Law & Valuation: Case Synopsis

CHANDLER, V.C.

MEMORANDUM OPINION

Petitioners, minority shareholders of Alabama By-Products Corporation ("ABC"), seek appraisal of their shares under 8 Del. C. § 262 as the result of a merger that became effective on August 13, 1985. After the merger, ABC was absorbed into the Drummond Company, Inc. ("Drummond"). n1 The minority shareholders of ABC who were cashed out pursuant to the merger received $ 75.60 for each of their shares.

n1 Pursuant to Chancery Rule 25(c), Drummond, as the successor-in-interest to ABC, has been joined as a party defendant for the purpose of enforcement of any judgment. For convenience, Drummond and ABC will be referred to as "respondents," except where the context requires identification of a particular entity.

[*2]

As dissenting minority shareholders, petitioners believe $ 75.60 per share was inadequate. They initiated this proceeding on December 3, 1985. It was tried on June 27 through July 7, 1989. A claim for unfair dealing was tried along with petitioners' appraisal action. Evidence regarding the costs, expert witness fees and attorneys fees incurred in connection with this proceeding was deferred until after decision on the unfair dealing claim. The questions before the Court now are: (1) what was the fair value of ABC's stock on August 13, 1985, and (2) whether respondents engaged in unfair dealing in connection with the cash out merger. This is the Court's decision on these issues.

I. BACKGROUND FACTS

ABC is a Delaware corporation engaged during the 1970s and 1980s (and for many years before that), primarily in three lines of business. It mined coal on a cost plus basis for Alabama Power Company (a major utility in Alabama); it mined coal for its own account from surface and underground mines that it owned; and it manufactured and sold foundry coke from a plant in Birmingham called the Tarrant plant. To a certain extent ABC was also engaged in the development and sale of timber and [*3] forestry products on lands it owned.

ABC's two classes of stock traded in the over-the-counter market and were not listed on an exchange. Trading history in the stock was sporadic, but shows that the average bid price between 1977 and 1984 ranged from $ 47 to $ 75 per share. Class A stock had voting rights, while class B stock did not. At all times relevant to this lawsuit, there were about 757,300 class A shares and 1,000,000 class B shares authorized, issued and outstanding.

Drummond, an Alabama corporation, is also engaged in the mining and sale of coal in the state of Alabama. In 1977 it became interested in acquiring ABC. Between September 1977 and February 1978 Drummond acquired, in privately negotiated transactions, about 75,800 class A shares of ABC stock and 188,167 class B shares. Drummond also obtained a controlling interest in Alabama Chemical Products Company ("ACPC"), a holding company which at the time held 476,420 class A shares of ABC stock (about 63% of those outstanding). Drummond paid the equivalent of $ 110 per share of ABC stock in these transactions. The book value of ABC's common stock on December 31, 1977, was $ 55.47 per share. Drummond eventually caused [*4] the liquidation of ACPC, with the resulting distribution of the ABC class A stock to Drummond and other ACPC stockholders.

Drummond reconstituted ABC's board of directors in December 1977, replacing five of the nine ABC directors with Drummond designees. At all relevant times for purposes of this litigation, a majority of ABC's directors were also directors or executive officers of Drummond. Around the time that it gained control of ABC's board, Drummond created an executive committee consisting of Gary Neal Drummond, E. A Drummond and the then current president of ABC. The executive committee had authority to act on behalf of ABC's board of directors. From its controlling position, Drummond caused ABC to lease some of its coal reserves to Drummond. Drummond also purchased ABC mined coal and resold it in certain markets.

In late December 1977 Drummond presented a merger proposal to ABC's board, proposing the acquisition of all outstanding shares not owned by Drummond. This proposal was later withdrawn. Three years later, in 1981, Drummond discussed with Goldman, Sachs and Company ("Goldman Sachs"), its investment banker, the possibility of acquiring the remaining equity in ABC. Goldman [*5] Sachs recommended at the time that Drummond propose a cash merger at a minimum price of $ 85 per share. Nevertheless, Drummond decided not to pursue the acquisition at that time.

On March 17, 1983, Drummond again proposed a merger to ABC's board of directors, a proposal by which each share of ABC not owned by Drummond would have been converted into the right to receive $ 65 in cash and ABC would have become a wholly-owned subsidiary of Drummond. A special committee of ABC's board of directors (consisting of three ABC directors who were not directors or executive officers of Drummond) recommended the retention of the firm of Kidder, Peabody and Company, Inc. ("Kidder Peabody"), to evaluate the 1983 merger proposal and to determine whether it was fair from a financial point of view to unaffiliated ABC shareholders. Kidder Peabody's report, submitted in September 1983, concluded that Drummond's $ 65 cash merger offer was not fair from a financial point of view to unaffiliated ABC shareholders. Drummond's 1983 proposal was later withdrawn.

Drummond acquired additional shares of ABC class A and class B stock in 1984 for $ 54.40 and $ 55 per share respectively. Although it was provided, [*6] in connection with the 1984 acquisitions, that additional payments would be made by Drummond if its board of directors formally approved a tender offer for shares or a merger with ABC within stipulated time limits, no tender offer or merger proposal was made during the time limits.

In December 1984 Drummond made a tender offer for any and all outstanding shares of class A and class B common stock of ABC at $ 75 per share. Neither Drummond nor ABC sought a fairness opinion from an independent investment banker or financial adviser with respect to the tender offer. Nor was a committee of outside ABC directors appointed to review or comment upon the fairness of the proposed transaction. ABC's board decided it would take no position with respect to the fairness of the tender offer price, leaving the ultimate determination to the judgment of the individual shareholder.

As a result of the tender offer, Drummond became the holder of more than 90% of ABC's outstanding and issued shares. Then, on August 13, 1985, Drummond effected a short-form merger under Delaware law, pursuant to which the minority shareholders were cashed out at $ 75.60 per share. This amount was determined by adopting [*7] the 1984 tender offer price ($ 75) and adding a 60-cent quarterly dividend that 'had been missed in 1985.

Following the August 13, 1985, merger, certain minority shareholders perfected their appraisal rights pursuant to § 262 of Title 8 of the Delaware Code. These minority shareholders own approximately 50,000 class A shares and 75,000 class B shares. n2

n2 Neither party has drawn a distinction between the two classes of stock for valuation purposes.

II. THE UNFAIR DEALING CLAIM

Relying on Cede & Co. v. Technicolor Inc., Del. Supr., 542 A.2d 1182 (1988) and Chancery Court Rule 18(a) (joinder of claims), petitioners characterize this proceeding as a two-pronged action in which separate claims for appraisal and for unfair dealing have been joined. Drummond, as successor to ABC, is the only necessary and appropriate defendant, say petitioners, as to both the unfair dealing claim and the appraisal claim. They read Cede as holding that a dissenting stockholder may maintain both an action for [*8] unfair dealing and an appraisal action until final judgment in both cases, as long as duplicative judgments are avoided.

Petitioners argue they have avoided the risk of double recovery by limiting the relief requested for the unfair dealing claim to (1) costs of the proceeding, (2) reasonable attorneys fees and disbursements, and (3) expert witness fees incurred by petitioners as part of the appraisal action. Much of the evidence introduced by petitioners to impeach the credibility of respondents' valuation contentions is also offered as support for the unfair dealing claim. For example, they contend that the notice of merger received by ABC stockholders was false, deceptive and materially misleading, in that it failed to include (a) information regarding the value of ABC's assets or business, (b) an explanation that the merger price was set by Drummond without arm's length bargaining with ABC's board or a special committee of the board and that no fairness opinion by a qualified, independent expert was ever obtained, (c) information about certain special benefits accruing to Drummond as a result of the merger, and (d) an explanation that no effort was made to determine ABC's going [*9] concern value or its liquidation value and that the merger price was not based on valuation principles applicable in an appraisal proceeding. As a result of these material omissions and misrepresentations, petitioners assert, stockholders were not able to make an informed judgment as to the fair value of their class A or class B stock. Thus stockholders had no informed basis on which to decide whether to accept the merger price or to exercise their appraisal rights. As a consequence, petitioners argue, they were compelled to expend considerable sums on expert witnesses to obtain critical information about ABC's coal reserves, the value of its foundry coke operation and other assets before they could press forward with this appraisal action. These asserted omissions, for the most part, went unchallenged by respondents.

