Mathematics for Management Reading Materials 2020

Chapter One: Linear Equations and Their Interpretative Applications in

Business
Objectives
This chapter is aimed to equip students with some basic concepts about linear functions and
introduce you with the areas of applications. After successfully completing your study of this
chapter, you will be able to:
 Define different terms such as algebraic expression, terms, variables,
constant, coefficients, and linear equations
 Develop equations of a line by using two point form, a slope point form and a
slope intercept form
 Identify the special characteristics of vertical, horizontal, parallel and
perpendicular lines when represented mathematically using linear equations
 Understand the application of linear equations like costs, revenue, profit etc.
 Determine breakeven point (BEP)
1.1. Linear Equations
EQUATION - A mathematical statement that says two algebraic expressions
are equal. E.g. y = 2x + 3. It is convenient and concise way of representing
relationship between quantities such as sales and advertising, profit and
time, cost and number of units manufactured, and so on.

Equations are used to model or represent real world situation.

Function:
Function: a relation between two sets such that to each element of the
domain (independent variable), there exists exactly one element of the
range (output).
e.g., y = 3x – 8 can be expressed in the form f(x) = 3x – 8, is a function
expressed in terms of x (independent variable), and y is the dependent
variable.
Algebraic expression: is an expression formed only from combination of
numbers and variables by using the operations addition, subtraction,
multiplication, division, exponentiation (rising to powers) or extracting the
roots. Example: 3x, x+2, 5x2y, 2x+3/1-5x2,
√2x+5

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Variable: it is something whose magnitude can vary or which can assume

various values. The variables used in applied mathematics include: sales,

price, profit, cost etc. since magnitude of variables can vary, therefore these

are represented by symbols (such as x, y, z etc) instead of a specific

number, in applied mathematics a variable is represented by the first letter

of its name, for example p for price or profit; q for quantity, c for cost; s for

saving or sales; d for demand and so forth. When we write x=5, the variable

takes specific value. When a function is defined by an equation, the variable

that represents the number in the domain (input) is called the independent

variable of the function and the variable that represents the range (output)

is called the dependent variable. Eg. Y= 2X+0.5, Y changes following the

change in x.

Constant: a quantity that remains fixed in the context of a given problem

or situation is called a constant.

Linear Equations: are equations with a variable and a constant with
degree one.
- Are equations whose terms (the parts separated by +, -, = signs)
- Are a constant, or a constant times one variable to the first power
- Are also called first degree equations
Example: 8X + 5Y = 10
- The degree (the power) of the variables is 1
- The constant or the fixed value is 10
- The terms of the equation are 8X and 5Y separated by + sign
An equation with only one independent variable is also called single variable
equation. Further, a single variable equation can be linear or non-linear
For example: y=3+2x, linear single variable equation
Y=2+3x-5x2+x2, non-linear single-variable equation
The following equations are examples of non-linear equations:
Example:
Example: a) 3x - 5xy2 = 9

b) 5x2 +3 y= 25

c) 10x + 8xy=42

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* No x2, x/y, xy, x terms are allowed.

- Linear equations are equations whose slope is constant throughout

the line.
Slope:
Slope: The slope of a line is defined as the change-taking place along the
vertical axis relative to the corresponding change taking place along the
horizontal axis, or the change in the value of Y relative to a one-unit change
in the value of X.
- The general notion of a linear equation is expressed in a form Y = mx
+ b where m = slope, b = the Y- intercept, Y = dependent variable
and X = independent variable.
If Y represents Total Cost, the cost is increased by the rate of the amount of
the slope m.

Slope (m) = if X1 ¹ X2

Slope measures the steepness of a line. The larger the slope the more steep
(steeper) the line is, both in value and in absolute value.

Y Y m = undefined
+ive slope
m=0
-ve slope
X X

1.1.1. Developing Equation of a Line

The commonly used three ways of developing the equation of a line are:
i. The slope-intercept form
ii. The slope-point form
iii. Two-point form
i. The Slope-Intercept Form
This way of developing the equation of a line involves the use of the slope
and the intercept to formulate the equation. Often the slope and the y-
intercept for a specific linear function are obtained directly from the
description of the situation we wish to model by using the relationship y =
mx + b.
Example 1: Given Slope, m = -11, y-intercept = -3, then slope-intercept
form: the equation of a line with slope = m and y- intercept b is
Y = mx + b, Y = -11x -3. X intercept is the point where Y=0 &intersects the
X-axis. Y intercept is the point where X=0 & intersects the Y-axis.

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ii. The Slope Point Form
The equation of a non-vertical line of slope, m, that passes through the
point (x1, y1) is defined by the formula y – y1 = m (x – x1)
Example: Determine the equation of a line that passes through the point
A(2,-5) and it has a slope of -8. Solution: m= -8, point A(2,-5)
y - y1 = m(x - x1)= y – (-5) = -8(x – 2)= y + 5 = -8x + 16= y = -8x + 11

iii. Two-Point Form

Two points completely determine a straight line and of course, they
determine the slope of the line. Hence we can first compute the slope, then
use this value of m together with either point in the point-slope form Y – Y 1
= m (X – X1) to generate the equation of a line.
Þ By having two coordinate of a line we can determine the equation of the
line.

Two point form of linear equation: (Y – Y 1) =

Example #1 given (1, 10) & (6, 0)

First slope = , then
Y – Y1 = m (X – X1) Þ Y – 10 = -2 (X – 1)
Y – 10 = -2X + 2
Y = -2X + 12
#2 A printer costs a price of birr 1,400 for printing 100 copies of a report &
br. 3000 for printing 500 copies. Assuming a linear relationship what would
be the price for printing 300 copies?
Answer: y = 4x + 1000
Cost = 4.0 (300) + 1000 = br. 2200
1.1.2. Special Formats
a) Horizontal & Vertical Lines
When the equation of a line is to be determined from two given points, it is
a good idea to compare corresponding coordinates because if the Y values
are the same the line is horizontal & if the X values are the same the line is
vertical. Example1: given the points (3, 6) & (8, 6) the line through them is
horizontal because both Y-coordinates are the same i.e. 6. The equation of
the line becomes Y = 6, which is different from the form Y = mx + b . If the
X-coordinates of the two different points are equal:
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Example: (5, 2) & (5, 12) the line through them is vertical, and its
equations is X=5 i.e. X is equal to a constant. If we proceed to apply the
point slope procedure, we would obtain. Slope. m = & if m
= ¥ infinite the line is vertical and the form of the equation is: X = constant
b) Parallel(
Parallel(//)
//) & Perpendicular(
Perpendicular(^) Lines
Two lines are parallel if they have the same slope, and two lines are
perpendicular if the product of their slopes is –1 or the slope of one is the
negative reciprocal of the slope of the other. However, for vertical &
horizontal lines, (They are perpendicular to each other), this rule of m 1 (the
first slope) times m2 (the second slope) equals –1 doesn’t hold true. i.e. m 1 x
m2 ¹ -1
Example: Y = 3X – 1 & Y = 3X + 4 are parallel because their slope are
equal i.e. 3. Y = 3/2X + 10 & Y = -2/3X + 100 are perpendicular to each
other because the multiplication result of the two slope are –1 i.e.

c) Lines through the Origin

Any equation in the variables X & Y that has no constant term other than
zero will have a graph that passes through the origin. Or, a line which
passes through the origin has an X-intercept of (0, 0) i.e. both X and Y
intercepts are zero.
1.2. Application of Linear Equations
1.2.1. Linear Cost Output Relationships – VC, FC, TC, AC, MC, TR, P:
TR
TR/TC profit TC = TVC + TFC
Or TP region TR = PQ

E T TP = TR - TC
Loss region BEP
G = PQ – (VC +FC)
A F FC
= PQ – Q.VC - TFC
B
C TFC D Q
= Q (P – VC) - FC
Q(No
Q(No of units)

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Where Q = units product & units sold in
revenue
TC = Total Cost
FC = Fixed Cost
V = Unit variable Cost

Interpretation of the graph:

1. The vertical distance between AB, FC, GD is the same because Fixed
Cost is the same at any levels of output.
2. There is no revenue without sales (because Total Revenue function
passes through the origin), but there is cost without production
(because of Fixed Cost) & the TC function starts from A and doesn’t
pass through the origin
3. Up to point T, Total Cost is greater than Total Revenue Þ results in
loss. While at point T, (Total Revenue = Total Cost) i.e. Breakeven. (0
profit), and above point T, TR > TC Þ +ve profit.
4. TFC remains constant regardless of the number of units produced,
given that there is no any difference in scale of production.
5. As production increases, Total Variable Cost increases at the same
rate and Marginal cost is equal with Unit Variable Cost (MC = VC) only
in linear equations.
6. As production increases TC increases by the rate equal to the AVC =
MC (average cost equal to marginal cost)
7. AVC is the same throughout any level of production, however Average
Fixed Cost (AFC) decreases when Quantity increases and ultimately
ATC decreases when Q increases because of the effect of the
decrease in AFC.
8. As Quantity increases TR increases at a rate of P. and average
revenue remains constant.
AR = = P Þ AR = P in linear functions
1.2.2. Breakeven Analysis
Break-even point is the point at which there is no loss or profit to the
company. It can be expressed as either in terms of production quantity or
revenue level depending on how the company states its cost equation.
Manufacturing companies usually state their cost equation in terms of
quantity (because they produce and sell) whereas retail businesses state
their cost equation in terms of revenue (because they purchase and sell)

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Case 1: Manufacturing Companies
Consider a Company with equation
Total cost = Variable cost + Fixed cost, i.e. TC = VC + FC
Total Revenue = Price x Quantity, i.e. TR = PQ
At Break-even point, TR = TC i.e TR – TC = 0
PQe = VC + FC where Q e = Breakeven
Quantity
PQe– V.Qe = FC FC = Fixed cost
Qe (P – V) = FC P = unit selling price
Qe = V = unit variable
cost

TC/TR TR
TC

Q
Qe

Example #1 A manufacturing Co. has a Total Fixed Cost of Br. 10,000 and a
Unit Variable Cost of Br. 5. If the company can sell what it produces at a
price of Br. 10?

a) Write the Revenue, cost & Profit functions

b) Find the breakeven point in terms of quantity and sales volume
c) Show diagrammatically the Total Revenue, Total Cost, Total Profit,
Fixed Cost and Variable Costs.
d) Interpret the results
Answer
a) TC = VC + FC TR = PQ Profit(P
Profit(P) = TR – TC
TC = 5Q + 10,000 TR = 10Q = 10Q – (5Q +
10,000)
= 5Q – 10,000
b) At breakeven point, TR = TC
10Q = 5Q + 10,000

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5Q – 10,000 = 0
Qe =
Qe = 2000 units
i.e. Breakeven Quantity is 2000 units
Sales volume = 2000 X 10 = 20,000 br.
TR = 10Q
TC=5Q+10,000

25000 TVC=5Q
20000 P = 5Q – 10,000
15000 TVC
10000 loss FC=10000
5000 TFC
0 Q
-5,000
-10,000 1000 2000 3000 4000 5000

Q(no. of units produced & sold)

Interpretation:
Interpretation:
When a company produces and sells 2000 units of output, there will not be
any loss or gain (no profit, no loss)
Þ The effect of changing one variable keeping other constant
Case 1 - Fixed Cost:
Assume for the above problem FC is decreased by Br. 5000, Citrus Paribus
(other things being constant)
TC = 5Q + 5000 Þ Qe = = 1000 units
TR = 10Q
Therefore, FC ¯ ® Qe ¯ FC & Qe have direct relationship
FC ® Qe
Case 2-Unit Variable Cost:
Assume for the above problem UVC decreased by 1 br. Citrus Paribus
(keeping other thing constant)
TC = 4Q + 10000 Þ Qe =
TR = 10Q

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Therefore, VC ¯ ® Qe ¯ VC & Qe have direct relationship
VC ® Qe
Case 3- Selling Price:
Assume for the above problem selling price is decreased by br. 1, Citrus
Paribus,
TC = 5Q + 10,000 Þ Qe =
TR = 9Q
Therefore P ¯ ® Qe Price and breakeven point have indirect relationship
P ® Qe ¯
In the above example a company has the following options (to minimize its
breakeven point and maximize profit).
- decreasing FC
- decreasing unit VC
- increasing the unit selling price
And if the organization is between option 2 & 3, it is preferable to decrease
the unit variable cost because if we increase the selling price, the
organization may lose its customers & also decreasing the FC is preferable.
TR

TC

TFC

Qe Q

Finding the quantity level which involves profit or loss

BEP = , any Q is related to the cost , profit----
P = TR – TC Where: BEP = breakeven
point
P = PQ – (VC.Q + FC) P = Profit
P = (P.Q – VC.Q) – FC TR = Total revenue
P = Q (P – VC) – FC TC = Total cost
Q = Quantity
VC = Unit variable cost

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Example #1: For the above manufacturing company. if it wants to make a
profit of 25000 br. What should be the quantity level?

TR = 10Q Q= when there is P, the quantity

produced & sold have to be greater than the Breakeven quantity
TC = 5Q + 10,000 =
P = 25,000 = 7000 units
Q=?
If it expects a loss of br. 5000 what will be the quantity level.
Q = * when there is loss, the quantity
produced & sold should be less than the BEQ
Case 2 Merchandising /Retail Business
Breakeven Revenue = BEQ X P
Assume a business firm with product A has the following cost & revenue
items.
Variable cost of A = 100 br.
Selling price = 150 br.
Markup = Selling price – Variable cost = 150 – 100 = 50
i. as a function of cost, the markup is 50/100 = 50%
ii. as a function of retail price, the markup is 50/150 = 33.3 % it is also
called margin.
Margin Cost of goods sold, CGS

The cost of goods sold = 100% - 33.3 % = 66.6% » 67%

Selling price
Given other selling expense = 1%of the selling price i.e. 0.01X
So, the TC equation becomes:
Y = 0.68X + FC
Where: X is sales revenue
Y is total cost
Out of 100% selling price 68% is the variable cost of goods purchased &
sold

Example: Suppose a retail business sale its commodities at a margin of

25% on all items purchased & sold. Moreover the company uses 5%
commission as selling expense & br. 12000 as a Fixed Cost.

