Wollo University

Collage of Business and Economics

Department of Accounting and Finance

Distance Module for Degree Program

Mathematics for Finance

(ACFN1041)

Prepared By: Seid Mohammed (MSc.)

Editor: Naod Mekonnen (MSc.)

Distance Education Program

2018
Dessie, Ethiopia
 Wollo University
Collage of Business and Economics
Department of Accounting and Finance

Mathematics for Finance

(ACFN1041)

Prepared By: Seid Mohammed

Editor: Naod Mekonnen

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 Preface

Dear Students! Mathematics for Finance is mathematics used by commercial enterprises to

record and manage business operations. Commercial organizations use mathematics in
accounting, inventory management, marketing, sales forecasting and financial analysis.
Mathematics typically used in commerce includes elementary arithmetic, elementary algebra,
statistics and probability. Business operations can be made more effective by the use of more
advanced mathematics such as calculus, matrix algebra and linear programming.

Why This Course? Dear student, welcome to the learning task Mathematics for Finance and its
application. This learning task is designed to expose you to the basic concepts and area of the
application of mathematics in businesses. It is divided into five chapter: The first section
deals with the linear equations and its applications; the second section is about the matrix
algebra and its applications; the third section deals with linear programming, the fourth
section is dedicated to mathematics of finance and the fifth section is about elements and
application of calculus. You will find learning activities in each sections. To successfully
accomplish this learning task you are expected to study and practice the provided examples
and exercises.

Thus this course is designed for accounting and finance students. The course will assist
students reaching a level of increased competence in mathematics and expanded
understanding of the application of mathematical concept in business activities. Emphasis is
placed upon learning mathematical concepts through practical applications to common
business problem.

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 About the Course

Course Code AcFn1041

Course Title Mathematics for Finance
Degree Program BA Degree in Accounting and Finance
Module Computational and Quantitative Methods for Finance
ETCTS Credits 6
Credit Hour 4
At the end of this course, students should be able to
 Differentiate the various techniques of mathematics that can be
employed in solving business problems
 Identify the way mathematical techniques are utilized
Course Objectives &  Appreciate the importance of mathematics in solving real world
Competences to be business problems
Acquired  Use different mathematical techniques for supporting managerial
Decisions
 Analyze real managerial problems using mathematical tools

Mathematics for Finance is one of the preliminary quantitative aids to

decision making that offers the decision-maker a method of evaluating
every possible alternative (act or course of action) by using various
techniques to know the potential outcomes. This course is designed to
Course Description expose finance students to the basic concepts and area of managerial
application of mathematics for decision making. Topics include:
linear equations and their applications, matrix algebra and its
applications, Markov chain analysis, linear programming,
mathematics of finance, elements and application of calculus.
Evaluation Type Weight
Assignment 35%
Tutorial Attendance 5%
Final exam 60%
Total 100%

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 Contents
Preface ...................................................................................................................................... ii
About the Course ................................................................................................................... iii
Contents .................................................................................................................................. iv
Chapter One: Linear Equations and their Interpretive Application ................................. 1
1.1. Meaning of linear equation ..................................................................................... 1
1.2. Parts of linear equation ........................................................................................... 2
1.3. Types of lines in linear equation............................................................................. 3
1.4. Developing linear equation ..................................................................................... 4
1.5. Applications of linear equations in Cost – Volume – Profit (CVP) analysis ......... 7
1.6. Summary............................................................................................................... 15
1.7. Review Questions ................................................................................................. 16
Chapter Two: Matrix Algebra and its Applications .......................................................... 20
2.1. Meaning and importance of matrix ...................................................................... 20
2.2. Types of matrices.................................................................................................. 22
2.3. Matrix Algebra ..................................................................................................... 24
2.4. The Multiplicative Inverse of a Matrix................................................................. 29
2.5. Matrix Applications .............................................................................................. 32
2.6. Summary............................................................................................................... 54
2.7. Review Questions ................................................................................................. 55
Chapter Three: Introduction to Linear Programming ..................................................... 60
3.1. Meaning of Linear Programming ......................................................................... 60
3.2. Linear programming Models (LPM) .................................................................... 61
3.3. Approaches to linear programming ...................................................................... 67
3.4. The Simplex Algorithm/Algebraic Solution Method ........................................... 71
3.5. Special Issues in LP .............................................................................................. 76
3.6. Limitations of linear programming....................................................................... 77
3.7. Summary............................................................................................................... 77
3.8. Review Questions ................................................................................................. 78
Chapter Four: Mathematics of Finance ............................................................................. 80
4.1. Introduction .......................................................................................................... 80
4.2. Terminologies ....................................................................................................... 81
4.3. Simple interest and discounts ............................................................................... 82
4.4. Summary............................................................................................................. 100
4.5. Review questions ................................................................................................ 102
Chapter Five: Elements and Applications of Calculus.................................................... 104
5.1. Introduction to Calculus ..................................................................................... 104
5.2. Differential Calculus........................................................................................... 104
5.3. Integral Calculus ................................................................................................. 112
5.4. Summary............................................................................................................. 116
5.5. Review Questions ............................................................................................... 111
References ............................................................................................................................ 115

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Chapter One: Linear Equations and their Interpretive Application

Chapter objectives
Dear students! after successful completion of this chapter, you are expected to:
 Understand linear equation and its components
 Develop linear equations using different method
 Demonstrate how linear equations can be used in cost -volume - profit (CVP) analysis
for manufacturing business
 Determine the Quantity and sales volume required to earn a target profit
 Understand how to apply linear equations in CVP analysis for merchandising business
 Compute the break-even point in terms of Quantity and sales revenue for
manufacturing and merchandising business

1.1. Meaning of linear equation

Before directly proceeding to the definition of linear equations, let’s start by defining terms
that are used in equation.

Equation can be defined as a mathematical statement which indicates that two algebraic
expressions are equal. In other words, it is a mathematical statement that equates (relates with
equal sign) two algebraic expressions. For example,
Equation is a statement that
y = 2x + 3, is an equation which equates y with 2x + y.
two quantities or algebraic
Equations are used to model or represent real world expressions are equal.
situations and are a convenient and concise way of Solving the equation is
representing relationship between quantities such as sales finding the value(s) of the
and advertising or sales commission, profit and time, cost variable(s) that make the
and number of units manufactured, and so on. equation true.
Two equations are said to be
An algebraic expression is a mathematical statement in equivalent if they have
which two numerical quantities are linked by exactly the same solution set.
mathematical operations (signs) such as + and – signs.
For instance, 2x + 3 in the above equation is an algebraic expression. The letters in algebraic
expressions are called variables (unknowns) and always represent a number. Thus, we can
perform mathematical operations on a letter. In other words, it can be added, subtracted,

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multiplied, and divided. The values or variables separated by + or – signs are called Terms.
Terms are often called monomials (mono = one) if an algebraic expression has one term. If
an expression has more than one term, it is called polynomials (poly = many).

Linear equations are equations with a variable and a constant with degree one (first power).
The terms of linear equations are a constant, or a constant times one variable to the first
power. Linear equations are equations whose slope is constant throughout the line.
E.g. 2x - 3y = 7 - degree 1
- Constant 7
- Terms 2x &3y separated by the minus sign
However, 2x + 3xy = 7 is not a linear equation; b/c 3xy is a constant times the product of two
variables. No X2 terms, no y terms & no XY terms are allowed in a linear equation.

1.2. Parts of linear equation

The general form of a linear equation is, Y = mx + b,

Where, Y = the dependent variable its value depends on the value of x.
X = the independent variable its change affects the value of y.
m = slope
b = y-intercept, the value of y when x=0.
One of the important parts that that differentiate linear equations is the slope. So,lets discuss
the slope and its interpretation.

Slope (m)
It is worth noting that this formula or notation holds true for all lines that are not parallel to
the y-axis. A vertical line is represented by the equation X=a. In cost output relationship, b is
the fixed cost, and m is the marginal cost. The cost is increases by the rate of the amount of
the slope, m.
y

 rise / fall )  Y 2  y1 
Slope (M) if = X1 # X2
x run X 2
 x
1

Slope measures the steepness of a line. The larger the slope the steeper the line is both in
value & in absolute value. A line’s slope number tells us how much the line falls (or rises)
for a stated change in x. Slopes can assume 4 different values: negative, positive, 0 and
undefined.
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 The line that is parallel to the X- axis is the gentlest of all lines, m= 0
 The line that is parallel to the Y - axis is the steepest of all lines, m = 

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.
In linear equation of Y= mx + b, the coefficient of the independent variable is the slope of the
line and the constant that stands alone is the vertical (y) intercept. That is, Dependent
variable = (slope x independent Variable) + Intercept.
Slope measures the amount
A positive value of m indicates that there is a direct by how much the dependent
relationship between the independent variable (x) and the variable (y) changes for
dependent variable (y). which means that the value of y each unit change in the
will increase by the value of m for each unit increases in independent variable x.
the value of x. on the other hand, a negative value of m
implies that there is an inverse (indirect) relationship between the value of X and the value of
Y (the value of y decreases by the value of m for each unit increases in x).

Intercepts - Those points at which the graph of a line, L, crosses the axes are called
intercepts. The X-intercept is the point at which the line crosses the X-axis and it is found at
(X, 0) and the Y-intercept is the point at which the y-axis is crossed. Its coordinate is at (0,
y).

1.3. Types of lines in linear equation

1.3.1. Horizontal and Vertical Lines

Horizontal lines are lines whose slope is zero. These lines are parallel to the X-axis. Vertical
lines are lines whose slope is undefined. These lines are parallel to the Y-axis. 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, and if
the x values are the same the line is vertical.

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Example
a) Given the points (3, 6) & (8, 6) - the line through them is horizontal because both y-
coordinates are the same (6). The equation of the line becomes y=6.
b) Given the points (5, 2) and (5, 12), the line that passes through them is vertical, and its
equation is x = 5. If we proceed to apply the point - slope procedure, we would
12  2 10
obtain    , and if m =  the line is vertical and the form of the equation is: x =
55 0
constant.

1.3.2. Parallel and Perpendicular Lines

Two lines are parallel if the two lines have the same slope, and two lines are perpendicular to
each other 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 and horizontal lines, (they are perpendicular to
each other), this rule of m1 . m2 = -1 doesn’t hold true.

Example:
1. Y= 2x-10 and Y=2x+14 are parallel.
3 2
2. Y= x +10 and Y = x +100 are perpendicular to each other.
2 3

1.3.3. Lines through the Origin

Any equation in the variables x and y that has no constant term other than zero will have a
graph that passes through the origin. Or, a line that passes through the origin has an x-
intercept and a y-intercept of (0,0). These lines are expressed in the form Y = mx.

Self-test 1.1.
Dear learners, considering the following two equations; y = 3x+7, and Y= -3x +7, What do
you understand about the relationship between the value of y and x for different values of X
such as 4,5, and 6. Again considering the equation y = 3x+7 and y = 3x2+ 7, what do you
understand about the change in y for the given value of x in the two equations

1.4. Developing linear equation

Depending on the situation to be modeled, one of the three methods can be used to formulate
a linear equation. These are:
1. The slope - intercept form
2. The slope - point form
3. Two-points form.

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1.4.1. 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 y-intercept for a specific linear function are
obtained directly from the description of the situation we wish to model.
E.g. Slope=10
Y-intercept=20
A line that has a slope of 10 and a y-intercept of 20 has the following equation:
Y=10x +20

Example: A Salesman has a fixed base salary of Br 200 a week. In addition, he receives a
sales commission that is 20 percent of his total Birr values of sales. State the relationship
between the salesman’s total weekly salary and his sales for the week. Total weekly salary
depends on total sales volume, thus,
Answer: Y = 0.2x + 200

1.4.2. The slope - point form

The equation of a non-vertical line, L, with slope, m that passes through the point (x, y is:
Y-Y1 = m (X-X1).

Slope = 4, point (1, 2), the equation becomes Y = 4X-2

Example: Assuming a linear relationship between total cost (y) and the number of units
produced (x, and cost increases by Br. 7 for each additional unit produced, and the total cost
of producing 10 units is Br. 180, formulate the equation that relates total cost (Y) and number
of units produced (x).

Solution
The total cost depends on the number of units produced, then
Given = Slope = Br. 7
points (10 , 180) using , Y-Y1 = m (X-X1)
= y- 180 = 7 (x-10)
= y = 7x-70 + 180
= y = 7x + 110

1.4.3. Two - Points 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, and then use this value of slope (m) together

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with either point in the point-slope form: Y-Y1 =m (X-X1) to generate the equation of a line.

y y
2 1
The slope can be computed using: (Y-Y1) = (X - X1)
x x2
x 1

E.g. given the points (1, 10) and (6, 0)

0  10 10
First, find the slope =   2 , then use the Slope-point form.
61 5
Y-Y1 = M (X-X1) = Y-10 = - 2 (X-1)
Y-10 = -2X + 2
Y = -2X + 2

Example: It costs a company Br. 400 to produce 20 units of a product and 30 units are
produced for br. 500, assuming a linear relation between total cost and number of units of a
product produced, assuming a linear relationship between total costs and number of units
produced, formulate a linear equation which relates total costs with number of units
produced.

