Compounding vs Discounting
Both compounding and discounting are concepts used to calculate the value of an investment at a point in time.
Compounding is used to determine the future value of an investment made in the present. It takes into account the value that is added through the accruing of interest.
On the other hand, discounting is used to calculate the present value of a cash flow that is due to come in the future.
By using a discount rate, the current value of future cash flow can be determined. The current value is the present value.
Comparison Table Between Compounding and Discounting (in Tabular Form)
|Parameter Of Comparison||Compounding||Discounting|
|Definition||Process of calculating the future value of a present investment||Process of calculating the present value of a future cash flow|
|Rate||Compound interest rate||Discount Rate|
|Formula||A = P (1+ r/n)nt||Dn = 1/(1+r)n|
|Used To||Determine the amount of earnings to be gained by making an investment||Determine how much should be invested to make maximum returns in the future|
What is Compounding?
Once you’ve made an investment, you expect to earn a certain amount of interest in it. Those earnings can also be invested in order to make more money.
When interest is earned on the principal and the entire amount is again invested to earn more money that is called compounding.
Usually, when money is invested with a bank or a credit firm, they compound interest in a fixed time period.
This could be weekly, monthly, half-yearly, or annually. The best way to understand this process is by example.
In this illustration let us suppose that you have invested a sum of $1000 with an interest rate of 10% per annum.
So in two years’ time, you would have earned another $200 bringing you to a total sum of $1200 without compounding your interests.
However, if you were compounding the interest on the amount annually, you would make more money. In the first year, you would have earned $100 bringing you to a total amount of $1100.
By compounding interest yearly, the earned $100 will be added to the principal amount and so in the second year, you will earn 10% interest on $1100 which is $110.
As time goes on your earnings will continue to increase.
Compounding helps you find out what the amount you’re investing now will grow into in the future through the compound interest formula given below:
A = P (1+ r/n)nt
Here A is the future value you are trying to calculate. P is the initial principal invested and r is the interest rate.
The n is the number of times interest will apply in a particular period of time and t is the number of time periods that have been completed.
The frequency at which you compound your interest is also a matter of concern. The more often you compound interest, for example, quarterly instead of annually, the more money you stand to make.
Being smart about compounding includes accounting for the frequency of compounding and the period of investment. These are the two things that are within your control and it is best to compound often and for a long period.
What is Discounting?
For an investment to be valuable, it must give the investor returns in the future. Calculating the value of those future cash flows in terms of the present by using a discount factor is called discounting.
This is an important process because it can be used to compare the possibilities arising from multiple options. It is a vital part of deciding where to invest capital.
In determining the discounted value of an investment, we must first calculate the returns that it will bring and the time period in which that will occur.
Then by applying the formula for discounting the discount factor for the time periods can be calculated.
The final step of this process is to multiply the first result by the second and that brings you to the present value of your investment.
The formula for discounting is given below:
Dn = 1/(1+r)n
Here Dn stands for discounting factor. The r is for discounting rate and the n is for the number of time periods being discounted.
If the discounting factor is high, then the risk involved with the investment will also be high.
Therefore following this process, an investor can understand how viable his investment is and whether he should go through with it.
The cash you have at hand is always worth more than the money you may get in the future and this is where discounting becomes important.
Only if the present value of an investment is positive is it worth making the investment. If it is negative it will simply become a financial drain.
Main Differences Between Compounding and Discounting
- Compounding refers to the method by which the future value of an investment is determined.
- By the process of discounting the present value of future cash flows is calculated.
- Compounding calculates an increase in the amount of money earned.
- Discounting calculates the decrease in the amount of money earned over time.
- Compound interest rates are used in the process of compounding.
- Discount rates are used in the process of discounting.
Frequently Asked Questions (FAQ) About Compounding and Discounting
- What is compounding in the time value of money?
The term compounding means calculating the future value of the present money.
This is a method that is used to determine that what will be the value of an amount that is presently invested at a fixed rate of interest compounded annually and with equal payments being made till the future date.
- What is discounting in the time value of money?
Discounting is a process in which the present value of a payment or many payments together is determined, all of which are to be received in the upcoming future.
So, in other words, discounting is the basic or the primary factor used for the purpose of pricing the stream of future cash flows.
- What is discounting the future?
Discounting the future is a term which is used by the players like investors, risk-takers, initiators and other such people which gives a gist that all the future cost are converted into the cost of the present value so that easy comparisons can be made and conclusions can be drawn out.
- What is the discounting principle?
The discounting principle is a principle that is used in the field of managerial economics.
This principle states that if a decision is taken which affects the cost and the revenues of the company in the long run period, then all those costs which are to be incurred and the revenues which will be generated must be discounted to the present value to draw comparisons.
- What is the discounted factor?
The term discounting factor is a weighting term.
This is a factor that comes out as a result of multiplication of the income, happiness and incurred losses so as to find out the main factor with which the money needs to be multiplied so as to come to the net present value of all the things.
- How do you find the discount rate?
The most common and simple way to calculate the discount rate is by multiplying the original price of any commodity by the decimal form of its percentage.
For example: if the rate of interest is 5%, then divide 5% by 1.05 to get the discount rate.
- What are the examples of compounding?
The best example to understand the process of compounding: Ramesh invests principal amount of Rs 20000 in the bank, compounded annually, at a 6% rate of interest and for 3 years.
So the final amount will be A=P(1+r) n=23820.32. Thus, the amount has been compounded over the course of three years.
Compounding and discounting seem like opposing concepts because the former is used to determine the future value of a present investment and the latter is used to determine the present value of future cash flow.
However, the common ground they share is that both are extremely useful for those who are looking to invest money.
Compounding is one of the easiest ways to grow investment and discounting is a vital factor in making the decision of whether to invest in a particular asset not.
Word Cloud for Difference Between Compounding And Discounting
The following is a collection of the most used terms in this article on Compounding And Discounting. This should help in recalling related terms as used in this article at a later stage for you.