Letter Decision No. LET-R-30-2020
2020-2021 Crop Year Cost of Capital Rate for the Canadian National Railway Company (CN) for the Transportation of Western Grain
SUMMARY
This determination addresses the following issues:
- Should commercial paper be included in the calculation of CN’s working capital?
- Should CN be permitted to roll over historical U.S. debt in perpetuity in the calculation of its cost of capital?
- What is the cost of capital rate for CN in respect of the 2020-2021 crop year for the transportation of western grain?
The Canadian Transportation Agency (Agency) will hold a consultation with respect to how commercial paper should be included in the calculation of working capital and sets working capital to zero in the interim.
The Agency will also continue to consult on how to allocate general purpose debt to Canadian rail operations.
CN did not provide sufficient information on the roll-over of its historical U.S. debt obligations to demonstrate to the Agency’s satisfaction that the inclusion of these debts is justified and, as such, the Agency will not include them in the calculation of CN’s cost of capital.
For the purpose of computing the volume-related composite index (VRCPI) in respect of the 2020-2021 crop year, the Agency determines for CN that:
- the cost of debt rate is 3.56 percent;
- the cost rate of deferred income taxes, investment tax credits and deferred downsizing is 0 percent;
- the after-tax cost of common equity rate is 7.11 percent;
- the cost of common equity rate adjusted to include an allowance for income tax is 9.72 percent; and
- the cost of capital rate is 5.19 percent.
The methodology used by the Agency in these determinations is presented in Appendix A. The resulting deemed capital structure is presented in Appendix B.
ANALYSIS AND DETERMINATIONS
Issue 1: Should commercial paper be included in the calculation of CN’s working capital?
On February 14, 2020, CN requested that the Agency not include commercial paper in the calculation of its working capital. CN argues that although commercial paper is issued as a short-term financial instrument, CN routinely rolls over these obligations such that it is more akin to long-term financing.
CN explains that the problem with including commercial paper in the calculation of its working capital is that it leads to negative working capital, which CN asserts does not make economic sense in the calculation of the cost of capital.
In Decision No. R-2017-198 (the 2017 Determination), the Agency defined working capital as the "cash and materials and supplies required by the company to maintain day-to-day operations", and approved a modified version of CN’s proposed classical accounting formula methodology to calculate working capital for both CN and CP:
…the annual working capital allowance would be estimated as an average of 12 monthly estimates of the requirements, where each monthly estimate is determined as the average of the opening and closing balances of current assets for the month, less the average of the opening and closing balances of current liabilities for the month.
Given that CN raised this issue, on March 2, 2020, Agency staff sought clarifications from the Canadian Pacific Railway Company (CP) on:
- whether CP makes use of commercial paper; and
- if it does, whether CP includes commercial paper in the calculation of its working capital in its cost of capital submission.
On March 6, 2020, CP responded that it did not include any commercial paper in its calculation of working capital, but stated that it is used to support a cash shortage related to its share buy-backs.
With respect to share buy-backs, the Agency has already determined, in Decision No. LETR492009, that debt incurred for the purpose of buying back shares in a company whose primary, if not exclusive, business line is the railway business is to be appropriately classified as identifiable rail debt. Consistent with that, the Agency has issued Decision No. LET-R-29-2020 in respect of CP, that debt issued for share buybacks is rail-related and is to be included in the calculation of CP’s capital structure.
With respect to whether commercial paper should be treated as current liabilities or as long-term debt, the Agency notes that CN did not provide sufficient evidence to allow the Agency to exclude commercial paper from current liabilities. The Agency notes that CN also did not include information on its commercial paper such as the interest rate and interest expense, which would be necessary if it were to be moved to long-term debt.
The Agency intends to launch a consultation in 2020, with respect to the question of including commercial paper in the calculation of the railway companies’ working capital, including but not limited to stakeholders who participated in the consultation leading up to the 2017 Determination. In addition to addressing this issue, the Agency will continue to consult on an alternative methodology to be applied equally to CN and CP to allocate general purpose debt for rail purposes in time for the determination of the 2021-2022 cost of capital rate for the transportation of western grain.
As CP has excluded all commercial paper from the calculation of its working capital, and CN has proposed to exclude all commercial paper from the calculation of its working capital, but has not provided the information necessary to do so, treatment of the railway companies in this regard would be inconsistent.
To avoid this, and notwithstanding the methodology set out in the 2017 Determination, the Agency will set working capital for both railway companies to zero to ensure a consistent approach in the interim.
Issue 2: Should CN be permitted to roll over historical U.S. debt in perpetuity in the calculation of its cost of capital?
In CN’s February 14, 2020 cost of capital submission, investments in its U.S. business are treated as a perpetual debt for the company, despite its previous annual submissions to the contrary.
For example, the CN purchase of Illinois Central was completed in 1998, on the basis of a number of separate debt issuances. One of these issuances expired in 2003, and in CN's submission, it has been replaced based on a 10-year debt issuance that expired in 2013. CN then allocated this face value against a new debt issuance in 2013. This treatment results in the full amount of this original investment being deducted from its total debt obligations for Canadian rail operations in 2019.
