One might say the set of utensils will cost a lot more. Well, not necessarily. It depends on the type of the restaurant. The above question is about the process of decision making – do both the transactions take same kind of decision making?
The basic difference between the above activities is that buying utensils is an asset acquisition transaction and buying food from a restaurant is an expense. Acquisition of an asset may create long term value. An expense does not create any long term value in general.
What is Long Term Value?
The non-mathematical definition of long term value is about receiving a sustained benefit for a considerably long time. Let us consider the examples mentioned above.
First, consider the transaction of paying for a meal at a restaurant. It is obvious that it creates some short term benefits – hunger is satisfied, some emotional satisfaction, etc. But, will the benefits sustain after even a week – most probably not, unless you met the love of your life during that meal.
Now, let us consider the case of buying the utensils. Depending on the quality of the utensils, the benefits can last for years. We can quantify the benefits by calculating the expected value of the savings cooking at home can bring, subtracting the other costs including your time.
We can see that out of the two transactions, the acquisition of utensils may create long term value – Why the “may”?
Asset Acquisition May Not Create Long Term Value
Consider a situation where after procuring the utensils you never used them. Will your asset acquisition create any long term value? Absolutely not.
This is a common issue in personal financial decision – confusing asset acquisition with long term value creation. So, how do we understand whether or not an asset will create long term value ?
In corporate finance there is metric called the ‘Asset Turnover Ratio’, which measures the revenue generated by per unit of assets held by a company. In personal finance, assets mostly contribute to savings – a car can reduce the transportation cost and save time, buying an apartment may save you the rent, etc. So we need to ask what kind of savings we are expecting from this asset?
The second question is – for how long this saving benefits can last i.e. the effective life of the asset?
The third question is – at what frequency we are going to use this asset?
The last question is – what is the resale price of the asset? Many assets may have significant resale price, even higher than the acquisition cost. For example, real-estate.
Now, if the answers of the above questions justify the cost of acquisition with a satisfactory margin of safety, the acquisition is likely to create long term value.
What is the Point of Doing All These Analysis?
Same cash outlay for an expense and an asset acquisition have completely different implications to your net-worth. As expenses do not create any long term value, a higher expense means a higher negative impact on your net-worth. In case of an asset acquisition, the relationship is different.
Consider the example of buying a meal and buying a set of utensils. If someone pays 20% more for the meal at the restaurant, that does not increase any long term benefit. But, a 20% more for a set of utensils may result in a may be a 40% -50% higher asset life. This means the distinction between expense and asset acquisition may help us decide whether or not to pay a premium for something.
Is Value only Defined by Financial Value?
While thinking about personal finance, many people often consider only the financial value. While financial value is obviously important, we cannot ignore some other important factors which affect our financial well being.
Let us talk about Human Capital. In simple language Human Capital defines the expected value of lifetime earnings of a person. In previous sections we only talked about making good financial transaction decisions. But, we need to consider those transaction decisions along with the implications on our earning ability.
Consider you are trying to decide whether you want to buy a vehicle or to continue to take the public transport. Now, it is possible that from a pure financial analysis the vehicle purchase does not make sense. But, consider that because of taking the public transport you are reaching your workplace already exhausted and as a result, experiencing lower productivity at work. Now, your lower productivity is going to lower the expected growth in your profession and along with that, your expected lifetime earnings. That means, by taking the vehicle purchase decision solely based on financial considerations, you can actually lower your lifetime earnings.
So, we need to take consideration of the non-financial values as well – productivity, mental peace, and social capital etc.
Understanding whether our financial transactions contribute to long term financial and non-financial value is vital for a healthy financial life. Distinguishing between an expense and asset acquisition helps us decide whether or not to pay a premium because the premium to an expense does not contribute to our financial future whereas premium paid to an asset allocation may.