Incremental IRR: Resolving NPV and IRR Conflicts

Imagine you’re choosing between two fantastic investment opportunities for your business. Let’s say Project A is a smaller venture, perhaps upgrading your existing equipment, while Project B is a larger undertaking, like building a new facility. You’ve run the numbers and found something interesting: Project A has a higher Internal Rate of Return, or IRR, but Project B has a higher Net Present Value, or NPV. This is where things get a little confusing because both are excellent metrics for evaluating projects.

NPV, or Net Present Value, essentially tells you the total value a project adds to your company in today’s dollars. Think of it as the net profit of the project, considering the time value of money. A higher NPV is generally better because it means more wealth creation.

IRR, or Internal Rate of Return, on the other hand, represents the percentage return you expect to earn on your investment. It’s like the interest rate your project is generating. A higher IRR is also generally preferred as it suggests a more efficient use of capital.

So, why would these two metrics ever disagree? The conflict often arises when comparing projects of different scales. Imagine you have two lemonade stands. Stand 1 is a small, basic stand. It requires a small investment but generates a high percentage return – say, 30% IRR – and a modest NPV of $500. Stand 2 is a deluxe, super-efficient stand. It requires a larger investment but, while its percentage return is lower, perhaps 20% IRR, it generates a much larger total profit, giving it a higher NPV of $1000.

In this scenario, IRR would favor Stand 1 because of its higher percentage return, making it seem like the better investment. However, NPV would favor Stand 2 because it ultimately adds more value to your lemonade empire with a larger dollar profit. This is the core conflict: IRR focuses on efficiency, while NPV focuses on absolute value creation.

This is where the concept of incremental IRR comes to the rescue, particularly when dealing with mutually exclusive projects. Mutually exclusive means you can only choose one project; choosing one automatically means you cannot choose the other. In our lemonade stand example, you can only build one stand, not both.

Incremental IRR helps you decide if it’s worth investing the extra money to move from the smaller project to the larger project. It asks: What is the return you get on the additional investment required for the bigger project?

To calculate the incremental IRR, you first find the difference in cash flows between the two projects. In our lemonade stand example, you would subtract the cash flows of Stand 1 from the cash flows of Stand 2. This gives you the incremental cash flows, representing the extra investment and extra returns associated with choosing the larger project.

Then, you calculate the IRR of these incremental cash flows. This incremental IRR represents the return you are earning specifically on the additional investment needed to go from the smaller project to the larger one.

Let’s say the incremental IRR between Stand 2 and Stand 1 is calculated to be 15%. Now, you need to compare this incremental IRR to your company’s required rate of return, also known as the hurdle rate. This hurdle rate is the minimum return your company expects to earn on its investments. If your hurdle rate is, say, 10%, and the incremental IRR is 15%, it means that investing the additional amount to build Stand 2 earns a return of 15%, which is higher than your required 10%. In this case, the incremental IRR analysis supports choosing Project B, the larger project, despite its lower overall IRR, because the additional investment is still generating an acceptable return and leads to a higher NPV.

In essence, incremental IRR bridges the gap between NPV and IRR by focusing on the return on the difference between projects. It helps you determine if the higher NPV of a larger project is worth the extra investment required, even if the larger project has a lower overall IRR. It’s about ensuring that the additional investment is justified by the additional return, ultimately leading to a decision that maximizes value creation for your business, as reflected by the NPV. So, when faced with conflicting signals from NPV and IRR for mutually exclusive projects, incremental IRR provides a valuable tool for resolving the conflict and making a sound investment decision.