|SURFACE TRANSPORTATION BOARD DECISION DOCUMENT|
|RAILROAD COST OF CAPITAL - 2010|
|DECISION FOUND THAT FOR 2010, THE CURRENT COST OF RAILROAD LONG-TERM DEBT WAS 4.61%; THE COST OF COMMON EQUITY WAS 12.99%; THE CAPITAL STRUCTURE MIX OF THE RAILROADS WAS 23.38% LONG-TERM DEBT AND 76.62% COMMON EQUITY; AND THE COMPOSITE RAILROAD INDUSTRY COST OF CAPITAL WAS 11.03%.|
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|Full Text of Decision|
41599 SERVICE DATE – OCTOBER 3, 2011
This decision will be printed in the bound volumes of
the STB printed reports at a later date.
SURFACE TRANSPORTATION BOARD
Docket No. EP 558 (Sub-No. 14)
RAILROAD COST OF CAPITAL—2010
Digest: The agency finds that the cost of capital for the railroad industry in 2010 was 11.03%. This figure represents the Board’s estimate of the average rate of return needed to persuade investors to provide capital to the freight rail industry. The cost-of-capital figure, which is calculated each year, is an essential component of many of the agency’s core regulatory responsibilities.
Decided: September 30, 2011
BY THE BOARD:
One of the Board’s regulatory
responsibilities is to determine annually the railroad industry’s cost of capital. This determination is one component used in
evaluating the adequacy of a railroad’s revenue each year pursuant to
49 U.S.C. § 10704(a)(2) and (3). Standards for R.R. Revenue Adequacy,
364 I.C.C. 803 (1981), modified, 3 I.C.C. 2d 261 (1986), aff’d sub nom. Consol. Rail Corp. v.
This proceeding was instituted in Railroad Cost of Capital—2010, EP 558 (Sub-No. 14) (STB served Feb. 22, 2011) to update the railroad industry’s cost of capital for 2010. In that decision, the Board solicited comments from interested persons on the following issues: (1) the railroads’ 2010 current cost of debt capital; (2) the railroads’ 2010 current cost of preferred equity capital (if any); (3) the railroads’ 2010 cost of common equity capital; and (4) the 2010 capital structure mix of the railroad industry on a market value basis.
We have received comments from the Association of American Railroads (AAR) that provides the information that is used in making the annual cost-of-capital determination, as established in Use of a Multi-Stage Discounted Cash Flow Model in Determining the Railroad Industry’s Cost of Capital, EP 664 (Sub-No. 1) (STB served Jan. 28, 2009). Western Coal Traffic League (WCTL) replied to AAR’s submission. WCTL asserts that the Board should make an appropriate adjustment for the exclusion of BNSF from the composite sample. Further, WCTL asserts that the Board should exclude certain analyst growth rate projections used by AAR in calculating the railroad industry’s cost of equity (COE) under the Morningstar/Ibbotson Multi-Stage Discounted Cash Flow Model (MSDCF). These issues will be addressed below.
2010 Cost-of-Capital Determination
previous cost-of-capital proceedings,
below, we have examined the procedures used by
Cost of Bonds, Notes, and Debentures (Bonds)
Cost of Equipment Trust Certificates (ETCs)
ETCs are not actively traded on
secondary markets. Therefore, their
costs must be estimated by comparing them to the yields of other debt
securities that are actively traded.
Following the practice in previous cost-of-capital proceedings,
were no new ETCs issued during 2010.
However, there were 11 ETCs issued prior to 2010 that were outstanding
during the year.
have examined the cost and market value of the ETCs using AAR’s data, and we
Cost of Conditional Sales Agreements (CSAs)
represent a small fraction (less than 1%) of total railroad debt, and only 2
CSAs (issued by CSX) were outstanding in 2010.
The cost of CSAs can be estimated by adding an additional factor to the
yield spread between government bonds and ETCs.
Capitalized Leases and Miscellaneous Debt
As in previous cost-of-capital
Total Market Value of Debt
Flotation Costs of Debt
To compute the overall effect of the
flotation cost on debt, the market value weight of the debt outstanding is
multiplied by the respective flotation cost.
The weight for each type of debt is based on market values for debt,
excluding all other debt. All other debt
is excluded from the weight calculation, because a current cost of debt for
that debt has not been determined.
Overall Current Cost of Debt
COMMON EQUITY CAPITAL
We estimate the cost of common equity capital by calculating the simple average of estimates produced by a Capital Asset Pricing Model (CAPM) and the Morningstar/Ibbotson MSDCF.
