Question

Discuss why the concept of compounding is not restricted to money, and how the future value formula can be applied to growth problems.

Answer 1

The concept of compounding entails that any growth occurs over the previous value. Due to this, the new absolute growth is higher due to growth on growth in the same way as interest on interest works when compound interest works on the money.

The future value formula for money is defined as

Future value = Initial value*(1+growth rate)^(Number of years)

Here, the compunding effect is taken into consideration. The same can be used for growth problems. For a example a company has a year on year growth or a CAGR of 12 percent. Here, if in 2020 it has a sales of $10 million and after 5 years the future value of sales would be $10*(1.12)^5 = $17.62 million worth of sales. This is the concept of compounding which applies to growth problems as well.