Why is Marginal Efficiency of Investment weak ? Explain

Marginal Efficiency of investment is weak because of the following:

Ignores Future Costs: The MEI is only concerned  with the projected cash flows generated by a capital injection and ignores the potential future costs that may affect profits. If you are considering an investment in trucks, for example, future fuel and maintenance costs might affect profit as fuel prices fluctuate and maintenance requirements change. A dependent project may be the necessity to purchase vacant land on which to park a fleet of trucks, and such cost would not factor in the MEI calculation of the cash flows generated by the operation of the fleet

Reinvestment problem: Calculation of the MEI assumes that all project cash flows can be reinvested to earn a rate of return exactly equal to the MEI itself. For example, a project with a MEI of say 7% assumes that all cash flows can be reinvested to earn a return of exactly 7% which induce managers to reject proposed projects that shareholders would like the company to accept. Also, if the manager has evaluated based on the average MEI of all capital projects undertaken, and if a proposed capital project offers a MEI that is above the company’s cost of capital, but below the average of all capital projects undertaken thus far, the proposed project would adversely affect the manager’s performance measure, although it would increase economic return of shareholders.

Scale problem: Another weakness is where MEI is likely to contradict present value criterion when there are two, mutually-exclusive projects of greatly differing scale. One that requires a relatively small investment and returns relatively small cash flows, compared to another that requires a much larger investment and returns much larger cash flows. The reason for this is that under present value criterion, the reinvestment assumes cash flows are reinvested at the cost of capital; under the internal rate of return, the reinvested rate is assumed to be reinvested at the internal rate of return. It yields overstated rates of return because it assumes cash flows are reinvested at the internal rate of return.

Timing problem: The other situation in which MEI is likely to contradict present value criterion, is that of two, mutually-exclusive projects whose cash flows are timed very differently - one that receives its largest cash flows early in the project versus another that receives its largest cash flows late in the project. It gives high ranking to projects, which bunch the benefits into the early part of their economic lives relative to other projects. The MEI therefore does not distinguish between a lending (investing) or a borrowing (borrow and invest) situation, whereas the present value criterion clearly points out the negative aspects of the borrowing strategy.

Example:

Year	Cash flows A	Cash flows B
0	-1	-1
1	0	0
2	0	2
3	4	1

Calculating  MEI (m) of A                                                    Calculating MEI(m) of B                   

0=-1+0+0/(1+m)+4/(1+m)²                                                    0=-1+0+2/(1+m)+1/(1+m)²                           

(1+m)²=4                                                                                     (1+m)² =1+2(1+m)

m_A=1                                                                                                           m²=2

                                                                                                                    m_B=1.414

Since m_A < m_B     project B is chosen base on the MEI criterion.

Calculating PV at very low market rate, r=0.

Calculating the PV for A                                                             Calculating the PV for B

PV_A=-1+0+0/1+4/1=                                                                   PV_B=-1+0+2/1+1/1

PV_A=3                                                                                               PV_B=2

Since PV_A  >PV_B   Project A is chosen due to higher PV based on PV criterion.

Therefore, at low interest rates, projects with delayed returns are better than those with earlier returns.