Example:

Congress passes the Surface Mining Control and Reclamation Act, which prohibits StripCo from continuing mining operations on its property. StripCo claims this governmental regulation is a "taking" under the US Constitution, which requires "fair compensation."

What has been taken and how much is it worth? The company provides evidence of likely coal production, comparable-company coal prices, likely operating costs over a 24-year period, and the prevailing average industry discount rate for proved coal reserves of 10% -- to come to a "discounted cash flow" estimate of the value of the company's coal reserves. The government counters with evidence of how much similar coal properties had sold for.

What is the value of the company's coal reserves?

Answer:

In a similar case, the court valued the company's coal (now no longer mineable) by using a "discounted cash flow" method to value the coal. See Whitney Benefits, Inc v. The United States, 18 Cl. Ct. 394 (1989) (Appendix B).

After determining that the SMCRA had rendered the coal property useless and constituted a constitutional taking, the court proceeded in three steps:

• Determination that company could mine and sell 2.5 million tons of coal per year for 24 years
  • 2 million tons to electric utilities, based on contracts for similar coal by other nearby mining companies (but not the 3 million tons the plaintiff had asserted)
  • 0.5 million tons to industrial users, based on contracts and operations by other mining companies (but not the 1 million tons the plaintiff had asserted)
• Determination of annual net revenues over 24 years, based on --
  • revenues: the annual production rate (as already determined) times the price of coal as of the taking, based on trade journal price analysis and actual long-term coal contracts by similar coal companies
  • costs: operating costs (labor, general corporate, insurance, taxes) and capital costs (equipment, engineering, permitting, reclamation), after adjusting the company's business plan to reflect a lower annual production rate (2.5 million rather than 4.0 million tons/year)
• Determination of present value of this stream of net revenues (total $52,755,000)
  • net revenues, which varied from year to year
  • a flat discount rate of 10%, based on rate generally applied in the coal industry for undeveloped coal reserves
• Adjustments and additions (final award $60,296,000)
  • present value of salable reserves (2.5 million tons/year) reduced to account for future reclamation costs (less $2 million) and basic uncertainty / "sensitivity analysis" (less 11%) - $45,172,000
  • present value of residual reserves not salable (89,441,000 tons) valued at 20% of salable reserves per ton - $15,124,000

There are a number of particularities. First, the court stated that it was not applying a "lost profit" analysis -- who is its DCF analysis different? Second, the court generally followed the company's business plan (the Boyd plan) in making its determinations of coal prices, costs and discount rates , but not with respect to expected annual sales -- why did the court cut the company's estimates? Third, the court assumed a discount rate of 10% even though in 1977 prevailing risk-free interest rates were comparable -- why did it not add a risk premium, or at least vary the discount rate, to reflect the long-range risk of coal, this coal region, mining operations? Fourth, what about the significant "fudge factors" the court used, such as the 11% "sensitivity analysis" factor or the 20% factor for valuing residual reserves -- what basis did the court have for making these adjustments?

Consider the chart below, reproduced on the attached spreadsheet. Notice that the court assumed that at the beginning costs would exceed revenues, hence the losses during the first three years.

What would the effect have been if the court had looked at a 35-year period? What if the court had used a variable discount rate -- 10% during the first 5 years, 12% for the next 10 years, and 15% thereafter?

In 2002, the Federal Claims Court addressed another case involving a takings issue under SMCRA. In Stearns Co. v. United States, 2002U.S. Claims LEXIS 206, the court employed the DCF method in part of its valuation, closely following its earlier ruling in Whitney Benefits.