Interviewer: Here we are in the fourth Interview exploring how to answer investment opportunities to conform to the SAS benchmark and prove-out Internal Equity Return.
Author: We’ve talked earlier how investment opportunities with deferred up-side operating performance are problematic for the traditional tools. In this Interview we’ll compare two exhibits contained in Schedule 4. Exhibit 1 has deferred up-side operating performance and Exhibit 2 has flat non-varying operating performance. We’ll show how Exhibit 2 can use the traditional tools, with a caveat, to answer its investment opportunity and how Exhibit 1 requires a process to produce Homogenizing Bridges to answer its investment opportunity.
Interviewer: What in the world are Homogenizing Bridges?
Author: Homogenizing Bridges are the result of a process to take an investment opportunity’s single or multiple varying assumptions and components and re-represent them as a repeating non-varying proxy over the time frame of the investment opportunity.
Interviewer: So, the proxy tricks the investment opportunity into thinking its assumptions are all non-varying over the investment opportunity time frame?
Author: Yes, that’s right.
Interviewer: Hey. I’m getting the hang of this stuff. So, why are Homogenizing Bridge proxy assumptions so important?
Author: Let’s take a look at Schedule 4, Line [3]. The difference between the traditional IRR and a capital cost is 11% for Exhibit 1 and 0% for Exhibit 2. Let’s focus on Exhibit 2 for now. There are two things unique about Exhibit 2’s 0% difference. First, Exhibit 2’s operating performance, Line [14] is a non-varying $139 for all five operating periods. Second, and this is the caveat I mentioned earlier, the 40% Secondary Flow return rate, Line [16] matches the Exhibit 2 40% Internal Equity Return, Line [17]. The non-varying $139 operating performance and the matching 40% Secondary Flow rate cause Exhibit 2 to have no differences between IRR and capital cost. The flat non-varying operating performance and matching Secondary Flow return rate cause Exhibit 2 to automatically conform to the SAS benchmark. Any deviations from these two standards, like in Exhibit 1, require Homogenizing Bridges to get back to a SAS investment answer.
Interviewer: That’s it? All this IRR and NPV replacement hoopla is about getting varying investment components to a non-varying state and a Secondary Flow return rate to match the Internal Equity Return?
Author: Well, it’s more about what to do when operating performance isn’t flat and Secondary Flow rate doesn’t match IER. Homogenizing Bridges create non-varying proxies by transforming investment opportunity assumptions and components from unabridged to an abridged proxy. Homogenizing Bridges can also reverse abridged components to form an unabridged investment answer. The two-part formula for homogenizing assumptions and components first utilizes the NPV (multiple amounts) or PV (single amount) function to condense everything to a period-zero single amount and then homogenizing uses the PMT( ) function to evenly re-represent the NPV( ) or PV( ) amount over the investment opportunity time frame.
Interviewer: I’m usually not good with formulas but I think I see what is trying to be accomplished.
Author: Homogenizing bridges re-represents Exhibit 1’s varying operating performance, it re-represents the two-part sale price and it compensates for a non IER Secondary Flow rate to maintain SAS.
Interviewer: Do you have any examples?
Author: Sure. Schedule 4, Lines [29] through [78] visualizes Exhibit 1’s four investment categories calculations each utilizing the same four Homogenizing Bridges, Lines [81], [83], [86] and [88] in similar but unique ways.
Interviewer: Ok. That’s starting to make some sense. An investment opportunity’s four investment categories use the same Homogenizing Bridges to create the four SAS investment category answers within a single assumption set.
Author: Yes. Here is a quirk about calculating Homogenizing Bridges. Homogenizing Bridges use either the Equity return, Line [22] or Capital Cost, Line [21] as a rate for the NPV( ), PMT( ) or PV( ) homogenizing functions. Equity return is used to homogenize Income Statement based assumptions and components and capital cost is used to homogenize Balance Sheet based assumptions and components. The Schedule 4, Line [78] $709 Sale Price is a good example of the two different homogenizing rates. The $709 Sale Price is comprised of two separate components. The $436 Sale Gain, Line [76] amount is Income Statement focused and therefore its (0.097) bridge, Line [88] is homogenized at 30% Equity return, Line [22]. The $273 Ending Book Value, Line [77] amount is Balance Sheet focused and therefore its (0.089) bridge, Line [86] is homogenized at 10% Capital Cost, Line [21].
Interviewer: Yeah. Ok, two homogenizing rates. What’s up with this Secondary Flow rate differing from IER stuff?
Author: A Homogenizing Bridge, Line [83] is also used to compensate for Exhibit 1's Secondary Flow rate difference between the 6.4% Secondary Flow rate, Line [25] and 30% Equity return, Line [22]. The Secondary Flow bridge formulas get a little complex, Lines [84] and [85].
Interviewer: Oh, me. I’m exhausted just looking at those two lines. Absolutely exhausted.
Author: Ok. That’s enough on Homogenizing Bridges, for now. Let’s discuss the actual scope of the new investment methodology.
Interviewer: Methodology scope? Ugh. You know how I am with this theoretical stuff.
Author: Actually, the investment methodology goes beyond the four predominant investment categories we’ve previously discussed. Although most investment opportunities are asked and answered in the four predominant investment categories, Full Picture Investment’s methodology can take any germane investment opportunity assumption and craft algorithms to solve for that answer while conforming to the SAS benchmark.
Interviewer: That’s good to know. Let’s move on.
Author: Ok. To make it easier for the business professional we’ve incorporated the four investment category algorithms in to one Microsoft Excel FPI() add-in function. In addition, a menu button can generate the corresponding Financial Statements.
Interviewer: Hold on there. Why did you just drag me through four agonizing Interviews if everything is condensed down to a function and menu button?
Author: The four Interviews discussions were important for you to understand all the relevant investment evaluation issues.
Interviewer: So, you do have everything boiled down into a single add-in spreadsheet function and menu button?
Author: Yes, the FPI( ) spreadsheet function solves for the four investment category answers and the menu button generates their affirming Financial Statements.
Interviewer: Does your FPI( ) add-in function works just like other native Excel functions?
Author: It’s more involved than the typical Excel function but, generally yes, it works like other native Excel functions.
Interviewer: Then why didn’t we just go straight to the FPI( ) function in the first place instead of making my head hurt so much with all these Interviews? Everyone knows how to work Excel functions.
Author: Without our background discussion, you would have found a reason to not embrace the new investment methodology.
Interviewer: Maybe, maybe not.
Author: Without our background discussion, would you be willing to help me convince business professionals they need to re-learn microeconomic investment decision making?
Interviewer: Good point! You are right; I wouldn’t have been convinced and they need to be convinced, like I have been.