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

r¸ ¨ i ! ©1  ¹  1 ª mº

m

COMPOUNDING + DISCOUNTING

When considering discrete sums of money, the PRESENT VALUE can be worked out using the following formulae:
P F r¸ ¨ ©1 ¹ ª mº
mT

F P ! rT e

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 rearranging the equations.

PRESENT VALUE OF FUTURE STREAMS
Discount Frequency Payment Regularity Annual Payments Annual Discounting More Frequent Discounting Continuous Discounting

d¨ 1 ©1  ! © r ª  r T 1

¸ ¹ ¹ º

¨ 1   m  mT 1 r ! d© ©  r m  1 ª 1 m

¸ ¹ ¹ º

¨ 1  e  rT P ! d© r © e 1 ª

¸ ¹ ¹ º

More Frequent

d¨ 1 ! ©1  r ©  r T 1 ª

¸ ¹ ¹ º

¨ 1 m  mT 1 r ! d© © r ª

¸ ¹ ¹ º

¨ 1  e  rT P ! d© © r ª

¸ ¹ ¹ º

COMPOUNDING + DISCOUNTING

The information in the previous slide can be used to calculate:
ANNUITIES (¶d· is the annuity). y MORTGAGES (¶d· is the payment) y PENSIONS (¶P· is the initial pension fund and ¶d· is the resulting annuity).
y

If payments are made multiple times in the year, then simply divide ¶d· by ¶m· ² ¶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/SEMIANNUAL rate of interest r/m.

GROWTH

Growth can be CONTINUOUS OR DISCRETE. Discrete growth is of the form:
y y

F = P(1 + i/m)mT F = PerT

Continuous growth is of the form: We can relate the two rates of growth by assuming that the future values are equal;
y y

P(1 + i/m)mT = PerT mT.ln(1+ i/m) = rT

Hence, the link between continuous and discrete growth rates is:
y

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·.
y

With exponential growth functions, proportional rate of growth is CONSTANT, with other functions it may vary with time.