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Example 2: Simple Capital Budgeting Example. Firm B is considering an investment in new production equipment. The cost of the new equipment is 500,000. The new machine will depreciated using the straight line method over 5 years assuming no salvage value. The new equipment is expected to generate the following revenue over a five year period. At the end of year 5, the equipment will be sold for 25,000. Revenue and expenses for the new machine are forecasted to be: Projected Income Statement for the new equipment: 2016 2017 2018 2019 2020 Revenue Cost of Good Sold Gross Margin 200,000 300,000 350,000 400,000 400,000 120,000 180,000 210,000 240,000 240,000 80,000 120,000 140,000 160,000 160,000 Expenses Depreciation Net Income 10,000 100,000 - 30,000 10,000 100,000 10,000 10,000 100,000 30,000 10,000 100,000 50,000 10,000 100,000 50,000 Question: should Firm B invest in this piece of new equipment? Step 1: Cash Flow Estimation: Net Income 30,000 10,000 30,000 50,000 50,000 Add back depreciation expense 100,000 100,000 100,000 100,000 100,000 Cash Flow (ignoring taxes) 70,000 110,000 130,000 150,000 150,000 Plus sale of old equipment Yr. 5 25,000 Note therefore that in year five, total cash flow is 175,000. Example 3. In this example, we assume that there are no cash inflows in year 1; that is we assume the same cash flows as in example 2 but they occur 2017 2021. We also assume a 20 percent interest rate. Points to consider: (1) we do not have to recalculate the cash flows as they are the same but occur at a different time, (2) we will have to do one additional step in the discounted cash flow calculation. Example 4: Firm C is considering investing in a plant that will produce cash flows for 20 years, beginning in year 4. Rate (r) = 20 percent. Cash flow years 3 to 20: $400,000 per year. Initial Investment: Year 0:$500,000 Year 1: $2,000,000 Year 2: $1,000,000 At the end of year 20 we sell the plant for $1,000,000. Should we invest in this machine? First, be careful in how you count the years. For the inflows, year 3 through 20, n is equal to 18