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CH 4 2.compounding and Discounting

MSU Compounding and Discounting

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81 views10 pages

CH 4 2.compounding and Discounting

MSU Compounding and Discounting

Uploaded by

namhandsome234
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Module 2 – Time Value of Money

Chapter 4:
Compounding and
Discounting
Compounding
• Compounding: The ability of an asset to generate earnings in
which the earnings also generate additional earnings.
• Compound interest is interest is earned on interest.

Compounding takes a Present Value and turns it into a Future Value,


given a specific Interest Rate, over a certain Number of Time Periods.

This contrasts with Simple Interest, in which only the principal


amount deposited earns interest (the interest earned does not earn
any interest).
Compounding
Suppose you are able to invest $1,000 for one year, earning 5%
interest per year. What is the future value in one year?
If using the formula rather than Excel:
• FV = PV x (1 + r)t
• FV = 1,000 x (1.05)1
• FV = 1,050
Suppose you leave the money in place for another year. How
much will you have two years from now?
• FV = 1,000 x (1.05)2
• FV = 1,102.50
Effects of Compounding
In the example from the previous slide:
• FV with simple interest = 1,000 + 50 + 50 = 1,100
– FV with compound interest = 1,102.50
– The extra 2.50 comes from the interest of .05(50) =
2.50 earned on the first interest payment.
Effects of Compounding
Effects of Compounding
Discounting
Discounting can be thought of as the reverse of compounding; in
Discounting, we are taking a Future Value, or future cash flow,
and determining its Present Value. In effect, we are
• determining how much a certain cash flow that will be received in the
future is worth to us today.
• or we use discounting to determine how much we need to invest
today to achieve a specific amount as some point in the future.
To do this, we need to rearrange the Time Value of Money
formula to isolate the Present Value as follows:
PV = FV / (1 + r)t
Discounting
Discounting example:
Suppose a proposed investment is expected to generate a
$30,000 cash flow 3 years from today. Using a 5% discount rate,
and assuming annual compounding, what is that cash flow worth
to us today?
• PV = 30,000 / (1.05)3
• PV = 25,915.13
Important TVM Relationships
1. For a given interest rate – the higher the
number of time periods, the lower the
present value
• The longer you have to wait to receive a cash flow, the less
value it has to you in today’s dollars.

2. For a given time period – the higher the


interest rate, the smaller the present value
• A higher interest rate means more forgone interest by having
to wait for the cash flow, therefore present value is smaller.
LEARNING CHECK
Q1. Of Simple Interest and Compound Interest,
which involves earning interest on interest as
well as principal balances?

Q2. True or False: The longer you have to wait to


receive a cash flow, the less value that cash flow
has to you in today’s dollars.

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