.
    \9\ Short term debt that has become a permanent portion of the 
regulated firm's financing is also included in the computation. 
Deferred taxes are included at zero cost (unless they have been 
deducted from rate base).
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    To illustrate the calculation of the WACC, consider a hypothetical 
regulated company that has total invested capital of $100 million, 
consisting of $25 million of long-term debt, $15 millon of preferred 
stock, and $60 million of common-stock equity. Assume that the firm's 
cost of long-term debt is 7 percent, cost of preferred stock is 9 
percent, and cost of common-stock equity is 12 percent. Further, assume 
that the firm operates in a world where corporate taxes do not exist. 
The WACC for this firm is calculated as follows: 

                         Calculation of WACC10                          
------------------------------------------------------------------------
                         Amount                                         
                       (millions    Proportion      Cost         WACC   
 Capital component    of dollars)   (percent)    (percent)    (percent) 
                                                                        
------------------------------------------------------------------------
Long-term debt......           25           25            7         1.75
Preferred stock.....           15           15            9         1.35
Common-stock equity.           60           60           12         7.20
                     ---------------------------------------------------
      Total.........          100          100  ...........       10.30 
------------------------------------------------------------------------
10 The algebraic expression for the overall cost of capital or the WACC,
  is as follows (ignoring taxes):                                       


TP07AP94.006


where:
Kd is the regulated firm's cost of long-term debt capital;
Kp is the regulated firm's cost of preferred stock capital;
Ke is the regulated firm's cost of common-stock equity capital;
D is the value of the regulated firm's long-term debt outstanding;
P is the value of the regulated firm's preferred stock outstanding; and
E is the value of the regulated firm's common-stock equity outstanding.

    Thus, given the assumptions of this example, the WACC is 10.30 
percent. The allowable rate of return for this hypothetical company 
should, therefore, be set at 10.30 percent, which would provide the 
firm with the opportunity to earn revenues sufficient to service the 
company's overall cost of capital.11
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    \1\1 In reality, a regulated firm typically does pay taxes, and 
the WACC must be adjusted to arrive at a final number for an 
allowable rate of return. Such adjustment is made by calculating the 
WACC on a before-tax basis (``BTWACC''). The BTWACC is described in 
detail later.
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    The costs of long-term debt and preferred stock capital may be 
calculated with relative precision. For the debt component, this is 
done by computing the actual total annual fixed charges on long-term 
debt for all issues, including any amortized discount or premium and 
issuance expense. The total annual fixed charges are then divided by 
the actual total value of long-term debt outstanding for all issues in 
order to arrive at the cost of debt stated as a percentage. For 
example, if the annual fixed charges on long-term debt are $1,750,000 
and the total long-term debt outstanding is $25 million, the cost of 
debt would be 7 percent ($1,750,000/$25 million=.07).
    The cost of preferred stock is calculated in similar fashion. The 
actual total annual dividend requirements on the preferred stock for 
all issues is divided by the actual total value of preferred stock 
outstanding for all issues in order to arrive at the cost of preferred 
stock stated as a percentage. For example, if the actual total annual 
dividend requirements amounted to $1,350,000 and the total value of 
outstanding preferred stock is $15 million, the cost of preferred stock 
would be 9 percent ($1,350,000/$15 million=.09).
    The calculation of the cost of common stock equity capital, the 
third component of the WACC, is more difficult. Commonly used methods 
are the Discounted Cash Flow (``DCF''), the Capital Asset Pricing Model 
(``CAPM'') and the Risk Premium (``RP''). Each of these models is based 
on market variables (e.g., stock market prices and bond yields) which 
reflect the expectations of investors in capital markets. More 
specifically, the DCF, CAPM and RP models are constructed under the 
generally accepted assumption that a company's stock market price at 
any moment in time reflects completely investors' current expectations. 
Because these market-based models are designed to reflect the 
expectations of investors, and because a company's cost of capital is 
defined as the rate of return expected by investors on alternative 
investments of equivalent risk, the WACC framework implemented through 
the use of such models will, in general, equate the allowable rate of 
return with the cost of capital.

II. The Commission's Comparable Earnings Test Compared to the WACC

A. Theoretical Issues
    The Commission has used its variation of the CET in a number of 
rate investigations. Commission orders adjudicating the reasonableness 
of rate increases under the CET have been repeatedly upheld by the 
courts. E.g., Matson Navigation Company, Inc. v. FMC, 959 F.2d 1039 
(D.C. Cir. 1992); and Puerto Rico Maritime Shipping Authority v. FMC, 
678 F.2d 327 (D.C. Cir.), cert. denied, 459 U.S. 906 (1982). However, 
the Commission's CET does present a theoretical shortcoming compared to 
the WACC method, in that it is unlikely to equate the allowable rate of 
return with the cost of capital, because it uses historical accounting 
data to calculate an average book value12 rate of return that the 
regulated carrier should be allowed.
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    \1\2 Book value means the value at which an asset is carried on 
a balance sheet.
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    The accounting rate of return for a company is not equivalent to 
the firm's true economic rate of return because accounting and economic 
concepts of income and value are substantially different. Accounting 
numbers are derived on the basis of generally accepted accounting 
principles while economics specifies the use of opportunity costs. This 
difference is particularly acute when the economy is characterized by 
high and variable rates of inflation. For example, accountants define 
asset values in terms of acquisition or historical costs while 
economists define asset values on the basis of market values or 
replacement costs. This distinction effects both the income statement 
as well as the balance sheet. Consequently, an accounting-based rate of 
return methodology such as the Commission's CET does not adequately 
measure a regulated carrier's true cost of capital. In Docket No. 91-
51, the State of Hawaii noted the problems associated with using 
accounting data and criticized the Commission's CET for being 
accounting-based and not market-based.
    Several empirical tests have demonstrated that there is a large 
discrepancy between accounting rate of return and true economic 
return.13 These studies also demonstrate that biases inherent in 
book returns are systematic, and that these biases do not cancel out by 
averaging across companies. Furthermore, the type and magnitude of bias 
for regulated firms are different than those of unregulated firms 
contained in the comparable risk group of firms selected in applying 
the Commission's CET method.14
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    \1\3 See, for example, Franklin M. Fisher and John J. McGowan, 
``On the Misuse of Accounting Rates of Return to Infer Monopoly 
Profits,'' 73 Am. Econ. Rev. 82-97, March 1983; and Richard Brealy 
and Stewart C. Myers, Principles of Corporate Finance, New York: 
McGraw-Hill, Chapter 12, 1981.
    \1\4 Regulators (including the FMC) commonly set rates on the 
basis of a book value rate base. In such instances, the economic 
(i.e., market) value of a regulated firm will tend to be closer to 
its book value in comparison to the economic values and book values 
of the unregulated firms contained in the proxy group. The book 
returns of the unregulated firms are, therefore, likely to be 
substantially more biased than those of the regulated firm under 
consideration.
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B. Practical Issues
    The WACC approach also presents some important technical 
advantages. First, the WACC uses the actual long-term interest expense 
currently provided by a regulated carrier to compute the company's cost 
of long-term debt capital, while the Commission's CET uses an estimate 
of a carrier's long-term interest expense based on moving averages of 
Baa-rated corporate bond yields in computing an allowable rate of 
return on rate base. By definition, a firm's actual long-term interest 
expense is more accurate than an estimate of that expense. In its 
comments in Docket No. 91-51, the State of Hawaii stated that the 
Commission's CET introduces imprecision into the calculation by 
requiring that parties substitute a proxy for carrier interest expense 
as a component of the carrier's rate of return, although this component 
is known and subject to verification.
    Second, the WACC, when implemented properly, ensures that the 
regulated carrier will be allowed a return on rate base that is large 
enough to ensure that the carrier will have the opportunity to earn, at 
a minimum, revenues that are sufficient to cover its embedded (actual 
historical) cost of debt. Assuming that debt capital financing is less 
expensive than preferred stock and common-stock equity capital 
financing, when the known cost of long-term debt is weighted by the 
regulated company's proportion of long-term debt capital outstanding, 
and then added to the firm's cost of preferred stock weighted by the 
firm's proportion of preferred stock capital outstanding and the firm's 
cost of common-stock equity capital weighted by the firm's proportion 
of common-stock equity capital outstanding, the resulting sum (i.e., 
the WACC) can be no less than the cost of the firm's embedded cost of 
debt. Such a guarantee is not available under the Commission's CET, as 
Matson Navigation Company, Inc. (``Matson''), has pointed out. For 
example, if the long-term interest expense estimate, derived on the 
basis of a moving average of historical Baa corporate bond yields, is 
not representative of the actual long-term interest expense of the 
regulated carrier, or if the historical financial data reflecting the 
financial picture of the benchmark group of firms are not 
representative of the regulated carrier's financial position, then the 
regulated carrier's calculated allowable rate of return on rate base 
could fall short of its embedded cost of debt.
    Third, the Commission's CET has proved difficult to apply in the 
case of the Puerto Rico Maritime Shipping Authority (``PRMSA''), which 
has a capital structure composed entirely of long-term debt and by law 
is not required to pay taxes. On the other hand, the WACC can be used 
effectively to establish an appropriate allowable rate of return for 
such a carrier. The WACC is computed for such a carrier by weighting 
the cost of long-term debt near or equal to one, the cost of preferred 
stock near or equal to zero, and the cost of common-stock equity near 
or equal to zero, and setting the corporate tax rate equal to zero. The 
WACC can be used effectively to compute an accurate estimate of the 
overall cost of capital and, in turn, to establish an appropriate 
allowable rate of return for a regulated carrier that is financed 
exclusively or almost completely by long-term debt15 and is tax-
exempt, because it distinguishes between such a carrier and one that is 
financed with substantial amounts of common-stock equity and is not 
tax-exempt. In its comments in Docket No. 91-51, PRMSA observed that 
the Commission's CET makes no such distinction because it uses as a 
benchmark for every regulated carrier, regardless of actual capital 
structure or tax status, a typical firm financed with a relatively 
balanced mixture of long-term debt and common-stock equity capital, and 
is not tax-exempt.
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    \1\5A profitable firm will generally have at least some amount 
of common-stock equity capital in its capital structure because such 
a firm will usually have an internal source of such capital in the 
form of retained earnings.
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    Lastly, the WACC method typically uses a number of different 
methods to calculate the regulated firm's cost of common-stock equity 
capital. This yields several different estimates of the firm's WACC 
providing a regulatory commission with a range of numbers from which a 
single number representing an allowable rate of return on rate base can 
be chosen. This minimizes the possibility that the allowable rate of 
return will be distorted by inappropriate subjective judgements or by 
extraordinary economic conditions existing during the time period used 
to measure that return. By comparison, the Commission's CET produces a 
single measure of an allowable rate of return.
    On the basis of its review, the Commission has determined to 
propose the use of the WACC methodology to evaluate the reasonableness 
of a carrier's rates in the domestic offshore trades. The Commission 
believes that the WACC approach set forth in the proposed rule 
represents a substantial improvement over the existing methodology and 
addresses the criticisms voiced in comments in Docket No. 91-51. We now 
turn to the proposed rule.

