Q1. Why Marginal Efficiency of Investment is Weak

a.There are certain investment projects whereby the MEI produces more than one interest rate. This involves those projects that have a mixture of negative and positive cash flows. A good example is a project that involves marketers who need to reinvent their styles in order to remain relevant in their trendy niches. If such a project has an initial outlay of sh. -50,000 in the first year, returns of sh. 115,000 in the second year and costs amounting to sh. 66,000 in the third year since the marketing department needed to revise the outlook of the project, a single MEI cannot be used. This is because MEI provides the discount rate that enables a project to break-even. As a result, if market conditions change over time, the project will end up having more than one MEI. In the scenario above there are two MEIs; 0.1 and 0.2.

b.Another weakness associated with MEI is that it uses a single discount rate to evaluate every investment. This is a weakness because discount rates tend to change substantially over time. A good example is where an analyst uses rate of return of a Treasury bill in the last 20 years as the discounting rate. A one-year treasury bill has had a return of between 1% and 12% within this period, meaning that the discount rate is changing. Without modification, MEI does not account for changing discount rates. This means that it is not adequate for longer-term projects whose discount rates are expected to change.

c.MEI also has a weakness in that it cannot be used to evaluate an investment when the discount rate is not known. This is because the decision rule of MEI is dependent on its comparison to the existing discount rate. When the MEI is more than the discount rate, the project is regarded to be feasible, and when it is below, the project is not feasible.

Q2. Comparison of the Present Value and Marginal Efficiency of Investment Criteria

Similarities

a.Both recognize the concept of time value for money. This is the notion that money available at the present time is worth more than the same amount in future due to its potential earning capacity. It is a core principle of finance that, provided the money in question can earn interest, any amount of money is worth more the sooner it is received.

b.Both consider all the cash flows over the entire life of the project/investment.

c.Both are easy to use when making a decision regarding an investment. For the P.V, the PV of cash flows needs to be positive for it to be feasible. For the MEI criterion, the MEI needs to be more than the discount rate provided for the investment to be feasible.

d.Both favor projects/investments that generate more returns (benefits) in their early life.

Differences

a.The criteria tend to differ in their decision rule of acceptance or rejection of an investment. For the Present Value criterion, an investment is deemed appropriate if the PV is more than zero (its positive). If there exist mutually exclusive projects, the project with the highest PV is chosen. For MEI, it is compared with the existing discount rate. When the MEI is greater than the discount rate, then the investment is accepted.

b.PV criterion is effective when evaluating projects/investments with multiple positive and negative cash flows. MEI on the other hand is not effective in this respect since it tends to yield more than one interest rate.

c.Present Value criterion always uses currency in its calculations while the Marginal Efficiency of Investment is expressed in terms of percentage.

Do you need an Original High Quality Academic Custom Essay?