The Income Method
The income method can be calculated in more than one way to value a project.
The Minnesota Tax Court chose a method that looked back in time rather than at projected earnings.
Minnesota Energy Resources Corporation is a local gas distribution company in Minnesota. It owns 3,611 miles of transmission and distribution lines. Property tax assessments of real property are handled by each county, but personal property — equipment — is assessed by the state.
The state assessed the company’s gas lines at $118.2 million in 2008 rising to $161.5 million by 2012. The company challenged the assessments. An appraiser hired by it said the state overvalued the gas lines, and the correct figures should have been $51.5 million in 2008 rising to $120.5 million by 2012. An expert hired by the state put the values even higher than the state assessments: $200 million rising to $297.9 million.
The Tax Court decided the correct 2008 value was in between the state assessment and the gas company figure, but it put the 2012 value above the state assessment. Its final figures were $94.7 million in 2008 rising to $174.7 million in 2012.
The court looked at the three standard methods for valuing equipment: depreciated replacement cost, comparable sales and the income method. It said there was not enough data publicly available about recent sales of similar assets or companies to use the comparable sales method.
It calculated the depreciated replacement cost, or the cost to build new gas lines, and then adjusted the amount for the age of the gas lines in question.
Turning to the income method, it said it was more comfortable relying on historic revenue rather than what the company was projecting it would earn in the future because the company had been consistently wrong in its earnings projections. It then used two approaches to distill the numbers to a market value.
Under one approach — the “direct capitalization method” — it divided the company’s net operating income for the year in question — for example, the 2008 net operating income — by a “capitalization rate” that is the weighted average cost of equity and debt for a comparable company. It used 7.51% as the capitalization rate in 2008 falling to 5.87% in 2012. It subtracted 5% of the prior year’s revenue as the value of working capital and 5% of business enterprise value as the value of intangible assets, neither of which is subject to property taxes.
The other way to calculate value under the income method is to discount projected cash flow. However, the court rejected that approach due to its lack of confidence in the gas company’s revenue projections, which it said experience has shown are 30% to 35% overstated. It did not believe that a potential purchaser would rely on the company’s forecasts.
In the end, the court assigned 80% weight to the income method and 20% weight to the depreciated replacement cost approach. One of the experts argued that the cost approach is less reliable than the income method because it does not measure the market value of a group of assets when they are used in combination with one another.
The case is Minnesota Energy Resources Corporation v. Commissioner of Revenue. The court released its decision on September 29.
— contributed by Keith Martin in Washington