AMTRAK: Acela Financing

NATIONAL RAILROAD PASSENGER CORPORATON

(“AMTRAK”): ACELA FINANCING

Case Background:

Amtrak was the primary provider of passenger rail service in the United States. Its national
network provided service to more than 20 million intercity passengers and operated 516
stations in 44 states. In its 30-year history, Amtrak had never been profitable and it was
relying heavily on federal subsidies. Withdrawal of federal subsidies for operating expenses
proved to be a major challenge for Amtrak. Hence, in order to be self-sufficient, Amtrak
developed a high-speed rail service named Acela that promised to offer faster trip times,
comfortable amenities and highly personalized services and was projected to bring in net
annual revenues of $180 million by fiscal year 2002. To operate the Acela Regional Service
as planned, Amtrak needed to purchase 15 dual cab, high horsepower electric locomotives
and 20 high speed train sets. The estimated total cost for all the equipment was approximately
$750 million, out of which Friner had already been able to arrange financing for a part of it
and was considering options for financing the balance 6 locomotives and 7 train sets
amounting to $267.9 million. There were three options available with Amtrak:
1. Borrow money and fund the purchase
2. Lease the equipment from a financial institution such as BNYCF or
3. Rely on federal sources for funding.
Friner had to evaluate these three options to determine which one was the most beneficial and
viable for the company.

Critical Financial Problems:

1. Public Market was saturated with Amtrak paper

Amtrak had already issued a very high amount of debt in the market. Public market was
saturated with Amtrak paper. Considering the fact that Amtrak had been heavily loss
making since the past 30 years, it is not very viable for Amtrak to be heavily debt-
funded. An analysis of the balance sheet scenario of Amtrak as on 30th September, 1998
reveals that its equity, even after considering the heavy losses and negative reserves, is
almost 3.5 times the total debt. It is a extremely risky for the lenders to have funded such
a loss making company since the chances of default are very high. This reduces the
credibility of the company and will make it difficult for Amtrak to obtain further
financing in future since the public will start questioning the going concern of the
company.
 AMTRAK: Acela Financing

2. Extremely low debt equity ratio

Debt/Equity Ratio is a debt ratio used to measure a company's financial leverage,
calculated by dividing a company’s total liabilities by its stockholders' equity. The D/E
ratio indicates how much debt a company is using to finance its assets relative to the
amount of value represented in shareholders’ equity.

The formula for calculating D/E ratios can be represented in the following way:

Debt - Equity Ratio = Total Long Term Debt / Shareholders' Equity

Given that the debt/equity ratio measures a company’s debt relative to the total value of
its stock, it is most often used to gauge the extent to which a company is taking on debts
as a means of leveraging (attempting to increase its value by using borrowed money to
fund various projects).
A high debt/equity ratio generally means that a company has been aggressive in
financing its growth with debt. Aggressive leveraging practices are often associated with
high levels of risk. This may result in volatile earnings as a result of the additional
interest expense.
A low debt/equity ratio indicates that the company is heavily utilizing equity for
financing its business, which proves to be costlier for the company, though less risky.

An analysis of the financials of the company reveals that the debt-equity ratio of Amtrak
is lower than 0.5. However, the public market is still flooded with Amtrak paper. This
indicates a contradictory situation and Amtrak must work towards increasing its debt
equity ratio to improve stability.

3. Heavy reliance on Federal grants

Amtrak is an entity created by the US Congress in order to improvise the national

transportation system. The government mandated Amtrak to take over the rail-passenger
operations of private rail roads. Since then, Amtrak had become the primary provider of
passenger rail-service in the United States. Historically, Amtrak had received annual
subsidies from Federal Government. It is heavily reliant on Federal grants for its
operations. An analysis of the profit and loss statement of Amtrak reveals that it has been
incurring heavy operating losses in the range of 800-1000 million. Federal grants to the
extent of 400-500 million per annum have enabled Amtrak to survive in the industry.
Since 1997, Congress passed the Amtrak Reform and Accountability Act (ARAA) which
stipulated that Amtrak eliminate its reliance on federal subsidies from 2002. This
represented a formidable challenge as Amtrak had never been profitable in its 30-year
history. It will be very difficult for Amtrak to recover from its losses and operate without
the aid of Federal grants.

