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Discounted Cash Flow Analysis

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June 27, 2015 Part 4

Discussion ....Extended Yield Methods

Extended Yield methods: Part 4
Where's the Sunshine?      06/27/2015

To sum up, extended yield methods were designed to deal with complex cash flows (cash flows wherein the rolling sum of the flows change signs more than once). they go from negative to positive and back to negative then to positive again such that their rolling forward sums give rise to yield curves that cross the zero rate axis more than once. The intent was and is to eliminate the wild swings in cash flows so as to limit the sign changes to only one.  Doing so eliminates the potential for other positive rates existing in the modified flow.  Any method that does not eliminate the multiple yield potential from the cash flows is not doing its' job. It leaves us with a transaction that can't be represented by rate of return, as many or more than one rate may exist. To pick one rate ignores the rest.  It also facilitates  the manipulation of rate by making it easy to move cash flows around the term as long the total flows remain the same. Many yield rates can be sought and landed on for many different adjusted flows using the "Pick Your Rate" method. This makes the model entirely arbitrary and hence unacceptable. It is not logically computed and does not provide a unique computation of rate inherent to the flow. It is just one of many rates that performs a mathematical function of resolving the present value to zero and nothing more.

We have tried to relate in this discussion how and why rate analysis must adhere to the mathematical principles espoused by Descartes' rule of signs.  The genesis of extended yield methods was created for the sole purpose of making it possible to adhere  to Descartes rule of signs.

PAMS-DCF's yield engine checks for adherence to Descartes' rule of signs in both the initially presented unmodified flow and the modified flow, giving appropriate warnings when necessary. If someone wishes to use  a non-unique rate to distribute income over the transaction term,  then they can do so. It may be a misrepresentation of the return on the transaction, and it may give rise to violations of good accounting principles that call for using a distribution that matches costs against revenues, full disclosure, a non-arbitrary basis for computation, etc., but so be it. The Investment Tax Credit  (does anyone remember the ITC ?) was taken into income all in the year of acquisition and not amortized over the life of the asset as good accounting demanded. The accounting profession objected loudly but with little success.  Congress said it was OK. 

Similar to the MISFM, now under long overdue serious scrutiny,  the ITC accounting served as an immediate economic incentive resulting in increased earnings per share in the early years. Rules are broken all day long, and principals are violated over and over again, but one should be aware of the what and wherefore of these issues so that they are not misapplied to other situations. I repeat, the MISFM had and may have a place, but not as representing a good example of yield analysis techniques.

We intend to demonstrate  that new investment is a non-starter in building cash flow models and using discounted cash flow analysis. We will be using examples of FASB13 in the next installment of this discussion on "Extended Yield Methods" because it is a well known example and easily available for study. It will clearly show that the modified cash flow generated by the MISFM results in arbitrarily adjusted cash flows distribution of income and is not the only rate that , once given the freedom to introduce "new Capital",  that will discount other adjusted flows  to zero within the confines of the transactions net income.   We will then proceed to review one or two methods that do work to eliminate the multiple yield issue and what their impact is on the timing of profit recognition within the transaction. 

The entire purpose of this exercise is to demonstrate that Descartes  Rule of Signs must be adhered to and that "Extended Methods" were created to for the sole purpose of making this possible. To create a method such as the MISFM that only partially adheres to the " rule of signs" by providing for only the first few negative flow and ignoring  the remaining negative flows is at best obscuring the technically correct approach, demonstrating incorrect concepts and principals and causing confusion about the techniques used in DCF analysis. It is an example of  obfuscation at its' best. On the positive side, the MISFM adds incentive to do these transactions. I do not see why EPS has to be tied to good DCF techniques! Let the EPS issue be whatever the parties agree to, but the mathematical truisms should always be honored.

As an aside, FASB13 is a great publication and it broke new ground in accounting in many areas including after tax income recognition. The concepts as noted in our book that accompanies PAMS-DCF, should not be discarded. That FASB13 did not land on a proper method for use in distributing  leveraged lease income is a minor flaw in the overall achievement, and can be easily fixed by simply clarifying it. Any method that results in an inherent unique yield should be acceptable to spread income with.

   Congress would not allow accounting firms to write an exception when ITC was taken in year one. I don't know of any firms that did.  I do not know if any other forces will prevent a change in the leveraged lease approach and it does not matter as long as the MISFM does not continue to confuse issues and demonstrate bad DCF techniques. Please, let the sun shine in so we can put this issue to bed! It is fundamental to learning good DCF techniques.

The other point to note is that even if the FASB eliminates all after tax accounting recognition, the economics of theses deals does not change and must be analyzed and depicted. That would leave a legacy need for the MISFM and a current analysis need for the SSFM. What you are learning here is still needed and valid.

(to be continued using examples as Part 5 " A Picture is Worth 1,000 Words")

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