What Is Marginal Rate of Return?
The marginal rate of return is a term that is used to identify the rate of return that is generated if a single unit is added to the current process, in comparison with choosing to maintain the status quo or taking some other type of action that exerts some effect on the returns realized. This type of calculation can aid investors as well as businesses in deciding what course of action to take and ultimately achieving the highest degree of overall benefit. When accurately predicted, the marginal rate of return can increase the chances for generating profit, reducing the possibility of loss, and essentially making the return on investment more appealing.
One of the easiest ways to understand how a marginal rate of return functions is to consider a property owner who is attempting to decide if holding onto a piece of real estate for another calendar year is the best approach, or if selling now would be a better strategy. In order to determine the marginal rate of return that would be generated by the sale, it is important to first identify how much the property could be sold for today. From there, it is necessary to project if the property will appreciate in value over the next year and if that appreciation is likely to lead to some sort of increased demand for the property. The owner must also allow for the benefits that may be derived from selling now and using the proceeds to settle debts that are accruing interest on an ongoing basis, the cost of upkeep on the property, and other factors that would impact the actual benefit derived from the ownership.
If the calculations indicate that the property will be worth 25% more one year from now, even allowing for the benefits of selling now rather than later, then the property owner may decide the marginal rate of return is sufficient to merit holding onto the property for another 12 months. At the same time, if there is some appreciation in value but not enough to offset the benefits associated with selling now rather than waiting a year, the marginal rate of return may be considered insufficient, indicating that overall the best approach would be to sell the property as soon as possible.
It is important to remember that in identifying the marginal rate of return, a number of factors must be taken into consideration. This includes evaluating the overall impact that the decision will have not only on the asset in question, but also on the other assets and liabilities currently held. To some degree, some of these factors may not be strictly financial. For example, if there is very little difference in what an owner could expect to earn from selling a house now rather than in a year, the fact that the money would be enough to buy a smaller, more energy-efficient home plus pay off some pressing debts may yield not only financial benefits but also provide an increase in the peace of mind and quality of life for the homeowner.
Discuss this Article
Post your comments