4. Inability to break-even even with the new project

The heavy losses for last 30 years make it very difficult for Amtrak to break-even even
with revenues of 180 million since its current losses range from 800-1000 million before
 AMTRAK: Acela Financing

considering benefits of Federal grants. It needs an extremely aggressive strategy to

turnaround completely and even break even for that matter.

5.

Analysis and Interpretations:

A few points to be noted before analysing the three options:

1. Amtrak has been a loss making entity since over 30 years. It is a company created by the
U.S. Congress and is heavily reliant on Federal grants for its operations. The current
bottom line losses of Amtrak (after considering the cash inflow from government grants)
fall in the range of 300-500 million, whereas the operating losses before considering
grants are as high as 800-1000 million. Acela, the high-speed rail service, is expected to
earn net revenues of $ 180 million p.a. After reducing operational costs (which are no
more going to be subsidized by Federal grants), the profits from Acela would certainly
fall below $100 million. Such profits are too low to turnaround Amtrak’s position and
convert it into a profitable company. Hence, even though DCF calculation has been done
in order to make a decision with respect to the choice of financing method, it won’t be
very fruitful in analysing the impact on the entity as a whole since the company won’t
even reach the break-even point.

2. Despite of the point stated above, in order to take the decision with respect to the
financing option, it has been assumed that this project would be a profitable one and that
Amtrak would be eligible and liable to pay taxes in the future. Accordingly, all
calculations have been done considering the tax impact @ 38%.

3. The leveraged lease option is structured in a manner that it consists of 80% debt and 20%
equity. There’s ambiguity with respect to the treatment of tax in case of the 20% equity
portion. Hence, it is assumed that the lease payments in case of leveraged lease option
are tax deductible and Amtrak would be eligible to take benefit of the same.
 AMTRAK: Acela Financing

4.

5. It has been assumed that there will be a potential market at the end of the loan period /
lease term and that the asset can be easily sold in the market at that point of time.

Evaluation of different options:

In order to take a decision as to which option is more beneficial / viable, Net Present Value
(NPV) has been calculated for each option by discounting their future cash flows using
Weighted Average Cost of Capital (WACC). Accordingly, the option with the highest NPV
shall be considered to be the best one in terms of financial cash flows, subject to other
factors.

Option 1: Borrow and Buy

The first option to be evaluated is loan from some bank or financial institution and use of
loan funds for financing the purchase of locomotives and train sets. Amtrak had received an
offer from a major bank to underwrite a bond issuance for Acela. The terms of the loan are as
follows:
Loan term 20 years
Interest rate 6.75% p.a.
Instalment amount 12.303 million
Periodicity of payment Semi Annual
Payments beginning from December, 1999
Collateral Locomotives and Train sets

A few points to be noted:

● 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%

● Since the instalments are to be paid semi-annually, a total of 40 periods are to be

considered and they are discounted at 6 monthly discounting rate of 5.9%

● Assuming that the company will be liable to pay tax, tax benefit on interest and
depreciation have been given impact to. Alternatively, we can ignore the tax component
and calculate the pre-tax cash flows and discount them using the pre-tax discounting rate.

Advantages and Disadvantages of Borrow and Buy option:

 AMTRAK: Acela Financing

● The advantages to this is it 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.

● An issue with borrowing is that Amtrak had recently issued debt in the market and the
public market was saturated with Amtrak paper. This would prove to be a disadvantage for
Amtrak.

● Another disadvantage is that the liability is recorded in full on the balance sheet, which
will affect the debt equity ratio, interest coverage ratio and weighted average cost of
capital of the company.

