1. (a) The income approach to estimate market value is based upon two (2) factors:

   1. (1) The income stream; and
   2. (2) The capitalization rate, yield or direct.

2. (b) Determination of the income stream — Yield capitalization method.

   1. (1) The future income stream to be capitalized is that income expected to flow from the property at the assessment date.

   2. (2)

      1. (A)
3. (i) The estimate of each company’s net operating income stream may be based on a historical analysis of one to five (1 – 5) years preceding the assessment date via consideration of:
4. (a) (a) Averages;
5. (b) (b) Weighted averages;
6. (c) (c) Net operating income adjusted for increases in net plant investment;
7. (d) (d) A least squares analysis of net operating income; and

8. (e) (e) Income level attained in the year immediately preceding the assessment date.

   1. (ii) Historical income should be adjusted to remove the effects of extraordinary income or expenses that will not be incurred in subsequent years.

      1. (B)

         1. (i) The income to be projected may include construction work in progress.
         2. (ii)
9. (a) (a) The income stream attributable to construction work in progress shall be determined by multiplying the amount subject to inclusion by a performance ratio.

10. (b) (b) The performance ratio is to be the capitalization rate determined in subsection (c) of this section discounted by twenty percent (20%).

    1. (iii) The income to be projected on additions made during the prior year in the determination of the future income stream shall be included at fifty percent (50%) of the booked amount.

       1. (iv) The income stream attributable to additions shall be determined by multiplying the amount subject to inclusion by the performance ratio.

    2. (3)

       1. (A) Forecasted future income streams, with the inclusion of a terminal, reversion, or proceeds upon sale amount, may be considered if such amounts can be reasonably determined.

       2. (B) These income forecasts would encompass income to be realized on construction work in progress and additions made during the year.

          1. (c) Determination of the capitalization rate — Yield capitalization method.

    3. (1)

       1. (A) The Tax Division of the Arkansas Public Service Commission shall compute the overall capitalization rate by the band of investment method.
       2. (B) This method assigns a cost to each component of the capital structure and weights that cost by the amount each component contributes to the total capital structure.
    4. (2) In estimating the yield capitalization rate, comparability should be determined by placing primary emphasis on risk.

    5. (3) The equity and debt costs are to be estimated in the following manner:

       1. (A) Common equity rate — Traded securities.

          1. (i)
11. (a) (a) The estimate of the common equity rate shall be derived by the use of the Discounted Cash Flow (DCF) Model.

12. (b) (b) Consideration may also be given to the Capital Asset Pricing Model (CAPM) and estimates made by independent analysts.

    1. (ii)
13. (a) (a) The DCF Model assumes the value of an investment is the present value of the future benefits of ownership.

14. (b) (b) In the case of an investment in common stock, the value is the present value of future dividends plus expected growth.

    1. (c) (c) This model may be expressed by the formula: R = D₁ / Po + g Where: R = Required rate of return. D₁ = Expected dividend at end of Year 1. Po = The current stock price, derived from monthly prices from the period of September through December of the year immediately preceding the assessment year. g = The expected future growth. The “g” factor in the DCF formula shall be derived from long-term projections made by stock analysts in the major capital markets. Sources to be used for analysts’ forecasts shall include The Value Line Investment Survey and other recognized financial sources.

       1. (iii)
15. (a) (a) The CAPM is based on the assumption that the cost of equity can be estimated by adding a risk premium to a risk-free rate of return.

16. (b) (b) According to the CAPM, the cost of equity can be stated as the risk-free rate plus a market risk premium that is adjusted by beta to reflect a particular security’s risk.

    1. (c) (c) The CAPM may be expressed as follows: R = Rf + (Km-Rf)*b Where: Rf = Risk-free rate, measured by the rate of return on long-term United States Treasury bonds. Km = Required return on the market. b = Beta, a measure of a stock’s volatility relative to the market as a whole, sources for which shall include The Value Line Investment Survey and other recognized financial sources.

       1. (iv)
17. (a) (a) Analysts’ estimates of common equity rates may be considered.

18. (b) (b) All calculations shall be adjusted for any abnormalities over the historical period reviewed and any other relevant information from stock analysts.

