Question

Explain investment decision through the Marginal Efficiency of Capital (MEC) or Internal Rate of Return (IRR).

Answer 1

The Marginal Efficiency of Capital (MEC) or Internal Rate of Return (IRR) is another important method used to evaluate and make investment decisions. It helps determine the expected rate of return from an investment project and compares it to the cost of capital.

• MEC is defined as the rate of return expected from an additional unit of capital investment, based on the expected future earnings from the project.
• IRR is the discount rate that makes the Net Present Value (NPV) of an investment zero.

NPV = `sum(R_t/(1+IR R)^t)-C=0`

Where:

• R_t​ = Cash inflow at time t
• C = Initial investment
• t = Time period
• IRR = Internal rate of return (MEC)

Example:

Suppose a company is considering a project that requires an initial investment of ₹ 1,00,000 and is expected to generate ₹ 40,000 annually for 3 years.

We need to find the IRR, i.e., the rate r that makes:

1,00,000 = `(40,000)/(1+r)^1+(40,000)/(1+r)^2+(40,000)/(1+r)^3`

Using trial and error or financial calculators,

• At r = 12%, NPV ≈ 0

Hence, IRR = 12%

If the firm’s cost of capital is 10%, since IRR > cost of capital, the project should be accepted.

In Keynesian terms, investment decisions depend on the relationship between:

• MEC (expected return) and,
• Rate of interest (cost of borrowing)

Keynes’ Rule:

• MEC > interest rate → invest
• MEC < interest rate → do not invest

Advantages:

• Considers the time value of money
• Provides a rate of return easy to interpret and compare
• Useful for evaluating mutually exclusive projects

Limitations:

• Complex to calculate without tools
• May give multiple IRRs when cash flows change signs
• Doesn’t account for scale of investment directly