Calculate IRR: guide to evaluating investments

The internal rate of return (IRR) is one of the most commonly used financial indicators to evaluate the profitability of an investment. In practice, it is the interest rate that makes the net present value of a project’s cash flows equal to zero. In other words, it is the return an investment offers, expressed as a percentage. Now then, how do you calculate the internal rate of return? 

Here’s a heads-up: performing the calculation is not an easy task, but in this post, we’ll help you with some tips and practical examples. In addition, we’ll explain the drawbacks of the IRR and how to interpret the result. Keep reading! 

What do you need to calculate the internal rate of return?

Before starting with the calculation steps, it’s important to know that the IRR is very useful for understanding the minimum return you should demand for an investment to be profitable. Moreover, if you’re unsure whether to accept a project or not, the IRR can help you make decisions depending on whether it’s higher or lower than the opportunity cost or discount rate.  

As for the calculation, here’s some good news: there are computer tools that make it easier to calculate the IRR, such as Excel, financial calculators, or spreadsheet programs. These tools usually include a specific function to calculate the IRR, which typically requires the following data: 

• The initial value of the investment, entered as a negative number since it represents an outflow of money. 
• The expected cash flows from the investment, entered as positive numbers since they represent income or inflows of money. 
• The number of periods the investment lasts, which can be annual, monthly, or quarterly. 

In the next section, we’ll explain the concept of IRR and its calculation in more detail with an example. 

Example of internal rate of return calculation

Let’s suppose we want to invest in a company that requires an initial investment of €50,000 and will generate net profits of €15,000, €20,000, €25,000, and €30,000 over the next four years. What is the IRR of this investment? Let’s use the IRR function in Excel to find out:

1. In cell A1, enter the initial investment value. Remember, it must be negative: -50,000 euros. 

2. In cells A2, A3, A4, and A5, enter the net profits. 

3. In cell A6, enter the formula =IRR(A1:A5) 

The result that Excel will return from this formula is 0.2874. Converting this to a percentage, the IRR of this investment would be 28.74%.  

Next, we’ll explain in more detail how to determine whether the investment is profitable or not.  

Interpreting the internal rate of return result

Once the IRR of a project has been calculated, it’s necessary to interpret the result to decide whether to accept or reject the project. To do this, the IRR should be compared with the opportunity cost or discount rate, which is the minimum expected return from an investment. 

In general: 

• If the IRR is greater than the opportunity cost, the investment is profitable and the project should be accepted. 
• If the IRR is lower than the opportunity cost, the investment is not profitable and the project should be rejected. 
• If the IRR equals the opportunity cost, the investment is indifferent and the project may be accepted or rejected. 

Continuing with the previous example, if the opportunity cost of this investment is 10%, then the IRR (28.74%) means that it’s profitable, and the project should be accepted. 

Drawbacks of the internal rate of return

Finally, although the IRR is a widely used indicator, it does have some drawbacks to consider:  

• It may yield incorrect or misleading results when a project’s cash flows change sign more than once — that is, when there are alternating inflows and outflows of money.  
• If projects with different durations or different investment sizes are compared, the results of the net present value may be inconsistent or contradictory.  
• The IRR assumes that the cash flows generated by a project are reinvested at the same interest rate as the IRR, which may not be realistic or optimal.  

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