The amount by which an investment will
grow over a given number of time periods
including the accumulation of interest.
Compounding is less frequently used than
discounting in investment analysis.
Discounting and compounding represent the
basic methods to determine the time value of
money.
Compounding involves three different
types of calculations; discounting involves
another three. In combination, they are
referred to as the six functions of a dollar
. Compounding can involve:
Compounding a single amount into the
future, e.g., interest on a loan that
compounds monthly but is not due until
the end of the term;
Compounding a stream of equal
payments, e.g., investment of equal
amounts over a specified period of time
at a given rate of interest; and
Compounding of a stream of equal
payments to create a future amount
(e.g., payments necessary to produce a
given future value). This form of
compounding is often referred to by
financial institutions as a sinking
fund.
Compounding is most frequently
encountered from a lender’s perspective when
calculating yield in relation to loans
advanced to borrowers, determining the value
of an annuity, or establishing the periodic
payments required to produce a specified
annuity.
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