Capital charge method

[George Philip]

CB1 April 2020 Q.6
The question :
The directors of a company are considering investing in a machine that will cost $38 million. The machine will have a useful life of 5 years. The cost of capital is 10% p.a. The directors have determined that the annual capital charge of this machine is $10 million. The machine will generate revenues of $14 million and will require annual running costs of $1.5 million. Which of the following statements is correct?

A The annual capital charge method indicates that the company should invest in the machine because it will increase shareholders’ wealth.

B The annual capital charge method indicates that the company should invest in the machine, but it does not indicate that the investment will increase shareholders’ wealth.

C The annual capital charge method indicates that the company should not invest in the machine because doing so will reduce shareholders’ wealth.

D The annual capital charge method indicates that the company should not invest in the machine, even though the investment will increase shareholders’ wealth.

The answer given is option A, but how do we come to this conclusion?

 

[Lynn Birchall]

We can use the annual capital charge to work out the effect that investing in the machine will have on the company's profits in each of the next five years. This gives annaul profit of $14m - $10m - $1.5m = $12.5m.
A stream of five years of positive profits indicates that the investment would increase shareholders' wealth.