SURFACE TRANSPORTATION BOARD DECISION DOCUMENT | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||

Decision Information | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||

Docket Number: | EP_558_16 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||

Case Title: | RAILROAD COST OF CAPITAL - 2012 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||

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

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

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

Decision Notes: | DECISION CORRECTED THE DECISION SERVED ON AUGUST 2, 2013, IN THIS PROCEEDING. THIS DECISION FINDS THAT THE COST OF CAPITAL FOR THE RAILROAD INDUSTRY IN 2012 WAS 11.12%. | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||

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43310 SERVICE DATE – LATE RELEASE AUGUST 30, 2013 EB
SURFACE TRANSPORTATION BOARD
CORRECTED DECISION*
Docket No. EP 558 (Sub-No. 16)
RAILROAD COST OF CAPITAL—2012
Decided: August 30, 2013
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 provide the information that is
used in making the annual cost-of-capital determination, as established in
Consistent with previous
cost-of-capital proceedings, AAR calculated the cost of capital for a
“composite railroad” based on criteria developed in
As discussed below, we have
examined the procedures used by AAR to calculate the following components for
the railroad industry’s 2012 cost of capital: (1) cost-of-debt capital;
(2) cost of common equity capital; (3) cost of preferred equity
capital;[4] (4) capital
structure; and (5) composite after-tax cost of capital. We estimate that
the 2012 railroad cost of capital was
AAR developed its 2012 current cost of debt using bond price data from Bloomberg Professional (Bloomberg), a subscription service. AAR’s cost-of-debt figure is based on the market-value yields of the major forms of long-term debt instruments for the railroad holding companies used in the composite. These debt instruments include: (1) bonds, notes, and debentures (bonds); (2) equipment trust certificates (ETCs); and (3) conditional sales agreements (CSAs). The yields of these debt instruments are weighted based on their market values.
AAR used data from Bloomberg for
the current cost of bonds, based on monthly prices and yields during 2012, for
all issues (a total of 69) that were publicly traded during the year.[5]
To develop the current (in 2012) market value of bonds, AAR used these traded
bonds and additional bonds that were outstanding but not publicly traded during
2012. Continuing the procedure in effect since 1988, AAR based the market
value on monthly prices for all traded bonds and the face or par value ($1,000)
for all bonds not traded during the year. AAR computed the total market value
of all outstanding bonds to be $27.2 billion ($26.9 billion traded, and $325
million non-traded).[6] Based on the yields for
the traded bonds, AAR calculated the weighted average 2012 yield for all bonds
to be 3.239%.[7] We have examined AAR’s
bond price and yield data and have determined that AAR’s computations are correct.
Our calculations and data for all bonds are shown in
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, AAR used government
securities with maturities similar to these ETCs as surrogates for developing
yields. After calculating the 2012 yields for these government securities, AAR
added basis points
There were no new ETCs issued during 2012.
However, there were 9 ETCs outstanding during the year.[9]
AAR calculated that the yield spread for ETCs was 80 basis points higher than
the yield for government bonds.[10] Using the yield
spreads, AAR calculated the weighted average cost of ETCs to be 2.097%
We have examined and accept the cost and market
value of the ETCs using AAR’s data.
CSAs represent a small fraction (less than 1%) of total railroad debt. For 2012, no CSAs were modeled.[13]
As in previous cost-of-capital determinations,
AAR excluded the cost of capitalized leases and of miscellaneous debt in its
computation of the overall current cost of debt because these costs are not
directly observable in the open market. Also, in keeping with past practice,
AAR included the book value of leases and commercial paper in the overall
market value of debt, which is used to determine the railroads’ capital
structure mix. AAR calculated that the market value for the capitalized leases
and miscellaneous debt was
AAR calculated that the total market value for
all debt during 2012 was
AAR calculated flotation costs for
bonds, notes, and debentures by calculating a yield based on the price to
investors and a yield that also included flotation costs. The difference
between the two yields is the flotation costs expressed in percentage points.
For 2012, six new issues were reported in five filings.[16]
A simple average of the six flotation costs is 0.062%.[17]
