Chapter 8
Nonfinancial
Investments
1
Chapter Goals
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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.
Chapter Goals, cont.
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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.
Defining and Detailing
Nonfinancial Assets
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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, humanrelated assets, and other assets.
Defining and Detailing
Nonfinancial Assets, cont.
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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
future use.
Defining and Detailing
Nonfinancial Assets, cont.
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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.
Defining and Detailing
Nonfinancial Assets, cont.
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Characteristics of household assets:
Defining and Detailing
Nonfinancial Assets, cont.
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8
Common household assets:
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.
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Household Finance and Total
Portfolio Management, cont.
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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.
Making Capital Expenditures
Decisions
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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).
The Capital Expenditure Process
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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.
The Capital Expenditure Process,
cont.
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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.
Net Present Value (NPV)
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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.
Net Present Value (NPV), cont.
n
CFt
NPV  
 CF0
t
t 1 (1  k )
Sum of Future Cash Inflows
 Cash Outflow in Current Period
Discount Rate
 Present Value of Future Cash Inflows - Cash Outflow in Current Period

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CF =
CF0 =
k =
t
=
n =
n
 =
t 1
Cash flow generated
Amount invested at time zero
Discount rate
Time period involved
Number of years
Sum of present values of cash flows
Net Present Value (NPV), cont.
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Calculator Solution:
Net Present Value (NPV), cont.
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To rank investments in terms of attractiveness we
can use the profitability index (PI).
NPV
Original Cost
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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 if the time was spent working.
Internal Rate of Return (IRR)
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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.
Internal Rate of Return (IRR), cont.
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Calculator Solution:
Comparison of IRR and NPV
Methods
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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
circumstances.
Durable Goods
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Consumer durable goods are capital expenditures
that can benefit many types of household operations.
Among the reasons that you would purchase a
durable good are:
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To take advantage of a technological improvement.
Physical wear and tear that results in an existing durable
good having reached the end of its useful life.
A change in circumstances.
To provide more pleasure.
To attempt to raise returns on assets.
The Automobile
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Major factors in deciding to change automobiles:
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State of Current Car: The higher the repair bills, the lower
the car’s attractiveness, and the more likely a trade-in will
be contemplated.
Existing Finances: The greater the cash on hand, the more
favorable the job and economic outlook, the more likely the
trade-in.
Current Car Promotions: At certain times in the economic
cycle the purchase of a new or used car may be particularly
attractive.
Attractiveness of New Car: New cars may have style, safety,
or mileage features that purchase.
Human Assets
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Human assets: the resource that reflects the current
value of all our future earnings.
Factors that directly influence a person’s incomeearning ability can be simplified as knowledge and
skills, with general health used as support for them.
Human assets are a nonmarketable asset that is
often rented to an employer for a period of time at an
hourly fee or a salary.
Without knowledge and skills human capital can be
viewed as a basic commodity with the ability to earn
just the minimum wage.
Capital expenditures include formal education and
other ways of developing knowledge.
Calculating Human Assets
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The value of your human assets varies over your life
cycle.
If you are a skilled employee, your asset value may
actually go up for a time.
As you age, the decline in the number of your
earning years generally results in a drop in your
human assets over your life cycle.
In effect, human assets depreciate over time.
Capital expenditures on human assets are treated
similarly to those for other assets with benefits
compared with costs.
Housing Features
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Unique Physical Characteristics: No two houses are
exactly the same.
Long-lasting: Through maintenance and renovation
the property’s overall asset value can often be
prevented from declining for many years.
Tax Benefits: The government provides tax benefits
to owners.
Appreciation Potential: Many properties tend to rise
in value over time.
A Fixed Location: A house’s location is significant.
Land: Land may fluctuate in value, but over a long
period of time value tends to rise.
Housing Uses
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Housing Uses:
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Provides shelter.
Long-term investment.
Provides pleasure to its occupants.
Because of its benefits and increases in household
discretionary income in this country, the rate of
home ownership has risen over the past 50 years.
