[Federal Register Volume 60, Number 171 (Tuesday, September 5, 1995)]
[Rules and Regulations]
[Pages 46047-46063]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-21845]



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FEDERAL MARITIME COMMISSION

46 CFR Part 552

[Docket No. 94-07]


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

AGENCY: Federal Maritime Commission.

ACTION: Final rule.

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SUMMARY: The Federal Maritime Commission is amending its regulations 
governing financial reporting requirements and rate of return 
methodology applicable to vessel-operating common carriers by water in 
the domestic offshore trades to discontinue use of the comparable 
earnings test in determining the reasonableness of a carrier's return 
on rate base. In its place, the Commission will use the weighted 
average cost of capital methodology. The Commission is modifying the 
calculation of the rate of return on rate base to a before-tax basis. 
In addition, the Commission is amending its rules pertaining to the 
computation of working capital. The rule addresses a number of shipper 
and carrier concerns regarding the Commission's current rate of return 
methodology and would align the Commission's ratemaking methodologies 
more closely with those used by numerous other regulatory agencies. The 
intent is to improve the Commission's methodology for evaluating the 
reasonableness of rates filed by carriers in the domestic offshore 
trades.

EFFECTIVE DATE: October 5, 1995.

FOR FURTHER INFORMATION CONTACT:

Richard R. Speigel or Anne M. McAloon, Bureau of Economics and 
Agreement Analysis, Federal Maritime Commission, 800 North Capitol 
Street, NW., Washington, DC 20573-0001, 202-523-5845 or 523-5790
C. Douglass Miller, Office of the General Counsel, Federal Maritime 
Commission, 800 North Capitol Street, NW., Washington, DC 20573-0001, 
202-523-5740

SUPPLEMENTARY INFORMATION: On April 7, 1994, the Federal Maritime 
Commission (``FMC'' or ``Commission'') published a Notice of Proposed 
Rulemaking (``NPR'' or ``proposed rule'') (59 FR 16592) which proposed 
to amend the regulations governing financial reporting requirements and 
rate of return methodology applicable to vessel-operating common 
carriers by water in the domestic offshore trades. The Commission 
proposed to change the method of determining the reasonableness of a 
carrier's return on rate base from the comparable earnings test 
(``CET'') to the weighted average cost of capital (``WACC'') 
methodology. At the request of Matson Navigation Company (``Matson''), 
the Commission extended the comment period for interested parties to 
file until July 20, 1994 (59 FR 27002). The following seven parties 
filed comments on the NPR: American President Lines (``APL''), Crowley 
Maritime Corporation (``Crowley''), Matson, Puerto Rico Maritime 
Shipping Authority (``PRMSA''), the Department of Transportation 
(``DOT''), Marsoft Incorporated (``Marsoft''), and the State of Hawaii 
(``Hawaii'').
    By notice published November 4, 1994, 59 FR 55232 (``Request for 
Reply Comments''), the Commission invited reply comments on four 
specific issues--the calculation of the cost of capital, working 
capital, the selection of proxy groups, and the deletion of alternative 
methodologies. The Commission extended the time for reply comments 
until January 6, 1995, partially granting a request of NPR, Inc. (59 FR 
62372). Reply comments were received from APL, Crowley, Matson, PRMSA, 
Hawaii, and Tobias E. Seaman (``Seaman''), president of the National 
Association of Shippers, Consignees, and Consumers for Maritime 
Affairs. With the exception of Seaman, all reply commenters had 
submitted initial comments on the proposed rule.
    PRMSA and NPR filed a motion for an evidentiary hearing on December 
2, 1994. The Commission does not believe that there is a need to hold 
an evidentiary hearing as suggested by PRMSA and NPR. There have been 
two rounds of comments which have given 

[[Page 46048]]
all interested parties, including PRMSA and NPR, adequate opportunity 
to comment on the proposed rule.
    The commenters raised concerns with many provisions of the proposed 
rule. The Commission has addressed all relevant comments. Any comment 
not specifically addressed has nevertheless been considered.

The Weighted Average Cost of Capital Approach

    Comments: The commenters generally support the adoption of the WACC 
methodology for determining the allowable rate of return on rate base. 
Crowley does not support, however, the change to the WACC methodology 
for the following reasons. Crowley argues that the WACC methodology 
contained in the NPR does not correct the alleged shortcomings of the 
CET, because the WACC methodology will also rely on a proxy group to 
determine the regulated carrier's cost of capital. Crowley further 
urges caution in the Commission's deliberations because of the 
uncertainty over the Interstate Commerce Commission's (``ICC'') 
continued jurisdiction over intermodal services and the Government of 
Puerto Rico's continued attempts to sell PRMSA. Crowley also contends 
that the rule would raise the cost of regulatory compliance 
substantially. Crowley disputes, as being too low, the Commission's 
estimate of the additional regulatory burden of the proposed rule 
(i.e., 1.5 weeks), because substantially more effort would be required 
in the first years as the carriers learn the new system. In his 
comments, Seaman echoes Crowley's opposition to the proposed rule.
    In its initial comments, PRMSA urged the Commission to require 
carriers initially to provide parallel testimony and information which 
would permit analysis under both the CET and the WACC methodologies. In 
its reply comments, however, PRMSA states that no need exists for the 
parallel CET analysis should the FMC decide to be less restrictive in 
specifying the permissible evidence in rate-of-return proceedings, and 
instead, permit carriers to submit evidence as to their demonstrated 
risk and, hence, their required rate of return.
    Both PRMSA and Matson argue that setting the maximum allowable rate 
of return on rate base equal to the carrier's weighted average cost of 
capital would not provide the regulated carriers with sufficient 
earnings to fund their operations and attract capital. PRMSA urges the 
Commission to adopt provisions which would allow an earnings 
``cushion'' above the before-tax weighted average cost of capital 
(``BTWACC'').1 PRMSA states that its required rate of return was 
less than that of the CET reference group, because it is 100 percent 
debt-financed and tax-exempt. Thus, it is said that PRMSA gained a tax 
advantage over the CET reference group. The earnings which the 
reference group devoted to tax payments was allegedly the ``cushion'' 
for PRMSA. The result, PRMSA states, is that the CET allows earnings 
levels which, when achieved, provide PRMSA with the ability to remain 
in business.

    \1\The BTWACC is a before-tax version of the WACC.
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    However, PRMSA maintains that the proposed BTWACC yields an 
untenable result for PRMSA, because it would strip away the earnings 
cushion which provides the ability to service debt which was acquired 
to finance past losses. PRMSA argues that this lack of an earnings 
``cushion'' would be potentially harmful to any company with 
substantial debt in its capital structure. PRMSA contends that the 
allowable rate of return must provide a sufficient cushion above the 
cost of overall debt to permit the carrier to weather a downturn in its 
business.
    Matson states that the Commission's definition of the cost of 
capital is the minimum rate of return necessary to attract capital to 
an investment. Matson also notes that in the proposed rule the maximum 
allowable return on rate base is the weighted average cost of capital. 
Matson claims that using the cost of capital to determine the allowable 
return on rate base sets the Commission's BTWACC as both the minimum 
and the maximum rate of return for the regulated carrier. Matson claims 
that for this to be correct, capital markets must be perfectly 
efficient. Matson claims that since it is recognized that capital 
markets are not perfectly efficient, by itself the BTWACC is not an 
adequate measure of the return on capital necessary to attract capital 
to the regulated carrier.
    Matson claims that since the cost of capital is a minimum rate of 
return necessary to attract capital to the regulated firm, the 
Commission should allow carriers to earn returns equal to their cost of 
capital plus a specified margin in excess. Matson states that the extra 
earnings above the cost of capital that carriers in the domestic trades 
would be given the opportunity to earn would not be ``gouging'' the 
public. Matson states that the carriers in the domestic offshore trades 
face competitive market conditions, and thus the carrier's ability to 
meet customer needs will determine what return the carrier will earn 
from its operations. Matson claims that modifying the proposed rule to 
allow for a cushion above the BTWACC would permit Matson to attract 
capital to finance the assets necessary to continue and to enhance its 
operations.
    Discussion: Crowley is correct that both the CET and BTWACC 
methodologies generally need to use some form of proxy group. However, 
for the following reasons, the Commission is convinced that the types 
of information used to calculate the BTWACC provide a better estimate 
than the CET of the allowable rate of return for each individual 
carrier. First, the BTWACC uses information specific to the regulated 
carrier's capital structure to calculate the carrier's required rate of 
return. Second, the BTWACC uses either the regulated carrier's cost of 
common-stock equity or a related proxy group's cost of common-stock 
equity to determine the required rate of return on equity, rather than 
the averages derived from all manufacturing firms that are used under 
the CET. Similarly, the BTWACC calculates the actual coupon payments 
for debt paid by the regulated carrier, rather than a proxy derived 
from a rolling average of Baa-rated corporate bonds. Therefore, the 
specificity that the BTWACC gives in determining the cost of capital of 
the individual regulated carrier is a vast improvement over the CET.
    Crowley's claims of additional regulatory burden appear to be 
overstated. Under the proposed rule, if a carrier filed a general rate 
increase, the extra regulatory burden is estimated to be 24 staff-
hours. An additional 41 staff-hours would have been required for the 
annual filing of the proxy group. Thus, the proposed rule estimated the 
increase in regulatory burden to be 41 to 65 staff-hours. The 
additional regulatory burden under the proposed rule, then, was quite 
modest. The Commission believes these estimates to be accurate 
approximations of the additional time necessary to comply with the 
final rule. Some firms may take more time while other firms may take 
less time, but on average the Commission believes that the estimates 
are accurate for the typical firm.
    However, the Commission is concerned that any additional regulatory 
burden required under the final rule be minimized. Therefore, as will 
be discussed later, the requirement that carriers annually file a proxy 
group has been dropped in the final rule and the procedure for 
estimating the cost of equity has been changed. Under the final rule, a 
carrier that does not file a general rate increase will incur no extra 
regulatory burden because it need not 

[[Page 46049]]
file a proxy group. In addition, one of the three methods used to 
estimate the cost of equity, the Capital Asset Pricing Model, will no 
longer be required. These modifications to the proposed rule will 
result in a significant lessening of the regulatory burden. If the 
carrier does file a general rate increase, the extra regulatory burden 
remains 65 staff-hours. The Commission believes that the improvement in 
rate-of-return regulation which will occur under the BTWACC methodology 
more than compensates for the extra staff-hours of regulatory burden 
which will be incurred by those carriers which file a general rate 
increase. Therefore, the Commission rejects the suggestion by Crowley 
and Seaman that the Commission abandon its proposal to implement a 
BTWACC approach to determine the allowable rate of return in the 
domestic trades.
    As will be discussed in the following sections, the Commission is 
modifying its proposed rule to allow for greater flexibility in the 
determination of the cost of common-stock equity. This modification 
should eliminate the need perceived by PRMSA in its initial comments 
that both the BTWACC and CET be utilized initially to determine an 
appropriate rate of return.
    The NPR explained the legal and economic rationale for setting the 
allowable rate of return equal to the regulated carrier's cost of 
capital. Two landmark Supreme Court cases2 established that 
investors in companies subject to rate regulation must be allowed an 
opportunity to earn returns sufficient to attract capital comparable to 
investments in other firms having the same amount of risk, and that 
revenues must not only cover operating expenses, but capital costs as 
well. The economic rationale for setting the allowable rate of return 
of a regulated company equal to its cost of capital is that in the long 
run the regulated firm's customers will pay the lowest cost for service 
while at the same time the company's earnings will be sufficient to 
attract capital so that the company is able to provide the customers' 
desired level of service. Based on the legal decisions and economic 
rationale, the Commission considers the BTWACC an appropriate measure 
of the allowable rate of return for regulated carriers. The Commission 
believes that the BTWACC methodology will allow carriers to attract 
adequate capital, thereby negating the concerns expressed by Matson. 
However, as PRMSA noted, a carrier with only debt financing would be 
allowed only to earn the cost of its long-term debt under the 
BTWACC.3 It appears that such a capital structure is highly 
unusual and unlikely to occur without substantial government backing of 
the carrier (as has been the case with PRMSA).