AAR calculated the 2012 flotation costs for bonds using publicly available data
from electronic filings with the U.S. Securities and Exchange Commission (SEC).
For the calculation of ETC flotation costs, AAR used a historical SEC study
composed of railroad ETC data for the years 1951, 1952, and 1955. SEC,
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.[18] All other debt is excluded from the weight calculation, because a current cost of debt for other debt has not been determined.[19] AAR calculated that flotation costs for debt equal 0.062%.[20]
We have reviewed AAR’s calculations concerning
flotation costs and find that the cost factors developed for the various
components of debt are reasonable.
AAR concluded that the railroads’ cost of debt
for 2012 was 3.29%.
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 2012 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 five 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,
AAR relies on the Federal Reserve website to retrieve the average yield to
maturity for a 20-year U.S. Treasury Bond. Using the average yield to maturity
in 2012 for a 20-year U.S. Treasury Bond, consistent with
Using the approach settled upon in the
The
Using the modified approach for assigning the
new shares outstanding, we calculate the cost of equity as RF + β × RP, or
2.54% + (1.1543× 6.70 %), which equals 10.27%.[27]
To calculate the 2012 market value of common equity for each railroad, AAR calculated each railroad’s weekly market value using data on shares outstanding from railroad 10-Q and 10-K reports, multiplied by stock prices at the close of each week in 2012. AAR calculated the combined 52-week average market value of the railroads as $100.1 billion.[28]
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 two 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 two 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, AAR divided the total cash flow in the 2008-2012 periods by the total sales over the same period. To obtain the 2012 average cash flow, the cash-flow-to-sales ratio is multiplied by the sales revenue from 2012. The 2012 average cash flow figure is then used as the starting point of the Morningstar/Ibbotson MSDCF model. The initial value of IBEI is determined through the same averaging process for the cash flows in stages one and two. According to AAR, the data inputs in the cash flow formula were retrieved from the railroads’ 2008-2012 10-K filings with the SEC.
Growth of earnings is also calculated in three stages. These three growth-rate stages are what make the Morningstar/Ibbotson model a “multi-stage” model. In the first stage (years one through five), the firm’s annual earnings growth rate is assumed to be the median value of the qualifying railroad’s three- to five-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 six through 10), the growth rate is the average of all growth rates in stage one. In the third stage (years 11 and onwards), the growth rate is the long-run nominal growth rate of the U.S. economy. This long-run nominal growth rate is estimated by using the historical growth in real GDP and the long-run expected inflation rate.
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 5.48% was calculated by using the sum of the long-run expected growth in real output (3.22%) and the long-run expected inflation (2.26%).[29]
After reviewing the evidence provided by AAR, we find the growth rates correct and consistent with the Board’s approved methodology, and we will employ them in the determination of the cost of equity for 2012.
We have reviewed AAR’s
evidence and find that the market values used in the 2012 estimate of the cost
of equity, using the Morningstar/Ibbotson
MSDCF model, should have applied the stock price for December 28, 2012, rather
than the stock price for December 31, 2012. December 31, 2012
falls outside of the 2012 data set for calculating the cost of equity because there was only one trading day in 2012 during that
week. The Board defines the first trading
week of a year to be the first week in the year that contains three or
more trading days.
AAR estimates a MSDCF cost of equity of 16.39%.[30]
Based upon our adjustment stated above, we calculate the MSDCF as 16.53%, and we
will average this estimate with the cost of equity derived from the CAPM
approach.
## Cost of Common Equity
Based on the evidence provided, we conclude that
the railroad cost of equity in 2012 is 13.40%.[31] This figure is based on
an estimate of the cost of equity using CAPM of 10.27% and a MSDCF estimate of 16.53%.
