Difference Between Compounding and Discounting (with Comparison Chart) - Key Differences
How to calculate Cash flows for Payback period or discounted payback . the difference in payback periods of discounted pay period and simple payback. All time value of money problems involve two fundamental techniques: compounding and discounting. Compounding and discounting is a. Learning Objectives Compounding and discounting form the basis for the valuation process used in finance. The equations represent the compounding relationship that is the basis for determining equivalent future and present values of.
There are several basic equations that represent the equalities listed above.Chapter 2 - Present Value #1
The solutions may be found using in most cases the formulas, a financial calculator or a spreadsheet. In the case of the standard annuity formula, there is no closed-form algebraic solution for the interest rate although financial calculators and spreadsheet programs can readily determine solutions through rapid trial and error algorithms.
These equations are frequently combined for particular uses. For example, bonds can be readily priced using these equations.
A typical coupon bond is composed of two types of payments: The two formulas can be combined to determine the present value of the bond. An important note is that the interest rate i is the interest rate for the relevant period. For an annuity that makes one payment per year, i will be the annual interest rate.
For an income or payment stream with a different payment schedule, the interest rate must be converted into the relevant periodic interest rate. For example, a monthly rate for a mortgage with monthly payments requires that the interest rate be divided by 12 see the example below.
Payback Period & Discounted Payback Period | Formula | Example
See compound interest for details on converting between different periodic interest rates. Since the timing of cash flows does not match with a period of profit, normally firms are more interested in cash flows.
- Time value of money
- Discounting and Compounding
This is because all sales and purchases and sales are not on a cash basis. Further depreciation is a noncash item and profit is calculated after considering depreciation.
Calculating Payback cash flows Various factors to keep in mind while arriving cash flows: Since depreciation 1s a noncash item it does not affect the cash flow.
However, the tax benefit from depreciation from depreciation affects cash flow. Opportunity cost is the income that would have been earned or cost that would have been incurred had the activity is done.
Sunk cost is the cost that is already spent and hence irrelevant for decision making. Every project requires working capital to run the project.
Discounting and Compounding | EME Geo-Resources Evaluation and Investment Analysis
Therefore while calculating cash flows, the initial working capital requirement should be treated as cash outflows and at the end of the project, its release should be treated as a cash inflow. In case additional working capital is required during the life of a project, then the additional working capital required is treated as cash outflow at that period of time.
Some overheads are allocated based on machine hours, labor hours etc, They may be allocated to the new project as well.