COMPOUNDING TECHNIQUE is the method of calculating the future values of cash flows and involves calculating compound interest. Under this process, interest is compounded when the amount earned on an initial deposit (the initial principal) becomes part of the principal at the end of the first compounding period. Principal refers to the amount of money on which interest is received that is, in compounding, future values of cash flows at a given interest rate at the end of the specified period of time are found. The future value (F) of a lump sum today (P) for n periods at i rate of interest is given by the formula
F_{n} = P(1+i)_{n}= P(CVF_{n,i}).
And the compound value factor can be found out by referring to the table of compound values. For example: if Rs 1000 is invested @ 10% compound interest for 3 years, the return for first year will be
Amount at the end of the 1st year = (1000) + (1000 x 0.10) = Rs, 1,100
Amount at the end of the 2nd year = (1000) + (1100 x 0.10) = Rs, 1,210
Amount at the end of the 3rd year = (1000) + (1210 x 0.10) = Rs, 1,331
The compound interest phenomenon is most generally associated with several savings deposited with them. As the interest rate increases for some given year, the compound interest factor also increases. Therefore, the higher the interest rate, the greater is the future sum.