Financial Management of the Channel Tunnel - Essay Example

Financial management of channel tunnel Eurotunnel was the firm that was created to build and ultimately profit from the tunnel under the English Channel, linking England and France. While the tunnel was readied for operation in the early 1990's, it was never a commercial success and reported significant losses each year after opening. Much of the financing for the tunnel had come from debt and at the end of 1997; eurotunnel had debt obligations in excess of 5,000 millions, raised from a variety of bond issues and bank debt. Adding the expected interest payments and coupon payments on the debt brings the total obligation of the firm up to 8,865 million. Debt type Face value( including cumulative coupons) Duration Short term 935 0.50 10 years 2,435 6.7 20 years 3,555 12.6 Longer 1,940 18.2 Total 8,865 million 10.93 years Figure 1: Debt Breakdown for Eurotunnel1 Eurotunnel was mainly financed by bank loans from a large consortium of over 100 European and Japanese banks. Eurotunnel also raised substantial amounts of equity in four public offerings during the construction of the Tunnel, mainly from small shareholders in France and the UK. The marketing of the shares was pitched towards small shareholders. In the end, the Channel Tunnel costs about 10 billion to build (compared with initial estimates 8 years earlier of about 5 billion). Of this 10 billion, 8 billion was raised in debt from banks and 2 billion in equity. The last fund-raising exercise took place in May 1994, just 2 months before the new services were to begin, when 800 million of new equity and 700 million of debt was raised to get the project finished and up and running. By then the banks and many shareholders were very nervous about the costs and delays to the project and the prospects of recouping their investment. Eurotunnel shareholders have seen their investment crumble by around 90% since the company went public in 1987. Construction costs spiralled and revenues fell short of forecasts, leaving the company struggling with debts of 9bn (6.4bn). Shareholders have never been paid a dividend. The UK government has already made it clear that there can be no question of any public money for Eurotunnel, and there is no change in that position. Eurotunnel shareholders are mostly French private investors. But it said it could not afford to do so without help in cutting the burden of repayments on debts which it ran up during vast cost over-runs on the tunnel's construction in the late 1980s and early 1990s. Euro tunnel begs for rescue plan (Clark, 2004)2. 2. Andrew, Clark, (2004) Guardian, retrieved from the website on 19th Feb' 06. (http://www.guardian.co.uk/) Financial Management of Channel Tunnel Rail Link (CTRL) The Channel Tunnel Rail Link (CTRL) is the largest civil engineering infrastructure project currently being constructed in the UK with a budget of 5.3 billion (S$14.8 billion). The Project is split into two sections. Section 1, 70 km long from the Channel Tunnel to Fawkham Junction in North Kent is scheduled for completion and operational running of Eurostar trains by September 2003. Section 2, 39 km long, completes the Link from North Kent to St Pancras in central London and is programmed to be operational in January 2007 (Davies and Joy, 2004)2. The London & Continental Railways Limited (LCR) was awarded the contract to build the CTRL in February 1996 and to run the British arm of the Eurostar International train service (Eurostar UK). Initially, LCR proposed to fund the construction of the link from private finance through debt and equity raised on the back of future revenue from Eurostar, UK and from direct government grants. This overtly optimistic plan backfired and LCR abandoned its plans to raise private finance and approached the Department for additional grants in return for a share of future profits. After reviewing the options, the department of transport decided to restructure the existing deal with LCR. In 1998, the government set out the principles of a negotiated restructuring which enhanced public sector support for the project. The government although refuse to increase direct grants, agreed to guarantee most of the private sector funding. It was also agreed that if the LCR ran out of cash, government would lend public money directly to LCR, up to a specified 2. Davies, H, Joy, D (2004) Channel Tunnel Rail Link, Planning, Design and Associated Urban Development, Tunneling and Underground Space Technology, vol.19, p.351. limit. Construction was split into two sections and railtrack group joined the project to eventually purchase section 1 and opted to purchase section 2 as well but following the entry of its subsidiary, railtrack plc into railway administration, railtrack withdrew from the project in 2002. The European Commission after a detailed scrutiny of the UK government loan guarantee to LCR, came to the conclusion that the State Guarantees that were provided by the UK Government were necessary for the promotion of the CTRL project, which is a concrete, specific and well defined project of common European interest that is deemed important, quantitatively as well as qualitatively. For this particular form of financial transactions (interest rate hedgings), it was not possible to calculate in advance the final amount that will be effectively covered by the guarantees. Therefore, the method used by the UK Government to