Comparison between MEI and Present Value criterion

The marginal efficiency of investment is the discount rate at which the net present value of the Investment is zero while in the present value criterion, the net cash flow is the difference between cash outflows and cash inflows over the life of the investment.

Similarities between MEI and PV criteria.

Use: Both of these measurements are primarily used in capital budgeting, the process by which. Companies determine whether a new investment or expansion opportunity is worthwhile. Given an investment opportunity, a firm needs to decide whether undertaking the investment will generate net economic profits or losses for the company.

Decision: Ease to compare projects since both give the same accept-reject decision for independent projects. If a project’s MEI exceeds the required rate of return accept it; otherwise reject it. If two projects are mutually exclusive, choose the investment with the highest MEI and in the case of present value criterion, if positive, accept the project. If it is negative, reject it. If two projects are mutually exclusive, choose the one with the highest NPV.

Derivation: Both are discounting methods that recognize time value of money and also consider all cash flows over the entire life of the project. MEI is measured by calculating the interest rate at which the present value of future cash flows equals the required capital investment. The advantage is that the timing of cash flows in all future years are considered and, therefore, each cash flow is given equal weight by using the time value of money.

Differences between Marginal Efficiency of Investment  and Present value criterion.

Convenience: Relative to NPV, the advantage of MEI is that it provides a performance measure that is independent of the size of the project. Hence, MEI can be used to compare projects that require significantly different initial investments. Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the MEI Method does not.

Reality: NPV is more realistic than the MEI by virtue of its assumption that discount rate is earned from the reinvestment of cash inflows generated by a capital investment. Indeed, MEI’s assumption that the reinvestment of cash inflows earns the MEI is unrealistic, especially when the MEI for a capital investment is high. Investment risks are straightforward and are not based on assumptions. Rather, they are used only to evaluate the assumptions made by the capital budgeting methods.

Calculation: As illustrated in the example above, whereas NPV has a straightforward calculation formula, MEI is calculated on trial and error basis. Moreover, NPV is calculated using a market-based discount rate while MEI is calculated using returns generated by invested capital. As such, NPV accounts for the opportunity cost of capital -- that is, the cost of foregoing alternative investments -- while MEI does not. The calculation of investment risk is entirely dependent on the nature of the capital investment and the capital budgeting method that is used to appraise it.

Consistency: Whereas NPV maintains consistency of solutions regardless of periodical changes in cash flows, MEI gives varied solutions with changes in cash flows from one period to another. This is confusing because it would suggest that there are multiple percentage values at which an investment’s present value benefits and costs would be equal. Investment risks show consistency regardless of the type of risk at hand.

Unit of Measure: NPV is expressed in currency value, while MEI is expressed in percentage form. Investment risk is not restricted to any particular unit of measure because it signals the magnitude of the negative consequences of pursuing any particular investment. For example, assets investments with high NPV discount rates signal higher levels of investment risks.

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.