Definition of unconventional cash flows

What is unconventional cash flow?

An unconventional cash flow is a series of cash flows in and out over time in which there is more than one change in the direction of the cash flow. This contrasts with a conventional cash flow, where there is only one change in the direction of the cash flow.

Understanding unconventional cash flow

In terms of mathematical notations, where the sign “-” represents an exit and “+” denotes an entry, an unconventional cash flow might appear as -, +, +, +, -, +, or alternatively, +, – , -, +, -, -. This would indicate that the first set has a net inflow of money and the second set has a net outflow of money. If the first set represented the cash flows of the first financial quarter and the second set represented the cash flows of the second financial quarter, the change in cash flow direction would indicate an unconventional cash flow for the business.

Cash flows are modeled for net present value (NPV) in a discounted cash flow (DCF) analysis in capital budgeting to help determine whether the initial capital cost of a project will be worth it compared to to the NPV of future cash flows generated by the project.

Unconventional cash flows are more difficult to manage in a NPV analysis than a conventional cash flow because they will produce multiple internal rates of return (IRRs), depending on the number of changes in the direction of the cash flows. .

In real life situations, examples of unconventional cash flow abound, especially in large projects where periodic maintenance can involve huge capital expenditures. For example, a large thermal power generation project where cash flows are projected over a 25-year period may have cash outflows during the first three years of the construction phase, inputs from the fourth to the 15th. year, one exit in the 16th year for scheduled maintenance, followed by entries up to year 25.

Challenges posed by unconventional cash flow

A project with a classic cash flow starts with a negative cash flow (investment period), where there is only one cash outflow, the initial investment. This is followed by successive periods of positive cash flow where all cash flows are inputs, which is the income of the project.

A single IRR can be calculated from this type of project, the IRR being compared to a company’s hurdle rate to determine the economic attractiveness of the planned project. However, if a project is subject to another set of negative cash flows in the future, there will be two IRRs, which will lead to decision uncertainty for management. For example, if the IRRs are 5% and 15% and the minimum rate of return is 10%, management will not have the confidence to make the investment.