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Find the Breakeven revenue for the retail business after developing the
equation
Solution Selling price 100% Let X represents selling price
Margin 25% Y = total cost
CGS 75% FC = 12000
Comm. Exp. 5% X e = Breakeven revenue
Total VC 80%
\Y = 0.8X + 12000
Break even revenue is obtained by making sales revenue & cost equals
At breakeven point TC = TR Y = mx + b
i.e. Y = X then, unit variable cost
0.8X + 12000 = X Þ
-0.2X = -12000
X = 60,000 br. Þ When the co. receives br. 60,000 as
sales revenue,
there will be no loss or profit.
The Breakeven revenue (BER = ) method is useful, because we can
use a single formula for different goods so far as the company uses the
same amount of profit margin for all goods. However, in Breakeven quantity
method or BEQ = it is not possible and hence we have to use
different formula for different items.
Example 1: It is estimated that sales in the coming period will be br. 6000 &
that FC will be br. 1000 & variable costs br. 3600, develop the total cost
equation & the breakeven revenue.
Answer: Y = X + 1000 = 0.6X + 1000
Where Y = Total Cost
X = Total revenue
BER = Xe =
At the sales volume of br. 2500, the company breaks even.
2. In its first year, ABC company had the following experience
Sales = 25,000 units Selling price = br. 100
TVC = br. 1,500,000 TFC = br. 350,000

Required:

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a) Develop Revenue, cost & profit functions for the company in terms of
quantity.
b) Find the Breakeven point in terms of quantity
c) Convert the cost equation in terms of quantity into a cost equation in
terms of revenue
d) Find the Breakeven revenue
e) If profit had been br. 500,000 what would have been the sales volume
(revenue) & the quantity of sales
f) What would have been the profit if sales were br. 2,000,000?
* When the breakeven revenue equation is for more than one item it is
impossible to find the breakeven quantity. It is only possible for one item by
Qe = Xe/P
Where Xe = Breakeven revenue
P = selling price
Qe = Breakeven quantity
To change the breakeven revenue equation in to breakeven quantity, we
have to multiple price by the coefficient of X. likewise, to change in to
breakeven revenue from break even quantity, we have to divide the unit VC
by price.
Example:
Example: A wholesaler bought a laptop computer for birr 6000 and sold it
to a retailer at a margin of 20% of the wholesale price. If the retailer’s
margin is 25% of the retail price, what is the selling price of the retailer?
Solution:
Solution: Let pw & pr be the selling price of the wholesaler and retailer
respectively.
pw = 6000+20%(pw)
pw= 6000+0.2pw
pw = 7500 br. Becomes the cost for the retailer
pr = 7500+0.25pr
0.75pr = 7500
pr = 10,000 br
1.2.3. Market Equilibrium Analysis
In this section, we introduced demand functions, which relate the quantity
of product consumers are willing and able to buy to the unit price of the
product. Linear demand functions have negative slope because demand
decreases when price increases. A supply function on the other hand,
relates the quantity producers are willing and able to the supply to the unit
selling price of the product, and linear supply functions have positive
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slopes because producers increases the supply when the selling price
increases. Supply and demand functions as the straight lines labeled supply
and demand respectively. The equations are:
E1: DD: P=-0.1q+40 (-ve slope)
E2: SS: P=0.2q+10 (+ve slope)
The intersection of DD and SS is found by
e1=P+0.1q=40
e2=P-0.2q=10
e1-e2 : 0.3q=30, so, that q=100units
from e1= p=-0.1(100)+40= 30 per unit
so we have the (100,30) equilibrium point, which shows the market price
that will equate the quantity consumers are willing and able to buy with the
quantity producers are willing and able to supply. What we wish to show in
this section is the effect of a change in the demand (but not supply)
function, and the effect of a change in the supply (but not the demand)
function. This can be done by finding the new equilibrium point, after a
change has occurred. For example, suppose demand changes to the
function D’D’ with supply remaining at SS. The two functions now are:
e1 = D’D’: P=-0.08q+52
e2: =SS : P=0.2q+10
We now find
e1: P+0.08q=52
e2: P-0.2q=10
e1-e2: 0.28q=42
q=150 and from e1, P= -0.08(150)+52=40
the new equilibrium point is (150,40), we see that the change in the
demand function is an increase in demand, which results in a higher
quantity and a higher price at the new equilibrium. In economic
terminology, the demand function shifted to the right so that a larger
quantity is demanded at each level. Thus, if there is a change in a supply
function, with the demand function unchanged, and the equilibrium points
are E (500,15) and E’ ( 400,20). The decrease in supply results in a lower
quantity, but a higher price at equilibrium. An increase in demand was
accompanied by an increase in both quantity and price, so a demand
change in one direction is accompanied by quantity and price changes in
the same direction. The effect of a supply change, however, is inverse in the
sense just illustrates a decrease in supply lowers the quantity but increases
the price; an increase in supply will increase quantity but lower price.
Exercise

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a. Graph the supply and demand functions.
SS: P= 0.1q+8
DD: P=-0.5q+50
b. Find the equilibrium point for (a)
c. Plot the new demand function D’D’
P= -0.6q+36 on the graph for (b)
d. Find the new equilibrium point.
e. Describe the change in the equilibrium points
CHAPTER TWO: MATRIX ALGEBRA AND ITS APPLICATIONS

Objectives
After completing this chapter, you will be able to:
 Define a matrix
 Identify different types of matrices
 Manipulate various matrix operations
 Understand matrix applications in solving linear
equations
 Understand the concept of Markov Chain
Analysis.
2.1. Matrix Concepts
Algebra - is a part of mathematics that deals with operations (+, -, x÷).
Matrix is a rectangular array of real numbers arranged in M rows and N
columns. Like sets, it is symbolized by a bold face capital letter enclosed by
brackets or parentheses as:

in which aij are

real nos.
Each number appearing in the array is said to be an element or
component, of the Matrix. Elements of a matrix are designated using a
lowercase form of the same letter used to symbolize the matrix itself.
These letters are subscript, as aij, to give the row and column location of
the element within the array. The first subscript always refers to the row
location of the element; the second subscript always refers to its column
location. Thus, component aij is the component located at the intersection
of the ith row and the jth column. The number of rows, m, and the number
of columns, n, of the array give its order, or its dimensions, mxn (read “m
by n”) = A mxn or [aij] (mxn).
Example: The following are examples of matrices
This is a 3 x 2 matrix ELEMENT
a12= 7

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a21 = 5
a32 = 2
a23 = no values for this – Because this is a 3 x 2 matrix.

X= this is a 4 x 4 matrix Elements X44 = 45 x32 = 7

Matrices provide a most convenient vehicle for organizing and storing large quantities of data. Because the basic
idea is to organize the data, we cannot over emphasize the importance of the location of each number with in the
matrix. It is not simply a matter of putting numbers in to rows and columns; each row-column location within
each matrix carries with it special interpretation; a matrix is, in essence, a tool for organizing vast quantities of
data. Matrices are used to represent complex systems and operations by compact entities. Matrix
representations are possible. Transportation matrix, Distance matrix, Cost matrix, Brand switching. Diet matrix,
Assignment matrix, Pay-off-matrix
2.2. Types of Matrices

1. Vector Matrix - is a matrix which consists of either one row or one column.
That is, it is an mx1 or a 1 x n matrix.
1.1. Row Vector = is a 1 x n matrix
E.g. W = [-1, 0, 6]
1.2 Column Vector - is a mx1 matrix
E.G. B =
1
3
1
5

2. SQUARE MATRIX - IS A MATRIX THAT HAS THE SAME

NUMBER OF ROWS AND COLUMNS. IT IS ALSO CALLED AN N TH
ORDER MATRIX OR SQUARE MATRIX OF ORDER N.
E.g. 2x2, 3x3,4x4 etc. if a matrix is not square then it is called rectangular
matrix
3. Null (Zero) Matrix - is a matrix that has zero for every entry. No matter
what the dimension is. It is generally denoted by O mn. In matrix operations
it is used in much the same way that the number zero is used in regular
algebra. Thus, the sum of a zero matrix and any matrix gives that given
matrix and the product of a zero matrix and any matrix equals a zero
matrix.

4. Identity (Unit) Matrix - a square matrix in which all of the primary

diagonal entries are ones and all of the off diagonal entries are zeros.
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Generally it is denoted as I n. Primary diagonal represents: a11, a22, a33, a44,
--- ann entries.

I2 = , I 4 =

The product of any given matrix and the identity matrix is the given matrix
itself. That is, A x I = A and I.A = A. Thus, the identity matrix behaves in
matrix multiplication like the number 1 in an ordinary arithmetic.
5. Scalar Matrix - is a square matrix where elements on the primary diagonal
are the same and the rest zeros. NB: An Identity matrix is a scalar matrix,
but a scalar matrix may not be an identity matrix
6. Diagonal Matrix- a square matrix where elements on the primary diagonal
are non zero and others zeros. For square matrix, the diagonal from the top
left to the bottom right corner is called the principal diagonal or main or
primary diagonal.
Example

2 0 0
0 5 0
0 0 1
7. Equal Matrices -Two matrices A & B, are said to be equal only if they
are of the same dimensions and if each element in A is identical to its
corresponding element in B; that is, if and only if a ij = bij for every pair of
subscripts i and j. If A = B, then B = A; or if A≠B, then B ≠A.
is equal to B =

However; is not equal to C =

Even though they contain the same set of numerical values, A and C are
not equal because their corresponding elements are not equal; that is, a 11
≠ C11 and so on.
2.3. Matrix Operations
2.3.1. Transpose of a Matrix
Given any matrix, we can form the transpose of the matrix by making the
columns of the original matrix the row in the transpose matrix, and by
making the rows of the original matrix the columns in the transpose matrix

The transpose of an mxn matrix denoted A -t is an nxm matrix whose rows

are the columns in A (in the same order) and whose columns are the rows
in A (in the same order).

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If then A-t =
The transpose of a row vector is a column vector and the transpose of a
column vector is a row vector.
2.3.2. Matrix Addition and Subtraction
Two matrices of the same dimensions are said to be conformable for
addition. The addition is performed by adding corresponding elements
from the two matrices and entering the result in the same row-column
position of a new matrix [element-wise addition].
Laws of Matrix Addition
The operation of adding two matrices that are conformable for addition has
the following basic properties:
1. A + B = B + A ---- The commutative law of matrix addition.
2. (A+B) +C = A+ (B+C) -------- the associative law of matrix addition.
3. K(A+B) =KA+KB
4. A+O=A=O+A (O is a null or zero matrix of the same dimension as A
5. A+(-A)=O=(-A) +A
6. A+C=B+C >A=B

+ =
Given that two matrices do have the same dimension, the way we subtract
a matrix from another matrix is the same as the way we add two matrices.

2.3.3. Matrix Multiplication

A. Matrix Multiplication by a Constant (Scalar Multiplication)
A matrix can be multiplied by a constant by multiplying each component in
the matrix by a constant. The result is a new matrix of the same dimensions
as the original matrix.
E.g. If X = [6 5 7], then 2X = [(2x6) (2x5) (2x7)]
2X = [12 10 14]
Laws of Scalar Multiplication
The operation of multiplying a matrix by a constant (a scalar) has the
following basic properties. If x and y are real numbers and A and B are
mxn matrices, conformable for addition, then:
1. XA = AX
2. (X+Y)A = XA+YA
3. X (A+B) = XA + XB
4. X (YA) = XY (A)
B. Vector-by-Vector Multiplication
In multiplying two vectors always a row vector is written in the first
position and the column vector in the second position. Each component of a
row vector is multiplied by the corresponding component of the column
vector to obtain a result known as partial product. The sum of all partial
products is called inner/dot product of two vectors, and this is a number
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not a vector. In other words, Vector- by- Vector results in a real number
rather than a matrix.
E.g. Consider the product (AB) of the following row and column vectors.
’ B= 2
5
7
0
3x2=6
4 x 5 = 20 partial products
-2 x 7 = -14
6x0=0
12 Inner/Dot Product
C. Matrix by Matrix Multiplication
If A and B are two matrices, the product AB is defined if and only if the
number of columns in A is equal to the number of rows in B, i.e., if A is an
m x n matrix, B should be an n x b. If this requirement is met, A is said to
be conformable to B for multiplication. The matrix resulting from the
multiplication has dimensions equivalent to the number of rows in A and
the number of columns in B. Matrix by matrix multiplication indicates a
row by column multiplication, where the entry in the i th row and jth column
of the product AB is obtained by multiplying the entries in the i th row of A
by the corresponding entries in the j th column of B and then adding the
results. That is, to obtain the entry in the i th row and jth column of the
product AB, use the ith row of A and the jth column of B in the following
form:

The first element in the row is multiplied by the first element in the
column; the second element in the row is multiplied by the second element
in the column and so on until the nth row element is multiplied by nth
column element. These products are then summed up to obtain the single
number that is the product of the two vectors.
If A is a matrix of dimension n x m (which has m columns) and B is a matrix
of dimensions p x q (which has p rows) and if m is different from p, the
product AB is not defined. That is, multiplication of matrices is possible
only if the number of columns of the first equals the number of rows of the
second. If A is of dimension n x m and if B is of dimension m x p, then the
product A.B is of dimension n x p.
Example

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B=

A.B = (2x-1) + (3x0) + (4x5) (2x7) + (3x8) + (4x1)

= 18 42

= (6x-1) + (9x0) + (7x5) (6x7) + (9x8) + (7x1)

= 29 121

AB =
BA= (-1x2) + (7x6) = 40
(-1x3) + (7x9) = 60
(-1X4) + (7X7)=45
(0X2) + (8X6)=48
(0X3)+(8X9)=72
(0X4)+(8X7)=56
(5X2)+(1X6)=16
(5X3)+(1X9)=24
(5X4)+ (1X7)=27 AB =
From the above multiplication result we can see that AB≠BA
SPECIAL PROPERTIES OF MATRIX MULTIPLICATION
1. The Associative and distributive laws of ordinary algebra apply to matrix
multiplication. Given three matrices A, B and C, which are conformable
for multiplication,
 A (BC) = (AB) C -------------------- Associative law, not C (AB).
 A (B+C) = AB + AC --------------Left Distributive law
 (A+B) C = AC + BC --------------Right Distributive law
2. The commutative law of multiplication does not apply to matrix
multiplication. For any two real numbers X and Y, the product XY is
always identical to the product YX. But for two matrices A and B, it is
not generally true that AB equals BA. (In the product AB, we say that B
is pre multiplied by A and that A is post multiplied by B). In many
instances for two matrices A and B, the product AB may be defined
while the product BA is not defined, or vice versa.

In some special cases, AB does equal BA. In such special cases A and B are
said to Commute. Example A=
B=
AB=BA=
3. The product of two matrices can be the zero matrix even though neither
of the two matrices themselves is zero matrix! We cannot conclude

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from the result AB = 0 that at least one of the matrices A or B is a zero
matrix.

A= ,B= ,

AB =

4. We cannot, in matrix Algebra, necessarily conclude from the results AB

= AC that B = C, even if matrix A is not equal to a zero matrix. Thus the
cancellation law does not hold, in general, in matrix multiplication.

,B ,C

AB = AC = but B ≠ C.
5. The product of any given matrix and the unit matrix is the given matrix
itself. In other words, the unit matrix behaves like the number one in
ordinary arithmetic where we say (a)(1)=(1)(a)=a

1 0 0 2 3 4 2 3 4
0 1 0 -1 -2 0 = -1 -2 0
0 0 1 5 2 -3 5 2 -3
The most property of the unit matrix is illustrated by the statements AI=A
and IA=A
2.4. Inverse of a Matrix
If A is a square matrix of order n, then a square matrix of its inverse (A -1) of
the same order n is said to be the inverse of A, if and only if AA -1 = I = A-1A.
Two square matrices are inverse of each other if their product is the

identity matrix: I = AA-1 = A-1A.

Not all matrices have an inverse. In order for a matrix to have an inverse,

the matrix must, first of all, be a square matrix. Still not all square matrices

have inverse. If a matrix has an inverse, it is said to be Inevitable or non-

singular. A matrix that doesn’t have an inverse is said to be singular. An

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inevitable matrix will have only one inverse; that is, if a matrix does have

an inverse , and that inverse is unique.