Solution
Since the total cost depends on the number of units produced;
Given = points (20, 400) and (30, 500).

y y
2 1
The slope (m) =
x x2
x 1

= 400 - 300/ 30- 20 = 100/10 = br.10 , Indicating that it costs br. 10 to produce
one additional unit of a product.
Once the slope is computed, the equation is formulated by using the slope and either of the
points in the sloe point form;
Y-Y1 =m (X-X1) ,using the first point (20,400)
= y- 400 = 10 (x- 20)
= y- 400 = 10x -200
= y= 10x+200
Alternatively using the points (30, 500), y-500 = 10( x-30) = y-500 = 10x-300
y = 10x +200

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Self-test 1.2. Dear learners answer the following questions
1. A salesman earns a weekly basic salary plus a sales commission of 20% of his total
weekly sales. When his total weekly sales total Birr 1000, his total salary for the week is
Birr 400. Derive the formula describing the relationship between total salary and sales.
2. Suppose the fixed cost for producing product x be Birr 2,000 and it costs Birr 10 per x
produced. If the total cost is represented by y:
A. Write the equation of this relationship in slope intercept form.
B. State the slope of the line and interpret this number.
C. State the y-intercept of the line and interpret this number.
3. A sales man has a base salary and, in addition, receives a commission, which is a fixed
percentage of his sales volume. When his weekly sales are Birr 1000, his total salary is
Birr 400. When his weekly sales are Birr 500, his total salary is Birr 300. Determine his
base salary and his commission percentage and express the relationship between sales
and salary in equation form. Answer: Y = 0.2x + 200
4. It costs Birr 1,400 for printing 100 copies of a report and Birr 3000 for printing 500
copies. Assuming a linear relationship what would be the price for printing 300 copies.

1.5. Applications of linear equations in Cost – Volume – Profit (CVP) analysis

One of the areas of accounting and finance in which linear equation can be applied is in cvp
analysis.

Cost –Volume –Profit (CVP) analysis is the examination of the relationship between costs
production and sales volume and profits.

Depending on their behavior costs can be classified as fixed and variable costs.
A) Fixed costs – are costs that remain constant in total regardless of the change in the
level of activity within the relevant range of activities.
In the total cost equation fixed costs represent the intercept
B) Variable cost – are costs that vary in total in proportion to the change in the level of
activity. However, variable cost per unit of a product remains constant. Thus, unit
variable cost (v) represents the slope in the total cost equation. In other words, it is the
amount by how much total cost will change for each additional units produced.

Total variable cost (TVC) = unit vu x units produced

TVC = V(Q)
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 Total cost = TVC + TFC

Total cost= V(Q) + TFC …. the total cost equation

Revenue also called sales is the amount of income generated by selling goods or providing
services to customers. Selling price is the slope of revenue equation indicating that total
revenue increases by the amount of selling prices for each unit of a product sold.

Total revenue = selling prices x number of units sold

TR = PQ ……..The revenue equation

Profit is the difference between revenues and total costs.

Profit = TR – TC, substituting the revenue and cost equations

= PQ – (V (Q) + TFC)
= PQ-VQ –TFC = since Q is common
P = (P-V) Q –TFC…..The profit equation

The relationship between costs, revenues and profit is depicted in the following graph.

TR
Profit
TC
F
Revenue/ cost

Revenue

BEP

A C
Variable cost

B D FC

Loss Fixed cost (FC)

(TR < TC)

Number of units (Q)

Graph 1.1. The relationship between costs, revenues and profit

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Interpretation of the graph
1. The vertical distance AB and CD is the same because fixed cost is the same at any level of
output.
2. There is no revenue without sales. Hence, total revenue passes through the origin, but
there is cost without production (because of total fixed cost) and the total cost function
starts form A and doesn’t pass through the origin.
3. Up to point F, total cost is greater than total revenue and results in loss while at point F,
TR = TC = Breakeven (zero profit), and above point F, TR >TC and results in profit.
4. TFC remains constant regardless of the number of units produced, given that there is no
any difference in scale of production. That is there is no either expansion or contraction
of the business.
5. As production increases, TVC increases at the same rate and MC = V only in linear
equations.
6. As production increases TC increases by the rate equal to the V = MC.
7. Unit variable cost V is the same throughout any level of production; however, AFC
decreases when Q increases and ultimately ATC decreases when Q increases because of
the effect of the decrease in AFC.
8. As Q increases TR increases at a rate of P and AR remains constant.
AR = TR

p. Q
 AR  P  in linear functions.
Q Q

1.5.1. Breakeven Analysis

Breakeven point (BEP) is the point at which total revenue equals total costs. In other words,
there is no loss or profit to the company at BEP. It can be expressed 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 business state their cost equation in terms of revenue
(because they purchase and sell).

Case 1. Manufacturing Companies

Consider a company with equation TR = PQ
TC= VQ + FC
At BEP, TR = TC where:
PQe = VQe + FC Qe = break even quantity
PQe - VQe = FC FC = fixed cost
Qe (P-V) = FC P = unit selling price

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 FC
Qe = V= unit variable cost
P V

Assumptions of Breakeven Analysis

1. Selling price is constant throughout the entire relevant range [relevant range – is the limit
of cost-driver activity within a specified relationship between costs and the cost driver is
valid].
2. Costs are linear over the relevant range.
3. In multi-product companies, the sales mix is constant.
4. In manufacturing firms, inventories do not change (Units produced = Units sold).
5. Expenses may be classified in to variable and fixed categories. Total variable expenses
vary directly with activity level. Total fixed expenses do not change with activity level.
6. Efficiency and productivity will be unchanged.

Example: A manufacturing company has a fixed cost of 10,000 and a unit variable cost of
Birr 5. If the company can sell what it produces at a price of Birr 10?
a. Formulate the revenue, cost and profit equations and interpret the result.
b. Find the breakeven point in terms of quantity and sales volume.

Solution

a) Revenue equation , TR = PQ = 10Q

Which implies that revenue increases by br.10 for each additional unit of a product sold.
Total cost equation, TC = VQ+ TFC = 5Q + 10,000
Indicating that total cost increases by br. 5 for each additional units of product
produced.
Profit equation, P = (P-V) Q – TFC = (10-5) Q – 10,000 = 5Q - 10,000
Which implies that the total profit will increase by br.5 for each additional units of a
product sold and the company will incurr a cost of br.10,000 if sales (production) is
zero.
b) BEP in Quantity = TFC/P-V = 10,000/ 10-5 = 10,000/5 = Br.2,000.
BEP in revenue = BEPq x p = 2,000 x Br. 10 = Br. 20,000.

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1.5.2. The Effect of Changing One Variable Keeping Others Constant on BEP

Changing one or more of the elements of CPV will have effects on the BEP.

Case 1: Fixed Cost

Assume for the above problem FC is decreased by Br 5,000, citrus paribus.
5,000
TC = 5Q + 5,000 Qe1 = = 1,000 units
5
TR = 10Q
 FC  Qe  
  FC & Qe have Direct relationship
 FC  Qe  
Therefore,

Case 2 - Unit variable cost

Assume for the above problem unit variable cost decreased by Birr 1, citrus paribus
10,000
TC = 4Q + 10,000 Qe2  6 = 1,667 units
TR=10Q

V  Qc  
Therefore,  V & Qe have direct relationship
V  Qe  

Case 3- Selling Price

Assume for the above problem selling price is decreased by Birr 1, Citrus Paribus.
TC = 5Q + 10,000  Qe  10, 000
4
 2,500 units
3

TR = 9Q

P  Qe 
Therefore,  P & Qe have indirect relationship
P  Qe 

In the above example if a company can’t produce and sell 5,000 units it has the following
options:
a) Decreasing FC
b) Decreasing unit variable cost
c) Increasing the unit selling price

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If the organization is faced between cases two and three, it is preferable to decrease the unit
variable cost because if we increase the selling price, the organization may loose its
customers; and also decreasing the FC is advisable.

1.5.3. Finding the Quantity level that involves profit or loss.

FC  0
BEP = , Any Q is related to the cost, profit, ---
Pv

  TR  TC
= PQ - (VQ + FC)
= Q (P-V) - FC
  Q( P  V )  FC
FC    Q( P  V )
FC  
 Q  For any quantity level.
P V
Example: For the above manufacturing company, if it wants to make a profit of Birr 25,000,
what should be the quantity level?

Solution

FC  
 Q
P V thus, Q= 10,000 + 25,000/5 =35,000/5 = 7,000 units.

This tells us when there is a profit; the quantities produced and sold have to be greater than
the break-even quantity.

1.5.4. Applications of linear equations in CVP analysis for merchandising companies

Merchandisers (retailers) are business that acquire goods to resale it at a price above the
purchase price. The difference between the selling price and purchase price is called a
markup which is used to cover other selling expenses and to provide profit.

Markup can be expressed as a function of cost and sales as follows;

Markup as a function of cost is called margin = markup/ cost
Markup as a function of sales = markup /selling price (sales)

Example : Assume a business firm with product A has the following cost and revenue items.
Purchase cost of A = 100 Br
Selling price = 150 Br
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Markup = Selling price - Cost = 150-100=50.
Mark up can be expressed:
As a function of cost, the mark-up percentage is 50/100 = 50%

As a function of retail price, the mark up is 50  33.3% , it is also called margin.

150
100%  33.3% = 66.6%  67%
  

Selling price margin Cost of goods sold

The cost of goods sold =
Selling expense = 1 percent of the selling price = 0.01x
So, the total cost equation becomes:
Y=0.68x + FC; Where X = sales revenue, and
Y = total cost.

The above 68% is interpreted as, Out of the 100% selling price 68% is the variable cost of
goods purchased and sold.
To get the break-even sales volume level, we equate the total cost, Y with the sales volume
level, X as Xe = Y = X, Y = mx + b
X = mx + b
X – mx = b
X (1 – m) = b
Xe = b
1 – m; Where m= unit variable cost /Birr of sales.
Example: Suppose a retail business sells its commodities at a margin of 25% of sales and the
company uses a 5% commission as selling expense and Birr 12,000 as a fixed cost. Find the
break-even revenue for the retail business after developing the TC equation.

Solution:
Let: x= sales revenue
Y= Total cost
Margin = 25% (0.25)
Purchase price = 1- margin = 1-.25 = 0.75
The vc = 0.75x + .05x (sales commission) , then the total cost equation is
Y= 0.8x + 12,000

The breakeven revenue = Total fc / 1-m = 12,000/1-0.2 = Br. 60,000.

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The break-even revenue 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 it is not possible and hence we have to use deferent formula for
different items.
When the break-even revenue equation is for more than one item it is impossible to find the
Xe
break-even quantity. It is only possible for one item. By Qe = where
P
Xe = break-even revenue.
P= Selling price.
Qe = break-even quantity.

Given that the company purchases and sells single product, to change the cost equation in
terms of revenue in to a cost equation in terms quantity we have to multiply price by the
coefficient of X that is m. To change the cost equation in terms of quantity in to a cost
equation in terms revenue we divide the unit variable cost, V, by the corresponding unit
selling price.

Self-test 1.3. Dear learners, Answer the following questions

1. ABC’ company’s cost function for the next four months is C= 500,000 + 5q.
Required:
d) The break-even dollar volume of sales if the selling price is Birr 6 per unit.
e) What would be the company’s cost if it decided to shut down operations for the next four
months?
f) If, because of a strike, the most the company can produce is 100,000 units, should it shut
down? Why or why not?
2. In its first year, A Company had the following data.
Sales = 25,000 units Selling price = Birr 100
Total variable cost = Birr 1,500,000 TFC = Birr 350,000
Required:
a) Develop revenues, cost, and profit functions for the company in terms of quantity.
b) The intercept of the revenue equation is zero, what do you think is the reason?
c) Find the break-even point in terms of quantity.
d) Convert the cost equation in terms of quantity in to a cost equation in terms of revenue.

14 | P a g e
 e) Find the break-even revenue.
f) If profit had been Birr 500,000 what would have been the sales volume (revenue) and
the quantity of sales.
g) What would have been the profit if sales were Birr 2,000,000?
3. A retail co plans to work on a margin of 44% of retail price and to incur other variable
costs of 4%. If it expects fixed cost of Birr 20,000,
a) Find the equation relating total cost to sales.
b) Find the profit it sales are Birr 60,000.
c) Find the breakeven revenue.
d) If profit is Birr 15,000, what should be the revenue level?
e) If the company has only one item at a price of Birr 15 per unit, how do you convert
the cost equation in terms of revenue in to a cost equation in terms of quantity?