III. Estimating the Weighted Average Cost of Capital

A. Capital Structure
    The first step in calculating the WACC is to determine an 
appropriate capital structure (i.e., the proportions of long-term debt, 
preferred stock, and common-stock equity capital issued by a firm to 
finance its operations) for the regulated firm. There are two important 
issues that may have to be resolved. The first is whether to calculate 
the WACC using a ``typical'' or ``ideal'' capital structure as some 
regulatory commissions do, or the actual capital structure or that 
expected in the near future, as others do. The second issue concerns 
the situation where the regulated company is a subsidiary of a parent 
company. The issue is whether to use the capital structure of the 
subsidiary or that of the consolidated system (i.e., the parent company 
and all of its subsidiaries) in computing the WACC.
    1. Hypothetical Versus Actual Capital Structure. The WACC may be 
much lower when the proportion of debt contained in a company's capital 
structure is relatively high compared to common-stock equity. This is 
because the interest rate on debt is usually much lower than the cost 
of common-stock equity.16 In addition, debt costs the firm and the 
ratepayer less than equity because equity earnings are subject to 
income taxes and debt is not. The revenue that a company is allowed to 
earn on its common-stock equity is increased by amounts added to that 
revenue for the purpose of paying income taxes. By contrast, since 
interest is deductible for income tax purposes, earnings to cover debt 
costs are computed before any income tax calculations, and are not 
subject to income tax. Consequently, within limits determined by such 
factors as the risk of a business, the WACC may be lower and ratepayers 
may pay less when the firm employs a relatively large proportion of 
debt than when it uses a relatively large proportion of equity. Given 
this differential, some regulatory commissions compute the WACC using 
what they believe to be the ``typical,'' or ``ideal,'' capital 
structure without regard to the actual capitalization of the regulated 
company in question. Other regulatory commissions base their WACC 
estimates on either the actual capital structure, or that expected in 
the near future when rates to be decided will be in effect.
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    \1\6There are two reasons for this: (1) debtholders have 
priority over equityholders as to the remaining assets of the firm 
in the event that the firm is liquidated; and (2) debtholders must 
be paid their contractual level of interest (i.e., their coupon 
payment) before equityholders receive any compensation (i.e., 
dividend payments). A company may reduce or eliminate dividend 
payments to equityholders in the event that it is under financial 
strain. However, it is far less likely that coupon payments will be 
eliminated because this could result in bankruptcy if the firm does 
not take corrective action. Equityholders, therefore, require a 
higher return than do debtholders. Consequently, it costs a firm 
more to issue common-stock equity than it does to issue debt. The 
more expensive common-stock equity financing could be borne by 
ratepayers in the form of higher rates.
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    There are strong reasons for using a regulated carrier's actual or 
expected capital structure rather than the alternative of a 
hypothetical or ideal capital structure in calculating the carrier's 
WACC. First, a regulated company's current capital structure could be 
the product of decisions that were logical and efficient at the time 
they were made, although a different capitalization might be consistent 
with a lower WACC at the time of a rate investigation and hearing. 
Although hindsight is always more accurate than foresight, a company 
must make financial decisions based on an evaluation of the present and 
projections of future conditions.17 Second, using a hypothetical 
or typical capital structure substitutes an estimate of what the WACC 
would be under conditions that do not exist for what it actually is or 
will soon be under existing conditions.18
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    \1\7Charles E. Phillips, supra note 4, at 390.
    \1\8James C. Bonbright, Albert L. Danielsen, and David R. 
Kamerschen, Principles of Public Utility Rates, 2nd ed., Public 
Utilities Reports, Inc., Arlington, Virginia, 1988, p. 309.
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    Accordingly, the Commission's proposed rule specifies the use of a 
regulated domestic offshore carrier's expected capital structure in 
computing the carrier's WACC. The proposed rule stipulates the use of 
the expected rather than the actual capital structure because the 
Commission uses a future instead of a historic test year.
    2. Subsidiary Versus Consolidated Capital Structure. Where a 
regulated company is a wholly owned subsidiary which obtains its 
common-stock equity capital through a parent company, regulators often 
use the capital structure of the consolidated system (i.e., the parent 
company and all of its subsidiaries) in computing the WACC. The 
consolidated capital structure is an appropriate capitalization to use 
in calculating a regulated subsidiary's WACC when: (1) No substantial 
minority interest in the subsidiary exists (i.e., the regulated 
subsidiary is wholly-owned by a parent company or nearly so), and (2) 
the risks are similar between the parent and subsidiary.\19\ In such a 
situation, investors' appraisals of the parent company's common stock 
are thought to represent the best measure of the current cost of 
common-stock equity to the subsidiary.\20\ When the consolidated 
capital structure is used, the consolidated system's cost of common-
stock equity capital (issued by the parent company), the consolidated 
system's cost of preferred stock, and the consolidated system's cost of 
long-term debt, rather than the respective capital component costs of 
the regulated subsidiary, are also used because the consolidated 
capital structure directly affects the capital component costs of the 
consolidated system and not those of the subsidiary.\21\ The use of the 
regulated subsidiary's capital component costs is inconsistent with the 
use of the consolidated system's capital structure and could, 
therefore, distort the WACC estimate obtained for the regulated 
subsidiary.
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    \19\The use of the consolidated capital structure differs from 
the ``double leverage'' concept used by some expert witnesses. The 
latter approach uses the parent company's WACC as a measure of the 
subsidiary's cost of common-stock equity capital along with the 
subsidiary's capital structure, the subsidiary's cost of preferred 
stock, and the subsidiary's cost of debt. Those that favor the use 
of such a method cite the advantage of using the actual data of the 
subsidiary for which an allowable rate of return is being computed. 
The merits of the approach are highly debatable, however, since it 
could produce an estimate of the cost of common-stock equity capital 
for the regulated subsidiary that is lower than the opportunity cost 
of such capital when the subsidiary is more risky than the parent, 
and an estimate that is higher when the subsidiary is less risky. 
The Commission's proposed rule does not, therefore, rely on the 
double leverage method of calculating the WACC for a regulated 
subsidiary company.
    \20\J. Rhoads Foster, ``Fair Return Criteria and Estimation,'' 
28 Baylor L. Rev. 889 (1976), in Charles E. Phillips, supra note 4, 
at 392.
    \21\To see how a company's capital structure could affect its 
component capital costs, consider, for example, the case of a 
heavily-leveraged company (i.e., one that has a relatively large 
proportion of debt in its capital structure). Such a company could 
be perceived by current and potential debtholders and equityholders 
as having a relatively high probability of bankruptcy (in which case 
coupon and dividend payments would be discontinued and the 
possibility that principal could also be lost would be heightened) 
and, therefore, as being a relatively high risk investment. 
Debtholders and equityholders would require a return on their 
investment funds that is commensurate with the relatively high risk 
of such a company in order for them to be willing to purchase and 
hold the company's debt and common stock. A heavily leveraged firm 
could, therefore, have relatively high costs of debt and common-
stock equity capital.
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    The use of the consolidated capital structure is not correct, 
however, when a substantial minority interest in the regulated 
subsidiary exists, or when the regulated subsidiary's risk differs 
substantially from that of the parent company. The appropriate approach 
in this situation is to ignore the parent-subsidiary relationship and 
to estimate the subsidiary's WACC using the subsidiary's own capital 
structure and capital component costs. This method, referred to as the 
``stand alone'' or ``subsidiary approach,'' recognizes the subsidiary 
as an independent operating company, and its cost of common-stock 
equity capital is inferred as the cost of common-stock equity of firms 
having risk comparable to that of the subsidiary.\22\ The basis for 
this method is that the required return on an investment depends on its 
risk (i.e., the subsidiary's risk) rather than on the parent's 
financing costs. In short, this method emphasizes the use, rather than 
the source, of the subsidiary's capital funds.
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    \22\The issue of selecting an appropriate sample of firms having 
risk similar to that of the regulated company under consideration is 
explored in detail below.
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    The Commission's proposed rule specifies that a subsidiary 
carrier's capital structure is to be used in computing the WACC unless, 
after notice and opportunity for comment, the Commission determines 
that: (1) The subsidiary carrier's parent company issues publicly 
traded common-stock equity; (2) no substantial minority interest in the 
subsidiary carrier exists; and (3) risks are similar between the 
subsidiary carrier and the parent company. Under the proposed rule, no 
substantial minority interest in a subsidiary carrier exists when a 
parent company owns 90 percent or more of the subsidiary's voting 
shares of stock. It also must be demonstrated that both the business 
and the financial risks facing the parent and subsidiary are 
similar.\23\
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    \23\Business risk is the variability that a company's internal 
(e.g., the skill levels and salaries of employees) and external 
(e.g., the number of competitors) operating variables impart to the 
earnings available to investors because of the fundamental nature of 
the company's business.
    Financial risk is the additional variability that debt and 
preferred stock financing impart to the earnings available to 
common-stock equityholders.
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    Such an evaluation may involve a comparison of such financial risk 
measures as total capitalization and debt-to-equity ratios, investment 
quality ratings on short-and long-term debt instruments, and coverage 
ratios such as the times interest earned and fixed charges coverage 
ratios.\24\ There must also be an assessment of the degree to which the 
regulated subsidiary comprises the parent's holdings. To the extent 
that a subsidiary accounts for a substantial majority of the 
consolidated system's revenues, expenses, and profits, the business 
risks of the parent and subsidiary would, in general, be the same. 
However, where a parent's holdings are diversified into areas of 
business unrelated to the regulated subsidiary, the business risks of 
the parent and of the subsidiary are more likely to differ.
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    \24\Times interest earned ratios (``TIER'') measure the extent 
to which operating income can decline before a firm is unable to 
meet its annual interest costs. TIER is computed by dividing a 
firm's earnings before interest and taxes by the firms' annual 
interest expense.
    The fixed charges coverage ratio (``FCCR'') measures the ability 
of a firm to satisfy all of its fixed obligations. FCCR is computed 
by dividing the total of net income, interest expense, depreciation 
and amortization expense, and the provision for income taxes, by 
fixed charges. Fixed charges are the total of interest expense, 
principal payments, and capital lease obligations.
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    Accordingly, the Commission's proposed rule states that the 
Commission shall consider some or all of the aforementioned business 
and financial risk criteria in determining whether to approve the use 
of a consolidated system's capital structure and component costs in 
computing the subsidiary's WACC.
    Other measures of business and financial risks may also be used in 
comparing the risk of a parent with the risk of a subsidiary. These 
could include those discussed later for selecting an appropriate proxy 
group of firms.
    3. Book Value Versus Market Value Capitalization Ratios. Another 
capital structure issue is whether to use market or book values in 
computing the capitalization ratios (i.e., the weights) in the WACC 
formula. Technically, capitalization ratios should be computed on the 
basis of market value. A capital structure computed on the basis of 
historical (i.e., book values) as opposed to current market values 
misrepresents the true capital structure over time, since price levels 
fluctuate. The common practice is, nevertheless, to compute 
capitalization ratios on the basis of book values. This is defended on 
grounds that a regulated firm supposedly raises capital in such a 
fashion that a target capitalization ratio expressed on the basis of 
book values is maintained by the company. Consequently, regulators must 
compute the firm's overall cost of capital on the same basis in order 
to ensure that the company's capital costs are adequately covered. In 
addition, book value capitalization ratios are stable and the regulator 
is, therefore, not required to deal with the uncertainties associated 
with volatile market weights. Further, effective regulation is said to 
force book and market values toward equality. Accordingly, the 
Commission's proposed rule requires the use of book value 
capitalization ratios in computing the WACC.
    4. Average Versus Year-End Capital Structure. Finally, there is the 
issue of whether a year-end or average capital structure should be used 
in computing the WACC. The fact that financial variables and ratios are 
commonly stated on an average basis argues in favor of using an 
expected average capital structure projected over a future test year, 
rather than a year-end capital structure. Earnings per share, for 
example, are typically expressed on the basis of average number of 
shares outstanding. Equity returns are also frequently expressed on the 
basis of average common-stock equity. In addition, an average capital 
structure computed over a future test year is likely to represent the 
company's capital structure during the time interval in which a 
proposed general rate increase will be in effect better than a year-end 
capital structure, because the company could acquire new capital from, 
or return existing capital to, investors during that period of time. 
The use of an average capital structure rather than a year-end capital 
structure is, therefore, more likely to enable a regulated firm to 
actually earn its allowable rate of return. Accordingly, the 
Commission's proposed rule specifies the use of test-year 
average25 book value capitalization ratios in computing the WACC.
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    \2\5Such average ratios are computed using the average amount of 
each capital component (expected to be) outstanding during the test 
year. The average test year amount outstanding for any class of 
capital is computed by adding the amount of a particular type of 
capital (expected to be) outstanding at the beginning of the test 
year to the amount of that same type of capital (expected to be) 
outstanding at the end of the test year, and dividing the sum of the 
two amounts outstanding by two.
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B. Annual Cost of the Capital Components
    Determining the cost of the regulated firm's senior capital (i.e., 
debt and preferred stock) and common-stock equity is the second step in 
estimating the WACC. The costs of each of these components are then 
applied to the capital structure (i.e., each is weighted on the basis 
of the proportion of the value of the total capital outstanding that 
each represents) in order to determine the WACC.
    1. Cost of Senior Capital. There are usually few problems 
encountered in computing the cost of senior capital with precision. 
Regulatory commissions traditionally compute cost of senior capital on 
the basis of embedded (actual historical) cost. This is done by first 
computing the actual total annual fixed charges on long-term debt, 
including any amortized discount or premium and issuance expense, and 
the actual total annual dividend requirements on the preferred (and 
preference) stock for all issues on a dollar basis. These dollar 
figures are then converted to a percentage by dividing the actual total 
annual fixed charges on long-term debt by the actual total value of 
long-term debt outstanding, and the actual total annual preferred stock 
dividend requirements by the actual total value of preferred stock 
outstanding for all issues. If a future (rather than a historical) test 
year is used (as the FMC does), the cost of senior capital is 
calculated on the basis of: (1) The embedded cost for the existing 
long-term debt and preferred stock, and (2) the current cost for any 
new long-term debt and preferred stock that the regulated firm 
anticipates issuing on or before the final day of the projected test 
year.
    The embedded cost is used to calculate the cost of existing senior 
capital in order to determine what the senior capital will cost the 
firm today, in view of the fact that the majority of it was issued at 
prior points in time, and under bond and stock market conditions that 
could have differed substantially compared to those prevailing today. 
The objective is not to determine what the existing senior capital 
would cost if issued today. Rather, the embedded debt cost measures 
precisely what the regulated firm needs to satisfy its contractually 
required interest payments to those holding existing long-term debt, 
and preferred-dividend payments to those holding existing preferred 
stock. The current cost of bonds and preferred stock is, therefore, 
estimated only to measure the cost to the regulated firm when such 
senior securities are to be issued in the near future.
    2. Cost of Common-Stock Equity Capital. The most critical problem 
in determining the WACC is that of estimating the cost of common-stock 
equity capital. The objective is to determine how much the regulated 
firm is required to earn in order to be able to entice investors into 
purchasing and holding its common-stock equity. A precise answer to 
this question is difficult to arrive at due to the absence of any 
expressed or fixed agreement as to the level of dividends that are to 
be paid by the regulated firm to its common-stock equityholders. 
Dividend payments, on the one hand, depend upon the profits of the 
regulated company. The allowable amount of profits, on the other hand, 
is the object of a rate investigation and hearing. A regulator, in 
allowing a fair rate of return, does not, therefore, have any 
predetermined gauge as to the level of profit and common-stock equity 
dividends required by investors.
    There are five major methods used to estimate the cost of common-
stock equity capital: DCF, RP, CAPM,26 Market-to-Book Ratio 
(``MBR''), and Comparable Earnings (``CE'').27 The DCF, CAPM, RP, 
and MBR methods are market-based approaches that emphasize the standard 
of capital attraction articulated in Hope and Bluefield by examining 
investors' expectations of the regulated firm's profits, dividends, and 
market prices. The CE method emphasizes the comparable earnings 
standard specified by those cases by estimating the return on book 
common-stock equity of firms having risk similar to that of the 
regulated firm under consideration. The five methods are reviewed in 
turn.
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    \2\6The CAPM is actually a specific type of RP model.
    \2\7The CE method is used by regulatory commissions 
traditionally to calculate the regulated firm's cost of common-stock 
equity capital. This approach differs significantly from the 
comparable earnings test currently used by the FMC, which estimates 
the rate of return on total invested capital (i.e., on long-term 
debt and common-stock equity) of the regulated carrier under 
consideration.
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    a. Discounted Cash Flow Method. The DCF method of estimating the 
cost of common-stock equity is the technique that is used with the 
greatest frequency by state and federal regulatory commissions and 
agencies. Its popularity reflects the intuitive appeal of the DCF model 
with its basis in valuation theory. That theory holds that the current 
market price of a common stock is equal to the present value of its 
expected future dividend payments plus the proceeds that an investor 
would expect to receive when the common stock is finally sold. Because 
the value of an amount of money to be received in the future is less 
than the value of the same amount of money received today,28 the 
expected value of the future dividends and ultimate proceeds must be 
discounted back to the present at the investor's required rate of 
return in computing the present value of a common stock. The most basic 
mathematical representation of this concept assumes that: (1) Dividends 
grow at a constant annual rate, and (2) that an investor will hold the 
common stock forever. The latter assumption implies that the value of 
the stock depends solely on the dividends that are expected to be paid. 
The basic DCF model is expressed algebraically as follows:

    \2\8 The value of a dollar received today is greater than that 
of a dollar received a year from today, for example, because today's 
dollar can be invested and begin to earn a rate of return 
immediately.

