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

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.

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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.

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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]]

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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.

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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.

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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.''

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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.

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(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