[Federal Register Volume 73, Number 30 (Wednesday, February 13, 2008)]
[Notices]
[Pages 8402-8403]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-2707]


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DEPARTMENT OF TRANSPORTATION

Surface Transportation Board

[STB Ex Parte No. 664 (Sub-No. 1)]


Use of a Multi-Stage Discounted Cash Flow Model in Determining 
the Railroad Industry's Cost of Capital

AGENCY: Surface Transportation Board, DOT.

ACTION: Notice and request for comments.

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SUMMARY: The Board is seeking comments on the use of a multi-stage 
Discounted Cash Flow Model to complement the use of the Capital Asset 
Pricing Model in determining the railroad industry's cost of capital.

DATES: Comments are due on or before April 14, 2008.

ADDRESSES: Send Comments (an original and 10 copies) referring to [STB 
Ex Parte No. 664 (Sub-No.1)] to: Surface Transportation Board, 395 E 
Street, SW., Washington, DC 20423-0001.

FOR FURTHER INFORMATION CONTACT: Paul Aguiar, (202) 245-0323. 
[Assistance for the hearing impaired is available through the Federal 
Information Relay Service (FIRS) at 1-800-877-8339.]

SUPPLEMENTARY INFORMATION: Each year the Board measures the cost of 
capital for the railroad industry in the prior year. The Board then 
uses this cost-of-capital figure for a variety of regulatory purposes. 
It is used to evaluate the adequacy of individual railroads' revenues 
for that year.\1\ It is also employed in cases involving rail rate 
review, feeder line applications, rail line abandonment proposals, 
trackage rights compensation cases, and rail merger review, as well as 
in our Uniform Rail Costing System (URCS).
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    \1\ See 49 U.S.C. 10704(a)(2),(3); Standards for Railroad 
Revenue Adequacy, 364 I.C.C. 803 (1981), modified, 3 I.C.C.2d 261 
(1986), aff'd sub nom. Consolidated Rail Corp. v. United States, 855 
F.2d 78 (3d Cir. 1988).
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    The Board calculates the cost of capital as the weighted average of 
the cost of debt and the cost of equity, with the weights determined by 
the capital structure of the railroad industry (i.e., the proportion of 
capital from debt or equity on a market-value basis). While the cost of 
debt is observable and readily available, the cost of equity (the 
expected return that equity investors require) can only be estimated. 
How best to calculate the cost of equity is the subject of a vast 
amount of literature. In each case, however, because the cost of equity 
cannot be directly observed, estimating the cost of equity requires 
adopting a finance model and making a variety of simplifying 
assumptions.
    In Methodology to be Employed in Determining the Railroad 
Industry's Cost of Capital, STB Ex Parte No. 664 (STB served Jan. 17, 
2008), the Board changed the methodology that it will use to calculate 
the railroad industry's cost of equity. We concluded that the time had 
come to modernize our regulatory process and replace the aging single-
stage DCF model that had been employed since 1981. We decided to 
calculate the cost of equity using a Capital Asset Pricing Model 
(CAPM). Many parties had urged that the Board use a multi-stage 
Discounted Cash Flow model (DCF) in conjunction with CAPM. The record 
in that proceeding did not support adopting any particular DCF model. 
However, we did not want to foreclose the possibility of augmenting 
CAPM with a DCF approach. As we explained in the January 2008 decision 
(footnotes omitted):

    There may be merit to the idea of using both models to estimate 
the cost of equity. While CAPM is a widely accepted tool for 
estimating the cost of equity, it has certain strengths and 
weaknesses, and it may be complemented by a DCF model. In theory, 
both approaches seek to estimate the true cost of equity for a firm, 
and if applied correctly should produce the same expected result. 
The two approaches simply take different paths towards the same 
objective. Therefore, by taking an average of the results from the 
two approaches, we might be able to obtain a more reliable, less 
volatile, and ultimately superior estimate than by relying on either 
model standing alone.

