money in the business and the dividends and growth rates requisite to supply these incentives, the opportunities in these respects provided in comparable businesses, and [the] related matters. . . . D. C. Transit System, Inc. v. WMATC, supra, 350 F.2d at 779. In the last fare case, concluded just eight months ago, we heard testimony from two witnesses on the subject of rate of return. The company called Mr. John F. Curtin of Simpson and Curtin, a transportation consultant with long and distinguished experience in the field. The staff presented testimony by Mr. David A. Kosh, a utilities expert and rate of return analyst who also brought to us the benefit of a long and distinguished career in the field.

In this case, the company again called Mr. Curtin to present rate of return data. Upon motion by the staff, all parties stipulated that Mr. Kosh's testimony and exhibits, both on direct and on cross-examination, in the last case (Docket No. 156) was relevant, and should become part of record in this proceeding. That stipulation was accepted by the Commission. We shall begin our consideration of the rate of return problem with a brief description and summary of the testimony of each of those witnesses.

Testimony of John F. Curtin

Mr. Curtin recommended a return of $2,700,000 to Transit. He stated that in arriving at that sum, he was guided by the concept that a fair rate of return requires consideration of the amount needed by Transit to safeguard its service, to attract capital and to provide sufficient income, over and above operating expenses, to insure the financial soundness of the company, after giving due consideration to the inherent differences between this business and others-other utilities, as well as other industries generally.

He then discussed various factors which he felt distinguished the transit industry from other utilities and from unregulated industries, insofar as its risk attributes and its attractiveness to investors are concerned. He included such

factors as automobile competition, labor costs, absence of natural growth, inelasticity of costs, and the absence of labor savings opportunities. He concluded that these factors make the transit industry more risky than other industries. thereby causing transit securities to be more speculative.

Mr. Curtin's data included tabulations showing the operating ratios of (a) public utilities serving the Washington Metropolitan Area, (b) railroads serving the entire country, and (c) a group of nine privately-owned transit systems. The witness testified that Transit is a typical transit utility because its characteristics are quite similar to most other transit companies; the similarity includes trend of patronage, population density, and in the relative degree of use of transit by the community. He emphasized the narrow degree of margin between revenues and expenses of Transit as compared to other utilities, by portraying the operating ratio of D. C. Transit for corresponding years. He emphasized that this comparison illustrates how little margin Transit has to withstand various economic impacts, such as a 5% increase in expenses, in comparison with other utilities.

Much of Mr. Curtin's presentation conformed to his approach in the previous case. For example, he discussed the risks inherent in the transit business from the long-term viewpoint, and discussed the long-term growth of public utilities. He stated that while the company's passenger volume trend had increased in the past few years, the trend broke last year, and the level of patronage actually declined. He contrasted this with what he noted was a strong growth trend existing among other major utilities of the metropoli

tan area.

The witness once again made a comparative analysis of the quality of public utility bonds and notes, comparing Transit with other utilities. Mr. Curtin also presented a comparative analysis of the company with other transit systems insofar as their basic market characteristics were concerned. He reaffirmed his previous conclusion that Washington is reasonably representative of the major metropolitan

areas in this country, both in terms of city and urban population density.

As before, the witness presented a comparative analysis of operating revenues, operating costs, wages and salaries, and miles of service for the company since 1961 updating it through 1967. In arriving at his conclusion, Mr. Curtin commingled what is known as the "comparable earnings" standard and the "attraction of capital" standard. To this end, Mr. Curtin presented the capitalization of various public utility groups in 1967, including electric, gas, telephone, water and transit. He tabulated the comparative price and debt capital among those public utility groups, again in 1967, and then gave his analysis of the tabulation. Correspondingly, he presented a comparison and analysis of the price of equity capital among that same group for the same year. That was followed by a comparison of the price of debt and equity capital among the same group, which was followed by a synopsis of the total return on capital, on a comparable basis for the same groups of utilities. Mr. Curtin concluded from this analysis that whereas the money market was willing to invest in other utilities which return yields between 5.5% and 6.7%, investors in the transit industry required a return of 8.1% on market value of debt and equity securities combined.

