Time Value of Money

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finance

The concept that money today is not necessarily the same amount as money in the next year. Essentially an investor can invest their current moneys and accrue more, through interest, by next year.

Discounting - given an expected return on investment and a fixed interest rate, discounting is the process by which we determine how much money should be invested now to get the expected return. Say I have a loan opportunity which will yield 10% interest every year and by year 5 I want £133.00 total. I need to invest \(133 / 1.1^3 = 99.92\) (the denominator here is the discount factor).

Compounding is the opposite of discounting. We calculate returns at a given time from a current investment.