APPENDIX B

METHODOLOGY FOR LONG-RUN ANALYSIS

1.

Balance Sheet Construction

The balance sheets characteristic of coal producers are derived from a combination of the survey results and corporate tax returns for 1983. The primary data source for this balance sheet information is the Schedule L information included on the survey conducted specifically for this study.

The Schedule L information from the survey includes only a total for depreciable assets. Since the tax treatment of depreciable assets varies significantly according to the type of asset, this aggregate must be split into several types. This division is accomplished by combining capital flows for coal mining companies obtained from the Commerce Department's Bureau of Industrial Economics (BIE) with the tax return information provided. Additional information on economic depreciation is obtained from a Hulten-study ("The Measurement of Economic Depreciation", by Charles R. Hulten and Frank C. Wykoff, included in Depreciation, Inflation and the Taxation of Income from Capital, edited by Charles R. Hulten).

To facilitate the interpretation of results, all balance sheets were next constructed based on a total of $100 of assets. The balance sheet constructed for each sector of the coal industry is included in Table B-1. A typical $100 expansion of mining operation would consist of $48.23 of depreciable assets, $10.04 of depletable assets, $2.29 of land, $3.48 of inventories, $14.80 of

B-3

current assets, $6.90 of long-term financial investments and $14.26 of other assets. These assets would be financed by loans of $17.58, equity contributed by stockholders of $57.09 current liabilities of $11.65 and other liabilities of $13.68

2. Income Statement Items

Income statement items are constructed from the balance sheet profiles of each category. Table B-2 displays the income statements which accompany the balance sheet in Table B-1. Values for the years 1 through 8, 20, and 30 (out of 30) of the investment period are included for demonstration.

Interest expense is calculated by applying a cost of funds rate to the total value of loans outstanding in each year. This cost of funds is based on prevailing interest rates. Interest income is calculated by applying a market rate of interest to the total long-term financial investments in the balance sheet. Asset depreciation is calculated by applying the Hulten-Wykoff decay rates to the inflation adjusted basis for each asset type, resulting in an "economic" measure of depreciation -- the annual decline in real value of the assets - rather than the more conventional accounting measure. Finally, economic depletion is calculated by applying an average annual rate of exhaustion (3 percent) to the inflation-adjusted basis.

If asset distributions are to remain unchanged throughout the investment period, depreciable and depletable assets must be replaced as they wear out. With non-zero inflation, this replacement must be made at current year prices. All replacement investment must also consist of the same mix of financing (debt, equity, etc.). The model calculates replacement investment in each year. The annual decay of each replacement vintage is added to the decay of the original assets placed in service. These calculations are made for each year in the investment period to produce the 30 years of depreciation and interest expenses. All other expenses are assumed to grow with the rate of inflation.

B-5

Before-tax cash flow is calculated by subtracting all expenses and new capital contributions for replacement of assets from business receipts (discussed below) plus investment income. After-tax cash flow is computed by subtracting taxes from beforetax cash flow.

3. Tax Calculations

Taxes for each of the coal operations are computed by applying the main provisions of each tax law to the financial items. The major deductions, exclusions and credits for each set of tax rules are contained in tax calculators. These tax calculators are sets of computer coding that consist of three parts.

Tax Calculations Under Present Law. First, the calculator applies the appropriate tax accounting rules to the items on the balance sheet and income statement that represent items of the tax base. Particular attention is given to the inclusion of income from different sources and special exclusions allowed in the computation of the tax base. For example, in Table B-3, the first period total business receipts of $51.01 are added to the taxable portion of total income earned on financial investments, $0.62, to obtain the total income used as tax base.

The calculator next applies all allowable deductions. Under an income tax, deductions that are allowed to account properly for income are taken from the income statement, with particular emphasis on the deductions allowed for depreciation, depletion, and any special exclusions allowed in the computation of gross income. In Table B-3, deductions are allowed in the amount of $1.93 for interest expense, $4.89 for taxes paid, $34.18 for other