value the guarantees, i.e. based on a hypothetical purchase price, were justified and represented the most accurate estimation of the value of the guarantees. The guarantees covered 100 % of the underlying transaction but took into consideration the fact that LCR counterparts, acting commercially, were not prepared to take any credit risk on LCR. If the guarantees were to cover less than 100 %, LCR would still have to provide collateral for the difference, using funds already raised with the result that less financial resources would ultimately be available to fund LCR's cash flow requirements for construction purposes. Under such circumstances, it could accept that the State guarantees in question covered the underlying financial transactions in full. The need for LCR's New Hedging Arrangements and any Further Hedging Arrangements have been brought about as a consequence of the fact that Railtrack Group (through RTUK) has decided to withdraw from the CTRL project and that the proposed amendment to the CTRL financing package (the Guarantees) has become necessary following circumstances beyond both LCR's and the UK Government's control. Notably, the guarantee serve to enable LCR to put into place hedging arrangements, which will protect it from adverse movements in interest rates that could jeopardise LCR's mid to long term financing requirements for the construction of the CTRL and covers in full LCR's potential exposure under these hedging arrangements. The measures are necessary for the promotion of the CTRL project, which is a concrete, specific and well defined project of common European interest (European Commission, 2003)3. The post 2001 financing for the project was obtained on good terms according to Royal Bank of Canada Group (RBC) and construction of section 1 was completed to time and budget. Construction of section 2 is also progressing well. Current revenue forecasts prepared for the Department suggest that the 1997 present value of the Government's loan to LCR to cover cash flow shortfalls could range between 0 and 400 million(1997 prices), net of repayments and the Government's share of revenue from forecast project related property developments. LCR expects that it will have repaid the loan by 2086, the year its concession is due to end and the economic justification for the project remains marginal. Justification of financial help to LCR (CTRL) There is intense debate in the UK on the benefits and merits of private funding, particularly for public transport projects. Worsey (2000)4 in a paper presented to the Australian Transport Research Forum stated: "Even though great strides have been made over the last 10 years to transfer risk 3. European Commission (2003) State aid N 687/2002 - United Kingdom Channel Tunnel Rail Link - Hedging guarantees, Brussels, Science Direct access through online library from the public to the private sector, the public sector will always remain the bearer of the ultimate risk of project failures, especially with flagship projects." In support of this view Worsey provides the example of Channel Tunnel Rail Link and stated that under the rescue plan for the CTRL, the UK Government was committed to put between $350 million and $900 million of public money into the project and take on the ultimate risk of the project failing by providing government guarantees to cover $9.5 billion of project debt. Worsey's view though not completely unfounded, the loan guarantee by the UK government to CTRL has its own justification. 1. To the extent that the economic case for infrastructure projects depends on regeneration benefits, the achievement of such benefits at the planned level is a key indicator of the success of the project. For the Channel Tunnel Rail Link, there are encouraging signs of the intended regeneration in the Thames Gateway and around the three international stations at St Pancras, Stratford and Ebbsfleet. LCR and its development partners have submitted a Master Planning Application for the development at King's Cross. The consultation phase for the development has been completed and negotiations with the London Boroughs of Camden and Islington are underway, who granted planning consent for the 150 million redevelopment of St Pancras Chambers, the former Midland Grand Hotel at the St Pancras terminus. Outline consent has been obtained for the development at Ebbsfleet (National Audit Office, Department of 4. Worsey, S. (2000). Funding Public Transport Infrastructure in the UK: Private Finance and Risk Transfer, retrieved from the website. (www.aar.com.au/pubs/baf/fofsepoo.htm) on 20th Feb'06 Transport, 2005)5. 2. The National Audit Office of UK has not recalculated the cost/ benefit ratio to determine the effect of lower revenues. While revenues have dropped below the 2001 low case forecasts, the impact is not as negative as the Department's 2001 analysis projected. The lower benefits from lower patronage are offset by the reduction in the additional public sector support through the access charge loan largely due to the reduction in LCR's cost of capital. In the Department's judgement, domestic transport benefits, which should emerge in 2009, the year when domestic train services are planned to start using the link will exceed the associated costs and improve the economies of the project (National Audit Office, Department of Transport, 2005) Justification of financial help to Eurotunnel (operator of Channel Tunnel) The