Petitioners also accuse Drummond of post-merger unfair dealing, complaining that Drummond's defense of the $ 75.60 merger price is based on contrived liabilities and transparent efforts to ascribe negative values to certain ABC assets, all of which were not disclosed to shareholders at the time of the merger. These allegedly manipulative tactics, added to the unfair [*10] dealing associated with the notice of merger and merger price, form the basis for petitioners' unfair dealing claim and, they insist, warrant an award of litigation costs.

Petitioners' reliance on Cede, in my opinion, is misplaced. In Cede the Supreme Court upheld this Court's rejection of a dissenting stockholder's motion to enlarge its appraisal action to include a claim for rescissory relief for, inter alia, breach of fiduciary duty. The Supreme Court carefully noted the distinct scope of an appraisal action and an entire fairness claim that is based on breaches of the duties of loyalty and care. Appraisal is a limited legislative remedy intended to provide shareholders dissenting from a merger on grounds of inadequacy of the offering price with a judicial determination of the intrinsic worth (fair value) of their shareholdings. Cede at 1186, citing Weinberger v. UOP, Inc., Del. Supr., 457 A.2d 701 (1983); Kaye v. Pantone, Inc., Del. Ch., 395 A.2d 369 (1978). Entire fairness, on the other hand, is a much broader inquiry into the merger transaction itself, allowing the court to provide whatever relief the facts of a particular [*11] case may require. At the heart of a fraud claim asserting unfair dealing and unfair price is wrongdoing in the merger, with broad remedies, including rescissory damages, available against those who caused the injury. See Cede, 542 A.2d at 1187-88.

While the Cede Court recognized that appraisal and entire fairness, though very different remedies, are not logically inconsistent and may be separately pursued, it also denied the attempt by the petitioner in that case (Cinerama) to enlarge its appraisal action to include claims for fraud and breach of fiduciary duty. Including fraud claims in an appraisal action, the Supreme Court noted, would impermissibly broaden the legislative remedy. "It would also fail to bring before the court the necessary parties for the fashioning of any appropriate relief for a fraud." 542 A.2d at 1189. Additionally, the Supreme Court worried that expanding appraisal proceedings to include unfair dealing claims "would likely create unforeseeable administrative and procedural problems for litigants and the courts." It added:

In most cases only a small proportion of shareholders will have perfected appraisal rights and thus [*12] have access to the expanded appraisal remedy. If shareholders are permitted to litigate fraud claims in appraisal proceedings, shareholders not seeking appraisal would be required to litigate 'entire fairness' claims identical to the claims litigated by shareholders with perfected appraisal rights but through separate actions. This would create a substantial risk of inconsistent judgments and raise issues of collateral estoppel. 542 A.2d at 1189-90 (citations omitted).

This is precisely what petitioners seek to do here, having grafted entire fairness claims onto an appraisal action. With respect to the entire fairness claim, they seek only to recover litigation expenses associated with the appraisal proceeding -- attorneys fees, court costs and expert witness fees. No directors of Drummond or ABC are parties to this litigation even though petitioners' evidence of wrongdoing is aimed directly at them. Nevertheless, plaintiffs contend that they are entitled to recover their litigation expenses against the Drummond Company.

Contrary to petitioners' assertions, there is no authority for joining an entire fairness claim with an appraisal proceeding as a vehicle to recover [*13] expert witness and attorneys fees. To authorize the joinder of appraisal and unfair dealing actions as proposed here would result in a hybrid appraisal action, effectively broadening the legislative remedy affored under 8 Del. C. § 262. As Vice Chancellor Jacobs observed in Pinson v. Campbell-Taggart, Inc., 1989 Del. Ch. LEXIS 50, Del. Ch., C. A. No. 7499 (Feb. 28, 1989, revised, Apr. 21, Aug. 11 and Nov. 8, 1989), Delaware's appraisal statute:

does not authorize the court to tax a petitioning stockholder's attorneys fees and other litigation expenses against the surviving corporation. Those expenses are recoverable only by a pro rata apportionment against the value of the shares entitled to an appraisal. 8 Del. C. § 262(j). Petitioners here do not seek to recover their litigation costs through such an apportionment. Rather, they seek to recover their expenses, as costs, against the corporation on the basis of a nonstatutory claim of unfair dealing. However, a claim of that kind is not independently cognizable in an appraisal proceeding. Cede & Co. v. Technicolor Inc., supra, 542 A.2d at 1189-90. Accordingly, petitioners are not entitled to an award of their attorneys [*14] fees and litigation expenses against the surviving corporation. Pinson slip op. at 20 (fn. omitted).

The core assertions by petitioners relate to the fair value of their ABC stock on the merger date. Very little evidence, and scant argument, n3 has been devoted to claims that the respondents breached their duties of candor, loyalty or due care.

n3 Petitioners devoted 100 pages of post-trial briefing to the fair value question. They dwelled on the unfair dealing issue for all of six pages.

There is no authority known to me for inserting unfair dealing claims into an appraisal proceeding so as to enable dissenting stockholders to recover litigation costs associated with the appraisal proceeding. Cede does not, in my view, authorize such a hybrid procedure, a procedure that would represent an indirect judicial expansion of a remedy afforded by statute. Petitioners may seek to recover their litigation costs through apportionment, as 8 Del. C. § 262(j) allows. Petitioners' entire fairness claim [*15] is dismissed.

I hasten to add, however, that this does not mean that the Court will ignore the manner and procedures by which the merger price was fixed. If corporate fiduciaries engage in self-dealing and fix the merger price by procedures not calculated to yield a fair price, these facts should, and will, be considered in assessing the credibility of the respondent corporations' valuation contentions. See Pinson v. Campbell-Taggart, Inc., supra. Accordingly, I have considered carefully the record evidence of unfair dealing while assessing the credibility of respondents' valuation contentions.

III. THE VALUATION ARGUMENTS

A. Petitioners' Methodology

Petitioners challenge the fairness of the merger price, noting that it was fixed unilaterally by Drummond without the benefit of independent expert opinion as to its fairness. They also point out that no committee, special or otherwise, was appointed to review the fairness of the merger proposal, that the merger notice to stockholders failed to disclose certain allegedly material financial information, causing stockholders to make decisions with regard to accepting the merger price or seeking appraisal on the basis of very [*16] limited information about the assets and prospects of ABC.

Petitioners contend that ABC's fair value was $ 193.40 per share on August 13, 1985. That conclusion rests upon the testimony of their valuation expert, Mr. Kenneth McGraw, based on an analysis performed by Benchmark Valuation Consultants, a division of the accounting firm Peat Marwick Maine & Co. ("Benchmark"), which in turn was based in part on an analysis and valuation of ABC's coal reserves and coal mining operations by Dames & Moore, a firm with expertise in geologic, mining and natural resource engineering.

