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Incremental rate of return typically refers to a rate of return on an investment that is positive, as the word “incremental” indicates an additive value. This can refer to a standard rate of return that is expressed as a positive value, which would mean that a profit has been made on an investment. An incremental rate of return can also be used in a more specific sense, such as an incremental internal rate of return. This may be a rate of return based on a comparison between two potential investments, in which one usually requires a greater investment upfront with less long-term investment required.
Though it can apply to many different types of investments, an incremental rate of return typically means that the overall return on an investment is positive. The rate of return on an investment is fairly easy to determine, as it requires only that the return on an investment be subtracted from the capital investment, and then this is divided by the capital and turned into a percentage. An initial investment capital of $100 US Dollars (USD), for example, with a return of $150 USD would have a rate of return of 50%, as this is the difference between the capital and the return, as a percentage of the original capital. Since this is a positive value, it could then be called an incremental rate of return for the investment.
In some situations, however, an investment may not have an incremental rate of return. If an investment has a capital of $100 USD, and the return is only $75 USD, then the rate of return on that investment would be -25%. As the term “incremental” indicates additional or positive growth, this type of investment would yield a negative rate of return.
There are also specific types of incremental rate of return, such as an incremental internal rate of return. This term is used to refer to a rate of return on an investment that is positive over time when related to the initial capital that may be required, and is often used in comparing two different potential investments. A company considering the purchase of a piece of equipment compared to leasing that equipment, for example, often performs an analysis on long-term costs involved in either option. If purchasing the equipment, which often has a greater initial cost, is ultimately more profitable an investment than the long-term investments of a lease would be, then that positive rate can be called an incremental internal rate of return.