Under CAPM, the cost of equity is equal to RF + β×RP, where RF is the risk-free rate, RP is the market-risk premium, and β (or beta) is the measure of systematic, non-diversifiable risk. In order to calculate RF, we asked the railroads to provide the average yield to maturity in 2010 for a 20-year U.S. Treasury Bond. Similarly, the railroads were asked to provide an estimate for RP based on returns experienced by the S&P 500 since 1926. Finally, we instructed the railroads to calculate beta using a portfolio of weekly, merger-adjusted railroad stock returns for the prior 5 years in the following equation:
R – SRRF = α + β(RM – SRRF) + ε, where
α = constant term;
R = merger-adjusted stock returns for the portfolio of railroads that meet the screening criteria set forth in Railroad Cost of Capital – 1984, 1 I.C.C. 2d 989 (1985);
SRRF = the short-run risk-free rate, which we will proxy using the 3-month U.S. Treasury bond rate;
RM = return on the S&P 500; and
ε = random error term.
RF – The Risk Free Rate
establish the risk-free rate,
RP – The Market-Risk Premium
Using the approach settled upon in
the Cost of Capital Methodology,
The Cost of Capital Methodology requires
parties to calculate CAPM’s beta using a portfolio of weekly, merger-adjusted
stock returns for the prior 5 years in the following equation: R – SRRF =
α + β(RM – SRRF) + ε.
WCTL asserts that BNSF’s exclusion from the cost-of-capital determination would likely lead to higher costs of equity and capital for most years, than if BNSF remained in the composite railroad group. As a result, WCTL suggests that the Board make an adjustment to account for BNSF’s exclusion from the composite sample. Specifically, WCTL states that the Board should explore various methodologies that would allow for BNSF’s inclusion in the industry cost-of-capital determination. In its reply statement, WCTL offers an approach to compute a surrogate COE for BNSF. This approach (a) develops the beta on the “pure play” railroads in the industry (UP, CSX, and NS); (b) removes the implicit leverage associated with each of the “pure play” railroads; (c) averages the unlevered betas to develop a railroad industry average unlevered beta; (d) applies the averaged unlevered beta to Berkshire Hathaway’s 2010 debt-to-equity ratio to develop a BNSF levered beta; (e) calculates a weighted-average beta for the railroad industry; and (f) applies the Blume Adjustment to the weighted average beta for the railroad industry.
also contests WCTL’s application of the Blume
Adjustment. AAR asserts that the Blume Adjustment is an inappropriate methodology for rail
industry purposes and is not part of the Board’s CAPM procedure. Moreover,
We will not include BNSF in the composite group at this time. Doing so would conflict with both the Board’s criteria in Railroad Cost of Capital—1984 and the Board’s cost-of-capital methodology adopted in Methodology to Be Employed in Determining the Railroad Industry’s Cost of Capital. As the Board has previously stated, we will not entertain arguments raised in EP 558 proceedings that propose a methodological change to the cost-of-capital determination. In Methodology to Be Employed in Determining the Railroad Industry’s Cost of Capital, slip op. at 18, the Board held that, “while in the past we have entertained challenges to the agency’s model in the 558 proceedings, we will no longer do so. As such, future requests to change the assumptions that form the elements of our CAPM model must be brought (in the form of a petition for rulemaking) in a 664 proceeding, not in the annual 558 proceeding, in which we calculate the cost of capital for a particular year.” Thus, parties in EP 558 proceedings should adhere to our established precedent, and not raise arguments that advocate a change to the cost-of-capital model.
In any event, WCTL has not convinced us that its suggested methodology, which would allow for BNSF’s inclusion in the industry cost of capital, is a more precise technique than our current process. Specifically, the record does not demonstrate that the approach of using levered and unlevered beta estimates is a more accurate approach than our current method of pooling the performance data of carriers in the composite railroad group and estimating a single beta for the railroad industry. WCTL provides only summary arguments for departing from the Board’s established methodology and why using a “surrogate” COE for a railroad leads to a better result. Additionally, WCTL’s approach requires the application of the Blume Adjustment to the industry beta. Although WCTL argues that the Blume Adjustment is “well recognized” and used by financial reporting services, WCTL did not provide academic research or empirical evidence to show that its own preferred application would be appropriate here.
Cost of Common Equity Capital using CAPM
Using the modified approach for assigning the new shares outstanding, we calculate the cost of equity as RF + β × RP, or 4.03% + ( 1.1619× 6.72%), which equals 11.84%. Tables 9 and 10 in the Appendix show the calculations of the cost of common equity using CAPM.