McGraw testified that Benchmark valued ABC using three alternative methods: historical earnings, net asset value, and discounted cash flow. By the historical earnings approach, Benchmark arrived at a value of $ 166 per share of ABC stock. The net asset methodology resulted in a value of $ 205 per share. The discounted cash flow approach resulted in a valuation of $ 225 per share. Benchmark then applied a weighted average, assigning the greatest weight (40%) to the historical earnings and net asset value approaches and the lowest weight (20%) to the discounted cash flow methodology, to arrive at a valuation, based on [*17] all three valuation methodologies, of $ 193.40 per share. n4

n4 Because trading in the over-the-counter market for both classes of ABC stock was negligible, none of the experts in this case relied upon the over-the-counter market as a reasonable indication of fair value of the stock in August 1985. Market prices of ABC stock before and during the relevant period is therefore not entitled to any weight in this proceeding.

1. Historical Earnings Method

Based upon ABC's historical earnings, Benchmark determined the freely traded value of the stock of ABC by taking into consideration, in addition to all other factors, the stock value of corporations engaged in lines of business similar to those of ABC that were actively traded on an exchange or over-the-counter. In determining the fully traded value of ABC stock, Benchmark used both the price earnings ratio and a ratio of market price to book value method, based upon a comparison with six publicly traded coal and natural resource companies considered comparable to [*18] ABC. Benchmark then weighted these two methods to determine the overall freely traded value of the ABC stock.

Benchmark's price-earnings method indicated the freely traded value of ABC's stock to be $ 114 per share on the valuation date. Based on its return on equity method of valuation, Benchmark concluded that the freely traded value of the ABC stock on August 13, 1985, was $ 118 per share. It then determined the weighted average of these two figures (assigning greater weight to the price-earnings indicated value than to the return on equity indicated value), with the resulting valuation of $ 115 per share.

Benchmark then added a premium to the freely traded per share value ($ 115) on the theory that if ABC were sold in its entirety a premium would apply to its total freely traded value. To do this, it determined the amount of premiums (over market price) at which natural resource companies had been sold from 1981 through 1984. These premiums ranged from 12% to 100%, so Benchmark selected 35% as the appropriate premium for the purchase of a natural resource company, thus resulting in an indicated enterprise value for ABC of $ 155 per share.

Benchmark also determined an amount of [*19] excess cash allegedly held by ABC above its working capital requirements, and added this amount ($ 52,449,000 or $ 29.85 per share) to ABC's enterprise value. The adjustment for excess cash, however, had to be reduced because of the impact of lower earnings and lower shareholders equity that the removal of such excess cash would entail. Accordingly, Benchmark reduced the adjustment for excess earnings to $ 11 per share, resulting in an adjusted indicated value of $ 166 per share using the historical earnings approach.

2. Net Asset Value Method

Recognizing that the worth of a natural resource company lies in the value of its underlying assets, Benchmark determined the going concern value of ABC stock using a net asset value method. It started with ABC's balance sheet as of July 31, 1985, but made certain adjustments, including (1) increasing the fair market value of ABC's surface lands and timber; (2) instead of book values of ABC's coal reserves, Benchmark used the Dames & Moore valuation which valued ABC's coal reserves at $ 145,187,000 as of the valuation date; (3) instead of the net book value of ABC's Tarrant coke plant (about $ 31,000,000) Benchmark accepted the insured value [*20] of the coke plant, which was $ 57,000,000; (4) a surplus of $ 13,695,000 in ABC's pension plan (which was not shown on the company's balance sheet) was added to the adjusted assets. As a result of these adjustments, Benchmark concluded that ABC's adjusted assets were valued at $ 457,779,000. After subtracting liabilities, the resulting stockholders equity of $ 361,041,000 yielded an indicated per share value of $ 205 using the net asset value approach.

3. Discounted Cash Flow Approach

The discounted cash flow methodology is based upon the premise that the value of a company is equal to the present value of its projected future cash flows. It is considered by experts to be the preeminent valuation methodology. See S. Pratt, Valuing A. Business: The Analysis and Appraisal of Closely Held Companies (2d ed. 1989). In applying this technique, Benchmark projected the future cash flow of the company, determined the terminal value of the company at the end of the period for which cash flow was projected, added these two amounts and discounted the total at an appropriate discount rate to determine the present value of the business and assets of ABC as of the valuation date. The [*21] future cash flow of ABC was determined by using its budget projections for the period 1985 through 1989. Cash flow was fixed by adding depreciation, income taxes and other noncash losses to the net income from the budget. Cash outlays consisting of the reduction in long-term debt, capital expenditures and working capital increases, if any, were deducted from cash flow. Benchmark then concluded that the appropriate discount rate for determining the present value of future cash flows of ABC was 14%. Using that discount rate, the present value of the future cash flows of ABC through 1989 was calculated to be $ 91,000,000. Fixing December 31, 1989, as the terminal date, Benchmark determined that the value of ABC on that date would be equal to a price earnings multiple of 14 times annual earnings for 1989 plus a premium for 100% ownership. The 1989 earnings were taken from ABC's 1985/1989 budget. Using the price earnings multiple of 14 and a premium for sale of the entire company to an unrelated third party, yielded a terminal value of $ 252,000,000 after a discount of 14% to determine present value. Adding future cash flows through 1989, excess working capital and the terminal value, [*22] Benchmark arrived at a total enterprise value of $ 395,000,000, or $ 225 per share of ABC common stock at the valuation date using the discounted cash flow methodology.

Taking the indicated values under each approach, Benchmark averaged the resulting valuations, although it assigned a higher weight (40%) to the historical earnings and net asset value approaches. That weighted average valuation, as noted earlier, was $ 193.40 per share of ABC common stock.

A. Respondents' Methodology

Respondents assert that the merger price was fair. The merger price, in fact, was extremely generous, because respondents contend that ABC's statutory fair value is only $ 64 per share, more than $ 11 less than Drummond paid in the merger. Respondents' valuation is based upon the testimony of their expert trial witnesses, Arnold Spangler, a general partner at Lazard Freres & Co. ("Lazard") and Robert Wilken of Paul Weir Company ("Weir") who estimated the company's coal reserves.

Lazard's valuation appears to have been based on a hybrid discounted cash flow and net asset methodology. The analysis was designed to predict the value of future cash flows from ABC's continuing operations, including ABC owned [*23] mines, power company mines and the Tarrant coke plant over a 13 year period from 1985 through 1997. This period corresponded to either the life of a variety of ABC's long-term contracts or to the exhaustion of its coal reserves, leaving only its Tarrant coke operation viable in 1997. Lazard arrived at a net after tax cash flow that ABC's continuing operations were expected to generate from 1985 to 1997, to which Lazard applied a multiple of five against the 1997 projected net cash flow (the terminal value) arriving at a value for ABC's activities following the terminal year.

The resulting projected net cash flows for 1985 through 1997 were discounted back to their present value as of August 1, 1985, by applying discount rates of 15% and 20%, which Lazard deemed appropriate given market, industry and business conditions. Based on this analysis, a range of present value for ABC of $ 131.9 million to $ 156.9 million was derived. Then, Lazard adjusted the ranges of present value by adding or subtracting certain additional operational activities, assets or liabilities. First, it added to the range of present value approximately $ 4.4 million to $ 5.4 million of other income which included [*24] various fees, income and deductions ABC was calculated to receive over the 1985 through 1997 projection period. These figures were tax adjusted and reduced to present value. Lazard also calculated the estimated excess working capital available to ABC, as well as the value of certain resources and land owned by ABC. Finally, Lazard adjusted for certain liabilities, including the Alixa Mine (VP-5), long-term debt, the Tarrant plant's environmental liabilities and retirement and medical obligations purportedly owed by ABC. After such adjustments, the net equity value of ABC resulted in a range from $ 96.6 million to $ 127.1 million, yielding a net equity value range per share of $ 54.97 to $ 72.33. From this range, Lazard opined that $ 64 was the fair value of ABC common stock on August 13, 1985. A summary of Lazard's valuation analysis is more easily displayed as follows:

[*25]

IV. VALUE, LIKE BEAUTY, IS IN THE MIND OF THE BEHOLDER n5

n5 S. Pratt, Valuing a Business, supra., p. 35.