    \2\Bluefield Water Works & Improvement Co. v. Public Service 
Commission of West Virginia, 262 U.S. 679 (1923) and Federal Power 
Commission v. Hope Natural Gas Company, 320 U.S. 391 (1944).
    \3\If a carrier is 100% debt-financed, the equity portion of the 
BTWACC equation equals 0.
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    PRMSA is unique among ocean carriers in the domestic offshore 
trades in that, until its recent sale to NPR in January 1995, it was 
government owned and 100 percent debt-financed. PRMSA contends that it 
lost money year after year and part of its debt was used to finance 
past losses.4 While a regulatory commission should minimize 
regulatory risk by ensuring that regulated firms are given the 
opportunity to earn a reasonable return on capital, it is the 
responsibility of the firm to achieve a viable capital structure and 
operate the business efficiently. The BTWACC is an appropriate measure 
of the cost of capital for carriers having a broad range of capital 
structures. The Commission cannot prevent a carrier from departing from 
the broad range of capital structures that are generally used. However, 
the Commission must assure that ratepayers do not pay a premium for 
such a decision by the carrier. Therefore, the Commission believes that 
ratepayers should not be required to pay for an additional ``cushion'' 
due to PRMSA's unique capital structure.

    \4\Similar to Crowley, PRMSA has filed many of its rates in ICC-
regulated or exempt tariffs since 1981, the last year in which that 
carrier's rates were subject to an FMC investigation.
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    Lastly, as a further clarification the Commission will state in its 
rule that the BTWACC is the ``allowable'' rate of return rather than 
the ``maximum allowable'' rate of return.

Accessibility of Carrier Financial Data

    Hawaii argues that the adoption of the BTWACC methodology will 
require that all parties have access to information regarding the 
carrier's financing and capitalization. Such information is company 
specific and can be obtained only through the carriers' annual 
financial reports filed with the Commission. Hawaii recommends that the 
Commission reverse its present policy of not requiring the carriers' 
annual reports to be made available to all parties.5 However, the 
issue was not raised in the NPR and there has been no opportunity for 
the other parties to comment on Hawaii's recommendation. Accordingly, 
it would not be proper for the Commission to rule on the merits of 
Hawaii's recommendation here.

    \5\Section 552.4(c) of the Commission's regulations protects the 
carrier's annual reports from public disclosure and treats them as 
confidential information in the files of the Commission.
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    Hawaii also requests the right of discovery by all parties, so that 
any questions which may arise concerning the carrier's financial 
situation may be pursued. Rule 67 of the Commission's rules of practice 
and procedure (46 CFR 502.67) currently provides for discovery in 
proceedings under section 3(a) of the Intercoastal Shipping Act, 1933 
(``1933 Act'') 46 U.S.C. app. 845 (a). Hawaii's request fails to 
explain why Rule 67 is deficient. In any event, an amendment to Rule 67 
is outside the scope of this proceeding and cannot be properly 
addressed here.

Deletion of Alternative Methodologies

    The proposed rule revised paragraph (b) of Sec. 552.1 by deleting 
the provision that the methodology employed in each case will depend on 
the nature of the relevant carrier's operations and financial 
structure. Also, the proposed rule added language to the paragraph that 
specifies the extent of possible alternative methodologies. Paragraph 
(b) reads:

    (b) In evaluating the reasonableness of a VOCC's overall level 
of rates, the Commission will use return on rate base as its primary 
standard. A carrier's allowable rate of return on rate base will be 
set equal to its before-tax weighted average cost of capital. 
However, the Commission may also employ the other financial 
methodologies set forth in Sec. 552.6(f) in order to achieve a fair 
and reasonable result.

    Paragraph (d) of the same section has been deleted. That paragraph 
provided that the Commission may use some other basis for allocation 
and calculation and may consider other operational factors in any 
instance where it is deemed necessary to achieve a fair and reasonable 
result.
    APL advised, in its initial comments, that these provisions are at 
the heart of a major dispute in FMC Docket No. 89-26, The Government of 
the Territory of Guam, et al. v. Sea-Land Service, Inc. and American 
President Lines, Ltd. It pointed out that the NPR does not give any 
reasons for the proposed changes to Sec. 552.1 and argued that the 
changes cannot be legally adopted unless and until the FMC identifies 
its reasons for such a change and allows opportunity for comment. 
Further, APL pointed out that the proposed changes could have no effect 
on a pending complaint docket focused on a prior time period.
    In the Request for Reply Comments, the Commission explained that 
the Guam trade is unique in that the trade is a very small portion of 
the carriers' overall service. Whether the current 

[[Page 46050]]
method of allocation is appropriate in such a case need not be decided 
in this proceeding because the two carriers serving Guam, APL and Sea-
Land Service, Inc., currently file most of their rates with the ICC. 
Neither carrier files full financial reports under 46 CFR part 552. If 
in the future a carrier serves Guam under FMC regulation, the 
Commission could address the need for any change in 46 CFR part 552 in 
a separate rulemaking proceeding. Paragraph (d) of Sec. 552.1 was 
eliminated because the Commission did not want such determinations to 
be made on an ad hoc basis during a rate investigation. It is essential 
that significant issues relating to the underlying methodology to be 
employed in determining the reasonableness of rates be settled prior to 
any rate investigation. The 180-day limit specified by section 3 of the 
1933 Act cannot be met if parties are permitted to change methodologies 
during the course of a rate investigation. Moreover, the Commission 
stated in its Request for Reply Comments that parties to a rate 
proceeding are entitled to rely on the Commission's rules. They should 
not have to respond to ever-changing methodologies proposed by other 
parties. The Commission also explained that any changes that may be 
made to part 552 as a result of this proceeding will only be applied 
prospectively and will have no application in pending cases such as 
Docket No. 89-26.
    Both APL and Matson support the proposed changes to Sec. 552.1. APL 
urges the FMC, in discussing the reply comments in this proceeding, to 
``avoid overbroad statements that might be argued to have application 
to pre-existing complaint dockets as opposed to GRI proceedings.'' (APL 
Reply at 3.) Matson concurs with the Commission that it is essential 
that significant issues relating to the underlying methodology to be 
used in determining the reasonableness of rates be settled prior to any 
investigation.
    Crowley argues that it is not clear that the Commission has 
adequately preserved its option of using other rate-of-return 
methodologies ``in order to achieve a fair and reasonable result.'' The 
carrier suggests that, while certainty in predicting the Commission's 
reaction to a proposed rate increase is important, it should not be 
achieved at the expense of the Commission's flexibility to consider 
legitimate alternatives for measuring a carrier's rate of return.
    Seaman does not comment on the merits of the proposed changes to 
this section, but rather repeats his opinion that the alternative 
methodologies should be applied to Matson's operations in the Hawaii 
trade. He further claims, as APL did in its initial comments, that 
because the NPR did not give any explanation for the proposed changes, 
the due process rights of those affected are violated.
    Crowley's and Seaman's concerns that methodologies other than rate 
of return on rate base be available appear to be overstated. The 
Commission believes that the proposed methodology should be appropriate 
for almost any conceivable situation. Moreover, neither Crowley nor 
Seaman provide sufficient reasons for altering the proposed changes to 
Sec. 552.1. The flexibility they appear to seek simply cannot be 
accommodated within the 180-day limit specified by section 3 of the 
1933 Act. Further, neither Crowley nor Seaman have addressed the fact 
that it is not fair to require parties to respond to ever-changing 
methodologies proposed by other parties. Therefore, unless the 
Commission prescribes an alternative methodology in its order 
commencing a rate investigation, all parties will be limited to the use 
of rate of return on rate base throughout the proceeding. The changes 
to Sec. 552.1 will be adopted as proposed.

Capital Structure

The Proposed Rule

    The proposed rule provided that a regulated domestic offshore 
carrier's expected capital structure is to be used in calculating that 
carrier's BTWACC. In the case of a regulated carrier that is a 
subsidiary of a larger parent company, the proposed rule provided that 
a subsidiary carrier's capital structure be used in computing the 
BTWACC unless, after notice and opportunity for comment, the Commission 
determines that the carrier may use the capital structure of the parent 
company (i.e., the consolidated system). Such a determination would 
require that: (1) The subsidiary carrier's parent company issues 
publicly traded common stock equity; (2) no substantial minority 
interest in the subsidiary exists;6 and (3) the risks are similar 
between the subsidiary carrier and the parent company.7 The NPR 
also proposed that the capitalization ratios (i.e., the weights) used 
in calculating the BTWACC be based on the test-year average book value.

    \6\Under the proposed rule, no substantial minority interest in 
a subsidiary carrier would exist when a parent company owns 90 
percent or more of the subsidiary's voting shares of stock.
    \7\In considering the similarity of both business and financial 
risks facing the parent and subsidiary, the following will be 
considered: Financial risk measures, such as total capitalization 
and debt/equity ratios, investment quality ratings on short and long 
term debt instruments; and coverage ratios, such as times interest 
earned and fixed charges coverage ratios, and the degree to which 
the regulated subsidiary comprises the parents' holding.
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    Comments: Hawaii agrees that the expected capital structure should 
be used when a company is an independent company. In the case of wholly 
owned subsidiaries,8 however, Hawaii recommends that the FMC allow 
greater flexibility in adopting the appropriate capital structure. 
Hawaii suggests that the Commission not declare a preference for either 
the subsidiary or consolidated financial data but avail itself of the 
option to decide, on a case-by-case basis, whether to use the 
subsidiary, consolidated system,9 or a hypothetical capital 
structure. By deciding on a case-by-case basis, Hawaii contends that 
the FMC will avoid prejudging which method will allow the most accurate 
estimation of the carrier's cost of capital.

    \8\Hawaii couched its comments on a wholly owned subsidiary in 
terms of Matson Navigation Co., Inc., which is a subsidiary of 
Alexander & Baldwin, Inc.
    \9\Hawaii requested clarification on the issue of whether all 
parties have the option to apply for the use of the consolidated 
system. The Commission anticipates that only the regulated carrier 
will be able to apply for use of the consolidated system's capital 
structure. In addition, the Commission's staff may also recommend 
the use of the consolidated system. Such application or 
recommendation will be subject, however, to notice and comment prior 
to Commission approval. It appears that interested parties will be 
provided with ample opportunity to comment on this issue.
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    Hawaii points out two potential drawbacks of using subsidiary data. 
The first drawback would be the need for a portfolio of comparable 
companies. Hawaii contends that finding a comparable group may be 
problematic or impossible within the framework of the proposed rule.
    The second drawback would be the possible artificiality of the 
capital structure of a subsidiary. Hawaii points out a situation it has 
encountered in which the capital structure of a subsidiary is reported 
to consist of all equity. The parent company holds and sells all debt, 
but the proceeds of the debt are used by the subsidiary. Hawaii states 
that it has

    no a priori reason to believe that data from a portfolio of 
comparable companies is a better base from which to estimate a 
carrier's cost of capital than data from the consolidated system of 
which a carrier is a part. There are necessarily pros and cons in a 
choice between the characteristics of a consolidated company, within 
which the characteristics of the relevant company are hidden, and a 
portfolio of proxy companies which may bear little resemblance to 
the relevant company.