TP07AP94.007

---------------------------------------------------------------------------
where:

Po is the current market price per share of the regulated 
company's common stock;
D1 is the dividend to be received at the end of year 1 
(mathematically D1=Do(1+g), where D0 is the current 
dividend);
Ke is the required or expected return on the regulated firm's 
common-stock equity capital (i.e., the cost of common-stock equity 
capital); and

g is the constant expected annual rate of growth in dividends per 
share.

    The equation is solved for Ke in rate of return testimony in 
order to determine the cost of the common-stock equity of the regulated 
firm under consideration. Solving the equation for Ke yields the 
following expression:


TP07AP94.008


Hence, the basic or standard DCF model states that the cost of common-
stock equity is equal to the expected (first-year) dividend yield plus 
the rate at which investors expect dividends to grow in the future.

    To illustrate the basic DCF model, assume that the current market 
price of a hypothetical regulated company's common stock is $30.00 per 
share, and that a single common stock share currently pays a $2.00 
dividend, which is expected to grow at a rate of 5 percent per year. 
The cost of common-stock equity capital for such a company is:

TP07AP94.009


i. Practical Issues

    (a) Expected Growth Rate of Dividends. The major practical issue 
involves determining ``g,'' the constant expected annual rate of growth 
in dividends per share. There are three techniques that are commonly 
used to estimate ``g'': (1) Historical growth rates; (2) professional 
investment services' projections; and (3) sustainable growth or 
retention growth. An average of the growth rates arrived at separately 
using each of the three methods is often used to produce a final growth 
estimate. This averaging procedure is the one reflected in the proposed 
rule.

    (i) Historical Growth Rate. The historical growth rate in dividends 
over some period, frequently five or ten years, is one method used to 
estimate ``g.'' Historical data are used because investors' 
expectations of future growth are based in part on growth rates 
experienced in the past. The historical growth in earnings per share, 
or book value per share, is sometimes used as a proxy for the growth in 
dividends, because dividends are often increased at discrete intervals, 
so that their estimated growth rate can differ considerably depending 
upon the precise beginning and ending points of the selected data 
series. The proposed rule, therefore, requires averaging the historical 
growth rate of dividends per share, earnings per share, and book value 
per share in arriving at an estimate of ``g.''
    The period over which ``g'' is to be measured must be sufficiently 
long to avoid distortions in the data resulting from short-term 
conditions and aberrational years, but sufficiently short to capture 
foreseeable influences relevant for investors' evaluation of the 
future. The most recent five- and ten-year periods are commonly used to 
calculate the growth rate. The proposed rule uses an average of the 
five- and ten-year growth rates on the basis that the average 
represents a reasonable trade-off between the incongruous requirements 
of representativity and statistical adequacy.
    (ii) Professional Investment Services' Projections. The expected 
growth rate of dividends is also commonly based upon the growth rates 
published by professional investment services, since investor 
expectations are the desired quantities in the DCF model, and 
investors' growth anticipations are based in part upon the projections 
of such services. Growth forecasts of dividends per share, earnings per 
share, and book value per share are published by several services, 
including Value Line Publishing, Inc. (``Value Line''), and the 
Institutional Brokers Estimation Service (``IBES''). Such growth rates 
are published on a regular basis, usually for five-year periods, and 
are readily available to investors. Expert witnesses usually develop a 
consensus forecast by averaging the forecasts of the professional 
analysts, and use this average in calculating ``g.'' The Commission's 
proposed rule similarly specifies that ``g'' will be measured by using 
the average of: (1) The five-year dividend, earnings, and book value 
forecasts published by Value Line, and of (2) the five-year earnings 
forecast published by IBES.29
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    \2\9IBES produces a consensus forecast of earnings based on the 
individual predictions of virtually every major brokerage house.
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    (iii) The Sustainable Growth Rate. The third technique used to 
estimate ``g,'' known alternately as the ``sustainable growth,'' 
``retention ratio,'' or ``plowback'' method, is to multiply the 
proportion of earnings expected to be retained by the company, ``b,'' 
by the expected return on book equity, ROE. The relationship is 
expressed algebraically as g=(b)(ROE). The theoretical underpinning for 
the method is that future growth in dividends for existing equity can 
only occur if a portion of the overall return to investors is plowed 
back into the firm rather than being paid out as dividends.

    To illustrate the sustainable growth rate method, assume that a 
hypothetical regulated company is expected to retain 75 percent of its 
earnings, and is expected to earn a 10 percent return on book equity. 
The company's sustainable growth rate estimate of ``g'' is:

g=.75(.10)
=.075 or 7.5 percent.

    Both historical and projected values of ``b'' and ROE are used to 
estimate ``g.'' Projected values are regarded as superior, however, 
since forecasted values incorporate current and predicted changes into 
the values. In addition, the use of historical realized book returns on 
equity in estimating ROE has been criticized because the realized 
returns are the product of the regulatory process itself, and are also 
subject to tests of reasonableness. Therefore, the Commission's 
proposed rule requires that the forecasted values of ``b'' and ROE 
published by Value Line be used in implementing the sustainable growth 
method.

    (iv) Final Estimate of ``g''. The final estimate of ``g'' for the 
DCF model is commonly based on an average of the separate estimates 
arrived at using the historical data, the professional investment 
services' projections, and the sustainable growth model. Thus, the 
Commission's proposed rule reflects such an averaging procedure.

    (b) Dividend Yield. Two methods are commonly used to calculate 
dividend yields in DCF analyses. The standard DCF model uses the annual 
dividend expected to be paid 12 months following the purchase of the 
security. This method assumes that dividends are paid annually. The 
other method uses the current dividend to compute the yield portion of 
the annual return. This method assumes that dividends are paid 
continuously. However, the assumption of annual payments results in an 
overstatement of the required return (i.e., the regulated firm's cost 
of common-stock equity capital), and the assumption of continuous 
payments results in an understatement of the required return. Since 
most firms pay dividends on a quarterly basis, however, it is proper to 
use a method that recognizes such quarterly installments. Such a method 
applies an adjustment factor to the current dividend yield to account 
for quarterly payment of dividends. The dividend yield, assuming 
quarterly payment of dividends, is calculated on the basis of the 
following formula:


TP07AP94.010

where:

D0 is the current annualized dividend (defined as four times the 
current quarterly installment) per share;
P0 is the current market price per share of the common stock; and
g is the constant expected annual rate of growth in dividends per 
share.

    To illustrate the quarterly dividend formula, assume that the 
current market price of a hypothetical regulated company's common stock 
is $30.00 per share, and that a single common stock share currently 
pays quarterly a 50 cent dividend ($2.00 annually), which is expected 
to grow at a rate of 5 percent per year. The dividend yield for such a 
company is:


TP07AP94.011

    The Commission proposes to use this formula in calculating the 
dividend yield in DCF analyses.
    In calculating the current price per share found in the denominator 
of the expression for the dividend yield, an average price over a 
period of time, rather than a price on a particular day, is often used 
in order to remove aberrations from the calculation. Such aberrations 
could be the result of events internal to the company (e.g., the stock 
may go ex-dividend30) or external factors (e.g., political events 
that affect the price of a firm's stock). The period over which to 
average the price of the common stock should be sufficiently long to 
remove the aberration, but sufficiently short so as not to obscure any 
real trends in the stock market. The Commission believes that the use 
of an average of the monthly high and low prices for a six-month period 
in computing the dividend yield meets these criteria, and such an 
average is, therefore, reflected in the proposed rule.
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    \3\0Ex-dividend is the interval between the announcement and the 
payment of the next dividend. An investor who buys shares during 
that interval is not entitled to that dividend. Typically, a stock's 
price moves up by the dollar amount of the dividend as the ex-
dividend date approaches, then falls by the amount of the dividend 
after that date.
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    (c) Company-Specific Versus Comparable Group DCF Approach. The DCF 
model can be applied directly to a regulated company which issues 
publicly-traded common-stock equity (so that the requisite stock market 
price data for doing so exist), to a group of companies comparable in 
risk to the subject carrier which issue publicly-traded common-stock 
equity, or, where possible, both. The company-specific DCF approach 
provides the stock market's most direct and meaningful measure of a 
company's cost of common-stock equity capital. Accordingly, the 
Commission's proposed rule requires that the DCF model be applied 
directly to the subject carrier where the carrier issues common-stock 
equity which trades publicly.31 Only where a carrier issues no 
publicly-traded common-stock equity is the DCF model to be applied to a 
comparable group of firms under the proposed rule. Some expert 
witnesses do, however, apply the DCF model to a comparable group of 
firms, even where direct stock market data are available, either in 
place of, or in addition to, the company-specific DCF approach. The 
Commission's proposed rule does not prescribe the comparable group DCF 
approach where direct stock market price data are available because it 
is not certain that this approach would improve upon the accuracy of 
the cost of common-stock equity capital estimate obtained using the 
carrier-specific DCF approach.
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    \3\1Alternatively, under the proposed rule, the DCF model is to 
be applied directly to the parent company of a subsidiary carrier 
where a consolidated capital structure and consolidated system 
capital component costs are to be used to calculate the WACC, 
assuming that the parent company issues common-stock equity which 
trades publicly.
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    b. Capital Asset Pricing Model. The conceptual basis of the CAPM is 
that investors hold diversified portfolios consisting of individual 
common stocks to minimize risk. Diversification reduces the risk of the 
portfolio because individual common stock rates of return32 are 
not perfectly correlated. The rate of return on some common stocks 
tends to be high while on others it tends to be low so that the average 
risk or variability of the return of the portfolio is less than the 
average risk of the returns of the common stocks contained in that 
portfolio. Diversification does not completely eliminate risk, however, 
since individual common stock returns are correlated to a certain 
degree due to the influence of pervasive forces not specific to a 
particular security that affect the overall market.
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    \3\2The annual rate of return on a common stock is the sum of 
two components: (1) The annual dividend yield, which is annual 
dividend income divided by the price of the common stock at the 
beginning of a given year; and (2) the annual capital appreciation 
or depreciation, which is the annual increase or decrease in the 
price of the common stock, divided by the price at the beginning of 
the given year.
---------------------------------------------------------------------------

    The total risk of a common stock is partitioned into two 
components: (1) The ``specific'' or ``unsystematic'' risk unique to a 
company that can be diversified away in a well-constructed portfolio, 
and (2) the ``market'' or ``systematic'' risk that cannot be 
diversified away. The core idea of the CAPM is that because investors 
can diversify away company-specific risk, they should not be rewarded 
for bearing this superfluous risk. Diversified risk-averse investors 
are exposed solely to market risk and are, therefore, rewarded with 
higher expected returns for bearing higher market risk.
    The CAPM provides a measure of market risk, known as ``beta,'' 
which gauges the degree to which an individual common stock's return 
moves with the overall market's return. Specifically, the common 
stock's historical returns are compared with the overall market's 
historical returns (commonly measured as the returns on a broad market 
index such as the Standard and Poor's 500). A common stock is 
considered to be of above average risk if the stock's return is more 
volatile than that of the market,33 and of below average risk if 
the stock's return is less volatile than that of the market.34 
``Beta'' is used in the CAPM model to adjust the market premium 
expected by investors in comparison to debt for the riskiness of an 
individual common stock.
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    \3\3The ``beta'' for such an above-average risk common stock is 
greater than one.
    \3\4The ``beta'' for such a below-average risk common stock is 
less than one.
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    The CAPM holds that the return on a common stock expected by an 
investor is equivalent to that which could be earned on a riskless 
investment, plus a premium for assuming risk that is proportional to 
the common stock's market risk (i.e., ``beta''), and the market price 
of risk (i.e., the difference between the overall expected stock market 
return and the expected return on a risk-free investment). The CAPM is 
represented algebraically as follows:

Ke=Rf+B(Rm-Rf)

where:

Ke is the expected return on the regulated firm's common stock 
(i.e., its cost of common-stock equity capital;
Rf is the expected risk-free return;
B is the relevant expected market risk ``beta'' of the regulated firm's 
common stock; and
Rm is the expected overall stock market return.

