Question

What is compounding? What is discounting?

   What is compounding? What is discounting?

Fundamentals of Corporate Finance

Fundamentals of Corporate Finance

Stephen A. Ross;… 11th Edition

Chapter 5, Problem 2

Instant Answer

Solved by Expert Mike Stern

07/05/2021

Step 1

In other words, it is the concept of earning interest on interest. This is commonly seen in savings accounts or investments where the interest earned is added to the principal amount, and future interest is calculated based on the new total. Show more…

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What is compounding? What is discounting?

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Key Concepts

Compounding

Compounding refers to the process of growing an amount of money by reinvesting earned interest, so that in subsequent periods, interest is earned on both the initial principal and the accrued interest. This concept is fundamental in finance as it illustrates how investments can grow exponentially over time.

Discounting

Discounting is the process of determining the present value of a future sum of money by applying a discount rate that reflects the time value of money and potential risks. This technique is essential for comparing cash flows occurring at different times and for valuing future financial benefits or costs in today’s terms.

Time Value of Money

The time value of money is a financial principle that underlines the idea that a sum of money is worth more now than the same sum will be in the future due to its potential earning capacity. This concept forms the basis for both compounding and discounting, as it emphasizes that money available now can be invested to generate returns over time.

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