1.6. Summary

Dear student, with confidence, you have already acquired knowledge about the concepts and
the interpretative applications of linear equations, functions, and graphs in business. In this
unit, we have considered the managerial applications of linear algebra and geometry so far.
In so, we have considered that linear equations are mathematical expressions written in the
form of
ymxb
The graph of such equation on coordinate plane is a straight line. As a result, the slope of the
line is constant for any given points on the line. The slope of a straight-line m, given two
points on the line with coordinates of (x1, y1) and (x2, y2) is expressed by the equation.
y 2  y1
m
x 2  x1
Further, we have considered how to compute the distance between two points on a coordinate
plane. Subsequently, approaches of developing equation of a line are discussed in the present
unit. Above all, we have seen the interpretive applications of linear equations: analysis of
linear cost-output relations, break-even analysis, and market supply and demand equilibrium
analysis. In the next section, we will advance with the study of the matrix algebra and its
application in solving business problems and backing management decisions that further
organizational interests.

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1.7. Review Questions

Part I: multiple choices

Instruction: Choose the best answer from the given alternatives

1. From the following which one is linear equation?

A. 6x2 + 2y = 7
B. 6x + 4y – 6 = 2
C. 2yx + 7y = 0
D. y + 2x = 5
2. Suppose travelling cost of one person to A.A from Dessie by airline have fixed airline
ticket of Birr 1,250. But the person should add 20 Birr for one Kilo gram materials it
take with him. What is the marginal cost of adding one kilo gram material which
transported with him?
A. 1,250 C. 20
B. 12 D. 1,270
3. From question # 3, what is the total cost travelling to A.A for one person if the
materials of the person are 10 kilo gram?
A. 1,450 C. 1,250
B. 1,270 D. 20
4. Suppose the cost of college for accounting courses are linear relationship with its
credit hours. To take 48 credit hours it costs 6000 Birr and for 64 credit hours 8000
Birr. On the first semester one student required to take 28 credit hours. The equation
for this relationship is:-
A. Y = 250x C. Y = 123x
B. Y = 122x + 5 D. Y = 125x
5. Assume that for question # 4, BS wants to study accounting in college. How much
birr it costs him for one semester.
A. 6,000 C. 8,000
B. 3,500 D. 4,000
6. X company produces and sales a commodity for $10. The company's cost function is
given by the equation (y) =5x + 250 where x is units of products produced and sold.
what profit is earned if the annual sale are 1000
A. 250 C. 4750
B. 5250 D. None

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7. A company expects fixed cost of Br. 100,000. It plans to work on a margin of 45% of
retail price and to incur variable costs of Br. 0.05 per Br. of sales. What is the
breakeven level of sales volume?
A. 250,000 C. 180,000
B. 280,000 D. None
8. For the function y = 3x + 2 the average rate of change of y when x increases from 1.5
to 1.7 is
A. 1 C. 0.6
B. 0.5 D. 0.3
9. What is the correct slope and y-intercept for the equation y = -3x?
A. slope: 0, y-intercept: -3
B. slope: -3, y-intercept: 0
C. slope: 3, doesn’t have a y-intercept
D. slope: -3, doesn’t have a y-intercept
10. If a line is horizontal, its slope is
A. 1 C. Undefined
B. 0 D. Negative
11. The following equations lines are parallel each other except one equations line, which
equations line is it?
A. 2x + y = 20 C. 3y + 9x + 3 = 0
B. 8y + 16x – 8 = 0 D. 24x + 12y = 7
12. The equation of the line that pass through the origin, parallel to the line y=3x -14 is:
A. Y=-1/3x C. y=3x + 14
B. y= 3x D. None
13. On the line passing through (4, 6) and (2, 10), what is the y-coordinate of the point
where x = 20
A. -10 C. 24
B. 26 D. None
14. break even quantity have:
A. A direct relationship with fixed cost
B. Indirect relationship with variable cost
C. A direct relationship with price
D. All
E. None

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 15. One of the following statement is false:-
A. As production increases TC increases by the rate equal to the V = MC.
B. Average fixed cost decreases when quantity increases and ultimately average
total cost decreases when quantity increases.
C. To change the cost equation in terms of revenue in to a cost equation in terms
quantity we have to dived price by the coefficient of X that is “m”
D. To change the cost equation in terms of quantity in to a cost equation in terms
revenue we divide the unit variable cost by the price.

Part II: work out

Dear learners you are required to attempt the following questions by showing all the
necessary steps.

1) A company expects fixed cost of birr 400,000. Margin estimated to be 52% of retail, and
variable cost in addition to cost of goods sold is estimated to be birr 0.007 per sales
Required

a) The total cost function

b) The total variable cost if sales is estimated to be 200,000
c) Break even sales point
d) Profit if sales is estimated to be 800,000
2) A manufacturer of cassette tapes has a fixed cost of Birr 75,000 and a variable cost of
Birr 7 per cassette produced. Selling price is Birr 10 per cassette.
a) Write the revenue, cost and profit functions

b) At what number of unit will break even occur?

c) At what sales volume (revenue) will break even occur?

d) If profit is Birr 15,000, what should be the revenue level?

e) Compute profit if;

i) 20,000 units are made and sold.

ii) 50,000 units are made and sold.

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Answer for chapter review Questions
Part one: Choice
1.B
2.C
3.A
4.D
5.B
6.C
7.A
8.C
9.B
10.B
11.C
12.B
13.D
14.A
15.C

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Chapter Two: Matrix Algebra and its Applications

Arthur Cayley (1821-1895) of England was the first Mathematician to introduce the term
“matrix” in the year 1858. But in the present day applied Mathematics in overwhelmingly
large majority of cases it is used, as a notation to represent a large number of simultaneous
equations in a compact and convenient manner. Matrix Theory has its applications in
Operations Research, Economics and Psychology. Apart from the above, matrices are now
indispensable in all branches of Engineering, Physical and Social Sciences, Business and
Statistics.

Chapter Objectives:
Dear students! at the end of this chapter you should be able to:
 Define matrix and identify the different types of matrices
 Perform a mathematical operation on the matrices including matrix addition, subtraction
and matrix multiplication
 Understand and demonstrate the application of matrices in solving linear equations using
inverse method.
 Understand the Gaussian method to solve word problems in the area of accounting and
finance.
 Understand the Cramer’s rule to solve word problems in the area of accounting and
finance

2.1. Meaning and importance of matrix

Matrix is a rectangular array of real numbers arranged in A matrix is a rectangular

m rows and n columns. like sets, it is symbolized by a array of numbers or elements
of a ring. One of the
bold face capital letter enclosed by brackets or principal uses of matrices is
parentheses as: in representing systems of
equations of the first degree
a11 a12    a1n  in several unknowns. Each
A  a21 a22    a2 n  in which aij are real numbers. matrix row represents one
 
am1 am 2    amn equation, and the entries in a
row are the coefficients of
Each number appearing in the array is called an element the variables in the
or component of the matrix. Elements of a matrix are equations, in some fixed
order.
designated using a lower case form of the same letter used
to symbolize the matrix itself. These letters are subscript, as aij, to give the row and column

20 | P a g e
location of the element with in the The size of a matrix is given by the number of
array. The first subscript always rows and columns, so that M1, M2, M3, and M4
refers to the row location of the are, in that order, of sizes 3 × 3 (3 by 3), 3 × 3, 3
× 2, and 2 × 3. The general matrix of size m × n
element; the second subscript always
is frequently represented in double-subscript
refers to its column location. Thus, notation, with the first subscript i indicating the
component aij is the component row number, and the second subscript j
indicating the column number; a23 is the element
located at the intersection of the ith
in the second row, third column. This general
row and the jth column. matrix

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). may be abbreviated to A = [aij], in which the
ranges i = 1, 2, ..., m and j = 1, 2, ..., n should be
Example: The following are examples explicitly given if they are not implied by the
of matrices text. If m = n, the matrix is square, and the
number of rows (or columns) is the order of the
matrix. Two matrices, A = [aij] and B = [bij], are
1 equal if and only if they are of the same size and
7
  if, for every i and j, aij = bij. The elements a11,
A  5 3  This is a 3 x 2 matrix a22, a33, ... constitute the main or principal
 
4 2

diagonal of the matrix A = [aij], if it is square.
The transpose AT of a matrix A is the matrix in
which the ith row is the ith column of A and in
which the jth column is the jth row of A.

Some of the above matrix elements are the followings: a11 = 1, a12= 7, a21 = 5, a22 = 3, a31=4
and a32=2

1 5 9 15 
2 6 10 20
 This is a 4 x 4 matrix Elements X44 = 45 x32 = 7
3 7 11 30
 
4 8 12 45

Importance of matrices
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

21 | P a g e
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
In general, matrices are used:
 To handle large linear systems
 To solve complex linear equations
 An effective means for summarizing and organizing voluminous data

Self-test 2.1. Dear learners, given the following matrix A;

A) Determine its dimension

B) Find the element a12, a23, a31, and a44

2.2. Types of matrices

Based on their dimension (order) or size, matrices are classified in to different ways. The
following are some of the matrices types:

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.
a. Row vector is a vector matrix which has only one row and two or more columns. It is
a 1 x n matrix.
E.g. W = [-1, 0, 6] is 1x3 row vector
b. Column Vector is a vector matrix which has only one column and two or more rows.
It is a mx1 matrix.

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 2
5 
E.g. B =   is a 4x1 column vector
7 
 
0 
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).

1 2 3 10  1 4 7
   
  2 5 8
If A  4 11 then A-t = A  
9
5 6
3 6
   
7 8 9 12 10 11 12
   
Note that aijt = aij
The transpose of a row vector is a column vector and the transpose of a column vector is a
row vector.

2. Square Matrix is a matrix that has the same number of rows and columns. It is also
called an nth order matrix.
1 5 9 15 
1 0  
E.g. 2x2, A    or 4x4, B= 2 6 10 20 are square matrices
0 1 3 7 11 30
   
4 8 12 45
3. Null (zero) matrix - is a matrix that has zero for every entry. It is generally denoted by
Omn. 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 that zero matrix.
4. Identity matrix - a square matrix in which all of the primary diagonal entries are ones
and all of the off diagonal entries are zeros. Generally, it is denoted as In. Primary
diagonal represents: a11, a22, a33, a44, --- ann entries.

1 0 0 0
1 0  
I2 = A    , I4 = A  0 1 0 0
0 1 0 0 1 0 
   
0 0 0 1
The product of any given matrix and the identity matrix is the given matrix it self. 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.

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5. Scalar matrix - is a square matrix where elements on the primary diagonal are the same
and the rest zeros.
6. Diagonal matrix- a square matrix where elements on the primary diagonal are
consecutive and others zeros.
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 aij = bij for every pair of subscripts i and j. If A = B, then B = A; or if A≠B,
then B ≠A.

1 2 1 2
A  Is equal to B= A 
3 4 3 4
   

1 2 4 2
However; A    is not equal to C = A   
3 4   3 1
   
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, a11 ≠ C11 and so on.
Self-test 2.2. Dear learners state whether do you agree or disagree for the following
statements and justify for your response.

1. An Identity matrix is a scalar matrix, but a scalar matrix may not be an identity
matrix………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………
2. A scalar matrix is a diagonal matrix but a diagonal matrix may not be a scalar
matrix………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………
…………..

2.3. Matrix Algebra

Algebra - is a part of mathematics that deals with operations (+, -, x÷). Thus, matrix algebra
is mathematical operation performed on the matrix. As well, it is also called as matrix
operation (the application of mathematical operations like addition, subtraction,
multiplication and division in matrices).

24 | P a g e
2.3.1. Matrix Addition (subtraction)
Two matrices of the same dimensions are said to conformable for addition. The addition is
performed by adding corresponding elements from the two matrices and entering the reset in
the same row-column position of a new matrix [element-wise addition].

If A and B are two matrices, each of size mxn, then the SUM of A and B is the mxn matrix C
whose elements are:
Cij = Aij + bij for i = 1, 2, ------- m
j = 1, 2, -------- n.

2.3.2. Laws of Matrix Addition

The operation of adding two matrices that are conformable for addition has these two 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.

1 3 7  8
9 12 
eg  +   =  
2 4 8
10  10  6
     
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

There are types of matrix multiplications. These are;
a. Scalar multiplication
b. Vector-by-Vector multiplication
c. Matrix by 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.

If K is any real number and A is an mxn matrix, then the product KA is diffident to be the
matrix whose components are given by k times the corresponding component of A; that is,
KA= [Kaij] (mxn).

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Example: 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 not a vector. In other words, Vector- by- Vector results in a real
number rather than a matrix.

