Question

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

Answer 1

Discounting is used when describing Present Value as expected future value is brought to the present value by dividing it from the required rate of return also known as discount rate considering the time to get the future cash flows. It helps in analyzing whether the expected future cash flows will be beneficial or not and by how much.

Compounding is used when describing Future Value as present value of funds are assumed to invested at rate of return considering the amount of time funds being invested. It helps in analyzing whether the investment opportunity is beneficial or not and if beneficial, then by how much compared to other investment opportunities.

Simple compounding is used to calculate the future value when rates are simple and interest are added to the principal amount at specific period of intervals while continuous compounding involves the concept of the natural logarithm, a constant rate is used to grow the principal amount continuously, the interest earned is continuously added to the principal amount and the proceeds is again re-invested at the constant rate.