    Ultimately, both CAPM and DCF are economic models that seek to 
measure the same thing. CAPM seeks to do so by estimating the level of 
expected returns that investors would demand given the perceived risks 
associated with the company. By contrast, DCF models estimate the 
expected rate of return based on the present value of the cash flows 
that the company is expected to generate. Both approaches are plausible 
and intuitive, but are merely models.
    The Federal Reserve Board noted in its testimony in STB Ex Parte 
No. 664 that ``academic studies had demonstrated that using multiple 
models will improve estimation techniques when each model provides new 
information. * * *''\2\ There is, in fact, robust economic literature 
confirming that in many cases combining forecasts from different models 
is more accurate than relying on a single model.\3\
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    \2\ February 2007 Hearing Tr. at 18.
    \3\ See generally David F. Hendry & Michael P. Clements, Pooling 
of Forecasts, VII Econometrics Journal 1 (2004); J.M. Bates & C.W.J. 
Granger, The Combination of Forecasts in Essays in Econometrics: 
Collected Papers of Clive W.J. Granger. Vol. I: Spectral Analysis, 
Seasonality, Nonlinearity, Methodology, and Forecasting 391-410 
(Eric Ghysels, Norman R. Swanson, & Mark W. Watson, eds., 2001); 
Spyros Makridakis and Robert L. Windler, Averages of Forecasts: Some 
Empirical Results, XXIX Management Science 987 (1983).
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    Though the record before us in STB Ex Parte No. 664 was 
insufficient for us to adopt a DCF model, it did illuminate a number of 
criteria to guide us in this effort. First, and foremost, the DCF model 
should be a multi-stage model. From 1981 through 2005, the agency 
relied on a single-stage DCF. That model required few inputs and few 
judgment calls, permitting the agency to promptly develop an estimate 
of the cost-of-equity component of the cost of capital. The simplicity 
of this model, however, was due in part to an assumption that the 5-
year growth rate would remain constant thereafter. That assumption 
proved problematic. In recent years, railroad earnings have grown at a 
very rapid pace, exceeding the long-run growth rate of the economy as a 
whole. While it is certainly possible that railroad earnings will 
continue to grow rapidly for many years, they cannot do so forever as 
the single-stage DCF model assumes. Thus, in years when the 5-year 
growth rate is very high, this model may overstate the cost of equity. 
Similarly, in years when the railroads experience a downturn and the 
predicted 5-year growth rate is very low, the model may understate the 
cost of equity.
    Second, the DCF model should not focus on dividend payments only. 
Finance theory suggests that the value of a firm should be independent 
of its dividend policy.\4\ Certainly, changes in

[[Page 8403]]

dividends do influence stock prices, but only because these changes are 
``news'' to which the market responds in valuing the stock; it is the 
``news,'' not the dividend distribution itself, that drives the change 
in prices. Moreover, companies return profits to their shareholders in 
ways other than increasing dividends, including buying back shares. As 
a result, we no longer think that a simple dividend distribution model 
is an acceptable framework for valuing firms. Rather, broader measures 
of cash flow or shareholder returns should be incorporated.
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    \4\ See, e.g., Franco Modigliani & Merton H. Miller, The Cost of 
Capital, Corporation Finance, and the Theory of Investment, 48 Am. 
Econ. Rev., 261-97 (1958). By integrating tax- and information-
related considerations on capital structure and dividend policy 
choices, Modigliani and Miller greatly influenced subsequent 
developments in the field of finance. See Sudipto Bhattacharya, 
Corporate Finance and the Legacy of Miller and Modigliani, 2 J. 
Econ. Perspectives 135-47 (1988).
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    Third, the DCF model should be limited to those firms that pass the 
screening criteria we set forth in Railroad Cost of Capital--1984, 1 
I.C.C.2d 989 (1985).\5\ Thus, while the general approach used in the 
Morningstar/Ibbotson multi-stage DCF model might prove satisfactory, we 
cannot consider the model as it applies to firms that do not meet our 
screening criteria.
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    \5\ Under those criteria, we include in the analysis only those 
Class I carriers that: (1) Had rail assets greater than 50% of their 
total assets; (2) had a debt rating of at least BBB (Standard & 
Poors) and Baa (Moody's); (3) are listed on either the New York or 
American Stock Exchange; and (4) paid dividends throughout the year. 
A Class I railroad is one having annual carrier operating revenues 
of at least $250 million in 1991 dollars. 49 CFR 1201.1-1.
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    Fourth, we must be satisfied that any multi-stage DCF we might 
adopt would, when used in combination with the CAPM model, enhance the 
precision of the resulting cost-of-equity estimate. In other words, we 
must be persuaded that, over a sufficiently lengthy historical analysis 
period, the combination forecast would result in a lower variance than 
reliance on the CAPM approach alone.
    In addition to these four criteria, interested parties are invited 
to identify and address any other criteria the Board should consider in 
evaluating a multi-stage DCF. For example, parties to STB Ex Parte No. 
664 indicated that atypically large capital investment by the railroads 
could affect the results of a DCF analysis. Parties should address this 
concern and show how a multi-stage DCF would account for such 
investments.
    Finally, all interested parties are invited to submit comments on 
an appropriate multi-stage DCF for use in the Board's cost-of-equity 
determination. Parties should include any workpapers needed to 
demonstrate that their proposal combining CAPM and DCF is more precise 
than the Board's CAPM methodology alone. Comments and workpapers are 
due to the Board on April 14, 2008. If we are not ultimately persuaded 
that use of a particular multi-stage DCF model would improve the 
Board's cost-of-equity calculation, we will terminate this proceeding.
    This action will not significantly affect either the quality of the 
human environment or the conservation of energy resources.
    Board decisions and notices are available on our Web site at http://www.stb.dot.gov.

    Decided: February 7, 2008.

    By the Board, Chairman Nottingham, Vice Chairman Mulvey, and 
Commissioner Buttrey.
Anne K. Quinlan,
Acting Secretary.
[FR Doc. E8-2707 Filed 2-12-08; 8:45 am]
BILLING CODE 4915-01-P