AMTRAK – ACELA FINANCING

Atif Raza Akbar – B17012

AMTRAK – ACELA FINANCING Atif Raza Akbar BM-A (B17012)

Case Background

The National Railroad Passenger Corporation, or Amtrak for short, is the

primary provider of passenger rail service in the United States. Amtrak was created
in 1970 with the agenda of ensuring that modern efficient intercity passenger rail
service remained an integral part of the national transportation system. Historically,
Amtrak has never been profitable in its 30-year history and has been supported by
annual subsidies from the Federal government. In 1997 the Amtrak Reform and
Accountability Act was passed which stipulated that Amtrak should eliminate its
reliance on federal subsidies and be self- sufficient by 2002.

Presently, Amtrak is implementing an ambitious new business plan to ensure

self-sufficiency, which includes high-speed rail services bringing revenues to the
tune of $180 million by 2002. This service was branded ‘Acela’ in the Northeast
Corridor. Most of the financing required to fund the $750 million worth of new
equipment for Amtrak had already been secured, and at the time of the case, Arlene
Friner, the CFO of Amtrak, is wondering about the options for funding the remaining
$267.9 million worth of equipment. The major options in front of her are – (1)
borrow from a major bank, (2) go for a leveraged lease, and (3) rely on federal
sources. The case majorly deals with a comparison of the net cash flows of first two
options on an NPV basis, taking into account the different tax benefits and terms of
both the options.

Critical Financial Problems

1. Debt or lease

The case presents a classic problem of debt vs lease financing. A major

bank offered to underwrite a bond issuance for Amtrak, with the
following terms -

 Term: 20-year
 Coupon: 6.75 percent per annum
 Semiannual payments: $12.303 million
 Payment beginning: Dec 1999
 Collateral for the loan: locomotives and trains sets

On the other hand, Amtrak has the option of a leveraged lease. BNCYF
could provide equity funds needed to finance the purchase.
AMTRAK – ACELA FINANCING Atif Raza Akbar BM-A (B17012)

Funds to be provided -
 EDC: 80% of required funds
 BNCYF: 20% of required funds; would receive lease payments
only after debtor had been paid

2. The discounting factor

In order to calculate the NPV, the discounting factor must be decided

both in the case of debt financing and lease financing.

3. Treatment of depreciation

A firm may go for depreciating the asset over a period of time that is
different from the actual useful life of the asset within the stipulated laws.
Certain asset classes and types of lease financing qualify for accelerated
depreciation. This allows a business to front load the tax savings and realize
them in the starting years of the acquisition of the equipment.

In the present case, according to the Modified Accelerated Cost

Recovery System (MACRS), a seven-year depreciation schedule is presented
(which goes up to 8 years owing to the half-year convention). Only the
declining balance method and straight line method of computing depreciation
are allowed under MACRS. So, it is Amtrak’s judgement call on whether to
go for the declining method or the straight line method. The tax benefits are
different in both cases and their effects on NPV of the lease or asset would
also be different.

4. Treatment of maintenance and salvage value

Maintenance and salvage value are harder to predict and the other cash
flows of an option and normally deserve a higher discount rate. In the present
case, the handling of the maintenance and salvage value would depend chiefly
upon the depreciation method employed. If the declining method is used, the
asset would be left with no salvage value by the end of the 8th year according
to the MACRS Depreciation Schedule.

Also, deciding upon a higher discount rate for maintenance and salvage
value returns might not always be objective as it would be very difficult to
compute. So, although a higher discounting factor is often warranted, many
AMTRAK – ACELA FINANCING Atif Raza Akbar BM-A (B17012)

firms employ a uniform rate in practice. This, again is Amtrak’s call on how
it wishes to compute the NPVs.

5. Rely on federal sources?

Although Amtrak couldn’t use federal funds for operating expenses, it could
still use the funds for capital appropriations which meant that it could still
purchase train and locomotive equipment using federal grants. It looks like
the easiest way to fund the equipment as the corporation does not have to
repay anything back to the federal government. But Amtrak does not consider
this as a serious option and prefers tapping into the financial market. What
can be the possible financial consequences of this decision?

Analysis and interpretation

For analyzing which option represents better value, Amtrak must consider the
Net Present Values of both the options. The discounted cash flows must be
calculated over the period of return payments and compared. We must understand
two concepts before going further– annuity and tax benefits derived from leasing
and debt.

The concept of annuity

An annuity is a series of payments made at equal intervals. Examples of
annuities are regular deposits to a savings account, monthly home
mortgage payments, monthly insurance payments and pension payments. Annuities
can be classified by the frequency of payment dates. The payments (deposits) may
be made weekly, monthly, quarterly, yearly, or at any other regular interval of time.
Valuation of an annuity entails calculation of the present value of the future annuity
payments. The valuation of an annuity entails concepts such as time value of
money, interest rate, and future value.
In the present case, the debt option has an annuity payment requirement
of $1,230,3000 semi-annually over the next 20 years.
AMTRAK – ACELA FINANCING Atif Raza Akbar BM-A (B17012)

Tax Advantages
A firm that has leases derives a tax advantage from those leases. In the case
of an equipment lease, the entire lease payment can be deducted from your firm's
taxable income. If you owned the equipment outright, you would write it off only
according to a lengthy depreciation schedule. By leasing, you can write off the
equipment quicker, giving you larger annual write-offs.

