Canadian National Railway Company - 2024-2025 Crop Year Cost of Capital Rate for the Transportation of Western Grain

April 16, 2024

Determination by the Canadian Transportation Agency (Agency) of the 2024-2025 Crop Year Cost of Capital Rate for the Canadian National Railway Company (CN) for the Transportation of Western Grain

[1] The Agency determines CN's maximum revenue entitlement for the movement of grain in each crop year in accordance with the formula set out in subsection 151(1) of the Canada Transportation Act, SC 1996, c 10. One component of this formula is the calculation of the Volume-Related Composite Price Index (VRCPI), which requires the determination of an appropriate cost of capital rate.

[2] The principles currently used by the Agency in determining cost of capital rates were established in the following decisions:

• Determination R-2022-16 dated February 11, 2022, and Determination R-2022-39 dated April 8, 2022: which set out the Agency's methodology to determine the railway company's calculation of net rail investment and capital structure for regulatory purposes;
• Determination R-2019-229 dated November 29, 2019: which adjusted the Agency's methodology to determine the cost rate of common equity for federally-regulated railway companies;
• Determination R-2017-198 dated December 5, 2017: which sets out the methodology to be used by federally-regulated railway companies to determine the working capital amounts and capital structure for regulatory purposes;
• Decision 425-R-2011 dated December 9, 2011: which adjusted the Agency's methodology to determine the cost of capital for federally-regulated railway companies;
• Decision 125-R-1997 dated March 6, 1997: which addresses issues pertaining to the Agency's cost of capital methodology for regulated railways; and
• The 1985 Cost of Capital Methodology Decision.

[3] For the purpose of computing the VRCPI in respect of the 2024-2025 crop year, the Agency has determined that for CN:

• the cost of debt rate is 4.03%;
• the cost rate of deferred income taxes, investment tax credits and deferred downsizing is 0%;
• the after-tax cost of shareholders' equity rate is 8.18%;
• the cost of shareholders' equity rate adjusted to include an allowance for income tax is 10.84%; and
• the cost of capital rate is 6.05%.

[4] The methodology used by the Agency in these determinations is contained in Appendix A. The resulting deemed capital structure is contained in Appendix B.

Appendix A to Determination R-2024-52

2024-2025 Crop Year Cost of Capital Rate for the Transportation of Western Grain

1.0 Net rail investment

The net rail investment is calculated using CN's 2023 consolidated balance sheets in accordance with Determination R-2022-16, Determination R-2022-39 and Determination R-2017-198. Total discount for long-term debt and net unamortized debt issue costs of $81 million and $90 million respectively was added as an asset. The resulting net rail investment is presented in Appendix B.

2.0 Capital structure

CN's capital structure from its 2023 consolidated balance sheet was adjusted to include total discount for long-term debt and net unamortized debt issue costs of $81 million and $90 million respectively in accordance with Determination R-2017-198. As well, $298 million of operating lease liabilities was reclassified as long-term debt to conform with Determination R-2022-16, Determination R-2022-39 and Determination R-2017-198.

3.0 Capital structure cost rates

The cost rate of debt at face value using CN's 2023 consolidated balance sheet is determined to be 4.03% in accordance with the methodologies set out in Determination R-2022-16, Determination R-2022-39, Determination R-2017-198 and Decision 425-R-2011.

The cost rate for deferred taxes, investment credits and deferred downsizing costs is determined to be 0% in accordance with Determination R-2017-198.

In accordance with Determination R-2019-229, the cost of shareholders' equity rate for the movement of grain is based on results obtained from the Capital Asset Pricing Model, using both Canadian and U.S. data, in the manner set out in the Appendix of Determination R-2019-229. The variables for these calculations are discussed below.

i) Appropriate risk-free rates

With respect to the Canadian cost of shareholders' equity rate, CN submitted a Canadian risk-free rate of 3.35%. The Agency accepts the risk-free rate submitted by CN, which is 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 2023.

The Agency accepts the U.S. risk-free rates of return submitted by CN. The 2019 Determination stipulates the use of 5-year and 10-year U.S. Treasury bonds as proxies for the risk-free rates of return used to determine two distinct cost of shareholders' equity rates, which are then averaged to estimate the U.S. cost of shareholders' equity rate.

CN submitted U.S. risk-free rates of 3.98% for U.S. 5-year bonds and 4.06% for U.S. 10-year bonds. 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 2023.

ii) Appropriate market risk premium

The Agency accepts CN's submitted market risk premiums of 5.02% for the Canadian cost of shareholders' equity rate based on 5- to 10-year Government of Canada bonds, and 7.32% for the U.S. cost of shareholders' equity rate based on 5-year Treasury bonds, and 6.99% for the U.S. cost of shareholders' equity rate based on 10-year Treasury bonds. 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 2023 period for the Canadian calculation, and by Standard and Poor's and the U.S. Federal Reserve for the 1954 to 2023 period for the U.S. calculations.

iii) Beta

CN submitted a Canadian beta of 0.72 and a U.S. beta of 0.76, based on daily returns averaged to weekly of the company share and the stock market. The Canadian beta was accepted, but the American beta was revised to 0.77. Betas were calculated using country-specific data to the end of January 2024, 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.

iv) Appropriate weighting factors used to determine the weighted Canadian/U.S. cost of shareholders' equity rate

The Canadian/U.S. cost of shareholders' equity rate is the weighted average of the Canadian and U.S. cost of shareholders' 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 2023. The Agency accepts CN's submitted weights of 51.75% for Canada and 48.25% for the U.S., based on CN's 2023 trading volumes of 304,536,200 shares for Canada and 588,435,000 shares for the U.S.

Conclusion

The cost of shareholders' equity rate of 10.84% (including an adjustment for an income tax allowance) and the resulting cost of capital rate of 6.05% estimated for the 2024-2025 crop year for CN are considered by the Agency to be fair and reasonable.

Appendix B to Determination R-2024-52

Canadian National Railway Company (CN) - Cost of capital and associated cost rates as at December 31, 2023

Determination of Net Rail Investment

(Amounts in millions of dollars)

Working capital	$(1,946)
Properties	$44,617
Deferred charges and other assets	$4,449
Total	$47,120

Capital structure	Amount	% of Total	Cost rate	Weighted rate
Long-term debt	$16,602	35.23%	4.03%	1.42%
Deferred taxes, investment tax credits and deferred downsizing costs	$10,401	22.07%	0.00%	0.00%
Shareholders' equity	$20,117	42.69%	10.84%	4.63%
Approved cost of capital rate for the 2024/2025 crop year	NA	NA	NA	6.05%

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