Final answer:
The incremental IRR is determined by the rate at which the net present value of the incremental cash flows from Project A over B equals the initial investment difference. If the required rate of return exceeds the crossover rate, Project B should be selected.
Step-by-step explanation:
To calculate the incremental internal rate of return (IRR), we first need to find the incremental cash flows between Projects A and B. We do this by subtracting the cash flows of Project B from Project A. Then we can find the IRR of these incremental cash flows to determine the incremental IRR.
The incremental cash flows can be calculated as follows:
Initial Incremental Investment: $75,000 - $60,000 = $15,000
Year 1 Incremental Cash Flow: $33,000 - $25,000 = $8,000
Year 2 Incremental Cash Flow: $33,000 - $30,000 = $3,000
Year 3 Incremental Cash Flow: $33,000 - $25,000 = $8,000
The incremental IRR is the rate at which the present value of these incremental cash flows is equal to the incremental investment of $15,000. We would solve for 'r' in the following equation:
$15,000 = $8,000 / (1 + r) + $3,000 / (1 + r)² + $8,000 / (1+r)³
The IRR is found by iteratively trying different 'r' values until the right side of the equation equals $15,000.
If the required rate of return (hurdle rate) is higher than the crossover rate (which is where the NPVs of the two projects are equal), the project with the lower initial cost ('B' in this case) should be chosen, assuming the projects are mutually exclusive.