Incremental IRRDefined along with Formula & How to Calculate

Lisa Borga
Last Updated: May 13, 2022
Date Published: May 13, 2022

What is Incremental IRR?

The incremental internal rate of return (IRR) refers to a form of analysis that compares the financial return of two potential investments with different cost structures.

It is used when a company wants to determine if an incremental expenditure should be made.

Although, the analysis can be made after an investment has already been made to see if a good decision was made.

incremental irr

Understanding the Incremental Internal Rate of Return

This analysis is done on the difference in costs of the two different investments being considered.

If an investor is trying to decide between two investments, the incremental rate of return should be computed so the investor can determine whether or not the extra amount they would need to invest would result in a profit.

This analysis also helps investors or companies consider the risks and costs involved in an investment so as to help them decide if the investment should be pursued.

The incremental rate of return will be used to compute the profit that can be made on the more expensive investment of the two investments being considered.

If the IRR for the more expensive investment is above what an investor or company considers an acceptable rate of return, the more expensive investment is generally the better choice.

Limits of Incremental Internal Rate of Return

It is essential to consider other issues that could cause increased risk.

So, it’s always best to look at any factors that may impact the incremental internal rate of return before making a final choice on which investment is better.

Although the incremental internal rate of return is a useful tool for assessing investments, not all investment decisions should be based on it.

Investments can have a very high rate of return and yet be very risky.

Risk should always be considered.

One way to account for this risk is to increase the rate of return that is considered acceptable for investments.

Calculating Incremental Internal Rate of Return

To find the incremental internal rate of return:

  • Find the project that has the higher initial investment (A) and the one that has the lower initial investment (B).
  • Subtract the lower initial investment (B) from the higher initial investment (A). This will give you the incremental initial investment.
  • Subtract the net cash flows of investment B from investment A. This will give you the annual incremental cash flows.
  • Calculate the incremental internal rate of return by comparing the incremental initial investment to the present value of the incremental cash flows.

Incremental Internal Rate of Return Example

Suppose a company is trying to decide whether to build a new store in Kansas or Indiana.

The company would need to invest $1 million to build a store in Kansas (Project A), and it will earn $1.5 million in the first year and $1.7 million in the second year.

Whereas the company would need to invest $2 million to build a store in Indiana (Project B), it would earn $3 million in the first year and $3.5 million in the second year.

The company’s acceptable rate of return is 11%.

The incremental initial investment for these two projects is $1,000,000 ($2,000,000 – $1,000,000).

The incremental cash flows are $600,000 ($900,000, – $300,000) for the first year and $660,000 ($980,000 – $320,000) for the second year.

Here is the equation for calculating the incremental internal rate of return.

The formula for calculating IRR is:

Internal Rate of Return = [(Cash flows) / {(1 + r)^i} – Initial Investment]

Where:

Cash flows = Cash flows in the time period

r = Discount rate

¡= Time period

0 = [{150,000 / (1 + IRR)^1} + {$180,000 / (1 + IRR)^2} – $1,000,000]

This equation can be solved by using the Excel IRR function, an online calculator, or trial and error.

The calculation gives an internal rate of return of 16.60%, which is above the company’s acceptable rate of return of 11%.

So, Project B would be considered the preferred project based on the incremental internal rate of return since it is the more expensive investment and has a return above the acceptable rate of return for the company.

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  1. Auburn University "Computer Notes on Incremental Analysis – Rate of Return " White paper. May 13, 2022

  2. The University of Texas El Paso "8.6 - Rate of Return Evaluation of Multiple Alternatives" Page 1 . May 13, 2022