Example: Consider the product (AB) of the following row and column vectors.
2
5 
A   3 4 2 6 ’ B=  
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

26 | P a g e
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 ith row and jth column of the product AB is obtained by multiplying the entries in the ith
row of A by the corresponding entries in the jth column of B and then adding the results. That
is, to obtain the entry in the ith row and jth column of the product AB, use the ith raw of A and
the jth column of B in the following form:

The first element in the raw 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 n th
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 dimension

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
2 3 4 1 7
A   B =  0 8
6  
9 7  5 1
 
A.B = (2x-1) + (3x0) + (4x5) (2x7) + (3x8) + (4x1)
= 18 42

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

= 29 121

AB = 18 42 
29 121
The result for BA is different:

B.A = (-1x2) + (7x6) = 40 (-1×3) + (7×9) = 60 (-1×4) + (7×7) = 45

= (0×2) + (8×6) = 48 (0×3) + (8×9) = 72 (0×4) + (8×7) = 56
= (5×2) + (1×6) = 16 (5×3) + (1×9) = 24 (5×4) + (1×7) = 27

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 40 60 45
BA = 48 72 56 
16 24 27 

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 -------------- Distributive law
 (A+B) C = AC + BC -------------- 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.

3. The product of two matrices can be the zero matrixes even though neither of the two
matrices themselves is zero matrix! We cannot conclude from the result AB = 0 that at
least one of the matrices A or B is a zero matrix.
3 0 0  0 0 0  0 0 0
 
A = 2 0 0 , B = 7 10 4 , AB = 0 0 0
   
1 0 0  8 3 2  0 0 0

4. 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.

 1 3  4  1 1 2
A , B , C  
 2  6 2 5  3 4
     

10 14 
AB = AC =  20 but B ≠ C.
  28 

28 | P a g e
Self-test 2.3. Dear learners, given the following three matrices A, B and C, try to answer the
following questions.

Required:
A) Assuming, 2A = 4B, find the value of x.
B) Compute A+B and B+A
C) Calculate A-B and B-A
D) Is matrix subtraction commutative? Why or why not……………………………………
………………………………………………………………………………………………………………
………………….
E) is the product AB defined? Why
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………
F) Are A and B matrices commute? Justify for your
response……………………………………………………………………………………………………
………………………………………………………………………………………………………………
……………
G) Proof the following;
 A (BC) = (AB) C
 A (B+C) = AB + AC
 (A+B) C = AC + BC

2.4. The Multiplicative 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 inevitable matrix will have only one inverse; that is, if
a matrix does have an inverse and that inverse is unique.
In short:

29 | P a g e
  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.
1 1
eg  
1 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. Now, if the
inverse matrix A-1 were known, we could multiply the matrices on each side of the vertical
line by A-1, as [AA-1/A-1I]. 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.
ii. A row can be multiplied by any non-zero real number /Multiple operations/. The
multiplication of any row by a non-zero number.
iii. A multiple of any row can be added to any other row /Add-A-Multiple operations/.
The addition /subtraction of (a multiple of) one row to/from) another row.

4 3 2   2 6 7 
Example. 1. A , B 4 3 2  = interchanging rows
 2  
6 7  
 

4 3 2  8 6 4
2. A  B=   multiplying the first row by 2
 2 6 7  2 6 7
   

30 | P a g e
 4 3 2  4 3 2 
3. A   B=   = Multiplying the first row by
 2 6 7 6 12 11
   
2 and add to 2nd row.

Theorem on row operations

A row operation performed on product of two matrices is equivalent to row operation
performed on the pre-factor.
Consider the following AB = C
1 2 3 1 2 
9 13 
A   B = 1 1  C, =
 13 19
2 3 4   
  2 3 

Interchange R1 with R2

2 3 4 1 2 
A  B = 1 1  C, = 13 19
1   9 13 
2 3 2 3   
 

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.
One’s First: Try to set ones first in a column and then zeros of the same column.
Go from left to right
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.

Self-test 2.4. Dear learners, find the inverse of the following matrices:
A)

B)

C)

31 | P a g e
 2.5. Matrix Applications

The inverse of the matrix is an important instrument in order to solve linear equations and
find the values of variables in the equation. The following two examples illustrates how to
solve linear equations using the inverse of a matrix.

2.5.1. Solving Systems of Linear Equations

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.
iii. Cramer’s rule – using determinants (independent study)

Elimination method
The elimination of variable procedure is generally satisfactory for solving systems of two
equations in two variables. However, for systems containing more than two equations and
involving more than two variables, this procedure is not as efficient as we would like; so we
find ourselves turning to another solution technique. The alternative solution procedure we
shall use employs a MATRIX FORMAT to organize the data.

The two linear equations of the system

a11x 1 + a12x2 = b1
a21x1 + a 22x2 = b 2
can be represented by the MATRIX EQUATION AX = B where
A = a11 a12
a21 a 22

is called the COEFFICIENT MATRIX,

X = x1
x2

is the SOLUTION VECTOR, or VECTOR OF UNKNOWNS,

B= b1
b2

32 | P a g e
 is called the RIGHT-HAND-SIDE VECTOR, or VECTOR OF
CONSTANTS.
The vector X = n1 represents a solution of the system if
n2 both equations are satisfied when we
substitute x1 = n1 and x2 = n2.

Matrix Method
i. Inverse Method
The inverse of the matrix is an important instrument in order to solve linear equations and
find the values of variables in the equation. The following two examples illustrates how to
solve linear equations using the inverse of a matrix.
Example 1: Find the value of X, Y, determinant method
x – 3y = 3
x + 2y = 8
Solution
After we get the inverse of the matrix, if we multiply the inverse with the product matrix we
will get the values of x and y.
x – 3y = 3
x + 2y = 8
The matrix form of the above equations is
x =
Here our intension is to change the left matrix in to identity matrix
R1: 1 -3 3 1 0
R2: 1 2 8 0 1

Goal 1: change row one column one in to 1

Step 1: just put it as it is, because it is already 1.
R1: 1 -3 3 1 0
R2: 1 2 8 0 1

Goal 2: Change row two column one in to 0

Step 2: Subtract row one from row two R2→ R2 – R1
R1: 1 -3 3 1 0
R2: 0 5 5 -1 1
Goal 3: Change row two column two in to 1
Step 3: divide row two by 5 R2→

33 | P a g e
R1: 1 -3 3 1 0
R2: 0 1 1

Goal 4: Change row one column two in to 0

Step 4: multiply row two by 3 and add from row one R1→ R1 + 3R2
R1: 1 0 6 Inverse of a matrix

R2: 0 1 1

Now the left side is changed to identity matrix then our result is x = 6 and y = 1. This value is
correct because we have already proved above.

Matrix Determinant
It is also possible to find the invers of a matrix using determinate method. Determinant of a
matrix is a number which determines either the matrix has an inverse or not.

2 x 2 matrix determinant
For any matrix which has 2 x 2 dimension, the determinant is calculated as follows. First, we

have to assign a, b, c, d for each element in the matrix as

Then, determinant of the matrix is denoted by det (A) or /A/ and calculated by ad – bc
Example 1: Find the determinant of the matrix A and B, if

A= B=

Solution: A =

Det (A) = /A/ = (ad) – (bc)

= (1x 8) – (5 x -2)
= 8 - - 10
= 8 + 10 = 18
Det (A) = 18. Since the determinant of this matrix is different from zero this matrix has an
inverse.

Solution: B =

34 | P a g e
 Det (B) = /B/ = (ad) – (bc)
= (- 4 x 6) – (- 2 x 12)
= -24 - - 24
= -24 + 24 = 0
Det (B) = 0 . Since the determinant of this matrix is zero this matrix has no inverse.

3 x 3 matrix determinant
Before we discuss the determinant and inverse of a 3 x 3 matrix, we need to introduce an
additional concept known as a cofactor. Corresponding to each element aij of a matrix A,
there is a cofactor, Aij. A 3 x 3 matrix has nine elements, so there are nine cofactors to be
computed.

The cofactor, Aij, is defined to be the determinant of the 2 × 2 matrices obtained by deleting
row i and column j of A, prefixed by a ‘+’ or ‘−’ sign according to the following pattern

For example, suppose we wish to calculate A22, which is the cofactor associated with a22 in
the matrix A= a 11 a 12 a 13
a 21 a 22 a 23
a 31 a 32 a 33

The element a22 lies in the second row and second column. Consequently, we delete the
second row and second column to produce the 2 × 2 matrix
A=
a 11 a 12 a 13
a 21 a 22 a 23
a 31 a 32 a 33

The cofactor, A22, is the determinant of this 2 × 2 matrices prefixed by a ‘+’ sign because

from the pattern

We see that a 22 is in a plus position. In other words, the cofactor for

A 22 = a 11 a 13
a 31 a 33

= (a11 x a33 - a13 x a31)

And the process continues until we get the cofactor for all elements of the matrix.

35 | P a g e
Example:1 Find the co-factor of the following matrix.

A=

a11 = = + ((7 x 5) – (4 x 6)) = 35 - 24 = 11

a12 = - = - ((2 x 5) – (4 x 4)) = -10 + 16 = 6

a13 = = + ((2 x 6) – (7 x 4)) = 12 - 28 = -16

a21 = - = - ((2 x 5) – (3 x 6)) = -10 + 18 = 8

a22 = = + ((1 x 5) – (3 x 4)) = 5 - 12 = -7

a23 = - = - ((1 x 6) – (2 x 4)) =-6+8=2

a31 = = + ((2 x 4) – (3 x 7)) = 8 - 21 = -13

a32 = = - ((1 x 4) – (3 x 2)) =-4+6=2

a33 = = + ((1 x 7) – (2 x 2)) =7-4=3

We are now in a position to describe how to calculate the determinant of a 3 x 3 matrix. The
determinant is found by multiplying the elements in any one row or column by their
corresponding cofactors and adding together. It does not matter which row or column is
chosen; exactly the same answer is obtained in each case. If we expand along the first row of
the matrix,
a= a 11 a 12 a 13
a 21 a 22 a 23
a 31 a 32 a 33

36 | P a g e
We get det (A) = a11 x A11 + a12 xA12 + a13 x A13

Similarly, if we expand down the third column, we get

Det (A) = a13 x A13 + a23 x A23 + a33 x A33
From our previous example matrix

Co-factor of Matrix a = A=

Here in order to find the determinant of a matrix, we can select any row or column. Let us
select the first row and the third column for a checkup. Hopefully, the result will be the
same.
If we select first row Det A = a11 x A11 + a12 xA12 + a13 x A13
= 11x 1 + 6 x 2 + -16 x 3
= 11 + 12- 48
= -25
If we select third column Det (A) = a13 x A13 + a23 x A23 + a33 x A33
= - 16 x 3 + 2 x 4 + 3 x 5
= - 48 + 8+ 15
= - 25
If we select the second row? Det (A) = a21 x A21 + a22 x A22 + a23 x A23
= 8 x 2 + (-7 x 7) + (2 x 4)
= 16 - 49 + 8
= - 25
Wow we got the same result. From the result we can also understand that this matrix is not
singular because its determinant is different from zero. As a result, we can find an inverse
for the given matrix.

ii. The Gaussian Method

One “matrix” procedure that can be used to solve systems of linear equations is known as the
Gaussian Method. This procedure was develoed by the mathematician Karl F. Gauss (1777-
1855). We begin with the augmented matrix representation [A|B] of the original system of
equations. Then we systematically reduce the augmented matrix to equivalent augmented
matrices in simpler form. We continue until we have reached the simplest possible
augmented matrix representation, one from which the solution of the sysem can be obtained
37 | P a g e
by inspection. Indeed, we seek to transform the augmented matrix [A| B] into the augmented
matrix [I|X], where I is the idemtity matrix and X is the solution vector.

The operations that may be performed on the augmented matrices to convert them to simpler
form are the ELEMENTARY ROW OPERATIONS (EROS). The elementary row
operation may consist of the following:

Operations permitted on the rows of a matrix are called ELEMENTARY

ROW OPERATIONS. They are as follows:

Type I. Any pair of rows in a matrix may be interchanged.

(EXCHANGE operation)
Type II. A row can be multiplied by any nonzero real number.
(MULTIPLY operation)
Type III. A multiple of any row can be added to any other row. (ADD A-
MULTIPLE operation)

Again, it is recommended that we follow the same step-by-step procedure for obtaining the
identity matrix format that we used when calculating an inverse. That is, working one column
at a time, obtain a one in the correct cell using ERO Type II, Then, obtain zeros in all other
cells of the column using ERO Type III and multiples of the row which has the one.
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.
Example: Using the Gaussian procedure, find the solution to the system of equations
2x + y = 60
x + 3y = 105
We set up the augmented matrix tableau
2 1 60
1 3 105
To obtain a 1 in the row one-column one cell, we multiply row one by ½, to obtain
1 ½ 30 R1  (½)R1
1 3 105
Now, a zero is required in the row two-column one cell. Employing ERO Type III, we
subtract row one from row two, to obtain
1 ½ 30
0 5/2 75 R2  R2 _ R1

Column one is now in the identity matrix format, and we turn our attention to column two.

To obtain a 1 in the row two-column two cell, we multiply row two by , as

38 | P a g e
 1 ½ 30
0 1 30 R2 (2/5) R2

Finally, to obtain a 0 in the row one-column two cell, we subtract ½ times row two from row
one, as
1 0 15 R1 R1_+ (-½) R2
0 1 30

The solution vector is

X = 15
30
which is interpreted as x = 15, y = 30.
Therefore, Gaussian method makes a distinction between no solution and infinite solution,
unlike the inverse method. 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.

