What is an Unconventional Cash Flow
An unconventional cash flow is a series of inward and outward cash flows over time in which there is more than one change in the cash flow direction. This contrasts with a conventional cash flow, where there is only one change in cash flow direction. In terms of mathematical notation, where the "-" sign represents an outflow and "+" denotes an inflow, an unconventional cash flow could appear as -, +, +, +, -, + or alternatively +, -, -, +, -.
Cash flows are modeled for net present value (NPV) analysis in capital budgeting. An unconventional cash flow is more difficult to handle in NPV analysis than conventional cash flow since it will produce multiple internal rates of return (IRR), depending on the number of changes in cash flow direction.
BREAKING DOWN Unconventional Cash Flow
In real life situations, examples of unconventional cash flows are abundant, especially in large projects where periodic maintenance may involve huge outlays of capital. For example, a large thermal power generation project where cash flows are being projected over a 25-year period may have cash outflows for the first three years during the construction phase, inflows from years four to 15, an outflow in year 16 for scheduled maintenance, followed by inflows until year 25.
Challenges Posed by Unconventional Cash Flow
A project with a conventional cash flow starts with a negative cash flow (investment period), followed by successive periods of positive cash flows. A single IRR can be calculated from this type of project, with the IRR compared to a company's hurdle rate to determine the economic attractiveness of the contemplated project. However, if a project is subject to another set of negative cash flows in the future, there will be two IRRs, which will cause decision uncertainty for management. For example, if the IRRs are 5% and 15% and the hurdle rate is 10%, management will not have the confidence to go ahead with the investment.