Option 2: Leveraged Lease Structure

The next option is to take the asset on finance lease from BNY Capital Funding LLC, a
wholly owned subsidiary of the Bank of New York. The lease will consist of two parts – 80%
debt and 20% equity. BNYCF would act as lessor and would provide equity funds to finance
the purchase. The debt portion would be fulfilled by EDC of Canada. The entire lease
transaction would be routed through Wilmington Trust who would act as the owner-trustee.
Lease payments were to be made semi-annually as per the schedule given.
The lease option further had two options:
Option 1: Amtrak had an option to buy the asset at the end of the lease term at higher of
terminal value or fair market value.
● In this case, if the terminal value is higher than fair market value, Amtrak will choose to
buy the asset from the market rather than buying it from BNYCF. Hence, in this case,
option of buying the asset won’t be utilized at all.

● Next scenario would be when fair market value would be higher than terminal value. In
this case, Amtrak would be indifferent whether to buy it from BNYCF or from the
market.

● Hence, while calculating the net present value, we have considered the fair market value
of the asset as on the date of end of the lease term. Due to lack of data, we have
considered the fair market value to be the terminal value + 25% (since the standard
deviation of market value fluctuations of train sets and locomotives has been given to be
25%).

Option 2: Early buy-out option – Amtrak could acquire the equipment from BNYCF for
$126.6 million in 2017.
 AMTRAK: Acela Financing

● This option would be beneficial if the market value at the end of 2017 is higher than
the early buyout value. However, due to lack of data, we cannot take a decision on
this basis.
The decision as to which option is better in case of leasing has been taken on the basis of
present value of future cash outflows in case of both the options.

Advantages and Disadvantages of Financial 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.

● 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.

Option 3: Rely on Federal Sources

● Congress had restricted Amtrak from using federal subsidies only for operational
expenses. Capital appropriations could still be Federal funded. Purchase of locomotives
and train sets could very well be considered as capital-asset acquisitions and accordingly
Amtrak was still eligible for availing benefit of the same.

● However, Friner and her staff were reluctant to use federal monies to fund this acquisition
since they considered federal grants to be a premium and precious commodity and
preferred to use it to fund capital projects that couldn’t be easily and cost effectively
financed.

● 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

Analysis of the 3 options:

The present value calculations of the three options have been attached as annexures to this
report
● We see that the present value of future cash outflows in case of borrow and buy is higher
than that in case of leveraged lease structure. This implies that this option proves to be
costlier in terms of cash outflows as compared to leveraged lease structure.

● Other advantages of leveraged lease structure as stated above include no risks of

obsolesce of asset, ability to purchase the asset at any point of time during the lease
period, lower responsibility of maintenance and wear and tear of assets, tax deductibility
of lease payments etc.

● Based on the above analysis, the option of leasing the asset seems to be the best and the
most convenient and viable option for Amtrak. Amtrak should accept the offer from
BNYCF and go ahead with the option of leveraged leasing.
 AMTRAK: Acela Financing

Specific recommendations and implementation:

1. Go ahead with lease financing

It is important for Amtrak to commence its operations immediately. Timely
commencement of the Acela service was crucial to Amtrak’s prospects for self-
sufficiency. Considering the above analysis, lease financing is a cheaper and more
viable option with other benefits too over the other options. Also, leasing the asset
would be quicker than all the other options. Hence, without any further delay, Friner
should take a decision and lease the asset to start operations as soon as possible.

2. Shut down / turnaround loss making operations:

It is seen that the current passenger rail service is heavily loss making since the past
30 years. 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
in United States and introduce Acela as its dominant service.

3. Improve on the debt-equity ratio:

As explained earlier, one critical financial problem is that the debt equity ratio of
Amtrak is extremely low. It signifies that Amtrak has very low debt funds as
compared to Equity. This figure is extremely low even after considering the heavily
negative reserves of the company. Amtrak must consider improvising on the debt
equity ratio by reducing its equity in the market. Since the public market is already
saturated with Amtrak paper, introducing more debt would not be a wise option.

4. Effective reduction of employee benefit expenses

It is observed that a major portion of expenses of Amtrak comprise of employee
benefit expenses. These comprise of more than 90% of the total revenues of Amtrak.
Considering the heavy losses made my Amtrak, it must consider cutting down or
reducing these expenses to stabilize its profit/loss position