Letter Decision No. LET-R-13-2016

In accordance with subsection 151(1) of the Canada Transportation Act (CTA), the Canadian Transportation Agency (Agency) is required to determine the maximum revenue entitlement for the movement of grain in a crop year. One component of this formula is the calculation of the composite price index, which requires the determination of an appropriate cost of capital rate.

This cost of capital rate is being set according to Decision 425-R-2011 dated December 9, 2011 in the matter of the review of the methodology used by the Canadian Transportation Agency to determine the cost of capital for federally-regulated railway companies (2011 Decision), and, where applicable for matters not addressed by the 2011 Decision, by previous determinations of the Agency and its predecessors related to cost of capital rates and principles.

For the purpose of computing the composite price index in respect of the 2016/2017 crop year, the Agency has decided that for the Canadian National Railway Company:

• the cost of debt rate is 4.54 percent;
• the cost rate of deferred income taxes, investment tax credits & deferred downsizing is 0 percent;
• the after tax cost of common equity rate is 6.59 percent;
• the cost of common equity rate adjusted to include an allowance for income tax is 8.97 percent; and,
• the cost of capital rate is 5.42 percent

The reasons for the Agency's Decision and the adjustments made to CN's submission of February 5, 2016, upon which the Agency's decision is based, are presented in Appendix A. The resulting deemed capital structure is presented in Appendix B.

The Agency shall not release the confidential financial information and CN's pro forma (or projected) capital structure. This information is commercially sensitive, the public disclosure of which may cause specific direct harm to CN. Therefore, the Appendix B to the Agency Decision that will be distributed to the public has been amended accordingly to avoid disclosing these projections.

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APPENDIX A

2016/2017 CROP YEAR COST OF CAPITAL RATE FOR THE TRANSPORTATION OF WESTERN GRAIN

REASONS FOR THE CANADIAN TRANSPORTATION AGENCY'S ADJUSTMENTS TO THE CANADIAN NATIONAL RAILWAY COMPANY'S SUBMISSION DATED FEBRUARY 5, 2016

1. Net Rail Investment - the net rail investment was accepted as submitted by the Canadian National Railway Company (CN) on February 5, 2016.
2. Capital Structure - the capital structure was accepted as submitted by CN on February 5, 2016.
3. Capital Structure Cost Rates – accepted as submitted by CN on February 5, 2016, with the exception of the cost of common equity rate.

In accordance with Agency Decision 97-R-2012, the Net Rail Investment and Capital Structure reflect the unamortized portion of the payments made towards statutory pension deficits and the financing of such payments, respectively.

In accordance with Agency Decision 425-R-2011, dated December 9, 2011 (2011 Decision), the cost of common equity rate for the movement of grain is based on results obtained from the Capital Asset Pricing Model (CAPM), using both Canadian and U.S. data, in the manner set out in Appendix A, paragraphs 8-19 of the 2011 Decision. The variables for these calculations are discussed in turn.

i. Appropriate Risk-Free Rates

With respect to the Canada cost of common equity rate, the Agency accepts CN’s submitted risk-free rate of 0.50 percent. It is the rate obtained by averaging the published daily bond yields for 3 to 5 year Government of Canada marketable bonds, as found on the Bank of Canada Web site, for the month of January 2016.

For the U.S. cost of common equity rate, the Agency accepts the U.S. risk-free rates of return submitted by CN. The 2011 Decision stipulates the use of 3-year and 5-year U.S. Treasury bonds as proxies for the risk-free rates of return used to determine two distinct cost of equity rates, which

are then averaged to estimate the U.S. cost of common equity rate. Risk-free rates of return of 1.14 percent for U.S. 3-year bonds and 1.52 percent for U.S. 5-year bonds were estimated by averaging the published daily bond yields individually for each of U.S. Treasury 3 year and 5 year Constant Maturities, as found on the U.S. Federal Reserve Web site, for the month of January 2016.

ii. Appropriate Market Risk Premium

CN’s submitted market risk premiums of 4.88 percent for the Canada cost of common equity rate based on 3 to 5 year Government of Canada bonds, and 6.90 percent for the U.S. cost of common equity rate based on 3 year Treasury bonds, and 6.64 percent for the U.S. cost of common equity rate based on 5-year Treasury bonds were accepted. These are the market risk premiums obtained by examining the average differences between the historical total returns on stocks and the income return in the month of January for bonds, as published by the TSX and the Bank of Canada for the period 1951 to 2015, for the Canadian calculation, and Standard and Poors and the U.S. Federal Reserve for the period 1954 to 2015, for the U.S. calculations.

iii. Beta

CN submitted betas of 0.87 for Canada and 1.01 for the U.S. Both were revised to a Canadian beta of 0.91 and a U.S. beta of 1.02. The U.S. beta was accepted as submitted. Betas were calculated using country specific data to the end of January 2016, based on five years of weekly observations of the percentage change in weekly returns of the company share and the stock market as a whole, with both rates of return adjusted by the weekly income return on 3-month treasury bills, and with the raw betas adjusted for convergence using the approved formula.

iv. Appropriate weighting factors used to determine the weighted Canada/U.S. cost of common equity rate

The Canada/U.S. cost of common equity rate is the weighted average of the Canadian and U.S. cost of common equity rates, with the weights for CN being based on the volume of shares traded on the Toronto and New York stock exchanges, respectively. Weights are determined as the relative proportions of the daily trading volumes of CN on the Toronto and New York stock exchanges during 2015. To calculate the weighted Canada/U.S. cost of common equity rate, CN submitted weights of 49.98 percent for Canada and 50.02 percent for the U.S. These weights were accepted based on 2015 trading volumes for CN of 351,321,900 for Canada and 351,648,800 for the U.S.

Conclusion

The cost of common equity rate of 8.97 percent (including an adjustment for an income tax allowance) and the resulting cost of capital rate of 5.42 percent estimated for the 2016/2017 crop year for CN, are considered by the Agency to be fair and reasonable.

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APPENDIX B

CN PRO FORMA DEEMED CAPITAL STRUCTURE AND ASSOCIATED COST RATES AS AT DECEMBER 31, 2015 AS APPROVED BY THE CANADIAN TRANSPORTATION AGENCY

	WEIGHTED RATE
LONG TERM DEBT	2.37%
FUTURE INCOME TAXES AND INVESTMENT TAX CREDITS	0.00%
COMMON EQUITY	3.05%
APPROVED COST OF CAPITAL RATE FOR THE 2016/2017 CROP YEAR	5.42%