    To illustrate the CAPM, assume that a hypothetical regulated 
company's expected ``beta'' is .95, the expected risk-free rate is 7 
percent, and the expected overall stock market return is 12 percent. 
The company's cost of common-stock equity capital is:

Ke=.07+.95(.12-.07)
    =.07+.0475
    =.1175 or 11.75 percent.

    i. Practical Issues. The practical application of the CAPM requires 
estimates of the expected ``beta'' of the regulated firm, the expected 
risk-free rate, and the expected return on the stock market. Each of 
these inputs is discussed in turn.
    (a) Risk-Free Rate. The yield on a 90-day Treasury Bill is 
theoretically risk-free. It is devoid of default risk and is subject to 
little interest rate risk. Treasury Bill rates vary widely, however, 
resulting in volatile and unreliable common-stock equity return 
estimates. In addition, 90-day Treasury Bill rates generally do not 
match investors' planning horizons, which typically are far in excess 
of 90 days. Short-term government obligations may also reflect the 
impact of factors (e.g., inflation) differently than long-term 
securities such as common stocks, or may reflect different factors than 
those influencing the long term securities. Long-term Treasury bonds 
(e.g., 30-year bonds) may more closely approximate investors' planning 
horizons, and their yields usually match more closely with common stock 
returns. The yields on long-term bonds are subject to substantial 
interest rate risk, however, and so are not truly risk-free. A 
compromise is to use the yields on Treasury securities of intermediate 
maturities as proxies for the risk-free rate. Accordingly, the 
Commission's proposed rule implements the CAPM using a six-month 
average of five-year Treasury Note yields.
    (b) ``Beta.'' The value of ``beta'' used in applying the CAPM 
should, in principle, be that which is expected in the future. The 
``beta'' actually used in the practical application of the model is, 
however, more commonly calculated on the basis of historical data. 
``Beta'' could be calculated by applying regression analysis, using 
historical price and dividend data for the regulated firm under 
consideration, in order to measure the variability of the return on the 
regulated firm's common stock relative to that of the market. The usual 
practice, however, is to use the ``betas'' published by an investment 
firm such as Value Line. Value Line ``betas'' are derived from a 
regression analysis between weekly percent changes in the price of a 
company's common stock and the weekly percent changes in the New York 
Stock Exchange Composite Indices over a period of five years.35 
Provided that the regulated firm's market risk is not expected to 
change appreciably in the future, ``betas'' based on historical data 
are appropriate for estimating the cost of common-stock equity. 
Therefore, the Commission's proposed rule specifies the use of Value 
Line's most current ``betas'' in implementing the CAPM.
---------------------------------------------------------------------------

    \3\5Value Line publishes adjusted ``betas.'' The adjustment 
recognizes the tendency of ``betas'' to move toward one. (The market 
index by definition has a value identically equal to one.) There are 
two justifications for making such an adjustment: (1) Empirical 
studies demonstrate that ``betas'' tend to move toward one over 
time, and (2) the average ``beta'' is known to be one, and adjusting 
an estimated ``beta'' toward one is, therefore, an appropriate use 
of existing information.
---------------------------------------------------------------------------

    (c) Market Return. The third input required by the CAPM is an 
estimate of the expected return on the stock market. One broad approach 
is to estimate the expected return on the market directly. One such 
technique is to apply a DCF analysis to a broad market index such as 
the Standard & Poor's 500. A second broad approach is the historically 
derived risk premium method, which involves two steps: (1) The 
arithmetic average difference between the actual annual returns 
realized in the past on the overall stock market and the risk-free rate 
is calculated,36 and (2) this historical differential is added to 
the currently prevailing yield on the risk-free security. The resulting 
sum is a measure of the return on the market. The rationale for this 
method is that investors anticipate that common stocks will yield a 
higher return than the return on lower risk, fixed income securities, 
and the additional return on the common stocks is expected to be 
approximately equal to what it was in the past. The Commission's 
proposed rule stipulates the use of the historically derived risk 
premium method because it is relatively easy to apply, and its data 
requirements are relatively light compared to methods designed to 
measure the expected market return directly.
---------------------------------------------------------------------------

    \3\6The arithmetic mean, not the geometric mean, should be used, 
since the quantity desired is the rate of return investors expect 
over the next year for the random annual rate of return on the 
market. The arithmetic mean is the unbiased measure of the expected 
value of repeated observations of a random variable.
---------------------------------------------------------------------------

    The historical risk differential is commonly based on the 
historical return series published annually by Ibbotson Associates in 
the Stocks, Bonds, Bills, and Inflation Yearbook (``SBBI Yearbook''). 
The SBBI Yearbook provides averages of the historical risk 
differentials relative to various government securities for the period 
1926 to the present, using Standard and Poor's 500 Index to compute the 
overall market rate of return. The Commission's proposed rule specifies 
the same source for measuring the arithmetic average risk premium 
relative to the required risk-free rate proxy (i.e., the five-year 
Treasury Note).
    The choice of a time period for measuring the historical 
differential sometimes differs, but frequently it matches the entire 
period over which Ibbotson Associates provides the data. Returns 
calculated over a substantially shorter horizon (e.g., five or ten 
years) are sometimes used to calculate the risk premium. This is not 
appropriate, however, due to the extreme volatility of the return on 
the overall stock market.37 Accordingly, the Commission's proposed 
rule stipulates that the entire length of the data series be used as 
the time horizon.
---------------------------------------------------------------------------

    \3\7In statistical terms, this extreme variability implies an 
extremely large standard deviation over any short period of time. 
Estimates of the overall market return calculated over such a short 
period of time are, therefore, unreliable.
---------------------------------------------------------------------------

    In summary, the proposed rule requires that the market return used 
in CAPM calculations be computed using a risk premium defined as the 
arithmetic average historical risk differential relative to the five-
year Treasury Note using the data published in the most current SBBI 
Yearbook for the period 1926 through the most recent date for which the 
data are available.
    c. Risk Premium Method. The RP method, alternately referred to as 
the ``risk positioning method'' or the ``stock-bond yield spread 
method,'' is based upon the premise that common-stock equity capital is 
riskier than debt from an investors' perspective and that investors, 
therefore, require a larger rate of return on investments in common 
stocks than on bonds to compensate them for bearing the extra risk. 
Common stock equity is riskier than debt because the payment of 
interest and principal to debtholders has priority over the payment of 
dividends and return of capital to common-stock equityholders. The RP 
method, therefore, estimates the cost of capital by adding an explicit 
premium for risk to a current interest rate, frequently an interest 
rate on a particular government security. The general mathematical 
expression for the RP model is as follows:

Ke=Kd+RP

where:

Ke is the regulated firm's cost of common-stock equity capital;
Kd is the incremental (i.e., current) cost of debt; and
RP is the risk premium.

    To illustrate the RP model, assume that the incremental cost of 
debt is 7 percent, and the risk premium is 5 percent. The regulated 
company's cost of common-stock equity capital is:

Ke=07+.05
    =.12 or 12 percent.

i. Practical Issues
    (a) Risk Premium. There are several procedures for estimating the 
risk premium. One common approach is to use the historical arithmetic 
average return differential between rates of return actually earned on 
investments in common-stock equities and bonds. This approach is 
expressed mathematically as follows:

