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Docket Number: | EP_558_14 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||

Case Title: | RAILROAD COST OF CAPITAL - 2010 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||

Decision Type: | Decision | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||

Deciding Body: | Entire Board | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||

Decision Summary | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||

Decision Notes: | 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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41599 SERVICE DATE – OCTOBER 3, 2011 EB This decision will be printed in the bound volumes of the STB printed reports at a later date. SURFACE TRANSPORTATION BOARD DECISION Docket No. EP 558 (Sub-No. 14) RAILROAD COST OF CAPITAL—2010
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.[2] 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).
This
proceeding was instituted in 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
Consistent with
previous cost-of-capital proceedings, As discussed
below, we have examined the procedures used by
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, There
were no new ETCs issued during 2010.
However, there were 11 ETCs issued prior to 2010 that were outstanding
during the year. We
have examined the cost and market value of the ETCs using AAR’s data, and we
agree with
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.
As in previous cost-of-capital
determinations,
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.
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 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.
To
establish the risk-free rate,
Using the approach settled upon in
the
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”[14] 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.[15] AAR
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 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.[16] 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.[17]
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%.
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. To
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.
## 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%. [18]
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.
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.
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
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%.
We conclude that this action will not significantly affect either the quality of the human environment or the conservation of energy resources.
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.
[1] 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. [2] 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. [3] 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). [4] These
companies, along with BNSF Railway Company (BNSF), were also used in [5] There was no
preferred stock outstanding in the year 2010.
[7] This is the
same spread used in 2009.
[9] AAR
approximated the market values of ETCs using the same procedures used in
previous cost-of-capital determinations.
[13] AAR uses the SAS General Linear Model
procedure to compute regression data.
The Board uses a standard Excel regression method. [14] 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.” [15] 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.
[17] 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. [18] 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%. |