In short:
 Inverse of a matrix is defined only for square matrices
 If B is an inverse of A, then A is also an inverse of B.
 Inverse of a matrix is unique.
 If matrix A has an inverse, A is said to be inevitable and not all
square matrices are inevitable.
E.g. inverse does not exist for this matrix
Properties of the Inverse
i. The inverse of the inverse is the original matrix, i.e. (A -1)-1=A
ii. The inverse of the transpose of a matrix is the transpose of its
inverse, i.e. (At)-1=(A-1)t
iii. The identity matrix is its own inverse, i.e. I -1=I
iv. The inverse of the product of two non-singular matrices is equal to
the product of two inverses in the reverse order, i.e. (AB) -1= B-1.A-1
Finding the Inverse of a Matrix
Let us begin by considering a tabular format where the square matrix. A is augmented with an identity matrix of
the same order, as [A/I]. This process is called ADJOINING. The combination of two or more matrices written as
one is called augmented matrix. The vertical bar separates the two original matrices. Then, because AA -1 = I and
A-1 I = A-1, we would have [I/A-1]. We do not follow this procedure, because the inverse is not known at this
juncture; we are trying to determine the inverse. We instead employee a set of permissible row operations on the
augmented matrix [A/I] to transform A on the left side of the vertical line in to an identity matrix (I). As the
identity matrix is formed on the left of the vertical line, the inverse of A is formed on the right side. The allowable
manipulations are called elementary row operations. These Elementary Row Operations are operations permitted
on the row of a matrix.

In a matrix Algebra there are 3 types of row operations.

i. Any pair of row in a matrix may be interchanged /Exchange
operations/. Interchanging rows. First elementary row
operation
ii. A row can be multiplied(divided) by any non-zero real number
/Multiple(divide) operations/. The multiplication (division) of
any row by a non-zero number. Second elementary row
operation
iii. A multiple(divide) of any row can be added to any other row /Add-
A-Multiple(divide) operations/. The addition /subtraction of (a
multiple of) one row to/from) another row. Third
elementary row operation

E.g. 1. ,B = interchanging
rows

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2. B= = multiplying the first

row by 2.

3. B= = Multiplying the first

row by 2 and add to 2nd row and replaces the second row.
The combination of two or more matrices written as one is called
augmented matrix. The vertical bar separates the two original matrices.

Basic Procedures to Find the Inverse of a Square Matrix

1. To get ones first in a column and next zeros (within a given column)
2. To get zeros first in a matrix and next ones.
Ones First: Try to set ones first in a column and then zeros of the same
column. Go from left to right. Eg. Find the inverse of the following matrix
A=
3 2
1 1
Solution first augment the given matrix A with the same dimensional unit matrix of order 2.
3 2 1 0
1 1 0 1
Interchanging row one with row two
1 1 0 1
3 2 1 0
Don’t change row one but change the second row by multiplying the first row by -3 and add to
R2
1 1 0 1
0 -1 1 -3
Change the second row by multiplying it by-1 and change the first row by adding to it the
second row
1 0 1 -2
0 1 -1 3
Therefore inverse of A is A-1 =
1 -2
-1 3

Zeros First: Find the off diagonal zeros first, and following this obtain
ones on the main diagonal. It can simplify the work involved in hand
calculation by avoiding fractions until the last step. Eg. Find the inverse of
the following matrix
A=
3 2
1 1
Solution

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3 2 1 0
1 1 0 1

Change the first row by adding to it -2 multiplied the second row(i.e.R1-2R2) and don’t change
the second row
1 0 1 -2
1 1 0 1
Don’t change the first row but change the second row by adding to it -1 multiplied by the
second row
1 0 1 -2
0 1 -1 3
Again the inverse of A is A = -1

1 -2
-1 3

Generally, Perform the elementary row operations on the augmented

matrix until the augmented matrix is reduced to form (I/B)

2.5. Matrix Applications

2.5.1. Solving Systems of Linear Equations
1. n by n systems
Systems of linear equations can be solved using different methods. Some
are:
 Elimination method for 2 variable problems (equations).
 Matrix method
i. Inverse method
ii. Gaussian Method.
Elimination method for two variable problems (equations)
Example, solve the following equations by elimination techniques
2x+3y=4
X+2y=2
Multiply the second equation by -2 and add with the first equation
2x+3y=4
-2x-4y=-4
-y=0
Y=0 , so insert 0 in the place of y in one of the original equations
2x+3(0)=4
2x+0=4
2x=4
X=4/2=2
Therefore the solution set is, x=2 and y=0
Exercise solve the following system of linear equations by using the
elimination method
X+3y=2

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2x+6y=-3
Inverse Method
This method is one of the methods used to solve a system of linear
equation if the number of equations and numbers of variables are equal. To
solve systems of linear equations using the inverse method the coefficient
matrix should be inevitable ( the inverse of the coefficient matrix exists,
and it involves the following steps:
1. Put all equations in a matrix form (square matrix form).
2. Find the inverse of the coefficient matrix.
3. Multiply the inverse with right hand side values (vector of
constants)
2. X+Y = 2
2x + 2y= 4
Step-1
1 1 X 2
2 2 y 4
Step-2
1 1 1 0
2 2 0 1
-2R+R2>R2=
1 1 1 0
0 0 -2 1
NB: This coefficient matrix has not inverse,
Another example 2x +3y=4
X+2y=2

Step-1
2 3 X 4
1 2 y 2
Step-2
2 3 1 0
1 2 0 1
R1—R2

1 2 0 1
2 3 1 0
-2R1+R2----R2
1 2 0 1
0 -1 1 -2
2R2+R1-----R1
1 0 2 -3
0 -1 1 -2
-R2-----R2
1 0 2 -3
0 1 -1 2

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Step-3
X 2 -3 4
Y -1 2 2

2x4 +(-3x2)=2
-1x4+2x2=0, So X=2 and Y=0
The inverse method provides us with unique solution, or no solution and
infinite solution (without separating them).
Exercise: solve the following application problems by
using matrix inverse method
If 3 kilos of sugar and 2kilos of coffee cost Birr 35 while 5 kilos of sugar
and 3 kilos of coffee cost Birr 55, find the price of sugar per kilo and coffee
per kilo.
Solution:
Let 1 kilo of sugar costs Birr X and 1 kilo of coffee costs Birr Y
3X +2Y=35
5X+3Y=55
Limitations of inverse method
 In addition to apply the method the coefficient matrix needs to have
an inverse
 It is only used whenever the coefficient matrix is square matrix
 It doesn’t differentiate between no solution and infinite solution cases

Gaussian Method:

The Gaussian elimination method developed by mathematician Karl F. Gauss

(1771-1855) can help to solve such system of linear equations which can be
either:
 The number of equations is equal to the number of variables ( m=n)
 The number of equations is greater than the number of variables (m>n), or
 The number of equations is less than the number of variables(m<n)
Solving systems of linear equations using the Gaussian method involves the
following steps:
1. Write all equations in a matrix form.
2. Change coefficient matrix in to identity matrix and apply the same
elementary row operations on the vector of constants
3. The resulting value (of the RHS vector) will be the solution.

Ax = B
Ix = C
x=C
The Gaussian Method helps us to obtain:
 Unique solution
 No. Solution

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 Infinite solution
E.g. 1. 2x + 3y = 4 2. x + y = 2 3. x + y = 5
x + 2y = 2 2x + 2Y = 4 x+y=8
IX = c
X=C
Therefore, Gaussian method unlike the inverse method, makes a distinction
between unique solution, no solution and infinite solutions.
The steps can be summarized as follows ( Gauss Jordan Elimination
Method)
1. Choose the leftmost nonzero column and use appropriate row
operation to get a 1 at the top.
2. Use multiples of the first row to set zeros in all places below the 1
obtained in step 1.
3. Delete(mentally) the top row and first column of the matrix. Repeat
step 1 and step 2 with the sub matrix. Continue this process if step of
1-3, until it is not possible to go further.
4. Consider the whole matrix obtained after mentally returning all the
rows and columns to the matrix. Begin with the bottom non zero row
and use appropriate multiples of of it to get zeros above the leftmost
1. Continue this process, moving up row by row until the matrix is
finally in a reduced form.
Summarizing our results for solving an “n” by “n” system, we start with
matrix (A/B), and attempt to transform it in to the matrix (I/C).
One of the three things will result:
1. An n by n matrix with the unique solution; e.g.

Eg. Solve the following equations by Gauss Jordan elimination method

2x-2y+z=3
3x+y-z=7
x-3y+2z=0
answer solution set is x=2,y=0and z=-1
2. A row that is all zeros except in the constant column, indicating that there
are no solutions; e.g.

3. A matrix in a form different from (1) and (2), indicating that there are an
unlimited number of solutions. Note that for an n by n system, this case

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occurs when there is a row with all zeros, including the constant column;
e.g.

2. M by n linear systems
The mxn linear systems are those systems where the number of rows (m)
and number of columns (n) are unequal or it is the case where the number
of equations (m) and the number of variables (n) are unequal. And it may
appear as m>n or m<n.
2.1 Linear equations where m>n
To solve an m by n systems of equations with m>n, we start with the
matrix (A/B), and attempt to transform it in to the matrix (I/C). One of the
three things will result:

1. An n by n identity matrix above m-n bottom rows that are all zeros,
giving the unique solution
E.g. 4x + 5y= 30
3x +2y= 19
2x + 5y=20
1 0 5 X
0 1 2 Y
0 0 0 0

The solution is, x=5, y=2, 0=0 is always true. Therefore, the solution set is
(x,y) (5,2)

2. A row that all zeros except in the constant column, indicating that there
are no solutions.
E.g. 4x +5y=30
3x+2y=19
2x+5y=30

1 0 5 X
0 1 2 Y
0 0 10 0
The solution is x=5,y=2 and 0=10 which is always false, the solution set is
empty; i.e. the system has not solution

3. A matrix in a form different from (1) and (2), indicating that there are an
unlimited number of solutions.

E.g. 3x +2y+z=6
6x+5y+3z=12

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9x+6y+3z=18
15x+10y+5z=30
1 0 1/3 2
0 1 1 0
0 0 0 0
0 0 0 0
X+1/3z=2
Y+z=0 where the number of unknowns is greater than the number of
equation, hence you have infinitely many solution

2.2. Linear equations where m<n

Our attempt transform (A/B) in to (I/C) in the case where m<n will result
in:
1. A row that is all zeros except in the constant column, indicating that
there are no solutions.
Eg. 4X+ 6y -3z=12
6x +9y -9/2z=20

1 3/2 -3/4 3
0 0 0 2

Therefore, from the last row of the row echelon form of the matrix you
observe that the system has no solution.
2. A matrix in a form different from (1), indicating that there are an
unlimited number of solutions.

Eg. 2x + 2y +z=36
X + 3y +2z=30
1 0 -1/4 12
0 1 3/4 6
X-1/4z=12
Y+3/4z=6
Therefore, you have two equations with three variables and have infinitely
many solutions.

“Every System of Linear Equations has No Solution, Exactly One Solution

or Infinitely Many Solutions.”

2.6. Markov Chains

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Concept, Model and Solutions
This model is a forecasting model. It is probabilistic model associated with
a system that involves change from one state to another in such a way that
we are only able to assign probability other than 0 and 1 to the occurrence
of future state. A Russian mathematician called Andrew Markov around
1907 developed this model.
Markov chain is a sequence of experiments (trials) or observations such
that the probability for the next states is completely determined by the
present state.
Markov chains are models which are useful in studying the evolution of
certain system over repeated trials. These repeated trails are often
successive time periods where the state (outcome, condition) of the system
in any particular time period cannot be determined with certainty.
Therefore, a set of transition probabilities is used to describe the manner
in which the system makes transition from one period to the next. Hence,
we can predict the probability of the system being in a particular state at a
given time period. We can also talk about the long run/equilibrium, steady
state.
System : which we want to study, machine, and person
Trials: successive time period any convenient length of time day, week,
month, year, etc.
State/Outcome, Condition: the system can have various number of
outcomes.
Transition Probabilities: set of input data, and are assumed to be
constant.
Long/Stead State: the system cannot change any more. There is the same
probability between n and n + 1 period after the long period.
Transition Matrix: is a square matrix having no negative entries and the
sum of the entries in each row is equal to 1.
Probability Matrix: is a row matrix having no negative entries and the
sum of the entries is equal to 1.
A probability matrix that gives a long range prediction for a given
transition matrix is called Fixed Probability Matrix
Let P be a transition matrix, then the probability matrix V is said to be a
fixed probability matrix if and only if VP=V.
The necessary assumptions of the chain are:

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1. The system has a finite number of states - the outcomes of the system
should be finite.
2. The system condition/outcome, state in any given period depends on its
state in the preceding period and on the transition probabilities
3. The transition probabilities are constant over time.
4. Changes in the system will occur once and only once each period. For
example, if it is a week, then it is only once in a week.
5. The transition period occurs with regularities. Example, if we start with
days, we use the day until we reach our end.
6. The states are both mutually exclusive and collectively exhaustive.
7. The system is a closed one, that is, there will be no arrival or exits from
the system.
Information flow in the Analysis
The Markov model is based on two sets of input data
 The set of transition probabilities.
 The existing or initial or current conditions or states.
The Markov process, therefore, describes the movement of a system from a
certain state in the current state/ time period to one of n possible states in
the next stage. The system move in an uncertain environment all that is
known is the probability associated with any possible move or
transition. This probability is known as transition probability
symbolized by Pij. It is the likelihood that the system which is currently in
state i will Smoke to state j in the next period.
From these inputs the model makes two predictions usually expressed as
vectors:
1. The probabilities of the system being in any state at any given future
time period.
2. The long run / equilibrium, steady state probabilities.
Markov chain analysis used among other things in Market share Analysis.
The example below shows this.
1. Currently it is known that 80% of customers shop at store 1 and 20% shop
at store 2. In reviewing a past data suppose we find that out of all
customers who shopped at store 1 in a given week 90% remain loyal for the
next week (store one again), 10% switch to store 2. Out of all customers
who shopped at store 2, in a given week 80% remain loyal for the next
week (store 2 again), 20% switch to store 1. What will be the proportion of
customers shopping at store 1 and 2
a) in each of the next two weeks?
b) in the long run?
Lets denote Store 1 by 1 and Store 2 by 2.
V12= (.8 .2) - initial state/ current state probability matrix.
To next weekly shopping period
From one week S1 S2

S1 0.9 0.1

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S2 0.2 0.8
 The sum of rows in the transition matrices should be one.
 We have to be consistent in writing the elements.
P11, P22, P33, P44 ---------------------Pnn that represent the primary diagonal show
loyalty. Others switching.
V12 (0) = (.8 .2)
V12 (1) = V12 (0) x P
= (.8 .2)
= (.8 x .9) + (.2x.2) (.8x.1) + (.2x.8)
= .72 + .04 .08 +. 16
= 0.76 .24

V12(1) = (.76 .24)

V12
(2)
= V12(1) x P
= V12(1) x P
= (.76 .24)
= (.8) .2) =(0.732 .268)
b. In the long run (V1 V2) (n) = (V1 V2) (n+1)
n p n+1
(V1 V2) = (V1 V2)
0.9V1 + .2V2 = V1
.1V1 + .8V2 = V2
V1 + V2 = 1
.9V1+.2(1-V1) =V1
.9V1 + .2 - .2V1 = V1
.7V1 + .2 = V1
.2 = .3V1
V1 = 2/3
V2 = 1 - V1
= 1 - 2/3
V2 = 1/3
In short, the switching over the sum of the switching gives us the long run
state.
To

S1 S2

From S1 .9 .1

S2 .2 .8

In the long run 67 of the customer will shop in store 1 and 33% in store 2.
Prediction: Long run - only the transition matrix.

