Flotation Costs of Debt As has been the case in past cost of capital decisions, the AAR's calculation of the current cost of debt includes a flotation cost factor comprised of costs associated with the issuance of new debt such as underwriters' fees, advertising costs, legal fees, etc. The AAR has determined that flotation costs for debt equal 0.15 percent, calculated as follows:& We have reviewed the AAR's calculations concerning flotation costs and have determined that the cost factors developed for the various components of debt are reasonable. Also, the overall cost rate of 0.15 percent is the same flotation cost rate we found to be reasonable and accepted in last year's proceeding. We therefore accept the use of a 0.15 percent flotation cost factor for debt. Overall Current Cost of Debt The AAR concludes that the railroads' current cost of debt for 1992 was 7.70%. We have reviewed the AAR's evidence relative to the current cost of debt and, calculate it to be 7.69%, rounded to 7.7%. Therefore, we The AAR's flotation cost factors are based on data developed by Salomon Brothers for ETCs and studies by the SEC concerning flotation costs for issuances of new bonds. CSAs have an estimated flotation cost factor that is the same as the one used in prior proceedings. have determined that the AAR correctly calculated the cost of debt. Our calculations are shown as follows: In previous cost of capital decisions, we have determined the cost of common equity using the Discounted Cash Flow (DCF) methodology. The AAR has submitted evidence as to the current cost of equity capital using the DCF method. This evidence has been prepared by Dr. Harvey A. Levine, the AAR's Vice President - Economics and Finance, and is essentially identical to that furnished by the AAR in prior cost of capital proceedings. 9 As has been the case since our findings in Railroad Cost of Capital - 1987, 4 I.C.C. 2d 621 (1988) (Cost 87), we have relied on the use of consensus analyst five-year earnings per share growth rate data published by the Institutional Brokers Estimate System (IBES) to develop the growth rate estimates used in the DCF approach. IBES data include growth rate estimates from essentially all major brokerage firms. Discounted Cash Flow (DCF) Method: The DCF method is a commonly used methodology for determining the cost of common equity. It is used by a majority of state regulatory agencies and has been used by the Commission for many years. Under the DCF method, the cost of common equity is the discount rate that makes the present value of expected returns from holding a stock (dividends and price appreciation) equal to the current market value of that stock. The DCF method considers two variables: dividend yield and expected growth in earnings per share. 10 Growth Rate: Dr. Levine uses the growth rate forecasts published monthly by IBES throughout 1992. He develops a growth rate for each of the study frame railroads by averaging the IBES forecasts for that railroad. He then weighs each railroad's growth rate according to its share of the market value for the total railroad sample group to arrive at a composite growth rate. Dr. Levine concludes that this composite growth rate is 10.14%, based on a truncated average of the forecasts, computed as follows:11 10 In Railroad Cost of Capital - 1982, 367 I.C.C. 662 (1983), the Commission developed the following DCF formula: K = [D(O) x (1 +g/2)/P(O)] + g, where: K = cost of common equity This formula assumes that, at the start of the year, an investor would require a return on equity (K) equal to [D(O)/P(O)] + g, where D(O)/P(O) represents the average dividend yield expected for the year and g represents an estimate of the anticipated growth rate. At the end of the year, the investor would be concerned with projected returns for the following year and would require a K equal to [D(O) x (1+g)/P(O)] + g, which would allow for dividend growth for the following year. The average of these two formulas produces our DCF formula. 11 IBES provides a simple average, the highest forecast, and the lowest forecast for each railroad. With the exception of Kansas City Southern (which had forecasts from only two analysts for 10 of the 12 months) the highest and lowest forecasts were excluded by Dr. Levine to arrive at the truncated average. This is the same procedure that has been followed in previous cost of capital determinations. This growth rate is 0.49 percentage point higher than the 9.65% growth rate developed in the 1991 cost of capital decision. 12 This rounds to 10.1%. The non-truncated value is 10.2% (computed by the AAR as 10.19%, before rounding) calculated as follows: We have reviewed the growth rate evidence submitted by the AAR. This review discloses no inaccuracies which would cause a change in the estimated growth rates developed by Dr. Levine. As has been the case in previous cost of capital determinations, we conclude that the truncated IBES growth rate should be used because there can be wide variations between the high and low estimates. Thus, we will use a growth rate equal to 10.1% for the DCF model to determine the 1992 cost of common equity capital. Dividend Yield: Dr. Levine computed the 1992 average dividend yield for the composite group of railroads using the same method which has been employed in past cost of capital determinations, i.e., the use of closing prices for each day during the month, weighting each company's monthly dividend yield on the basis of its proportionate share of total market value for each day during |