Question

Compounding and discounting are different sides of the “time value of money” coin. In your own words, explain both concepts, and give practical examples of each.

Answer 1

In Time Value of Money (TVM) we generally predict the value of money changes w.r.t time. The USD worth today will not remain the same in future or the USD worth today was not the same in future. To measure the value of money through TVM, there are two ways:

Compounding: Simply, through compounding we calculate the future value (FV) of present money (PV). This method is useful to predict the future values of the cash flows (recurring or one time) for a particular period.

Discounting: In discounting, we compute the present value (PV) of future money (FV).

Comparison	COMPOUNDING	DISCOUNTING
Definition	Predicts future value of current investment.	Calculates present value of future money.
In simple terms	It calculates the amount we get in a future date for the invested money today	It calculates how much we need to invest today to get a specific amount in future.
Use of	Compound interest rate	Discount rate
Known	Present Value	Future Value
Factor	Future Value Factor or Compounding Factor	Present Value Factor or Discounting Factor
Formula	FV = PV (1 + r)^n	PV = FV / (1 + r)^n
Example	Principal at the beginning: $1,000 Interest : 10% Time: 2 years Principal at the end (FV): 1,000*(1+10%)^2 = $1,210	FV: $1,210 Interest: 10% Time: 2 years PV: $1,000