Question

Compare and contrast the process of compounding to determine future values and the process of discounting to determine present values. No copy and paste pls. Thank you

Answer 1

Compounding process

The compounding process is the process where you are taking the frequency of compounding and then calculating the future value factor to calculate the future value. Here the focus is on calculating the future value by using the Future value of factor. Here the focus is on earning interest income on interest.

Let’s take an example of $1000 deposited today. The interest rate is 7% per annum compounded monthly. What is the future value of deposit at the end of year 5? Here the frequency of compounding is monthly, that is 12 in a year so future value factor would be

= (1+0.07/12)^(5*12) = 1.417625

The future value would be = 1000*1.417625 = 1417.625

Discounting process

Discounting is the process by which you calculate the discounting factor to calculate the present value today of an amount which is occurring in future.

Let’s say, you expect to receive $1000 5 years from now, the interest rate is 7% per annum, compounded monthly.

The discounting factor would be

= 1/(1+0.07/12)^(5*12) = 0.705405

The present value would be = 1000*0.705405 = 705.405