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- Chapter 8
Nonfinancial
Investments
1
- Chapter Goals
Make better choices by recognizing that household
assets and investment planning is broader than
believed.
Differentiate a typical household cost from a capital
expenditure.
Become more effective in decision making by
employing TPM, the household’s all-asset approach.
Benefit from linking household outlays on durable
goods with business capital expenditures.
2
- Chapter Goals, cont.
Apply the methods of calculating returns on capital
expenditures.
Establish the advantages of owning a home.
Determine whether to buy or lease a home or car.
Utilize the knowledge that your salary is often your
largest household asset.
3
- Defining and Detailing Nonfinancial
Assets
Financial assets: Assets in which ownership is
represented and traded solely through pieces of
paper.
Fully marketable assets: Assets that can be sold
currently in a public forum for fair value at low
transaction costs.
Nonfinancial assets: All the other assets that the
household possesses.
Nonfinancial assets include real assets, human-
related assets, and other assets.
4
- Defining and Detailing Nonfinancial
Assets, cont.
Real assets: Nonfinancial assets that you can see or
touch that have market value.
Sometimes real assets are called tangible assets,
physical assets, or hard assets.
Real assets can be separated into real estate and
durable goods.
Aside from their physical features, real assets differ
from financial ones in that real assets generally
decline in value over time, with the exception being
the home, which, if maintained properly, can
appreciate, at least for a relatively long time.
Real assets are generally used in the household
currently while financial assets may be reserved for
5 future use.
- Defining and Detailing Nonfinancial
Assets, cont.
Human-related assets: Assets that derive their value
from particular people.
In personal finance we are principally concerned with
assets in this category that generate income.
People generate income directly through their work
efforts, through corporate and government pensions,
or through anticipated gifts and bequests.
Human related assets are sometimes called
intangible assets.
Other assets is a catch-all category that includes any
other assets of worth.
6
- Defining and Detailing Nonfinancial
Assets, cont.
Characteristics of household assets:
7
- Defining and Detailing Nonfinancial
Assets, cont.
Common household assets:
8
- Household Finance and Total
Portfolio Management
Household finance looks at the household as one
enterprise that resembles a business.
Each of its operations can require investments that
can be evaluated from three perspectives.
1. Individual Asset Basis: When looked at by itself, is
this asset attractive?
2. Within Activity Basis: How does this proposed
expenditure compare with current or future
alternatives within the same activity?
3. Fully Integrated Basis: Decisions are not made on a
per asset or per activity basis but on an overall
household basis.
9
- Household Finance and Total
Portfolio Management, cont.
Under the fully integrated basis, we perceive that
each activity has assets that benefit the household.
These assets can be grouped into financial and
nonfinancial categories that form a portfolio of
assets, the household portfolio.
The process of developing and maintaining an
efficient combination of assets is designated Total
Portfolio Management (TPM).
TPM allows us to identify which assets to place in
the household portfolio and how to weigh them.
TPM incorporates both risk and return, and
sometimes correlations.
10
- Making Capital Expenditures
Decisions
Capital expenditures: Outlays that provide benefits
over an extended period of time.
Capital expenditure is the term used for outlays for
real or human-related assets only.
The benefits of capital expenditure may be greater
revenues, lower cash cost, less time to produce a
desired result, or an immediate increase in
satisfaction.
When faced with a variety of capital expenditure
alternatives, we decide which to fund using the
business capital budgeting techniques, such as Net
Present Value (NPV) and Internal Rate of Return
(IRR).
11
- The Capital Expenditure Process
Review Goals: It is important to place our
nonfinancial investments in the context of our overall
goals.
Establish Required Rate of Return: Our capital
outlays must reach a required rate of return for all
projects, based on market figures for savings and
investing in financial assets.
Identify Potential Projects.
Evaluate Projects: We evaluate the projects using
the costs and returns for each project. We calculate
returns using IRR or NPV.
12
- The Capital Expenditure Process,
cont.
Rank All Projects: We rank within activity, within
category, and Total Portfolio. Risk and correlations
should be taken into account.
Establish Overall Capital Availability: Taking into
account all factors, the amount of capital to be made
available is established.
Select and Invest in Final Projects: Some projects
are eliminated; others are brought up at a future time
as attractiveness and financial resources change.
13
- Net Present Value (NPV)
Net Present Value (NPV): The present value of all
projected future cash inflows and outflows.
We calculate NPV by discounting all cash flows back
to the present at an appropriate discount rate.
This discount rate, designated the required rate of
return, is generally equal to the return that can be
earned on marketable securities with similar risk
characteristics.
If NPV is positive the capital expenditure is
preferable to a marketable investment. If NPV is
negative, we have not earned the required return
and the proposed expenditure is rejected.
14
- Net Present Value (NPV), cont.
n
CFt
NPV CF0
t 1 (1 k ) t
Sum of Future Cash Inflows
Cash Outflow in Current Period
Discount Rate
Present Value of Future Cash Inflows Cash Outflow in Current Period
CF = Cash flow generated
CF0 = Amount invested at time zero
k = Discount rate
t = Time period involved
nn = Number of years
= Sum of present values of cash flows
15 t 1
- Net Present Value (NPV), cont.
Calculator Solution:
16
- Net Present Value (NPV), cont.
To rank investments in terms of attractiveness we
can use the profitability index (PI).
NPV
Original Cost
Any savings in the opportunity cost of time should be
included in calculating the additional cost or benefits
for household expenditures as this time used
potentially could be employed in developing
additional cash flows.
We assign a cash flow figure to the cost of time
based on the hourly wage rate that could be received
17 if the time was spent working.
- Internal Rate of Return (IRR)
The Internal Rate of Return (IRR): The rate of return
that makes the present value of cash inflows equal to
that of cash outflows.
The IRR is the discount rate that makes NPV equal
to 0.
We compare the IRR with our required rate of return,
the return we could get on marketable securities with
the same risk.
If the IRR is greater than the required rate of return,
we accept it. If it isn’t, we reject the proposed capital
outlay.
18
- Internal Rate of Return (IRR), cont.
Calculator Solution:
19
- Comparison of IRR and NPV
Methods
NPV is the purer, more accurate method.
However, since IRR is expressed in percentage
return terms, it can be easier to understand and
relate to.
Moreover, an IRR can compare returns for
expenditures of different amounts and time frames.
A major difference in approach is that NPV assumes
that cash flows from projects are invested at the
required rate of return while IRR assumes they are
reinvested at the rate of return of that particular
project.
IRR also gives multiple answers under some
20 circumstances.
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