Question

Compare and contrast the process of compounding to determine future values and the process of discounting to determine present values.

Please do not copy and paste, thank you.

Answer 1

Both compounding and discounting are the applications of Time Value of Money which is the effect of application of interest. An amount received today is worth more than the same amount received on a future date. Because the money received or paid today will earn interest for the interim period and will grow in volume during that period. Inversely, the amount received or paid on a future date is equivalent to a lesser amount today, the difference being interest during this period.

Compounding is the process of charging interest on the amount of interest applied for the previous period. For example, for a loan or deposit for one year, if interest is to be compounded and at monthly rests, interest is calculated at the end of every month and added to the principal so that interest for next month is calculated on the combined sum (principal and interest for the earlier month) and so on.

Discounting is the process by which Present Value (PV) of a sum is ascertained. PV is today’s equivalent of a sum received or paid on a future date. It is the future sum, net of interest during the interim period. Since interest fetches interest applicable for earlier period (compound interest), interest reduced from the future sum, for arriving at the present value, is the interest compounded at specified intervals.