Ke=Kd+Historical bond-equity spread

    The historical bond-equity spread, in turn, is often based on the 
data series published annually in the SBBI Yearbook. The portfolio of 
common stocks used as the benchmark for estimating the risk premium 
should be one that is composed of a broad array of firms and is well 
diversified, in order to minimize the potential for it to be 
contaminated by the peculiarities of a particular group of common 
stocks. The SBBI Yearbook database is based upon the Standard & Poor's 
500 Index, which meets these criteria. The range of companies in such a 
broad group as the Standard & Poor's 500 Index covers the broad 
dimensions of investor perceptions of the trade-off between risk and 
return, and serves as a benchmark for investor-required returns. The 
Commission's proposed rule stipulates the use of the historical bond-
equity spread based on the data published in the SBBI Yearbook.
    Risk premiums based on the historical differential can be extremely 
volatile and may fluctuate as macroeconomic and microeconomic 
conditions change. The time period over which the risk premium is 
selected should, therefore, be sufficiently long that short-term 
aberrations are smoothed out. Such a time period must encompass at 
least several business and interest rate cycles. The Commission's 
proposed rule requires the use of the entire data series (1926-present) 
published annually in the SBBI Yearbook in estimating the risk premium.
    (b) Debt Security. The particular debt security used to implement 
the RP model should be one which is, at least in theory, risk-free and 
embodies a premium for inflation similar in magnitude to that reflected 
in common stocks. Satisfying these criteria would isolate the spread 
component of the return and obviate the need to make any type of 
adjustment to the debt yield to account for default risk, which can 
vary over time, and obscure the long-term relationship between returns 
on common stocks and debt. These criteria are the same as those 
identified for selecting a debt security to measure the risk-free rate 
in implementing the CAPM.
    Accordingly, the Commission's proposed rule stipulates the use of 
the six-month average five-year Treasury Note yield in implementing the 
RP model, for the reasons identified for selecting this same yield as 
the risk-free rate in implementing the CAPM.
    (c) Risk Adjustment. The risk premium estimate derived from a 
composite market index is sometimes adjusted if there are differences 
in the risk of the firms represented in the common-stock equity index 
and that of the regulated firm under consideration. The CAPM (which is 
actually the company-specific form of the general RP model), for 
example, adjusts for such risk differences by multiplying the risk 
premium by ``beta,'' which serves as the measure of relative risk in 
the CAPM model. The Commission's proposed rule specifies that the RP 
model be used in its general form without making any adjustment for 
risk, because the generic form provides a useful benchmark for the 
range of companies contained in the Standard & Poor's 500 Stock Index 
on which it is based and, therefore, measures the broad dimensions of 
investor perceptions of the trade-off between risk and return. The cost 
of capital estimate produced using the RP model is not to be used as 
the estimate, but instead is to be used as a check on, and in 
combination with, the cost of capital company-specific estimates 
produced using the DCF and CAPM models.
    d. Market-to-Book Ratio Method. The MBR method is based on the 
notion that the market value of a regulated firm's common-stock equity 
should be equal to its book value (plus some allowance for 
underpricing), and will be so if the firm's allowable rate of return on 
common-stock equity capital is equal to the firm's cost of common-stock 
equity capital. The MBR approach is considered solid conceptually, but 
is criticized widely for being impractical or even impossible to 
implement. In order to apply the MBR, a regulator must be able to 
accurately predict the effect that its rate order will have on the 
common stock price of a regulated firm in attempting to maintain the 
equality between the market value and book value of the firm's common 
stock. Critics argue that regulators are unable to produce such 
accurate forecasts even when sophisticated econometric models are used. 
In addition, a regulator may influence, but cannot control completely, 
the market price of the regulated firm's stock. Even if it could, the 
exercise of such control would produce violent swings in rate levels 
which would be uneconomical to both the ratepayer and the regulated 
firm alike. Finally, diversification by the regulated firm into 
unregulated activities could result in a market price that differs from 
book value, although the earnings of the regulated segment are 
restrained.
    The severe practical problems involved with implementing the MBR 
method of computing an allowable rate of return on common-stock equity 
capital sharply reduces the utility of the approach. Accordingly, the 
Commission does not propose the MBR method of computing an allowable 
rate of return on common-stock equity capital.
    e. Comparable Earnings Method. The CE method is based upon the 
fundamental economic concept of opportunity cost. This concept states 
that the cost of using any resource (i.e., land, labor, or capital) in 
a particular activity is what that resource could have earned in its 
next best alternative use. Thus, the opportunity cost of an investment 
in a regulated firm's common stock is what the invested funds could 
have earned in their next best alternative investment (e.g., in another 
company's common stock, in a government or corporate bond, in real 
estate, in gold, etc.). In brief, the CE method infers a regulated 
company's cost of common-stock equity capital from the average 
(sometimes the adjusted average) book value rate of return on common-
stock equity of a group of firms comparable in risk to the regulated 
company.
    As already discussed above, the CE method is not thought to be well 
grounded in economic theory, primarily because the method is 
implemented using accounting data rather than market information, and 
does not accurately reflect the regulated carrier's cost of common-
stock equity capital. Accordingly, the proposed rule does not specify 
the CE method for computing the regulated firm's cost of common-stock 
equity capital.
    f. Final Cost of Common-Stock Equity Capital Estimate. Rather than 
choosing between the DCF, CAPM, and RP methods, the Commission believes 
that all three methods should be used to produce separate estimates in 
arriving at a final estimate of a regulated carrier's cost of common-
stock equity capital, in order to avoid any inappropriate judgments 
that could be embodied in any one of the individual estimates. 
Accordingly, the proposed rule states that the Commission shall 
consider the cost of common-stock equity capital estimates obtained 
using the DCF, CAPM, and RP methods in arriving at a final cost of 
common-stock equity capital estimate.
C. Other Cost of Capital Issues
    1. Comparable-Risk Companies. a. Comparable-Risk Cost of Common-
Stock Equity Capital Estimates. When a regulated firm finances assets 
with common-stock equity that does not trade publicly, it is necessary 
to use a surrogate to impute the firm's cost of common-stock equity 
capital. The cost must be imputed because the regulated firm's equity 
position is not explicitly recognized in the capital market and, 
consequently, the necessary data for directly estimating the regulated 
firm's cost of common-stock equity do not exist. This occurs when: (1) 
The regulated firm is an independent company (i.e., one which has no 
corporate parent) which issues no publicly traded common-stock equity, 
or (2) the regulated firm is a subsidiary of a parent company, and the 
subsidiary issues no publicly traded common stock of its own.
    In the case of the independent regulated company which issues no 
publicly-traded common stock, the cost of common-stock equity capital 
must be imputed from a sample of firms having risk similar to that of 
the regulated company. Once an appropriate sample is selected, the cost 
of common-stock equity capital is calculated using the methods 
described earlier (i.e., DCF, CAPM, and RP) to produce a range of 
estimates for the independent regulated company. In the case of the 
regulated subsidiary, as discussed above, it may be appropriate to use 
the consolidated system's capital structure and component costs to 
estimate the subsidiary's WACC. If so, the consolidated system's cost 
of common-stock equity is obtained by applying the DCF, CAPM, and RP 
methods directly to the parent company, provided that the parent issues 
publicly-traded common-stock equity so that the stock market price data 
required for such an application exist. Otherwise, the regulated 
subsidiary's capital structure and component costs are used, and it is 
necessary to impute the subsidiary's cost of common-stock equity from a 
sample of firms having risk similar to that of the subsidiary.
    b. Selecting a Proxy Group. The proxy group must be composed of 
companies whose business and financial risks are substantially 
comparable to the risk of the regulated firm. Since no two companies 
are identical in risk characteristics, and because a company's risk 
profile may not be perfectly stable over time, at least several 
companies must be chosen to maximize the reliability of the estimated 
cost of common-stock equity capital computed for the regulated company.
    The criteria for selecting the proxy companies should evaluate the 
comparability of each company's business risk and financial risk with 
those of the regulated firm. Comparability with regard to business risk 
is most readily and directly accomplished by selecting companies in the 
same line of business as the regulated firm. The comparability of 
financial risk can be established by analyzing various financial 
statistics and investment quality ratings which are commonly used as 
measures of risk by investors. The Commission's proposed rule sets 
forth a set of risk criteria for selecting proxy companies.
    The proposed rule further directs carriers that must rely on proxy 
companies to impute their cost of common-stock equity capital to use 
the prescribed risk criteria in selecting proxy companies, and to 
annually submit their selection of proxy companies along with their 
annually filed statement of financial and operating data, as required 
in Sec. 552.2. After notice and opportunity for comment, the Commission 
shall annually designate the respective proxy group of companies for 
each applicable carrier in accordance with its prescribed risk 
criteria. The sequence of steps for selecting the proxy companies and 
the prescribed risk criteria are discussed in detail below.
i. Risk Criteria
    (a) Step 1: U.S. Companies Listed in Value Line. The Commission's 
proposed rule stipulates that the proxy companies must be U.S.-based, 
and must be those for which The Value Line Investment Survey (``Value 
Line'') provides financial data. The proxy companies are to be based in 
the U.S. so as to maintain consistent accounting and tax requirements. 
Value Line contains financial information on 1,700 companies that 
publicly issue common stock for over 95 industries, including the 
transportation sector. The use of Value Line as a resource for 
selecting proxy companies is particularly suitable since it contains 
the requisite historical and projected financial data for estimating 
the cost of common-stock equity.
    (b) Step 2: Companies that Operate as Common Carriers. Consistent 
with the concept of selecting firms of comparable business risk, the 
proxy companies should be those which are in the same line of business 
as the regulated firm. The proxy companies should operate and derive a 
major portion of their gross revenues primarily as common carriers in 
the business of freight transportation. The proxy group, for example, 
could be comprised of common carriers that transport freight by air, 
truck, water, and/or rail. The companies should also own or operate 
transportation vehicles or vessels. Excluded from this group are 
companies with gross revenues equal to or less than the $25,000,000 
waiver level for vessel operating common carriers in the domestic 
offshore trades, as described in 46 CFR Sec. 552.2(e).
    (c) Step 3: Financial Analysis of Comparable Risk. The proposed 
rule further states that the Commission may also consider a company's 
financial strength in evaluating the degree of financial risk faced by 
each of the selected companies. This may include an examination of 
some, but not necessarily all, of the factors listed below.
    (i) Total Capitalization Ratios and/or Debt/Equity Ratios. Total 
capitalization ratios and debt/equity ratios measure the proportional 
mix of financing in a company's capital structure. They are useful 
measures of financial risk because they indicate the extent of leverage 
or fixed-cost financing in a company (i.e., the degree to which the 
company's assets are financed by long-term debt and/or preferred 
stock). A low percentage of fixed-cost financing generally denotes a 
low level of financial risk.
    (ii) Debt Ratings. Investment analysis services, such as Standard & 
Poor's and Moody's, provide investment quality ratings of companies' 
long-term debt instruments. These include ratings on corporate bonds 
and commercial paper. The ratings reflect a company's risk of default 
on debt obligations and the possible risk of bankruptcy. The primary 
basis of the debt ratings is interest coverage. This represents the 
number of times a company's earnings are greater than its fixed 
contractual charges or interest costs.
    (iii) Stock Safety Rankings. Both Value Line and Standard & Poor's 
provide common-stock equity rankings for each company listed in their 
respective publications. While the basis of their ranking systems 
differ, they both measure the degree of risk associated with each 
company's common-stock equity. Value Line bases its ranking system on 
the stability of the common stock's price adjusted for trends, as 
measured by the standard deviation of weekly percent changes in the 
stock's market prices over a five-year period, and partially on the 
subjective analysis of its financial experts. Value Line's safety scale 
ranges from 1, the highest, to 5.
    (iv) Financial Strength Ratings. Value Line rates the financial 
strength of each of the 1,700 companies listed in its publication 
relative to all the others. The ratings are based on key variables that 
determine financial leverage, business risk, and company size. The 
ratings range from A++, the highest, to C.
    (v) Standard Deviation. The standard deviation is a common 
statistical measure which can be used to determine the variability of a 
company's common-stock price changes, or returns on common-stock 
equity. A high standard deviation indicates a high variability in the 
range of price changes or returns relative to the average price change 
or return. Thus, a high standard deviation implies a greater degree of 
risk associated with a particular company's common stock. Value Line 
provides a price stability index which ranks the standard deviation of 
the weekly percentage changes in the market price of each company's 
common stock over a five-year period.
    (vi) The Beta Coefficient. Beta is a regression coefficient that 
measures the volatility of a company's common-stock price changes, or 
returns on common-stock equity, relative to the stock market as a 
whole. Where beta for the stock market equals one, common stocks with 
beta values of less than one are said to be less risky than the market, 
while stocks with beta values greater than one are said to be riskier 
than the market. Value Line and Standard & Poor's provide the beta 
values associated with the common stock of each company listed in their 
respective publications.
    The Commission may also consider other information commonly 
accepted by investors as measures of risk in a company. In this regard, 
commenters may wish to address whether an accurate measure of 
comparable risk should include some consideration of the regulated 
firm's status as a subsidiary of a larger organization and, if so, 
whether the criteria for inclusion in the proxy group should include 
position in a larger corporate structure.
    2. The Before-Tax Weighted Average Cost of Capital. The WACC was 
defined above as the composite of the cost of the various classes of 
capital used by the regulated firm weighted on the basis of the 
proportions of the total which each class represents. Corporate taxes 
were excluded. In reality, a regulated firm typically does pay taxes, 
and the WACC must be adjusted accordingly in arriving at a final 
allowable rate of return. The use of the WACC to determine an allowable 
rate of return without making such an adjustment would result in an 
understatement of the total cost of servicing capital to ratepayers. 
Assuming a 40 percent corporate income tax rate, for example, a company 
requires only $1.00 of revenue to provide a $1.00 return to bondholders 
because interest payments are tax deductible for corporate income tax 
purposes. The same company requires $1.67 of revenue, however, to 
provide a $1.00 return to preferred stock and common-stock equity 
shareholders because the firm must pay corporate income taxes, and 
dividend payments to such shareholders are not tax deductible.
    The following before-tax expression of the WACC (``BTWACC'') 
recognizes explicitly the existence of income taxes and is, therefore, 
the appropriate formula to use in computing an allowable rate of 
return:


TP07AP94.012

where:

Kd is the regulated firm's cost of long-term debt capital;
Kp is the regulated firm's cost of preferred stock capital;
Ke is the regulated firm's cost of common-stock equity capital;
D is the value of the regulated firm's long-term debt outstanding;
P is the value of the regulated firm's preferred stock outstanding;
E is the value of the regulated firm's common-stock equity outstanding; 
and
T is the corporate income tax rate.

    To illustrate the calculation of the BTWACC, consider a 
hypothetical regulated company that has total invested capital of $100 
million, consisting of $25 million of long-term debt, $15 million of 
preferred stock, and $60 million of common-stock equity. Assume that 
the firm's cost of long-term debt is 7 percent, cost of preferred stock 
is 9 percent and cost of common-stock equity is 12 percent, and that 
the corporate income tax rate is 40 percent. The BTWACC for this firm 
is calculated as follows: 

                                             Calculation of BTWACC                                              
----------------------------------------------------------------------------------------------------------------
                                       Amount                                                                   
                                     (millions    Proportion      Cost         WACC      Tax factor             
        Capital component           of dollars)   (percent)    (percent)    (percent)     (1/1-T)       BTWACC  
                                                                                                                
----------------------------------------------------------------------------------------------------------------
Long-term debt....................           25           25            7         1.75         1.00         1.75
Preferred stock...................           15           15            9         1.35         1.67         2.25
Common-stock equity...............           60           60           12         7.20         1.67        12.02
                                   -----------------------------------------------------------------------------
      Total.......................          100          100  ...........        10.30  ...........       16.02 
----------------------------------------------------------------------------------------------------------------

    The allowable rate of return for this hypothetical company should, 
therefore, be set at 16.02 percent, which would provide the firm with 
the opportunity to earn revenues sufficient to service the total cost 
of capital and taxes.
    The Commission's proposed rule specifies that the allowable rate of 
return on rate base for a regulated carrier in the domestic offshore 
trades shall be set equal to the carrier's WACC calculated on a before-
tax basis. The proposed rule also stipulates the use of the regulated 
carrier's normalized corporate income tax rate (i.e., the statutory 
corporate income tax rate, not the actual or effective corporate income 
tax rate) in computing the BTWACC. This is consistent with the approach 
the Commission uses currently in calculating the rate of return on rate 
base. Furthermore, the large majority of regulatory commissions in the 
U.S. use the normalized income tax rate for ratemaking and accounting 
purposes.38
---------------------------------------------------------------------------

    \3\8See NARUC, ``Table 40--Accounting Treatment Of Tax 
Reductions--All Utilities,'' supra note 4, at 95-96.
---------------------------------------------------------------------------

    3. Flotation Costs. Three factors could theoretically result in a 
firm receiving as net proceeds from the issuance of common stock an 
amount less than the pre-announcement common stock price: (1) The cost 
of floating new issues (e.g., the fee paid to the underwriter) and 
other administrative expenses (e.g., printing, legal, and accounting 
expenses); (2) the downward market pressure resulting from the 
increased supply of the common stock (i.e., the ``market pressure'' 
effect); and (3) the potential market price decline related to external 
market variables (i.e., the ``market break'' effect).
    The Commission's proposed rule specifies that an allowance for the 
cost of common-stock equity capital financing be made for those 
flotation costs that are actually incurred (i.e., those that are 
identifiable and directly attributable to underwriting, printing, 
legal, and accounting expenses), but only in the event that the 
regulated carrier under consideration plans on issuing new common stock 
to the general public during the test year in question.
    No allowance would be made for any hypothetical costs such as those 
associated with market pressure and market break effects. The proposed 
rule also specifies that the allowance is to be applied solely to the 
new common-stock equity and not to the existing common-stock equity 
balance.39 The regulated carrier would be required to supply the 
requisite information for computing the allowance.
---------------------------------------------------------------------------

    \3\9The appropriate formula for computing such as allowance is 
as follows:

    k=Fs/(1+s)

    where:

    k is the required increment to the cost of the regulated firm's 
common-stock equity capital that will allow the company to recover 
its flotation costs;
    F is the flotation costs expressed as a decimal fraction of the 
dollar value of new common-stock equity sales; and
    s is the new common-stock equity sales expressed as a decimal 
fraction of the dollar value of existing common equity.
---------------------------------------------------------------------------

Deferred Taxes and The Capital Construction Fund

    Under its current rules, the Commission does not address the issue 
of deferred taxes for calculating rate base. The Commission proposes to 
amend its rules to provide for the treatment of deferred taxes, 
including the Capital Construction Fund (``Fund'').
    The Fund is comprised of three components: (1) The capital account, 
which results from contributions, (2) capital gains on investment 
transactions, and (3) ordinary income, representing the earnings of 
Fund assets. Section 607 of the Merchant Marine Act, 1936, 46 U.S.C. 
app. Sec. 1177, which governs the Fund, provides for different tax 
treatment for withdrawals from the various components of the Fund. 
Section 607 requires that the basis of vessels, barges or containers 
purchased with monies from the Fund be reduced by the amount of funds 
withdrawn from the ordinary income and capital gains components of the 
Fund. The proposed rule takes a similar approach, and would require 
carriers to reduce the cost of an asset as shown in rate base by the 
amount of funds withdrawn from the ordinary income and capital gains 
components of the Fund which are used in acquiring the asset.
    A certain portion of a carrier's physical capital (rate base) is 
financed by deferred taxes. Unlike the debt, preferred stock, and 
common-stock equity components of financial capital, deferred taxes 
cost the carrier nothing. Deferred taxes are in the nature of an 
interest-free loan from the government. Given that these funds are 
obtained at zero cost, we believe that the carrier should not be 
allowed a return on that portion of rate base which results from 
deferred taxes, except on that portion that results from deferred taxes 
that may arise from the Fund or the expired Investment Tax Credit, and 
that rate base be reduced accordingly.
    This treatment comports with the treatment of deferred taxes by 
other federal agencies, as well as a majority of state regulatory 
agencies.40 When it is necessary to allocate such accumulated 
deferred taxes between Commission and non-Commission regulated 
activities, such allocation shall be on the ratio of vessels and other 
property and equipment included in rate base, less accumulated 
depreciation, to total company vessels and other property and 
equipment, less accumulated depreciation.
---------------------------------------------------------------------------

    \4\0See NARUC, ``Table 39--Treatment Of Accumulated Deferred 
Income Taxes In Rate Base--All Utilities,'' supra note 4, at 93-94.
---------------------------------------------------------------------------

Working Capital

    The inclusion of working capital in rate base is intended to 
recognize the necessity for the carrier to maintain an adequate supply 
of cash for the purpose of meeting expenditure requirements during the 
period between the payment of expenses and the collection of revenue. 
Average voyage expense is used as the measure of working capital for a 
self-propelled vessel operator under the Commission's existing rule.
    With regard to the treatment of insurance expense in the 
computation of average voyage expense, the Commission's current 
regulations provide for the inclusion of 90 days' hull and machinery 
insurance and protection and indemnity insurance. Hawaii suggests that 
insurance expense be treated in the same manner as other operating 
expenses, i.e., include that amount applicable to the duration of an 
average voyage. The proposed rule adopts that approach.

