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 investment.
- Incremental IRR analysis is a technique that is used to determine if an incremental expenditure should be made. Incremental analysis can also be used when one already incurred an expense and he wants to determine if it is a good decision to spend additional funds.
- When investors analyze two potential investments, where one is expensive and other is cheap then IRR for expensive project is calculated to find the extra potential of the investment and help investor analyze that investing extra amount will be profitable or not and it also helps investor to calculate risk and through this investor decide where expensive investment will yield potential return or not considering additional cost and risk. Here, IRR basically calculates the potential investment and profit which expensive investment can make. If the IRR is higher than the minimum acceptable rate of return, the more expensive investment is considered the better one.
- As per the analysis, one needs to select best investment opportunity and preferably it should be an expensive one if incremental IRR is higher than the hurdle return but one thing to be considered is qualitative issues leads to increase in risk. Therefore, an investor must consider various types of factors that effect IRR and before making an investment decision.
- This rate of return may or may not be the deciding factor in making an investment decision as there is always risk involve and before making any decision rate of return and risk are two component which helps one to analyze potential investment and it can be possible that an investor yield average rate of return and low risk and other investment has high return of return and high risk here investor can adjust for this risk by increasing the minimum return considerable accepted.
How to Calculate Incremental IRR?
There are two projects with a different investment. Let us consider a project with cash flow stream for both investment projects. Assuming a 10% discount rate.
The IRR/NPV can be calculated in Excel by using a function of IRR & NPV, whereas NPV is net present value.
Investment A project has below cash flow:-
The IRR for this cash flow is 14%
And the NPV is 193.10.
Investment B project has below cash flow:-
The IRR for this cash flow is 13%
and the NPV is 1210.
As investment project B cost more than A, then we should calculate incremental IRR. It is defined as the internal rate of return of the incremental cash flows.
The incremental cash flow is the difference between the cash flows of the two projects.
The IRR for incremental cash flow is 11%
and the NPV is 310.
- Thus, incremental IRR is a way to analyze the financial returns when there is two competing investment opportunity involving different amounts of 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.
ACME prints are considering obtaining a color printer and it can do so either with a lease or by purchase. The rent or lease of such product involves a payment every year for the three-year useful life of the printer, while 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 same buy option is having positive incremental IRR. This purchase option is best then lease option.
Here, in the analysis of 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 flow. 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 amount.
This 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 –