The NPV calculations

Discount rates

1. Debt financing – The bank has offered a bond issuance at 6.75%

payable semi-annually over the next 20 years. Hence discounting factor
is taken as 6.75%/2= 0.03375

2. Lease financing – WACC of the company has been considered as the

discounting rate for NPV calculations. Accordingly, cash flows have
been discounted at 11.8% p.a. WACC already considers impact of tax
hence the adjustment of the same has not been made separately. Since
the instalments are to be paid semi-annually, 6 monthly rate is
considered i.e. 11.8/2 = 5.9%. Hence, the discounting factor is taken at
11.8%/2 = 0.059
Debt financing 0.03375

Lease financing 0.059

Lease financing
In order to evaluate the value of the lease financing option over the course of
the entire period, we must consider the following cash flows and discount them
appropriately –
 Lease payments
 Tax shield on lease payments
AMTRAK – ACELA FINANCING Atif Raza Akbar BM-A (B17012)

Debt financing
In order to evaluate the value of the debt financing option over the course of
the entire period, we must consider the following cash flows and discount them
appropriately –
 Loss in depreciation
 Loss in depreciation tax shield
 Interest payments
 Tax shield on interest payments
Comparing the three options
Borrow and Buy
 This is the easiest method for National Railroad. It involves relatively less
complications and paper work and is easier to avail.

 Based on the financial statements of National Railroad, they can easily obtain debt
from a financial institution in order to make the purchase.

 Amtrak had recently issued debt in the market. This would prove to be a
disadvantage for Amtrak he public market was saturated with Amtrak paper.

 Since liability is recorded in full on the balance sheet, it will affect the debt equity
ratio, interest coverage ratio and weighted average cost of capital of the company.

 Calculating the NPV of outflows regarding this option comes to be $95419299

Lease
 Lease payments are tax deductible and would enable Amtrak to claim tax benefits
on the same. This benefit is absent in the option of borrow and buy since only
interest payments are tax deductible and not the loan repayment part.

 There is no need for any immediate lump-sum payment to be made in case of

finance lease. This saves the company from immediate requirement of funds since
the company in itself is a heavily loss making company and is completely reliant
on federal grants.
AMTRAK – ACELA FINANCING Atif Raza Akbar BM-A (B17012)

 One disadvantage for Amtrak is that Amtrak will not be able to avail tax benefits
on depreciation since, in case of leveraged leases, depreciation can be claimed by
the lessor and not the lessee.

 In case the equipment is returned to the lessor at the end of lease period, Amtrak
will lose out on the salvage value of the asset which it would’ve been able to avail
of had it owned the asset.

 Calculating the NPV of outflows regarding this option comes to be $337778220

Rely on federal sources

 Although Congress had restricted Amtrak from using federal subsidies for
operational expenses, capital appropriations could still be Federal funded.
Purchase of locomotives and train sets could be considered as capital-asset
acquisitions and therefore Amtrak was still eligible for availing the benefit in
the case of Acela.
 The decision-makers were reluctant to use federal grants to fund this
acquisition since they considered federal grants to be a premium and precious
commodity and preferred to use it to fund other riskier projects that couldn’t
be easily and cost effectively financed.
 In this case, external funding is easily available for Acela and Amtrak is
already considering two options of borrow and buy and lease financing for the
same. Considering the above factors, it is a wise option to utilize the federal
money for higher risk projects and to fund projects where it would be difficult
to avail outside funding.
AMTRAK – ACELA FINANCING Atif Raza Akbar BM-A (B17012)

Final recommendations
1. Go for lease financing – After evaluating the NPV of the cash flows from the
two external funding options, it would seem prudent for Friner to green flag
the lease funding option. The cash outflows are more favourable when
compared with the borrowing option after discounting using the appropriate
discount rates. This option is also recommended over the federal grants option
as it can be kept as a reservation for other projects where external funding is
not as readily available.

2. Additionally, the option in case of leasing where Amtrak would buy the asset
at the end of the lease term is marginally beneficial than the early buyout
option. Hence, the buyout option would be preferred. This is contingent to
other factors such as market value of the asset at the time of early buyout and
therefore, it is difficult to make a completely objective comment.

3. Rectify the loss-making structure at Amtrak – Amtrak has been a loss-

making entity for the past 30 years and this points to a fundamental flaw in
the structure. Amtrak must consider improvising / redefining its current
operations to make them profitable. Also, considering the fact that Amtrak is
now introducing Acela, which is much faster, better and convenient than the
current passenger rail service, it can consider the option of completely
redefining the passenger rail system.

A major portion of all of Amtrak’s revenues (>90%) goes into employee

benefits expenses. As an entity that has not been profitable for the last 30
years, this must be questioned.
AMTRAK – ACELA FINANCING Atif Raza Akbar BM-A (B17012)

Exhibits

NPV of Cash Outflows

Borrow 337778219.7
Lease
95,419,298.89

Discount rates
Borrow 0.03375
Lease 0.059