What Is an Unconventional Cash Flow?
An unconventional cash flow is a sequence of inward and outward financial flows with several direction changes over time. In contrast, with a typical cash flow, the direction of the cash flow changes just once.
Comprehending Non-Traditional Cash Flow
If we were to describe an unusual cash flow mathematically, where “-” stands for an outflow and “+” for an inflow, it may look like this: -, +, +, +, -, +, or perhaps like this: +, -, -, +, -, -. This would suggest a net cash inflow for the first group and a net cash outflow for the second. The shift in the cash flows’ direction would point to an unusual cash flow for the firm if the first set reflected cash flows in the first financial quarter and the second set represented cash flows in the second financial quarter.
In capital budgeting, cash flows are modeled for net present value (NPV) in a discounted cash flow (DCF) analysis to assess whether the project’s original investment cost would be justified based on the project’s future cash flows’ NPV.
Since unconventional cash flows may create various internal rates of return (IRR), depending on how often the flow direction changes, they are more challenging to manage in an NPV analysis than conventional cash flows.
Examples of non-traditional cash flows in real life are common, particularly in major projects where considerable capital expenditures may be required for periodic maintenance. For instance, cash outflows during the first three years of the construction phase, inflows from years four to fifteen, an outflow for scheduled maintenance in year sixteen, and inflows until year twenty-five could be observed in a large thermal power generation project whose cash flows are projected over 25 years.
Difficulties Raised by an Unusual Cash Flow
A typical cash flow project begins with a negative (investment phase) cash flow, meaning there is only one cash outflow—the initial investment. Subsequent positive cash flow periods follow, during which all cash flows are inflows derived from project revenues.
This kind of project may provide a single IRR, which can then be used to evaluate the project’s economic attractiveness against a company’s hurdle rate. However, there will be two IRRs if a project is susceptible to more negative cash flows in the future, making management’s decisions more questionable. If the hurdle rate is 10% and the IRRs are 5% and 15%, respectively, management will need more confidence to proceed with the investment.
Conclusion
- A company’s cash flow that shifts from inward to outward or vice versa is known as an unusual cash flow.
- Capital planning becomes challenging when there is an irregular cash flow since several internal rates of return (IRR) are needed.
- Most projects have a traditional cash flow, with several cash inflows from revenue and one outflow of funds from capital investment.
