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 IRR/NPV can be calculated by using Excel IRR/NPV functions.
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.
You can also download the Incremental IRR Workbook FREE!
This is great way to analyse two competing projects, thanks for sharing.
So useful explanation! Very happy with the examples.
Modified irr mean?
it is better to give the mathematical explanation also with the theoretical explanation over the line “If the incremental IRR is higher than the minimum return you consider acceptable, you should take project 2 i.e. project with higher investment.” here you should indicate which is the minimum return
The profitability index method is giving me an otherwise result.
project 1 (1.13) is more attractive than project 2 (1.11)
PI is favouring the project with the higher IRR. However the NPV is in contrast supporting the project with the higher overall NPV.
If the nature of the project is as such that it can be duplicated (i.e. a product sold twice), then project 1 will be more attractive as investing in it with the same amount as project 2 will result in a higher NPV (257) and IRR (13.27%).
What happens when we have more than 2 projects?
even unlimited alternatives just you need to get the result of IRR from each alternative and compare it with your acceptable interest rate. if the IRR is lower than your acceptable interest rate then reject the alternative and if above acceptable interest rate then accept the alternative. if you have a lot of alternatives and all of them are acceptable the just accept the highest IRR from your alternatives
this was very helpful to me, thanks for your contribution.
What about if we have to make decision among three projects?
select the highest IRR
“If the incremental IRR is higher than the minimum return you consider acceptable, you should take project 2 i.e. project with higher investment.?
Its not clear about what minimum return is acceptable.Please explain.
for example : IRR
Can you please explain which project should I invest, when I get incremental IRR =0?
What should i do when i get incremental irr as 0%