Unequal cash flows refer to a series of payments made over time, while fixed payments are equal. Financial managers use financial formulas to find the present value of future cash flows to calculate the fair value of an investment. Unconventional bonds, such as index-linked bonds, have cash flows that reflect changes in an index, making it difficult to estimate cash flows. Capital budgeting is the process of making decisions related to long-term investments.
Basically, unequal cash flows refer to a series of unequal payments made over a given period of time. For example, one may receive the following annual payments over a five-year period: $500 United States Dollars (USD), $300 USD, $400 USD, $250 USD, and $750 USD. On the other hand, if the regular payments were fixed at a particular amount, then the cash flows would be equal. For example, one may receive an annual payment of $500 USD, which is also known as an annuity. Also, uneven cash flows can be associated with all kinds of financial situations, including capital budgeting.
In finance, capital budgeting is basically the process of making decisions related to long-term investments. During this process, managers can use various financial management tools to forecast and estimate the value of irregular cash flows associated with a particular investment. This will give them a basis for making a decision to accept or reject the project.
Both fixed and unequal cash flows are vital elements in valuing all types of investments. Financial managers use financial formulas to find the present value of a series of future cash flows. This process helps them calculate the fair value of the investment in question. For example, a financial manager might calculate that the present value of a series of unequal cash flows is $1,000. If this stream of irregular cash flows was produced by a given asset, then he or she may decide that the most he or she is willing to pay for the asset is its present value, which is $1,000.
Another example of a series of unequal cash flows is payments received from investing in what are known as unconventional bonds. Unlike common bonds, also known as vanilla bonds, unconventional bonds do not pay a fixed coupon or interest rate. These bonds include index-linked bonds, so named because they are linked to an index, such as the consumer price index (CPI) which measures the rate of inflation. With these bonds, the cash flows reflect changes in the index to which they are linked.
To illustrate, consider a hypothetical index-linked bond with cash flows tied to changes in the CPI. Suppose that after issuance, the bond pays $100 in interest. However, the following year, if the CPI increased by a given percentage rate, the interest payment would increase accordingly. For example, you can increase to $105 USD. Simply put, it is quite difficult to estimate with any certainty the cash flows associated with such a bond, since changes in the CPI will lead to uneven cash flows.
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