1 0 0 10 
 
0 1 0  5
0 0 1 3 


2. A row that is all zeros except in the constant column, indicating that there are no solutions;
e.g.
1 0 0 3
 
0 1 0 5
0 0 0 7 


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 occurs when there is a row with all
zeros, including the constant column; e.g.
1 0 2 5 
 
0 1 3  3
0 0 0 0 


Using the inverse to solve a system of equations

Given an n  n system of linear equations, represented in matrix notation as AX = B, we may
be able to find the solution vector using the inverse of A. If the coefficient matrix A is
invertible, the system has a unique solution which is given by
39 | P a g e
 X = A-1B
The result stems from the fact that, if A has an inverse, both sides of the matrix equation can
be multiplied by that inverse, as
AX = B
A-1AX = A-1B
(A-1A)X = A-1B
IX = A-1B
X = A-1B
To solve systems of linear equations using the inverse method the coefficient matrix should
be inevitable, 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)
Example x1 + 3x2 = 16
2x1 + 2x2 = 16
The inverse of the coefficient matrix
A= 1 3
2 2
is found by using elementary row operations to covert the augmented matrix [A  I] into the
format [I  A-1]. This inverse is

A-1 = -½ ¾
½ -¼
This inverse can be used to determine the solution to the system. Accordingly the solution is
given as follows:

-½ ¾ . 16 = x1
½ -¼ 16 x2

(-½  16) + (¾  16) = x1

(½  16) + (-¼  16) x2

x1 = 4
x2 4

40 | P a g e
When the information becomes that 18 for the right hand side value for the first equation and
16 as it is for the second one, the solution can easily be determined by introducing tha new
change to the solution procedure as given below.

-½ ¾ . 18 = x1
½ -¼ 16 x2

x1 = 3
x2 = 5

The inverse could be used in this manner to determine new solution. The inverse method
provides us with unique solution, or no solution and infinite solution (without separating
them).

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.

A. 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
2. A row that all zeros except in the constant column, indicating that there are no solutions.
3. A matrix in a form different from (1) and (2), indicating that there are an unlimited
number of solutions.

B. Linear equations where m<n

Our attempt transform (A/B) in to (I/C) in the case where m<n will result in either of the two:
A row that is all zeros except in the constant column, indicating that there are no solutions.
Or a matrix in a form different from (2), indicating that there are an unlimited number of
solutions. Generally, every system of linear equations has either no solution, exactly one
solution or infinitely many solutions.”

41 | P a g e
Self-test 2.5. Dear learners, find the value of the variables for the following linear equations
using the inverse and Gaussian methods;

1. 3x – 2y = 14
X + 3y = 1

2. -2x + y = -3
X – 4y = -2

3. 2X- 3Y = 6
X + 5Y = 29
3X – 4Y = 11

4. The weights of six people before taking a weight reduction program were 350, 249, 260,
195, 275, and 295. The weights of these same people after the weight reduction program
are 345, 200, 220, 140, 200, and 230, respectively. Summarize this information in a (6 by
2) matrix.

5. LLM produces three grades of commercial fertilizers. A 100-lb bag of grade-A fertilizer
contains 18 lb of nitrogen, 4 lb of phosphate, and 5 lb of potassium. A 100-lb bag of
grade-B fertilizer contains 20 lb of nitrogen and 4 lb each of phosphate and potassium. A
100-lb bag of grade-C fertilizer contains 24 lb of nitrogen, 3 lb of phosphate, and 6 lb of
potassium. How many 100-lb bags of each of the three grades of fertilizers should
Lawnco produce if 26,400 lb of nitrogen, 4900 lb of phosphate, and 6200 lb of potassium
are available and all the nutrients are used?

6. A private investment club has $200,000 earmarked for investment in stocks. To arrive at
an acceptable overall level of risk, the stocks that management is considering have been
classified into three categories: high-risk, medium-risk, and low-risk. Management
estimates that high-risk stocks will have a rate of return of 15%/year; medium-risk stocks,
10%/year; and low-risk stocks, 6%/year. The members have decided that the investment
in low-risk stocks should be equal to the sum of the investments in the stocks of the other
two categories. Determine how much the club should invest in each type of stock if the
investment goal is to have a return of $20,000/year on the total investment. (Assume that
all the money available for investment is invested.)

42 | P a g e
iii. Cramer’s rule
In business decision making from many of the variables, only a few of the variables are
actually needed. For instance, if we have the following equations
x+y+z=8
- x+2y+z=8
x - 4y + 2 z = 15
The variable x might be the only variable which is needed to make a decision. Under these
circumstances, it is clearly wasteful expending a large amount of effort calculating the
inverse matrix, particularly since the values of the remaining variables, y and z are not
required.
In this section, we describe an alternative method that finds the value of one variable at a
time. This new method requires less effort if only a selection of the variables is required. It is
known as Cramer’s rule and makes use of matrix determinants. Cramer’s rule for solving
any n xn system, Ax b, states that the ith variable, i, can be found from

i=

Where Ai is the n xn matrix found by replacing the ith column of A by the right-hand-side vector b.

To understand this, let us find the value of X from our previous example which is 2 x 2,
Example 1:
x – 3y = 3
x + 2y = 8
x =
Our interest is the first variable i. e X =? We are not interested in y. Hence,

x= A= Ax =

Here, A is the original coefficient matrix A, while Ax is the matrix found from A by
replacing the first column (since we are trying to find the first variable x) by the right hand-

side vector .

As a result, the determinants of A and Ax are calculated as follows.

Det /Ax/ = (ad) – (bc)

= (3 x 2) – (-3 x 8)
= 6+24
= 30

43 | P a g e
Det /A/ = (ad) – (bc)
= (1 x 2) – (-3 x 1)
= 2+3
=5
x= = = 6, yes it is correct.

What if our interest was y?

y= A= Ay =

Det /Ay/ = (ad) – (bc)

= (1 x 8) – (3 x 1) = 8-3 =5
Det /A/ = (ad) – (bc)
= (1 x 2) – (-3 x 1) = 2+3 =5
y= = = 1, yes it is correct. Wow! This method is time saving.

3x3 or above
The procedure for Cramer’s rule is the same for any n x n matrix.

2.5.2. Markov Chains: Concept, Model and Solutions

This model is a forecasting model. It is probabilistic/ stochastic model. A Russian
mathematician called Andrew Markov around 1907 developed this model. 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.

44 | P a g e
The necessary assumptions of the chain are:
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.
5. The transition period occurs with regularities.
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 moves
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.
The set of transition probabilities are necessary for both predictions (time period n, and
steady state), but the initial state is needed for only the first prediction.

Input data Predictions/ outcomes

Set of transition Steady states/long run states

Probabilities
About past
The probability of the
system being in any state at
Current/initial state any given time
About today
being in any state at any
given time
being in any state
45 | P at
age
any given time
Example: 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?

Solution
a)In each of the next two weeks

Let’s 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

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.

Markov Chain Formula

nth state of a Markov Chain.

Vij (n) = Vij (n-1) x p, or Vij (n) = Vij (0) x (P) n.

Or
Vij (n) = Vij (0) x (P) n.
Where: P = transition matrix
Vij (n) = Vector for period n.
Vij (n-1) = vector for period n-1.

46 | P a g e
V12 (0) = (.8 .2)
V12 (1) = V12 (0) x P
 .9 .1 

= (.8 .2)  
 .2 .8 
 
= (.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)
 .9 .1 

= (.76 .24)   =(0.732 .268)
 .2 .8 
 

b) In the long run (V1 V2) (n)*(p) = (V1 V2) (n+1)

n p n+1
 .9 .1 

(V1 V2)   = (V1 V2)
 .2 .8 
 
0.9V1 + .2V2 = V1
.1V1 + .8V2 = V2
V1 + V2 = 1
- 0.1V1 + .2V2 = 0 
 one is the - ve of the other.
0.1V1 + - .2V2 = 0 

.9V1+.2(1-V1) =V1
.9V1 + .2 - .2V1 = V1
.7V1 + .2 = V1
.2 = .3V1
V1 = 0.2/0.3 = 2/3
V2 = 1 - V1
= 1 - 2/3
V2 = 1/3

47 | P a g e
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

Switch to state 1 Switch to state 2

V1= V2 =
Switch to state 1  switch to state 2 Switch to state 1  switch to state 2
.2 2 .1 1
=  = 
.2  .1 3 .2  .1 3

2 1
(V1 V2) =  
3 3
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.

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.

Absorbing Markov Chain

It is a special type of Markov chain in which at least one of the states eventually doesn’t lose
members. We call such a state absorbing because it can absorb members from other states,
but doesn’t give up any of its members.

For example, if we take the above example and change the transition matrix

S1 S2
S1 1 0
S2 .2 .8

The state S1 (store 1) in absorbing

In short:
Consider a Markov chain with n different states {S1, S2, and S3 --- Sn}.

48 | P a g e
The ith state Si is called absorbing if Pii = 1. Moreover, the Markov chain is called absorbing
if it has at least one absorbing state, and it is possible for a member of population to move
from any non-absorbing state to an absorbing one in a finite number of transitions.

Remark: Note that for an absorbing state Si, the entry on the main diagonal p must be P ii = 1
and all other entries in the ith row must be 0.

To
Example a.
S 1 S 2 S 3

 S 0.4 0 0.6
 1

fromS 2
0 1 0  Absorbing Markov Chain
 0.5 0.5
 S 3
0

To
Example b.
S 1 S 2 S 3

 S 0.4 0 0.6
 1 
fromS 2 .5 0.5 0  has no absorbing states.
 
 S 3 0 0.5 .5 

To
S 1 S 2 S 3 S 4

 S1 .5 .5 0 0
 
 0
from S 2
0 1 0 The second state is
6
 S3
0 0 .4

 .5 
S4 0 0 5 
absorbing. However the corresponding Markov chain is not observing. Because there is no
way to move from state 3 or state 4 to state 2.

A Markov chain is absorbing it has at least one absorbing state, and if from every state it is
possible to go to an absorbing state (not necessarily in one step).

Example: 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.

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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
 .95 .05
= 0.27 0.73  
 .10 .90
= (.3295 0.6705)

3. VU VN = (? ?)

switchtoN
Switchtou  SwitchtoU
VU = VU =
.05
  0.33
.15
VU VN = 0.67 0.33
VUN (n) = 0.67 0.33
Example: A city has two suburbs: suburb x and suburb y. Over the past several years, the
city has experienced a population shift from the city to the suburbs, as shown in the table
below.
To the next year
From one City (C) Suburb x (X) Suburb y (Y)
year City (C) .85 .07 .08
Suburb x (X) .01 .96 .03
Suburb y (Y) .01 .02 .97

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In 20xo, the city had a population of 120,000, suburb x had a population of 80,000, and
suburb by had a population of 50,000. Assuming that the population in the metropolitan area
remains constant at 250,000 people,
a. How many people will live in each of the three areas in 20X2?
b. How many people will live in each of the three areas in the long run
Solution

Let C stands for the city

X stands for the suburb X.
Y stands for the Suburb y.
C 120,000 120,000/250,000 0.48
X 80,000 80,000/250,000 0.32
Y 50, 000 50,000/250,000 0.20
Total 250,000 1.00

Initial state V(0)c x y (0.48 0.32 0.20)

The transition matrix. From one year
 C X Y 
 
 C .85 .07 .08 
P= 
X .01 .96 .03 
 
 Y .01 .02 .97 
 
 
 
 .85 .07 .08 
V(1)cxy = V(0)cxy * p = (.48 .32 .20) 
.01 .96 .03 
 
 .01 .02 .97 

V (1)cxy = (.4132 .3448 .2420)

 
 
( )  .85 .07 .08 
V 2 cxy = (.4132 .3448 .2420) 
.01 .96 .03 
 
 .01 .02 .97 

( )
V 2 cxy = (.3571 .3648 .2781)

Thus, in 20X2, 89,275, 91,200 and 69,525 people will live in the city, suburb x and suburb y
respectively.

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long run
b. n p n+1
 .85 .07 .08 
(Vc Vx Vy)   (Vc Vx Vy)
 .01 .96 .03 
 .01 .02 .97 
 
.85C + .01x + .01y = C
.07C + .096x + .02y = x
.08C + .03X + .97y=y
c + x + y =1 Vc Vx Vy = 1

-.15C + .01x + .01y = 0

.07c - .04x + .02y = 0
.08C + .03x - .03Y = 0
X = 1-C-Y

.07c - .04 (1-c-y) + .02y = 0

.07c - .04 + .04c + .04y + .02y = 0
(.07c + .04c) - 04 + (04y + .02y) = 0

.11c+.06y - .04 = 0 --- ----------(1)

.08c + .03 (1-c-y) - .03y = 0
.08c + .03 - .03c - .03y - .03y = 0
(.08c - .03c) + .03 - .03y - .03y = 0

.05C +.03 - .06y = 0 --- (2)

.11c + .06y - .04 = 0

.05C - .06Y + .03 = 0
.16C - .01 = 0
.16C = .01

.01
C=
.16
C = 0.0625

.11 (.0625) + .06y - .04 = 0

.006875 + .06y - .04 = 0
.06y = .033125
y = 0.5521

C+X+y = 1
.0625+x+.5521=1
0.6146+x=1
X = .3854

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(Vc Vx Vy) = (.0625 .3854 .5521)

In the long run 15,625, 96,350 and 138,025 people will live in the city suburban X and
suburban respectively.