The contrasting opinions regarding ABC's value in August 1985 demonstrate how differently petitioners and respondents view the business prospects and asset valuations of ABC. These starkly contrasting views have been presented to the Court through expert witnesses who have relied on complex business valuation methodologies. Although Benchmark relied on three different methodologies, there has been remarkably little disagreement over the legitimacy of the valuation techniques used by the parties in this case. Dispute has been over the assumptions on which the methodologies have been based as well as the underlying information supplied to the experts. With expert opinions arrayed on each side of widely divergent arguments about the worth of certain assets, or the scope of certain liabilities, the Court is forced to pick and choose among the competing contentions, in search of a reasonable, and fair, value. [*26] That is this Court's mandate: determine the fair value of the stock of ABC on August 13, 1985.

Both sides have relied on a discounted future returns model and a net asset model, with petitioners' expert also using a historical earnings analysis. n6 Other valuation approaches, with equivalent theoretical legitimacy, could have been used. But I am satisfied that respondents discounted future cash flow methodology is the appropriate valuation model in this case, especially since it was also used by petitioners' expert.

n6 There are troubling features to petitioners' historical earnings analysis which, independently considered, would cause me to reject it here. It relied on comparisons with six other companies, but close scrutiny of these companies suggests significant differences with ABC. Moreover, Benchmark's addition of an acquisition premium to the formula, in the circumstances of this case, is not justified. Cf. Cavalier Oil Corp. v. Harnett, Del. Supr., 564 A.2d 1137 (1989). See also Polk v. Good, Del. Supr., 507 A.2d 531, 537 (1986); Weinberger v. UOP, 1985 Del. Ch. LEXIS 378, Del. Ch., C. A. No. 5642, Brown, C. (Jan. 30, 1985).

[*27]

The more difficult task is to move beyond the analytical framework in order to test the underlying assumptions about ABC that the experts poured into the valuation models. This is the heart of the matter, for, as one commentator has noted, methods of valuation, including a discounted cash flow analysis, are only as good as the inputs to the model. S. Pratt, Valuing A Business: The Analysis and Appraisal of Closely Held Companies (2d ed. 1989) at p. 84. A valuation methodology can produce a correct answer for any type of input. So the relevant question is not how correct the resulting answer is, but how correct was the input or datum that produced the answer. Id. Accordingly this Court must review the assumptions and underlying factual premises for the valuation methodology actually used by both respondents and petitioners. Not every assumption need be scrutinized, however, for the parties have managed to agree, despite their best efforts, on certain assumptions and facts. Serious disputes exist in about eight different areas. The four principal areas of disagreement concern the value of ABC's coal reserves, the value of ABC's investment in the VP-5 mine in Virginia, the amount [*28] of ABC's excess working capital and, finally, the EME report on the purported environmental liability at ABC's Tarrant coke plant.

A. Coal Reserve Valuations

Three major points of difference exist between the experts for respondents and petitioners over the value of ABC's coal reserves.

1. Owned Coal Sufficient for Future (Underground and Surface) Mines

The parties' experts (Weir for respondents; and Dames & Moore for petitioners) agree that ABC owned substantial coal reserves suitable for future mining. Some of this coal was suitable for surface mines, some was suitable only for underground mines. Interestingly, the estimates of coal suitable for future mining estimated by both parties' experts far exceeded ABC's own reported quantities of coal in reserve in 1985.

Weir estimated ABC owned 66 million tons of recoverable (i.e. minable) coal reserves. Dames & Moore estimated 71 million tons, for a difference of about 5 million tons. n7 The difference for valuation purposes lies not in the coal quantities, however, but in the value ascribed to the resource itself. Weir assigned an overall value of $ 800,000 to ABC's owned recoverable coal reserves, while Dames & Moore valued [*29] these very same reserves at $ 58,372,000.

n7 The five million ton difference is due in large part to the different recovery rates applied by Weir and Dames & Moore. Weir used a 49.5% rate of recovery, while Dames & Moore evidently used ABC's historic rate of 55%. I view the overall calculations as sufficiently comparable, given the complexity of such estimates, to render the 5 million ton discrepancy immaterial. Nevertheless, I have accepted Dames & Moore's estimate for calculation purposes, because it is based on ABC's actual experience in recovery rates and because I found the testimony of petitioners' expert (McCulloch) more persuasive.

To establish the fair market value of ABC's undeveloped coal properties that might support a future mine, respondents' expert, Weir, estimated the likely royalty income that each property would generate and, after applying appropriate discount rates, calculated the present discounted value of the future stream of royalty income. The discounted royalty income stream, according [*30] to Weir, represented the fair market value that could be applied to these properties. Weir's basic estimates were premised on its conclusion that (a) ABC would experience difficulty and great expense in developing its undeveloped coal properties and (b) ABC would likely not develop the properties for many years. Delayed development would diminish the fair market value of such reserves. These critical assumptions by Weir led it to conclude that ABC's recoverable coal reserves, both underground and surface, would not be exploited until after the year 2000, thus resulting in a relatively low value for these reserves. It is interesting to note, however, that Weir assigned a higher value ($ 1.5 million) to ABC's unminable coal properties, than it did to ABC's recoverable (minable) coal reserves ($ 800,000).

Dames & Moore's valuation of the recoverable coal reserves is based on a comparable sale method. In 1981, Republic Steel sold a one-half interest in its North River Energy Company to Gulf Oil. Gulf paid $ 120 million for a one-half interest in Republic Steel's Alabama coal reserves. Since the North River property contained approximately 250 million tons of coal, Gulf's $ 120 million [*31] payment for a one-half interest (or 125 million tons of coal) yields a per ton price of 96 cents. Dames & Moore discounted that figure to 78 cents per ton, recognizing that coal prices between 1981 and 1985 had dropped n8 and allowing for the minor differences that are inherent in any two separate transactions. Multiplying the 76 cents per ton figure by the 56.405 million tons of estimated recoverable coal reserves suitable for underground mining, yielded a fair value for these reserves of $ 43,996,000.

n8 Although prices in Alabama had actually increased during that period, the experience nationally was to the contrary.

With respect to ABC's owned coal sufficient for future surface mining, Dames & Moore accepted ABC's estimate of 20 million tons of in-place coal, with 15.3 million recoverable tons available for future surface mines. It then projected that ABC's surface properties would generate 500,000 tons per year of coal production, based on evidence that approximately 650,000 to 1,000,000 tons of coal were being [*32] placed into production during the mid-80s in Alabama through new mines each year. Using a per ton price of $ 30 and projecting royalties at 12% of the sales price, Dames & Moore calculated a value for these reserves of $ 14,376,000, after applying a 14% discount rate. Had Dames & Moore instead used the comparable sales analysis for these coal properties, the valuation would have been $ 11,982,360.