(Hawaii at 7). Hawaii suggests that the choice between two 
inappropriate 

[[Page 46051]]
capital structures could be avoided by using a hypothetical capital 
structure.
    Hawaii also points out the interrelationship between the capital 
structure and the required rate of return on equity. As the share of 
equity increases in the capital structure, financial risk and total 
risk are lessened. Thus, the required rate of return on equity declines 
as the proportion of equity increases, all other things being equal.
    With respect to the NPR's provision for basing the capitalization 
ratios and amounts on average book values, PRMSA asserts that the 
capital structure using historic book valuation may differ 
significantly from a capital structure computed using market 
valuation.10 Depending on how the book value of equity deviates 
from its market value, the Commission may be allowing a rate of return 
that is either too high or too low.

    \10\PRMSA's initial comments on this issue continued its 
characterization of the Commission's reasons for proposing a change 
from the CET to the BTWACC as resulting from a desire to eschew the 
use of accounting data in favor of the use of market data. PRMSA 
contends that because the proposed rule relies extensively on 
historic accounting data, the shortcomings of the CET are 
perpetuated in the proposed rule.
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    Discussion: The Commission is not persuaded by Hawaii's argument to 
decide the capital structure on a case-by-case basis. The Commission 
believes the capital structure of the subsidiary will generally be the 
most direct measure of the regulated carrier's capital structure. 
However, where the regulated carrier can show that the business and 
financial risk of the parent company and the subsidiary are similar, 
the Commission may allow the use of the consolidated system's capital 
structure because its cost of capital will likely be the same as the 
subsidiary's cost of capital. Moreover, the calculation of the 
consolidated system's cost of capital will be more direct because there 
will be no need to select a proxy group to estimate the cost of common-
stock equity. Thus, in some cases, the use of the consolidated system's 
capital structure will likely give the best measure of the regulated 
carrier's capital structure.
    With respect to hypothetical capital structures, some regulatory 
commissions do use a hypothetical capital structure. However, the 
Commission believes that good reasons exist for using the actual 
capital structure rather than a hypothetical capital structure. First, 
capital structures are the products of decisions, which may be assumed 
to be logical and efficient at the time they are made, although a 
different capitalization might be consistent with a lower BTWACC at the 
time of investigation and hearing. Second, the hypothetical capital 
structure substitutes the judgment of the regulator for the judgment of 
those operating the business as to the best mix of debt and equity for 
the company. The initial decision as to the best debt/equity mix should 
be left to the company management, with regulatory oversight by the 
Commission.
    A review of regulatory commission practice indicates that, in 
general, the actual capital structure is used, unless that structure is 
wasteful or not otherwise in the long-term public interest. In cases 
where the Commission might find evidence of wasteful or imprudent 
investment, it is permitted to deduct such investment from the 
carrier's rate base.11 Therefore, the Commission believes that it 
has ample authority to deal with imprudent or wasteful investment 
without employing a hypothetical capital structure.

    \11\ Likewise, the Commission may disallow questionable expense 
items for a carrier's income statement.
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    In situations in which the Commission determines that the capital 
structure of a subsidiary does not represent the true capitalization of 
a carrier (e.g., debt ``hidden'' in a parent company's capital 
structure), the Commission believes that it has adequate options for 
ensuring that the subsidiary's capital structure reflects its 
financing. First, the Commission can order that the capital structure 
of the consolidated system be used. If the consolidated system consists 
of a number of subsidiaries or its capital structure is very complex, 
the Commission can fashion an appropriate proceeding to determine the 
appropriate capital structure. At the conclusion of the proceeding, the 
Commission would weigh all the information it had collected to 
determine the most realistic and meaningful capital structure possible 
for the regulated carrier. The Commission does not believe, however, 
that such proceedings will be necessary in most cases.
    The NPR recognized that valid theoretical reasons exist for 
measuring the capital structure on the basis of the market value of its 
components. However, the common practice of regulatory commissions is 
to compute capitalization ratios on the basis of book values for a 
number of practical considerations. First, a regulated firm is believed 
to raise capital in such a fashion that a target capitalization ratio 
expressed on the basis of book values is maintained by the company over 
time. Consequently, regulators must compute the firm's overall cost of 
capital on the same basis to ensure that the company's capital costs 
are adequately covered. Second, effective regulation is said to result 
in book and market values approaching equality. Last, and most 
importantly, book-value capitalization ratios are stable, removing the 
problems that volatile market prices can present when determining the 
appropriate capitalization ratio. The Commission remains convinced that 
the practical considerations outweigh the theoretical issues involved 
in using book-value capitalization ratios. Therefore, the process of 
determining the regulated carrier's capital structure is adopted 
without change from the proposed rule.
Calculation of the Before-Tax Weighted Average Cost of Capital

    In its initial comments, PRMSA pointed out that the formula for the 
BTWACC12 is inconsistent with the Commission's formula for the 
rate of return on rate base.13 This inconsistency resulted from 
computing the cost of capital on a before-tax basis while the rate of 
return on rate base is computed on an after-tax basis. PRMSA further 
commented that the after-tax rate of return formula currently used by 
the Commission and retained in the proposed rule is technically 
deficient; because, in the numerator, it adds the full amount of 
interest expense to income. PRMSA noted that more modern financial 
analysis recognizes that only the after-tax cost of interest should be 
added back to the numerator in computing after-tax rate of return. 
PRMSA suggested either changing the cost of capital to an after-tax 
basis so it can be compared to the after-tax return on rate base, or 
retaining the BTWACC 

[[Page 46052]]
and changing the rate of return on rate base to a before-tax basis.

    \12\ The proposed rule states the before-tax weighted average 
cost of capital will be calculated using the following equation.
    BTWACC=(D/D+P+E)Kd\+(P/D+P+E)Kp(1/1-T)+(E/
D+P+E)Ke (1/1-T)
    where:
    Kd is the regulated firm's cost of long-term debt capital;
    Kp is the regulated firm's cost of preferred stock capital;
    Ke is the regulated firm's cost of common-stock equity 
capital;
    D is the value of the regulated firm's long-term debt 
outstanding;
    P is the value of the regulated firm's preferred stock 
outstanding;
    E is the value of the regulated firm's common-stock equity 
outstanding;
    T is the corporate income tax rate
    \13\ Current FMC regulations (46 CFR 552.6 (d)(2)) provide that 
return on rate base is computed by dividing Trade net income plus 
interest expense by Trade rate base.
---------------------------------------------------------------------------

    In the Request for Reply Comments, the Commission proposed 
retaining the BTWACC contained in the NPR and changing the calculation 
of the rate of return on rate base to a before-tax basis. Comments were 
sought on the following change to Sec. 552.6(d)(2):

    (2) Return on Rate Base. The return on rate base will be 
computed by dividing Trade net income plus interest expense plus 
provision for income taxes by Trade rate base.


    In its reply comments, Hawaii recognizes the basis for PRMSA's 
concern that the proposed BTWACC and the rate of return on rate base 
are not directly comparable. However, Hawaii prefers that the proposed 
rule be changed so the weighted average cost of capital is computed on 
an after-tax basis and the rate of return on rate base remain as it is 
currently defined in the Commission's rule. According to Hawaii, the 
Commission's current definition of return on rate base embodies the 
conventional idea of payment (or return) to lenders and equity holders 
who have advanced the money for capital purchases. Payments to 
governments in taxes on revenue and earnings from the employment of the 
purchased capital are not strictly ``returns'' and it would distort the 
concept to include tax payments in the definition.
    Crowley and Matson comment favorably on the proposed change to the 
rate of return on rate base. Although Seaman opposes the proposed 
methodology for calculating the allowable rate of return, he 
acknowledges the comparability problem.
    All parties have recognized that a change must be made to either 
the calculation of the BTWACC or the calculation of the rate of return 
on rate base to make the two terms compatible. The Commission believes 
that putting the BTWACC and the rate of return on rate base on a 
before-tax basis will result in the appropriate determination of the 
allowable rate of return. The Commission's research indicates that most 
regulatory agencies determine the allowable rate of return on a before-
tax basis. While Hawaii expresses a preference for using the after-tax 
calculation, it agreed that putting the weighted average cost of 
capital and the rate of return on rate base either on a before-tax 
basis or after-tax basis is correct as long as the two terms are 
compatible. Therefore, the Commission will adopt a BTWACC and modify 
the calculation of the return on rate base as indicated in the Request 
for Reply Comments.

Cost of Equity Estimation

    The NPR specified that three methods of determining the cost of 
common-stock equity--the discounted cash flow (``DCF''), capital asset 
pricing model (``CAPM''), and risk premium (``RP'') methods--would be 
used to produce separate estimates in arriving at a final estimate of a 
regulated carrier's cost of common-stock equity capital. The Commission 
would thereby avoid any inappropriate judgments that could be embodied 
in any one of the individual estimates.
    Both Matson and PRMSA contend that the DCF is unsuitable for FMC-
regulated carriers, because most of those carriers are either 
subsidiaries of larger entities or privately owned firms. PRMSA avers 
that choosing a proxy group for the regulated carriers is impossible, 
therefore, the DCF and also the CAPM methods are not valid methods for 
the FMC to use in estimating the cost of equity.
    In both sets of comments, PRMSA criticizes the derivation of the 
expected annual growth in dividends per share, or ``g'', as specified 
in the NPR. The NPR provides that in the DCF model three methods of 
estimating ``g'' would be used: (a) The average of the historical 
growth rate of dividends per share, earnings per share, and book value 
per share; (b) the average of (1) the five-year dividend, earnings and 
book value forecasts published by Value Line Investment Survey (``Value 
Line''), and (2) the five-year earnings forecast published by the 
Institutional Brokers Estimation Service (``IBES''); and (c) the use of 
the sustainable growth rate method, which relies on forecasted values 
of the earnings retention rate. To derive a final estimate of ``g'' the 
separate estimates of ``g'' would be averaged.
    PRMSA states that there is no certain method to ascertain ``g'' 
directly. To the extent that ``g'' is wrong, the cost of capital is 
incorrectly estimated. Further, PRMSA states that the proposed 
averaging of the estimates has no theoretical or practical basis and 
might be ``contra-indicated'' when the disparities between the 
estimates are large. In its comments, PRMSA used data from one carrier, 
Overseas Shipping Group, to derive an estimate of ``g'' based on the 
methodology prescribed in the proposed rule. PRMSA showed that the 
historic growth rate method resulted in an estimate for ``g'' of 20.4 
percent, while the sustainable growth rate estimate of ``g'' was 11.2 
percent. According to PRMSA, the results of its study demonstrate that 
the methodology used in the proposed rule will likely result in widely 
divergent results among the three estimation procedures. PRMSA asserts 
that averaging these numbers results in a meaningless estimate. It 
argues that since many of the numbers are derived from historical book 
value, the proposed methodology offers no advantage over the CET, which 
involves looking directly at history and basing judgments directly 
thereon. PRMSA contends that the frailties of the methodology cannot be 
remedied by averaging.
    Several commenters point out deficiencies in the CAPM model. Hawaii 
does not oppose its use, but notes that many regulatory analysts are 
moving away from using the CAPM as a cost of equity model. Hawaii 
suggests that the use of the CAPM in a regulatory rate setting removes 
it from its intended purposes.14 Hawaii also states that the most 
salient criticisms of CAPM lie with its central element, beta.15 
Hawaii states that these criticisms include the following: (1) Beta is 
a measure of variability not risk; (2) beta is not forward looking (in 
keeping with a future test year); (3) betas typically have very low 
correlation coefficients; and (4) recently it has been shown that there 
is no statistical relationship between beta and return. PRMSA also 
notes that the CAPM literature has begun to question the model's 
empirical underpinnings. Matson advises that it is widely acknowledged 
that the CAPM does not adequately account for firm size in determining 
expected return.