Multi-Stage Discounted Cash Flow
The cost of equity in a Discounted Cash Flow (DCF) model is the discount rate that equates a firm’s market value to the present value of the stream of cash flows that could affect investors. These cash flows are not presumed to be paid out to investors; instead, it is assumed that investors will ultimately benefit from these cash flows through higher regular dividends, special dividends, stock buybacks, or stock price appreciation. Incorporation of these cash flows, as well as the expected growth of earnings, are the essential elements of the Morningstar/Ibbotson MSDCF model.
The Morningstar/Ibbotson MSDCF model defines cash flows (CF), for the first 2 stages, as income before extraordinary items (IBEI), minus capital expenditures (CAPEX), plus depreciation (DEP) and deferred taxes (DT), or
CF = IBEI – CAPEX + DEP + DT.
The third-stage cash flow is based on 2 assumptions: depreciation equals capital expenditures, and deferred taxes are zero. That is, cash flow in the third stage of the model is based only on IBEI.
obtain an average cash flow to sales ratio,
Growth of earnings is also
calculated in 3 stages. These 3 growth-rate
stages are what make the Morningstar/Ibbotson model a “multi-stage” model. In the first stage (years 1-5), the firm’s
annual earnings growth rate is assumed to be the median value of the qualifying
railroad’s 3- to 5-year growth estimates, as determined by railroad industry
analysts, and published by Institutional Brokers Estimate System (I/B/E/S). In the second stage (years 6-10), the growth
rate is the average of all growth rates in stage 1. In the third stage (years 11 and onwards),
the growth rate is the long-run nominal growth rate of the
AAR calculated the first- and second-stage growth rates according to the I/B/E/S data, which was retrieved from Thomson One Investment Management. The third-stage growth rate of 5.8% was calculated by using the sum of the long-run expected growth in real output (3.3%) and the long-run expected inflation (2.6%).
In its comments, WCTL asserts that
the Board should exclude purportedly stale analyst growth rate projections in
calculating the MSDCF COE for the railroad industry. WCTL contends that, of the 18 analyst growth
rates used by
In its rebuttal comments, AAR
states that all of the analysts’ growth rate projections used in its MSDCF
calculation were in effect at the end of 2010 and are taken from the I/B/E/S
analyst growth rate estimates distributed by Thompson Financial through its
Thompson One Investment Management Service.
AAR clarified that all growth rates were reviewed by analysts during
2010, and that
After reviewing the evidence provided by AAR, it is apparent that all 18 growth rates have been reviewed in 2010. We have no reason to conclude that the growth rates do not use the most current and accurate information available. Therefore, we accept the growth rates provided by AAR as correct and consistent with the Board’s approved methodology, and we will employ them in the determination of the cost of equity for 2010.
Market Values for MSDCF
final inputs to the Morningstar/Ibbotson MSDCF model are the stock market
values for the equity of each railroad.
Cost of Common Equity Capital using MSDCF
Cost of common equity
Based on the evidence provided, we conclude that the railroad cost of equity in 2010 is 12.99%. This figure is based on an estimate of the cost of equity using CAPM of 11.84% and a MSDCF estimate of 14.13%.  Table 12 shows both costs of common equity for each model, and the average of the 2 models.
Preferred equity has some of the characteristics of both debt and equity. Essentially, preferred issues are like common stocks in that they have no maturity dates and represent ownership in the company (usually with no voting rights attached). They are similar to debt in that they usually have fixed dividend payments (akin to interest payments).
There were no preferred stock issues outstanding at the end of 2010.
CAPITAL STRUCTURE MIX
The Board will apply the same inputs used in the market value for the CAPM model to the capital structure.
We have determined that the average market values of debt and common equity are $24.371 billion and $79.891 billion, respectively. The percentage share of debt decreased, from 29.10% in 2009 to 23.38% in 2010. The percentage share of common equity increased, from 70.90% in 2009 to 76.62% in 2010. Table 13 in the Appendix shows the calculations of the average market value of common equity and relative weights for each railroad. Table 14 in the Appendix shows the 2010 capital structure mix.
COMPOSITE COST OF CAPITAL
Based on the evidence furnished in the record, and our adjustments to the calculations discussed above, we conclude that the 2010 composite after-tax cost of capital for the railroad industry, as set forth in Table 15 in the Appendix, was 11.03%. The procedure used to develop the composite cost of capital is consistent with the Statement of Principle established by the Railroad Accounting Principles Board: “Cost of capital shall be a weighted average computed using proportions of debt and equity as determined by their market values and current market rates.” R.R. Accounting Principles Bd., Final Report, Vol. 1 (1987). The 2010 cost of capital was 0.6 percentage points higher than the 2009 cost of capital (10.43%).