Allocation of Assets and Expenses

    In 1980, the Commission amended its rules governing the allocation 
of assets and expenses. As a result of these changes, cargo cube or 
space occupied replaced weight or revenue ton as the basis for 
allocations. The rationale for this decision was that in a 
containership operation, the cost of providing service is the cost of 
providing space. The Commission concluded that the carrier's cost per 
container remains the same regardless of the amount of cargo in the 
container or revenue generated by the container.
    Accordingly, part 552 currently prescribes that vessels, 
accumulated depreciation and vessel expense shall be allocated on the 
cargo-cube-mile relationship as defined in 46 CFR 552.5(n), while those 
expenses related to cargo handling are allocated on the basis of cargo 
cube loaded and discharged. Other property and equipment, and 
administrative and general expenses are required to be allocated on the 
voyage expense relationship, as defined in 46 CFR 552.5(p).
    Commenters in Docket No. 91-51 suggested several alternative 
allocation methods, including a method based on cargo carried on the 
outbound portion of the voyage or based on revenue generated by 
Commission and non-Commission regulated cargo. These proposals stemmed 
from the bifurcation of regulatory authority in the domestic offshore 
trades between the Commission and the Interstate Commerce Commission. 
However, that split in jurisdiction has no direct connection with the 
costs a carrier incurs in providing service. The Commission shall not 
attempt to contrive an allocation methodology as a solution to an issue 
that can best be remedied by legislative action.
    The Federal Maritime Commission certifies pursuant to section 
605(b) of the Regulatory Flexibility Act, 5 U.S.C. 605(n), that this 
rule will not have a significant economic impact on a substantial 
number of small entities, including small businesses, small 
organizational units and small government jurisdictions. The Commission 
grants a waiver of the detailed reporting requirements to carriers 
which earn gross revenues of $25 million or less in a particular trade 
in accordance with 46 CFR 552.2(e).
    The collection of information requirements contained in this 
proposed rule have been submitted to the Office of Management and 
Budget for review under the provisions of the Paperwork Reduction Act 
of 1980 (Pub. L. 96-511), as amended. The incremental public reporting 
burden for this collection of information is estimated to range from an 
average of 41 hours to 65 hours per response, including the time for 
reviewing instructions, searching existing data sources, gathering and 
maintaining the data needed, and completing and reviewing the 
collection of information. Send comments regarding this burden 
estimate, including suggestions for reducing this burden, to Sandra L. 
Kusumoto, Director, Bureau of Administration, Federal Maritime 
Commission, Washington, DC 20573 and to the Office of Information and 
Regulatory Affairs, Office of Management and Budget, Washington, DC 
20503.

List of Subjects in 46 CFR Part 552

    Maritime carriers, Reporting and recordkeeping requirements, 
Uniform system of accounts.

    Therefore, pursuant to 5 U.S.C. 553, sections 18 and 43 of the 
Shipping Act, 1916, 46 U.S.C. app. 817 and 841a, and sections 2 and 3 
of the Intercoastal Shipping Act, 1933, 46 U.S.C. app. 844 and 845, 
Part 552 of Title 46, Code of Federal Regulations, is proposed to be 
amended as follows:

PART 552--FINANCIAL REPORTS OF VESSEL OPERATING COMMON CARRIERS BY 
WATER IN THE DOMESTIC OFFSHORE TRADES

    1. The authority citation for part 552 continues to read as 
follows:

    Authority: 5 U.S.C. 553; 46 U.S.C. app. 817(a), 820, 841a, 843, 
844, 845, 845a and 847.

    2. In Sec. 552.1, paragraph (b) is revised to read as follows and 
paragraph (d) is removed:


Sec. 552.1  Purpose.

* * * * *
    (b) In evaluating the reasonableness of a VOCC's overall level of 
rates, the Commission will use return on rate base as its primary 
standard. A carrier's allowable rate of return on rate base will be set 
equal to its before-tax weighted average cost of capital. However, the 
Commission may also employ the other financial methodologies set forth 
in Sec. 552.6(f) in order to achieve a fair and reasonable result.
* * * * *
    3. In Sec. 552.2, paragraph (a) is amended by revising the filing 
address contained therein, paragraph (b) is redesignated as paragraph 
(b)(1) and revised, a new paragraph (b)(2) is added, paragraph 
(f)(1)(iv) is amended by removing ``and,'' from the end thereof, 
paragraph (f)(1)(v) is amended by changing the period at the end 
thereof to a semicolon and adding ``and,'' to the end of the paragraph, 
and a new paragraph (f)(1)(vi) is added reading as follows:


Sec. 552.2  General requirements.

    (a) * * *

Federal Maritime Commission, Bureau of Tariffs, Certification and 
Licensing, 800 North Capitol Street, NW., Washington, DC 20573-0001

    (b)(1) Annual statements under this part shall consist of Exhibits 
A, B, and C, as described in Sec. 552.6, and shall be filed within 150 
days after the close of the carrier's fiscal year and be accompanied by 
a company-wide balance sheet and income statement having a time period 
coinciding with that of the annual statements. A specific format is not 
prescribed for the company-wide statements.
    (2) Concurrently with the filing of the carrier's annual financial 
statements required under this section, a carrier that issues no 
publicly traded common-stock equity must submit for Commission approval 
annually:
    (i) A proxy group of companies to impute the carrier's cost of 
common-stock equity capital in accordance with the requirements set 
forth in Sec. 552.6(e)(3); or
    (ii) An application to use a consolidated capital structure in 
accordance with the requirements set forth in Sec. 552.6(e)(4).
* * * * *
    (f) * * *
    (1) * * *
    (vi) Projected schedules for capitalization amounts and ratios 
(Schedule F-I); cost of long-term debt capital calculation (Schedules 
F-II and F-III); cost of preferred (and preference) stock capital 
calculation (Schedules F-IV and F-V); corporate income tax rate 
(Schedule F-VI); and flotation costs (Schedule F-VII) for the 12-month 
period used to compute projected midyear rate base in paragraph 
(f)(1)(ii) of this section.
* * * * *
    4. In Sec. 552.5, paragraphs (b) and (c) are revised, and 
paragraphs (v), (w), (x), (y), (z), (aa), and (bb) are added to read as 
follows:


Sec. 552.5  Definitions.

* * * * *
    (b) The service means those voyages and/or terminal facilities in 
which cargo subject to the Commission's regulation under 46 CFR 
514.1(c)(2) is either carried or handled.
    (c) The trade means that part of the Service subject to the 
Commission's regulation under 46 CFR 514.1(c)(2), more extensively 
defined in this section under Domestic Offshore Trade.
* * * * *
    (v) Book value means the value at which an asset is carried on a 
balance sheet.
    (w) Capital structure means a company's financial framework, which 
is composed of long-term debt, preferred (and preference) stock, and 
common-stock equity capital (par value plus earned and capital 
surplus).
    (x) Capitalization ratio means the percentage of a company's 
capital structure that is long-term debt, preferred (and preference) 
stock, and common stock-equity capital.
    (y) Consolidated system means a parent company and all of its 
subsidiaries.
    (z) Subsidiary company means a company of which more than 50 
percent of the voting shares of stock are owned by another corporation, 
called the parent company.
    (aa) Long-term debt means a liability due in a year or more.
    (bb) Times-interest-earned ratio means the measure of the extent to 
which operating income can decline before a firm is unable to meet its 
annual interest costs. It is computed by dividing a firm's earnings 
before interest and taxes by the firm's annual interest expense.
    5. In Sec. 552.6, paragraph (a)(1), the first sentence of paragraph 
(a)(2), the introductory text of paragraph (b)(1), paragraphs (b)(4)(i) 
and (b)(5), and the heading of paragraph (b)(9) are revised; paragraph 
(b)(10) is added; paragraphs (c)(5) and (c)(10) are revised; paragraphs 
(d)(1) and (d)(2) are revised; paragraphs (e) and (f) are redesignated 
(g) and (h); a new paragraph (e) is added and paragraphs (d)(3) and 
(d)(4) are redesignated (f)(1) and (f)(2) and the paragraph headings 
thereof revised reading as follows:


Sec. 552.6  Forms.

    (a) General. (1) The submission required by this part shall be 
submitted in the prescribed format and shall include General 
Information regarding the carrier, as well as the following schedules 
as applicable:

Exhibit A--Rate Base and supporting schedules;
Exhibit B--Income Account and supporting schedules;
Exhibit C--Rate of Return and supporting schedules;
Exhibit D--Application for Waiver;
Exhibit E--Initial Tariff Filing Supporting Data; and
Exhibit F--Allowable Rate of Return schedules.

    (2) Statements containing the required exhibits and schedules are 
described in paragraphs (b), (c), (d), (e), (g), and (h) of this 
section and are available upon request from the Commission. * * *
    (b) Rate base (Exhibits A and A(A))-(1) Investment in Vessels 
(Schedules A-I and A-I(A)). Each cargo vessel (excluding vessels 
chartered under leases which are not capitalized in accordance with 
Sec. 552.6(b)(10)) employed in the Service for which a statement is 
filed shall be listed by name, showing the original cost to the carrier 
or to any related company, reduced to reflect the use of funds from the 
Capital Construction Fund's capital gains account or ordinary income 
account, plus the cost of improvements, conversions, and alterations, 
reduced to reflect the use of funds from the Capital Construction 
Fund's capital gains account or ordinary income account, less the cost 
of any deductions. All additions and deductions made during the period 
shall be shown on a pro rata basis, reflecting the number of days they 
were applicable during the period. The result of these computations 
shall be called the Adjusted Cost.
* * * * *
    (4) Investment in other property and equipment; accumulated 
depreciation other property and equipment (Schedule A-IV and A-IV(A)). 
(i) Actual investment, representing original cost to the carrier or to 
any related company, reduced to reflect the use of funds from the 
Capital Construction Fund's capital gains account or ordinary income 
account, in other fixed assets employed in the Service, shall be 
reported as of the beginning of the year. Accumulated depreciation for 
these assets shall be reported both as of the beginning and as of the 
end of the year. The arithmetic average of the two amounts shall also 
be shown and shall be the amount deducted from original cost in 
determining rate base. The cost of additions and deductions during the 
period, adjusted to reflect the use of the Capital Construction Fund, 
shall also be reported. The carrier shall report as though all such 
changes took place at midyear, except those involving substantial sums, 
which shall be prorated on a daily basis. Allocation to the Trade shall 
be based upon the actual use of the specific asset or group of assets 
within the Trade. For those assets employed in a general capacity, such 
as office furniture and fixtures, the voyage expense relationship shall 
be employed for allocation purposes. The basis of allocation to the 
Trade shall be set forth and fully explained.
    (ii) * * *
    (5) Working Capital (Schedule A-V). Working capital for vessel 
operators shall be determined as average voyage expense. Average voyage 
expense shall be calculated on the basis of the actual expenses of 
operating and maintaining the vessel(s) employed in the Service 
(excluding lay-up expenses) during the average length of time of all 
voyages (excluding lay-up periods) during the period in which any cargo 
was carried in the Trade. Expenses for operating and maintaining 
vessels employed in the Trade shall include: Vessel Operating Expense, 
Vessel Port Call Expense, Cargo Handling Expense, Administrative and 
General Expense and Interest Expense allocated to the Trade as provided 
in paragraphs (c) (2), (4) and (5) of this section.
* * * * *
    (9) Capitalization of leases (Schedules A-VII and A-VII(A)). * * *
     (10) Accumulated Deferred Taxes (Schedules A-VIII and A-VIII(A)). 
Accumulated deferred taxes, excluding deferred taxes that may arise 
from the Capital Construction Fund or the expired Investment Tax 
Credit, shall be reported both as of the beginning and the end of the 
year and the arithmetic average of the two amounts shall be shown. 
Allocation to the Trade shall be based upon the ratio of Trade 
Investment in Vessels (Schedules A-I and A-I(A)) less Accumulated 
Depreciation (Schedules A-II and A-II(A)) plus Other Property and 
Equipment less Accumulated Depreciation (Schedules A-IV and A-IV(A)) to 
total company investment in vessels and other property and equipment 
less accumulated depreciation.
    (c) * * *
* * * * *
    (5) Interest expense and debt payments (Schedules B-IV and B-
IV(A)). This schedule shall set forth the total interest and debt 
payments, apportioned between principal and interest, short and long-
term, on debt and lease obligations. Payments on long-term debt are to 
be calculated consistent with the method set forth in Sec. 552.6(e)(7) 
for computing the cost of long-term debt capital. Principal and 
interest shall be allocated to the Trade in the ratio that Trade rate 
base less working capital bears to company-wide assets less current 
assets. Where related company assets are employed by the filing 
company, the balance sheet figures on the related company's books for 
such assets shall be added to the company-wide total in computing the 
ratio. In those instances where interest expenses are capitalized in 
accordance with paragraph (b)(9) of this section, a deduction shall be 
made for the amount so capitalized.
* * * * *
    (10) Provision for income tax. Federal, State, and other income 
taxes shall be listed separately. If the company is organized outside 
the United States, it shall indicate the entity to which it pays income 
taxes and the rate of tax applicable to its taxable income for the 
subject year. Federal, State and other income taxes shall be calculated 
at the statutory rate. Such tax rates are to be identical to those set 
forth in Schedules F-VI or F-VI(A) used in determining the carrier's 
allowable rate of return unless the carrier is a subsidiary of a parent 
company and a consolidated capital structure is to be used in that 
determination.
* * * * *
    (d) Rate of Return (Exhibits C and C(A))--(1) General. All carriers 
are required to calculate rate of return on rate base. However, the 
Commission or individual carriers, at the Commission's discretion, may 
also employ fixed charges coverage and/or operating ratios as provided 
for in paragraph (f) of this section.
    (2) Return on rate base. The return on rate base will be computed 
by dividing Trade net income plus interest expense by Trade rate base.
    (e) Maximum allowable rate of return on rate base (Exhibits F and 
F(A))--(1) General. A carrier's maximum allowable rate of return on 
rate base shall be set equal to the carrier's weighted average cost of 
capital calculated on a before-tax basis (``BTWACC''). The BTWACC is 
defined mathematically by the following expression:


