Incremental IRR

What is Incremental IRR?

Incremental IRR or Incremental internal rate of return is an analysis of the return over investment done with an aim to find the best investment opportunity among two competing investment opportunities that involve different cost structures. As the costs of two investments is different, an analysis is done on the difference amount.

Incremental IRR Analysis

IRR is an internal rate of return; it is a tool to calculate the profitability of an investment.

How to Calculate Incremental IRR?

Example #1

There are two projects with different investments. Let us consider a project with a cash flow stream for both investment projects. You are assuming a 10% discount rate.

The IRR/NPV can be calculated in Excel by using a function of IRR & NPV, whereas NPV is the net present value.

Investment A project has below cash flow:-

Year012345Total
Cash Flow-1500200140560700800900

The IRR for this cash flow is 14%

Incremental IRR Example 1-1

And the NPV is 193.10.

Incremental IRR Example 1

Investment B project has below cash flow:-

incremental irr investmentB table1

The IRR for this cash flow is 13%

Incremental IRR Example 1-2

and the NPV is 1210.

Incremental IRR Example 1-3

As investment project B cost more than A, then we should calculate incremental IRR. It is defined as the internal rate of returnInternal Rate Of ReturnInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected.read more of the incremental cash flows.

The incremental cash flow is the difference between the cash flows of the two projects.

incremental irr diff bet A&B table1

The IRR for incremental cash flow is 11%

Incremental IRR Example 1-4

and the NPV is 310.

Incremental IRR Example 1-5
  • Thus, incremental IRR is a way to analyze the financial returns when there is two competing investment opportunity involving different amounts of the initial investment.
  • If investment IRR is higher than the minimum return, then one should take the project with higher investment (in this case, it is Project B)
  • However, a qualitative issue must be considered before making an investment decision. There may be an incremental risk associated with the more expensive investment option.

Example #2

ACME prints are considering obtaining a color printer, and it can do so either with a lease or by purchase. The rent or leaseLeaseLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.”read more of such a product involves a payment every year for the three-year useful life of the printer. In contrast, the purchase option involves continuing maintenance and cost of purchase, but one thing to consider is it is an asset, and it also has resale value.

The following analysis of the incremental differences between the two options which are available that is to buy or to get it on a lease. If we analyze, the same buy option has a positive incremental IRR. This purchase option is best then the lease optionLease OptionA Lease Option is an agreement between the lessor & the lessee where the latter can buy the property (commercial/residential) after paying up at the end of the lease term or after a particular period. read more.

Incremental IRR Example 2

Here, in analyzing two investment alternatives (one more expensive than the other), the return on the additional cost. It is computed as the internal rate of return on the incremental cash flowIncremental Cash FlowIncremental cash Flow is the additional cash inflow that a business might receive by acquiring a particular project. In other words, it is basically the resulting increase in cash flow from operations due to the acceptance of new capital investment or a project.read more. In this analysis, the alternative with an incremental internal rate of return higher than the minimum acceptable rate of return is considered the better choice.

Hence, incremental IRR is a way to analyze the financial return when there are two competing investment opportunities involving different investment amounts.

This article has been a guide to what is Incremental IRR Analysis. Here we discuss how to calculate incremental IRR using its formula along with practical examples in excel. You may also take a look at the below useful excel modeling articles –

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