Respondents vigorously attack Dames & Moore's use of a comparable sales analysis. First, they point out that the valuation is based on a single transaction, which robs the analysis of much of its reliability. Second, respondents' expert, Weir, concluded that the ABC properties and the North River properties were not comparable. North River was a single block of property containing about 250 million tons of undeveloped coal reserves. These reserves were separated into several 50 million ton blocks. In contrast, ABC's largest undeveloped reserve block contained 28 million tons. Larger coal reserves are more valuable because they support a mine of larger production capacity allowing recovery of a greater percentage of capital expenses. Third, ABC's potential underground mines, according to [*33] Weir, would require more expensive shaft entry techniques, while the North River properties could be developed with less expensive slope entry techniques. Slope entry is cheaper because the coal may be removed on a conveyor belt, while shaft entry requires an elevator by which coal equipment is lowered into the mine and coal lifted out. Fourth, underground reserves in ABC's properties averaged 40 inches in seam height, while North River underground reserves averaged 60 to 62 inches. Seam height of an underground reserve is critical in determining its value because the seam height affects the productivity of mining. Thicker coal seams can be mined using more efficient long-wall mining techniques, whereas thinner seams must be mined using a "room and pillar" method, a far less efficient mining technique. The thinner seams of coal on ABC's properties would therefore have been subject to a lower recovery rate (perhaps 55%) whereas the North River properties had a higher recovery rate (perhaps 67%). Finally, respondents quarrel with Dames & Moore's use of a 78 cent per ton value because, they say, it is based on a false comparison. According to respondents, the North River property included [*34] more than just recoverable coal reserves; it included an open and operating million ton a year underground mine and a one quarter million ton a year surface mine, both of which were used to supply coal under an existing contract with Alabama Power Company. These developed and operating mines were obviously valuable components of the North River sale, far more valuable, say respondents, than the undeveloped and unassigned reserves on ABC's properties. Respondents thus assign much of the value in the North River sale to the mining operations already in place and the existing contracts with Alabama Power with respect to those mining operations. They fault Dames & Moore for failing to adjust downward the 78 cent per ton figure it used. n9

n9 Respondents also criticize Dames & Moore's valuation of ABC's owned coal sufficient for future surface mines, principally on the ground that Dames & Moore failed to consider zoning restrictions, power lines, highways and other obstacles to the development of these potential future surface mines. There is a certain hollowness to this criticism, however, because Dames & Moore relied on ABC's own internal documents indicating that these properties were suitable for future surface mining. Even Weir concluded that there were 20 million tons of recoverable coal owned by ABC and suitable for future surface mining.

[*35]

Both experts' estimates of ABC's undeveloped, but minable, coal reserves agree, roughly, on the quantity of the reserves. Weir, however, used a discounted royalty stream approach that effectively assigned a very low value to ABC's coal reserves. Central to the analysis was Weir's assumption that ABC's existing mines would be operated until exhaustion and that new coal reserves would not be brought into active mining operations until the year 2000 or later.

While one may adopt such assumptions, I am not persuaded, based on the record, that they should be accepted here. Having considered and weighed the testimony of Mr. Charles W. Adair ("Adair"), ABC's president and chief executive officer before and at the time of the merger, I conclude that ABC's longstanding business relationship with Alabama Power Company would most probably have resulted in renewed power contracts and the development of new coal mines to replace Knob, Chetopa, and other coal mines that were nearing depletion. It seems far more reasonable, in my opinion, to assign a value to ABC's recoverable coal reserves as of August 1985 that reflects what those reserves actually would have brought on the market in 1985. [*36] A reliable indication of value can be obtained by looking to the fair market value of similar coal reserves in the region. The North River sale was considered comparable because it involved large underground reserves, it involved the very same coal seams (the Pratt and Mary Lee seams) or comparable coal seams, and it involved noncontiguous properties interspersed with adverse ownership as was true of ABC's properties. Having considered and carefully weighed all of the testimony on this issue, I am persuaded by Dames & Moore's conclusion that the North River sale is a legitimate comparison for valuing ABC's coal reserves in 1985.

It is true that the North River sale is a single transaction. Nevertheless, it is the most reliable indication, in my judgment, of the August 1985 value of ABC's owned coal sufficient for future underground or surface mining. For that reason, I find that both the underground and surface mine recoverable coal reserves should be valued by multiplying 78 cents per ton by the total number of recoverable tons (71,767,000), yielding a fair value of $ 55,978,360 for ABC's owned minable coal reserves.

2. ABC Coal Properties Leased to Others

ABC owned certain [*37] coal properties that it leased to others. Two leases were to Cobb Coal Company and Drummond. Dames & Moore gave these leases a combined value of $ 17.8 million while Weir valued them at $ 8.9 million. Weir's valuation is based on the estimate that ABC owned 8.2 million tons of clean recoverable coal in the leased coal category. Dames & Moore, on the other hand, estimated that ABC owned 6.7 million tons of clean recoverable coal subject to leases. The difference in valuations between Weir and Dames & Moore, again, is attributable to Weir's lower estimates of value with respect to ABC's own coal leased to Drummond. n10 To estimate the royalty income expected from a property, Weir applied the royalty rates in the contracts and the price realized for the coal from each property. It then discounted the production payments at an 18% rate and used a 12% discount rate for the minimum royalty payments under the lease. At trial, Wilken, the expert for Weir, testified that the discount rate should reflect the risk associated with the payments and that payments based on the production of coal carried greater risks than minimum payments, which must be paid under the lease whether or not production [*38] occurs. Based on the estimates of the likely development of ABC's leased coal property, Weir calculated that ABC's leases were worth $ 8.9 million.

n10 Weir estimated a higher value with respect to the coal leased to Cobb than did Dames & Moore. Weir estimated an annual production of 384,000 tons and a royalty based upon a sales price of $ 33 per ton with respect to the Cobb lease, whereas Dames & Moore estimated an annual production of 200,000 tons and a royalty based upon a sales price of $ 30 per ton.

Dames & Moore assumed a rate of production of 600,000 tons per year from the leases. This assumption included the belief that the Drummond leases would produce 400,000 tons a year, even though three of the Drummond mines were idle in 1985 and were expected to remain idle for many years. Petitioners respond that the idling of these properties was not foreseeable at the time of the merger, and constitutes post-merger data that should not be considered. The record, however, indicates that these properties were not in production [*39] at the time of the merger. Moreover, ABC's own budget projections for 1985-1989 show that these leases were not expected to produce royalties for ABC for many years to come.

Because no independent evidence justifies Dames & Moore's assumed rate of production for the leased properties, I am satisfied that Weir's valuation on this issue is more reasonable. Accordingly, ABC's owned coal leased to others had a fair value of $ 8,900,000 on August 13, 1985.

C. Unminable Coal

ABC's unminable coal reserves were valued at $ 1.44 million by Weir and at $ 1 million by Dames & Moore. I accept Weir's valuation on this issue.

***The aggregate fair value of ABC's coal reserves on August 13, 1985, was $ 66,318,360: $ 55,978,360 for owned coal sufficient for future underground/surface mines, $ 8,900,000 for owned coal leased by ABC to others at active operations, and $ 1,440,000 for otherwise unminable coal.

B. ABC's Investment in the VP-5 Partnership

ABC invested in a coal mining joint venture with Island Creek Coal Company, a subsidiary of Occidental Petroleum, in 1976. Known as VP-5 (Virginia Pocahontas No. 5), the joint venture involved Island Creek operating the mine and managing the [*40] partnership, with ABC as a passive investor with a one-third interest. ABC's investment was made through its wholly-owned subsidiary, Alixa Mining Corporation.

Petitioners insist that VP-5 should be valued at $ 45 million, the value that is reflected on ABC's monthly financials for the period ending August 31, 1985. They also point to Adair's testimony that he was unaware of any financial statements prepared by anyone in 1985 that suggested a write-down of the value of ABC's investment in VP-5. In addition, audited financial statements prepared on behalf of the VP-5 partnership itself by Arthur Anderson reflect that as of December 31, 1985, ABC's ownership interest in VP-5 was valued at $ 45,260,683, a figure consistent with ABC's July 31 and August 31, 1985, monthly financials.

