X Company purchased a locomotive four years ago.

Information relating to the existing locomotive:

It was purchased 4 years ago for $4,050,000

It had an expected life of 9 years

There was no expected residual for depreciation calculations

The expected disposal value at the end of 9 years was estimated at $1,000,000

The current disposal value is estimated at $2,500,000

They have received a proposal for a new locomotive to replace the current one now. The proposal consists of:

$5,000,000 for the new locomotive (including all delivery costs)

The new locomotive is considered to be more fuel efficient and is expected to save $600,000 per year in fuel and maintenance costs

The new locomotive has an estimated life of 5 year

There is no residual value used for depreciation calculations

At the end of 5 years, the estimated disposal value is $1,500,000

Other information relevant to the decision:

Depreciation method is straight line

Company tax rate is 30%

The Weighted Average Cost of Capital (WACC) is 10%

Tax effects occur in the same year as the income/expense

Required:

(i)Calculate the NPV of the cash flows for the existing locomotive

(ii)Calculate the NPV of the cash flows of the new locomotive proposal

(iii)Recommend which option should be adopted based on the results of the NPV calculations.