Question

A friend asks you to sit down to discuss how to invest fifty thousand dollars he recently received. Your friend is trying to decide on the best way to invest the money for 5-years, and wants your help (because you took a finance class!)  .   Your friend wants to discuss two different investment ideas for the five years:

1. Use the money to produce a row crop
2. Use the money to run a small cow-calf operation.

When you ask for his estimates of the cash flows from the row crop and cow-calf investments, he gives you Table 1. The net returns in year five assume that he will be able to recover his fifty thousand dollar investment (by selling off all equipment, stock, etc…this is a salvage value) as well as earn profits from production for that year.

Table 1. Estimated Net Returns for Jake's Proposed Investments
Year	Row Crop	Cow-Calf
0	-50000	-50000
1	5000	0
2	5000	3000
3	5000	5000
4	5000	9000
5	55000	60000
Total Net Return	25000	27000

Your friend says he figured he’d just go with the investment with the highest total net return (cow-calf), because that would give him the most cash at the end of the five years. In exactly four words, what is your friend failing to account for if he uses this method to choose an investment?

Answer 1

The friend is failing to account for "Time Value of money" when he decides to go ahead with the investment giving the highest total return . He is forgetting the time or the year in which the returns are coming. Earlier returns give us the option to invest these somewhere else and hence increases our profitability