Letter Decision No. LET-R-23-2015

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 No. 425-R-2011 dated December 9, 2011 in the matter of the review of the methodology used by the 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, to 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 2015/2016 crop year, the Agency has decided that for the Canadian Pacific Railway Company (CN):

• the cost of debt rate is 5.34 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 8.09 percent;
• the cost of common equity rate adjusted to include an allowance for income tax is 10.98 percent; and,
• the cost of capital rate is 7.31 percent.

The reasons for this Decision and the adjustments made to CP’s submission of February 16, 2015, upon which this Decision is based, are presented in Appendix A. The resulting deemed capital structure is presented in Appendix B.

The Agency shall not release the management projections of CP’s earnings and the pro forma (or projected) capital structure. This information is commercially sensitive, the public disclosure of which may cause specific direct harm to CP. Therefore, the public version of Appendix B to this Decision has been amended to avoid disclosing these projections.

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APPENDIX A: 2015/2016 CROP YEAR COST OF CAPITAL RATE FOR THE TRANSPORTATION OF WESTERN GRAIN

REASONS FOR THE CANADIAN TRANSPORTATION AGENCY’S ADJUSTMENTS TO CANADIAN PACIFIC RAILWAY COMPANY’S SUBMISSION DATED FEBRUARY 16, 2015

1. Net Rail Investment - accepted as submitted by Canadian Pacific Railway Company (CP), on February 16, 2015.
2. Capital Structure - accepted as submitted by CP on February 16, 2015, with the exception of an adjustment to long-term debt to remove misclassified items. This also resulted in a corresponding adjustment to equity.
3. Capital Structure Cost Rates - accepted as submitted on February 16, 2015 with the exception of a recalculation of the cost of debt, as a result of adjustments made to long-term debt, and adjustments to the cost of common equity rate.

In accordance with Agency Decision No. 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 No. 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 rate of common equity, the Agency accepts CP’s submitted risk-free rate of 0.90 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 2015.

The U.S. risk-free rates of return were revised from the rate submitted by CP. 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 common equity rates, which are then averaged to estimate the U.S. cost of common equity rate. CP submitted a single U.S. risk-free rate of return of 1.14 percent. U.S. risk-free rates of 0.90 percent for U.S. 3-year bonds and 1.37 percent for U.S. 5-year bonds were substituted. These rates were estimated by averaging the published bond yields individually for each of U.S. Treasury 3-year and 5-five year Constant Maturities, as found on the U.S. Federal Reserve Web site, for the month of January 2015.

ii. Appropriate Market Risk Premium

CP’s submitted market risk premium of 5.09 percent for the Canada cost rate of common equity was accepted. It is the premium obtained by examining the average difference between the historical total returns on the TSX, as published by the TSX, and the income return in the month of January for 3 to 5 year Government of Canada marketable bonds, as published by the Bank of Canada, for the period 1951 to 2014.

The U.S. market risk premiums were revised from the one submitted by CP. The 2011 Decision stipulates that the U.S. cost of common equity rate is determined by averaging an estimate of two distinct U.S. cost of common equity rates, one based on 3-year U.S. Treasury bonds and the other based on 5-year U.S. Treasury bonds, with the market risk premium for each being the arithmetic average of annual excess returns of the stock market over the income return for the respective bond instrument, as measured from the year 1954 to the present. CP submitted a single U.S. market risk premium of 6.84 percent. This was substituted with U.S. market risk premiums of 7.00 percent for U.S. 3-year bonds and 6.75 percent for U.S. 5-year bonds. These premiums were estimated by individually examining the average difference between the historical total returns on the S&P 500, as published by Standard and Poors, and the income return for January on each of U.S. 3-year and 5-year Treasury bonds, as published by the U.S. Federal Reserve, over the period 1954 to 2014.

iii. Beta

CP’s submitted betas of 1.03 for Canada and 1.18 for the U.S. were revised. Values of 1.02 for the Canada beta and 1.13 for the U.S. beta were substituted. These were calculated using country specific data to the end of January 2015, 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 rate of common equity

The Canada/U.S. cost rate of common equity is the weighted average of the Canada and U.S. cost rates of common equity, with the weights for CP 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 CP on the Toronto and New York stock exchanges during 2014. To calculate the weighted Canada/U.S. cost of common equity rate, based on unspecified trading volumes of 86,414,400 for Canada and 207,537,100 for the U.S., CP submitted weights of 29.30 percent for Canada and 70.70 percent for the U.S. These weights were adjusted to 29.21 percent for Canada and 70.79 percent for the U.S., based on 2014 trading volumes for CP of 85,787,300 for Canada and 207,917,600 for the U.S.

Conclusion

The cost of common equity rate of 10.98 percent (including an adjustment for an income tax allowance) and the resulting cost of capital rate of 7.31 percent estimated for the 2015/2016 crop year for CP, are considered by the Agency to be fair and reasonable.

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APPENDIX B

CP And Associated Cost Rates As At December 31, 2014 As Approved By The Canadian Transportation Agency

	Weighted Rate
Long Term Debt	1.25%
Future Income Taxes And Investment Tax Credits	0.00%
Common Equity	6.06%
Approved Cost Of Capital Rate For The 2015/2016 Crop Year	7.31%