Move amounts to a common date
Amounts received on different dates cannot be added as though their timing were identical. Discount a future receipt using the rate for each interval between today and receipt. Once the amounts are expressed at time zero, add them to compare the full cash-flow stream with an initial payment.
Match the rate to the period count
For an annual rate and annual cash flows, one year is one discount period. For monthly cash flows, first decide whether the quoted annual rate is nominal or effective before deriving a monthly rate. Dividing every annual rate by twelve is not universally valid: the quotation convention matters.
| Question | What to establish |
|---|---|
| What is one interval? | Year, half-year, month or another regular period |
| How is the rate quoted? | Effective or nominal, and the associated frequency |
| When is the first amount? | Time zero or a future period |
| Are the amounts receipts or payments? | A consistent sign convention |
Keep signs and timing explicit
A payment made now normally enters an investment cash-flow calculation as a negative time-zero amount. Future receipts enter as positive amounts. If you move the initial payment one period into the future by accident, you discount a value that should not have been discounted. Draw the timeline before entering numbers.