Question

a) What is incremental rate of return analysis ΔIRR?

b) When is ΔIRR used?

c) When setting up a ΔIRR analysis, which alternative is the minuend?

d) What is the criteria for ΔIRR if borrowing?

e) What is the criteria for ΔIRR is investing?

Answer 1

The incremental internal rate of return is an analysis of the financial return to an investor or entity where there are two competing investment opportunities involving different amounts of investment. The analysis is applied to the difference between the costs of the two investments. Thus, you would subtract the cash flows associated with the less expensive alternative from the cash flows associated with the more expensive alternative to arrive at the cash flows applicable to the difference between the two alternatives, and then conduct an internal rate of returnanalysis on this difference.

One popular use of IRR is in comparing the profitability of establishing new operations with that of expanding old ones. For example, an energy company may use IRR in deciding whether to open a new power plant or to renovate and expand a previously existing one. While both projects are likely to add value to the company, it is likely that one will be the more logical decision as prescribed by IRR.

Miscalculating using IRR in this way may lead to the belief that a project is more profitable than it actually is. This, along with the fact that long projects with fluctuating cash flows may have multiple distinct IRR values, has prompted the use of another metric called modified internal rate of return (MIRR). MIRR adjusts the IRR to correct these issues, incorporating cost of capital as the rate at which cash flows are reinvested, and existing as a single value. Because of MIRR’s correction of the former issue of IRR, a project’s MIRR will often be significantly lower than the same project’s IRR.

Corporations use IRR in capital budgeting to compare the profitability of capital projects in terms of the rate of return. For example, a corporation will compare an investment in a new plant versus an extension of an existing plant based on the IRR of each project. To maximize returns, the higher a project's IRR, the more desirable it is to undertake the project. If all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first.

Internal rate of return for borrowing the interest rate paid on the unpaid balance of a loan such that the payment schedule makes the unpaid loan balance equal to 0 when the final payment is made.

The IRR rule is a guideline for evaluating whether to proceed with a project or investment. The IRR rule states that if the internal rate of return (IRR) on a project or an investment is greater than the minimum required rate of return, typically the cost of capital, then the project or investment should be pursued. Conversely, if the IRR on a project or investment is lower than the cost of capital, then the best course of action may be to reject it.

The higher the IRR on a project and the greater the amount by which it exceeds the cost of capital, the higher the net cash flows to the investor. The IRR rule is used to evaluate projects in capital budgeting, but it may not always be rigidly enforced. For example, a company may prefer a project with a lower IRR over one with a higher IRR because the former provides other intangible benefits, such as being part of a bigger strategic plan or impeding competition. A company may also prefer a larger project with a lower IRR to a much smaller project with a higher IRR because of the higher cash flows generated by the larger project.