Letter Decision No. LET-R-70-2010

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 2010/2011 crop year pursuant to subsection 151(1) of the CTA, the Agency has decided that for the Canadian National Railway Company:

• the cost of debt rate is 5.10 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 5.31 percent;
• the cost of common equity rate adjusted to include an allowance for income tax is 7.70 percent; and,
• the cost of capital rate is 5.79 percent.

The reasons for the Agency's Decision and the adjustments made to CN's submission of February 5, 2010, 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

2010/2011 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, 2010

1. Net Rail Investment - the net rail investment was accepted as submitted by the Canadian National Railway Company (CN) on February 5, 2010.
2. Capital Structure - the capital structure was accepted as submitted by CN on February 5, 2010, 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 5, 2010, 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 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 2010/2011 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 are based on subjective assessments of dividend growth rates and 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. Therefore, 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 and long-term 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, typically 1-3 years and 10+ years respectively, during the month of January, and to monitor such rates for their reasonableness in setting the cost of common equity rates. This year, it was apparent that 1-3 year bond yields continued to be downwardly influenced by measures in place to bolster the economy in light of the 2009 recession, despite consensus forecasts and widespread expectations that these measures will end sometime in 2010. Because of this unique circumstance, the Agency considered it necessary to extend its analysis of short term rates to include an examination of Government of Canada marketable bonds with a 3-5 year horizon.

The Agency considers these 3-5 year rates to more accurately forecast a short term rate appropriate for the 2010/2011 crop year. The rates were taken from the Globe and Mail, during the month of January 2010. On the basis of prevailing interest rates and economic forecasts, the Agency has determined that the appropriate rate for the 2010/2011 crop year is 3.16%. This rate is the result of an average of the short-term rate of 2.26% (3-5 years) and the long-term rate of 4.06% (10+ years).

With respect to the MRP (MRP) used in the CAPM, the Agency calculated the MRP by examining the difference between the historical returns on stocks and bonds. The Agency examined a 45-year period (1965-2009) for both short and long-term bonds. For the period up to 2007, the Agency used historical return information obtained from the publication entitled Economic Statistics - Report on Canadian Economic Statistics 1924-2007 published by the Canadian Institute of Actuaries (CIA) in March 2008 (Tables 1A and 4B). As subsequent editions of this publication are no longer accessible to the Agency, it performed the historical return calculations for the years 2008 and 2009 in-house, using data from the same sources as those used by the CIA. The time period of the instruments used to assess short term MRP was consistent with the 3-5 year Canadian bond rate used above. The resulting average MRP is 2.66% (3.19% for 3-5 year bonds and 2.12% for 10+ year bonds).

The Agency conducted in-house calculations for beta, based on five years of both monthly and weekly observations, using Canadian and US data, to February 2010. The Agency also researched Yahoo.com (US data), Reuters.com (Cdn. data) and Bloomberg.com (Cdn. Data) to corroborate the results of its calculations. Based on these in-house calculations and this research, the Agency used a beta for CN of 0.81. This result is based on five years of weekly observations of Canadian data, calculated by both the total return method and, at the suggestion of CN, by the effective return method, and adjusted for convergence. It should be noted that the effective return method yielded a beta that was not appreciably different than that yielded by the total return method, up to four decimal places.

CN also questioned the sufficiency of the S&P/TSX as a market proxy for beta calculations, favouring the use of the US S&P 500. The Agency’s position on the use of the S&P/TSX as a suitable market proxy for calculating beta is stated in the 2004 Decision:

“With respect to an appropriate data source to be used for estimating beta for CN and CP, the Agency concurs with CN on the use of a broad value-weighted index. As a reflection of the Toronto Stock Exchange, the seventh largest stock market in the world and the third largest market in North America, the Agency finds the S&P/TSX Composite Index, which covers approximately 95% of Canadian equity market capitalization, to be an acceptably broad market measure, suitable for calculating beta values for Canadian regulatory purposes.”

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 the Agency determined that only other specific types of freight traffic were relevant comparators. Again in 1997 the Agency concluded that the carriage of grain was not less risky than the carriage of other commodities and assessed no downward or upward adjustment to the cost of common equity for the movement of grain. It should be noted that in doing so the Agency did, in fact, acknowledge an increased risk for grain from previous determinations to that of the equivalent of other commodities. During the interval between the 1985 Decision and the 1997 Decision the Agency had assessed a 1% reduction to the cost of equity each year, attributed to a lower risk associated with the movement of grain as compared to other commodities, primarily due to the regulatory regime in effect at the time.

After taking many factors into consideration, including the potential variability of grain volumes and weather factors from year to year, 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.

It is considered that the conclusions reached 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. Therefore, for the 2010/2011 crop year, the grain risk adjustment to the cost of common equity rate of CN is zero.

During the process of this determination, as well as during the process for the three previous crop years, CN commented in its February 5, 2010 submission and in correspondence dated March 29, 2010 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 MRP, 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.

In August 2009, the Agency initiated a consultative review of cost of capital methodologies. During the course of this review CN and other interested parties will have opportunities to raise any issues or concerns pertaining to the Agency’s established cost of capital methodology. The Agency will continue to use its existing methodology, which includes the use of accounting book values rather than market values to determine capital structure, the treatment of deferred taxes as a source of zero cost financing, the consistent use of a sufficiently long time period for examining MRP, and the exclusive use of Canadian data, throughout the course of the review process. In view of this, the Agency will not address the above-mentioned methodology concerns and comments raised by CN at this time.

The cost of common equity rate of 7.70% (including an adjustment for an income tax allowance) and the resulting cost of capital rate of 5.79% estimated for the 2010/2011 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, 2009 AS APPROVED BY THE CANADIAN TRANSPORTATION AGENCY

	WEIGHTED RATE
LONG TERM DEBT	2.00%
FUTURE INCOME TAXES AND INVESTMENT TAX CREDITS	0.00%
COMMON EQUITY	3.79%
TOTAL APPROVED COST OF CAPITAL RATE FOR THE 2010/2011 CROP YEAR	5.79%