In its comments, WCTL argues that use of the MSDCF methodology produces a higher cost of equity than the CAPM, and that such a disparity in values should prompt inquiry as to the underlying cause and consideration of which value is more probative. Toward this end, WCTL alleges that a reduction in the number of outstanding shares can cause earnings-per-share (EPS) estimates to increase faster than overall earnings and potentially lead to a disparity such as the current one between the MSDCF and CAPM results. WCTL urges the Board to rely exclusively on CAPM to estimate the cost of equity at least until the MSDCF methodology can be corrected. On rebuttal, AAR argues, among other things, that WCTL should not be permitted to collaterally attack the Board’s prior decision to include the MSDCF model in the railroad industry’s cost of equity. AAR notes that WCTL does not argue that the AAR had erred in its calculation or misapplied the Board’s established methodology, including the MSDCF model. Moreover, AAR argues that: (1) WCTL’s attempted collateral attack on the Board’s approved methodology relies on counsel’s argument and is not supported by expert testimony; (2) it is equally true that reducing the outstanding number of shares would cause EPS to decrease faster than overall earnings if earnings decrease, and there are times when the number of outstanding shares will actually increase; and (3) WCTL has not demonstrated that the analysts who predict relevant growth rates do not take into account the effect of stock issuances and repurchases in their estimates.
We will not address WCTL’s argument
as this proceeding is not the proper forum for a party to propose changes to
the Board’s cost-of-capital methodology. As the Board stated in
Preferred equity has some of the characteristics of both debt and equity. Essentially, preferred stock 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 2012.
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
Based on the evidence furnished in
the record, and our adjustments to the calculations discussed above, we
conclude that the 2012 composite after-tax cost of capital for the railroad
industry, as set forth in
1. The current cost of railroad long-term debt was 3.29%.
2. The cost of common equity was 13.40%.
3. The capital structure mix of
the railroads was
4. The composite railroad industry
cost of capital was
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 September 29, 2013.
2. This proceeding is discontinued.
By the Board, Chairman Elliott, Vice Chairman Begeman, and Commisioner Mulvey.
* This decision corrects the decision served on August 2, 2013. In that decision, the Board determined that the cost of capital for the railroad industry in 2012 was 11.11%. By letter filed on August 20, 2013, the Association of American Railroads (AAR) provided notice of an inadvertent error contained in its workpapers filed on April 19, 2013. According to AAR, page 21 of its workpapers, “NS Debt ($000) 2012,” contains an inaccurate value in both the “Used” and “Mkt Value” column of the “A/R Securitization [LT + current]” row. Instead of 200,000, AAR states that the correct value is 100,000, which can also be found on page 9 of its workpapers, “Norfolk Southern Corporation Debt Instruments,” in the “Long Term Balance” column. Correcting Norfolk Southern Corporation’s miscellaneous debt increases the 2012 cost of capital by .01%. Thus, the cost of capital for the railroad industry in 2012 was 11.12%. As a result of the correction to AAR’s workpapers, certain figures in this decision have changed. These figures are noted in italics. This decision will become effective on September 29, 2013. [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] There was no preferred stock outstanding in the year 2012. [5] AAR Opening, V.S. Gray 9. [6] AAR Opening, V.S. Gray 9. [7] AAR Opening, V.S. Gray 10.
[9] AAR Opening, V.S. Gray 14. [10] AAR Opening, V.S. Gray 13. This is the same spread used in 2011.
[12] AAR Opening, V.S. Gray 14. AAR approximated the market values of ETCs using the same procedures used in previous cost-of-capital determinations. [13] AAR Opening, V.S. Gray 16. Modeled CSAs are CSAs that can be used in AAR’s model to determine market value. According to AAR, non-modeled CSAs are included in the miscellaneous debt category.
[15] AAR Opening, V.S. Gray 18. [16] AAR Opening, V.S. Gray 21. [17] AAR Opening, V.S. Gray 23. [18] All other debt represents capitalized leases, miscellaneous debt, non-modeled ETCs, and non-modeled CSAs. [19] Current costs can be determined for three of the four debt categories—bonds, ETCs, and CSAs. Therefore, the weighted average cost of debt is based upon these three (of the four) debt categories. AAR Opening, V.S. Gray 18. [20] AAR Opening, V.S. Gray 23.
[23] AAR Opening, V.S. Gray 28. [24] AAR Opening, V.S. Gray 29. [25] For the purposes of determining the number of shares outstanding, new shares outstanding are assigned to the first Friday on, or after, the effective date. [26] AAR Opening, V.S. Gray 33. AAR uses the SAS General Linear Model procedure to compute regression data. The Board uses a standard Excel regression method. [27] AAR Opening, V.S. Gray 34. [28] AAR Opening, V.S. Gray 25. [29] AAR Opening, V.S. Gray 40. [30] AAR Opening, V.S. Gray 42. [31] AAR Opening, V.S. Gray 42-43. |