Example: A vigorous television advertising campaign is conducted during the football

season to promote a well-known brand X shaving cream. For each of several weeks, a survey
is made and it is found that each week 100% of those using brand X continue to use it. It is
also found that of those not using brand x, 20% switch to brand X while the other 80%
continue using another band.
a. Write the transition matrix, assuming the transition percentages continue hold for
succeeding weeks.
b. If 20% of the people are using brand X at the start of the advertising campaign, what
percentage will be using brand X one week later? Two weeks later?
c. What portion of the market will be using brand X area the end of the season, assuming
the transition matrix remains the same? Find the Steady-state matrix)
solution.
X nonx
A. X 1 0
nonX .2 .8
1 0
B . V(n)xx1 = V(0)xx1p = (.2 .8)  
 .2 .8 
V(1)xx1 = (.36.64)
1 0
V(2)xx1 = V(1)xx1xp = (.36 .64)  
 .2 .8 
= (.488 .512)
0.2
C. Vx = =1
0.2  0
0
Vx' = =0
0.2  0

Self-test 2.6. Dear learners, check your progress using the following question.
In a certain college class, 70% of the students who receive an “A” on the current
examination will receive an “A” on the next examination. Moreover, 10% of the students
who do not receive an “A” on the current examination will receive an “A” on the next
examination. Assuming that this pattern continues, what is the stable matrix?
Answer: VA VA1 = (.25 .75)

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 2.6. Summary

Dear learner! We have seen about types of matrices, matrix operations, inverse of a matrix,
ways of finding an inverse and applications of matrix algebra. The following gives the
summary of major points. The equality of matrices is assured by equality of corresponding
elements of the same dimension. Matrix addition and subtraction is defined for matrices of
the same dimension but matrix multiplication is defined by considering the equality of inner
dimensions. Inverse of a matrix is defined only for square matrices. Inverse of a matrix is
unique. If matrix B is the inverse of matrix A, then matrix A is the inverse of matrix B. Every
square matrix may not have an inverse. If a matrix has no inverse, then it is said to be
singular and if a matrix has an inverse, it is said to be invertible or non- singular. Matrix
algebra is applied in solving system of linear equations.

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 2.7. Review Questions

Dear learners, the following questions are selected to assess your progress for this specific
chapter. Thus, attempt to answer all of the following questions.
Part -I: Multiple Choices (choose the correct answer among the given alternatives.)

1. Which one of the following is correct about the inner/dot product?

A. Inner/Dot product is always an mx1 matrix
B. Inner/ Dot product are the product of every Vector matrix.
C. Inner/Dot product is the product of column vector and row vector
D. Inner/Dot product is the product of row vector and column vector
E. All
2. From the following statement one is correct about the transpose matrix?
A. The transpose of the 2x3 dimension matrix is 3x2 dimension matrix
B. The transpose of the square matrix is always the same and equal as its original
square matrix
C. The transpose of the identity matrix is non-identity matrix
D. The off diagonal element of the transpose matrix is the same as the original
matrix.
E. None
3. All of the following statement is incorrectly stated except one:
A. Scalar matrix is always identity matrix
B. The product of any given matrix and the identity matrix is the given matrix
itself.
C. The sum of a zero matrix and any matrix gives that zero matrix
D. Diagonal matrix is always Identity matrix
4. Which one of the following is false about special property of matrix multiplication?
A. Associative law and distributive law works for matrix multiplication if the
matrixes are conformable for multiplication
B. Commutative law works for matrix multiplication two if two matrix are
conformable for multiplication
C. The cancellation law does not hold in matrix multiplication.
D. All
E. None

55 | P a g e
5. If matrix A have dimension of m by n and matrix B have dimension of z by j and
conformable for multiplication then the dimension of their product is
A. n by z
B. m by z
C. m by j
D. m by n
6. From the following one is true about the inverse matrix?
A. Inverse matrix only works for square matrix
B. All square matrix have an inverse
C. The product of inverse matrix and it original matrix is original matrix
D. The matrix which is inevitable is said to be singular matrix
7. The mathematics test of three students before taking tutorial is 2, 3 & 5. But after
taking tutorial and long study the results of each student changed in to 12, 13 & 14
respectively. If the teacher puts their result for comparison as matrix each student in
column, it should be

A.

B.

C.

D. It is not matrix type.

56 | P a g e
 Part-II: Workout Questions
1. A manufacturing company produces two types of boats: one-person and two-person
models. The company has two plants x and y at different parts of the country. In both
plants, there are two departments, fabricating and finishing. A one-person boat requires 4-
labor hr in the fabricating department and 1 labor hr in the finishing department. The two-
person boat requires 6-labor hr in the fabricating department and 1.5-labor hr in the
finishing department. Suppose the hourly rates of labor cost in the fabricating and
finishing departments be Br 8 and Br 6 respectively at plant x, and Br 7 and Br 4 at plant
Y. Using matrix algebra, find the labor cost of making one unit of each product at each of
the two plants. Interpret the results.
2. ABC Carpet Company has in inventory 1,500 square yards of wool and 1,800 square yards
of nylon for the manufacture of carpeting. Two grades of carpeting are produced. Each roll
of superior grade carpeting requires 20 sq. yards of wool and 40 square yards of nylon.
Each roll of quality-grade carpeting requires 30 square yards of wool and 30 square yard
of nylon. If Asrat would like to use all the material in inventory, how many rolls of
superior and how many rows of quality carpeting should be manufactured?
3. A manufacturer is costing out one product line which consists of three different models, A,
B, and C. These models are assembled from three types of parts, 1,2 and 3. The
manufacturer would like to produce such quantities of the three models as to completely
deplete the inventory of parts of hand, in the final production run. Each model a uses one
unit of part 1, three units of part 2, and two units of part 3. Each unit of model B uses one
unit of part 1, two units of part 2, and one unit of part 3. Each model C uses two units of
part 1, and three units of part 3. Inventory records show that there are on hand 1,500 units
of part 1 and 1,900 units each of part 2 and 3. How many of each model should the
manufacturer plan to produce?
4. Alemayehu invested a total of 10,000 in three different savings accounts. The accounts
paid simple interest at an annual rate of 8 percent, 9 percent and 7.5 percent respectively.
Total interest earned for the year was Br 845. The amount in the 9 percent account was
twice the amount invested in the 7.5 percent account. How much did Alemayehu invest in
each account?
5. Attendance records indicate that 40, 000 people attended the 12th African Youth
championship at its opening ceremony at the Addis Ababa Stadium. Total ticket receipts
were Br 1, 750,000. Admission prices were Br 37.5 for the second class and Br 62.5 for
57 | P a g e
 the first class. Determine the number of people who attended the opening ceremony at first
class and second class.
6. A population of 100,000 consumers makes the following purchases during a particular
week: 20,000 purchases Brand A, 35,000 Brand purchase B and 45,000 purchase neither
brand. From a market study, it in estimated that of those who purchase Brand A, 80% will
purchase it again next week, 15% will purchase Brand B next week, and 5% will purchase
neither brand. Of those who purchase B, 85% will purchase it again next week, 12% will
purchase brand A next week, and 3% will purchase neither band. Of those who purchased
neither brand, 20% will purchase as A next week, 15% will purchase Brand B next week,
and 65% will purchase neither band next week. If this purchasing pattern continues, will
the market stabilize? What will the stable distribution be?
7. A manufacturing firm which manufactures office furniture finds that it has the following
variable costs in dollars.
Desks Chairs Tables Cabinets
50 20 15 25 
30 15 12 15 

30 15 8 20 

Assume that an order of 5 desks, 6 chairs, 4 tables and 12 cabinets has just been received.
What are the total material, labor and overhead costs associated with the production of
ordered items?
8. A person invests in A, B and C rated bonds. The average yield is 8% on A bonds, 6% on B
bonds, and 7% on C bonds. Twice as much is invested in C bonds as B bonds. Moreover,
the total annual return for all three types of bonds in Br. 2800. How much is invested in
each type of bond if the total investment is
a. 37,500? b. 40,000?

58 | P a g e
 Answer for chapter review questions
Part one: Choices
1.D 3.B
2.A 4.B
5.C 7.A
6.A

Part two: Workout Questions

1.Answer Product
Plant One person Two person

X 38 57

Y 32 48
2. Answer: 15 and 40.
3. Answer: 100, 800, and 300.
4. Answer: Br 1,000, Br 6,000 and Br 3,000
5. Answer: 30,000 and 10,000.
6. Answer: Yes YA Vb Vc = (.4 .5 .1)
7. Answer: Birr 1,710.
8. Answer: a. Answer: Br 22,500, 5,000 and 10,000
b. Br 10,000, 10,000 and 20,000

59 | P a g e
Chapter Three: Introduction to Linear Programming

Chapter objectives
Dear students! after completing this chapter, you are expected to:
 Internalize linear programming and linear programming models.
 Identify and understand the components of linear programming models.
 Understand the assumption of linear programming models.
 Demonstrate the formulation of linear programming models.
 Understand and demonstrate the graphical approach to solve linear programming
models.
 Demonstrate how to solve linear programming models using the Simplex Solution
method.

3.1. Meaning of Linear Programming

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

Linear Programming, is a
maximization (such as profit, revenue, sales, and
mathematical and operations-
market share) or minimization (such as cost, time,
research technique, used in
and distance) a certain objective function. It implies
administrative and economic
that in LP we cannot max/min two quantities in one
planning to maximize the linear
model. It involves linearly related multivariate
functions of a large number of
functions, i.e., functions with more than one
variables, subject to certain
independent variable. The goal in linear
constraints.
programming is to find the best solution given the
constraints imposed by the problem; hence the term constrained optimization.

60 | P a g e
 3.2. Linear programming Models (LPM)

Linear Programming models (LPM) are mathematical representations of linear

programming problems. Some LPM has a specialized format, whereas others have a more
generalized format. Despite this, LPM has 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.

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

3.2.1. Components of LP model

Linear programming model has four different components.
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 ads 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

61 | P a g e
 (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 whereas, 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.

3.2.2. Assumption of LP Models

Linear programming models are formulated based on four assumptions.
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 (fro
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:
3.5TV sets/hr would be acceptable  7 TV sets/2hrs.
3. Certainty - the certainty requirement involves two aspects of LP models.

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 i) With respect to model parameters (i.e., the numerical values) – It in assumed
that these values are known and constant e.g. in the above example each unit
of product 1 requires 2lab his 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.

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.

3.2.3. 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.

Formulation of 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 mother 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.
Note that: a. The units of all the coefficients in the objective function must be the same.
For example, if the contribution of type 1 is in terms of Birr so does for
type 2.
b. All terms in the objective function must include a variable each term has to
have 1 variable.
c. All decision variables must be represented in the objective function.

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 4. Identifying the constraints
- System constraints - more than one variable
- Individual constraints - one variable
- Non-negative constraints
Example: 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 manger 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.

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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.
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
Example: 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.

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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
2.5X1 + 1.8X2 + 2.0X3  2250 minutes Ass. time station 1 System constraint
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

Subject to : 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

Self-test 3.1: Dear learns, answer the following question.

A farm consists of 600 hectares of land of which 500 hectares will be planted with corn,
barley and wheat, according to these conditions.
(1) At least half of the planted hectare should be in corn.
(2) No more than 200 hectares should be barley.
(3) The ratio of corn to wheat planted should be 2:1

It costs Birr 20 per hectare to plant corn, Birr 15 per hectare to plant barley and Birr 12
per hectare to plant wheat.

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Required: Formulate this problem as an LP model that will minimize planting cost while
achieving the specified conditions.

3.3. Approaches to linear programming

There are two solution approaches to linear programming. These are;

1. The graphic solution and
2. The simplex approach/ Algebraic solution

1. The Graphic Solution Method

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 s not used to solve them.

Example: 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.

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 22 2X1 + X2 = 22

20

16

12 3X1 + 3X2 = 39
(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; 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.

3.1 Determine the values of the decision variables at each corner point. Sometimes, this
can be done by inspection (observation) and sometimes by simultaneous equation.
3.2 Substitute the value of the decision variables at each corner point.
3.3 After all corner points have been so evaluated, select the one with the highest or
lowest value depending on the optimization case.

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 Points Coordinates How Determined Value of Objective function
X1 X2 Z = 60X1 + 50X2
A 0 0 Observation Birr 0
B 11 0 Observation Birr 660
C 9 4 Simultaneous Birr 740
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 X1 Originally Amount of slack
= 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

Constraints that have no slack are sometime 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.

