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Case Background
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
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.
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.
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?
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.
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.
Discount rates
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.
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.
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.
Exhibits
Discount rates
Borrow 0.03375
Lease 0.059