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At specified time - the transition matrix and state vector.
Hence, unless the transition matrix is affected, the long run state will not
be affected. Moreover, we cannot know the number of years, weeks, or
periods to attain the long run state, point but we can know the share.
Exercises
1. A division of the ministry of public health has conducted a sample
survey on the public attitudes towards the use of condoms. From the
results of the survey the department concluded that currently only 20% of
the population uses condoms and every month 10% of non-users become
users, where as 5% of users discontinue using.
Required

a. Write the current transition matrices.

b. What will be the percentage of users from total population just after two
months?
c. What will be the proportion of the non users and users in the long run?

Solution

Let. U - Stands for users, and N- stands for nonuser

1. Initial state VUN (0) = 0.2 0.8

To the next month

From one month Users (U) Non Users (N)

Users (U) .95 .05

Non Users (N).10 .90

2. V (1) UN = V (0) UN x P
= 0.2 0.8
=
(0.27 0.73)

V (2) UN = V (1) UN x P
= 0.27 0.73
= (.3295 0.6705)

3. VU VN = (? ?)

VU = VU =

VU VN = 0.67 0.33
VUN (n) = 0.67 0.33

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CHAPTER THREE: INTRODUCTION TO LINEAR PROGRAMMING

Objectives
At the end of this chapter students
will be able to:
 Explain what linear
programming is
 Formulate linear programming
models
 Solve optimization problems
applying linear programming
techniques
 Apply knowledge of linear
programming to solve
managerial problems
3.1. Linear Programming Basic
Concepts
Linear Programming- is an optimization method, which shows how to allocate scarce
resources such as money, materials or time and how to do such allocation in the best possible
way subject to more than one limiting condition expressed in the form of inequalities and/or
equations.
It enables users to find optimal solution to certain problems in which the solution must satisfy a
given set of requirements or constraints.
Optimization in linear programming implies either maximization (such as profit, revenue, sales,
and market share) or minimization (such as cost, time, and distance) a certain objective
function. It implies that in LP we cannot max/min two quantities in one model. It involves
linearly related multi-variate functions, i.e., functions with more than one independent variable.
The goal in linear programming is to find the best solution given the constraints imposed by the
problem; hence the term constrained optimization.
Linear Programming Models (LPM)
Linear Programming (LP) models are mathematical representations of LP
problems. Some LP models have a specialized format, whereas others have
a more generalized format. Despite this, LP Models have certain
characteristics in common. Knowledge of these characteristics enables us
to recognize problems that are amenable to a solution using LP models and
to correctly formulate an LP model. The characteristics can be grouped
into two categories: Components and Assumptions. The components
relate to the structure of a model, whereas the assumptions reveal the
conditions under which the model is valid.

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Components Assumptions
1. Objective function 1. Linearity
2. Decision variables Model 2. Divisibility Model
3. Constraints Structure 3. Certainty Validity
4. Parameters & RHSV 4. Non-negativity

Components of LP model
1. The Objective Function- is the mathematical or quantitative
expression of the objective of the company/model. The objective in problem
solving is the criterion by which all decisions are evaluated. In LPMs a
single quantifiable objective must be specified by the decision maker. For
example, the objective might relate to profits, or costs, or market share,
but to only one of these. Moreover, because we are dealing with
optimization, the objective will be either maximization or minimization, but
not both at a time.
2. The Decision Variables - represent unknown quantities to be
resolved for. These decision variables may represent such things as the
number of units of different products to be sold, the amount of Birr to be
invested in various projects, the number of advertising to be placed with
different media.Since the decision maker has freedom of choice among
actions, these decision variables are controllable variables.
3. The Constraints - are restrictions which define or limit the
feasibility of a proposed course of action. They limit the degree to which
the objective can be pursued. Atypical restriction embodies scarce
resources (such as labor supply, raw materials, production capacity,
machine time, storage space), legal or contractual requirements (e.g.
Product standards, work standards), or they may reflect other limits based
on forecasts, customer orders, company policies etc.
4. Parameters - are fixed values that specify the impact that one unit
of each decision variable will have on the objective and on any constraint it
pertains to as well as to the numerical value of each constraint.
 The components are the building blocks of an LP model. We can
better understand their meaning by examining a simple LP model as
follows.
Example:
Maximize: 4X1 + 7X2 + 5X3 (Profit) ________________ objective function
Subject to:
2X1 + 3X2 + 6X3  300 labor hrs
5X1 + X2 + 2X3  200 lb raw material A System constraints
3X1 + 5X2 + 2X3  360
X1 = 30 Individual
X2  40 constraints
X1, X2, X3  0  Non-negativity constraints.
System constraints – involve more than one decision variables.

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Individual constraints – involve only one decision variable.
None-negativity constraints specify that no variable will be allowed to take
on a negative value. The non-negativity constraints typically apply in an LP
model, whether they are explicitly stated or not.
Assumption of LP Models
1. Linearity. The linearity requirement is that each decision variable
has a linear impact on the objective function and in each constraint in
which it appears. Following the above example, producing one more unit of
product 1 adds Br. 4to the total profit. This is true over the entire range of
possible values of X1. The same applies to each of the constraints. It is
required that the same coefficient (for example, 2 lb. per unit) apply over
the entire range of possible value so the decision variable.
2. Divisibility. The divisibility requirement pertains to potential values
of decision variables. It is assumed that non-integer values are acceptable.
For example: 3.5 TV sets/hr would be acceptable  7 TV sets/2hrs.
3. Certainty. The certainty requirement involves two aspects of LP
models.
i) With respect to model parameters (i.e., the numerical values) – It is
assumed that these values are known and constant e.g. in the
above example each unit of product 1 requires 2lab this is known
and remain constant, and also the 300 lab/hr available is deemed
to be known and constant.
ii) All the relevant constraints identified and represented in the model
are as they are.
4. Non-negativity. The non-negativity constraint is that negative
values of variables are unrealistic and, therefore, will not be considered in
any potential solution; only positive values and zero will be allowed.
3.2. Formulating LP Models
Once a problem has been defined, the attention of the analyst shifts to
formulating a model. Just as it is important to carefully define a problem, it
is important to carefully formulate the model that will be used to solve the
problem. If the LP model is ill formulated, ill-structured, it can easily lead
to poor decisions.
Formulating linear programming models involves the following steps:
1. Define the problem/problem definition
* To determine the # of type 1 and type 2 products to be produced
per month so as to maximize the monthly profit given the
restrictions.
2. Identify the decision variables or represent unknown quantities
* Let X1 and X2 be the monthly qualities of Type 1 and type 2 products
3. Determine the objective function
* Once the variables have been identified, the objective function can
be specified. It is necessary to decide if the problem is maximization
or a minimization problem and the coefficients of each decision
variable.

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Note: a. The units of all the coefficients in the objective function must
be the same. E.g. If the contribution of type 1 is in terms of Br
so does for type 2.
b. All terms in the objective function must include a variable
each term have to have 1 variable.
c. All decision variables must be represented in the objective
function.
4. Identifying the constraints
- System constraints - more than one variable
- Individual constraints - one variable
- Non-negative constraints
Example
1. A firm that assembles computer and computer equipment is about to start
production of two new microcomputers. Each type of micro-computer will
require assembly time, inspection time and storage space. The amount of
each of these resources that can be devoted to the production of
microcomputers is limited. The manager of the firm would like to
determine the quantity of each microcomputer to produce in order to
maximize the profit generated by sales of these microcomputers.
Additional information
In order to develop a suitable model of the problem, the manager has met
with design and manufacturing personnel. As a result of these meetings,
the manager has obtained the following information:
Type 1 Type 2

Profit per unit Birr 60 Birr 50

Assembly time per unit 4hrs 10hrs
Inspection time per unit 2hrs 1hr
Storage space per unit 3cubic ft 3cubic ft
The manager also has acquired information on the availability of company
resources. These weekly amounts are:
Resource Resource available
Assembly time 100hrs
Inspection time 22hrs
Storage space 39 cubic feet
The manager also meet with the firm’s marketing manager and learned
that demand for the microcomputers was such that whatever combination
of these two types of microcomputer is produced, all of the output can be
sold.
Required: Formulate the Linear programming model.
Solution:
Step 1: Problem Definition
- To determine the number of two types of microcomputers to be
produced (and sold) per week so as to maximize the weekly
profit given the restriction.

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Step 2: Variable Representation
- Let X1 and X2 be the weekly quantities of type 1 and type 2
microcomputers, respectively.
Step 3: Develop the Objective Function
Maximize or Zmax = 60X1 + 50X2
Step 4: Constraint Identification
System constraints: 4X1 + 10X2  100hrs Assembly time
2X1 + X2  22hrs inspector time
3X1 + 3X2  39 cubic feet Storage space
Individual constraint No
Non-negativity constraint X1, X2  0
In summary, the mathematical model for the microcomputer problem is:
Zmax = 60X1 + 50X2
Subject to: 4X1 + 10X2  100
2X1 + X2  22
X1 + 3X2  39
X1, X2  0
2. An electronics firm produces three types of switching devices. Each type
involves a two-step assembly operation. The assembly times are shown in
the following table:
Assembly time per Unit (in minutes)

Section #1 Section #2
Model A 2.5 3.0
Model B 1.8 1.6
Model C 2.0 2.2
Each workstation has a daily working time of 7.5 hrs. The manager wants
to obtain the greatest possible profit during the next five working days.
Model A yields a profit of Birr 8.25 per unit, Model B a profit of Birr 7.50
per unit and Model C a profit of Birr 7.80 per unit. Assume that the firm
can sell all it produces during this time, but it must fill outstanding orders
for 20 units of each model type.
Required: Formulate the linear programming model of this problem.

Solution:
Step 1. Problem definition
To determine the number of three types of switching devices to be
produced and sold for the next 5 working days so as to maximize the
5 days profit.
Step 2. Variable representation
Let X1, X2 and X3 be the number of Model A, B and C switching
devices respectively, to be produced and sold.
Step 3. Develop objective function
Zmax: 8.25X1 + 7.50X2 + 7.80X3
Step 4. Constraint identification

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2.5X1 + 1.8X2 + 2.0X3  2250 minutes Ass. time station 1 System
3.0X1 + 1.6X2 + 2.2X3  2250 minutes Ass. time station 2
X1  20 Model A
X2  20 Model B Individual constraint
X3  20 Model C
X1, X2, X3 0 Non negativity
In summary:
Zmax: 8.25X1 + 7.50X2 + 7.80X3
: 2.5X1 + 1.8X2 + 2.0X3  2250 minutes
3.0X1 + 1.6X2 + 2.2X3  2250 minutes
X1  20 model A
X2  20 model B
X3  20 model C
X1, X2, X3  0 non negativity
3. A diet is to include at least 140 mgs of vitamin A and at least 145 Mgs of
vitamin B. These requirements are to be obtained from two types of foods:
Type 1 and Type 2. Type 1 food contains 10Mgs of vitamin A and 20mgs of
vitamin B per pound. Type 2 food contains 30mgs of vitamin A and 15 mgs
of vitamin B per pound. If type 1 and 2 foods cost Birr 5 and Birr 8 per
pound respectively, how many pounds of each type should be purchased to
satisfy the requirements at a minimum cost?
Vitamins
Foods A B
Type 1 10 20
Type 2 30 15

Solution:
Step 1. Problem definition
To determine the pounds of the two types of foods to be purchased to
make the diet at a minimum possible cost within the requirements.
Step 2. Variable representation
Let X1 and X2 be the number of pounds of type 1 and type 2 foods to
be purchased, respectively.
Step 3. Objective function
Cmin: 5X1 + 8X2
4. Constraints
10X1 + 30X2  140 System constraints
20X1 + 15X2  145
X1, X2 0 non-negativity constraints.
3.3. Solution Approaches to Linear Programming
Problems
There are two approaches to solve linear programming problems:
1. The Graphic solution method
2. The Algebraic solution/ simplex algorithm method
A. The Graphic Solution Method

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It is a relatively straightforward method for determining the optimal
solution to certain linear programming problems. It gives as a clear
picture. This method can be used only to solve problems that involve two
decision variables. However, most linear programming applications involve
situations that have more than two decision variables, so the graphic
approach is not used to solve them.
E.g.: 1. solving the micro-computer problem with graphic approach
Zmax = 60X1 + 50X2
: 4X1 + 10X2  100
2X1 + X2  22
3X1 + 3X2  39
X1, X2  0
Steps:
1. Plot each of the constraints and identify its region – make linear
inequalities linear equations.
2. Identify the common region, which is an area that contains all of
the points that satisfy the entire set of constraints.
3. Determine the Optimal solution- identify the point which leads to
maximum benefit or minimum cost.

24
22 2X1 + X2 = 22

20

16

3X1 + 3X2 = 39
12
(0, 13) E
8
(5, 8)D 4X1 + 10X2 = 100
4 (9, 4) C

(0, 0) A 4 8 B 12 16 20 24 28

To identify the maximum (minimum) value we use the corner point

approach or the extreme point approach. The corner point/extreme point
approach has one theorem: It states that;

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For problems that have optimal solutions, a solution will occur at an
extreme, or corner point. Thus, if a problem has a single optimal
solution, it will occur at a corner point. If it has multiple optimal
solutions, at least one will occur at a corner point. Consequently, in
searching for an optimal solution to a problem, we need only
consider the extreme points because one of those must be optimal.
Further, by determining the value of the objective function at each
corner point, we could identify the optimal solution by selecting the
corner point that has the best value (i.e., maximum or minimum,
depending on the optimization case) at the objective function.
Determine the values of the decision variables at each corner point.
Sometimes, this can be done by inspection (observation) and sometimes by
simultaneous equation. Substitute the value of the decision variables at
each corner point. After all corner points have been so evaluated, select
the one with the highest or lowest value depending on the optimization
case.

