Principle of aggregating or seggregating money

Principle of aggregating or seggregating money

The core of all finance & investment activity

In all of investment and financing activity, there runs a central theme. This theme is so strong that it recurs in all investment classes, investment vehicles and is central to any asset class investment as well as financing. This is “Principle of money “aggregation-seggregation”

The principle of money aggregation-segregation can be explained easily as follows:

“The act of money changing hands for financing or investment purpose happens mainly to suit the varied needs related to timing of money-flows, of each party to the money transaction. This in turn has the impact of either breaking up (segregating) money flows in different parts for one party to the transaction. For the other party to the transaction it results in combining (aggregating) money flows into a single part.”

An investment or financing transaction in itself necessitates a change in pattern of cash flows and will take place only if this primary objective is in line with the needs of the transacting parties. The profitability merely makes the transaction attractive and is a catalyst.  The necessity or the main reason for the transaction is the need to change the pattern of timing of returns. To elaborate, let us look at the following:

1.      Investing: This is taken as an investment in an asset which will generate returns in future. An investment decision is an offshoot of this principle. The act of buying any asset is converting a single lump sum amount to result in either of these possibilities:          

a.       A lump sum cash flow in the future by way of disposal (sale) of the asset

b.      A periodic cash flow (or flows) in between the purchase day to final disposal

OR a combination of the above

To compensate for this lag in time, an investor needs more nominal amount of money later than what is invested now. The basic need to do this is already present: to convert the lump sum available into an asset generating flows later. Thereafter, it is the profitability of the investment, which helps the buyer to decide the best way to fulfill the need.

Similarly, the seller of an asset needs a lump sum amount at the time of selling the asset. The idea is to convert future streams of cash flows / returns to an amount now. The seller’s decision to sell the asset is based on this need. The seller’s outlook of lower time adjusted returns from the asset in future (whether periodic or in lump sum) helps catalyze the decision to sell.

The necessity or main reason for the transaction to happen from view point of both seller and buyer is the need to change the pattern of cash flows from this particular asset being transacted.

In the above transaction, one may say that the seller undertakes to sell the asset not for his need for the lump sum amount, but to invest elsewhere to gain higher returns i.e. the ultimate objective is higher returns. However, as far as the particular transaction in question in concerned, the need is to convert the timing of flow of money from this particular asset to a way suited to the seller. The new investment will further place this seller in the position similar to that of an investor, as outlined above, with a need for converting lump sum amount to periodic cash flows (the new investment being catalyzed by higher returns and the last transaction catalyzed by lower returns).

Here we assume a rational investor as well as a rational seller acting on a logical set of decision making framework & not acting on whims and fancies or emergency/peculiar situations.

2.      Financing: One can put finances (in asset /business), by way of debt or equity.  Even this transaction impacts the timing of returns.

In case of a debt or loan being given, we first see the lender’s perspective. The lender changes his lump sum amount to:

a.       A lump sum cash flow in the future by way of return of principle and interest

b.      A periodic cash flow (or flows) in between the lending day to final closure of loan by way of return of principle and interest

(Or the above in various permutations & combinations)

From the point of view of borrower, it is easy to see that he is taking a lump sum now and parting with flows in future i.e. an inverse of the lender’s position outlined above.

Similarly, in case of equity investments the equity stakeholder parts with a lump sum and the recipient of equity money takes the lump sum cash flow (parting with the stake in asset or business). In terms of understanding of the principle, the other mechanics remain quite the same in terms of cash flows arising out of loan.

In both cases of loan and equity finance, the catalyst (profit/ gain) is similar though outlined a bit differently. The profitability generation, seen alongside risk aspects, has different characteristics. In case of loan, the profitability for lender (or cost by borrower) is defined by the interest. In case of equity it is simply gain (or loss) by way of share in residual profits after all costs, including interest costs.

As seen above, the act of money changing hands for financing or investment purposes happens mainly to suit the varied needs for timing of  returns (in terms of cash flow) of any party to the money transaction. The risks and returns are at best either deterrents or catalysts.