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. A conventional cash flow would have only one internal rate of return (IRR), making it a relatively easy task for a company — if it is considering two or more options that meet the hurdle rate — to make a choice among these investments that exhibit this normal pattern of out/inflows.

Cash flows are modeled for NPV analysis in capital budgeting for a corporation that is contemplating a significant investment. A project 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. 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 to determine the economic attractiveness of the project. Contrast the conventional type to unconventional. Unconventional cash flows involve more than one change in cash flow direction, which result in two IRRs. Two IRRs can cause decision uncertainty for management if one IRR exceeds the hurdle rate and the other does not. Not sure about which IRR will prevail, management will not have the confidence to go ahead with the investment.

A mortgage is also a good example of a typical 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.