Respondents, on the other hand, contend that ABC's investment in the VP-5 partnership represented a liability to ABC. Respondents justify this negative value as follows. In 1974 ABC was using Pocahontas coal in its coking operations and the cost of that coal was rising rapidly in the spot market. Accordingly, ABC decided to invest in a joint venture to supply the coke operations. Unfortunately, the VP-5 operation [*41] did not produce the low sulfur coal that ABC had hoped for, resulting in ABC having to pay its partner a commission to sell the coal from the VP-5 mine at a price less than the cost of mining the coal. Matters got worse in April 1982 when an explosion and mine fire shut down VP-5's production. Although there were discussions with Island Creek about whether to reopen the mine, failing to reopen the mine would have meant foregoing the business interruption insurance available as a result of the explosion and fire. Shutting down the mine permanently also would trigger additional liabilities (maintenance and cleanup, etc.), so VP-5 was reopened. According to Adair, VP-5 was reopened even though it was not expected to earn a profit. In light of these events, respondents contend that ABC's investment in VP-5 has no value. Indeed, because ABC was required to put money into VP-5 in order to keep the mine open, n11 respondents argue it had a negative value.

n11 This is not consistent with Adair's testimony that ABC was "not having to put any cash" into VP-5, which he cited as a reason why ABC had not shut down the mine. See transcript vol. 1 at 207.

[*42]

Neither valuation presented by the parties is reliable in my opinion. First, the book value heralded by petitioners merely reflects the cost of ABC's investment. As petitioners' own coal expert admitted, however, cost is not an appropriate basis for placing a fair market value on a coal property. Respondents' expert, Lazard, valued ABC's one-third interest in the VP-5 mine as a continuing operation. Lazard then calculated the investment's discounted cash flow, including ABC's commitment to purchase one-third of the mine's output. Based on that calculation, Lazard determined that VP-5 was actually a liability, rather than an asset for ABC. Lazard also assumed that ABC would have to invest $ 1,580,000 each year in order to keep the mine in operation, even though Adair testified that ABC had not tried 'to shut down the mine because it was not having to put any cash into it. Lazard's analysis is flawed, in my view, because it completely ignored ABC's internal financial documents and the Ernst & Whinney (ABC's outside accountants) work papers dated October 1986 regarding VP-5's potential. Lazard's analysis is also flawed because it accepted the proposition that VP-5 coal would not be [*43] used by ABC at its Tarrant coke plant. No independent basis for Lazard's assumptions regarding VP-5 exist and, for that reason, I do not credit them.

ABC's investment in VP-5 had not gone as planned, but that is not to say that the partnership had no value to ABC. ABC's financial reports show that it did have a value. Most creditable in this regard are ABC's audited financials for 1985. Those show that ABC's VP-5 investment had been written down to $ 17 million. That write-down was approved by Ernst & Whinney in 1986. Petitioners challenge the Ernst & Whinney report as reflecting post-merger information that should not be considered. They do not dispute, however, that ABC's audited financials for calendar year 1985 show a write-down to $ 17 million. I am satisfied that the fair value of ABC's investment in VP-5 as of August 1985 was $ 17 million.

C. Value of ABC'S Tarrant Coke Plant's Machinery and Equipment

Significant revenues were earned by ABC from its coking operation, known as the Tarrant coke plant. n12 Respondents' expert, Lazard, used a discounted cash flow analysis in valuing the coking business as well. Petitioners insist, however, that Lazard should have included [*44] in its valuation the excess value of the Tarrant coke plant as shown on ABC's insurance policy. The issue, therefore, is whether the book value or the insured value was the fair value of the plant and equipment as of August 1985. The insurance policy on the property indicates that the coverage is for the actual cash value, not the repair or replacement costs, of the assets covered by such policy. This value is $ 56,112,160. The book value is $ 32,130,000.

n12 ABC also had another coking plant outside Philadelphia, Pennsylvania, known as Keystone Coke. It was closed in 1981 because there was no market for the coke.

As respondents correctly note, petitioners argument ignores the fact that Adair and Weaver Self ("Self") testified that the values supplied to the insurance company represented the replacement value of the equipment at the Tarrant plant and not its fair market value. Self was directly responsible for procuring insurance for the Tarrant plant for more than 20 years, and personally supplied the same numbers [*45] to the insurance company that served as the basis of petitioners evaluation of the plant. See Transcript Volume 6 at 63-64. One could reasonably interpret the insurance policy in either fashion urged by the parties, but it seems more reasonable to look to the uncontroverted testimony of the individual responsible for filing the statement of values with the insurance company. That testimony demonstrates that replacement cost, not fair market value, was the basis for the values supplied to the insurance company regarding the Tarrant plant.

Accordingly, I conclude that no adjustment should be made to Lazard's determination to use the book value ($ 32.1 million) as the basis for its valuation of the Tarrant facility.

D. ABC's Long-term Debt

Lazard, respondents' expert, analyzed ABC on a debt-free basis, assuming an immediate payment and elimination of ABC's long-term debt, which, as of August 31, 1985, was $ 48,675,000. It treated this number as a current liability. In doing so, a slight increase in the discounted cash flow analysis occurs because cash flows are increased by virtue of the elimination of interest payments on the long-term debt. The record demonstrates that this [*46] increase in the discounted cash flow, as a result of the debt elimination, resulted in Lazard increasing the cash flow figure for continuing operations by $ 25.4 million. The increase in cash flow figures resulting from the elimination of debt service, however, is offset by the assumed immediate payment of long-term debt, which results in $ 48,675,000 being cast into the "other liabilities" section of Lazard's valuation analysis. By assuming immediate payment of long-term debt, the net equity value of ABC was reduced by $ 23,275,000, or $ 13.50 per share.

The record shows unequivocally that ABC had, in the past, employed long-term debt to its advantage. It also shows that ABC had relied on long-term debt for a number of years. ABC's budget projections for 1985-89 reflect the continued use of long-term debt. Debt is used by many companies with the expectation that more income may be generated from borrowed money than the debt service will cost, which was ABC's historic experience.

Respondents have offered no justification for Lazard's assumption that all of ABC's long-term debt would be eliminated in calculating its value on August 13, 1985. The record indicates that long-term debt [*47] was part of the capital of ABC. The record contains no justification that it be deemed paid for purposes of a discounted cash flow analysis. Instead, it would appear more reasonable to value ABC on an ongoing basis with continued long-term debt and debt service. Accordingly, because I am not satisfied by respondents' explanation for the assumption of immediate payment of long-term debt, see Pinson v. Campbell-Taggart, Inc., 1989 Del. Ch. LEXIS 50 at *42-44. I conclude that Lazard's elimination of long-term debt should be rejected and its valuation approach adjusted by adding $ 23,275,000 to the net equity value of ABC. This consists of $ 48,675,000 in long-term debt less $ 25,400,000 in debt service costs, or $ 23,275,000.

E. Excess Working Capital

According to its financial statement on July 31, 1985, ABC had $ 97,571,000 in current assets, with $ 19,389,000 in total current liabilities, resulting in working capital (current assets less current liabilities) of over $ 78 million. Analyzing ABC's working capital and considering comparable companies, Benchmark, petitioners' expert, determined that ABC had $ 52 million in excess working capital in August, 1985.

Respondents contend that [*48] the excess working capital amounted to $ 33 million. On behalf of respondents, Lazard accepted the claim that ABC needed $ 20 million in cash on hand at any one time to satisfy its current obligations. This analysis, however, failed to consider the $ 23 million in current accounts receivable or the $ 19 million in current inventories, ignoring the fact that accounts receivable and inventories will be converted into cash in the ordinary course of business or can be used as security for short-term cash loans. Most of ABC's accounts receivable were due from its principal customer, Alabama Power Company, representing a dependable source of cash income.

