# How to Calculate Marginal Efficiency of Capital

Marginal efficiency of capital (MEC) is the discount rate at which the present value of the future yields from a capital asset are equal to its cost of acquisition. The idea behind computing the MEC of a potential investment is to learn the relationship between the projected rate of return (profits) an asset could generate versus its initial cost. In other words, MEC determines how much additional output (profits) an investment yields. Marginal productivity of capital, natural interest rate, net capital productivity and rate of return over cost are other names for MEC.

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Determine the acquisition cost of a new investment. If the investment under consideration is a new piece of equipment, the total acquisition cost of the equipment includes its negotiated price and all of the costs to put it in place ready to operate. If the acquisition is an intangible asset, such as intellectual property, its acquisition cost includes all costs to transfer its ownership.

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Determine the service life and future profits from the investment. The service life or usable life of an asset determines the number of years of profits possible from its investment. If a new piece of equipment has a service life of eight years, then the MEC calculation considers eight years of profits.

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Calculate future profits from investment. In determining the amount of profits (contributions) a new investment can generate over its service life, many factors come into play. The primary consideration is capacity and how much additional production capacity the investment provides. For example, if the investment adds 20 percent additional capacity, profits should increase at least 20 percent, assuming demand exists for all produced goods.

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Calculate MEC. Divide the sum of the projected profits from the investment (over the item's service life) by the total investment under consideration. For example, if the projected profits from the eight years of service life of new equipment is $32,000 ($4,000/year) and the total cost of the item is $560,000, the MEC is 5.7 percent. However, the MEC should reflect the present value (PV) of the flow from the service life of each of the items, so that the comparison is made in today's values. Most financial calculators and electronic spreadsheet software include a function to compute the present value of an item, which requires the use of the current interest rate.

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Compare present value MEC to current interest rate. The result of the MEC using present values for all profit flows should exceed the current interest rate. If it doesn't, the investment may not be wise considering that merely depositing the investment would yield the same return. When the MEC exceeds the current interest rate, the investment should provide a reasonable return, if all included factors are accurate. However, a comparison of this investment opportunity to other opportunities available should identify the better investment.

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Tips

- MEC is only as accurate as the projections of future profits from an investment. Consider all costs of operation and the yields of the investment in projecting future flows.
- Avoid the tendency of investment analysts to understate operational costs, down time, operating training, repair and maintenance when projecting the future cash flows from new assets.

Writer Bio

Ron Price, MBA, has extensive senior level experience in business, information technology, and education. Under his pen name Ron Gilster, Price has written over 40 books for several leading publishers on a topics ranging from business and finance to IT certifications to real estate.