Question

iii) Briefly explain how you would construct an unconventional cash flow in order to have k possible IRRs, where k > 1. Next, comment on the likelihood of such a cash flow occurring in real life, when k is large.

Answer 1

Unconventional cash flows means a series of cash flows that do not follow a symmetric pattern that means they do not have a direction either inflows or outflows.

Now let us take some notations like for inflows we have ''+ " and for outflows we have " - '' sign.

Majorly the projects have a series of cash flows that require an initial capital invesment and then the cash flows are only the revenues and even if they require any additional capital investment it doesn't exceed the revenue generated in the current year and thus have an overall positive cash inflow.

The pattern is : -, -, +, +, +.....,+ then it is discounted and we get a single IRR

But for constructing an unconventional cash flow we have no pattern followed and thus it is difficult to find an IRR for a project.

The pattern is : -, -, +, +, +, -, +, +, +

In this type of projects there are two IRR's because of the fact that the one set generates Positive cash flows while other generates Negative cash flows and thus when we are certain of the fact that the project will require future cash outlays we have to find two IRR's .

This is how we can construct an Unconventional Cash flows.

Yes, definitely the cash flows can occur in large number of projects that require huge maintainence outlays every quarter or semiannually . This mainly involves capital Intensive Projects such as Power Projects.

Thus there is a High probability of such cash flows occuring in our daily life depending on the type of the projects