It is of course true that part of a company's cash is needed to fund its ongoing operations, and the value of that cash is already reflected in one sense in the discounted present value of those operations. But the balance of the cash is "excess" and may be added to the discounted cash flow. Lazard's estimate, however, is not independently justified in its report or in the trial testimony of Spangler. Moreover, Self's testimony that ABC needed approximately $ 20 million on a regular basis to operate is a conclusion unsupported by the [*49] record. Even accepting it as true, however, it fails to account for the over $ 24 million in accounts receivable and $ 20 million in inventories available to ABC. For these reasons I am persuaded that Benchmark's conclusion that ABC had $ 52 million in excess working capital is more credible. Accordingly, Lazard's calculation of excess working capital at $ 33 million must be increased by $ 19 million.

F. Overfunding of ABC's Pension Plan

ABC's pension plans had net assets available for benefits as of May 1, 1985, of $ 31,915,000, with an actuarial present value of accumulated plan benefits of $ 28,220,000. According to petitioners, an overfunding of the plan in the amount of $ 13,695,000 existed. This overfunding is said by petitioners to represent an asset to ABC that should have been included in Lazard's valuation.

Respondents insist that the overfunding was not an asset, contending that the pension plans included stipulations that the assets of the plans "shall never inure to the benefit of [ABC] and shall be held for the exclusive purposes of providing benefits" to members of the plans. According to respondents, ABC could recover excess funding only after satisfaction of all [*50] liabilities under the plans, but all liabilities could be satisfied only if the plans were terminated. Accepting petitioners' assertions, according to respondents, would be to treat ABC as if it were liquidating rather than considering its value as an ongoing business. Respondents also insist that ABC did not have the right to terminate the plans.

Petitioners' expert testified that excess funding of a pension plan can be withdrawn or be realized by the employer through reduction in future contributions. While it is conceded that the plans are overfunded, Lazard's analysis failed to recognize the overfunding as an asset. n13 Recognizing the overfunding as an asset, which I am convinced must be done, means that $ 13,695,000 should be added to the overall net equity value of ABC in Lazard's valuation analysis.

n13 There is a suggestion that because Lazard relied on ABC's budget projections for 1985-89, its discounted cash flow analysis reflected any reductions which were created by the overfunding by the company in future pension contributions. Nothing in the record demonstrates, to my satisfaction, that the overfunding was reflected on ABC's balance sheets, a fact confirmed by Adair. Transcript Volume 1 at p. 130.

[*51]

G. Alleged Retirement and Medical Liabilities

Lazard reduced its estimate of the valuation range for ABC by subtracting $ 6.4 to $ 7.8 million because of ABC's potential liability for the medical costs of workers who retired from the Alabama Power Company ("Alabama Power") mines. Petitioners' expert, Benchmark, concluded that no liability existed or was foreseeable on August 13, 1985, and thus found no basis for deducting for the alleged medical liability.

Respondents insist that the liability is clear, pointing out that they are currently in a dispute with Alabama Power over these costs and that if the dispute is lost, respondents' total liability could be as much as a $ 100 million. The issue was first raised in 1984 when ABC was negotiating an agreement with Alabama Power concerning the recovery of coal out of the pond finds at its Maxine mine. Alabama Power sought to amend the closing agreement to terminate its liabilities for all medical and retirement costs as of December 31, 1986. ABC, however, rejected the proposed amendment. The issue was again raised in connection with the closure of the Gorgas and Segco mines, although the record is unclear whether these discussions [*52] occurred before or after the August 13, 1985, merger. Self testified that the issue was raised by Alabama Power in mid-1985, while J. D. Thornburgh, a Power Company representative, testified at deposition that Alabama Power made Drummond aware of its position regarding medical costs in the fall of 1985. Thornburgh was unsure as to the precise date of these discussions.

Petitioners point out that Lazard's creation of the medical liability is based on the August 1986 Mercer-Meidinger Report, a report that is based upon data from July 1, 1985, through June 30, 1986. Moreover, Lazard knew that the Mercer-Meidinger Report relates to retired Maxine mine workers whose medical costs were contractually assumed and paid by Alabama Power, and that Alabama Power paid those costs up to 1988 when the issue of future liabilities then became the subject of arbitration. Petitioners also note that although such liabilities are obviously material, they were not disclosed to shareholders of ABC. None of ABC's financial statements refer to the Mercer-Meidinger Report, nor do ABC's monthly financial statements and audited financials for the period ending December 31, 1985, make reference to the potential [*53] medical liability. Moreover, Thornburgh's testimony at deposition was that Alabama Power raised the issue of the medical and retirement liability with Drummond in the fall of 1985. This confirms, according to petitioners, that the issue had not been raised with ABC and that it had been raised after the merger date.

The record does not support respondents' contention that ABC's potential liability for medical costs of workers who retired from Alabama Power mines was known or foreseeable when the merger was effected in August 1985. It was undisputed that Alabama Power had sought to amend agreements with ABC in order to terminate its liabilities for such costs. ABC had steadfastly, and successfully, resisted such efforts to amend existing coal supply agreements. Nothing in the record suggests that ABC had any reason to believe that it would be required to assume the medical and retirement costs of workers retiring from Alabama Power mines. Alabama Power had been contractually obligated for such costs and had actually paid them through the time of the merger. At issue now between Alabama Power and respondents (and subject to arbitration) are claims for post-1988 liabilities. Because [*54] the record evidence and the testimony of Weaver Self on this point are unpersuasive, no basis exists for Lazard's subtraction of $ 6.4 to $ 7.8 million from ABC's overall valuation.

H. The Keystone Coking Obligations

Lazard also reduced ABC's overall valuation by $ 1 million Eo $ 1.3 million based on alleged liabilities at ABC's Keystone coking plant. No explanation for this adjustment appears in Lazard's report and no independent basis for it exists in the record. As petitioners correctly note, none of ABC's financial statements or documents submitted to shareholders in connection with the merger mention liabilities in connection with the Keystone plant. Because such information was not disclosed to shareholders in connection with the merger nor otherwise revealed in contemporaneous financial documents, no basis exists for deducting such costs from Lazard's overall valuation of ABC on August 13, 1985.

I. Environmental Liabilities at the Tarrant Coke Plant

Respondents contend that when the minority shareholders of ABC were cashed out on August 13, 1985, there existed environmental liabilities ranging from $ 52 to $ 54 million relating to the surface, soil or ground water [*55] at ABC's Tarrant coke plant. Accordingly, Lazard's valuation of ABC deducted that amount from the overall valuation as an environmental liability. Spangler, on behalf of Lazard, testified that, in his experience, an environmental problem usually, if not always, exists with heavy industrial companies. He testified regarding other proposed transactions involving heavy industrial companies that collapsed after the scope of environmental problems were explored. At the time of the merger in 1985, the Tarrant plant had been in operation for nearly 70 years. In the 1980s the United States enacted comprehensive legislation that would ultimately require the treatment and removal of accumulated hazardous waste. See 42 U.S.C. § § 6901, et seq. (Resource Conservation and Recovery Act); 42 U.S.C. § § 6911, et seq. (Comprehensive Environmental Response, Compensation and Liability Act). So, even though ABC's own financial statements did not include specific references to cleanup costs associated with coke plants, Lazard sought to estimate what the environmental cleanup costs at the Tarrant plant might be. At first Lazard estimated the costs at $ 50 to $ 150 million, basing these numbers [*56] on the estimated costs of cleaning up the Koppers coke plant in Woodward, Alabama. Eventually, Lazard was provided with a report by Environmental Management and Engineering, Inc. ("EM&E"), a firm recognized in the area for determining the costs of cleaning up hazardous waste sites. The president of EM&E, Dr. Gonsoulin, concluded that it would require $ 52 to $ 54 million to cleanup a coke plant of the size and age of the Tarrant plant, based on his estimate of $ 650,000 to $ 675,000 per acre to remediate problems on 80 of the 275 acres of a plant site. Dr. Gonsoulin's per acre costs were based on his work at several other sites, including at least three coke plants. He also considered the costs of cleanups of other heavy industrial facilities. Nevertheless, the EM&E report is not based on an actual examination of the Tarrant site.

