What is Incremental IRR?

Incremental IRR Analysis

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

  • Incremental IRR analysis is a technique that is used to determine if an incremental expenditure should be made. Incremental analysisIncremental AnalysisIncremental analysis is the financial analysis undertaken by the company to evaluate the available options and improve profitability by optimizing the capacity utilization and workforce of the business.read more 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 the other is cheap, the IRR for an expensive project is calculated to find the extra potential of the investment and helps investors analyze that investing extra amount will be profitable or not. It also assists an investor in calculating risk, and through this, investors 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 the best investment opportunity, and preferably it should be an expensive one if incremental IRR is higher than the hurdle return. Still, one thing to be considered is qualitative issues leads to an increase in risk. Therefore, an investor must consider various types of factors that affect 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 involved. Before making any decision, the rate of return and risk are two-component, which helps one analyze the potential investment. It can be possible that an investor yields an average rate of returnAverage Rate Of ReturnAverage Rate of Return (ARR) is the expected rate of return on an investment or asset divided by the initial investment cost or average investment during the project’s life. The formula for calculating the average rate of return is: Average annual net earnings after taxes/Initial investment * 100%read more and low risk and another investment has a high return of return and high risk here; investors can adjust for this risk by increasing the minimum return considerably accepted.

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:-

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 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.

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 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.

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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