Marginal Efficiency of Capital

# Marginal Efficiency of Capital Assignment Help

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# Marginal Efficiency of Capital

Marginal Efficiency of Capital Marginal Efficiency of Capital (MEC) is that rate of discount which makes the sum expected annual returns from capital just equal to its supply price (i.e., purchase price or the cost of capital asset). As discussed earlier, we can find out the total present value of the series of returns when we know the amount of annual returns R1, R2, R3,..Rn and the rate of interest (i), by the formula,

PV = R1/(1+i)1 + R2/(1+i)2 + R3/(1+i)3 +.... Rn/(1+i)n

Similarly, if in the above equation, we know the present value of the sum of annual returns (PV) as well as the annual returns R1,R2,...Rn, we can solve the equation to find the discount rate (i) which equals the total present value PV to the annual series of returns over the life of the machine. Thus, out of three variables, viz., PV, rate of return (R1,R2, etc)and rate of interest, when we know the value of any two variables, we can calculate the value of third one. To calculate the MEC, we now replace the PV with the cost of capital or value of Investment which is known. Therefore, in place of PV, we put in the present value of investment as given by the cost of purchase of that capital good, machinery and equipment and is denoted by the alphabets. The estimate of the flow of annual returns, viz., from the investment (viz., R1,R2,...Rn)has also been made and is thus known and given. So, what remains is to calculate the rate of discount that has been put in the equation as an unknown variable r, in place of the rate of interest i whose value was known and given in the previous equation. The value of r which equates these two, viz., the present value of annual returns and the cost of capital. This can be found out by solving the equation :

C = R1/(1+r)1 + R2/(1+r)2 + R3/(1+r)3 +.... Rn/(1+r)n

Here, C is the cost of capital or purchase price of machine and R1,R2,...Rn is the series of estimated annual returns. So, we have to find out r, which is the rate of discount that equates the present value of the series of annual returns with the cost of capital. This rate of discount (r) which we find out from the above equation is called the marginal efficiency of capital (MEC) because it makes the present value of income stream produced by the capital good just equal to the cost of capital good.

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