If a debt obligation has been paid off in full by CN, there no longer exists principal or interest payments, and the cost of capital will cease to exist.
The cost of capital allowance is provided to CN for its current debt obligations. The Agency cannot accept the roll-over of debt without supporting evidence to demonstrate that such obligations continue to exist today, including:
- details of the debt roll-over, including revised terms of agreement where applicable;
- purpose of the debt issuance; and
- principal that has been paid in respect of the original debt issuance.
With respect to any approved roll-over of CN’s of U.S. debt, the Agency will continue to apply the RTM-based approach as outlined in Decision No. LET-R-41-2019.
Issue 3: What is the cost of capital rate for CN in respect of the 2020-2021 crop year for the transportation of western grain?
Pursuant to subsection 151(1) of the Canada Transportation Act, S.C., 1996, c. 10, as amended (CTA), the Agency determines the maximum revenue entitlement for the movement of grain in a crop year. One component of this formula is the calculation of the VRCPI, which requires the determination of an appropriate cost of capital rate.
The cost of capital rate is set in accordance with the methodological approaches set out in Determination No. R-2019-229, dated November 29, 2019 (2019 Determination), and previous determinations by the Agency and its predecessors related to cost of capital rates.
For the purpose of computing the VRCPI in respect of the 2020-2021 crop year, the Agency determines for CN that:
- the cost of debt rate is 3.56 percent;
- the cost rate of deferred income taxes, investment tax credits and deferred downsizing is 0 percent;
- the after-tax cost of common equity rate is 7.11 percent;
- the cost of common equity rate adjusted to include an allowance for income tax is 9.72 percent; and
- the cost of capital rate is 5.19 percent.
The methodology used by the Agency in these determinations is presented in Appendix A. The resulting deemed capital structure is presented in Appendix B.
APPENDIX A - 2021 CROP YEAR COST OF CAPITAL RATE FOR THE TRANSPORTATION OF WESTERN GRAIN
1.0 Net rail investment
The working capital allowance in the calculation of net rail investment was adjusted to $0 in the interim until the Agency makes a determination on the use of commercial paper.
2.0 Capital structure
CN recorded the debt used to purchase BC Rail in discounted value rather than face value. According to the 2017 Determination, long-term debt reported in the capital structure must reflect the face value of the debt instruments.
3.0 Capital structure cost rates
Deferred taxes and Investment cost rate are accepted as submitted on February 14, 2020. Total debt cost rate was adjusted by staff in accordance with the revenue ton mile (RTM) interim approach and the associated adjustments made to long-term debt as stated in section 1.0. The cost of common equity rate was also adjusted by staff in accordance with the 2019 Determination.
In accordance with 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 the 2019 Determination, the cost of common equity rate for the movement of grain is based on results obtained from the Capital Asset Pricing Model, using both Canadian and American data, in the manner set out in the Appendix of the 2019 Determination. 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 riskfree rate of 1.51 percent. It is the rate obtained by averaging the published daily bond yields for 5 to 10-year Government of Canada marketable bonds, as found on the Bank of Canada’s website, for the month of January 2020.
For the U.S. cost of common equity rate, CN submitted risk-free rates of return of 1.56 percent for U.S. 5-year bonds and 1.76 percent for U.S. 10-year bonds, which is accepted by the Agency. These rates were estimated by averaging the published daily bond yields individually for each of U.S. Treasury 5 year and 10-year Constant Maturities, as found on the U.S. Federal Reserve’s website, for the month of January 2020.
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 5 to 10-year Government of Canada bonds, and 7.03 percent for the U.S. cost of common equity rate based on 5-year Treasury bonds, and 6.70 percent for the U.S. cost of common equity rate based on 10-year Treasury bonds. These were accepted. They 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 1951 to 2019 period, for the Canadian calculation, and by Standard and Poors and the U.S. Federal Reserve for the period 1954 to 2019, for the American calculations.
iii. Beta
CN submitted betas of 0.97 for Canada and 0.93 for the U.S. The Canadian beta was revised to 0.98, the American beta was revised to 0.95. Betas were calculated using country-specific data to the end of January 2020, based on 5 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 the American 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 2019. To calculate the weighted Canada/U.S. cost of common equity rate, CN submitted weights of 55.85 percent for Canada and 44.15 percent for the U.S. These weights were substituted for weights of 55.84 percent for Canada and 44.16 percent for the U.S. based on 2019 trading volumes for CN of 279,183,900 for Canada and 220,761,800 for the U.S.
Conclusion
The cost of common equity rate of 9.72 percent (including an adjustment for an income tax allowance) and the resulting cost of capital rate of 5.19 percent estimated for the 20202021 crop year for CN are considered by the Agency to be fair and reasonable.
APPENDIX B
WEIGHTED RATE | |
---|---|
LONG TERM DEBT | 1.64% |
FUTURE INCOME TAXES AND INVESTMENT TAX CREDITS | 0.00% |
COMMON EQUITY | 3.55% |
APPROVED COST OF CAPITAL RATE FOR THE 2020/2021 CROP YEAR | 5.19% |
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