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Interpretation: The Company is advised to produce 9 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 hours that
can be used for other purposes.

Example: 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 Determined Value of the objective function

X1 X2 Z = 5X1 + 8X2
A 0 9.67 Observation Birr 77.30
B 5 3 Simultaneous Birr 49
equations
C 14 0 Observation Birr 70

Basic solution: X1 = 5 pounds

X2 = 3 pounds
C = Birr 49
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

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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.

3.4. 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.

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, S2 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

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equalities. Furthermore, every variable in a 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 + 0S2 + 0S3

S.t. : 4X1 + 10X2  100 S.t. : 4X1 + 10X2 + S1 = 100
2X1 + X2  22 2X1 + X2 + S2 = 22
3X1 + 3X2  39 3X1 + 3X2 + S3 = 39
X1, X2  0 X1, X2, S1, S2, S3  0

1. 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 jut 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 raw.
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)
Compute values for row Zj
Compute 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
S3 0 3 3 0 0 1 39 39/3 = 13 variable
Zj 0 0 0 0 0 0
Cj-Zj 60 50 0 0 0 0

Entering variable Pivot column Pivot row

* Pivot Element
2. Develop subsequent tableaus
2.1. Identify the entering variable - a variable that has a largest positive value is the
Cj – Zj raw.
2.2. Identify the leaving variable - Using the constraint coefficients or substitution
rates in the entering variable column divide each one into the corresponding

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 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.
3. Find unique vectors for the new basic variable using row operations on the pivot
element.
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 1/2 0 ½ 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
4. Compute the Cj – Zj raw
5. If all Cj – Zj values are zeros and negatives you have reached optimality.
6. If this is not the case (step 6), rehear 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 is raw c - z in every column whose
variable is in solution, indicating that its maximum contribution to the objective function
has been realized.
Example: 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

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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.
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 ho 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

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 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 Leaving
X2 70 1/3 1 0 1/6 0 50 50/. 333 =150 variable
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

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.

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 3.5. Special Issues in LP

1. Unbounded solutions
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.

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 3.6. 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 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.

3.7. Summary

The standard form of LP problem should have the characteristics of(1)All the constraints
should be expressed as equations by slack or surplus and/or artificial variables (2)The
right hand side of each constraint should be made non-negative; if it is not, this should be
done by multiplying both sides of the resulting constraint by -1 and (3) Three types of
additional variables, namely (1) Slack Variable(S)(2) Surplus variable (-S), and (3)
Artificial variables (A) are added in the given LP problem to convert it into standard
form for two reasons: the extra variables needed to add in the given LP problem to
convert it into standard form is given below:

Coefficient of extra Presence of variables in

variables the initial solution mix
Types of
Extra variables to be added in the objective function
constraint
MaxZ
MinZ
< Add only slack variable 0 Yes
0
Subtract surplus variable 0 No
> 0
Add artificial variable -M Yes
+M
= Add artificial variable -M Yes
+M

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2. Test of optimality
- If all Cj - Zj < 0, then the basic feasible solution is optimal (Maximization case).
- If all Cj - Zj > 0, then the basic feasible solution is optimal (Minimization case).

3. Variable to enter the basis

- A variable that has the most positive value in the Cj - Zj row (Maximization case)
- A variable that has the highest negative value in the Cj - Zj row (Minimization
case)
N:B-‘Highest negative’ values in this case refers to the negative value which is far
from zero on the number line!
4. Variable to leave the basis
- The row with the non-negative and minimum replacement ratio (For both
maximization and minimization cases
i.e: RR > 0

3.8. Review Questions

Dear learners, the following questions are selected to assess your progress for this
specific chapter. Thus, attempt to answer all of the following questions.

1. 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?
2. 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 A Product B Product C
Assembly 2 4 2
Inspection 3 2 1

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,

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 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.
3. The state chairman of a political party must allocate an advertising budget of birr
3,000,000 among three media: radio, television, and newspapers. The expected
number of votes gained per birr spent on each advertising medium is given below.

Expected votes per Birr spent

Radio Television Newspapers
3 5 2
Since these data are valid with in the limited amounts spent on each medium, the
chairman has imposed the following restrictions:
 No more than Birr 500,000 may be spent on television ads.
 No more than Birr 1,200,000 may be spent on radio ads.
 No more than Birr 2,400,000 may be spent on television and newspaper ads
combined.
How much should be spent on each medium in order to maximize the expected number of
votes gained?

Answer for chapter review questions

1. Answer Vitamins
Foods A B
Type 1 10 20
Type 2 30 15
2. 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.
3. Answer: Birr 500,000 should be spent on radio ads.
Birr 1,200,000 should be spent on television ads.
Birr 1,200,000 should be spent on newspaper ads.
Slack in the budget constraint is Birr 100,000.
Z = 9,900,000 is the maximum expected number of votes gained.

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Chapter Four: Mathematics of Finance

Chapter objectives
Dear learners, after successfully completed this chapter, you are expected to:
 Understand and compute of simple and compound interest
 Understand and compute Present Value of compound interest
 Understand and compute equivalent rates
 Understand and compute effective rate
 Understand and compute Annuities
 Understand and compute Ordinary annuity

4.1. Introduction

Dear student! What do you know about mathematics of finance? Why we need to learn
mathematics of finance?
________________________________________________________________________
__________________________________________________________________
Mathematics of finance is concerned with the analysis of time-value of money. The
fundamental premise behind such analysis is the concept that entails the value of money
changes overtime. Putting it in simple terms, the Money has a time value i.e. a Birr
value of one birr today is not the same after a year. today is worth more than a Birr
Mathematics of finance has an important tomorrow, which is expressed in
implication in organizations as transactions and terms of interest charges. Since the
business dealings are mostly pecuniary. Such use of money bears the cost of

matters as lending and borrowing money for interest, management must

optimize the use the employment
various purposes, leasing materials, accumulating
of investable money (funds); it
funds for future use, sell of bonds are some of the
must choose a wide array of
cases that involve the concept of time value of
investment opportunities and
money. Likewise, finance mathematics is equally
choose the one which is most
important in our personal affairs. For example, we profitable.
might be interested in owning a house, in financing

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our educational fees, having a car, having enough retirement funds etc. All these cases
and others involve financial matter. Cognizant of this fact, we proceed to the study of
mathematics of finance in this section.

4.2. Terminologies

1) 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 (borrowed) or it may be the
initial value or cost of plant asset or machinery.
2) 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” is
usually a number of years, it could represent other time periods, such as a number of
quarters or months.
3) Rate of interest (i) is the name given to appropriate amount of money which is added
to some principal amount (invested or borrowed). It is normally denoted by “r” and
expressed as a percentage rate per annum. For example, if Birr 100 is invested at
interest rate 10% per year (annum), it will accumulate to Birr 100+ (10% of 100)
which is at the end of one year.
4) Accrued amount (accumulated amount A): is the amount of money after some time
has elapsed for which interest has been calculated and added.

Today, businesses and individuals are faced with a bewildering array of loan facilities and
investment opportunities. In this section we explain how these financial calculations are
carried out to enable an informed choice to be made between the various possibilities
available.

We begin by considering what happens when a single lump sum is invested and show
how to calculate the amount accumulated over a period of time.

Assume that someone gives you the option of receiving Birr 500 now or Birr 500 in three
years’ time. Which of these alternatives would you accept? Most people would take the
money now, partly because they may have an immediate need for it, but also because they
recognize that Birr 500 is worth more today than in 3 years’ time. Even if we ignore the
effects of inflation, it is still better to take the money now, since it can be invested and
will increase in value over the 3-year period. In order to work out this value we need to
know the rate of interest and the basis on which it is calculated. Let us begin by assuming

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that the Birr 500 is invested for 3 years at 10% interest compounded annually. What
exactly do we mean by ‘10% interest compounded annually’? Well, at the end of each
year, the interest is calculated and is added on to the amount currently invested. If the
original amount is Birr 500 then after 1 year the interest is 10% of Birr 500, which is:

* Birr 500 = 0.1 * Birr 500 = Birr 50. So the amount rises by Birr 50 to Birr 550.

What happens to this amount at the end of the second year? Is the interest also Birr 50?
This would actually be the case with simple interest, when the amount of interest
received is the same for all years. However, with compound interest, we get ‘interest on
the interest’, which means an interest generated in last period would be added to the
principal and generate interest in the next period.

4.3. Simple interest and discounts

Simple Interest is interest that is paid solely on the amount of the principal P is called
simple interest. Simple interest formula:

I = pin
Where, I = Simple interest (in dollars or birr)
P = Principal (in dollar, or birr) and it is the amount
i = Rate of interest per period (the annual simple interest rate)
n = Number of years or fraction of one year

In computing simple interest, any stated time period such as months, weeks or days
should be expressed in terms of years. Accordingly, if the time period is given in terms
of,

i. Months, then
n= Number of months
12
ii. Weeks, then
n= Number of Weeks
52
iii. Days, then
a. Exact interest
n= Number of days
365
b. Ordinary simple interest
n= Number of days
360

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Maturity value (future value) represents the accumulated amount or value at the end of
the time periods given. Thus,
Future value (F) = Principal (P) + Interest (I)

Example: A credit union has issued a 3 year loan of Birr 5000. Simple interest is charged
at a rate of 10% per year. The principal plus interest is to be repaid at the end of the third
year.
a. Compute the interest for the 3-year period.
b. What amount will be repaid at the end of the third year?

Solution:

Given values in the problem

3 – Years loan = Principal = Birr 5000
Interest rate = i = 10% = 0.1
Number of years (n) = 3 years

a. I=pin
I = 5000 x 0.1 x 3
I = Birr 1500
b. The amount to be repaid at the end of the third year is the maturity (future) value
of the specified money (Birr 5000). Accordingly, F = P + I
F = 5000 + 1500
F = Birr 6500
Or, using alternative approach,
F=P+I
Then, substitute I = P i n in the expression to obtain
F = P + Pin
F = P (1 + in)

Consequently, using this formula we can obtain

F = 5000 (1+ (0.1x3)
F = 5000 x 1.3
F = Birr 1500

4.3.1. Ordinary and Exact Interest

In computing simple interest, the number of years or time, n, can be measured in days. In
such case, there are two ways of computing the interest.
i. The Exact Method: if a year is considered as 365 days, the interest is called exact
simple interest. If the exact method is used to calculate interest, then the time is
n = number of days / 365

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 ii. The Ordinary Method (Banker’s Rule): if a year is considered as 360 days, the
interest is called ordinary simple interest. The time n, is calculated as
n = number of days/ 360
Example: Find the interest on Birr 1460 for 72 days at 10% interest using,
a. The exact method
b. The ordinary method
Solution:

Given a) P=1460 b) P=1460

P = Birr 1460 n=72/365 n= 72/360
n = 72 days i= 0.1 i=0.1
i = 10% = 0.1 I=Pin =1460*72/365*0.1=28.8 I=Pin= 1460*72/365*0.1=29.2

4.3.2. Simple Discount: Present Value

The principal that must be invested at a given rate for a given time in order to produce a
definite amount or accumulated value is called present value. The present value is
analogous to a principal P. It involves discounting the maturity or future value of a sum of
money to a present time. Hence, the simple present value formula is derived from the
future value (F) formula as follows.
Future Value = Principal + Interest
F = P + I but I = Pin
Thus, F = P + Pin
F = P (1+ in)
Then from this, solve for P.

PF
1  in
If P is found by the above formula, we say that F has been discounted. The difference
between F and P is called the simple discount and is the same as the simple interest on P.

Example: 90 days after borrowing money a person repaid exactly Birr 870.19. How
much money was borrowed if the payment includes principal and arch nary simple
interest at 9 ½ %?

Solution:
Given values in the problem,
n in ordinary method = Number of days / 360
= 90 /360
n = 0.25

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 F = the amount repaid = Birr 870.19
i = 9 ½% = 9.5% = 0.095

Required:
The amount borrowed which is the same as simple present value, P.

PF
1  in
= 870.19 / (1+ (0.095 x 0.25))
P = 870.19 ÷ 1.024
P = Birr 849.795

4.3.3. Promissory Notes and Bank Discount

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
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
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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.

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 = ?

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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

Self-test 4.1. Dear learners, the following questions concerns simple interest, attempt to
answer.

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?

4.3.4. The Compound Interest:

If an amount of money, P, earns interest compounded at a rate of I percent per period it
will grow after n periods to the compound amount F, and it is computed by the formula:

Compound amount formula: Fn = P (1 + i) n

Where, P = Principal
i = Interest rate per compounding periods
n = Number of compounding periods (number of
periods in which the principal earn interest)
F = Compound amount

A period, for this purpose, can be any unit of time. If interest is compounded annually, a
year is the appropriate compounding or conversion or interest period. If it is compounded
monthly, a month is the appropriate period. It is important to know that the number of
compounding period/s within a year is/are used in order to find the interest rate per
compounding periods and it is denoted by i in the above formula. Consequently, when the
interest rate is stated as annual interest rate and is compounded more than once a year, the
interest rate per compounding period is computed by the formula:

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 i = j / m, where j is annual quoted or nominal interest rate
m number of conversation periods per year or the
compounding periods per year
n = m x t, where t is the number of years

Example: Assume that we have deposited Birr 6000 at commercial Bank of Ethiopia
which pays interest of 6% per year compounded yearly. Assume that we want to
determine the amount of money we will have on deposit (our account) at the end of 2
years (the first and second year) if all interest is left in the savings account.