TP07AP94.013

where:

Kd is the carrier's cost of long-term debt capital;
Kp is the carrier's cost of preferred (and preference) stock 
capital;
Ke is the carrier's cost of common-stock equity capital;
D is the average book value of the carrier's long-term debt capital 
outstanding;
P is the average book value of the carrier's preferred (and preference) 
stock capital outstanding;
E is the average book value of the carrier's common-stock equity 
capital (par value plus earned and capital surplus) outstanding; and
T is the carrier's composite statutory corporate income tax rate.

    A carrier's BTWACC shall be calculated in precise accordance with 
the rules set forth in this section.
    (2) Subsidiary carrier's capital structure. Where a carrier is a 
subsidiary that obtains its common-stock equity capital through a 
parent company, the capital structure of the subsidiary shall be used 
in computing the BTWACC. The subsidiary carrier's cost of common-stock 
equity capital, the subsidiary carrier's cost of long-term debt 
capital, the subsidiary carrier's cost of preferred stock capital, and 
the subsidiary carrier's composite statutory corporate income tax rate 
shall also be used in computing the BTWACC. The subsidiary carrier's 
cost of common-stock equity capital shall be inferred as the cost of 
common-stock equity capital estimated for a sample of firms having 
business and financial risk comparable to the subsidiary carrier when 
the subsidiary carrier's capital structure is used in calculating the 
BTWACC.
    (3) Comparable risk companies. (i) Concurrently with the filing of 
the annual financial statements required under Sec. 552.2, a carrier 
must submit for Commission approval a proxy group of companies to 
impute the carrier's cost of common-stock equity capital where:
    (A) The carrier is an independent company (i.e., it has no 
corporate parent) which issues no publicly-traded common-stock equity, 
or
    (B) The carrier is a subsidiary that obtains its common-stock 
equity capital through a parent company.
    (ii) After notice and opportunity for comment, the Commission will 
approve a proxy group of companies based on the following criteria:
    (A) The proxy companies shall be based in the United States and 
shall be listed in The Value Line Investment Survey.
    (B) The proxy companies shall operate and derive a major portion of 
their gross revenues primarily as common carriers in the business of 
freight transportation, and shall own or operate transportation 
vehicles or vessels. Companies with gross annual revenues equal to or 
less than the $25,000,000 shall be excluded from the proxy group.
    (C) In addition, comparable risk companies shall be selected by 
examining some, but not necessarily all, of the following risk 
indicators:
    (1) A company's total capitalization ratio and/or debt-to-equity 
ratio;
    (2) The investment quality ratings of a company's long-term debt 
instruments;
    (3) The investment safety ranking of a company's common-stock 
equity;
    (4) The rating of a company's financial strength, as provided by 
Value Line;
    (5) The variability of a company's common-stock price changes or 
returns on common-stock equity (i.e., the standard deviation);
    (6) The volatility of a company's common-stock price changes or 
returns on common-stock equity relative to the stock market as a whole 
(i.e., the beta coefficient); or
    (7) Other such valid indicators deemed appropriate by the 
Commission.
    (iii) Any proxy group of companies that has received Commission 
approval will not be subject to challenge in a subsequent rate 
investigation brought under section (3) of the Intercoastal Act, 1933.
    (4) Consolidated capital structure. (i) Upon application, after 
notice and opportunity for comment, the Commission may authorize use of 
the capital structure of the consolidated system (i.e., the parent 
company and all of its subsidiaries) in computing the BTWACC. The 
application must show that:
    (A) The subsidiary carrier's parent company issues publicly traded 
common-stock equity;
    (B) The subsidiary carrier's parent company owns 90 percent or more 
of the subsidiary's voting shares of stock; and
    (C) The business and the financial risks of the subsidiary carrier 
and the parent company are similar.
    (ii) The similarity of the parent company's and subsidiary 
carrier's business risk shall be evaluated by examining the degree to 
which the consolidated system's profits, revenues, and expenses are 
composed of those of the subsidiary carrier, and the extent to which 
the parent's holdings are diversified into lines of business unrelated 
to those of the subsidiary carrier, and/or other indicators of business 
risk deemed appropriate by the Commission. The similarity of the parent 
company's and subsidiary carrier's financial risk shall be evaluated by 
examining the consolidated system's and the subsidiary's total 
capitalization ratios, debt-to-equity ratios, investment quality 
rankings on short- and long-term debt instruments, times-interest-
earned ratios, fixed charges coverage ratios (calculated to include 
both FMC and non-FMC regulated operations), and/or other measures of 
financial risk deemed appropriate by the Commission.
    (iii) When the consolidated capital structure is used, the 
consolidated system's cost of common-stock equity capital (issued by 
the parent company), the consolidated system's cost of long-term debt 
capital, the consolidated system's cost of preferred (and preference) 
stock capital, and the consolidated system's composite statutory 
corporate income tax rate shall also be used in estimating the 
subsidiary's BTWACC.
    (iv) Where the Commission has approved the use of a consolidated 
capital structure, such use will not be subject to challenge in a 
subsequent rate investigation brought under section (3) of the 
Intercoastal Act, 1933.
    (5) Book-value, average capitalization ratios. Capitalization 
ratios representing the capital structure used in deriving a carrier's 
BTWACC shall be computed on the basis of average projected book value 
outstanding over the 12-month period used to calculate projected 
midyear rate base in Sec. 552.2 (f)(1)(ii). The average amount of any 
class of capital outstanding used in determining the capitalization 
ratios is computed by adding the amount of a particular type of capital 
expected to be outstanding as of the beginning of the 12-month period 
to the amount of that same type of capital expected to be outstanding 
as of the end of the 12-month period, and dividing the sum of the two 
amounts outstanding by two.
    (6) Capitalization amounts and ratios (Schedules F-I and F-I(A)). A 
carrier shall show its long-term debt, preferred stock, and common-
stock equity capitalization amounts outstanding, stated in book value 
terms, as of the beginning and as of the end of the 12-month period 
used to calculate projected midyear rate base, and the average amounts 
and average ratios for that 12-month period. Where a carrier is a 
subsidiary of a parent company, the carrier shall show its own 
capitalization amounts and ratios unless the carrier applies for and 
receives permission from the Commission to use a consolidated capital 
structure in computing the BTWACC. Where such permission is granted, 
the carrier shall show instead the consolidated system's capitalization 
amounts and ratios.
    (7) Cost of long-term debt capital (Schedules F-II, F-II(A), F-III, 
and F-III(A)). (i) The cost of long-term debt capital1 shall be 
calculated by the carrier for the 12-month period used to compute 
projected mid-year rate base on the basis of:
---------------------------------------------------------------------------

    \1\The cost of sinking fund preferred stock shall be computed in 
accordance with the regulations in this section for calculating the 
cost of long-term debt.
---------------------------------------------------------------------------