Point Coordinates How Value of Objective function

s X1 X2 Determined Z = 60X1 + 50X2
A 0 0 Observation Birr 0
B 11 0 Observation Birr 660
C 9 4 Simultaneou Birr 740
s equations
D 5 8 Simultaneous Birr 700
equations
E 0 10 Observation Birr 500
Basic solution
X1 = 9, X2 = 4, Z = Birr 740
After we have got the optimal solution, we have to substitute the value of
the decision variables into the constraints and check whether all the
resources available were used or not. If there is an unused resource we can
use it for any other purpose. The amount of unused resources is known as
SLACK-the amount of the scarce resource that is unused by a given
solution. The slack can range from zero, for a case in which all of a
particular resource is used, to the original amount of the resource that was
available (i.e., none of it is used).
Computing the amount of slack
Constraint Amount used with Originally Amount of slack
X1 = 9 and X2 = 4 available (available – Used)
Assembly time 4(9) + 10(4) = 76 100 hrs 100 – 76 = 24 hrs
Inspection time 2(9) + 1 (4) = 22 22 hrs 22 – 22 = 0 hr
Storage space 3(9) + 3(4) = 39 39 cubic ft 39 – 39 = 0 cubic
ft

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Constraints that have no slack are some time referred to as binding
constraints since they limit or bind the solution. In the above case,
inspection time and storage space are binding constraints; while assembly
time has slack. Knowledge of unused capacity can be useful for planning. A
manager may be able to use the assembly time for other products, or,
perhaps to schedule equipment maintenance, safety seminars, training
sessions or other activities.
Interpretation: The Company is advised to produce9 units of type 1
microcomputers and 4 units of type 2 microcomputers per week to
maximize his weekly profit to Birr 740; and in do so the company would be
left with unused resource of 24-assembly hrs that can be used for other
purposes.
2. Solving the diet problem with graphic approach
Cmin: 5X1 + 8X2
10X1 + 30X2  140
20X1 + 15X2  145
X1, X2 0

16

12
20X1 + 15X2 = 145
(0, 9.67) A
8

10X1 + 30X2 = 140

4 B (5, 3)

C (14,0)
4 8 12 16 20

Points Coordinates How Value of the objective

X1 X2 Determined function
Z = 5X1 + 8X2
A 0 9.67 Observation Birr 77.30
B 5 3 Simultaneou Birr 49
s equations
C 14 0 Observation Birr 70
Basic solution: X1 = 5 pounds
X2 = 3 pounds
C = Birr 49

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Interpretation: To make the diet at the minimum cost of Birr 49 we have
to purchase 5 pounds of Type1 food and 3 pounds Type 2
food.
If there is a difference between the minimum required amount and the
optimal solution, we call the difference surplus: That is, Surplus is the
amount by which the optimal solution causes a  constraint to exceed the
required minimum amount. It can be determined in the same way that
slack can: substitute the optimal values of the decision variables into the
left side of the constraint and solve. The difference between the resulting
value and the original right-hand side amount is the amount of surplus.
Surplus can potentially occur in a  constraint.
B. The Simplex Algorithm/Algebraic Solution Method
The simplex method is an iterative technique that begins with a feasible
solution that is not optimal, but serves as a starting point. Through
algebraic manipulation, the solution is improved until no further
improvement is possible (i.e., until the optimal solution has been
identified). Each iteration moves one step closer to the optimal solution. In
each iteration, one variable that is not in the solution is added to the
solution and one variable that is in the solution is removed from the
solution in order to keep the number of variables in the basis equal to the
number of constraints.
The optimal solution to a linear programming model will occur at an
extreme point of the feasible solution space. This is true even if a model
involves more than two variables; optimal solutions will occur at these
points. Extreme points represent intersections of constraints. Of course,
not every solution will result is an extreme point of the feasible solution
space; some will be outside of the feasible solution space. Hence, not every
solution will be a feasible solution. Solutions which represent intersections
of constraints are called basic solutions; those which also satisfy all of the
constraints, including the non-negativity constraints, are called basic
feasible solutions. The simplex method is an algebraic procedure for
systematically examining basic feasible solutions. If an optimal solution
exists, the simplex method will identify it.
The simplex procedure for a maximization problem with all  constraints
consists of the following steps.
1. Write the LPM in a standard form: when all of the constraints are
written as equalities, the linear program is said to be in standard form. We
convert the LPM in to a standard form by applying the slack variables, S,
which carries a subscript that denotes which constraint it applies to. For
example, S1 refers to the amount of slack in the first constraint, S 2 to the
amount of slack in the second constraint, and so on. When slack variables
are introduced to the constraints, they are no longer inequalities because
the slack variable accounts for any difference between the left and right-
hand sides of an expression. Hence, once slack variables are added to the
constraints, they become equalities. Furthermore, every variable in a

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model must be represented in the objective function. However, since slack
does not provide any real contribution to the objective, each slack variable
is assigned a coefficient of zero in the objective function.
Slack = Requirement – Production, surplus = Production – Requirement
Taking the microcomputer problem its standard form is as follows:
Zmax = 60X1 + 50X2 Zmax = 60X1 + 50X2 + 0S1 + S2 + 0S3
: 4X1 + 10X2  100 : 4X1 + 10X2 + S1 = 100
2X1 + X2  22 2X1 + X2 + S2 = 22
3X1 + 3X2  39 3X1 + 3X2 + S3 = 39
X1, X2  0 X 1, X2, S1, S2, S3  0

2. Develop the initial tableau: the initial tableau always represents the
“Do Nothing” strategy, so that the decision variables are initially non-basic.
a) List the variables across the top of the table and write
the objective function coefficient of each variable just above it.
b) There should be one row in the body of the table for
each constraint. List the slack variables in the basis column, one per
row.
c) In the Cj column, enter the objective function coefficient
of zero for each slack variable. (Cj - coefficient of variable j in the
objective function)
d) Compute values for row Zj
e) Computer values for Cj – Zj.

Sol/n Cj 60 50 0 0 0
basis X1 X2 S1 S2 S3 RHSV Øj = bj/xj (aij)
S1 0 4 10 1 0 0 100 100/4 = 25
S2 0 2 1 0 1 0 22 22/2 = 11 Leaving
* variable
S3 0 3 3 0 0 1 39 39/3 = 13
Zj 0 0 0 0 0 0
Cj-Zj 60 50 0 0 0 0

Entering variable Pivot column Pivot row

* Pivot Element
3. Develop subsequent tableaus
3.1. Identify the entering variable - a variable that has a largest positive
value is the Cj – Zj row.
3.2. Identify the leaving variable - Using the constraint coefficients or
substitution rates in the entering variable column divide each one into
the corresponding quantity value. However do not divide by a zero or
negative value. The smallest non-negative ratio that results indicate
which variable will leave the solution.
4. Find unique vectors for the new basic variable using row operations on
the pivot element.

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Sol/n Cj 60 50 0 0 0
basis X1 X2 S1 S2 S3 RHSV Øj = bj/xj (aij)
S1 0 0 8 1 -2 0 56 56/8 = 7
X1 60 1 ½ 0 1/2 0 11 11/. 5 = 22
S3 0 0 3/2 0 -3/2 1 6 6/1.5 = 4
Zj 60 30 0 30 0 660 Leaving
Cj-Zj 0 20 0 -30 0 0 variable

Entering Variable

Sol/n Cj 60 50 0 0 0
basis X1 X2 S1 S2 S3 RHSV Øj = bj/xj (aij)
S1 0 0 0 1 6 -16/3 24
X1 60 1 0 0 1 -1/3 9
X2 50 0 1 0 -1 2/3 4
Zj 60 50 0 10 40/3 740
Cj-Zj 0 0 0 -10 -40/3
Optimal solution: X1 = 9
X2 = 4
S1 = 24 hrs
Z = Birr 740
5. Compute the Cj – Zj row
6. If all Cj – Zj values are zeros and negatives you have reached
optimality.
7. If this is not the case (step 6), repeat step 2to5 until you get optimal
solution.

“A simplex solution is a maximization problem is optimal if the Cj – Zj row

consists entirely of zeros and negative numbers (i.e., there are no positive
values in the bottom row).”
Note: The variables in solution all have unit vectors in their
respective columns for the constraint equations. Further, note that
a zero appears in row c - z in every column whose variable is in
solution, indicating that its maximum contribution to the objective
function has been realized.
Example 2
A manufacturer of lawn and garden equipment makes two basic types of
lawn mowers: a push-type and a self-propelled model. The push-type
requires 9 minutes to assemble and 2 minutes to package; the self-
propelled mower requires 12 minutes to assemble and 6 minutes to
package. Each type has an engine. The company has 12 hrs of assembly
time available, 75 engines, and 5hrs of packing time. Profits are Birr 70 for
the self-propelled models and Birr 45 for the push-type mower per unit.
Required:
1. Formulate the linear programming models for this problem.

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2. Determined how many mower of each type to make in order to
maximize the total profit (use the simplex procedure).
Solution:
1.
a) To determine how many units of each types of mowers to
produce so as to maximize profit.
b) Let X1 - be push type mower.
X2 - be self-propelled mower.
c) Determine the objective function
Zmax = 45X1 + 70X2
d) Identify constraints
9X1 + 12X2  720 minutes Assembly time
2X1 + 6X2  300 minutes packing time
X1 + X2  75 engines Engines
X1, X2  0
In summary:
Zmax = 45X1 + 70X2
: 9X1 + 12X2  720
2X1 + 6X2  300
X1 + X2  75
X1, X2  0

2.
a. Write the LPM in a standard form
Zmax = 45X1 + 70X2 + OS1 + OS1 + OS3
: 9X1 + 12X2 + S1 = 720
2X1 + 6X2 + S2 = 300
X1 + X2 + S3 = 75
X1, X2, S1, S2, S3  o
b. Develop the initial tableau – in LP matrices are commonly called
tableaus
Sol/n Cj 45 70 0 0 0
basis X1 X2 S1 S2 S3 RHSV Øj = bj/xj (aij)
S1 0 9 12 1 0 0 720 720/12 =60
S2 0 2 6 0 1 0 300 300/6 =50 Leaving
S3 0 1 1 0 0 1 75 75/1 = 75 variable
Zj 0 0 0 0 0 0
Cj-Zj 45 70 0 0 0

Entering variable
c. Develop the subsequent tableaus
- Identify the entering variable
- Identify the leaving variable
Sol/n Cj 45 70 0 0 0
basis X1 X2 S1 S2 S3 RHSV
Øj = bj/xj (aij)
S1 0 5 0 1 -2 0 120 120/5 = 24
X2 70 1/3 1 0 1/6 0 5050/. 333
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=150
S3 0 2/3 1 0 -1/6 1 25 25/.666 = 75
Zj 70/3 70 0 70/6 0 3500
Cj-Zj 65/3 0 0 -70/6 0
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Leaving variable

Entering variable
Sol/n Cj 45 70 0 0 0
basis X1 X2 S1 S2 S3 RHSV Øj = bj/xj (aij)
X1 45 1 0 1/5 -2/5 0 24
X2 70 0 1 -1/15 3/10 0 42
S3 0 0 0 -2/15 1/10 1 9
Zj 45 70 13/3 3 0 4020
Cj-Zj 0 0 -13/3 -3 0
Optimal solutions: X1 = 24 units
X2 = 42 units
S3 = 9 engines
Z = Birr 4020
Interpretation: The Company is advised to produce 24 units of push type
mowers and 42 units of self-propelled mowers so as to
realize a profit of Birr 4020. In doing so the company
would be left with unused resource of 9 engines which can
be used for other purposes.
3. A firm produces products A, B, and C, each of which passes through
assembly and inspection departments. The number of person hours
required by a unit of each product in each department is given in the
following table.
Person hours per unit of product
Product Product Product
A B C
Assembl 2 4 2
y
Inspecti 3 2 1
on
During a given week, the assembly and inspection departments have
available at most 1500 and 1200 person-hours, respectively. if the unit
profits for products A, B, and C are Birr 50, Birr 40, and Birr 60,
respectively, determine the number of units of each product that should be
produced in order to maximize the total profit and satisfy the constraints of
the problem.
Answer: 0 unit of product A, 0 unit of product B, 750 units of product C,
unused inspection time of 450 hours, and a maximum profit, Z ,of Birr
45,000.
Some special Issues in LP
1. Unbounded solutions

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A solution is unbounded if the objective function can be improved without
limit. The solution is unbounded if there are no positive ratios in
determining the leaving variable. A negative ratio means that increasing a
basic variable would increase resources! A zero ratio means that
increasing a basic variable would not use any resources. This condition
generally arises because the problem is incorrectly formulated. For
example, if the objective function is stated as maximization when it should
be a minimization, if a constraint is stated  when it should be, or vice
versa.
2. Multiple optimal solutions
The same maximum value of the objective function might be possible with
a number of different combinations of values of the decision variables. This
occurs because the objective function is parallel to a binding constraint.
With simplex method this condition can be detected by examining the Cj –
Zj row of the final tableau. If a zero appears in the column of a non-basic
variable (i.e., a variable that is not in solution), it can be concluded that an
alternate solution exists.
E.g. Z = 60X1 + 30X2
4X1 + 10X2  100
2X1 + X2  22
3X1 + 3X2  39
X1, X2  0
The other optimal corner point can be determined by entering the non-
basic variable with the C - Z equal to zero and, then, finding the leaving
variable in the usual way.
3. Degeneracy
In the process of developing the next simplex tableau for a tableau that is
not optimal, the leaving variable must be identified. This is normally done
by computing the ratios of values in the quantity column and the
corresponding row values in the entering variable column, and selecting
the variable whose row has the smallest non-negative ratio. Such an
occurrence is referred to degeneracy, because it is theoretically possible
for subsequent solutions to cycle (i.e., to return to previous solutions).
There are ways of dealing with ties in a specific fashion; however, it will
usually suffice to simply select one row (variable) arbitrarily and proceed
with the computations.
Limitations of Linear Programming
1. In linear programming uncertainty is not allowed, i.e., LP methods
are applicable only when values for costs, constraints, etc. are known, but
in real life such factors may be unknown.
2. According to the LP problem, the solution variables can have any
value, whereas sometimes it happens that some of the variables can have
only integral values. For example, in finding how may machines to be
produced; only integral values of decision variables are meaningful. Except
when the variables have large values, rounding the solution to the nearest

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integer will not yield an optimal solution. Such situations justify the use of
Integer Programming.
3. Many times, it is not possible to express both the objective function
and constraints in linear form.

CHAPTER FOUR: MATHEMATICS OF FINANCE

Objectives
After completing this chapter, students should be able to:
 Understand the concept of simple interest and its computation
 Differentiate between simple interest and compound interest
 Understand the concept of an ordinary annuity
 Explain different types of annuities
 Perform computations relating to future value and present value of an annuity
Compute amortization and mortgage payments
4.1. Introduction

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In this chapter let us introduce mathematical methods and formula that are
useful in business and personal finance. From the financial stand point
business transactions may be considered as inflows and outflows of funds
over time. Funds must be borrowed on long term, a year or longer basis to
replace, improve, or add to existing facilities such as buildings, equipment,
and machinery. Funds must also be borrowed on short term, less than a
year basis to meet immediate needs such as raw materials or obligations
such as payroll (employees’ salary). But money has a time value that is a
birr today is worth more than a birr tomorrow, which is expressed in terms
of interest charges.
Important terms in mathematics of finance:
Principal amount (p) this is the amount of money that is initially being
considered. It might be an amount about to be invested or loaned
Number of time periods (n) the number of time periods over which amount
of money is being invested or borrowed is normally denoted by the symbol
‘n’. Although ‘n’ is usually a number of years, it could represent other time
periods, such as a number of quarters or months
Interest (i) interest is the name given to a proportionate amount of money
which is added to some principal amount ( invested or borrowed). Interest
is the price paid for the use of a sum of money over a period of time. It is
the charge for exchanging money now for money later. Interest - Simple
interest.
- Compound interest

Interest rate(r) is normally denoted by symbol ‘r’ and expressed as a

percentage rate per annum.
Accrued amount (A). This term applies generally to the amount of money
after some time has elapsed for which interest has been calculated and
added.
4.2. Simple Interest

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When we borrow money the money borrowed or the original sum of money
lent (borrowed or invested) is called the principal. (The principal remains
fixed during the entire interest period). Interest is usually expressed as a
percentage of the principal for a specified period of time which is generally
a year. This percentage is termed the interest rate. If interest is paid on
the initial amount only and not on subsequently accrued interest, it is called
simple interest.

