Incremental IRR is a way to analyze the financial return when there are two competing investment opportunities involving different amounts of initial investment.
In this post we will explore how to calculate incremental IRR and how it helps in deciding between two projects with different investment.
Let's consider a project with following cash flow stream:
Assume 10% discount rate.
The project IRR is 13.27% and the NPV is 128.5.
Now let's consider another project with following cash flow stream:
The IRR for this project is 12.78% and the NPV is 220.1.
So which project should we take? If you notice, the initial investment for the second project is twice the investment required for the first project.
In such situations 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 the incremental cash flow is 12.29% and the NPV is 91.7.
So what should we do? Should we take project 1 or project 2?
If the incremental IRR is higher than the minimum return you consider acceptable, you should take project 2 i.e. project with higher investment.
However, qualitative issues must be considered before making any investment decision. There may be an incremental risk associated with the more expensive investment option.
Hope you enjoyed this post on incremental IRR. If you have any questions, let me know through the comment section below.
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