Marginal efficiency of capital | Economipedia

The marginal efficiency of capital allows determining the probable return that an investment will achieve in a future period of time. Basically, this return will depend on the costs and the expected sales in the period of the useful life of the capital good.

Also, it can be said that the marginal efficiency of capital allows determining the return that a capital investment will achieve in a specific period of time in which the investment is made.

This indicator explains the relationship between the expected return (or probable return) of an investment and the replacement cost of the capital good. This cost is what was spent on the acquisition of the asset.

Therefore, to obtain the marginal efficiency of capital, it will be necessary to know the value of the capital good used in the production process of a certain product. Likewise, the price at which the product is expected to be sold or what is known as the demand price must be known. In addition, it will be necessary to know what the costs of producing it are or the offer price.

Marginal Efficiency Of Capital 1
Marginal efficiency of capital
What is it?

How to understand in a simple way the marginal efficiency of capital?

To understand this concept in a simple way, let’s start by explaining these fundamental points:

1. Performance is uncertain

First of all, the marginal efficiency of capital only reflects the expected probability of an investment’s return. This means that it operates under conditions of uncertainty. In other words, it operates with the expectation of obtaining a possible return in the future. This return will be the profit obtained on future sales that are uncertain.

To illustrate, let’s assume that we are going to invest $1,000 and that we expect to obtain future sales income of $1,300. If this were the case, the marginal efficiency of capital would result from applying the following formula:

EMK = π /I

  • Where EMK is equal to the marginal efficiency of capital.
  • I is equal to the investment and represents the $1,000 that is being invested.
  • π is equal to the profit level and the profit depends on the expected level of sales. In this case it would be the projected $1,300.

By applying the formula we will obtain: EMK=$1,300/$1,000 = 1.30.

  • Which will be equal to doing the following: EMK = (π-I/I) * 100.
  • When operating it, it is as follows: EMK = ($1,300-$1,000/$1,000) *100 = 30%.
  • The return or capital gain is 30%.

2. You have to know the price of the offer

The bid price represents the cost of the capital good. To correctly understand the concept of the offer price, it is necessary to have an idea of ​​the following terms:

  • Future value: It is the value that manages to reach a sum of capital at the end of a certain period. It could be said that it is the return that an investment capital will obtain in a future time.
  • Present value: It is the value that a capital that we will receive in the future has at this moment.

Continuing with the previous example, if we wanted to calculate the future value of the investment, we should apply the following formula:

FV = VA(1+i)

  • Where FV is equal to future value.
  • VA is equal to the current or present value and is $1,000.
  • i is equal to the interest rate on the principal, which in this case is 30%.
  • When operating, the formula will be: FV = VA(1+i) = FV = $1,000(1+0.3) = $1,300.

Then, to calculate the present value, the following formula would be used:

VA = FV/(1+i)

  • If we solve it, it will look like this: VA = FV/(1+i) = VA = $1,300/ (1+0.3) = $1,000

3. The price of the demand for the capital good must be known

On the other hand, it is necessary to know the demand price or the market value that the capital good will have. That is, the price at which the product is expected to be sold in the future or the price of the company’s shares in the capital market.

Continuing with our example, to calculate the future value of the demand for the investment good we should apply the following formula:

FV = VA(1+EMK)

  • When operating the formula will be: FV = VA(1+EMK) = 1,000$(1+0.3) = 1,300$.

Then, to calculate the present value, the following formula would be used:

  • VA = FV/(1+EMK)
  • If we solve it, it will look like this: VA = FV/(1+EMK) = VA = $1,300/ (1+0.3) = $1,000
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Marginal efficiency of capital

It is important to clarify that in this example we are equating the interest rate and the marginal efficiency of capital (both are 30%) because we are evaluating the point where the demand price and the supply price are equal. At that point no gains or losses are generated, it is the lower limit that is required to make the investment.

How do you find the marginal efficiency of capital?

An investment is made as long as the demand price or sale price of the good is greater than the offer price or cost price, that is, Pd > Po. The limit of investment is when Pd and Po are equal: Pd = Po.

  • The demand price is presented as the division between the profit and the interest rate: Pd = π/i
  • The supply price is represented as the division between the profit and the marginal efficiency of capital: Po = π/EMK
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