Housing Uses, cont.
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Home Ownership Rates by Household and Type of
Structure:
Total
One-family
Apartments with
Mobile homes
detached house 5 or more units
1950
55.0%
73.0%
4.1%
79.4%
42.1%
1960
61.9%
78.3%
4.6%
88.3%
40.8%
1970
62.9%
81.6%
5.2%
84.5%
42.4%
1980
64.4%
85.6%
10.2%
79.8%
43.5%
1990
64.2%
85.5%
9.6%
79.8%
48.7%
2000
66.2%
N/A
N/A
N/A
N/A
2004
69.0%
N/A
N/A
N/A
N/A
Source: US Census Bureau, Historical Census of Housing Tables.
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One-person
households
Tax Benefits for a Home
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Mortgage interest and property taxes are tax
deductible, and appreciation in home value is not
taxed until the home is sold.
Upon sale the first $250,000 of gain per person or
$500,000 per couple is tax free with amounts over
that taxed at capital gains rates.
Capital expenditures on home improvements are
added to the purchase price in calculating your basis
in the property, which reduces the ultimate gain.
This $250,000 or $500,000 benefit is allowed once
every two years for those people who have had their
home as their primary residence for any two of the
past five years.
Traditional Durables vs. House
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Return on House for Period
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One way to obtain the benefits of a home is to
include the cost of renting the home in the
calculation of return.
The outcome is that you save the cost of renting the
home.
Annual returns are therefore specified as follows:
Increase in House
Value During Period
Rent Not Paid
Return on House
for Period
Market Value of House
Beginning of Period
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Cost of Upkeep
Home Affordability
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Factors that influence home affordability include:
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Current Income: The more you earn, the larger the home
outlay you should be able to afford.
Tax Bracket: The higher your tax bracket, the greater the
“government subsidy” for tax-deductible real estate taxes
and interest expense, the more expensive the home you
can buy.
Liquid Assets and Debt Accumulated: The larger the down
payment, the larger the home you can afford since ongoing
demands on household cash flow will be lessened.
 On the other hand, the greater the amount of nonmortgage debt, outstanding, the lower the overhead
costs that can be undertaken through home purchase.
Home Affordability, cont.
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Value System: The more important the home, the greater
the sacrifice you are willing to make in other areas, and
thus the higher priced home you can afford.
The Local Realities: Homes vary in price in different
markets.
Outlook: The more optimistic you are about your future
income situation and about the price appreciation of real
estate, the greater the outlay you will be willing to assume.
Risk Tolerance: The higher your risk tolerance, the greater
the mortgage payment you will be willing to assume relative
to your available cash flow.
An Introduction To Leasing
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We tend to purchase durable goods for their benefits
for household activities today and for periods in the
immediate future.
Owning them does not provide appreciation in those
assets as, say, owning stocks would.
Therefore, we often considering leasing assets.
A lease is a way to acquire the use of an asset
without purchasing it.
The lease allows you to receive the asset's
operating benefits in return for an obligation to make
a series of payments over the term of the lease.
The maintenance and overhead costs may be paid
by the lessor.
Reasons for Leasing
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Economic reasons for leasing include:
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The lessor may absorb the risk of technological or fashion
obsolescence or large unforeseen expenditures on the
asset.
The lessor is sometimes able to develop efficiencies in
specializing in that asset.
The business owner may receive tax benefits that the
lessor will not.
The cost of leasing generally is greater than the cost
of purchasing.
The lessor’s administrative cost including the need
for profit.
Reasons for Leasing, cont.
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Leasing may be advisable when the asset is needed
for only part of the period.
A common reason for leasing an asset is that
households are short of capital. Leases may be
offered with no down payment.
Leasing is generally not presented as a liability on
the household’s balance sheet, as it often is on the
business statement.
Therefore, when the household is short of funds and
has limited liability to borrow, leasing may not show
up in qualifying for a new loan.
