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Discounting, Compounding and Growth

This document discusses compounding, discounting, and growth. It provides formulas for calculating present and future value under different compounding scenarios (discrete, continuous, annually, more frequently). It also discusses how to relate discrete and continuous growth rates and calculate proportional growth rates.

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hishamsauk
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93 views6 pages

Discounting, Compounding and Growth

This document discusses compounding, discounting, and growth. It provides formulas for calculating present and future value under different compounding scenarios (discrete, continuous, annually, more frequently). It also discusses how to relate discrete and continuous growth rates and calculate proportional growth rates.

Uploaded by

hishamsauk
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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INTERMEDIATE METHODS:

DISCOUNTING, COMPOUNDING
AND GROWTH
COMPOUNDING + DISCOUNTING
 You COMPOUND a sum if you’re interested in the FUTURE
VALUE of it  Compounding interest rate once every couple
of months.
 You DISCOUNT a sum if you’re interested in the PRESENT
value of it  Discounting a future sum/stream of money.

 Important to note the difference between the NOMINAL and


the EFFECTIVE rate of interest. The Nominal rate is that
quoted on loans, the effective rate is that factoring in any
compounding.
 Nominal rate of interest = r
 Effective rate of interest = i

m

 r
i  1    1
 m
COMPOUNDING + DISCOUNTING
 When considering discrete sums of money, the
PRESENT VALUE can be worked out using the
following formulae:
F
P F
P  rT
mT
 r
 1   e
 m

 Depending on whether the discounting is continuous (the


second equation), or occurs a discrete number of times
per year (the first equation).
 The Future Value (F) can be calculated by re-arranging
the equations.
PRESENT VALUE OF FUTURE STREAMS
Discount Annual More Frequent Continuous
Frequency Discounting Discounting Discounting
Payment
Regularity

Annual
Payments
d    1  e  rT 
m
1  1  1  r  mT 
P  1   P  d   P  d  r 
r  1  r  T  1  r  m  1 
  m   e 1 

More
Frequent
d 1   1  1  mr   mT   1  e  rT 
P  1   P  d   P  d  
r  1  r  T  r 
    r 
COMPOUNDING + DISCOUNTING
 The information in the previous slide can be used to
calculate:
 ANNUITIES (‘d’ is the annuity).
 MORTGAGES (‘d’ is the payment)
 PENSIONS (‘P’ is the initial pension fund and ‘d’ is the
resulting annuity).
 If payments are made multiple times in the year, then
simply divide ‘d’ by ‘m’ – ‘m’ being the number of
payments per year, which we assume to be the same as
the number of times interest is discounted.
 Hence, for ‘more frequent’ discounting, we calculate the
MONTHLY/QUARTERLY/SEMI-ANNUAL rate of
interest  r/m.
GROWTH
 Growth can be CONTINUOUS OR DISCRETE.
 Discrete growth is of the form:
 F = P(1 + i/m)mT
 Continuous growth is of the form:
 F = PerT
 We can relate the two rates of growth by assuming that the future values
are equal;
 P(1 + i/m)mT = PerT
 mT.ln(1+ i/m) = rT
 Hence, the link between continuous and discrete growth rates is:
 r = m.ln(1 + i/m)
 If estimating the continuous growth rate, given two figures a couple of
years apart, simply use F = Pert to estimate ‘r’.
 If calculating the PROPORTIONAL rate of growth, it is the time
differential of the function divided by evaluating the function at time ‘t’.
 With exponential growth functions, proportional rate of growth is CONSTANT,
with other functions it may vary with time.

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