Interest rate, expected return and investment
Investment, the purchase of capital, leads to economic growth. The fund for investment comes from various sources, but the main sources are the shareholders and the bank. A firm may raise additional finance by selling shares to both existing and new shareholders. This method is really beneficial to the company because it is a permanent source of finance – the company does not return the money. Also, there is no need to pay interest because shareholders are owners of the business, not lenders.
However, as good as this method appears, it may not provide enough money to allow the business to take advantage of business opportunities. Firstly, the company may not be able to raise enough money from the sale of shares if there is apathy toward stocks because the stock market has crashed. Secondly, the existing shareholders may be against the idea of bringing in new shareholders because they want to avoid losing control, a situation known as equity dilution. Thirdly, it may not be able to raise enough money, necessitating borrowing from the bank.
The loan from the bank comes at a cost – interest rate. The company must return more than what it borrowed. The extra amount over the principal is the interest. If the interest rate (stated in percentage) is high, borrowing is expensive, discouraging investment, while a low interest rate makes borrowing cheaper.
In reality, businesses do not just consider whether the interest rate is high or low. Rather, they usually compare it with the expected return on the investment. Expected return is expected profit on investment, and it is also stated in percentage form. The company will only agree to take the loan if the expected return from the investment is equal to or greater than the interest rate. For example, the company will not take the loan if the expected return is 5% but the interest rate is 8%. Comparing expected return with interest rate as a condition for borrowing for investment is a concept known as the Marginal Efficiency of Capital in Economics.
What is Marginal Efficiency of Capital (MEC)?
According to Keynes, MEC is the discount rate that will equate the sum of the present values of expected returns over an asset’s lifetime to the supply price (or capital cost). The marginal efficiency of capital is simply the maximum rate of return that can be expected from an additional unit of capital over its lifetime.
Calculation of MEC
It is the ratio of the expected return of additional capital and the cost. If an additional unit of capital is $1,000, and the annual return is $300. The MEC is:
300
____ x 100 = 30%
1000
In reality, the returns from a project extend beyond a single year. Future returns are susceptible to uncertainty and inflation. For example, $100 now is worth more than $100 in 1 year. Future returns are, therefore, converted to what they are worth today, that is, their present values.
Marginal Efficiency of Capital is the rate at which the sum of the present value of expected returns from an asset is the same as the cost of the asset. Thus, MEC is:
Where
C = Cost of capital
R1, R2, R3, R4 = Expected returns in years 1, 2,3 and 4
k = Discount rate or MEC
Normally, a firm buys an asset if the present value is greater than the capital cost or supply price. It implies that if MEC is equal to or greater than the interest rate, the firm can borrow to finance it because it is worthwhile.
Limitations of the Marginal Efficiency of Capital (MEC)
Expected returns
One of the limitations of MEC is the use of expected returns or yields for future years, as the benefits of a project usually extend beyond a single year. Returns expected in the future cannot be forecast accurately because the future is uncertain and changes in the economic environment may make it difficult for those returns to be realised. In other words, the future return may vary widely from what is expected or may not be realised at all. Competitive pressure, technology, and regulations may change, making it difficult for predicted returns to materialise.
Business confidence
MEC is compared with the interest rate to determine the desirability of an investment project. However, interest rate is just one of those factors that determine the level of investment in an economy. For instance, business confidence or the optimism businesses have about the economy also determines investment. If firms have low confidence about the prospects of the economy, they will refuse to borrow for investment even if the rate of interest is low. It may be because of a volatile political environment, such as political instability, unstable government policies, etc.
Gross Domestic Product (GDP)
The GDP can be used to estimate the expected sales level by a firm. Rising GDP means that output is increasing. It implies that more people are being employed and incomes are rising. The sales level is expected to increase if GDP increases, thereby encouraging investment. If estimated sales are low owing to falling GDP, investment decreases, no matter how low the interest rate is. It will only be profitable if sales revenue is enough to cover the cost of investment.
Firms may be irrational
One of the assumptions of economic theory is rationality. A rational business tries to maximise profit. But because firms do not have access to perfect information to determine costs, benefits and profits, they may not want to maximise profit or expected return on investment. A business, therefore, may focus on other objectives rather than returns, e.g. revenue maximisation, environmental objective, etc.
Inflation rate
The interest rate is usually subtracted from the nominal interest rate to determine the real interest rate. If the inflation rate rises, the real interest rate falls, encouraging borrowing and investment. But if the interest rate falls, borrowing is discouraged as the real interest rate increases.
The expected inflation rate also affects investment. If businesses anticipate a high inflation rate, they can cut down on investment as their costs are expected to rise. Increasing expected costs will translate to low profits, thereby discouraging investment.
Some projects are large and indivisible
MEC is the expected return from undertaking an additional unit of capital. However, some projects are large and indivisible. They cannot be undertaken in parts; it is either the whole project is handled or postponed. Therefore, a firm cannot estimate the expected return from embarking on an additional unit of these projects.