    \14\Hawaii states that the CAPM was developed for, and is widely 
used in, the estimation of the return probabilities of a diversified 
stock portfolio relative to the return of the theoretical market.
    \15\Beta is the coefficient of regression of a stock's price 
variability relative to the variability of the whole stock market. 
It gauges the degree to which an individual stock price moves 
relative to the overall stock market.
---------------------------------------------------------------------------

    Matson concurs with the NPR which stated that the DCF, CAPM, and RP 
each have strengths and weaknesses. However, according to Matson, the 
RP has an advantage that compels its use. The RP can be adjusted to 
reflect the fact that the cost of common stock equity is a function of 
firm size. Matson argues that the NPR's use of the RP16 is 
deficient because the risk of investment in a small company, such as 
Matson, is not the same as that of a Standard & Poor's 500 Stock Index 
(``S&P 500'') firm.

    \16\The NPR proposed that the RP method was to be used in its 
generic form without any adjustments for any possible differences in 
the risks of the firms contained in the Standard & Poor's 500 Stock 
Index and that of the regulated carrier. 

[[Page 46053]]

---------------------------------------------------------------------------

    In both its initial and reply comments, Matson advocates the 
Commission's adoption of one method to calculate the cost of common-
stock equity and urges the adoption of the RP model adjusted for firm 
size. Matson comments that neither the explanatory text nor the rule 
language in the NPR indicates how the three estimation methods are to 
be ``blended'' to arrive at a final cost of common-stock equity 
estimate. It believes there is inefficiency and unfairness in any 
system that determines a regulated company's allowable earnings by 
taking the results of three separate calculations and then, using some 
unexplained process, arrives at a single result. According to Matson, 
this unexplained process cannot be understood by the regulated carriers 
and financial markets. Further, effective judicial review would be 
problematic.
    The RP model advocated by Matson is the arithmetic average return 
differential between rates of return actually earned on investments in 
firms of the same size as the carrier, and the five-year Treasury Note. 
Matson states that the risk premium in such a model should be based on 
the historical data series ``Decile Portfolios of the NYSE'' published 
annually in Stocks, Bonds, Bills and Inflation (``Ibbotson Yearbook''), 
and should directly correspond to that decile that matches the 
carrier's own size.
    Likewise, in its reply comments, PRMSA urges the Commission to use 
only the RP method to estimate the cost of common-stock equity. PRMSA 
recommends that the proposed RP method be modified to allow for several 
adjustments for risk. One such adjustment would be for firm size, 
similar to that suggested by Matson. It also recommends adjustments for 
illiquidity (in the case of privately-owned carriers), industry risk, 
and individual carrier risk (as compared to the industry average for 
publicly traded firms).
    Marsoft comments that the RP model is designed to reflect the 
return on equity of the large, diverse range of companies included in 
the S&P 500. Marsoft, therefore, contends that the NPR puts a heavy 
weight on the assumption that all regulated companies are identical and 
are no more or less risky than companies included in the S&P 500. In 
contrast to the suggestions of Matson and PRMSA, Marsoft recommends 
that the Commission give lower weight to non-specific standards such as 
the RP model.
    In addition to commenting on the specific provisions of the cost of 
equity estimation models, several commenters contend that the process 
of estimating the cost of equity is too rigidly prescribed in the NPR. 
Most commenters point out the importance of allowing judgment to enter 
into the estimation process.
    Marsoft states that the proposed cost of equity methodology is 
excessively restrictive and is likely to result in biased estimates of 
the appropriate rate of return on equity. Under the BTWACC methodology, 
it believes that the Commission will need to exercise considerable 
judgment in determining the appropriate estimate for the cost of 
common-stock equity. Marsoft suggests the Commission use information 
from security analysts, management reports, and other industry-based 
sources in determining the appropriate rate of return on equity.
    Hawaii points out that the NPR's specification of using a six-month 
average stock price as a base for calculating dividend yield may limit 
appropriate subjective judgments and preclude Commission consideration 
of valid information.17 It suggests that in addition to 
prescribing that the average stock prices be used in the DCF (and 
interest rates in the CAPM and RP models), the Commission should also 
allow parties to use the most recent stock price in calculating the DCF 
model. Hawaii contends that some financial analysts argue that the use 
of average stock prices and interest rates may lead to greater forecast 
error in determining the test year stock price and interest rate than 
will occur when the most recent stock price and interest rate are used. 
According to Hawaii, allowing parties to calculate these models using 
both a six-month average stock price and interest rate, as well as the 
most recent stock price and interest rate, would add flexibility to the 
proposed rule and increase the information upon which the Commission 
could base its judgment.

    \17\Hawaii commented similarly on the CAPM and RP models. In 
those models, the NPR specified the use of a six-month average of 
five-year Treasury note yields.
---------------------------------------------------------------------------

    Hawaii also states in its initial comments that access to several 
data sources is required to determine the cost of common-stock equity 
under the proposed rule. One of the required data sources used to 
compute the DCF model is published by IBES. In addition, data from 
Ibbotson Associates must be used to compute the CAPM and RP models. 
Hawaii requests that, depending on the cost of acquiring the necessary 
data, the Commission consider making both the IBES and Ibbotson 
Associates data available to non-subscribing parties.
    In drafting the proposed rule, the Commission attempted to specify 
in detail the calculation of the cost of common-stock equity in order 
to prevent prolonged debate that would accompany more subjective and 
flexible methodologies. Under section 3 of the 1933 Act not only must 
the FMC rule within 180 days, but also carriers and protestants have 
similar time limits in that hearings must be completed within 60 days.
    The commenters have taken issue with the NPR's specification of the 
estimation methods and have suggested that the proposed rule would 
unduly limit the amount of information that the Commission could 
consider in the course of a proceeding, to the detriment of obtaining a 
just and reasonable result. The Commission believes that these comments 
have merit. If a party to a proceeding follows a predetermined formula 
in preparing testimony, the resultant testimony may not contain the 
necessary judgment required in using these estimating techniques. There 
are many different applications of these methodologies, and an 
important part of the estimating procedure is the skill with which the 
practitioner implements the methodology. As a consequence, the 
Commission, as decision maker, would not be making the fullest use of 
the expertise that the testimony could provide in arriving at an 
appropriate determination of the cost of common-stock equity for the 
regulated carrier.
    The Commission has decided, therefore, to modify the cost of equity 
estimation procedures contained in Sec. 552.6 of the proposed rule. 
Carriers will still be required to use the DCF and RP methods to 
determine the cost of common-stock equity. However, they will not be 
required to follow the proposed rule's detailed specifications in 
implementing the techniques.
    The Commission has decided to strike the requirement to use the 
CAPM method. As the NPR explained, the CAPM is actually the company-
specific form of the general RP model. The central feature of the CAPM 
model, beta, has been commented upon disparagingly not only by the 
instant commenters, but also by an increasing number of academicians. 
The major criticisms of Beta are that: beta measures variability not 
risk; beta is not forward looking; and no statistical relationship 
exists between a firm's beta and its return. Given that the merits of 
beta and, therefore, the CAPM are increasingly suspect, the Commission 
does not believe that this deletion will negatively impact upon the 
FMC's responsibilities under the 1933 Act. 

[[Page 46054]]

    The Commission is not persuaded that the selection of the proxy 
group is so problematic that the requirement to use the DCF model 
should be eliminated. The DCF method remains a standard tool used by 
regulatory agencies to determine cost of common-stock equity in rate 
cases. The Commission acknowledges that selecting a proxy group may be 
an extremely controversial matter, given that no two companies have 
exactly the same risk characteristics. Nevertheless, any alleged 
arbitrariness should be able to be overcome by a judicious 
determination of the business and financial risk factors of the 
regulated carrier. Further, with the requirement to use the CAPM being 
eliminated, the Commission does not believe that it should limit itself 
to only one method of estimating the cost of common-stock equity.
    The proposed rule provided that the estimate produced by the RP 
method was to be used as a check on, and in combination with, the 
company-specific estimates produced using the DCF and CAPM models. With 
the CAPM being deleted, however, the RP will become more prominent in 
the determination of the cost of equity. In order to produce a more 
representative estimate of the risk premium required by investors for a 
particular carrier, the final rule will permit, but not require, 
carriers to argue for a risk adjustment for firm size. The final rule 
also allows for an RP model in its generic form.
    In contrast to most commenters, Matson states that the Commission's 
process of determining the cost of capital is not spelled out clearly 
enough. The Commission does not agree with Matson on this point. The 
Commission requires the flexibility to consider all issues relevant to 
estimating the regulated carrier's cost of capital. The Commission 
recognizes that each of the methodologies are estimates only and that 
reasoned judgment is necessary in the process of determining the final 
estimate of the regulated company's cost of capital. Therefore, the 
process of combining the estimates of the cost of equity in the final 
rule will remain as it is in the proposed rule, though only the DCF and 
RP estimates of the cost of equity will be used to reach a final 
determination.
    If a proceeding is initiated, the Commission will evaluate the 
testimony of the carrier, the FMC staff, and all protesters in arriving 
at its decision on the allowable rate of return. The Commission will 
then issue a ruling that spells out its reasoning so that the parties 
can see how the Commission arrived at its decision. Therefore, the 
Commission does not accept Matson's assertion that the process of 
combining the two estimates of common-stock equity is unfair. The 
combining process will be arrived at openly and will take into account 
the vagaries of cost of capital estimation.
    With regard to the use of average prices, the Commission stated in 
the proposed rule that regulatory agencies often use average prices 
over time rather than a price on a particular day to remove aberrations 
in stock price movements. Such aberrations could be the result of 
events internal to the company (e.g., the stock may go ex-dividend) or 
due to factors external to the company (e.g., political events that 
affect the price of a firm's stock). The Commission continues to 
believe that the use of an average will be appropriate in most 
instances to filter out potential aberrations in stock prices and 
interest rates. However, to avoid the possibility that use of an 
average may serve to blind the Commission to significant changes or 
trends, the rule will permit, but not require, parties to calculate 
these models using both a six month average stock price and interest 
rate as well as the most recent stock price and interest rate as 
suggested by Hawaii.
    With respect to the suggestion that the FMC consider providing 
access to the required data, the Commission has considered this, but 
has decided that the costs of such information are not prohibitive. 
Under the final rule no particular data source is required for the DCF 
analysis. IBES data can be obtained inexpensively from Compuserve, an 
on-line information provider. The Ibbotson Yearbook and Value Line are 
available at many libraries or through subscription at nominal cost.