    1. (c) (c) The above methods shall be based on data derived from the parent company, provided the parent is in the same risk class and is not engaged in diversified business activities different from the subsidiary, or companies of comparable risk;

       1. (B) Long-term debt and preferred stock.

          1. (i) The rates for long-term debt and preferred stock shall be the market cost of long-term debt and preferred stock and the current cost of any other outstanding debt.
          2. (ii) The market rate of debt shall be determined based upon the current yield to maturity for long-term debt of comparable risk.
          3. (iii) The market rate for preferred shall be determined by the amount of preferred dividend requirement divided by the current market value of preferred; and

       2. (C) Deferred income tax and investment tax credits.

          1. (i)
19. (a) (a) Deferred income taxes and investment tax credits will be treated as cost-free debt in the determination of the overall capitalization rate.

20. (b) (b) The proxy for market value of these items is thirty-five percent (35%) of the book value on the company’s balance sheet.

    1. (ii) Deferred income taxes and investment tax credits will not be considered in the capital structure as cost-free debt when forecasted future income streams take these into account as separate items.

       1. (d) Income capitalization — Direct capitalization method.
    2. (1) Direct capitalization may be considered in conjunction with the above outlined income capitalization method or methods.

    3. (2) Determination of income stream — Direct capitalization method.

       1. (A) The income stream to be capitalized is that income expected to flow over the appropriate time period from the property at the assessment date.

       2. (B)

          1. (i) The estimate of each company’s net operating income stream may be based on a historical analysis of one to five (1 – 5) years preceding the assessment date via consideration of:
21. (a) (a) Averages;

22. (b) (b) Weighted averages;

    1. (c) (c) A least squares analysis of net operating income; and

       1. (d) (d) Income level attained in the year immediately preceding the assessment date.

          1. (ii) Historical income should be adjusted to remove the effects of extraordinary income or expenses that will not be incurred in subsequent years.
          2. (iii) These income forecasts would encompass income to be realized on construction work in progress and additions made during the year in a manner consistent with the development of the direct capitalization rate.

23. (e) Determination of the capitalization rate — Direct capitalization method.

    1. (1)

       1. (A) The division shall compute the overall capitalization rate by the band of investment method.
       2. (B) This method assigns a rate to each component of the capital structure and weights that rate by the amount each component contributes to the total capital structure.

    2. (2) When determining comparability in direct capitalization, primary emphasis should be placed on each of the following items:

       1. (A) Industry classes;
       2. (B) Risk;
       3. (C) Growth;
       4. (D) Profitability;
       5. (E) Size and physical characteristics; and
       6. (F) Other characteristics.

    3. (3) The equity and debt rates are to be estimated in the following manner:

       1. (A) Common equity rate — Traded securities.

          1. (i)
24. (a) (a) The estimate of the common equity rate may be derived by the use of the Earnings-Price Model.

25. (b) (b) The Earnings-Price Model expresses the relationship between net income and price.

    1. (c) (c) It is derived by an analysis of earnings-price ratios from the stock market or other financial sources.

       1. (d) (d) The earnings-price ratio, the inverse of the price-earnings multiple, may be derived from monthly ratios from the period of September through December of the year immediately preceding the assessment date, with consideration given to ratios derived from the same time period in the three (3) years immediately preceding the assessment date, or the earnings-price ratio may be derived using future earnings estimates made by security analysts and current prices.

          1. (ii) The above method shall be based on data derived from the parent company, provided the parent is comparable and is not engaged in diversified business activities different from the subsidiary, or from comparable companies; and

       2. (B) Long-term debt and preferred stock.

          1. (i) The market rate of debt shall be determined by the amount of annual interest actually paid divided by the current market value of debt.
          2. (ii) The market rate of preferred shall be determined by the amount of annual dividends actually paid divided by the current market value of preferred.
26. (f) Income streams and capitalization rates determined for use in direct capitalization should be derived from the same time period for both the subject and comparable companies.

Codification Notes: This section was promulgated as part of Section II of the Market Valuation Rules for Telephone Companies prior to codification into the Code of Arkansas Rules.