In deriving a rate of return, Mr. Curtin used several approaches. The first related to historical cost rate base. The witness selected nine transit companies26 which he deemed were representative of the industry. In 1967, these companies had an average return on historical rate base of 11.27%; the low was 3.99% and the high was 21.56%. He noted that Transit's proposed fares would earn $2,186,514, or, on an average rate base of $26,730,779, a return of 8.18%, which was less than the rate earned by seven of the nine companies in 1967. His recommended return-$2,700,000-would equate to 10.10%.

He made a similar analysis of the operating ratios of the nine companies over the past eight years. He concluded 26 This witness selected the same companies studied by Mr. Kosh.

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that Transit has had, between 1960 and 1967, a return on operating revenue much lower than the other companies.

Mr. Curtin studied the earnings, yield, and price-earnings ratios of the common stock of the nine transit companies, as well as of Transit, for 1967. The witness also computed the percentage of bonds and notes to total capitalization, for 1967, of each of the companies; also, he showed the dividend pay-out ratios, 1960-1967. While the average payout ratio was 65.1%, Transit's was 37.1%.

Mr. Curtin arrived at his final recommendation in light of three conditions: (1) A rate of return of 9% to 10% on the fair value of the system. Such a return, he claimed, was warranted by the higher risks prevailing in the transit industry. (2) An operating ratio of 92.0 to 92.5, which was justified by the short-term risk exposure of the company. (3) The debt service requirement of the company.

Mr. Curtin noted that Transit's aggregate outstanding debt on April 30, 1968, was $20,736,164; the weighted average interest rate was 6.06% (previously, 5.95% as of May 31, 1967). He further noted that recent financing was at a 7% rate.

Unlike the last case, the witness did not provide a return on equity capital, although he acknowledged that a return on the book value of equity could be computed. He indicated, however, that return on book value of equity has no significance because, in his opinion, the book value of equity of the company bears no meaningful relationship to the market value of the company. Accordingly, the actual return on market value of equity would be lower than return on book value.

Mr. Curtin summarized his recommended return as fully meeting the return standards laid down by the court of appeals. He stated that it would provide the four essential elements as follows: interest on debt - $1,352,500; dividends on stock - $500,000; down payment on new buses and balance of return on equity as retained earnings - $847,500.

Testimony of David A. Kosh

We have stated, supra, the stipulation of Mr. Kosh's testimony and exhibits into this record. In order to maintain the continuity of this opinion, we shall repeat here our comments from Order No. 773.

Mr. Kosh approached his problem from two points of view--the classic rate of return on rate base, and the operating ratio. In laying the foundation for his recommendations, Mr. Kosh noted that prices in general were set by the forces of price competition; where businesses vested with the public interest exist without competition, the substitute for competition is regulation. He noted, however, that regulation must make it possible for the utility to compete in the capital markets for the funds it needs. The utility's earnings, both historical and prospective, must be sufficient to maintain existing capital and attract the required additional capital on reasonable terms. Mr. Kosh concluded that the fair return should be identified with the price a utility must pay, that is, the earnings it must hold out to attract capital. He concluded that the basic ingredient of a fair rate of return is the cost of capital. He declared that the cost of capital is determined by considering the pure rate of interest and the compensation for subjecting one's capital to uncertainty, i.e., the degree of risk.

Mr. Kosh stated that where a company's securities are actively traded, the terms on which it is traded provide evidence of the cost of that particular type of capital to that company; accordingly, the yields of a company's bonds reflect cost of debt, and the earnings/price ratios indicate the cost of equity.

In effect, Mr. Kosh stated that the fair rate of return is basically equal to the cost of capital, and that the cost of capital is determined in the investment markets. Contrary to the position taken by Mr. Curtin, Mr. Kosh declared that the capital structure of a company affects both the cost of debt and the cost of equity.