Proxy Group

    If a carrier is an independent company which issues no publicly-
traded common-stock equity or is a subsidiary that obtains its common-
stock equity capital through a parent company, a proxy group of 
companies must be selected to impute the carrier's cost of common-stock 
equity. Under the proposed rule, the proxy group is selected from 
companies listed in Value Line that operate and derive a major portion 
of their gross revenues primarily as common carriers in the business of 
freight transportation, and own and operate transportation vehicles or 
vessels. Further, under the proposed rule, carriers relying on proxy 
companies are to use the prescribed risk criteria in selecting proxy 
companies and are to submit their selection of proxy companies, along 
with their annual report of financial and operating data, as required 
in Sec. 552.2.
    In its initial comments, Hawaii was concerned that the companies in 
Value Line which satisfy the Commission's criteria for the proxy group 
do not have business risks similar to those of Matson. Hawaii claimed 
that these companies are generally consolidated companies; are not 
dominant in their markets; and do not operate in industries with 
statutory barriers to entry.
    Marsoft stated that according to its research only three marine 
transportation companies and four trucking companies meet the proposed 
guidelines for the proxy group. Marsoft did not believe that airlines, 
railroads, or full-load trucking companies should be included in the 
proxy group, because they do not provide comparable services. Marsoft 
also stated that in many cases large, geographically and operationally 
diverse companies will be compared to small, highly specialized private 
carriers. Marsoft contends that the comparison may not be credible in 
some cases. Further, Marsoft urged the Commission to allow non-U.S. 
based firms to be included in the proxy group.
    PRMSA commented that the proxy group should not be restricted to 
the freight transportation business. PRMSA asserted that equity capital 
in the regulated carrier competes against the broad spectrum of 
companies in the economy, not just against companies involved in 
freight transportation. PRMSA stated that the nature of a company's 
business is only one ingredient of business risk, not the sole 
determinant. PRMSA noted that as of June 1994, there were a total of 39 
companies listed in Value Line involved in transport by air, truck, 
water, and railroad. Allegedly, not all of these companies were 
involved in freight transportation as required by the proposed rule. 
PRMSA concluded from this that the potential list of comparable 
companies is highly limited.
    In its Request for Reply Comments, the Commission sought specific 
suggestions on industries other than freight transportation to be added 
to the current proxy group criteria. In its reply comments, Hawaii 
concurs with the parties who have suggested that dependence on data for 
proxy groups reported in Value Line and IBES imposes a limitation on 
finding appropriate proxy group members. Hawaii is unable to suggest 
other sources from which the required financial data would be 
available. However, Hawaii urges the Commission not to unduly limit the 
data that may be used to present evidence, especially 

[[Page 46055]]
with respect to the proxy group. Hawaii also points out that undue 
limitation of the companies that may be used as proxies might introduce 
the statistical problems inherent in small samples.
    Hawaii states that the Commission should not expect to be able to 
apply the results of estimations based on proxy groups directly to the 
regulated carrier. It urges the Commission to allow the introduction of 
information which relates to the comparability of the proxy group and 
the applicant company. In addition, Hawaii states that if each expert 
witness is allowed to provide estimates based on different proxy 
groups, the Commission would gain valuable insight into the impact of 
various risk characteristics on the cost of common-stock equity.
    Matson argues that the Commission should retain the proxy group 
identified in the NPR and not add other industries. According to 
Matson, business risk is dependent on the diversification of a 
business, the cyclicality of its operations, and the operating leverage 
employed in its business. It suggests that transportation companies 
generally have similar levels of cyclicality and degrees of operating 
leverage. Matson claims that it would be extremely difficult to 
identify companies outside of the transportation industry that have the 
same amount of cyclicality and degree of leverage as transportation 
companies.
    In its reply comments, PRMSA notes that the most serious deficiency 
of the proposed rule is the use of the proxy groups to compensate for 
the lack of market data for non-publicly traded companies. PRMSA points 
out that most domestic offshore carriers are either privately owned or 
subsidiaries of larger consolidated systems for which no market data 
exists. PRMSA asserts that the Commission has embarked on an impossible 
task in attempting to enumerate specific companies and/or industries to 
serve as a proxy for the regulated company. PRMSA says that the 
selection of proxy companies will necessarily be arbitrary, negating 
the mathematical exactitude that can be achieved under the DCF model.
    With respect to the annual submission of proxy groups, PRMSA 
contends that this proposal would actually require a greater use of 
agency resources than are currently devoted to rate-of-return analysis 
in the domestic offshore trades. PRMSA argues that the proposed 
selection process raises serious due process issues, because it 
attempts to bar members of the public from challenge at a time when 
their interests are at stake, because of their failure to have made a 
challenge when no injury could be alleged.
    Crowley advocates opening up the proxy group to companies outside 
the freight transportation business because, it contends, the key 
comparison is not the line of business. Crowley notes that companies 
within the same industry may have different business characteristics, 
and different attractions to investors. Crowley would, however, 
restrict the selection to any company listed in Value Line. Crowley 
also states that other suitable industries would be those characterized 
by large initial capital investments, seasonal markets, and common 
carrier operations. Crowley proposes that passenger transportation and 
certain telecommunications industries might be possible sources of 
proxy groups.
    In Seaman's comments, he notes that the commenting parties have 
given ample reason why the selection of a proxy group is flawed. Seaman 
contends that without a comparable portfolio of companies, estimates of 
the cost of common-stock equity are meaningless. He concludes, 
therefore, that the Commission will not be able to determine a fair 
rate of return under the BTWACC methodology.
    The Commission does not agree with the contention that the proxy 
group selection is unworkable. The use of proxy groups is a common 
regulatory practice, especially in conjunction with the DCF model in 
estimating cost of common-stock equity. Selecting a proxy group will 
require, however, an assessment of the regulated carrier's operations 
and financial status in order to determine the appropriate business and 
financial risk. The results of this assessment will be used to select 
companies to be included in the proxy group. Because no two companies 
will be identical in all aspects of risk, the proposed rule specified a 
number of risk indicators that might be used in selecting a proxy 
group.
    After carefully reviewing all of the comments on comparable risk 
companies, the Commission has determined to drop three proposals. 
First, the Commission has decided that requiring the annual submission 
of a proxy group of companies which would be subject to notice and 
approval would expend considerable resources. Little benefit would be 
gained from the exercise if the regulated carrier were not to file any 
rate increases during its fiscal year. Thus, the final rule allows for 
the submission of the proxy group of companies at the same time as the 
submission of direct testimony in support of a proposed general rate 
increase.
    Second, the Commission has decided not to limit the selection of 
the proxy group only to companies followed by Value Line. The proposed 
rule required Value Line to be used because it contains all the data 
necessary to complete the cost of equity calculations specified in the 
proposed rule. Since the final rule will not be as specific as the 
proposed rule in delineating the methods and data sources to be used in 
estimating the cost of common-stock equity, the Commission believes the 
need to use only Value Line data is lessened. Therefore, in addition to 
Value Line, other data sources will be permitted for proxy group 
selection.
    Nevertheless, the Commission believes that Value Line provides the 
best overall data available for determining a proxy group. It provides 
analysis of many factors necessary for the selection of comparable risk 
companies. While Value Line does not cover every company that issues 
stock, the Commission expects that most proxy group companies will be 
found in it. The Commission does not want to proscribe the use of 
companies not followed by Value Line that would make good proxy group 
members. However, if a party selects proxy group members based on data 
from sources other than Value Line, the burden is on that party to 
prove that the data source is reliable and the data are sufficiently 
detailed to calculate the BTWACC.
    Finally, the Commission has decided not to limit the allowable 
proxy group members only to companies which operate in the 
transportation industry. The final rule will require that the majority 
of the proxy companies be companies which operate in the transportation 
industry. This will allow those giving testimony some latitude in 
selecting proxy group members from outside the transportation industry.
    Crowley is the only commenter suggesting other industries that 
might be included as candidates for the proxy group. Crowley suggests 
that proxy group members could be selected from the passenger 
transportation and telecommunications industries. Crowley offered very 
little analysis as to why these industries should be included. A 
thorough analysis would be required to persuade the Commission that 
companies in these industries would make acceptable proxy group 
members.
    The Commission is concerned that the difficulty commenters had in 
suggesting alternative industries from which proxy group members might 
be selected is illustrative of the difficulties that may be found in 
attempting to find proxy group members outside the transportation 
industry. Most 

[[Page 46056]]
commenters, however, were quite concerned that in some cases it may be 
difficult to select an adequate list of proxy group members within the 
confines of the transportation industry. To balance these two concerns, 
some of the proxy group members will be permitted to come from outside 
the transportation industry. However, a majority of the proxy group 
members will be required to come from the transportation industry. 
Those seeking to include companies outside the transportation industry 
in the proxy group shall have the burden of establishing that the firms 
selected have business risks comparable to the regulated carrier.
    The final rule will continue to require that the proxy group be 
limited to U.S. companies. In many instances foreign accounting 
procedures are different from U.S. accounting practices. In order to 
ensure that accurate estimates of the cost of common-stock equity can 
be made from the proxy group, the exclusion of foreign companies will 
continue. Lastly, based on the prior discussion of the concerns 
regarding the use of beta, two of the risk indicators specified in the 
proposed rule to be used in selecting the proxy group will be 
eliminated, the volatility of a company's common-stock price changes as 
measured by both beta and standard deviation.

Deferred Taxes and the Capital Construction Fund

    The proposed rule provided for two amendments to allow for the 
treatment of deferred taxes in the calculation of rate base. First, the 
cost of an asset included in the rate base would be reduced by the 
amount of funds withdrawn from the ordinary income and capital gains 
components of the Capital Construction Fund (``CCF'').\18\ Second, the 
rate base would be reduced by the amount of deferred taxes, except that 
portion resulting from the CCF or the expired Investment Tax Credit.

    \18\The Capital Construction Fund is comprised of three 
components: the capital account, the capital gains account, and the 
ordinary income account.
---------------------------------------------------------------------------

Capital Construction Fund

    Matson, Crowley and DOT oppose the Commission's proposal to exclude 
CCF withdrawals from the rate base. Hawaii's comments appear to support 
the proposal, although most of its comments address deferred taxes.
    The opposition to the proposed treatment of the CCF falls into two 
main areas. First, several commenters contend that the proposed changes 
are contrary to the Congressional intent behind the Merchant Marine 
Act, 1936, 46 U.S.C. app. section 1100, et seq., as amended, which 
governs the CCF. Matson points out that the Commission recognized the 
Congressional intent in Docket No. 78-46, Part 512. Financial Reports 
of Common Carriers by Water in the Domestic Offshore Trades. In that 
proceeding, Matson states that the Commission gave the reasons for its 
complete rejection of methodologies which penalized the carrier for 
using the financing benefits provided by the Merchant Marine Act, 1970. 
That legislation amended the 1936 Act and, inter alia, extended the CCF 
provisions to include the domestic offshore carriers. Matson points out 
that, in Docket No. 78-46, the Commission stated that:

    The Commission is persuaded that the Congress, in enacting the 
Merchant Marine Act, 1970 sought to provide carriers with tax 
incentives in order to encourage investment aimed at modernizing and 
expanding the fleet serving the domestic offshore trades. As MARAD 
indicated [in its comments], the adoption of the flow-through 
methodology would not be in accordance with the Congressional 
intent. Docket No. 78-46, 19 SRR at 1305. (Matson at 8).

