What Is an Unconventional Cash Flow?
Let me explain what an unconventional cash flow is. It's a series of inward and outward cash flows over time where the direction changes more than once. This is different from a conventional cash flow, which only has one change in direction.
Key Takeaways
- An unconventional cash flow means a shift in a company's cash flow direction over time, from inward to outward or vice versa, happening more than once.
- It makes capital budgeting tough because you end up with more than one internal rate of return (IRR).
- Most projects stick to conventional cash flows: one outflow for the initial investment, followed by multiple inflows from revenues.
Understanding an Unconventional Cash Flow
In mathematical terms, where a minus sign shows an outflow and a plus sign shows an inflow, an unconventional cash flow might look like -, +, +, +, -, +, or +, -, -, +, -, -. This means the first group has a net inflow, and the second has a net outflow. If these represent cash flows in different financial quarters, you're dealing with an unconventional cash flow for the company.
You model cash flows for net present value (NPV) in a discounted cash flow (DCF) analysis during capital budgeting. This helps decide if the initial investment in a project is worth it compared to the NPV of future cash flows from that project.
Unconventional cash flows are harder to manage in NPV analysis than conventional ones because they create multiple internal rates of return (IRR), based on how many times the direction changes.
In real scenarios, you'll find plenty of unconventional cash flows, especially in big projects with periodic maintenance requiring large capital outlays. Take a large thermal power generation project projected over 25 years: outflows in the first three years for construction, inflows from years four to 15, an outflow in year 16 for maintenance, then inflows until year 25.
Challenges Posed by an Unconventional Cash Flow
A project with conventional cash flow begins with a negative cash flow during the investment period—one outflow for the initial investment—followed by positive cash flows that are all inflows from revenues.
From this setup, you can calculate a single IRR and compare it to your company's hurdle rate to assess if the project is economically viable. But if there's another negative cash flow set later on, you'll get two IRRs, creating uncertainty for management. For instance, if the IRRs are 5% and 15% with a 10% hurdle rate, you won't have the confidence to proceed with the investment.
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