However, if the interest for each period is added to the principal in

computing the interest for the next period, the interest is called compound
interest. The sum of the original amount (principal) and the total interest is
the future amount or maturity value or Amount. A = P + I
Simple interest is generally used only on short term notes often of duration
less than one year. The concept of simple interest, however, forms the
basis for compound interest concepts.
Simple interest is given by the formula:
I = Prt
Where P= principal amount/ original amount borrowed or invested
r = Simple interest rate per year (expressed in decimal)
t= duration of the loan or investment in years
I = amount of interest in Birr.
If a sum of money, P is invested at a simple interest its value increases by
the same amount each year. Therefore, there is a linear relationship
between amount and time.
Taking P= principal, r = rate of interest, t = time in years and A = amount,
their relationship is as follows:

I = Prt --------------------------- 1
A=P+I
= P + Prt
A = P (1+rt) ----------------------2
P = --------------------------- 3
P=
r=
t=
Example:

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Mr. X wanted to buy a leather sofa for his new family room. The cost of the
sofa was Birr 10,000. He was short of cash and went to his local bank and
borrowed Birr 10,000 for 6 months at an annual interest rate of 12%. Find
the total simple interest and the maturity value of the loan.
Solution
I = Prt A = P+I
= 10,000 + 600
= Birr 600 = Birr 10,600 or

A = P (1+rt)
10,000(1  .12 x 1 )
2
= 10,000 (1.06) = Birr 10,600
How long will it take if Birr 20,000 is invested at 5% simple interest to
double in value?
Solution. I=A-p
t= = 40,000 - 20,000
P = 20,000 Birr = 20,000
r = 5%
A = Birr 40,000
t=?

3. At what interest rate will Birr 6,000 yield 900 Birr in 5 years time?
Solution.
r= I tP
P = Birr 6,000
i = Birr 900 = 900 6000 x 5
t = 5 years
= 3% annual rate
r =?

4. How much money must Mr. Z has to invest today at 6% simple interest if
he is to receive Birr 3,100 as an amount in 4 years?

Solution.
P = Birr? =
A = 3,100 Birr 2,500
t = 4 years
r = 6%

When time over which interest is paid is given in months, t is simply the
number of month divided by 12. If time is given as a number of days, then
one of two methods of computing t may be used:
Ordinary interest year - uses a 360 - day year -
When time is determined in this way, the interest is called ordinary simple
interest.

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#ofdays
Exact time- uses a 365-day year = t = t  or a 366 for leap year.
365
Interest computed in this way (using exact time) is called exact simple
interest.
5. Find the interest on Birr 1,000 at 5% for 45 days.
Solution
1. Using ordinary Interest year:
p = Birr 1,000 I = prt
r = 5% = 1,000 x .05 x
t = 45 days Birr 6.25
I=

2. Using exact time:

I = Prt Always ordinary simple
45 interest is greater than
= 1,000 x .05 x exact simple interest.
365
= Birr 6.16

4.3. Promissory Notes and Bank Discount

Definitions: A promissory note is a promise to pay a certain sum of money on a specified date.
It is also considered as a written contract containing an unconditional promise by the debtor
called the maker of the note to pay a certain sum of money to the creditor called the payee of
the note, under terms clearly specified in the contract. Promissory note is unconditional in a
sense that it gives the maker of the note an exclusive right either to sell, borrow, or discount it
against the value of the note.

A bank discount is the amount of money received or collected after discounting a note before
its due date. It is not unusual when borrowing money from a bank that one is required to pay a
charge based on the total amount that is to be repaid (maturity value), instead of the principal
used. If the maturity value is used in determining the charge for use of money, we say that the
promissory note (or simply the note) is discounted. Consequently, a charge of loan computed
in this manner is called ‘Bank Discount’ and it is always computed based on the maturity
value. Bank discount is the amount that is charged on maturity value. Hence, the amount of
money payable to the debtor or the amount that the borrower receives is called ‘Proceed.’ The
amount that the borrower is going to pay to the creditor (lender) is called ‘maturity value.’ To
further our understanding of this concept, let’s develop mathematical expressions (formula) for

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computation of the variables at stake.
Proceed = Maturity Value – Bank Discount

Symbolically,

P = F – D , and D = Fdt

Where, P = Proceed
F = Maturity value
D = Bank discount
d = Rate of discount
t = Time of discount

Now we can further elaborate the above formula for proceed. To begin with,
P = F – D, but D = Fdt
Therefore, P = F – Fdt = F (1 – d t)

In sum, proceeds can be calculated by

P = F (1 – d t)

For example, if Birr 1000 is borrowed at 12% for 6 months, the borrower receives the
proceeds, P, and pays back F = Birr 1000. The proceeds will be Birr 1000 minus the interest
on Birr 1000. This will be:

P = 1000 – (1000 x 0.12 x 6/12) = Birr 940

Or, P = 1000 (1 – (0.12 x 6/12) P = Birr 940

i. Proceeds are an amount received now for payment in the future. Therefore, they are
analogous to present value. Yet, proceeds are not equal to present value because the proceeds
from a futures obligation to pay are always less than the present value of that obligation if, of
course, the same rate of interest is used in both adulations.
ii. Proceeds should be completed when the interest rate is stated by the qualifier word as
discount rate or a bank discount or interest deducted – in – advance, and present value
should be computed where the interest is given without such qualifiers, discount.
iii. The computation of simple interest and bank discount is the same except in the former case
principal and in the later case the maturity values are used for between trimmings the amount
discount.

Having the idea of promissory notes and bank discounts, we may now progress to consider
some illustrative problems.

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Example: Find the bank discount and proceeds on a note whose maturity value is Birr 480
which is discounted at 4% ninety days before it is due.

Solution: Given values in the problem

F = Birr 480
d = 4% = 0.04
t = 90 days or 3 months = 3/12 = 90/360 = 0.25
D = ? and P = ?

To find the value of the bank discount, we use the formula D = Fdt. Accordingly,
D = 480 x 0.04 x 3/12
D = Birr 4.8 is the amount of bank discount.

In the same manner, the proceed can be obtained as follows.

P = F–D or P = F (1 – d t)
P = 480 – 4.8 or P = 480 (1 – (0.04 x 0.25)
P = Birr 475.2 or P = 480(0.99) = Birr 475.2

Learning Activity 4.1

Dear learner, we have seen above the concepts of promissory notes and bank discount with
examples now, would you try to do this question. A borrower signed a note promising to pay a
bank Birr 5000 ten months from now.
a. How much will the borrower receive if the discount rate is 6%?
b. How much would the borrower have to repay in order to receive Birr 5000 now?

4.4. Compound Interest

If the interest which is due is added to the principal at the end of each
interest period, then this interest as well as the principal will earn interest
during the next period. In such a case the interest is said to be
compounded. The result of compounding interest is that starting with the
second compounding the account earns interest on interest in addition to
earning interest on principal.
4.4.1. Compound Amount (Maturity Value)
The sum of the original principal and all the interest earned is the
Compound Amount. The difference between compound amount and the

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original principal is the Compound interest. The compound interest method
is generally used in long-term borrowing. There is usually more than one
period for computing interests during the borrowing time. The time interval
between successive conversions of interest in to principal is called the
interest period or conversion period or compounding period, and may
be any convenient length of time. The interest rates are always given as
annual percentages; no matter how many times the interest is compounded
per year. Hence, interest rate must be converted in to or adjusted to the
appropriate interest rate per conversion period (i) for computational
purposes; and we use the number of conversion periods as time.

The i is equal to the stated annual interest rate /nominal rate (r) divided by
the number of conversion periods in one year (m) = i =

Conversion # of conversions per year, m

Daily 365
Monthly 12
Quarterly 4
Semi annually 2
Annually 1

Example:
1. What are the compound amount and compound interest at the end of one
year if Birr 10,000 is borrowed at 8% compound quarterly?
Solution
P = Birr 10,000 total # of conversions = 4
r = 8% t = one year
Total number of conversion periods (m) = 4 times = quarter
i= = = 2%
In general, the compound amount can be found by multiplying the principal
by (1+i) n where i is the interest rate per conversion period and n is the total
number of conversion periods.
In Short, Amount with compound interest is calculated as:
A = P (1 + tm = P (1 + i) n
Where:
A = compound amount, after n conversion periods.
P = principal
r = stated annual rate of interest
m = number of conversion periods a year
t = total number of years
I = r/m = interest rate per conversion period
n = mt = Total number of conversion periods.
So, for the above question, the amount is equal to
A = P (1 + I) n

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= 10,000 (1.02)4
= 10,824.3216 Birr
Compound interest = compound amount - original principal
= 10,824.3216 - 10,000
= Birr 824.3216
using logarithm Rules of log
A = 10,000 (1.02)4 1. log aa = 1
log A = log 10,000 + log (1.02)4 2. logmp = p logm
= log 10,000 + 4 log 1.02 3. logmn = logm + logn
= 4 + 4 (0.0086) 4. logm/n = logm - logn
= 4+ 0.0344
log A = 4.0344
A = antilog 4.0344
= 10,824.30

2. Find the compound amount compound interest resulting from the

investment of Birr 1000 at 6% for 10 years,
2.1. Compounded Annually.
Solution
P = Birr 1,000 A = p(1+i)n
t = 10 years = 1,000 (1.06)10
m=1 = Birr 1,790.85
r = 6%
A =? Compound interest = Compound amount -
i = 6% principal
n = 10 = 1,790.85 - 1000
= 790.85 Birr
2.2. Compounded Semiannually.
Solution
P = Birr 1,000 A = p(1+i)n
r = 6% = 1,000 (1.03)20
m=2 = Birr 1,806.11
t = 10 years Compound interest = compound amount -
i = 3% principal
n = 20 = 1,806.11 - 1000
= Birr 806.11
2.3 compounded quarterly.
Solution
P = Birr 1,000 A = 1,000 (1.015)40
r = 6% = Birr 1,814.02
m=4
t = 10 years Compound interest = compound amount -
i = .015 principal
n = 40 = 1814.02 - 1000
= Birr 814.02

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1.4. Compounded monthly.

Solution
P = Birr 1000 A = 1,000 (1.005) 120
r = 6% = 1,819.40 Birr
t = 10 years
m=12 Compound interest = compound amount -
i = .005 principal
n = 120 = 1,819.40 - 1000
= 819.40 Birr
2.5. If compounded weekly
Solution
P = Birr 1000 A = 1,000 (1.0012)520
r = 6% = 1,821.49 Birr
t = 10 years
m=52 Compound interest = compound amount -
i = .0012 principal
n = 520 = 1821.49 - 1000
= Birr 821.49

2.6. Compounded daily

P = Birr 1000 A = 1,000 (1.0001644)3650
r = 6% = 1,822.03
t = 10 years
m=365 Compound interest = compound amount -
i = .01644% principal
n = 3650 = 1,822.03 - 1000
= Birr 822.03

2.7. Compounded hourly

P = Birr 1000 A = 1,000 (1.00000685)687,600
r = 6% = 1,822.12 Birr
t = 10 years
m= 8760 Compound interest =compound amount -
i = .000685% principal
n = 87600 = 1,822.12 - 1000
= Birr 822.12 Birr

2.8. Compounded continuously (instantaneously).

P = Birr 1000 A = Pert, e =2.71828
r = 6% = 1,000 e.06x10 = 1000 e.6
t = 10 years = Birr 1,822.12
m=infinite compound interest = compound amount - principal
1,822.12 - 1000 = Birr 822.12

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3. How long will it take to accumulate Birr 650 if Birr 500 is invested at 10%
compound quarterly?
Solution
P = 500 A = p(1+i)n
A = 650 650 = 500 (1.025)n
r = 10% 1.3 = (1.025)n
i=2.5% log1.3= log(1.025)n
m=4 log1.3 log1.025
n
10.625 2 log1.025 log1.025
t=? n/m = 2 years
4 3 n=
n =? 10.625 quarters = 10.625 quarters

4. Birr 2000 is deposited in an account. After one year of monthly

compounding, the balance in the account is Birr 2,166. What is the annual
percentage rate for this account?
Solution
P = Birr 2,000 A = p(1+i)n
A = Birr 2,166 2166 = 2000 (1+i)12
r =? 1.083 = (1+i)12
i=r/12 log1.083= log(1+i)12
t=1 =12log1+i
m = 12 0.0028857 = log1+i
anti log .0028857 = 1+i
1.0066667 = 1+i
.0066667 = i
.006667 x 12 = r = i x m
= 8% = r

4.4.2. Present Value (Principal) of Compound

Amount

Frequently it is necessary to determine the principal P which must be

invested now at a given rate of interest per conversion period in order that
the compound amount A will be accumulated at the end of n conversion
periods. This process is called discounting and the principal is now a
discounted value of a future income A.

A = P (1+i) n dividing both sides by (1+i) n leads to

P = = p = A (1+i)-n
Present values of a compound amount:

P = A (1+i)-n
Where:
p = principal / present value

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A = compound amount (or future value)
i = interest rate per conversion period
n = total number of conversion periods
Example:
1. Find the present value of a loan that will amount to Birr 5,000 in four
years if money is worth 10% compounded semi annually.
Solution.
A = 5,000 Birr P = A (1+i)-n
t = 4 years = 5,000 (1.05)-8
m=2 = Birr 3,384.20
r = 10%
P =?
2. How much must be deposited now in an account paying 6% compounded
monthly in order to have just 20,000 Birr in the account 4 years from now?
A = 20,000 Birr P = A (1+i)-n
t = 4 years = 20,000 (1.005)-48
m = 12 = Birr 15,742
r = 6%
P =?