    Crowley adds that it ``makes no sense for the FMC to take away the 
benefit of the CCF program, or to steer CCF funds away from the 
domestic trades, when the program is a part of the basic U.S. 
government policy to support the U.S. Merchant Marine.'' (Crowley at 
8). DOT asserts that the proposed rule would frustrate Congress' intent 
in establishing the CCF program by directly penalizing companies that 
participate in the program, which would in turn impede DOT's efforts to 
maintain and expand the U.S.-flag fleet.
    Second, the carriers and DOT contend that the proposed changes in 
the accounting treatment of the CCF and accumulated deferred taxes are 
based on a misunderstanding of the actual financial and tax 
consequences of the CCF and deferred taxes. Crowley argues that the 
Commission has misconstrued the character of the contributions to the 
three components of the CCF. In its comments, DOT explained that under 
the CCF program both deposits from taxable income and any subsequent 
investment earnings are temporarily sheltered from federal income 
taxes. These tax benefits are assured only if the deposits and earnings 
thereon are withdrawn to meet the company's CCF program objectives, 
principally vessel construction or reconstruction. Any unauthorized 
withdrawals are fully taxable. The recovery of the tax benefit of CCF 
deposits is accomplished by reducing the income tax basis of a vessel 
built with CCF monies. The reduction of the taxable basis of the CCF 
vessel reduces otherwise allowable depreciation over time which, in 
turn, increases taxable income, thereby recovering the initial benefits 
of the CCF deposit. DOT points out that this tax deferral has no 
connection to the cost of a vessel and therefore, should have no impact 
on the FMC's determination of a carrier's rate base for setting an 
allowable rate of return.
    Matson contends that the Commission has grossly overstated the 
benefit of the CCF investment. According to Matson, the sole economic 
benefit which flows from the use of a CCF is the interest-free use of 
the deferred tax monies until the taxes are paid through the loss of 
tax-depreciation on the CCF investment. Matson points out that the tax 
repayment period is 10 years for vessels, and 5 years for containers. 
According to Matson, not only has the FMC overstated the benefit but 
also, the duration of the benefit because its proposal would ``exclude 
forever 100% of the CCF investment.''
    Based on the comments received, the Commission is abandoning the 
proposed treatment of the CCF. The NPR indicated that of the three 
accounts comprising the CCF (capital account, capital gains account, 
and ordinary income account) the capital account is the only account 
containing carrier contributions to the CCF. The NPR likewise indicated 
that the capital gains and ordinary income accounts were comprised 
solely of the carriers' earnings on money contributed to the CCF. 
Several commenters clarified that the capital gains account consists of 
capital gains from the sale of CCF vessels as well as earnings from 
that account, and the ordinary income account consists of CCF vessel 
income plus earnings from that account. Only the capital gains and 
ordinary income accounts are tax deferred. Given the commenters' 
clarifications that the capital gains and ordinary income accounts are 
comprised of carrier contributions along with earnings, it appears that 
to require carriers to reduce the cost of the vessel by the amount of 
funds withdrawn from these two components of the CCF would indeed 
penalize CCF carriers and serve as a disincentive to carrier 
participation in the CCF. Such disincentive would appear to be contrary 
to the Congressional intent in establishing the CCF program.

Deferred Taxes

    Hawaii supports the changes to the treatment of deferred taxes in 
the proposed rule. The State points out that 

[[Page 46057]]
the Commission appropriately decided in Docket No. 78-46 to require 
carriers to calculate their income tax expense at the applicable 
statutory rate. Before issuing the final rule in Docket No. 78-46, the 
Commission had ordered deferred income taxes deducted from rate base in 
two rate investigations.19 However, in Docket No. 78-46, the 
Commission reversed its prior rulings and decided not to require 
carriers to deduct accumulated deferred income taxes from rate base. 
Hawaii also notes that the proposed treatment of deferred taxes 
conforms with the policy of a majority of state regulatory commissions, 
as well as the Federal Communications Commission and the Federal Energy 
Regulatory Commission.

    \19\See FMC Docket No. 75-57, Matson Navigation Co.--Proposed 
Rate Increase in the United States Pacific Coast/Hawaii Domestic 
Offshore Trade and FMC Docket No. 76-43, Matson Navigation Company--
Proposed Rate Increase in the United States Pacific Coast/Hawaii 
Domestic Offshore Trade.
---------------------------------------------------------------------------

    In its initial comments, Matson asserts that the deferred taxes 
account arises only due to the different treatment of depreciation for 
tax purposes than for expense purposes. According to Matson, when an 
asset is allowed to depreciate faster for tax accounting purposes than 
for book accounting purposes, a timing difference occurs and is 
reflected in deferred taxes. The differences in taxes booked versus 
taxes paid is recorded as a ``book'' liability. Matson claims that this 
is not a real liability but only the recognition that more taxes have 
been expensed than have yet to be paid. If the generally accepted 
accounting principles (``GAAP'') allowed for recording as an expense 
only the amount of taxes paid, no book liability for deferred taxes 
would occur. Matson argues that the value of deferred taxes is only in 
the time value of money, and this value reverses over a relatively few 
years. Matson claims that the benefit that the Commission refers to in 
the proposed rule does not exist. It is merely a philosophical 
difference between GAAP and the Internal Revenue Service code.
    In its reply comments, Matson addresses Hawaii's statement that the 
majority of regulatory agencies surveyed by the National Association of 
Regulatory Utility Commissioners treat deferred taxes similarly to the 
Commission's proposed treatment. Matson argues that such treatment of 
deferred taxes by state regulatory agencies resulted from the 
requirements of the Tax Reform Act of 1969 that required utilities to 
deduct deferred taxes from the rate base, if the utilities planned to 
use accelerated depreciation.
    PRMSA argues that the proposed rule would negate the stimulating 
effect on investment that was intended by public policy. It further 
argues that prohibiting returns on shipping assets financed by funds 
generated through the tax treatment of accelerated depreciation creates 
a disincentive to investment in the regulated shipping trades. PRMSA 
suggests that it is clear that a firm's decision to invest funds 
provided by deferred taxes is a decision that puts its investor-
provided equity at risk. Therefore, PRMSA contends that the FMC should 
focus on providing a rate of return on deferred taxes more akin to that 
provided by equity. Nevertheless, PRMSA suggests that the return could 
be adjusted downward to recognize the fact that the initial funds are 
not investor provided, although once the firm uses those funds its own 
equity is at risk and some reward is required.
    DOT avers that the proposed treatment of deferred taxes is unfair 
to CCF companies. DOT states that a consequence of participation in the 
CCF program is that companies tend to have large deferred tax 
liabilities. Therefore, the Commission's proposal would penalize CCF 
vessels, which are all U.S. flag, by reducing the rate base by the 
amount of the tax benefit, which would directly devalue the CCF 
incentive conferred by Congress. DOT takes issue with the statement in 
the NPR that accumulated deferred taxes should be eliminated from the 
rate base, because ``unlike debt, preferred stock, and common-stock 
equity, deferred taxes cost the carrier nothing.'' (NPR at 52). In its 
discussion of the CCF, DOT argues that deferred taxes are not cost free 
to the carrier, because over the life of a vessel, CCF companies will 
tend to pay higher taxes in later years than those carriers not 
participating in the CCF program.
    The Commission views the issue of deducting deferred taxes arising 
from accelerated depreciation from the rate base as being similar to 
that of deducting CCF withdrawals from the cost of a vessel or 
equipment. The Commission believes that carriers should not be 
penalized for using accelerated depreciation by deducting accumulated 
deferred taxes from the rate base and that such a deduction would 
likely serve to reduce the incentive of carriers to invest in the 
industry. Congress clearly intended companies to benefit from the use 
of accelerated depreciation and the Commission does not believe it 
should take any action which would minimize that benefit. Therefore, 
the Commission will not require carriers to deduct accumulated deferred 
taxes arising from accelerated depreciation from the rate base as was 
proposed. This is in conformance with current Commission policy 
determined in Docket 78-46, Financial Reports of Common Carriers by 
Water in the Domestic Offshore Trades.

Working Capital

    In the NPR, the Commission proposed to amend its regulations 
governing the computation of working capital to remove the 
extraordinary treatment of insurance expense. Only Hawaii commented on 
the proposed change. In addition to supporting the proposed change, 
Hawaii proposed two additional changes. First, Hawaii suggested that, 
in determining the amount of working capital to be included in rate 
base, the Commission adopt what it termed a ``modified lead-lag 
approach''. Hawaii's second proposal is to exclude interest expense 
from the calculation of working capital.
    In Docket No. 78-46, and Docket No. 91-51, Financial Reports of 
Common Carriers by Water in the Domestic Offshore Trades, Hawaii 
recommended the use of a ``lead-lag study'' in calculating the amount 
of working capital to be included in rate base. Taking into account the 
complexities inherent in adopting such an approach, the Commission 
declined to abandon average voyage expense as the basis for calculating 
working capital.20

    \20\ In Docket No. 78-46, the Commission wrote, ``There is no 
persuasive evidence in this proceeding or otherwise available which 
would indicate that average voyage expense incurred by a carrier 
utilizing self-propelled vessels is not a fair measure of that 
carrier's working capital requirements.''
---------------------------------------------------------------------------

    Hawaii stated that ``the modified lead-lag approach compares the 
lag in paying for major operating expenses (excluding depreciation and 
amortization, and interest expense) with the lag in receiving the 
revenues to pay for these expenses.'' (Hawaii at 19) Although Hawaii 
downplays the complexity of this method, its very description of the 
process belies this conclusion. The Commission can envision carriers 
spending inordinate amounts of time analyzing various accounts to 
develop the working capital component of rate base. On the other hand, 
the Commission believes that the average voyage expense calculation is 
straightforward and uniquely suited for the maritime industry.
    Hawaii also proposed removing interest expense from the calculation 
of working capital. In its initial comments, Hawaii stated:

    Interest expenses should also be excluded from the working 
capital computation because they represent a source of working 

[[Page 46058]]
capital funds. Interest is not paid to bondholders until after the 
related revenue is received by the carrier. Thus, interest expense 
does not create a need for working capital.

(Hawaii at 20).

