Letter Decision No. LET-R-49-2009

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.

For the purpose of computing the composite price index in respect of the 2009/2010 crop year pursuant to subsection 151(1) of the CTA, the Agency has decided:

• that the after tax cost of common equity rate for the Canadian National Railway Company (CN) is 6.43 percent;
• that the cost of common equity rate adjusted to include an allowance for income tax for CN is 9.40 percent; and,
• that the cost of capital rate for CN is 6.34 percent.

The reasons for the Agency's Decision and the adjustments made to CN’s submission of February 3, 2009, upon which the Agency’s decision is based, are presented in Appendix A. The resulting deemed capital structure is presented in Appendix B. The capital structure depicted in CN’s revised submission dated February 27, 2009 was rejected. The Agency does not consider debt incurred for the purpose of buying back shares in a company whose primary, if not exclusive, business line is the railway business to be appropriately classified as identifiable non-rail debt within the meaning of Agency Decision No. 125-R-1997.

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: 2009/2010 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 3, 2009

1. Net Rail Investment - the net rail investment was accepted as submitted by the Canadian National Railway Company (CN) on February 3, 2009.
2. Capital Structure - the capital structure was accepted as submitted by CN on February 3, 2009, with the exception of a technical adjustment to long-term debt to account for the current portion of long-term debt.
3. Capital Structure Cost Rates - accepted as submitted by CN on February 3, 2009, with the exception of a technical adjustment to the cost of debt resulting from the removal of the current portion of long-term debt and with the exception of the cost of common equity rate.

The after tax cost of common equity rate for the movement of grain was based on the result obtained from the Capital Asset Pricing Model (CAPM). The Canadian Transportation Agency (Agency) has calculated the cost of common equity rate using the Discounted Cash Flow (DCF) model and the CAPM. After a comparison of the results, the Agency is of the opinion that for the 2009/2010 crop year, the CAPM produces an estimate of the cost of common equity rate that better reflects the state of capital markets and is a better indicator of changes in financial markets through the risk free rates. Major inputs into the DCF model include company-specific share price and estimated earnings growth rate information. These inputs tend to fluctuate significantly. While bond yields can vary as well over the crop year, the Agency finds that such fluctuations are not as dramatic as the fluctuations of the inputs to the DCF model. As a result, the Agency finds that the CAPM has produced a more meaningful result for the upcoming crop year’s cost of common equity rate than that produced by the DCF model.

With respect to the risk-free rates used in the CAPM, the Agency used both short-term (1-3 years) and long-term (10+ years) Government of Canada bond rates as proxies for the risk-free rate of return. The Agency’s March 1997 Decision on the Cost of Capital Methodology requires the Agency to assess short and long-term bond rates during the month of January and to monitor such rates for their reasonableness in setting the cost of common equity rates. The rates were taken from the Globe and Mail, and the Bank of Canada website in some instances, during the month of January 2009. On the basis of prevailing interest rates and economic forecasts, the Agency has determined that the appropriate rate for the 2009/2010 crop year is 2.39%. This rate is the result of an average of the short-term rate of 1.12% (1-3 years) and the long-term rate of 3.65% (10+ years).

With respect to the market risk premium used in the CAPM, the Agency calculated the market risk premium by examining the difference between the historical returns on stocks and bonds. This information was obtained from the publication entitled "Economic Statistics - Report on Canadian Economic Statistics 1924-2007" published by the Canadian Institute of Actuaries in March, 2008 (Tables 1A and 4B). The Agency examined the period 1963-2007 and the resulting average market risk premium is 3.68% (4.42% for 1-3 years bonds and 2.94% for 10+ years bonds).

CN’s estimated beta of 1.10 was accepted as submitted.

With respect to any risk adjustment for grain, the 1997 Decision concluded that the carriage of grain was not less risky than the carriage of other commodities. Arguments were advanced that similar to the revenue of one item in a portfolio being inherently riskier than the revenue of the entire portfolio, the revenue of a single commodity such as grain is riskier than the revenues of all of CN’s commodities.

The Agency’s intent when evaluating the appropriateness of a grain risk adjustment is not predicated on the assumption that it be based on the risk of transporting grain relative to freight transportation as a whole. If that was so, the basic theory of diversification would imply that there would usually be a grain risk adjustment.

In the 1985 Decision, after hearing evidence and examining the grain risk question from the perspective of the risk of grain relative to the whole, relative to regulated public utilities and relative to other specific types of freight traffic, the Agency determined that the latter was the only relevant comparator. Again in reviewing the grain risk adjustment for the 1997 Decision, in addition to looking at the impact of the repeal of the WGTA on the transportation of grain, the Agency looked at whether the risk of transporting grain should be different than the risk associated with transporting other commodities and how the characteristics of grain transportation are different from other commodities. The relative risk of grain to the whole was not contemplated. 

After taking many factors into consideration, the 1997 Decision concluded that the carriage of grain was not less risky than the carriage of other commodities. The Agency has determined in all the ensuing crop years that the grain risk adjustment to CN’s cost of common equity rate, which is used to determine the cost of common equity rate for the movement of grain by CN, was zero.