struggling cross-Channel tunnel operator Eurotunnel, already crippled by more than 6bn of debts, made a net loss of 570m last year. This follows the mammoth 1.33bn loss of 2003. This is indicative of the company's too slow a response to changes in the cross channel market where it has faced tough competition from ferry company's and low cost airlines The restructuring experts felt that the best possible solution is a debt for-equity swap that can help reducing the burden below the 4 billion or raise the credibility of the -------------------------- 5. NAO, Department of Transport (2005) Progress on the Channel Tunnel Rail Link, Report by the Comptroller and Auditor General, Retrieved from website: (www.nao.org.) p.4. company from the banker's perspective. But the present French chairman of the eurotunnel wants the banks to write off the debts without compensation. Negotiation with the bank is at a dead end due to disagreement over the scale of fees Eurotunnel would have to pay on behalf of its 122 banking creditors. Under the terms of its borrowing agreement, it is obliged to pick up the fees of advisers called in by lenders to guide them in debt restructuring talks. But the tunnel operator, whose revenues are insufficient to pay its interest bill, is keen to cap additional outgoings. The need for wholesale debt restructuring has long been apparent, because traffic through the tunnel, which opened a decade ago, has fallen far below forecasts while fares have been hit by tough competition from ferry operators. As a result, the tunnel generates only enough operating profit to pay around half the interest on the company's debt. The company had already notified creditors most of whom are French private investors of the proposals for restructuring the debt. Company insiders believe that Eurotunnel can only sustain about 2.2bn of debt - restructuring will involve creditors writing off the balance. A consensus in this regard is yet to be reached (Frost, 2004)6. The Joint Board of Eurotunnel [LSE: ETL], at its meeting on 28 September 2005, decided not to use the option, which is available under the 1998 restructuring agreement, to convert the Stabilisation Advances and Notes into shares before 31 December 2005. 6. Frost, L, (2004) Eurotunnel CEO ousted, board expected to follow, Business News, Associated press. Based on the 526million Stabilisation Advances and Notes that were outstanding on 30 June 2005 and the current Credit Agreements, an additional financial charge of approximately 24million a year would be incurred by the Group from 1 January 2006 on the basis of current interest rates in the event that the Stabilisation Advances and Notes are not converted into Units Although the project fails to transfer risk and deliver value for money in the way that the public agency anticipated, the possibility of enforcing the arrangements and/or dissolving the partnership is in practice severely circumscribed for both legal and operational reasons. The impending closure of the eurotunnel saw hasty move by the UK government to withdraw leaving the shareholders at a lurch. The French government is equally reluctant to help eurotunnel from going bankrupt. What is required at the moment is perhaps an impartial and compassionate attitude on the part of the government as well as the stakeholders to initiate a dialogue and together they need to isolate areas of common interest such as development of economy through better infrastructures. By recognising and addressing the underlying issues of the eurotunnel bankruptcy, and by extending a helping hand, the government will gain confidence of the people; the stakeholders too should accordingly change their attitude of defiance to break the impasse. Comparison of financing approach of Channel Tunnel and Channel Tunnel Rail Link Nothing better summarizes the difference between the approaches of the two governments towards big projects than the channel tunnel. The difference between the French and British approach was that while the French combined vision with massive funding and authoritative central government planning powers and liberal use for fund for building first class infrastructure, the British approach, as illustrated in the beleaguered history of the Channel Tunnel Rail Link, is an unhappy association of private caution and government frugality. The channel tunnel is completely funded by the private investors, mostly French. Though right from the beginning the eurotunnel faced financial crunch and asked for government help, both the French and the British government had outright refused to extend help to the ailing company. The British government justified its stand by saying that British Prime Minister Mrs. Margaret Thatcher during the opening of the channel tunnel made it absolutely clear that the UK government will not extend financial help to the eurotunnel and as such there is no question of either providing or seeking financial support from the UK government. The channel tunnel, an odd mix of the two approaches, was misconceived from the start. In 1985 French government persuaded the British government that a tunnel would be an important link between the two countries. The British government from the beginning insisted that it should be entirely funded by the private sector and the banks were persuade into putting up the money. A bit of underhand public support was thrown in through getting the national rail companies to