    Crowley and Seaman comment on this proposal. Crowley opposes 
Hawaii's suggested treatment of interest. Crowley argues that interest 
expense is a cost of doing business not unlike any other liability for 
which working capital is required, such as employee costs, equipment 
acquisition and maintenance and repair, and similarly accrues on the 
carrier's books. Seaman merely endorses Hawaii's position.
    The Commission agrees with Crowley that interest expense is no 
different from a carrier's other liabilities for which working capital 
is required. The Commission believes that the working capital component 
of the rate base is intended to provide for a return on the cash 
required for the carrier's day-to-day operations and that interest 
expense meets this criteria. Therefore, the final rule eliminates only 
the extraordinary treatment of insurance expense from the calculation 
of the working capital component of rate base.
    The Federal Maritime Commission certifies pursuant to section 
605(b) of the Regulatory Flexibility Act, 5 U.S.C. 605(n), that this 
rule will not have a significant economic impact on a substantial 
number of small entities, including small businesses, small 
organizational units and small government jurisdictions. The Commission 
grants a waiver of the detailed reporting requirements to carriers 
which earn gross revenues of $25 million or less in a particular trade 
in accordance with 46 CFR 552.2(e).
    The collection of information requirements contained in this rule 
have been approved by the Office of Management and Budget under the 
provisions of the Paperwork Reduction Act of 1980, as amended, and have 
been assigned OMB control number 3072-0008. Under the proposed rule the 
incremental public reporting burden for this collection of information 
was estimated to range from an average of 41 hours to 65 hours per 
response, including the time for reviewing instructions, searching 
existing data sources, gathering and maintaining the data needed, and 
completing and reviewing the collection of information. The annual 
filing of a proxy group was estimated to require 41 man-hours while 
Schedule F was estimated to require 24 man-hours to complete. Since the 
final rule no longer requires that a proxy group of companies be filed 
annually, carriers which do not file a general rate increase as 
described in 46 CFR 552.2(f) will incur no additional regulatory 
burden. To be conservative, the estimated regulatory burden for 
carriers which file a general rate increase is still estimated to be 65 
man-hours. However, the cost of equity estimation has been simplified 
by eliminating the requirement that a capital asset pricing model be 
used in deriving the final estimate of the cost of equity. Thus, an 
extra cushion of time within the 65 man-hours has been created for 
carriers which file a general rate increase. Send comments regarding 
this burden estimate, including suggestions for reducing this burden, 
to Bruce Dombrowski, Deputy Managing Director, Federal Maritime 
Commission, Washington, DC 20573 and to the Office of Information and 
Regulatory Affairs, Office of Management and Budget, Washington, DC 
20503.

List of Subjects in 46 CFR Part 552

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

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

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

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

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

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


Sec. 552.1  Purpose.

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

    (a) * * *
Federal Maritime Commission, Bureau of Economics and Agreement 
Analysis, 800 North Capitol Street, NW, Washington, DC 20573-0001

    (b) Annual statements under this part shall consist of Exhibits A, 
B, and C, as described in Sec. 552.6, and shall be filed within 150 
days after the close of the carrier's fiscal year and be accompanied by 
a company-wide balance sheet and income statement having a time period 
coinciding with that of the annual statements. A specific format is not 
prescribed for the company-wide statements.
* * * * *
    (f) * * *
    (1) * * *
    (vi) Projected schedules for capitalization amounts and ratios 
(Schedule F-I); cost of long-term debt capital calculation (Schedules 
F-II and F-III); cost of preferred (and preference) stock capital 
calculation (Schedules F-IV and F-V); corporate income tax rate 
(Schedule F-VI); and flotation costs (Schedule F-VII) for the 12-month 
period used to compute projected midyear rate base in paragraph 
(f)(1)(ii) of this section.
* * * * *
    4. In Sec. 552.5, paragraphs (b) and (c) are revised, and 
paragraphs (v), (w), (x), (y), (z), (aa), and (bb) are added to read as 
follows:


Sec. 552.5  Definitions.

* * * * *
    (b) The service means those voyages and/or terminal facilities in 
which cargo subject to the Commission's regulation under 46 CFR 
514.1(c)(2) is either carried or handled.
    (c) The trade means that part of the Service subject to the 
Commission's regulation under 46 CFR 514.1(c)(2), more extensively 
defined below under Domestic Offshore Trade.
* * * * *
    (v) Book value means the value at which an asset is carried on a 
balance sheet.
    (w) Capital structure means a company's financial framework, which 
is composed of long-term debt, preferred (and preference) stock, and 
common-stock equity capital (par value plus earned and capital 
surplus). 

[[Page 46059]]

    (x) Capitalization ratio means the percentage of a company's 
capital structure that is long-term debt, preferred (and preference) 
stock, and common stock-equity capital.
    (y) Consolidated system means a parent company and all of its 
subsidiaries.
    (z) Subsidiary company means a company of which more than 50 
percent of the voting shares of stock are owned by another corporation, 
called the parent company.
    (aa) Long-term debt means a liability due in a year or more.
    (bb) Times-interest-earned ratio means the measure of the extent to 
which operating income can decline before a firm is unable to meet its 
annual interest costs. It is computed by dividing a firm's earnings 
before interest and taxes by the firm's annual interest expense.

    5. In Sec. 552.6, paragraph (a)(1), the first sentence of paragraph 
(a)(2), (b)(5), and the heading of paragraph (b)(9) are revised; 
paragraphs (c)(5) and (c)(10) are revised; paragraphs (d)(1) and (d)(2) 
are revised; paragraphs (e) and (f) are redesignated (g) and (h); a new 
paragraph (e) is added and paragraphs (d)(3) and (d)(4) are 
redesignated (f)(1) and (f)(2) and the paragraph headings thereof 
revised reading as follows:


Sec. 552.6  Forms

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

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

    (2) Statements containing the required exhibits and schedules are 
described in paragraphs (b), (c), (d), (e), (g), and (h) of this 
section and are available upon request from the Commission. * * *
    (b) * * *
    (5) Working Capital (Schedule A-V). Working capital for vessel 
operators shall be determined as average voyage expense. Average voyage 
expense shall be calculated on the basis of the actual expenses of 
operating and maintaining the vessel(s) employed in the Service 
(excluding lay-up expenses) for a period represented by the average 
length of time of all voyages (excluding lay-up periods) during the 
period in which any cargo was carried in the Trade. Expenses for 
operating and maintaining vessels employed in the Trade shall include: 
Vessel Operating Expense, Vessel Port Call Expense, Cargo Handling 
Expense, Administrative and General Expense, and Interest Expense 
allocated to the Trade as provided in paragraphs (c) (2), (4) and (5) 
of this section.
* * * * *
    (9) Capitalization of leases (Schedules A-VII and A-VII(A)). * * *
    (c) * * *
* * * * *
    (5) Interest expense and debt payments (Schedules B-IV and B-
IV(A)). This schedule shall set forth the total interest and debt 
payments, apportioned between principal and interest, short and long-
term, on debt and lease obligations. Payments on long-term debt are to 
be calculated consistent with the method set forth in Sec. 552.6(e)(7) 
for computing the cost of long-term debt capital. Principal and 
interest shall be allocated to the Trade in the ratio that Trade rate 
base less working capital bears to company-wide assets less current 
assets. Where related company assets are employed by the filing 
company, the balance sheet figures on the related company's books for 
such assets shall be added to the company-wide total in computing the 
ratio. In those instances where interest expenses are capitalized in 
accordance with paragraph (b)(9) of this section, a deduction shall be 
made for the amount so capitalized.
* * * * *
    (10) Provision for income tax. Federal, State, and other income 
taxes shall be listed separately. If the company is organized outside 
the United States, it shall indicate the entity to which it pays income 
taxes and the rate of tax applicable to its taxable income for the 
subject year. Federal, State and other income taxes shall be calculated 
at the statutory rate. Such tax rates are to be identical to those set 
forth in Schedules F-VI or F-VI(A) used in determining the carrier's 
allowable rate of return.
* * * * *
    (d) Rate of Return (Exhibits C and C(A))--(1) General. All carriers 
are required to calculate rate of return on rate base. However, the 
Commission or individual carriers, at the Commission's discretion, may 
also employ fixed charges coverage and/or operating ratios as provided 
for in paragraph (f) of this section.
    (2) Return on rate base. The return on rate base will be computed 
by dividing Trade net income plus interest expense plus provision for 
income taxes by Trade rate base.
    (e) Allowable rate of return on rate base (Exhibits F and F(A))--
(1) General. A carrier's allowable rate of return on rate base shall be 
set equal to the carrier's weighted average cost of capital calculated 
on a before-tax basis (``BTWACC''). The BTWACC is defined 
mathematically by the following expression:
[GRAPHIC][TIFF OMITTED]TR05SE95.000

where:

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

    A carrier's BTWACC shall be calculated in precise accordance with 
the rules set forth in this section.
    (2) Subsidiary carrier's capital structure. Where a carrier is a 
subsidiary that obtains its common-stock equity capital through a 
parent company, the capital structure of the subsidiary shall be used 
in computing the BTWACC unless the carrier has received prior approval 
by the Commission to use the consolidated capital structure. The 
subsidiary carrier's cost of common-stock equity capital, the 
subsidiary carrier's cost of long-term debt capital, the subsidiary 
carrier's cost of preferred stock capital, and the subsidiary carrier's 
composite statutory corporate 

[[Page 46060]]
income tax rate shall also be used in computing the BTWACC. The 
subsidiary carrier's cost of common-stock equity capital shall be 
inferred as the cost of common-stock equity capital estimated for a 
sample of firms having business and financial risk comparable to the 
subsidiary carrier when the subsidiary carrier's capital structure is 
used in calculating the BTWACC.
    (3) Comparable risk companies. (i) A proxy group of companies shall 
be selected to impute the carrier's cost of common-stock equity capital 
where:
    (A) The carrier is an independent company (i.e., it has no 
corporate parent) which issues no publicly-traded common-stock equity, 
or
    (B) The carrier is a subsidiary that obtains its common-stock 
equity capital through a parent company.
    (ii) The selection of the proxy group of companies shall be based 
on the following criteria:
    (A) The proxy companies shall be based in the United States.
    (B) The proxy companies shall be listed in The Value Line 
Investment Survey or equivalent data source. If a party uses data from 
sources other than The Value Line Investment Survey, the burden is on 
that party to prove that the data source is reliable and the data are 
sufficiently detailed to calculate the BTWACC.
    (C) A majority of the proxy companies shall operate and derive a 
major portion of their gross revenues primarily as common carriers in 
the business of freight transportation, and shall own or operate 
transportation vehicles or vessels. Companies with gross annual 
revenues equal to or less than $25,000,000 shall be excluded from the 
proxy group. Proxy group companies whose businesses are not in the 
transportation industry must clearly be demonstrated to have business 
risk equivalent to the regulated carrier's business risk.
    (D) In addition, comparable risk companies shall be selected by 
examining some, but not necessarily all, of the following risk 
indicators:
    (1) A company's total capitalization ratio and/or debt-to-equity 
ratio;
    (2) The investment quality ratings of a company's long-term debt 
instruments;
    (3) The investment safety ranking of a company's common-stock 
equity;
    (4) The rating of a company's financial strength;
    (5) Other such valid indicators deemed appropriate by the 
Commission.
    (4) Consolidated capital structure. (i) Upon application, after 
notice and opportunity for comment, the Commission may authorize use of 
the capital structure of the consolidated system (i.e., the parent 
company and all of its subsidiaries) in computing the BTWACC. The 
application must show that:
    (A) The subsidiary carrier's parent company issues publicly traded 
common-stock equity;
    (B) The subsidiary carrier's parent company owns 90 percent or more 
of the subsidiary's voting shares of stock; and
    (C) The business and the financial risks of the subsidiary carrier 
and the parent company are similar.
    (ii) The similarity of the parent company's and subsidiary 
carrier's business risk shall be evaluated by examining the degree to 
which the consolidated system's profits, revenues, and expenses are 
composed of those of the subsidiary carrier, and the extent to which 
the parent's holdings are diversified into lines of business unrelated 
to those of the subsidiary carrier, and/or other indicators of business 
risk deemed appropriate by the Commission. The similarity of the parent 
company's and subsidiary carrier's financial risk shall be evaluated by 
examining the consolidated system's and the subsidiary's total 
capitalization ratios, debt-to-equity ratios, investment quality 
rankings on short- and long-term debt instruments, times-interest-
earned ratios, fixed charges coverage ratios (calculated to include 
both FMC and non-FMC regulated operations), and/or other measures of 
financial risk deemed appropriate by the Commission.
    (iii) When the consolidated capital structure is used, the 
consolidated system's cost of common-stock equity capital (issued by 
the parent company), the consolidated system's cost of long-term debt 
capital, the consolidated system's cost of preferred (and preference) 
stock capital, and the consolidated system's composite statutory 
corporate income tax rate shall also be used in estimating the 
subsidiary's BTWACC.
    (iv) Where the Commission has approved the use of a consolidated 
capital structure, such use will not be subject to challenge in a 
subsequent rate investigation brought under section (3) of the 
Intercoastal Shipping Act, 1933.
    (5) Book-value, average capitalization ratios. Capitalization 
ratios representing the capital structure used in deriving a carrier's 
BTWACC shall be computed on the basis of average projected book value 
outstanding over the 12-month period used to calculate projected 
midyear rate base in Sec. 552.2(b)(1)(ii). The average amount of any 
class of capital outstanding used in determining the capitalization 
ratios is computed by adding the amount of a particular type of capital 
expected to be outstanding as of the beginning of the 12-month period 
to the amount of that same type of capital expected to be outstanding 
as of the end of the 12-month period, and dividing the sum by two.
    (6) Capitalization amounts and ratios (Schedules F-I and F-I(A)). A 
carrier shall show its long-term debt, preferred stock, and common-
stock equity capitalization amounts outstanding, stated in book value 
terms, as of the beginning and as of the end of the 12-month period 
used to calculate projected midyear rate base, and the average amounts 
and average ratios for that 12-month period. Where a carrier is a 
subsidiary of a parent company, the carrier shall show its own 
capitalization amounts and ratios unless the carrier has applied for 
and has been granted permission from the Commission to use a 
consolidated capital structure in computing the BTWACC. Where such 
permission has been granted, the carrier shall show instead the 
consolidated system's capitalization amounts and ratios.
    (7) Cost of long-term debt capital (Schedules F-II, F-II(A), F-III, 
and F-III(A)). (i) The cost of long-term debt capital1 shall be 
calculated by the carrier for the 12-month period used to compute 
projected mid-year rate base on the basis of:

