Current through Register Vol. 61, No. 4, April 1, 2022
The capital structure of a company refers to the make-up of its
financial structure, i.e., long-term debt and equity. For ad valorem appraisal
purposes, the appropriate capital structure for a company is the typical
capital structure for the industry group to which the property belongs based
upon current market cost of debt and equity. If it can be shown that use of an
industry capital structure would not reflect the market value of the property
because of the unique nature of the property or its operation, the current
owner's capital structure may be used. The procedures to be followed in
determining capital structure are as follows:
(a) Select industry group, i.e., electric
utility, airline, railroad, lumber, food processing, etc.
(b) Determine if it is necessary to have
industry sub groups. Sub groups are groupings of properties within an industry
type that have similar characteristics and that are different from other sub
groups within the industry type. Sub groups have similar qualities such as bond
ratings, degree of risk if unrated, business activities and size.
(c) For each group or sub group, a sufficient
number of companies should be selected that have publicly traded securities and
similar debt ratings (e.g., Moody's Aa, A, Baa, etc.). The company or companies
whose property is subject to appraisal may be included as part of the data set.
(d) The appropriate capital
structures shall be determined by a correlation of the capital structures of
the companies in the selected group.
(e) Capital structures for companies with
nonrated debt must be estimated from the best data available, such as balance
sheets, public utility commission-approved structures, sales data, lenders'
opinions, industry recommendations, or patterns established by companies with
rated debt within the same industry.
BASIC DISCOUNT RATE. Basic discount rate,
cost of capital, and capitalization rate are synonymous as used herein. The
band-of-investment method is the preferred method for calculating basic
discount rate. An example of this method, assuming a capital structure of 50
percent debt, 10 percent preferred stock, and 40 percent common equity, is
shown below: [Table not included. See ED. NOTE.]
(a) The band-of-investment capitalization
rate can readily be converted to an after-tax rate. The after-tax interest rate
is substituted for the current cost of debt in the band-of-investment
procedure. This after-tax cost of debt is calculated by multiplying the current
cost of debt by one minus the corporate tax rate. When the after-tax cost of
capital is used, the tax expense of the prospective purchaser must be deducted
from the income to be capitalized as though the property had no tax shelter
from debt interest to avoid double counting the deduction for income taxes.
Cost of Debt. The cost of debt
is the current market rate for new securities. The embedded rate on securities
previously issued is not a proper measure. In order to determine the cost of
debt the appraiser should:
(A) Refer to the
rates for seasoned bond issues from Moody's Utility, Industrial, and
Transportation weekly news reports or other rating services for at least two
months immediately prior to the appraisal date. This should be done by bond
rating (Aa, A, Baa, etc.) and industry type.
(B) Obtain information on new bond issues by
industry type and bond rating from Moody's Bond Survey or other publications
for at least two months immediately prior to the appraisal date.
(C) Consider recommendations on debt rates
submitted by industry.
rates for each industry group by bond rating after analyzing the data in the
Preferred Stock. The cost of preferred stock is determined from the current
market rates, not the embedded rate.
(d) Cost of Equity. The two preferred methods
for determining the cost of equity capital are the Discounted Cash Flow (DCF)
model and Capital Asset Pricing Model (CAPM). The appraiser should consider
other models if circumstances and data justify their use. [Table not included.
See ED. NOTE.] Information on the risk free rate (Rf) can be obtained from the
Federal Reserve Bulletin containing rates for U.S. Treasury notes or bonds as
near the appraisal date as possible. Data for Beta (Bi) and the market rate
(Rm) shall be obtained from a reliable source such as Value Line. A single
number for risk premium (Rp) such as those published by Ibbotson Associates,
Kidder Peabody, and others may be used. The CAPM equity rate for the industry
group is determined by correlating equity rates of return computed for the
companies in the industry capital structure group.
(3) EFFECTIVE DATE: This rule first applies
to property valuations as of January 1, 1990.