Incremental Benefits: The Scale Problem
The IRR method’s recommendations for mutually exclusive investments are less reliable than are those that result from the application of the NPV method because the former fail to consider the size of the investment. Let us assume that we must choose one of the following investments for a company whose discount rate is 10%: Investment A requires an outlay of $10,000 this year and has cash proceeds of $12,000 next year; investment B requires an outlay of $15,000 this year and has cash proceeds of $17,700 next year. The IRR of A is 20%, and that of B is 18%.
A quick answer would be that A is more desirable, based on the hypothesis that the higher the IRR, the better the investment. When only the IRR of the investment is considered, something significant is left out¾and that is the size of the investment. The important difference between investments B and A is that B requires an additional outlay of $5,000 and provides additional cash proceeds of $5,700. Table 1 shows that the IRR of the incremental investment is 14%, which is clearly worthwhile for a company that can obtain additional funds at 10%. The $5,000 saved by investing in A can earn $5,500 (a 10% return). This is inferior to the $5,700 earned by investing an additional $5,000 in B.
Figure 1 shows both investments. It can be seen that investment B is more desirable (has a higher present value) as long as the discount rate is less than 14%.
We can identify the difficulty just described as the scale or size problem that arises when the IRR method is used to evaluate mutually exclusive investments. Because the IRR is a percentage, the process of computation eliminates size; yet, size of the investment is important.