IRR Explained with Simple Examples (Apples and Pears)
If you’ve ever heard about the Internal Rate of Return (IRR), it might have sounded like something only analysts care about. In reality, IRR is a very practical tool for any business owner, founder, or manager who needs to decide where to put money and time.
Here’s the “apples and pears” version: what IRR is, why it matters, how to calculate it in Excel, and how to read it without drowning in formulas.
What is IRR?
The Internal Rate of Return (IRR) is a profitability metric that tells you the average annual return of an investment or project.
Imagine you lend €100 and one year later you get €110 back. You earned 10%. In that simple case, the IRR is 10%.
Now think about a business project where you invest upfront and you recover the money gradually over several years. IRR helps you answer: “What yearly return am I getting when I consider every cash flow of the project?”
Why does it matter?
Because it helps you answer questions like:
- Is this project worth it compared to other options?
- Does it beat my minimum required return (cost of capital)?
- Am I using the company’s money well?
Real life has limited resources (cash, time, people). When you must choose between projects, IRR gives you a percentage that makes comparisons easier across different timelines and cash-flow patterns.
A practical example: a fruit shop 🍎🍐
Imagine you run a fruit shop and you’re choosing between two projects:
- Project A: buy an industrial fridge for €1,000. It lets you sell more fresh fruit and earn €400 extra per year for 3 years.
- Project B: install an automatic juice machine, also €1,000, generating €300 per year for 5 years.
Both recover the initial investment, but Project A will usually have a higher IRR because you get your money back faster and over a shorter period. That often makes it more attractive in annual-return terms.
How to calculate it (without heavy formulas)
You don’t need to memorize the math. You can calculate IRR with Excel or Google Sheets.
In Excel, list the cash flows by year (the initial investment as a negative number, the inflows as positive numbers) and use:
=IRR(...)
(In some locales you may see different function names; the logic is the same.)
Example cash flows:
| Year | Cash flow (€) |
|---|---|
| 0 | -1000 |
| 1 | 400 |
| 2 | 400 |
| 3 | 400 |
How to interpret IRR
- If IRR is higher than your cost of capital (or your minimum required return), the project creates value.
- If IRR is about the same, you’re basically just getting your money back.
- If IRR is lower, the project doesn’t compensate and destroys value.
IRR vs other financial metrics
IRR vs NPV (Net Present Value)
- IRR gives you a percentage.
- NPV tells you how much value you create in euros.
They complement each other. A high IRR with a tiny NPV might not be worth the effort (and the opposite can also happen).
IRR vs ROI (Return on Investment)
ROI is usually simpler, but it doesn’t account for time. IRR does, which is why it’s more useful when cash flows happen over several years.
IRR limitations
IRR is useful, but it has limits:
- It assumes reinvestment at the same IRR rate (often unrealistic).
- With intermediate negative cash flows, you can get multiple solutions.
- A project with a higher IRR can still create less total value than a lower-IRR project with a higher NPV.
That’s why IRR works best alongside other metrics, not alone.
When to use IRR in your company
- To evaluate investments: equipment, expansion, new products.
- To prioritize internal projects by expected profitability.
- To compare alternatives with different time horizons.
- To justify decisions to partners or investors with clear numbers.
IRR isn’t reserved for experts. It’s simply a way to put an “annual return percentage” on your decisions. And if you’re going to invest, knowing it changes the game.
Next time you evaluate an investment, ask: what’s the IRR? Investing without it is like driving without a map.