3. How much should be deposited in an account paying 8% compounded

quarterly in order to have a balance of Birr 8,000 nine years from now?
Solution:
A = Birr 8,000 P = A (1+i)-n
t = 9 years = 8,000(1.02)-36
n = 36 = 3,921.79 Birr
m=4
i=2%
r = 8%
P =?
Present value with continuous compounding
A Pe rt
  P  A rt
ert ert e
 Ae  rt

4.4.3. Nominal and Effective Interest

Rates
Equivalent Rates
Sometimes it is helpful to convert interest rates from, for example, a
compounded quarterly basis to a compounded annually basis, from a
compounded quarterly basis to compounded monthly basis, etc. this is
easily accomplished as long as we understand the concept of equivalent
interest rates, which is defined as follows:
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If at the beginning of a specified time period, the same amount of money is invested at various
rates so that the resulting compound amounts are equal at the end of the time period, then the
interest rates are equivalent rates.
Although we can use any length time period, we usually use a 1-year time
interval. Thus, if Birr P is invested at annual rate r compounded m times a
year, and another Birr P is invested at annual rate s compounded k times a
year, then the rates are equivalent as long as
P (1 +r/m) m = P (1 +s/k) k
Dividing both sides of the above equation by P gives the equivalent rates
equation which can be solved for either r or s, depending on which the
unknown.
Use this equation to find equivalent rates: (1 +r/m) m = (1 +s/k) k
1. What rate compounded monthly is equivalent to 8% compounded
quarterly?
Solution
(1+r/12)12 = (1+.08/4)4
= (1.02)4, solving for r, we take the 12th root of each side to
obtain, (1+r/12) = ((1.02)4)1/12
= (1.02)3
r/12 = (1.02)3 -1
= 1.006622 -1
r/12 = .006622
r = 12(.006622)
r = .079476
= 7.95%

2. What nominal annual rate of interest converted monthly corresponds to

16% converted quarterly?
Solution
(1+r/12)12 = (1+.16/4)4
= (1.04)4, solving for r, we take the 12th root of each side to
obtain, (1+r/12) = [(1.04)4]1/12
= (1.04)1/3
r/12 = (1.04)1/3 -1
= 1.013159404 -1
r/12 =. 013159404
r = 12(013159404)
r = .157912845
= 15.79%
A stated rate of 15.79% compounded monthly would earn interest
equivalent to that earned with a stated rate of 16% compounded quarterly.
Effective Rate

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Obviously, for a stated annual interest rate, the amount of interest
accumulated depends upon the frequency of conversion. This is because
interest which has been earned subsequently earns interest itself. When
interest is compounded more than once a year, the stated annual rate is
called a Nominal Rate. The effective rate corresponding to a given nominal
rate r converted m times a year is the simple interest rate that would
produce an equivalent amount of interest in one year. Effective rates are,
therefore, the simple interest rates that would produce the same return in
one year had the same principal been invested at simple interest without
compounding.
If P = Principal, A = Amount, r = nominal rate, m = number of conversion
periods per year, the compound interest for one year on principal p is,
I=A-P
= p (1 + r/m) m - p
The effective rate of interest is (re)= . From the above statement:
I = p (1 + r/m) m - p
= P [(1+r/m) m - 1) Divide both sides by p
 r m 
I/p = P   1   1
  m  
m
 r
re =  1 m   1
= (1+i) m - 1
In continuous compounding case:
A = Pert for one year A = Per
I=A-P
= Per - p, multiplying both sides by 1/p
1/p x I = P (er-1) x 1/p
re = er-1
Effective rates are used to compare competing interest rates
offered by banks and other financial institutions.
Example:
1. What is the effective rate of money invested at 6% compounded
quarterly?
Solution.
R = 6% re = (1+r/m)m-1
m=4 = (1+ ) 4 - 1
= (1.015)4 -1
= 6.14%
2. An investor has two opportunities to invest his money. The first
investment opportunity (Opp A) pays 15% compounded monthly and the
second investment opportunity (Opp B) pays 15.2% compounded
semiannually. Which is the better investment, assuming all else is equal.

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Solution
Nominal rates with different compounding periods cannot be compared
directly. We must first find the effective rate of each nominal rate and then
compare the effective rates to determine which investment will yield the
larger return.
Effective rate for inv. opp. A Effective rate for inv. opp. B
re= (1+r/m)m - 1 re= (1+r/m)m - 1
= =

Since the effective rate for A is greater than the effective rate for B,
Investment opportunity A is the preferred investment.

4.5. Ordinary Annuities

An ordinary annuity is a series of equal periodic payments in which each

payment is made at the end of the period.
In an ordinary annuity the first payment is not considered in interest
calculation for the first period (because it is paid at the end of the first
period for which interest is calculated) and the last payment doesn’t qualify
for interest at all since the value of the annuity’s computed immediately
after this last payment is received.
4.5.1. Amount (Future Value) of an Ordinary Annuity
The amount (future value) of an ordinary annuity is the sum of all payments
plus all interests earned.
EXAMPLE
1. What is the amount of an annuity if the size of each payment is Birr 100
payable at the end of each quarter for one year at an interest rate of 4%
compounded quarterly?
Solution
Periodic payment (R) = Birr 100
Payment interval = conversion period = quarter
Nominal (annual rate), r, = 4%
Interest rate per conversion period (i) = r/m = 4%/4 = 1%
Future value of (sum of) an annuity =?
Taking
R = amount of periodic payment
I = interest rate per payment period
n = total number of payment periods
A = Future value (Amount) of an O. Annuity at the end of its term.
[(1.01) 4 - 1]
For the above example: A = 100 = Birr 406.04
0.01
Compound interest = Amount - R (n)
= 406.04 - 100(4)
= Birr 6.04
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2. A newly married couple are both working and decide to have Birr 1000 at
the end of a month for a down payment on a home. The account earns 12%
compound monthly. How large a down payment will they have saved in
three years?
Solution
R = Birr 1000 [(1  i ) n  1] Compound interest = A -
t = 3 years. A R(n)
i
m = 12 = 43,076.88 - 36,000
1000[(1.01)36  1]
n = 36  = 7,076,88 Birr
r = 12% 0.01
i=1%  Birr 43,076.88
A =?

3. A person deposits Birr 200 a month for four years in to an account that
pays 7% compounded monthly. After the four years, the person leaves the
account untouched for an additional six years. What is the balance after the
10 year period?
Solution
R = Birr 200 A4 = 200 [(1 + .07)48 – 1]
t = 4years 0.07/12
m = 12 = 200 (55.20924)10
r = 7% = 11,041.85 Birr
After the end of the fourth year, we calculate compound interest rate taking
Birr 11,041.85 as principal compounded monthly for 6 years.
P = 11,041.85 Birr A10 = 11,041.85 (1 + .07)72
t = 6years 12
m = 12 = 11,401.85 (1.5201)
I = 7% = Birr 16,784.77
A10 =?
4. A person deposits Birr 500 a year for 10 years in to an account that pays
6% compounded annually. After 10 years the person transfers the money
into another account that pays 8% compounded quarterly. The money is left
in the second account for 8 years. What is the balance after the 18-year
period?
Solution.
For the first 10 years:
R = Birr 500 A10 = 500 [(1.06)10 – 1]
t = 10years .06
m=1 = 500 (13.180795)
r = 6% = Birr 6590.40
A10 =?
For the next 8 years, Birr 6590.40 is taken as single deposit (Principal) in an
account which pays 8% compounded quarterly.

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P8 = A10 = Birr 6950.40
t = 8years A18 = A10 (1 +i) n
m=4 = 6950.40 (1.02)32
r = 8% = 6950.40 (1.88454)
A18 =? A18 = Birr 12,419.87

The balance after 18 years is Birr 12,419.87 out of which Birr 7,419.87 (Birr
12,419.87 – Birr 5000) is interest earned.
4.5.2. Sinking Fund Payments- Increasing Annuity
A Sinking fund is a fund in to which equal periodic payments are made in
order to accumulate a specified amount at some point in the future. Sinking
funds are generally established in order to satisfy some financial obligation
or to reach some financial goal. Its purpose may be to repay the principal of
a loan in one installment, or to provide for replacement or modernization of
a manufacturing, or for expansion of a business etc.
If the payments are to be made in the form of an ordinary annuity, then the
required periodic payment into the sinking fund can be determined by
reference to the formula for the a mount of an ordinary annuity. That is, if
A = R [(1+i) n –1]
i
Then A____
R = [(1+i) n - 1]
i

 i 
R = A 
 1 i  
n
1

Example:
1. What monthly deposit will produce a balance of Birr 100,000 after 10
years? Assume that the annual percentage rate is 6% compounded
monthly. What is the total amount deposited over the 10-year period?
Solution.

A = Birr 100,000 R=A[ i ]

(1+i)n – 1
t = 10years
m = 12 = 100,000 [ .005 ]
(1.005) – 1
120

r = 6% = 100,000 (0.006102)
R =? = Birr 610.21

The total amount deposited over the 10-yr period is 120 (610.21) = Birr
73,225.

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2. Ms. X has a saving goal of Birr 25,000 which she would like to reach
10 years from now. During the first five years she is financially able to
deposit only Birr 100 each month into the savings account. What must her
monthly deposits over the last five years be if she is to reach the goal? The
account pays 12% interest compounded monthly.

Solution.

For the first five years

R = 100 A60 = 100 [(1.01)60 - 1]
t = 5years 0.01
m = 12 = 100 (81.6697)
r = 12% = Birr 8166.97
A60 =?

For the last five years:

The amount at the end of the first 5 years (Birr 8,166.97) serves as single
principal and it earns interest for the next five years.

A = 8,166.97 (1.01)60
= Birr 14,836.90

To determine the periodic payment we subtract 14,836.90 Birr from Birr

25,000 to obtain the amount of an ordinary annuity for the last five years.

A60 = Birr 25,000 – Birr 14,836.90

= 10,163.10

R2 = 10,163.120 X .01___
(1.01)60 – 1
= Birr 124.44

The proper R is (if normally deposited the same amounts)

R = 25,000 [ .01 ]
(1.01)120 – 1
= Birr 108.68

3. XYZ Company purchased a tract of land under a purchase agreement

which requires a payment of Birr 500,000 plus 5% interest compounded
annually at the end of 10 years. The company plans to setup a sinking fund
to accumulate the amount required to settle the land purchase debt. What

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should the quarterly deposit into the fund be if the account pays 15%
interest, compounded quarterly?

Solution.
First we have to find the total debt at the end of five years as

A = P (1+i) n i = 5%
= 500, 000 (1+0.05)10
= Birr 814,447.31

The amount is taken as Future Value of an Ordinary annuity with r = 15%

Compounded quarterly for 10 years
 .0375 
A40 = Birr 814,447.31 R = 814,447.31  
 1.0375  1
40

t = 10 years
m=4 = 9,088.80 Birr
r = 15%
i= 3.75%
R =?
4.5.3. Present Value of an Ordinary Annuity
The present value of an ordinary annuity is the amount of money today,
which is equivalent to the sum of a series of equal payment in the future. It
is the sum of the present values of the periodic payments of an annuity,
each discounted to the beginning of an annuity. The present value
represents the amount that must be invested now to purchase the payment
due in the future.
The following types of problems are generally related with finding the
present value:
1. Amount borrowed or loan to be repaid
2. Overdraft
3. A machine or some other thing purchased on installment
4. House, machine or wagon purchased on making part-payment
5. pension
Example
1. What is the PV of an annuity if the size of each payment is Birr
200 payable at the end of each quarter for one year and the interest rate is
8% compounded quarterly?
Solution.
R = Birr 200 r = 8%
m=4 t = 1yr
P =?
I =2%

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 1  (1  i )  n 
P R  
 i 

R = Birr 200 P = R [1 – (1+i)-n]

r = 8% i
m=4 = 200 [1 – (1.02)-4]
t = 1yr .02
P =? = 200 (3.08773)
= Birr 761.55
2. What is the cash value of a car that can be bought for Birr 200
down payment and Birr 82 a month for 18 months, if money is worth 12%
interest compounded monthly?
Solution.
Cash Value = down payment + PV of an O. annuity
= 200 + 82[1 – (1.01)-18]
.01
= 200 + 82(16.39827)
= 200 + 1,344.658
= Birr 1,544.658

3. How much should you deposit in an account paying 6%

compounded quarterly in order to be able to withdraw Birr 1000 every 3
months for the next 3 years?
Solution.
R = Birr 1000 PV = 1000[1 – (1.015)12]
t = 3years .015
m=4 = 1000(10.9075)
r = 6% = Birr 10, 907.50
PV =?
4.5.4. Amortization- Decreasing Annuity
Amortization means retiring a debt in a given length of time by equal
periodic payments that include compound interest. After the last payment,
the obligation ceases to exist-it is dead-and it is said to have been
amortized by the payments.
In amortization our interest is to determine the periodic payment, R, so as
to amortize (retire) a debt at the end of the last payment. Solving the PV of
ordinary annuity formula for R in terms of the other variables, we obtain the
following amortization formula:

 i 
R P   n
 1 1 i  
Where:

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R = periodic payment
P = PV of loan
i= interest rate per period
n = number of payment periods

Example
1. Suppose you borrow Birr 5000 from a bank and agree to repay the
loan in five equal installments including all interests due. The bank’s
interest charges are 5% compounded annually. How much should each
annual payment be in order to retire the debt including the interest in 5
years?
Solution.
PV = Birr 5000 R = 5000[ .05 ]
t = 5years 1 – (1.05) -5

m=1 = 5000(.230975)
r = 5% = Birr 1,154.87
R =? Interest = (1,154.87 X 5) – 5000
= Birr 774.35

2. At the time of retirement, a person has Birr 200,000 in an account

that pays 12% compounded monthly. If he decides to withdraw equal
monthly payments for 10 years, at the end of which time the account
will have a zero balance, how much should he withdraw each month?
Solution.

PV = Birr 200,000 R = 200,000 [ .01 ]

t = 10years 1 – (1.01)-120
m = 12 = 200,000(0.014347)
r = 12% = Birr 2,869.42
R =?
3. Ato Abebe borrowed Birr 7000. The loan plus the interest is to be
repaid in equal quarterly installments made at the end of each quarter
during a 2 year interval. The interest rate is 16% compounded
quarterly.
a) Find the quarterly payment
b) Find the interest accumulate

Solution

 i 
P = Birr 7000 a) R P  n
 1 1 i  
r = 16%, i = 4%
 .04 
m=4 R 7000 8 
 1  1 .04 

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t = 2 years, n = 8 R = Birr 1,039.69
R =?
b) Interest accumulated = R (n) - A
= 1,039.69(8) - 7,000
= Birr 1317.52

4.5.5. Mortgage Payments

In atypical house purchase transaction, the home-buyer pays part of the
cost in cash and borrows the remained needed, usually from a bank or a
savings and loan association. The buyer amortizes the indebtedness by
periodic payments over a period of time. Typically, payments are monthly
and the time period is long-30 years is not unusual.
Mortgage payment and amortization are similar. The only differences are
- The time period in which the debt/loan is amortized/repaid
- The amount borrowed.
- In mortgage payments m is equal to 12 because the loan is repaid
from monthly salary, but in amortization m may take other values.
In Mortgage payments we are interested in the determination of monthly
payments.
Taking A = total debt
R = monthly mortgage payment
r = stated nominal rate per annum
n = 12 x t
R can be determined as follows:

 r / 12   i 
R A   n  Or
R A  n
 1 1 r / 12   1 1 i  

 1 1 i  n 
Similarly A R  
 i 
Example:
1. Mr. Alemu purchased a house for Birr 115,000. He made a 20% down
payment with the balance amortized by a 30 year mortgage at an annual
interest of 12% compounded monthly.

a) What is the amount that Mr. X should pay

monthly so as to retire the debt at the end of the 30 th yr?
b) Find the interest charged.