    (A) Embedded cost for existing long-term debt; and
    (B) Current cost for any new long-term debt expected to be issued 
on or before the final day of the 12-month period.
    (ii) The arithmetic average annual percentage rate cost of long-
term debt capital calculated on the basis of all issues of long-term 
debt expected to be outstanding as of the beginning and as of the end 
of the 12-month period used to compute projected mid-year rate base 
shall be the cost of long-term debt capital used in computing the 
BTWACC.
    (iii) The annual percentage rate cost of long-term debt capital for 
all issues of long-term debt expected to be outstanding as of the 
beginning and as of the end of the 12-month period used to compute 
projected mid-year rate base shall be calculated separately for the two 
dates by:
    (A) Multiplying the cost of money for each issue under paragraph 
(e)(7)(v)(A)(10) of this section by the principal amount outstanding 
for each issue, which yields the annual dollar cost for each issue; and
    (B) Adding the annual dollar cost of each issue to obtain the total 
dollar cost for all issues, which is divided by the total principal 
amount outstanding for all issues to obtain the annual percentage rate 
cost of long-term debt capital for all issues.
    (iv) The arithmetic average annual percentage rate cost of long-
term debt capital for all issues to be used as the cost of long-term 
debt capital in computing the BTWACC shall be calculated by:
    (A) Adding the total annual dollar cost for all issues of long-term 
debt capital expected to be outstanding as of the beginning of the 12-
month period used to compute projected mid-year rate base to the total 
annual dollar cost for all issues of long-term debt capital expected to 
be outstanding as of the end of the 12-month period, and dividing the 
resulting sum by two, which yields the average total annual dollar cost 
of long-term debt for all issues for the 12-month period;
    (B) Adding the total principal amount outstanding for all long-term 
debt issues expected to be outstanding as of the beginning of the 12-
month period used to compute projected mid-year rate base to the total 
principal amount outstanding for all long-term debt issues expected to 
be outstanding as of the end of the 12-month period, and dividing the 
resulting sum by two, which yields the average total principal amount 
expected to be outstanding for all issues for the 12-month period; and
    (C) Dividing the average total annual dollar cost of long term debt 
for all issues for the 12-month period by the average total principal 
amount expected to be outstanding for all issues for the 12-month 
period, which yields the average annual percentage rate cost of long-
term debt capital for all issues to be used in computing the BTWACC.
    (v)(A) Cost of long-term debt capital calculation (Schedules F-II, 
F-II(A), F-III and F-III(A)). The carrier shall calculate the annual 
percentage rate cost of long-term debt capital for all issues of long-
term debt expected to be outstanding as of the beginning and as of the 
end of the 12-month period used to compute projected mid-year rate base 
separately for the two dates, and shall also calculate the average 
annual percentage rate cost of long-term debt for all issues for the 
12-month period. The carrier shall support these calculations by 
showing in tabular form the following for each class and series of 
long-term debt expected to be outstanding as of the beginning and as of 
the end of the 12-month period separately for the two dates:
    (1) Title;
    (2) Date of issuance;
    (3) Date of maturity;
    (4) Coupon rate (%);
    (5) Principal amount issued ($);
    (6) Discount or premium ($);
    (7) Issuance expense ($);
    (8) Net proceeds to the carrier ($);
    (9) Net proceeds ratio (%), which is the net proceeds to the 
carrier divided by the principal amount issued;
    (10) Cost of money (%), which, for existing long-term debt issues, 
shall be the yield-to-maturity at issuance based on the coupon rate, 
term of issue, and net proceeds ratio determined by reference to any 
generally accepted table of bond yields; and, for long-term debt issues 
to be newly issued on or before the final day of the 12-month period, 
shall be based on the average current yield (published in such a 
publication as Moody's Bond Survey) on long-term debt instruments 
similar in maturity and investment quality as the long-term debt 
security that is to be issued;
    (11) Principal amount outstanding (%);
    (12) Annual cost ($); and
    (13) Name and relationship of issuer to carrier.
    (B) Where a carrier is a subsidiary of a parent company, the 
carrier shall show the cost of long-term debt calculations and 
information required in this paragraph (e)(7)(v) for its own cost of 
long-term debt unless the carrier applies for and receives permission 
from the Commission to use a consolidated capital structure in 
computing the BTWACC. Where such permission is granted, the subsidiary 
carrier shall show the required cost of long-term debt calculations and 
information for the consolidated system's long-term debt.
    (vi) In the event that new long-term debt is to be issued on or 
before the final day of the 12-month period used to compute projected 
mid-year rate base, the carrier shall submit a statement explaining the 
methods used to estimate information required under paragraphs 
(e)(7)(v)(A) (1) through (13).
    (8) Cost of preferred (and preference) stock capital Schedules F-
IV, F-IV(A), F-V, and F-V(A)). (i) The cost of preferred (and 
preference) stock capital shall be calculated by the carrier for the 
12-month period used to compute projected mid-year rate base on the 
basis of:
    (A) Embedded cost for existing preferred (and preference stock); 
and
    (B) Current cost for any new preferred (and preference) stock to be 
issued on or before the final day of the 12-month period.
    (ii) The arithmetic average annual percentage rate cost of 
preferred (and preference) stock capital calculated on the basis of all 
issues of preferred (and preference) stock expected to be outstanding 
as of the beginning and as of the end of the 12-month period used to 
calculate projected mid-year rate base shall be the cost of preferred 
(and preference) stock capital used in computing the BTWACC.
    (iii) The annual percentage rate cost of preferred (and preference) 
stock capital for all issues of preferred (and preference) stock 
expected to be outstanding as of the beginning and as of the end of the 
12-month period used to compute projected mid-year rate base shall be 
calculated separately for the two dates by:
    (A) Multiplying the cost of money for each issue under paragraph 
(e)(8)(v)(A)(9) of this section by the par or stated amount outstanding 
for each issue, which yields the annual dollar cost for each issue; and
    (B) Adding the annual dollar cost of each issue to obtain the total 
for all issues, which is divided by the total par or stated amount 
outstanding for all issues to obtain the annual percentage rate cost of 
preferred (and preference) stock capital for all issues.
    (iv) The arithmetic average annual percentage rate cost of 
preferred (and preference) stock capital for all issues to be used as 
the cost of preferred (and preference) stock capital in computing the 
BTWACC shall be calculated by:
    (A) Adding the total annual dollar cost for all issues of preferred 
(and preference) stock capital expected to be outstanding as of the 
beginning of the 12-month period used to compute projected mid-year 
rate base to the total annual dollar cost for all issues of preferred 
(and preference) stock capital expected to be outstanding as of the end 
of the 12-month period, and dividing the resulting sum by two, which 
yields the average total annual dollar cost of preferred (and 
preference) stock for all issues for the 12-month period;
    (B) Adding the total par or stated amount outstanding for all 
preferred (and preference) stock issues expected to be outstanding as 
of the beginning of the 12-month period used to compute projected mid-
year rate base to the total par or stated amount outstanding for all 
issues expected to be outstanding as of the end of the 12-month period, 
and dividing the resulting sum by two, which yields the average total 
par or stated amount expected to be outstanding for all issues for the 
12-month period;
    (C) Dividing the average total annual dollar cost of preferred (and 
preference) stock for all issues for the 12-month period by the average 
total par or stated amount expected to be outstanding for all issues 
for the 12-month period, which yields the average annual percentage 
rate cost of preferred (and preference) stock capital for all issues to 
be used in computing the BTWACC.
    (v)(A) Cost of preferred (and preference) stock capital calculation 
(Schedules F-IV, F-IV(A), F-V, and F-V(A)). The carrier shall calculate 
the annual percentage rate cost of preferred (and preference) stock 
capital for all issues of preferred (and preference) stock expected to 
be outstanding as of the beginning and as of the end of the 12-month 
period used to compute projected mid-year rate base separately for the 
two dates, and shall also calculate the average annual percentage rate 
cost of preferred (and preference) stock for all issues for the 12-
month period. The carrier shall support these calculations by showing 
in tabular form the following for each issue of preferred (and 
preference) stock as of the beginning and as of the end of the 12-month 
period separately for the two dates:
    (1) Title;
    (2) Date of issuance;
    (3) Dividend rate (%);
    (4) Par or stated amount of issue ($);
    (5) Discount or premium ($);
    (6) Issuance expense ($);
    (7) Net proceeds to the carrier ($);
    (8) Net proceeds ratio (%), which is the net proceeds to the 
carrier divided by the par or stated amount issued;
    (9) Cost of money (%), which, for existing preferred (and 
preference) stock issues, shall be the dividend rate divided by the net 
proceeds ratio; and, for preferred (and preference) stock issues to be 
newly issued on or before the final day of the 12-month period, shall 
be the estimated dividend rate divided by the estimated net proceeds 
ratio;
    (10) Par or stated amount outstanding ($);
    (11) Annual cost ($); and
    (12) If issue is owned by an affiliate, name and relationship of 
owner.
    (B) Where a carrier is a subsidiary of a parent company, the 
carrier shall show the cost of preferred (and preference) stock 
calculations and information required in this paragraph (e)(8)(v) for 
its own preferred (and preference) stock unless the carrier applies for 
and receives permission from the Commission to use a consolidated 
capital structure in computing the BTWACC. Where such permission is 
granted, the subsidiary carrier shall show the required cost of 
preferred (and preference) stock calculations and information for the 
consolidated system's preferred (and preference) stock.
    (vi) In the event that new preferred (and preference) stock is to 
be issued on or before the final day of the 12-month period used to 
compute projected mid-year rate base, the carrier shall submit a 
statement explaining the methods used to estimate information required 
under paragraph (e)(8)(v)(A) (1) through (12).
    (9) Cost of common-stock equity capital. A carrier's cost of 
common-stock equity capital shall be calculated using the Discounted 
Cash Flow (``DCF''), Capital Asset Pricing Model (``CAPM''), and Risk 
Premium (``RP'') methods. A final estimate of that cost shall be 
derived from the separate estimates obtained using each of the three 
methods.
    (10) DCF method. (i) The DCF model that shall be used in 
calculating a carrier's cost of common-stock equity is defined 
algebraically as follows:


TP07AP94.014

where:

Ke is the carrier's cost of common-stock equity capital;
D0 is the carrier's current annualized dividend (defined as four 
times the current quarterly installment) per share;
P0 is the current market price per share of the carrier's common 
stock; and
g is the constant expected annual rate of growth in the carrier's 
dividends per share.

    (ii) Current market price per share of common stock. The current 
market price per share of the carrier's common stock used in the DCF 
model shall be an average of the monthly high and low market prices 
during a six-month period commencing not more than nine months prior to 
the date on which the proposed rates are filed.
    (iii) Estimated growth rate of dividends. The estimate of g used in 
the DCF model shall be an average of three separate estimates obtained 
using historical growth rate data, professional investment services' 
projections, and the sustainable growth rate model.
    (iv) Historical growth rate estimate of g. The historical growth 
rate estimate of g shall be an average of the carrier's most recent 
five- and ten-year historical growth rate averages of dividends per 
share, earnings per share, and book value per share.
    (v) Professional investment services' projections estimate of g. 
The professional investment services' projections estimate of g shall 
be an average of Value Line's five-year forecasted growth rate of 
dividends per share, earnings per share, book value per share, and the 
Institutional Brokers Estimation Service's five-year forecasted growth 
rate in earnings per share for the carrier.
    (vi) Sustainable growth rate estimate of g. The sustainable growth 
rate estimate of g shall be obtained by multiplying the proportion of 
earnings expected to be retained by the carrier by the expected return 
on book equity. Value Line's forecasted values for expected retained 
earnings and expected return on book equity shall be used in arriving 
at the sustainable growth rate estimate of g.
    (11) CAPM. (i) The CAPM that shall be used in calculating a 
carrier's cost of common-stock equity is represented algebraically as 
follows:

Ke = Rf + B(Rm - Rf)

where:

Ke is the carrier's cost of common-stock equity capital;
Rf is the expected risk-free rate of return;
B is the relevant market risk beta of the carrier's common stock; and
Rm is the expected overall stock market return.

    (ii) Expected risk-free rate of return. A six-month average of 
five-year Treasury Note yields computed over a period not more than 
nine months prior to the date on which the proposed rates are filed 
shall be used as the estimate of the expected risk-free rate of return 
in the CAPM.
    (iii) Expected beta. Value Line's most current market risk beta of 
the carrier's common-stock shall be used as the estimate of the 
expected beta in the CAPM.
    (iv) Expected overall market return. The expected overall return on 
the stock market shall be estimated by adding the six-month average of 
five-year Treasury Note yields used as the estimate of the expected 
risk-free rate to the arithmetic average difference between the actual 
annual returns realized historically by the Standard & Poor's 500 Stock 
Index and the five-year Treasury Note. The arithmetic average 
differential shall be based on the complete historical series published 
annually by Ibbotson Associates in the most recent Stocks, Bonds, Bills 
and Inflation Yearbook, for the period 1926 through the most recent 
date for which the specified data are available.
    (12) RP method. (i) The RP model that shall be used in calculating 
a carrier's cost of common-stock equity is defined mathematically as 
follows:

Ke = Kd + RP

where:

Ke is the regulated carrier's cost of common-stock equity capital;
Kd is the incremental cost of debt; and RP is the risk premium.

    (ii) Risk premium. The risk premium used in the RP model shall be 
the historical arithmetic average return differential between rates of 
return actually earned on investments in the Standard & Poor's 500 
Stock Index and the five-year Treasury Note. This risk premium shall be 
based on the complete historical data series published annually in the 
Stocks, Bonds, Bills and Inflation Yearbook, for the period 1926 
through the most recent date for which the specified data are 
available.
    (iii) Incremental cost of debt. A six-month average of five-year 
Treasury Note yields computed over a period not more than nine months 
prior to the date on which the proposed rates are filed shall be the 
estimate of the incremental cost of debt in the RP model.
    (iv) Risk adjustment. The RP model shall be used in its generic 
form and the risk premium specified herein shall not be adjusted for 
any possible differences in the risk of the firms represented in the 
Standard & Poor's 500 Stock Index and that of the carrier under 
consideration. The generic RP model shall be used as a benchmark for 
the range of companies contained in the Standard & Poor's 500 Stock 
Index on which it is based, and, therefore, shall be used to measure 
the broad dimensions of investor perceptions of the trade-off between 
risk and return.
    (13) Corporate income tax rate (Schedules F-VI and F-VI(A)). The 
corporate income tax rate used in computing the BTWACC shall be the 
carrier's composite statutory corporate income tax rate for the 12-
month period used to compute projected midyear rate base. Such rate 
shall be a composite of the carrier's Federal and State income tax 
rates, and of any other income tax rate to be applied to the carrier's 
income by any other entity to which the carrier is to pay income taxes. 
The carrier shall calculate and show its composite statutory corporate 
income tax rate as well as its Federal, State, and any other applicable 
statutory income tax rates separately for the 12-month period used to 
compute projected midyear rate base. The carrier shall also state the 
name of any entity other than the Federal and State governments to 
which it is to pay taxes. Where a carrier is a subsidiary of a parent 
company, the carrier shall show its own statutory corporate income tax 
rates unless the carrier applies for and receives permission from the 
Commission to use a consolidated capital structure in computing the 
BTWACC. Where such permission is granted, the carrier shall show 
instead the consolidated system's statutory corporate income tax rates.
    (14) Flotation costs (Schedules F-VII and F-VII(A)). (i) A 
carrier's cost of common-stock equity capital shall be adjusted to 
reflect those costs of floating new issues that are actually incurred, 
but only in the event that new common stock is to be issued to the 
general public during the 12-month period used to compute projected 
midyear rate base. Those flotation costs for which an allowance shall 
be made must be identifiable, and must be directly attributable to 
underwriting fees, and printing, legal, accounting, and/or other 
administrative expenses. No allowance shall be made for any 
hypothetical costs such as those associated with market pressure and 
market break effects. The allowance shall be applied solely to the new 
common-stock equity and shall not be applied to the existing common-
stock equity balance. The formula that shall be used to compute such an 
allowance is as follows:

k = Fs/(1+s)

where:

k is the required increment to the cost of the carrier's common stock 
equity capital that will allow the company to recover its flotation 
costs;
F is the flotation costs expressed as a decimal fraction of the dollar 
value of new common-stock equity sales; and
s is the new common-stock equity sales expressed as a decimal fraction 
of the dollar value of existing common-stock equity capital.

    (ii) Flotation costs data (Schedules F-VII and F-VII(A)). (A) In 
the event that new common-stock equity is to be issued during the 12-
month period used to compute projected midyear rate base, the carrier 
shall show separately by category the estimated costs of floating the 
new issues to the extent that such costs are identifiable and are 
directly attributable to actual underwriting fees, and to printing, 
legal, accounting, and/or other administrative expenses that must be 
paid by the carrier. The carrier shall submit a statement explaining 
the method used in estimating the flotation costs. The carrier shall 
also show estimates of the date of issuance; number of shares to be 
issued; gross proceeds at issuance price; and net proceeds to the 
carrier.
    (B) Where a carrier is a subsidiary that obtains its common-stock 
equity capital through a parent company, and the parent company intends 
to issue new common-stock equity during the 12-month period, the 
carrier shall show separately by category the estimated costs to the 
parent company of floating the new issues, and estimates of the above 
items relative to the parent company's issuance of new common-stock 
equity, provided that such carrier applies for and receives permission 
from the Commission to use a consolidated capital structure in 
computing the BTWACC.
    (f) Financial ratio methods--(1) Fixed charges coverage ratio. * * 
*
    (2) Operating ratio. * * *

    By the Commission.
Joseph C. Polking,
Secretary.
[FR Doc. 94-8226 Filed 4-6-94; 8:45 am]
BILLING CODE 6730-01-W