What Is Conventional Cash Flow?
Conventional cash flow is a series of inward and outward cash flows over time in which there is only one change in the cash flow direction. A conventional cash flow for a project or investment is typically structured as an initial outlay or outflow, followed by a number of inflows over a period of time. In terms of mathematical notation, this would be shown as -, +, +, +, +, +, denoting an initial outflow at time period 0, and inflows over the next five periods.
A frequent application of conventional cash flow is net present value (NPV) analysis. NPV helps determine the value of a series of future cash flows in today's dollars and compare those values to the return of an alternative investment. The return from a project's conventional cash flows over time, for example, should exceed the company's hurdle rate or minimum rate of return needed to be profitable.
- Conventional cash flow means that a project or investment has an initial cash outlay followed by a series of positive cash flows generated from the project.
- Conventional cash flows have only one internal rate of return (IRR), which should exceed the hurdle rate or minimum rate of return needed.
- Conversely, unconventional cash flows have multiple outlays of cash over a project's life and as a result, multiple IRRs.
Understanding Conventional Cash Flow
A project or investment with a conventional cash flow starts with a negative cash flow (the investment period), followed by successive periods of positive cash flows generated by the project once completed. The rate of return from the investment or project is called the internal rate of return (IRR).
Cash flows are modeled for NPV analysis in capital budgeting for a corporation that's contemplating a significant investment. Think of a new manufacturing facility, for example, or an expansion of a transportation fleet. A single IRR can be calculated from this type of project, with the IRR compared to a company's hurdle rate or minimum rate of return to determine the economic attractiveness of the project.
Conventional vs. Unconventional Cash Flows
Conversely, unconventional cash flows involve more than one change in cash flow direction and result in two rates of returns at different intervals. In other words, unconventional cash flows have more than one cash outlay or investment, while conventional cash flows only have one.
If we refer back to our example of the manufacturer, let's say there was an initial outlay to buy a piece of equipment followed by positive cash flows. However, in Year Five, another outlay of cash will be needed for upgrades to the equipment, followed by another series of positive cash flows generated. An IRR or rate of return will need to be calculated for the first five years and another IRR for the second period of cash flows following the second outlay of cash.
Two rates of return for a project or investment can cause decision uncertainty for management if one IRR exceeds the hurdle rate, and the other doesn't. If there's uncertainty surrounding which IRR might prevail, management won't have the confidence to go ahead with the investment.
Example of Conventional Cash Flow
A mortgage is an example of conventional cash flow. Suppose a financial institution lends $300,000 to a homeowner or real estate investor at a fixed interest rate of 5% for 30 years. The lender then receives approximately $1,610 per month (or $19,325 annually) from the borrower towards mortgage principal repayment and interest. If annual cash flows are denoted by mathematical signs from the lender's point of view, this would appear as an initial -, followed by + signs for the next 30 periods.