Kramerica Inc is engaged in the business of mining gold using a process that pumps water from underground mines and then filters the gold out of the water. The current equipment they use to pump from the mines is three years old (the cost was $5,000,000) three years ago), and the IRS allows such equipment to be depreciated straight line over a 5-year period. The equipment, however, is expected to last another five years (so total life is 8 years). Today, the old equipment can be sold for $1,500,000. The older machinery requires a lot of maintenance, and the cost of operating it is $2,000,000 per year. If Kramerica keeps the old equipment, it will be worthless at the end of the additional 5 years of operation.

Kramerica is considering buying a new machine to replace the old pumping machine. Newman, the head of engineering at Kramerica, spent $450,000 last year testing the new machine, which would cost $6,000,000 and last for five years. The new machine would be depreciated straight line over five years and would also be worthless at the end of the 5 years. Newman figures that the cost of operating the new machinery would be only $500,000 per year, though because of its sophistication, Net Working Capital (NWC) would need to be increased by $200,000 at the time of the acquisition. At the end of the five years, the increase in NWC will be completely recovered. Total revenue (before expenses) will be $2,500,000 under either scenario and would be unaffected by the switch in equipment. The firms tax rate is 20% and the cost of capital is 12%.

1. What is the after-tax salvage value of the old machine if sold today?

2. What is the incremental OCF for year 3 of the project?

3. What is the NPV of this replacement project?

4. Would you recommend to Kramerica to move forward with this project (replacing the machine)? (Yes or No)[recommendation]