pay high prices for paths through the tunnel that were unlikely ever to be used. The French shareholders helped fund a stunning piece of infrastructure. They have made a worthwhile sacrifice, just as in the CTRL, investors, most of them ordinary people, got very little in return for their role in creating a vital part of London's transport network, by financing the LCRs outstanding liabilities through tax. The Government's guarantee of commercial borrowing was deemed not to count towards the public sector borrowing requirement, because, the chances of a call being made on the guarantee were less than 20 per cent. The guaranteed bonds have received AAA ratings by three rating agencies, and on 10 February 1999 1.225 bn of bonds maturing in 2028 and 425 million maturing in 2038 were issued. The issues were heavily oversubscribed, with the markets regarding them as "gilt proxies". This is a striking example of how commercial debt can be used to finance a commercially non-viable piece of infrastructure, given the appropriate support from the state. (Glaiser et al, 1999)7. Application of Option Pricing Theory for government loan guarantee Guarantees by a parent company of loans made to its subsidiaries or government guarantees of loans made to private corporations is a common loan arrangement. As with other forms of insurance, the issuing of a guarantee imposes a liability or cost on the guarantor. In this paper, a formula is derived to evaluate this cost. Merton (1977)8 applied a common method is to demonstrate an isomorphic correspondence between loan guarantees and common stock put options, and then to use the well developed theory of option pricing to derive the formula. 7. Glaister, Stephen et al. (1999) The Way Out, An alternative approach to the future of the underground, LSE London Discussion paper no. 1, London School of Economics. 8. Merton, Robert, C (1977) An analytical derivation of the cost of deposit insurance and loan guarantees, An application of modern option pricing theory, Journal of Banking and Finance 1, North-Holland Publishing Company , pp.3-11. The essential terms of a 'European'7 put option on a common stock are that its Owner has the right to sell a specified number of shares of a given stock at a specified price per share- the 'exercise price' - on a specified date- the 'expiration date'. A put option purchase is different from the sale of a futures contract because the put owner has a choice whether or not to 'exercise his option' to sell at the specified price. Indeed, if this option is not exercised on the expiration date, the contract expires and is worthless. Hence, if on the expiration date the stock price per share, S, is higher than the exercise price per share, E, the put owner would clearly not exercise his right to sell the stock at the exercise price when he could sell it on the open market at a higher price. In this case, the owner would allow the put to expire worthless. However, if on the expiration date the stock price was lower than the exercise price, then the put owner would exercise his right, and the value of the put option would be the difference between the exercise price and the stock price, (E- S), times the number of shares specified in the put contract. Thus, the value of a put on one share of stock at the expiration date can be written as P(0) = Max [0,E- S], (1) where P(T) is the price of a put with length of time T to go before expiration. Since the value of the put at expiration depends on the stock price, its value prior to expiration will depend on the probability distribution for the range of stock prices on the expiration date (Merton, 1977). 9. The term 'European' is applied to options that can only be exercised on the expiration date. An 'American' type option can be exercised on or before the expiration date. References Andrew, Clark, (2004) Guardian, retrieved from the website on 19th Feb' 06. (http://www.guardian.co.uk/) Damodaran, A (2006) Dealing in distress in valuation, Stern School of Business retrieved from the website (www.pages.stern.nyu.edu) on 20th Feb' 2006. Davies, H, Joy, D (2004) Channel Tunnel Rail Link, Planning, Design and Associated Urban Development, Tunneling and Underground Space Technology, vol.19, p.351. Edwards, Pamela., Shaoul, Jean. (2003) Partnerships: for better, for worse, Accounting, Auditing & Accountability, vol.16, no.3, pp. 397-421 European Commission (2003) State aid N 687/2002 - United Kingdom, Channel Tunnel Rail Link - Hedging guarantees, , Brussels, C(2003)1283fin, accessed from Science Direct Journal via online library Glaister, Stephen et al. (1999) The Way Out, An alternative approach to the future of the underground, LSE London Discussion paper no. 1, London School of Economics, retrieved from the website on 19th Feb' 06. (www.lse.ac.uk/collections/LSELondon/images/LSEL_DP1.pdf) Merton, Robert, C (1977) An analytical derivation of the cost of deposit insurance and loan guarantees, An application of modern option pricing theory, Journal of Banking and Finance 1, North-Holland Publishing Company , pp.3-11. NAO, Department of Transport (2005) Progress on the Channel Tunnel Rail Link, Report by the Comptroller and Auditor General, Retrieved from website: (www.nao.org.) p.4. Worsey, S. (2000). Funding Public Transport Infrastructure in the UK: Private Finance and Risk Transfer, retrieved from the website: (www.aar.com.au/pubs/baf/fofsepoo.htm) on 21st Feb'06. Read More