Understanding Conventional Cash Flow: Definitions and Examples

Conventional cash flow is a series of cash flows which, over time, go in one direction. It means that if the initial transaction is an outflow, then it will be followed by successive periods of inward cash flows. Although rare, conventional cash flow can also mean that if the first transaction is a cash inflow, it is followed by a series of cash outflows.

Mathematically, conventional cash flow is represented as:

–a + b + c + d + e

From the formula above, we can see that there’s a cash outflow in Year 1, which is followed by cash inflows for the following four years. Conventional cash flow is a technique often applied in discounted cash flow analysis. With DCF analysis, an investor uses either Net Present Value (NPV)Net Present Value (NPV)Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the entire life of an investment discounted to the present. or Internal Rate of Return (IRR)Internal Rate of Return (IRR)The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project zero. In other words, it is the expected compound annual rate of return that will be earned on a project or investment. to evaluate the potential returns that a particular investment project can yield. Both NPV and IRR can be used to assess independent or dependent projects.

Unconventional vs. Conventional Cash Flows

Unconventional cash flow is characterized by a series of cash flows in multiple directions over a given period. The unconventional cash flow profile is very popular among businesses that undergo periodic repair and maintenance checks.

Let us consider an investor who owns a 15-room motel. He will experience an unconventional cash flow if, after every three years, the property undergoes a maintenance check.

Another instance of unconventional cash flow is seen in a person’s financial practices. Individuals often withdraw money from their accounts to cater for monthly expenses. If one maintains a record of his monthly expenses, then he will know exactly how much he should withdraw. However, very few individuals do such a thing. Most people end up withdrawing more than they need and then depositing back the surplus amount they are left with.

In contrast, conventional cash flow will only flow in one direction. Often, the outflow happens only at the beginning of the project, followed by subsequent inflows. The initial outflow is the capital that a company spends to finance the project. The cash inflows that follow represent the revenue and profits that the project yields.

If a company finances a project using a loan from a bank or other financial institution, then the initial transaction is a cash inflow. As an example, think of a company that decides to open a new branch office in a metropolitan area. If it takes a loan to finance the project, this sum of money will be recorded as a cash inflow.

Outflows are recorded when all or a portion of this loan is used in building the new office. However, any revenues the company receives are cash inflows. On the other hand, any money that it pays to the bank in the form of interest or principal is a cash outflow.

Another good example of conventional cash flow is mortgagesMortgageA mortgage is a loan – provided by a mortgage lender or a bank – that enables an individual to purchase a home. While it’s possible to take out loans to cover the entire cost of a home, it’s more common to secure a loan for about 80% of the home’s value.. Assume that a homeowner has taken mortgage amounting to $300,000 to be repaid at a fixed interest rate of 5% for 30 years. The individual will need to pay the lender $1,610 every month for the stipulated period. From the lender’s perspective, he will record an initial outflow of $300,000, followed by monthly cash inflows for the next 30 years.

Benefits of Conventional Cash Flow

As illustrated in the examples above, a conventional cash flow involves a series of transactions in a single direction. It creates just one IRR, which makes it very easy to evaluate investments. To establish whether a project is likely to yield significant returns, the IRR is compared with a company’s hurdle rate. The hurdle rate is simply the lowest rate of return on an investment required by an investor.

The rule of thumb is to approve any projects where the IRR is equal or higher than the hurdle rate. If it’s not, the project is likely to be rejected.

Now, if a project was to be subjected to other cash outflows in the future, it will lead to two or more IRRs. The practice makes it challenging to evaluate the project and come up with a decision. For example, if the two IRRs stand at 8% and 16%, respectively, yet the hurdle rate is 12%, the management or investors will not want to undertake the project because of uncertainty.

Summary

Conventional cash flow is one whereby an outflow happens only once. Usually, the transaction happens at the onset of the project. A case in point is when people take loans from banks. They usually withdraw the whole sum of money and then pay back in installments. In such a way, the bank experiences cash outflow only once, followed by subsequent inflows over a given period.

It is different from an unconventional cash flow where outflows happen more than once. Conventional cash flow is the most recommended form as it leads to one IRR, which makes it easy to assess and decide the projects to undertake.

Related Readings

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