Amtrak Darden Case Study Analysis

...

---------------------------------------------------------------

Analysis and Interpretation of the Problems

The most objective means to assess the merit of each of the financing options would be to calculate the net present value of each of the alternatives. We can discount the future cash flows and the option with the highest resultant net present value will be selected.

Net Present Value

Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of a projected investment or project. A positive net present value indicates that the projected earnings generated by a project or investment (in present dollars) exceeds the anticipated costs (also in present dollars).

The following is the formula for calculating NPV:

[pic 2]

Ct = net cash inflow during the period t

Co = total initial investment costs

r = discount rate

t = number of time periods

Discount Rate

The discount rate refers to the interest rate used in discounted cash flow analysis to determine the present value of future cash flows. For example, to determine the present value of $1,000 a year from now, and assuming a discount rate of 10%, the present value would be:

=1000/(1+0.1) = $909.09

Conversely, if we expect to receive $1,000 in two years, the present value would be $826.45 at a 10% discount rate.

-

Net Present Value of Leasing Option

Here, there are two options available:

Option 1: Amtrak buys the asset at the end of the lease term at higher of terminal value or fair market value

If terminal value > fair market value, Amtrak would rather buy the asset from the market than from BNYCF. Hence, the option of buying the asset won’t be utilized at all. If fair market value > terminal value, Amtrak would be indifferent about buying it from either BNYCF or from the market.

- The discount rate for calculating the NPV is taken as 3.375% compounded half yearly (3.375% x 2 = 6.75% p.a. – the opportunity cost of taking a lease)

- Terminal value is calculated as 15% of the equipment cost, which is the value of equipment after 25 years. Thus, the depreciable value is calculated as $227,715,000

- Annual depreciation calculated on straight line basis is $9,108,600

- The tax rate is taken to be 38%.

Referring Exhibit 1, the NPV calculated is $29,251,425. It means the leasing option is cash positive. Since, they are making losses, taxes would not be considered.

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

This option would only be exercised if the market value at the end of 2017 is higher than the early buyout value.

The NPV calculated for this option is $27,289,935.26. It means, it would pay Amtrak to go for this option. Since they are making losses, taxes should not be considered.

Thus it is clearly viable for Amtrak to go for the option to buy the asset at the end of the lease term at higher of terminal value or fair market value. One of the benefits for the leasing option is that there is no immediate impact on the ratios since it’s an off balance sheet adjustment and rating agencies also do not include financial leases in the liability section.

-

Net Present Value of Borrow and Buy Option

The option to be evaluated is a bond issuance for Acela to be underwritten by a major bank. We ignore taxes as the company is making losses, despite the expected revenue of $180.

The NPV of the bond is calculated by discounting the future cash flows at 6.75% p.a. Thus the NPV calculated (ignoring the taxes) is $(267,902,362) which is effectively the same as the loan amount, as expected. Clearly this option is cash negative and does not seem viable.

-

Funding from Federal Grants

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 Amtrak wants to leverage this facility for its riskier projects which find financing harder to come by, so this option also does not appear appealing.

Comparative Analysis

Clearly from the NPV calculated above, the leasing alternative with the flexibility of ownership via an option to buy the asset at the end of the lease term at higher of terminal value or fair market value, seems most attractive. This is not only because it is expected to be cheaper than the other two options but also because the company can rest assured it will not get stuck with the asset if its value starts depleting in the market or, conversely, it will be able to exploit the gains if the asset’s market price rises. Other advantages of leveraged lease structure include lower responsibility of maintenance and wear and tear of assets, tax deductibility of lease payments (if overall profits are being made) etc.

---------------------------------------------------------------

Recommendation

- Based on the case analysis, the most viable source of financing the purchase of equipment for operating Acela Regional Service is recommended as the alternative of leasing with an option to buy the asset at the end of the lease term at higher of terminal value or fair market value, as it is expected to be cheaper than the other two options

- Other benefits of leveraged lease are that liability is recorded in the financial statement but would not be recorded in the balance sheet unlike borrow and buy