We find that for 2010:
1. The current cost of railroad long-term debt was 4.61%.
2. The cost of common equity was 12.99%.
3. The capital structure mix of the railroads was 23.38% long-term debt and 76.62% common equity.
4. The composite railroad industry cost of capital was 11.03%.
Environmental and Energy Considerations
We conclude that this action will not significantly affect either the quality of the human environment or the conservation of energy resources.
It is ordered:
1. This decision is effective on November 2, 2011.
2. This proceeding is discontinued.
By the Board, Chairman Elliott, Vice Chairman Begeman, and Commissioner Mulvey.
2010 Traded & Non-traded Bonds
2010 Bonds, Notes, & Debentures
2010 Equipment Trust Certificates
2010 Conditional Sales Agreements
2010 Capitalized Leases & Miscellaneous Debt
2010 Market Value of Debt
2010 Flotation Cost for Debt
2010 Cost of debt
2010 Summary Output
2010 CAPM Cost of Common Equity
2010 MS-DCF Railroad Cost of Equity
($ in millions)
2010 Cost of Common Equity Capital
2010 Average market Value
2010 Capital Structure Mix
2010 Cost-of-Capital Computation
 The digest constitutes no part of the decision of the Board but has been prepared for the convenience of the reader. It may not be cited to or relied upon as precedent. Policy Statement on Plain Language Digests in Decisions, EP 696 (STB served Sept. 2, 2010).
 The railroad cost of capital determined here is an aggregate measure. It is not intended to measure the desirability of any individual capital investment project.
 The composite railroad includes those Class I carriers that: (1) are listed on either the New York or American Stock Exchange; (2) paid dividends throughout the year; (3) had rail assets greater than 50% of its total assets; and (4) had a debt rating of at least BBB (Standard & Poor’s) and BAA (Moody’s).
 These companies, along with BNSF Railway Company (BNSF), were also used in Railroad Cost of Capital—2009, EP 558 (Sub-No. 13) (STB served Oct. 29, 2010). Due to the acquisition of BNSF by Berkshire Hathaway, Inc., in the beginning of 2010, the Board has not included BNSF in the 2010 sample base because BNSF no longer meets the criteria for inclusion in the composite group.
 There was no preferred stock outstanding in the year 2010.
 A basis point equals 1/100th of a percentage point.
 This is the same spread used in 2009.
 This percentage is lower than the 2009 figure of 3.551%.
 AAR approximated the market values of ETCs using the same procedures used in previous cost-of-capital determinations.
 This figure consists of $1.945 billion of capitalized leases and $161 million of miscellaneous debt. Non-modeled ETCs and non-modeled CSAs, as defined by AAR, are included in the miscellaneous debt category.
 AAR calculated the 2010 flotation costs for bonds using publicly available data from electronic filings with the SEC.
 This percentage is lower than the 2009 cost of debt (5.72%). As explained above, our measurement of the railroads’ cost of debt entails the calculation of a weighted average of the current yields of the various debt instruments issued by the 3 railroads in our sample.
 According to Morningstar, Inc., “for a company to be considered a pure play company in an industry, the revenue that the company generates from that industry should constitute a vast majority of the company’s total revenue.” See Ibbotson SBBI 2011 Valuation Yearbook: Market Results for Stocks, Bonds, Bills and Inflation 1926-2010, at 79 (2011).
 The Blume Adjustment is an approach that adjusts betas based upon the belief that betas tend to revert toward their mean value, or the market beta of one. In essence, high historical betas (those in excess of one) tend to overestimate betas in future time periods, and low historical betas (those under one) tend to underestimate betas in future time periods. See Marshall E. Blume, On the Assessment Risk, 26 J. of Fin. 1, 1-10 (1971).
 The Verified Statement of Crowley and Fapp, submitted in support of WCTL’s filing, provided a more sophisticated approach, which included the use of a full information beta. However, the record is insufficient for the Board to consider this method, as WCTL has failed to provide an analysis of why this method is a more accurate approach than our current process.
 The Verified Statement of Crowley and Fapp further adjusts the Board’s approved cost-of-capital methodology by including the weighted cost of Berkshire Hathaway’s CAPM and MSDCF costs of equity with the three railroad companies included in the composite group. These adjustments result in a CAPM cost of equity of 11.01% and an MSDCF cost of equity of 12.86%, for an average cost of equity of 11.94%. See WCTL Reply, V.S. Crowley/Fapp 39. The Board finds that this method is unrepresentative of the Class I railroad industry, as it relies heavily on Berkshire Hathaway’s Capital Structure.