National Railroad Passenger Corporaton (“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.

1. 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.

1. 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.

1. 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 considering benefits of Federal grants. It needs an extremely aggressive strategy to turnaround completely and even break even for that matter.

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.

1. 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%.

1. 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.

1. Depreciation for the purpose of tax accounts is calculated based on Seven Year MACRS Depreciation Schedule. Depreciation for the first 7 years (Split over 8 years) is based on the MACRS Schedule and is straight-lined thereafter. Since as per law, wherever the depreciation calculated using the MACRS formula is lower than depreciation under straight-line method, the straight line depreciation for the previous year is taken as the relevant depreciation deduction for the rest of the recovery period.

1. The salvage value of the assets is assumed to be constant at 15% of the cost at the end of the 25th year. The same has been factored in for the purpose of computation of depreciation and NPV.

1. 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.

1. Terminal value of the asset at the end of the lease period has been considered by calculating the present value of salvage value of asset at the end of lease period. It is basically calculated by multiplying salvage value with discounting factor at the end of Year 21 and dividing by discounting factor at the end of Year 25.

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.