MARGINAL EFFICIENCY OF CAPITAL

SYNOPSIS• Introduction• Marginal efficiency of capital.• Factors effecting MEC• MEC and interest rates• How companies maintain Capital using MEC• Case study• Conclusion

INTRODUCTION Irving Fisher was first economist to make use of concept MEC in

1920.

He gave it a name Rate of return over cost.

Simply MEC means “expected rate of profitability of new

investment”.

It’s calculation depends upon two factors mainly

I. amount of profit

II. cost of capital asset

MARGINAL EFFICIENCY OF CAPITAL

The marginal efficiency of capital (MEC) is that rate of

discount which would equate the price of a fixed capital asset

with its present discounted value of expected income.

In short, MEC is the internal rate of return of an extra unit of

capital.

The theory of marginal efficiency indicates that investment decisions will be influenced by:

I. The marginal efficiency of capital II. The interest rates

MEC CURVE

Factors Affecting the Marginal Efficiency of Capital

Marginal Efficiency of

Capital

Cost of Capital

Demand for goods

Marginal rate of Tax

Availability of Finance

Expectations and

confidence

Technological

Innovation

Factors Affecting the Marginal Efficiency of Capital1. The cost of capital:

If cheap capital is available for investment, then investment

opportunities become more attractive.

Factors Affecting the Marginal Efficiency of Capital

2. Demand for goods and services

If tastes and preferences change and demand for a good increases,

then the increased demand is likely to increase profitability.

3. The marginal rate of tax

If the marginal rate of tax is increased then the net return on

an investment will fall, reducing the marginal efficiency of

capital.

4. The availability of finance

Restrictions on lending will limit investment. A relaxation of

credit controls will make investment easier.

Factors Affecting the Marginal Efficiency of Capital

5. Expectations and confidence

If people believe that growth in economy is slowing and

unemployment may rise in the foreseeable future, then demand in the

economy may contrast.

6. Technological change

Innovation in products or processes may increase the potential size of

the market or help to drive down costs.

MEC AND INTEREST RATES

An investor while taking an investment decision makes a comparison

between MEC and rate of interest.

when ROI is less than MEC (ROI<MEC) investor make more

investment.

When ROI is more than MEC (ROI>MEC) no investment will be

made.

When ROI is equal to MEC (ROI=MEC) investor stop making

any more investment.

HOW COMPANIES MAINTAIN CAPITAL USING MEC

EXAMPLE:

• Suppose the price of machine is 30000.Duration of life of

machine is 10 years, expected income during this period is 60000.

NOW

Total Profit of machine is 60000-30000= 30000

Average profit per year - 30000/10 = 3000

MEC = 3000/30000 *100= 10%

CASE STUDY• This is case is about Nike which is a popular brand in

sporting apparel division.• Nike generated 2.81billion$ in operating income on revenue

of 20.9billion$ in FY 2014 end of may.• Nike planning on expansion in to fashion apparel segment.• 2.5billion$ is capital investment (marginal capital) they are

going to invest.• Expected market share will be at 2% in first year.• Gross profit margins are expected to be a 23% of revenues.• Total time period is 12 years.• Nike has used MEC for taking decision on expansion plan

investment .

CONCLUSION

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