With respect to the report, the parties in this case made the following stipulations: (1) The EM&E report is not predicated upon the actual level of contamination, whatever it may be, at the Tarrant plant, which is unknown to EM&E and Dr. Gonsoulin; (2) Neither Dr. Gonsoulin nor EM&E has actual or constructive knowledge of any proposed or threatened claim [*57] to the effect that the Tarrant plant was in violation of any applicable environmental rules, laws or regulations referable to surface, soil or ground water as of August 1985. These stipulations make it clear that the EM&E report is based on a hypothetical coke plant, not the Tarrant plant. It is also clear that the purported environmental liability of the Tarrant plant was not known to ABC in August 1985 since it was not mentioned in the offering circular in connection with Drummond's December 1984 tender offer nor was it disclosed in any other documents between December 1984 and August 1985. Moreover, EM&E has conceded that the cost figures in its report do not account for ongoing cleanup operations at the coke plant, and that in order to predict the scope of any cleanup at the Tarrant plant would require a feasibility study exploring the various alternatives to bring such a facility into compliance with applicable environmental rules or regulations. It is undisputed that no feasibility study was undertaken by EM&E.

The record fails to support inclusion of the EM&E report as a reliable indication of a potential environmental liability at ABC's Tarrant plant. The report is admitted [*58] by its own author to be an estimate of cleanup costs at a hypothetical coke plant. Respondents did not seek to introduce the report into evidence, which is not surprising since it stood little chance of meeting the standards of reliability required under the rules of evidence. See DRE Rule 703; In re Agent Orange Product Liability Litigation, 611 F. Supp. 1223 (E.D. N.Y 1985), aff'd 818 F.2d 187 (2d Cir. 1987). Even respondents' expert witness, Spangler, admitted that the EM&E report "may not be most accurate." It clearly is not evidence of the type reasonably relied upon by experts in valuing a business.

A potential liability of a hypothetical coke foundry is not the standard. It was respondents' burden to prove the existence of an actual or reasonably foreseeable problem or liability at the Tarrant facility as of August 1985. This they failed to do. No witness described groundwater or surface problems and no governmental reports regarding contamination problems were produced. Financial reports and other company documents fail to mention any environmental concerns at the Tarrant facility, which would certainly be expected given the alleged [*59] magnitude ($ 54 million is equivalent to about $ 30 per share of ABC common stock) of the problem.

The record is devoid of evidence that would support the existence of a $ 54 million environmental liability of the Tarrant plant in August 1985. EM&E's report of a potential problem at a hypothetical coke foundry is not a credible basis for Lazard's fair value calculation. Lazard's subtraction of $ 54 million from the August 1985 equity value of ABC was improper.

J. The Discount Rate

Lazard, respondents' expert, used two separate discount rates, 15% and 20%, in determining the valuation range for ABC. Based on a discounted cash flow methodology, the higher discount rate yields a lower net equity value per share of ABC's capital stock, while the lower discount rate yields a greater value per share. Lazard's Spangler relied on a nearly 11% interest rate on 10 to 30 year Treasury bills as the appropriate risk-free rate. To that risk-free rate, Spangler added a risk premium of four to nine percentage points, which resulted in a total discount rate of 15% to 20%.

Petitioners' expert, Benchmark, selected a 14% discount rate, based upon its use of the capital asset pricing model. Interestingly, [*60] respondents' expert, Spangler, testified that he also performed a calculation using the capital asset pricing model, and that he obtained a discount rate of between 15% and 16%. In addition, Ernst & Whinney, ABC's accountants, used discount rates of 10% and 15% to determine the present value of their estimated cash flow of the VP-5 mine. Lazard also used these same work papers in its treatment of ABC's investment in VP-5, but otherwise chose to disregard the discount rates used by ABC's accountants and auditors.

Considering the record evidence suggesting low risk in the business segments of ABC (cost plus contracts with Alabama Power, ABC's company owned mines which supplied ABC's Tarrant plant, and the evidence that the Tarrant plant was projected to become increasingly profitable) a lower discount rate seems warranted. Because the low end (15%) of Spangler's computation of the appropriate discount rate is more consistent with ABC's own accountants (10%-15%), as well as with petitioners' expert (14%), the 15% discount rate appears more reasonable. Accordingly, the higher discount rate is rejected.

***Adjusting Lazard's analysis in accordance with the Court's findings and conclusions [*61] can be depicted in Lazard's summary valuation. Only one column, reflecting Lazard's 15% discount rate assumption, need be displayed.

ALABAMA BY-PRODUCTS CORPORATION
Summary Valuation Analysis
(aggregate dollars in millions, except per share)

	Valuation Range
	(As of August 1, 1985)

	Low	High

Continuing Operations	$ 131.9 -	$ 156.9

Other Income	4.4 -	5.4

Other Assets:
Excess Working Capital	33.0 -	33.0
Resources	11.2 -	11.2
Land Values	31.6 -	31.6
Alixa (VP-5)	(3.7) -	(2.9)
Subtotal	$ 208.4 -	$ 235.2

Other Liabilities:
Long-Term Debt	$ 48.7 -	$ 48.7
Keystone Coking Obligations	1.3 -	1.0
Tarrant Environmental	54.0 -	52.0
Retirement Medical	7.8 -	6.4

Total Other Liabilities	$ 111.8 -	$ 108.1

Net Equity Value	$ 96.6 -	$ 127.1

No. of Shares Outstanding	1,757,300

Net Equity Value Per Share	$ 54.97 -	$ 72.33

Valuation As Of August 1, 1985

Continuing Operations	$ 131.5 MM (adjusted by subtracting
	$ 25.4 million that re-
	sulted from the elimina-
	of debt service)

Other Income	$ 5.4 MM

Other Assets:
Excess Working Capital	$ 52.0 MM
Resources	$ 66.3 MM
Land Values	$ 31.6 MM
Alixa (VP-5)	$ 17.0 MM
Pension Funds	$ 13.6 MM

Subtotal	$ 317.5 MM

Other Liabilities:

Long Term Debt	$ 0
Keystone Coking Obligations	$ 0
Tarrant Environmental	$ 0
Retirement Medical	$ 0

Total Other Liabilities	$ 0

Net Equity Value	$ 317.5 MM

No. of Shares Outstanding	1,757,300

Net Equity Value Per Share	$ 180.67

	Eastern			No. Am.
	Gas & Fuel	Gulf Res.	MAPCO	Coal	Pyro	Western

1985 price	$ 22.81	14.57	36.39	56.38	8.60	17.50

1989 price	$ 30.62	10.00	39.00	50.12	12.00	22.25

Total % increase	34.2%	-31.3	7.2	-11.1	48.9	27.1

Average annual %	8.6%	- 7.8	1.8	- 2.8	12.2	6.8

Dividend yield	4.6%	- 3.7	2.6	1.2	0	0

Annual return	13.2%	- 4.1	4.4	- 1.6	12.2	6.8