Question

Answer each question succinctly yet completely. Be mindful of the multiple parts to each question.

9. Why is discounting used when describing PV and compounding used when depicting FV? What is the difference between simple and continuous compounding?

Answer 1

In compounding, future values of cash flows at a given intrest rate at the end of a given period of time are found. Compounding is the process of finding the future values of cash flows by applying the concept of compound intrest. Compound intrest is the intrest that is received on the original amount (principal) as well as on any intrest earned but not withdrawn during earlier periods. Simple intrests is the intrest that is calculated only on the original amount (principal) and thus no compounding of intrest takes place.

In discounting, the present value of cash flows at a given intrest rate at the beginning of a given period of time is computed. The present value concept is the most important concept in financial decision making.

Present value of a future cash flow is the amount of current cash that is of equivalent value to the decision maker. Discounting is the process of determining present values of a series of future cash flows.

Compounding- there are varoius types of compounding that shows the ending value of the investment when the intrest is compounded annually, monthly, daily and continuosly.

1. Annual compounding

2. Semi annual compounding

3. Quarterly compounding

4. Monthly compounding

5. Daily compounding

6. Continuos compounding

When an intrest rate is compounded annually, semi annually, quarterly and monthly then it is known as Multiperiod Compounding. When intrests compound for more than once in a given period of time, it is called multi period compounding (discounting).

Sometimes compounding may be done continuosly. For example, banks may pay intrest continuosly, they call it daily compounding. The Continuos compounding function takes the form of the following formula:

Fn=P*e^(i*n)=P*e^x

Where x= intrest rate multiplied by the number of years n and e is equal to 2.7183.

Intrest is the cost of borrowing money, where the borrower pays a fee to the lender for using the latter money. The intrest expressed as a percentage, can be either simple or compounded. Simple intrest is based on the principal amount of a loan or deposit while compound intrest is based on the principal amount and the intrest that accumulates on it every period.