In this regard the 1997 Decision states, in part, "The Agency is of the view that the variability of revenues and returns, and of the intensity of use of assets provided by the railway companies for the movement of grain, creates a certain riskiness not dissimilar to the riskiness of other commodities."

The Agency finds that the reasons cited in the 1997 Decision are still valid and that the carriage of grain today is no less or more risky than the carriage of other commodities. Accordingly, the Agency has determined that the grain risk adjustment will remain zero for the 2009/2010 crop year.

During the process of this determination, as well as during the process for crop years 2007/2008 and 2008/2009, CN commented in its February 3, 2009 submission and in correspondence dated March 30, 2009 that its submitted cost of capital was in accordance with the Agency’s methodology, however it disagreed with the methodology. CN indicated that the methodology understates the true cost of capital and overstates fluctuations in the cost of capital over time. CN specifically disagreed with the use of book values rather than market weights to determine capital structure, the inclusion of deferred taxes as a source of zero cost financing, the Agency’s parameters for calculating market risk premium, including the holding periods examined and the use of holding period returns for government bonds that occasionally demonstrate negative returns, as well as the Agency’s exclusive reliance on Canadian data.

Regarding these concerns, the Agency reiterates its position as noted in its determination of the cost of capital for CN for the 2007/2008 and 2008/2009 crop years.

A capital structure based on market values is approximate, volatile, significantly influenced by profitability, and its total does not correlate to the net investment deployed. For the Agency’s regulatory purposes maintaining the link between the capital structure and a railway’s Canadian asset base is integral, in that the cost of capital rates developed by the Agency are used for Canadian rail traffic programs (i.e. western grain revenue cap, Interswitching Rate Regulations, domestic rail/shipper service complaints, etc.). In this context, the Agency is of the opinion that a capital structure based on book values and aligned to net investment is significantly more relevant than one based on market values.

On the matter of the inclusion of deferred taxes in capital structure, in the 1985 Decision the Agency concluded:

"...from a cost viewpoint, accumulated deferred taxes are in essence an interest-free loan and as such must be considered as a zero cost source of capital, since the objective is to determine a fair level of compensation....to allow the cost of equity rate on these balances, would provide excess returns to the shareholders...."

The fact remains as it was then that deferred income tax balances arise because an entity may, through the claiming of capital cost allowances, depreciate fixed assets for income tax purposes at a faster rate than it depreciates the same assets for accounting purposes. The Agency continues to consider the resulting tax deferral to be an interest-free loan to the entity as it pays no costs on the taxes deferred.

The market risk premium is the difference between the expected return on the market portfolio, or a proxy for it, and the return on a risk-free asset, both defined over the same holding period. Because the return is an expectation, neither it nor the expected market risk premium are directly observable. Therefore, it must be estimated using measurable proxies. A risk-free asset is an investment considered to have no or low risk, typically measured using a government bond rate for a proxy, because of the likelihood of a government’s greater financial stability, as compared to that of a corporation or the market. The term "risk-free" does not connote an investment that is guaranteed to never post a loss. It merely identifies an investment that has a lower probability of not meeting its expectation, and consequently a lower expected return, than other investment instruments.

With reference to the holding periods examined by the Agency to calculate market risk premium, the 2004 Decision states:

"In this regard, the Agency acknowledges the commonly accepted principle that an average based on a long data series minimizes the distorting impact of an unusual year and incorporates a range of outcomes. The Agency further notes that long-term averages over periods of 30 years or more do tend to produce stable results. However, building on its earlier conclusions, the Agency finds that a very extended time period is inappropriate because it puts emphasis equally on recent and early historic data. The Agency is of the opinion that in forecasting the future, the distant past cannot be considered as relevant as the current past. The Agency considers market data reflecting the business practices, investor behaviour and expectations, government policies, accounting practices, taxation rules and the politics of modern times to be a better predictor of reasonable future returns on equity. The Agency is also of the view that a moving time period keeps these reflections contemporary."

The issue of the exclusive use of Canadian data for cost of equity calculations was carefully examined by the Agency in the deliberations leading to the 2004 Decision. The 2004 Decision concluded:

"With regards to the appropriate benchmark to be used for cost of equity determinations, the Agency has taken all of the above elements into consideration. Mindful that the primary determining factor in this issue is not shareholder mix, but rather the relevance and relativity of the United States experience on a cost of equity rate that has a focussed application on a specific segment of the railway companies’ Canadian market, the Agency determines that cost of equity estimations should continue to be based on Canadian data."

In the absence of any compelling reasons to the contrary, the Agency’s position on the appropriate risk free proxies and holding periods for calculating market risk premium, and the exclusive use of Canadian data for cost of capital calculations remains unchanged.

The cost of common equity rate of 9.40% (including an adjustment for an income tax allowance) and the resulting cost of capital rate of 6.34% estimated for the 2009/2010 crop year, 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, 2008 As Approved By The Canadian Transportation Agency

	Weighted Rate
Long Term Debt	2.75%
Future Income Taxes And Investment Tax Credits	0.00%
Common Equity	3.59%
Approved Cost Of Capital Rate For The 2009/2010 Crop Year	6.34%