Solution

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Selling price = Birr 115,000 r = 12% i= 1%
Down payment (20%x115,000)= 23,000 m = 12
Mortgage (A) Birr 92,000 t = 30yrs n= 360
R =?
 i 
R A  n
 1 1 i  

 .01 
R 92,000   360 
 1 1.01 
= 92,000 (.010286125)
= Birr 946.32

Interest = Actual payment – Mortgage (loan)

= (946.32 X 360) - 92000
= Birr 340,675.20 – 92,000
= Birr 248,675.20

2. w/ro. Aster purchased a house for Birr 50,000. She made an amount
of down payment and pay monthly Birr 600 to retire the mortgage for 20
years at an annual interest rate of 24% compounded monthly.

Required: Find the mortgage, down payment, interest charged, and the
percentage of the down payment to the selling price.

Solution.
Selling price = Birr 50,000 Mortgage (A) = R [1- (1+i)-n]
Down payment =? i
Mortgage (A) =? = 600 [1- (1.02)-240]
R = Birr 600 0.02
r = 24% i = 2% = Birr 29,741.13
m = 12 Down payment = Selling price – mortgage
t = 20 n = 240 = 50,000 – 29,741.13
= Birr 20,258.87
Interest charged = actual payment- mortgage
= 600 x 240 - 29,741.13
= 144,000 - 29741.13
= Birr 114,258.87

Down payment
Percentage of down payment = x100
Selling Pr ice
20,258.87
= x100
50,000
= 40.52%
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CHAPTER FIVE: ELEMENTS AND APPLICATIONS OF CALCULUS

Objectives
At the end of this chapter students will be able to:
 Understand the concept of calculus
 Clarify the difference between differential calculus and integral
calculus
 Evaluate different parts of calculus
 Understand the concept of calculus in business related decisions
5.1. Introduction

Calculus is the Branch of mathematics that concerns itself with the rate of
change of one quantity with respect to another quantity. It is a

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mathematical tool used to solve problems in science, business, economics,
and other areas. Calculus has two main Branches: Differential Calculus -
which deals with the problems of finding the rate at which a known but
varying, quantity changes: and Integral Calculus - which deals with the
problem of finding a quantity, given that we know the rate at which it is
changing. It is the inverse of differential calculus or vice versa like that of
log and antilog
5.2: Differential Calculus

Broadens the concept of slope - rates of change

There are two core concepts which lie down the foundation for differential calculus. These are:
Limits and Continuity.
Limits: In calculus there is often a concern about the limiting value of a
function as the independent variable approaches some specific value, a, this
limiting value when it exists is called a limit.
Notation:
Lim f (x) = L
Xa
A function f has a limit L (where L is some real number) as x approaches a if
the values of the dependent variable f (x) differ arbitrarily little from L for all
values of X which lie very close to a. The limit as X approaches a is
symbolized:
Lim f (x) = L
Xa

Continuity of a Function

The continuity of a function can be determined at a specific point or over an

interval.

Continuity at a point

A function is said to be continuous at a point when there exists no gap at

that point. At the point of discontinuity we can’t find marginal functions
(MR, MC---)

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 A function f is continuous at x = a if and only if all these conditions
apply to f at a:
1. f(a) is defined (that is, the domain of a f includes x = a)
2. Lim f(x) exists
xa
3. Lim f(x) = f (a) whether x approaches a from the left or right.
X a
Geometrically, a function, f is seen to be continuous at a point x=a when
there is neither a hole nor a gap in the graph of f at x = a
If any one of the three requirements specified above is not satisfied, the
function is f is said to be discontinuous at x = a.
Continuity and Differentiability

The relationship between continuity and differentiability is that: A function

differentiable at x=a is continuous at x=a. That is, differentiability implies
continuity. But the converse of the preceding statement is not true;
continuity doesn't imply differentiability. In other words, it is possible for a
continuous at x=a but not differentiable at x=a.
Rules of Differentiation

The process of finding a derivative is called differentiation. A set of rules of

differentiation exists for finding the derivatives of many common functions.
A few of the more commonly used rules are:
1. Constant Function Rule
Derivative of a constant function is zero
f(x) = k e.g. f(x) = 10 - horizontal straight line
f '(x) = 0 f '(x) = 0
2. Power Rule
The derivative of a variable raised to the constant power, n, where n is any
real number and n0, is equal to the power n multiplied times the variable
raised to the power n-1.
F(x) = Xn e.g. f(x) =X3 f(x) = x2 f(x) =X
F '(x) = n x n-1
f '(x) = 3x 2
f '(x) = 2x f '(x) = 1
F (x) =
F '(x) = =

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3. Constant Multiplier Rule
The derivative of a constant times a function is the constant times the
derivative of the function.
F(x) = kg(x)
f1(x) = k. g '(x) E.g. f(x) = 5x3 f(x) = 3x
f (x) = 5.3x = 15x
1 2 2
f ' (x) =3
4. Sum or Difference Rule
The derivative of the sum (or difference) of two functions is the sum (or
difference) of their respective derivatives.
F(x) = [g(x) + h(x)]
f '(x) = [g '(x) + h'(x)] E.g. F(x) = 6x4 - 5x2 f(x) = 3x
f '(x) = 24x 10x
3-
f ' (x) =3
5. Product Rule
The derivative of a product is the deviate of the first factor multiplied by the
second, plus, the first factor multiplied by the derivative of the second.
H(x) = [f(x). 8 (x)] E.g. f(x) = (2x2-5) x+3)
h '(x) = [f '(x).g(x)] + [f(x) x g (x)]
'
f '(x) = [(4x) .(x+3)] + 1 (2x 2-
5)
= 4x2 + 12x + 2x2-5
= 6x2 + 12x -5
6. Quotient Rule
The derivative of a quotient is the denominator times the derivative of the
numerator, minus the numerator times the derivative of the denominator,
all over the denominator squared.

E.g.

= =

H(x) =

= = =

Higher Order Derivatives

If a function F has a derivative for each value of X in some specified interval,

then the derivative function f’ is defined for that interval, if inturn derivative
function itself has a derivative for points in that interval this new derivative

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function is called the second derivative of the original function f on the first
derivative of f’
Rule
1. Find f’(x), set is equal to zero, and solve for candidate value,x.
2. Find f’’(x) and evaluate f’’(x)
A. If f’’(x) is negative, a local maximum occurs at x
B. If f’’(x) is positive, a local minimum occurs at x
C. If f’’(x) is zero; the test fails to determine what happens at x
F’’(x)=0 is called stationary points. The slope of the line is tangent to a
curve
Eg.f(x)=3x2 +5x2 +2x+3, where f= The Original Function
F=relates information about the behaviour of f
F’’=relates information about f’
F’(X)= 9X2 +10X +2
F’’(X)=18X+10
F’’’(X)=18
F’’’’(X)=0
Given f
If f’(x)>0 f is increasing
If f’(x)<0 f is decreasing
If f’(x)=0 f is constant
If f’’(x)<0 f’ is decreasing
If f’’(x)>0 f’ is increasing
If f’’(x)=0 f’ is constant
Business Application of Differential Calculus

Marginal Analysis
One important use of the derivative in business and economics involves
marginal analysis MC, MR, MP, and MU.

MC - It is the rate of change in total cost per unit change in production at an

output level of x-units at any production level x (non - linear functions)

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Example
1. Suppose the total cost c(x) in thousands of dollars for manufacturing x unit is
given by the function C (x) = 575 + 25x -1/4x 2
a. Find the marginal cost at a production level of x units
C' (x) = 25 - 1/2x

b. Find the marginal cost at a product level of 40 units and interpret the
result
C ' (40) = 25 - 40/2 = 5,000.

At a production level of 40 units the rate of change of total cost relative to

production is Birr 5000. The cost of producing one more unit at this level of
production (40 units) is approximately 5,000 Birr. The cost of producing the
41st unit of product.

c. Find the actual cost of producing the 41st unit and compare this cost with
the result found in question 2.

C (41) - C (40) = [575 + 25(41)-41/4] - 575+25(40)-40/4]

= (1025 - 420.25) - (1000 - 400)
= 604.75 - 600
= 4.75 = Birr 4,750

2. The market research department of a company recommends that the

company manufacture and market new transistor radio. After suitable
market testing the research department presents the following demand
equation
X = 10,000 - 1000 p (x is demand at Birr/radio)
P = 10 - x/1000

The financial department provides the following cost equation C(x) = 7000
+ 2x. Conduct a marginal analysis for the company

Solution.

C(x) = 7000 + 2x TR= PQ = (10 - x/1000) X

C' (x) = 2 = 10x - x2/1000
MR = R'(x) = 10 - 2x/1000
= 10 - .002x
P(X) = R(x) - C(x)
= 10x - x2/1000 - (7000 + 2x)
= 8x - x2/1000 - 7000
P (X) = 8-0.005x
'

Optimization Problems

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1. A company manufactures and sells x transistor radios per week. If the
weekly cost and demand equations are: C(x) = 5000 + 2x and P = 10-x/1000
[0, 8000]

Find for each week

a. The production level that leads to maximum revenue the maximum
revenue.
b. The production level that leads to maximum profit and the maximum
profit.
c. The production level that leads to the minimum cost and the minimum
cost.

Solution
a. TR = P(x) = 10x - x2/1000 b. Profit (P(x) = R(x) - c(x)
R' (X) = 10- 2x/1000 = 10x - .001x 2 - (5000-2x)
= 10-0.002x P(x) = 8x - .001x2-5000
TR get its maximum when P'(x) = 8-.002x
MR=0, so 10-0.002x=0 p(x) gets maximum when P'(x) =0
x = 5000 units 8 = .002x
R' (x) = - .002 - Absolute max. x = 4000 units
R(x) = 10(5000) - 50002/1000 P (4000) = 8(4000)-0.001(40002)-5000
= 25,000 Birr = 11,000 birr, R(x) = 24,000 Birr
(5000, 25,000) = P =Birr 5. (4,000 11,000) Price 6=Birr.

C. If the cost function is a 1st degree equation, the minimum cost is at x= 0

2. The Ethiopian Airlines purchases a particular type of plane at a cost of Birr

1,800,000. The company estimates that the average operating cost is a
function of x, the number of hours of flight time. Average operating cost,
stated in Birr per hour of flight time, is estimated by the function 0(x) =
0.05x - 200

a. Determine how many hours a plane should be flown if the objective is to

minimize the total average cost.
b. What is the minimum total average cost?
Solution
Average operating cost = 0.05x - 200
a. Total operating cost = 0.05x2 - 200x
Total cost = 0.05x2 - 200x + 1,800,000
C¯ (X) = 0.05x2-200x + 1, 800,000
x
= 0.05x - 200 + 1,800,000/x

The total average cost is minimum if C¯ '(x) = 0

C¯ '(x) = 0.05 - 1,800,000/x2

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.05 = 3,600,000/x2
.05x2 = 36,000,000
x = 6000 hours.

b. C(x) = .05x -200+1,800,000/x

= .05(6000)-200+1,800,000/6,000
= 300-200+300
= Birr 400

5.3. Integral Calculus

Integral calculus is the reciprocal of the differential calculus. Given the rate
of change f '(x), by integral calculus we can find the original function f(x).
E.g. f(x) = 5
F(x) = 5x +c
F'(x) = 5
Because the derivative of a constant is zero, once an antiderivative of a
function is found, another antiderivative of the same function can be
formulated simply by adding a non-zero constant to the first derivative.
Thus, F(x), by itself is not unique; it is only one member of a family of
antiderivatives for some specified function, each of these antiderivatives for
some specified function, each of these anti-derivatives differing from the
others only by an arbitrary constant C. Thus, if F(x) is an antiderivative of
f(x), the general expression F(x) + C is called the ANTIDERIVATIVE of f(x), or
the INDEFINITE INTEGRAL, and is denoted by the symbol f(x)dx.

Given F(x, an antiderivative of f(x), the indefinite integral of f(x) is defined to

be F(x)+c = f(x)dx read as the indefinite integral of function f(x) with
respect to the variable x.
 - Integral sign
- indicates that the operation of anti differentiation
(integration) is to be performed.
f(x) - Integrand

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dx - indicates integration is to be performed with respect to the
variable X.
C - Constant of integration
The process for finding f(x)dx is called indefinite integration.
E.g. Find the indefinite integral for the following
1. f(x) = 10x 2. f(x) = 3x - 10
f(x)dx = 5x2+c f(x)dx = 3/2x2-10x+c
Find the function that has a slope of 10x 4 at each point and that passes
through the point (2, 74).
f(x) = 10x4
f(x)dx = 10x4dx = 2x5+c Therefore, F(x) = 2x5 + 10
Y = 2(25) + C
74 = (2 x 32) + C
C = 10
Basic Rules for Integration

The determination of anti-derivatives by trial and error is cumbersome. So

many rules for integration have been developed from the corresponding
theorems concerning derivatives. The most common are:
1. Constant Rule
f(x) = K f(x) = 3 f(x) = 0
f(x)dx = Kx+C 3dx = 3x+C 0dx = 0+c =C
2. Power Rule
f(x) = xn f(x) = x f(x) = x2
f(x)dx = ; n1 f(x)dx = +C f(x)dx =
If n = -1, ln x + C
It is because logarithmic functions are not defined for negative values of x.

3. Constant Multiplier Rule

f(x) = kg(x) f(x) = 5x
if f(x) exists, f(x)dx = 5 +C

f(x)dx = Kg(x)dx+c = 5( )+C

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f(x) = =

f(x)dx = x2dx + C

4. Sum or Difference Rule

f(x) = h(x)  g(x) , if h(x) and g(x) exist
f(x) = h(x)dx  g(x)dx
E.g. f(x) = 3x+6
f(x) = 3xdx + 6dx

= ; where C = C1 + C2

5. Product Rule
f(x) = (x+2)2
= x2+4x+4

f(x)dx =

Business Applications of Integral Calculus

Finding Total Functions
Exercises
1. The marginal revenue function for a company product is given by the
function f(x) = 50,000 - x; where x is the number of units produced and sold.
Moreover, TR = 0 when no units are produced and sold. Find the company's
TR function.

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f(x) - marginal revenue
TR = the integration of MR
= F(x)dx = (50,000 - x)dx
= 50,00dx - xdx
= 50,000x - x2/2 + C
0= 50,000(0) - (0/2) + C
0=C
R(x) = 50,000x - x2/2
2. The function describing the MC of producing a product is f(x) = x+100, where
x = the number of units produced. It is also known that TC = 40,000 Birr
when x is 100 units. Determine the total cost function.
Solution.
MC = x + 100
TC = MC
= (X+100) dx
= xdx + 100dx
= x2/2 + 100x + C
40,000 = (1002/2) + 100(100) +C
=15,000 + C
C = 25,000
C(x) = x2/2 + 100x + 25,000
3. The function describing the marginal profit from producing and selling a
product is f(x) = - 6x+750 where x = the number of units produced and sold.
Moreover, when 100 units are produced and sold, total profit equals Birr
25,000. Determine the total profit function.
Solution
MP = - 6x+750 = -3x2+750x+c
TP = MP dx 25,000 = -3(1002) + 750(100) + C
= (-6x + 750)dx 25,000 = 45,000 + C
= -6xdx + 750dx + C C = -20,000

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= -6x/2 + 750x + C P(x) = -3x2+750x-20,000

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