Automobile Leasing
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Factors to consider when deciding whether to lease or
purchase an automobile:
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How Long the Car is to Be Held: Depreciation in prices of a car
moderates after the first few years.
The Age of the Car: New cars offer fewer problems and are
covered by warranty.
The Cost of Time: Selling a car that you own involves time and
can expose you to price risk.
Inspection Standards: Lessees must comply with inspection
standards when returning the car
Mileage Charges: Leases contain maximum mileage charges.
Lease Obligation: A lease is made for a fixed period of time
Ability to Fund Monthly Payments: Monthly payments for
leasing will be lower than loan payments. But once your loan
payments have been completed, you own the car.
Overall Appraisal of the Home as
an Investment
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Two key factors in making the purchase of a home:
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Thus, the house provides a hedge against inflation
and returns on the investment when sold.
Other factors:
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Tax benefit.
Continued growth of the house at around the inflation rate and in some cases significantly beyond that rate.
Pride of ownership.
The forced-savings feature of homes.
Overall Appraisal of the Home as
an Investment, cont.
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The disadvantages of home ownership include:
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Its lack of short-term liquidity should immediate sale
become necessary.
The responsibility for maintaining the home and grounds.
The cyclical nature of home prices over shorter periods of
time.
On balance, for expected holding periods of, say,
three years or more, owning a home has historically
been a highly rewarding investment.
Overall Appraisal of the Home as
an Investment, cont.
Type of Capital
Expenditure
Category
Durable Goods
Nondiscretionary
Nondiscretionary
Nondiscretionary
Discretionary
Discretionary
Revenue Related
Revenue Related
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Summary of
Capital
Expenditures
Household
Overhead
Specific Cost
or Activity
Examples of Activity
or Specific Capital
Expenditure
Mortgage interest, Boiler, furniture
rent, fuel,
electricity
Household Work Cooking,
Dishwasher, oven
cleaning,
childcare,
shopping
Biological
Food, clothing,
Bed
Maintenance
sleep
Active
Sports, traveling Skis, golf clubs
Passive
Watching TV
Television, stereo
Human Revenues Work
Automobile as
transportation
Marketable Assets Investing
Computer
Table continues next slide.
Overall Appraisal of the Home as
an Investment, cont.
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Table continues from previous slide.
Type of Capital
Expenditure
Category
Human Assets
Education
Real Estate
Home
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Specific Cost
or Activity
Nondiscretionary
Summary of
Capital
Expenditures
All
Discretionary
All
Any
Revenue Related
Human Revenues Work
Revenue Related
Nondiscretionary
Discretionary
Marketable Assets
Household
Overhead
Active or Passive
Revenue Related
Real Assets
Any
Investing
See Durable
Goods above
Exercising,
watching
television
Investing
Examples of Activity
or Specific Capital
Expenditure
Books and seminars
on improving
productivity
Books and seminars
on increasing pleasure
College, graduate
school conferences
Conferences
See Durable Goods
above
Construction of a denexercise room
Purchase of a home
Chapter Summary
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Our objective is to select the best mix of household
assets overall. Investment returns can be measured
on an individual asset basis, within a household
activity, or on a Total Portfolio Management Basis.
Capital expenditures can be evaluated using either
an NPV or an IRR approach. In each case, returns
on projected outlays are compared with similar
market-based investment returns. NPV uses market
returns to develop current values and accepts all
investments that have a positive present value. IRR
provides a return that is compared directly with the
market-based return that is used to accept or reject a
proposed outlay.
Chapter Summary, cont.
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Real assets are often durable goods such as a car or
an appliance. Human-related assets consist of jobrelated income discounted to the present plus those
related to human work and other rights and
relationships and anticipated gifts and bequests.
Home ownership is an asset with unique
characteristics. It often presents advantages over
renting because of its tax benefits.
Leasing is an alternative way to obtain use of an
asset. It is generally more costly than purchase, but
is attractive for people who are short of capital or
who desire more flexibility with their monies.