I am part of a networking group, today a guy in the group as part of a presentation tossed out part of an anology that torqued my sensibilities a bit.
His claim was as follows:
If I had a way of selling an investment that guarenteed a $100K would return $25K a year in dividends, you would have a line a mile long waiting to buy.
If you try to sell a business “product X” for $100K that will save them $25K a year you tend to get dismissed.
I approched him after the presentation and asked him about what I felt was the difference and that his presentation seemed to present a false anology between the two.
My POV was with scenario A even if the investment only makes $5K I still have my $100K, whereas scenario B I am still down at best $75K.
I started doodling on a napkin
Start $1,000K (-100K for productx) $1,000K
year 1 Scenario A Scenario B
900K 900K (+100K in investment principal)
year 2 925K 925K (+principlal =$1025K)
year 3 950K 950K (+principlal =$1050K)
year 2 975K 975K (+principlal =$1075K
year 2 1000K 1000K (+principlal =$1100K
year 2 1025K 1025K (+principlal =$1125K
year 2 1050K 1050K (+principlal =$1150K
And pointed out that Scenario B always leaves you with $100K more and has the potential for compounded interest. and the only way this would be a fair comparison is if you are willing to give me my $100K back after a few years if I am unhappy with product X.
He swears there is no diffference and is looking at me like I sprouted another head for suggesting it.
In the dividends scenario, he is describing something that essentially does not exist - an investment where the principal is guaranteed and so are market-beating returns. At least, that’s my interpretation of your description of his description. If he could indeed offer that type of investment, yes, people would beat down his door. [It reminds me of the housing bubble, with the assumption that housing prices would never go down. As we saw, that wasn’t real.]
In the savings scenario, he is describing something that may well exist for some businesses. There may be one or more $100K capital equipment investments that would save $25K/ year going forward. He’d have to compete with all the other potential investments of $100K that would return either profits or savings, though.
Change those thousands of dollars to pennies. Change those years to five-second intervals.
First, the investment. He gives you a dollar, which you put in his “investment account” (your hand). Every five seconds, you give him a quarter. How much does he have at the end of 20 seconds? What if he sells his investment?
Second, the product. He gives you a dollar, which you put in your profit account (your pocket). Every five seconds, you give him a quarter. How much does he have at the end of 20 seconds? Can he get a refund for the product?
His point is solid in a way: some investments you can’t sell to get back. Generally, though, we think of investments as things that, if they’re profitable, can be sold: you’ve got your initial capital PLUS you have your profit.
There are huge differences, although I would say you are sort of a tool for agruing about what was supposed to be a simple analogy. Yes, if you push the analogy too far it breaks but it is true that a 25% return on an investment would get a lot more attention than a chance to save that same amount of money.
That said, if he really can’t see the major differences between the two then he is the tool. One major difference is that he would get $100K of my money in the “product X” scenario; money I would never see again.
I think his point is valid. If – as he specifically says – the risk is zero in both cases, then they’re financially equivalent (if you’re getting 25% return, you’re never going to want your capital back. Even if you need the capital for something else, you’re better off using it as collateral for a loan, and paying the loan interest with the dividends from the original investment).
Now, in the real world, risks are going to be different, but external investments aren’t risk-free either, and there’s no guarantee you’re going to get your original investment back (Hint: Madoff, Stanford, and GM stock). It’s actually easier to predict cost savings than financial investment returns, so bringing up risk I think argues in favor of the cost savings investment.
Finally, I think you’re quibbling about details and either avoiding the main point he’s making (that business managers tend to devalue cost-saving investments), or perhaps demonstrating it (because you’re looking for nitpicking reasons to argue against cost-saving investments).
There’s no difference between a cash income and a cash cost savings, assuming your choices are really equivalent except for that one difference. In his example you bought an instrument that pays $25,000 annually for $100,000. You no longer have the $100,000 and you never get it back. I think you’re mistaken in assuming you’d still have the $100,000 in one of his scenarios. If that’s really what he meant then of course you’re correct but I think that’s obvious to anyone and unlikely that he realy said or meant that. His point was that two positive cash flows are equivalent whether they represent an incremental increase in revenue or an incremental decrease in costs, and he’s absolutely correct.
That would indeed be a better analogy, except like the hypothetical investment, it’s completely unrealistic - of course people would be happy to buy and income for life of $25k/yr for an investment of $100k. He’s being stupid either way.
ETA: if this is what he meant, as per the most recent responses - i.e., you don’t get the $100k back in either scenario - well, that makes more sense. But this needs to be made more explicit.
AND if option A couldn’t be sold at will. Even then they’re not quite equivalent.
If I’m an investor, and I can get the kind of return he mentions, of course I’ll take it. But what if a 30% return option comes along? I’ll really want to take my money and put it there instead. Even if I can’t, though, that’s okay: it just means someone else is making more than me.
But if I’m a business owner, and I buy that $100,000 cost-reducing item, I’ve got four years before I start making a profit. That’s a major outlay that I’m making in hopes of being able to beat out my competitors. What if, after two years, a product comes along that results in a 30% reduction in cost, and my competitors buy it? I’m out a net of $50,000 compared to my competitors at this point. Either I suck it up, trash my old investment as a loss, and purchase the new item, or I keep my old item, recognizing that my competitors now have a significant advantage over me. Either way, I lose.
The investment option is risk-free. The new equipment/process item is not.
I think this is an example of you “fighting the hypothetical.” He meant (even though he may not have said it very well) that a person would buy an investment (i.e., exchange money for something and never be able to get the money back). In that case, he’s absolutely right that a penny earned is a penny saved.
You are positing a different type of investment, i.e., where the principal remains safe (e.g., government securities) or can be readily realized (e.g., publicly traded stock).
So, you are both right, you are just looking at different alternatives for the investment scenario.
Except that, in the business world, they’re not really the same. Sure, each individual penny that you earn is the same as an individual penny you save. What is unspoken here is that you can only save pennies you already spend, it’s limited. Pennies earned are limited by the number of pennies the entire world spends.
GE did not become one of the worlds biggest companies by saving pennies, but by making investments to earn pennies.
They’re the same thing from the point of view of a proper corporate finance decision. If everything boils down to the same details except option A offers an incremental cost reduction of $25,000 and option B offers an incremental boost in revenue then you have two financially equivalent offers.
Obviously in the real business world, you are unlikely to ever have two and only two options available whose risks and costs are exactly equivalent except one cost reduces and one grows revenue. But that’s why we start with the basics. So that when you are making real life complicated decisions you don’t make the mistake of believing that a dollar in cost reduction is inherently worth something less than a dollar in new revenue.