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

    (A) Embedded cost for existing long-term debt; and
    (B) Current cost for any new long-term debt expected to be issued 
on or before the final day of the 12-month period.
    (ii) The arithmetic average annual percentage rate cost of long-
term debt capital calculated on the basis of all issues of long-term 
debt expected to be outstanding as of the beginning and as of the end 
of the 12-month period used to compute projected mid-year rate base 
shall be the cost of long-term debt capital used in computing the 
BTWACC.
    (iii) The annual percentage rate cost of long-term debt capital for 
all issues of long-term debt expected to be outstanding as of the 
beginning and as of the end of the 12-month period used to compute 
projected mid-year rate base shall be calculated separately for the two 
dates by:
    (A) Multiplying the cost of money for each issue under paragraph 
(e)(7)(v)(A)(10) of this section by the principal amount outstanding 
for each issue, which yields the annual dollar cost for each issue; and 


[[Page 46061]]

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

[[Page 46062]]
amount expected to be outstanding for all issues for the 12-month 
period, which yields the average annual percentage rate cost of 
preferred (and preference) stock capital for all issues to be used in 
computing the BTWACC.
    (v)(A) Cost of preferred (and preference) stock capital calculation 
(Schedules F-IV, F-IV(A), F-V and F-V(A)). The carrier shall calculate 
the annual percentage rate cost of preferred (and preference) stock 
capital for all issues of preferred (and preference) stock expected to 
be outstanding as of the beginning and as of the end of the 12-month 
period used to compute projected mid-year rate base separately for the 
two dates, and shall also calculate the average annual percentage rate 
cost of preferred (and preference) stock for all issues for the 12-
month period. The carrier shall support these calculations by showing 
in tabular form the following for each issue of preferred (and 
preference) stock as of the beginning and as of the end of the 12-month 
period separately for the two dates:
    (1) Title;
    (2) Date of issuance;
    (3) Dividend rate (%);
    (4) Par or stated amount of issue ($);
    (5) Discount or premium ($);
    (6) Issuance expense ($);
    (7) Net proceeds to the carrier ($);
    (8) Net proceeds ratio (%), which is the net proceeds to the 
carrier divided by the par or stated amount issued;
    (9) Cost of money (%), which, for existing preferred (and 
preference) stock issues, shall be the dividend rate divided by the net 
proceeds ratio; and, for preferred (and preference) stock issues to be 
newly issued on or before the final day of the 12-month period, shall 
be the estimated dividend rate divided by the estimated net proceeds 
ratio;
    (10) Par or stated amount outstanding ($);
    (11) Annual cost ($); and
    (12) If issue is owned by an affiliate, name and relationship of 
owner.
    (B) Where a carrier is a subsidiary of a parent company, the 
carrier shall show the cost of preferred (and preference) stock 
calculations and information required in this paragraph for its own 
preferred (and preference) stock unless the carrier has applied for and 
been granted permission from the Commission to use a consolidated 
capital structure in computing the BTWACC. Where such permission has 
been granted, the subsidiary carrier shall show the required cost of 
preferred (and preference) stock calculations and information for the 
consolidated system's preferred (and preference) stock.
    (vi) In the event that new preferred (and preference) stock is to 
be issued on or before the final day of the 12-month period used to 
compute projected mid-year rate base, the carrier shall submit a 
statement explaining the methods used to estimate information required 
under paragraph (e)(8)(v)(A) (1) through (12) of this section.
    (9) Cost of common-stock equity capital. A carrier's cost of 
common-stock equity capital shall be calculated using the Discounted 
Cash Flow (``DCF'') and the Risk Premium (``RP'') methods. A final 
estimate of that cost shall be derived from the separate estimates 
obtained using each of the methods.
    (10) DCF method. (i) The DCF model that shall be used in 
calculating a carrier's cost of common-stock equity is defined 
algebraically as follows:

[GRAPHIC][TIFF OMITTED]TR05SE95.001

where:

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

    (ii) Current market price per share of common stock. A DCF analysis 
in which the current market price per share of the carrier's common 
stock is an average of the monthly high and low market prices during a 
six-month period commencing not more than nine months prior to the date 
on which the proposed rates are filed is required. Supplemental DCF 
analysis using the most recent stock price as a basis for the current 
market price per share of common stock may also be used.
    (iii) Additional Studies. Other analysis or forms of the DCF model 
may be included in the computation and determination of the DCF 
estimate of the cost of common-stock equity.
    (11) RP method. (i) The RP model that shall be used in calculating 
a carrier's cost of common-stock equity is defined mathematically as 
follows:

Ke=Kd+RP

where:

Ke is the regulated carrier's cost of common-stock equity 
capital;
Kd is the incremental cost of debt; and
RP is the risk premium.
    (ii) Risk Premium. The risk premium used in the RP model shall be 
the historical arithmetic average return differential between rates of 
return actually earned on investments in the Standard and Poor's 500 
Stock Index and the five-year Treasury note. A risk adjustment specific 
to the carrier for firm size may be included in the computation and 
determination of the risk premium. The risk premium shall be based on 
the complete historical data series published annually in the Stocks, 
Bonds, Bills and Inflation Yearbook, for the period 1926 through the 
most recent date for which the specified data are available.
    (iii) Incremental cost of debt. A six-month average of five-year 
Treasury Note yields computed over a period commencing not more than 
nine months prior to the date on which the proposed rates are filed 
shall be the estimate of the incremental cost of debt in the RP model. 
Supplemental RP analysis using the most recent five-year Treasury Note 
yield as a basis for the incremental cost of debt may also be used.
    (12) Corporate income tax rate (Schedules F-VI and F-VI(A)). The 
corporate income tax rate used in computing the BTWACC shall be the 
carrier's composite statutory corporate income tax rate for the 12-
month period used to compute projected midyear rate base. Such rate 
shall be a composite of the carrier's Federal and State income tax 
rates, and of any other income tax rate to be applied to the carrier's 
income by any other entity to which the carrier is to pay income taxes. 
The carrier shall calculate and show its composite statutory corporate 
income tax rate as well as its Federal, State, and any other applicable 
statutory income tax rates separately for the 12-month period used to 
compute projected midyear rate base. The carrier shall also state the 
name of any entity other than the Federal and State governments to 
which it is to pay taxes. Where a carrier is a subsidiary of a parent 
company, the carrier shall show its own statutory corporate income tax 
rates unless the carrier has applied for and been granted permission 
from the Commission to use a consolidated capital structure in 
computing the BTWACC. Where such permission has been granted, the 
carrier shall show instead the consolidated system's statutory 
corporate income tax rates.
    (13) Flotation costs (Schedules F-VII and F-VII(A)). (i) A 
carrier's cost of common-stock equity capital shall be adjusted to 
reflect those costs of floating new issues that are actually incurred, 
but only in the event that new common stock is to be issued to the 
general 

[[Page 46063]]
public during the 12-month period used to compute projected midyear 
rate base. Those flotation costs for which an allowance shall be made 
must be identifiable, and must be directly attributable to underwriting 
fees, and printing, legal, accounting, and/or other administrative 
expenses. No allowance shall be made for any hypothetical costs such as 
those associated with market pressure and market break effects. The 
allowance shall be applied solely to the new common-stock equity and 
shall not be applied to the existing common-stock equity balance. The 
formula that shall be used to compute such an allowance is as follows:

k = Fs/(1+s)
where:

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

    (ii) Flotation costs data (Schedules F-VII and F-VII(A)). (A) In 
the event that new common-stock equity is to be issued during the 12-
month period used to compute projected midyear rate base, the carrier 
shall show separately by category the estimated costs of floating the 
new issues to the extent that such costs are identifiable and are 
directly attributable to actual underwriting fees, and to printing, 
legal, accounting, and/or other administrative expenses that must be 
paid by the carrier. The carrier shall submit a statement explaining 
the method used in estimating the flotation costs. The carrier shall 
also show estimates of the date of issuance; number of shares to be 
issued; gross proceeds at issuance price; and net proceeds to the 
carrier.
    (B) Where a carrier is a subsidiary that obtains its common-stock 
equity capital through a parent company, and the parent company intends 
to issue new common-stock equity during the 12-month period, the 
carrier shall show separately by category the estimated costs to the 
parent company of floating the new issues, and estimates of the above 
items relative to the parent company's issuance of new common-stock 
equity, provided that such carrier has applied for and been granted 
permission from the Commission to use a consolidated capital structure 
in computing the BTWACC.
    (f) Financial ratio methods--(1) Fixed charges coverage ratio. * * 
*
    (2) Operating ratio. * * *
* * * * *
    By the Commission.
Joseph C. Polking,
Secretary.
[FR Doc. 95-21845 Filed 9-1-95; 8:45 am]
BILLING CODE 6730-01-W