The Incremental IRR
Despite their apparent wealth maximization defects, IRR project rankings that conflict with NPV
can be brought into line by a supplementary IRR procedure whereby management:
Determine the incremental yield (IRR) from an incremental investment,
which measures marginal profitability by subtracting one project’s cash
inflows and outflows from those of another to create a sub-project
(sometimes termed a ghost or shadow project).
To prove the point, let us incremental the data from Section 3.1.Two projects that not only
differ with respect to their cash flow patterns ( size and timing ) but also their investment cost.
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 IRR(%) NPV
15% (10%)
1 less 2 (35) (30) - 20 40 50 11.1
You will recall that IRR maximization favored a higher percentage return on the smaller more
liquid investment (Project1), whereas NPV maximization focused on higher money profits
overall (Project 2). Now see how the incremental IRR (15%) on the incremental investment
(Project 1 minus Project 2 = £35k) exceeds the discount rate (10%) so Project 1 is accepted.
Moreover, this corresponds to Equation (1) on single project acceptance. The incremental NPV is
positive (£11.1k) because its discount rate r < incremental IRR.
Despite their apparent wealth maximization defects, IRR project rankings that conflict with NPV
can be brought into line by a supplementary IRR procedure whereby management:
Determine the incremental yield (IRR) from an incremental investment,
which measures marginal profitability by subtracting one project’s cash
inflows and outflows from those of another to create a sub-project
(sometimes termed a ghost or shadow project).
To prove the point, let us incremental the data from Section 3.1.Two projects that not only
differ with respect to their cash flow patterns ( size and timing ) but also their investment cost.
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 IRR(%) NPV
15% (10%)
1 less 2 (35) (30) - 20 40 50 11.1
You will recall that IRR maximization favored a higher percentage return on the smaller more
liquid investment (Project1), whereas NPV maximization focused on higher money profits
overall (Project 2). Now see how the incremental IRR (15%) on the incremental investment
(Project 1 minus Project 2 = £35k) exceeds the discount rate (10%) so Project 1 is accepted.
Moreover, this corresponds to Equation (1) on single project acceptance. The incremental NPV is
positive (£11.1k) because its discount rate r < incremental IRR.
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