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**CFA Practice Question**

SkyAirlines has spent $3 million doing a feasibility study for studying the benefits of the new computer system. It has estimated that installing the computer system will cost $15 million. It will be able to depreciate the cost equally over 5 years. It will result in savings of $5 m a year for the 5 years. After this time is over, the computer system will be worthless (zero salvage value). Suppose the computer system also takes up office space that SkyAirlines owns and can otherwise rent for $1M a year. The discount rate is 11% for SkyAirlines and the tax rate is 34%. What is the NPV of the project?

A. -$0.2164 M

B. $0.9663 M

C. -$1.4730 M

**Explanation:**Depreciation = Cost / # of years

EBIT = Savings - Depreciation - Opportunity Cost

The 'Opportunity Cost' can be subtracted directly to get EBIT, because even though you do not actually subtract it when you calculate taxes, however if you did not do the project then you would be receiving the 'Opportunity Cost' and paying taxes on it. Alternatively calculate EBIT and Cash Flows without considering the 'Opportunity Cost' and subtract the annuity of 'Opportunity Cost' at the very end. You will get the same answer.

Taxes = EBIT * Tax Rate

NI = EBIT - Taxes

Cash Flow = NI + Depreciation

NPV = Cash Flow Annuity for # of years - Cost

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**User Contributed Comments**
5

User |
Comment |
---|---|

CFunder |
why would you not be able to deduct interest/amortization when determining taxes? |

jpducros |
Every year, there is : + 5 of Savings -1,7 taxes on savings +1,02 tax effect on depreciation = +4,32/year during 5 years. PMT -4,32, i = 11%, n= 5 PV : 15,96 15,96 - 15 of initial invest = 0,9663 What am I missing ? |

GoDawgs |
$660,000 net loss on rental income |

chandsingh |
EBIT = savings (5 mil) - depreciation (3mil) - (opp cost of 1 mill foregone) - $1 mil EBIT * tax rate = 660k Cashflow for NPV computation = NI of 660k + depreciation of 3mil = 3.66mil use npv computation -15mil cf of 3.66mil for 5 years at 11% discount = NPV of -1.4730m. Discount each cf by 11% and add to initial investment of 15mil will give the answer |

seon |
In my opionion the easiest way is to use the normal NPV method: 3 mio research are sunk costs. Therfore: CF0: -15.000.000 CF1-5: (+1,02 tax shield from depreciation, +5 savings, -1,7 loss tax shield savings - 1 rental loss + 0,34 tax back rental lost) = 3.660.000 i= 11 compute NPV and you get -1.473.017 |