Help explain diminishing returns on a portions of a cash flow

[jwn]

Hi,
I was hoping someone could explain to me why if you have a cash flow stream paying a fixed return (say 12%) and you sell off 50% of that cash flow stream in a senior position at a fixed 9% return and the remaining junior position gets the left over cash flow (so returns would be something above 12%), why would that subordinate cash flow position's return decline with a longer hold period? I would have thought with a fixed return coming in and a fixed return being sold off to the senior position, the junior position would also receive a fixed return. However, if you vary the length of the hold, the junior position IRR declines over time while the senior (and overall) position remain constant.

Could someone please help explain that to me? It would be much appreciated.

Thank you!

 

[stapel]

I was hoping someone could explain to me why if you have a cash flow stream paying a fixed return (say 12%) and you sell off 50% of that cash flow stream in a senior position at a fixed 9% return and the remaining junior position gets the left over cash flow (so returns would be something above 12%), why would that subordinate cash flow position's return decline with a longer hold period? I would have thought with a fixed return coming in and a fixed return being sold off to the senior position, the junior position would also receive a fixed return. However, if you vary the length of the hold, the junior position IRR declines over time while the senior (and overall) position remain constant.

We can't really teach courses here, so I'm not sure how much "explaining" can be done. Are you asking this question in reference to an exercise on which you're working? If so, could you maybe post the exercise, and specify the parts that aren't making sense to you? Then maybe folks can try to find links to online lessons that could help clear up any confusion.

Thank you!

 

[jwn]

thanks for the response. Unfortunately I dont have an exercise I am working on. Just a concept I dont understand. It clearly has to do with the compounding, but im at a loss for why that is. I dont really know how else to explain my question without numbers to prove my point. would that be helpful?

 

[mmm4444bot]

… I dont really know how else to explain my question without numbers to prove my point. would that be helpful?

A concrete example wouldn't hurt. We do have some financial wizards who frequent this board; actual figures might be helpful for them. :cool:

 

[jwn]

Hopefully this makes sense:

	Yr0	Yr1	Yr2	Yr3	Yr4
Cash Flow Stream fixed return	-30.60	0	38.38	0	0
IRR	12.00%
Senior CF Stream fixed return	-18.00	0	21.19	0	0
IRR	8.50%
Junior CF Stream variable return	-12.60	0	17.19	0	0
IRR	16.82%

vs this

	Yr0	Yr1	Yr2	Yr3	Yr4
Cash Flow Stream fixed return	-30.60	0	0	0	48.15
IRR	12.00%
Senior CF Stream fixed return	-18.00	0	0	0	24.95
IRR	8.50%
Junior CF Stream variable return	-12.60	0	0	0	23.20
IRR	16.49%

Why does the return change in the bolded scenarios?

 

[tkhunny]

My first impression is, "Because it does." It's not clear to me what motivates your concern.

All of your arithmetic appears to be correct. Perhaps it is only your familiarity with the idea that needs some time to soak in?

Duration matters. and there is nothing linear about this arrangement.

 

[JeffM]

Denis,

Your answer is of course clear, concise, and correct, but I think tkhunny was on to something. The OP seems to be disconcerted that change is not proportional to time. The only way to correct that false intuition is to experiment with change in non-linear functions of time and to recognize that functions involving compounding are not linear with respect to time.