Monday, January 09, 2006

The Danger of Cash Flow Thinking

I have a friend at work - let's call him Don (the name has been changed to protect the foolish). After many white board sessions, my friends and I convinced him to put a full 15% of his salary into our company's Employee Stock Purchase Plan(ESPP). As I have discussed before, if your plan is set-up properly and you can sell your shares immediately, participating in a ESPP is a financial slam dunk.

Now, Don wants to buy a house... "Great!" I say - a house is one of the best net worth growers in existence. I heard through the grapevine, however, that he plans on ceasing his ESPP contribution so that he can afford the house payments. What!?! You are no longer going to participate in a plan that generates an annualized return on your investment of over 100% almost risk-free.

Looks like we're going to need another white-board session. I'm afraid Don is viewing the ESPP payroll deduction as an expense and not as an investment. He has a good handle on his cash flow (most people do) but he's missing the net worth boat.

When you are faced with a cash flow shortfall you need to ask yourself a few questions:
  • Is this shortfall permanent or temporary? - If you make some fundamental change (like buying a house) that hurts your cash flow, you need to take a step back and re-evaluate all of your savings, debt and spending.
  • What is the opportunity cost of reducing my savings / investment rate and how does that compare to my debt costs? - This is the analysis that Don needs to do. His ESPP investment has an annualized return of over 120%. A HELOC or good credit card has an annual cost of 7-15%... any questions?

The bottom line is that Don needs to look for alternate ways to shore-up his cash flow crunch. Eliminating his ESPP participation is a cash flow positive move that comes with a severe net worth cost.

2 Comments:

At 1:27 PM, Anonymous Anonymous said...

I would tell your coworker to wait on the house.

Unless you guys live in an inexpensive area, every major metro area could experience some deals over the next year.

 
At 1:36 PM, Blogger Early Riser said...

Good point... our area isn't 'bubblish' but there has been 30% + appreciation from just a few years ago.

 

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