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Unconventional Cash Flow Meaning Overview Challenges

Unconventional Cash Flow Meaning Overview Challenges

Unconventional Cash Flow: Meaning, Overview, Challenges

What Is an Unconventional Cash Flow?

An unconventional cash flow is a series of inward and outward cash flows over time that involves more than one change in direction.

Key Takeaways

  • An unconventional cash flow involves a change in the direction of a company’s cash flow over time.
  • It makes capital budgeting difficult because it requires multiple internal rates of return (IRR).
  • Most projects have a conventional cash flow, with one cash outflow for the initial investment and multiple cash inflows from revenues.

Understanding an Unconventional Cash Flow

In terms of mathematical notations, an unconventional cash flow could appear as -, +, +, +, -, +, or alternatively, +, -, -, +, -, -. The first set represents a net inflow of cash and the second set represents a net outflow of cash. This change in direction of cash flows signifies an unconventional cash flow for the company.

When modeling cash flows for net present value (NPV) in a discounted cash flow (DCF) analysis, unconventional cash flows are more challenging to handle than conventional cash flows. They result in multiple internal rates of return (IRR) depending on the number of changes in direction.

In real-life situations, examples of unconventional cash flows are abundant, particularly in large projects involving periodic maintenance that requires significant capital outlays. For instance, a large thermal power generation project projected over 25 years may have cash outflows during the construction phase, inflows from years four to 15, an outflow in year 16 for scheduled maintenance, followed by inflows until year 25.

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Challenges Posed by an Unconventional Cash Flow

A project with a conventional cash flow starts with a negative cash flow during the investment period, followed by successive periods of positive cash flows from project revenues.

A single internal rate of return (IRR) can be calculated for this type of project, which is then compared to a company’s hurdle rate to determine the economic attractiveness of the project. However, if the project experiences another set of negative cash flows in the future, there will be two IRRs, leading to decision uncertainty for management. For example, if the IRRs are 5% and 15%, and the hurdle rate is 10%, management will lack confidence in proceeding with the investment.

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