COMPOUNDING AND DISCOUNTING

B.COM CC204 SEMESTER 2

UNIT 3 (MATHEMATICS OF FINANCE)

BUSINESS MATHEMATICS AND

STATISTICS

• BY : CS REENA KUMARI
• ASSISTANT PROFESSOR

• DEPARTMENT OF COMMERCE

• PATNA WOMEN’S COLLEGE (AUTONOMOUS)

• EMAIL ID: REENAKUMARI19JAN@GMAIL.COM

 Time value of money

Compounding

Discounting

INDEX Discounting rate and Conversion Period

Formulas

Relationship between compounding and discounting

Difference between compounding and discounting

Practical sums

BY CS REENA KUMARI
 TIME VALUE OF MONEY
1) It is defined as a concept which states that purchasing
power of money declines with the passage of time. Inflation is
the reason for fall in the purchasing power of money. Due to
inflation a given amount of money buys fewer goods in the
future than it will now.
2) Time value of money means that the value of a unity of
money is different in different time periods. The sum of
money received in future is less valuable than it is today. In
other words the present worth of money received after some
time will be less than a money received today. Since a money
received today has more value rational investors would prefer
current receipts to future receipts. If they postpone their
receipts, they will certainly charge some money i.e. interest.
BY CS REENA KUMARI
 COMPOUNDING

Compounding is the method used in finding out

the future value of the present investment.

Compounding refers to the process of earning interest on

both the principal amount, as well as accrued interest by
reinvesting the entire amount to generate more interest.

For understanding the concept of compounding, first of all, you

need to know about the term future value. The money you invest
today, will grow and earn interest on it, after a certain period,
which will automatically change its value in future. So the worth
of the investment in future is known as its Future Value.
 DISCOUNTING
• Discounting is the process of converting the future amount into its Present Value. The current
value of the given future value is known as Present Value. The discounting technique helps to
ascertain the present value of future cash flows by applying a discount rate. The following
formula is used to know the present value of a future sum:

Where 1,2,3,…..n represents future years

FV = Future Cash flows generated in different years,
R = Discount Rate
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 DISCOUNTING RATE

A discount rate is
the rate of return used
to discount future cash
flows back to their
present value.

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 CONVERSION PERIOD
THE VARIOUS CONVERSION PERIODS ARE GIVEN BELOW :

Conversion Description Number of conversion

period period in a year The period at the end of which
Compounded
1 day daily 365 the interest is compounded is
1 month Compounded 12 called conversion period.
monthly
Example :- When the interest is
3 months Compounded 4
quarterly calculated and added to the
6 months Compounded 2
semi annually
principal every six months the
12 months Compounded 1 conversion period is six months.
annually

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 FORMULAS

Where in ,
i = interest rate
n = no. of conversion periods
t = time

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 RELATIONSHIP BETWEEN
COMPOUNDING AND
DISCOUNTING

The concept of compounding and

discounting are similar in the sense
that discounting brings a future sum of
money to the present time using a
discount rate and compounding brings
a present sum of money to future time.

BY CS REENA KUMARI
 DIFFERENCE BETWEEN COMPOUNDING AND DISCOUNTING
COMPOUNDING
• Meaning : The method used to determine
the future value of present investment is
known as Compounding.
• Concept : If we invest some money today
,what will be the amount we get at a future
date.
• Use of : COMPOUND INTEREST RATE
• Also known as : Future Value Technique
BY CS REENA KUMARI
DISCOUNTING
• The method used to determine the present
value of future cash flows is known as
Discounting.
• If we want a certain sum of money in
future ,how much amount should be
invested at present.
• DISCOUNTING RATE
• Present Value Technique
 PRACTICAL SUM 1 (COMPOUNDING)
• Assume you put Rs.10,000 in a bank for interest rate of 5 %.How much money will bank give you after 5 years?
Solution,
• It is a basic sum of compounding.
• Future value = Present value (1 + i) n
= 10000 (1 + 0.05 )5 = 10000 x 1.2763 =Rs. 12,763/-
Note : Sometimes ,the value of (1.05)5 will be given in sum. If not, calculate it.
Year 1 1.05 x1 = 1.05
Year 2 1.05 x1.05 = 1.1025
Year 3 1.05 x1.1025 = 1.57625
Year 4 1.05 x1.57625= 1.2155
Year 5 1.05 x1.2155 = 1.27628 or 1.2763
BY CS REENA KUMARI
 PRACTICAL SUM 2 (DISCOUNTING)

• Lets suppose Mr Z require Rs.1,00,000/- after 5 years ,Market interest rate is 10%.Advise Mr Z
how much amount he should invest now to get Rs.1,00,000/- after 5 years.
Solution ,
The sum is based on calculation of present value.
Method 1: By formula ,PV = FV = 100000 = 100000 = Rs.62,092/-
(1 + i) n ( 1+ 10 )5 (1.1 )5

100

Interpretation : If Mr Z invest Rs.62,092 at present at 10% for 5 years. He will get Rs.1,00,000/-
after 5 years.
Note : Check answer : 62092 (1+0.1)5 =99999.786 =Rs.1,00,000/-
BY CS REENA KUMARI
 SOLVING THE PREVIOUS SUM USING DISCOUNTING RATE

Method 2 : Calculate discounting rate /factor of 10% for the 5th year.
Dn = 1 / (1+i) n
D5 = 1/ (1+ 0.1) 5 = 0.62092 is the discounting factor of 10 % for 5th year.
Calculate PV =FV x df (Discounting rate /factor)
=1,00,000 x .62092 = Rs.62,092/-
Note 1 : Answer will be same by both the methods.
Note 2 : Sometimes, value of discounting factor given in the sum, if
not use formula to calculate.
BY CS REENA KUMARI
 PRACTICAL SUM 3 (CALCULATING DISCOUNTING FACTOR)

Calculate the discounting factor of 10 % for the 5 years. (Dn = 1/(1+ i)n)

Year Rate Formula Df

1 10 % 1 / (1+ 0.1 )1 0.909

2 10 % 1 / (1+ 0.1 )2 0.826

3 10 % 1 / (1+ 0.1 )3 0.751

4 10 % 1 / (1+ 0.1 )4 0.683

5 10 % 1 / (1+ 0.1 )5 0.621

Sum of =.909+0.826+0.751+0.683+0.621
Annuity =3.79 –sum of annuity of 10% for
BY CS REENA KUMARI 5 years
 KEEP
LEARNING
,HAPPY
LEARNING
BY CS REENA KUMARI