Solution:
Give values in the problem, P = Birr 6000, j = 6% = 0.06, t=2
years
m = compounded annually = i.e. only once
n=mxt =1x2 = 2
i = j / m = 0.06 / 1 = 0.06

Then, the required value is the maturity or future value

F = P(1 + i )n
= 6000 (1 + 0.006)2
= Birr 6000 (1.06)2 = Birr 6741.6

Example: An individual accumulated Birr 30,000 ten years before his retirement in order
to buy a house after he is retried. If the person invests this money at 12% compounded
monthly, how much will be the balance immediately after his retirement?

Solution:

Given values, P = Birr 30,000 , t = 10 years , i = 12% = 0.12

m = compounded monthly = 12
i = j / m = 0.12 / 12 = 0.01
n = m x t = 12 x 10 = 120 and what is required is the Future Value F.
n
Then, F = P (1 + i)
= 30,000 (1.01)120
= 30,000 (1.01)120
F = Birr 99,011.61
Having the understanding of how compound interest works and computation of future
value, in subsequent example, we will consider how to determine the number of periods it
will take for P birr deposited now at i percent to grow to an amount of F birr.

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4.3.5. Present Value of a Compound Amount
Future (maturity) value is the value of the present sum of money at some future date
(time). Conversely, present value (or simply principal) is the current birr or dollar value
equivalent of the future amount. It is the sum of money that is invested initially and that is
expected to grow to some amount in the future at a specified rate. If we put the present
and future (maturity) values on a continuum as shown below, we can observe that they
are inverse to one another. And, future value is always greater than the present value or
the principal since it adds/earns interest over specified time-period.

0 1 2 3 . . . n
Present Value (P) Future Value (Compound Amount)

Future value is obtained by compounding technique and the expression (1 + i) n is called

compound factor. On the other hand, present value is obtained by discounting techniques
and the expression (1 + i) -n is referred to as the compound discount factor.

Fn
P  Fn (1  i) n Fn  P(1  i) n
(1  i) n

The formula for present value of compound amount is simply derived from compound
amount formula by solving for P.

Examples:

1. What is the present value of

a. Birr 5000 in 3 years at 12% compounded annually?
b. Birr 8000 in 10 years at 10% compounded quarterly?
2. Suppose that a person can invest money in a saving account at a rate of 6% per year
compounded quarterly. Assume that the person wishes to deposit a lump sum at the
beginning of the year and have that some grow to Birr 20,000 over the next 10 years.
How much money should be deposited at the beginning of the year?
3. A young man has recently received an inheritance of birr 200,000. He wants to make
a portion of his inheritance and invest it for his late years. His goal is to accumulate
Birr 300,000 in 15 years. How much of the inheritance should be invested if the

89 | P a g e
 money will earn 8% per year compounded semi-annually? How much interest will be
earned over the 15 years?

Solution:

1. (a) Given the values, Fn = F3 = Birr 5000, t = 3 years m = 1 (compounded

annually)
n= txm =3x1=3
j = 12 % = 0.12
i = j / m = 0.12/1 = 0.12 and we are required to find Present Value
P.

Thus, P = Fn (1 + i) -n
= 5000 (1 + 0.12)-3
= 5000 (1.12-3)
= 5000 (0.7118)
P = Birr 3559

(b) Fn = F40= Birr 8000, t = 10 years , m = quarterly = 4

n = t x m = 10 x 4 = 40 , i = 10% = 0.1 , i = j / m = 0.1 / 4 = 0.025
-n
p = ? but P = Fn (1 + i)
= 8000 (1 + 0.025)-40 = 8000 (1.025) -40
P = Birr 2979.5

2. Given the values, i = 6% = 0.06 , m = quarter = 4 times a year

i = j ÷ m = 0.06 ÷ 4 = 0.015
F = Birr 20,000 shall be accumulated
t = 10 years
n = m x t = 10 x 4 = 40 interest periods
P = how much should be deposited now?
P = Fn(1 + i)-n
= 20,000 (1+0.015)-40 = 20,000(1.015-40)
P = Birr 11,025.25

3. Inheritance = Birr 200,000

Fn = Birr 300,000 (the person's goal of deposit) , t = 15 years , j = 8% =
0.08
m = semi-annual = 2 times a year
i = j ÷ m = 0.08 ÷ 2 = 0.04
n = t x m = 15 x 2 = 30 interest periods/semi-annuals
P = how much of the inheritance should be invested now? P = Fn(1 + i)-n
I = Amount of interest?
= 300,000 (1+0.04)-30 = 300,000(1.04)-30 = 300,000(0.3083)
= Birr 92,490

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The present value of Birr 300,000 after 15 years at 4% semi-annual interest rate is equal
to Birr 92,490. Therefore, from the total inheritances received Birr 92,490 needs to be
deposited now.
Amount of compound interest = Future Value – Preset Value = 300,000 –
92,490
Amount of compound interest = Birr 207,510

4.3.6. Annuities:
Annuity refers to a sequence or series of equal periodic payments, deposits, withdrawals,
or receipts made at equal intervals for a specified number of periods. For instance, regular
deposits to a saving account, monthly expenditures for car rent, insurance, house rent
expenses, and periodic payments to a person from a retirement plan fund are some of
particular examples of annuity. Payments of any type are considered as annuities if all of
the following conditions are present:
i. The periodic payments are equal in amount
ii. The time between payments is constant such as a year, half a year, a quarter of
a year, a month etc.
iii. The interest rate per period remains constant.
iv. The interest is compounded at the end of every time.

Annuities are classified according to the time the payment is made. Accordingly, we have
two basic types of annuities.

i. Ordinary annuity: is a series of equal periodic payment is made at the end of

each interval or period. In this case, the last payment does not earn interest.
ii. Annuity due: is a type of annuity for which a payment is made of the
beginning of each interval or period.

It is only for ordinary annuity that we have a formula to compute the present as well as
future values. Yet, for annuity due case, we may drive it from the ordinary annuity
formula. To proceed, let us first consider some important terminologies that we are going
to use in dealing with annuities.

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 i. Payment interval or period: it is the time between successive payments of an
annuity.
ii. Term of annuity: it is the period or time interval between the beginning of the first
payment period and the end of the last one.
iii. Conversion or interest period: it is the interval between consecutive
conversions of interest.
iv. Periodic payment/rent: it is the amount paid at the end or the beginning or each
payment period.
v. Simple annuity: is the one in which the payment period and the conversion
periods coincides each other.

4.3.7. Sum of Ordinary Annuity: Maturity Value

Maturity value of ordinary annuity is the sum of all payments made and all the interest
earned there from. It is an accumulated value of a series of equal payments at some point
of time in the future. Suppose you started to deposit Birr 1000 in to a saving account at
the end of every year for four years. How much will be in the account immediately after
the last deposit if interest is 10% compounded annually?

In attempting this problem, we should understand that the phrase at the end of every year
implies an ordinary annuity case. Likewise, we are required to find out the accumulated
money immediately after the last deposit which also indicates the type of annuity.
Further, the term of the annuity is four years with annual interest rate of 10%. Thus, we
can show the pattern of deposits diagrammatically as follows.

The Present The Future

0 1st 2 nd
3rd
4 th

1000 1000 1000 1000

Birr 1000
Birr 1100
Birr 1210
Birr 1331
Total Future Value = Birr 4641
The first payment earns interest for the remaining 3 periods. Therefore, the compound
amount of it at the end of the term of annuity is given by,

92 | P a g e
 F = P (1 + i) n = 1000 (1 + 0.1)3 = Birr 1331

In the same manner, the second payment earns interest for two periods (years). So,
F= 1000 (1+0.1)2 = 1210

The 3rd payment earns interest for only one period. So,
F=1000(1+0.1)1 = 1100

No interest for the fourth payment since it is made at the end of the term. Thus, its value
is 1000 itself. In total, the maturity value amounts to Birr 4641. This approach of
computing future value of ordinary annuity is complex and may be tiresome in case the
term is somewhat longer. Thus, in simple approach we can use the following formula for
sum of ordinary annuity (Future Value).

 (1  i) n - 1
Fn  R  
 i 
Where, n = the number of payment periods
i = interest rate per period
R = payment per period
Fn = future value of the Annuity or sum of the annuity after n periods

Now, let us consider the above example. That is,

R = Birr 1000
i = 0.1 and n=4
 (1  0.1)4 - 1
F4  1000 
 0.1 

Future Value = Birr 4641

Example: A person plans to deposit 1000 birr in a savings account at the end of this year
and an equal sum at the end of each following year. If interest is expected to be earned at
the rate of 6% per year compound semi-annually, to what sum will the deposit
(investment) grow at the time of the fourth deposit?

Solution:
The known values in the problem are,
R = 1000, j = 6% = 0.06 , m = semi-annual = twice a
year
i = 0.06 ÷ 2 = 0.03
n=4

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  (1  i ) n  1
F4 = ? F4 = R  
 i 
 (1  0.03) 4  1
= 1000  
 0.03 

= 1000 (1.03) 4  1 / 0.03 
= 1000 x 4. 183627
F = Birr 4183.63

Self-test 4.2. Dear learners, try to solve yourself.

A 12 years old student wants to begin saving for college. She plans to deposit Birr 50
in a saving account at the end of each quarter for the next 6 years. Interest is earned at
a rate of 6% per year compounded quarterly. What should be her account balance 6
years from now? How much interest will she earn?

4.3.8. Ordinary Annuities: Sinking Fund Payments

A sinking fund is a fund into which periodic payments or deposits are made at regular
interval to accumulate a specified amount (sum) of money in the future to meet financial
goals and/or obligations. The equal periodic payment to be made constitute an ordinary
annuity and our interest is to determine the equal periodic payments that should be made
to meet future obligations. Accordingly, we will be given the Future Amount, F, in n
period and our interest is to determine the periodic payment, R. Then we can drive the
formula for R as follows.

 (1  i ) n  1
Fn  R  
 i 
Multiplied both sides by
That is
i
 (11 i ) n  1
Fn  (1 
i i) n  i
 R  
(1  i )  1
n
 i  (1  i )  1
n

Then,

 i 
R  Fn   is the sinking found formula.
 (1  i )  1
n

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Where, R = Periodic payment amount of an annuity
i = Interest per period which is given by j ÷ m
j = Annual nominal interest rate
m = Number of conversion periods per year
n = Number of annuity payment or deposits (also, the number of
compounding
periods)
F = Future value of ordinary annuity

In general, a sinking fund can be established for expanding business, buying a new
building, vehicles, settling mortgage payment, financing educational expenses etc.

Example:

A corporation wants to establish a sinking fund beginning at the end of this year. Annual
deposits will be made at the end of this year and for the following 9 years. If deposits earn
interest at the rate of 8% per year compounded annually, how much money must be
deposited each year in order to have 12 million Birr at the time of the tenth deposit? How
much interest will be earned?

Solution:
1. Future level of deposit desired = Fn = Birr 12 million
Term of the annuity = t = 10 years
Conversion periods = m = annual = 1
n = t x m = 10 x 1 = 10 annuals
j = 0.08
i = j ÷ m = 0.08 ÷ 1= 0.08

R = the amount to be deposited each year to have 12 million at the end of the 10th year =
? Then to obtain the value of R, we shall use the formula for sinking fund.

 i 
R  Fn  
 (1  i )  1
n

R = Birr 828,353.86

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On the other hand, the amount of interest, I, is obtained by computing the difference
between the maturity value (Fn = 12,000,000) and the sum of all periodic payments made.

 0.08 
R  12,000,000 
 (1  0.08)  1
10

 0.08 
 0.08  R  12,000 ,000  
R  12,000,000  1.158925 
 (1.08)  1
10

Thus,
I= Fn - R (10)
= 12,000,000 – 823,353.86 (10)
= 12,000,000 – 8,283,538.6
= Birr 3,716,461.4

4.3.9. Present Value of Ordinary Annuity:

The present value of annuity is an amount of money today, which is equivalent to a series
of equal payments in the future. It is the value at the beginning of the term of the annuity.
The present value of annuity calculation arise when we wish to determine what lump sum
must be deposited in an account now if this sum and the interest it earns will provide
equal periodic payment over a defined period of time, with the last payment making the
balance in account zero. Present value of ordinary annuity is given by the formula:

1  (1  i )  n 
P  R 
 i 

Where, R= Periodic amount of an annuity

i = Interest per period which is given by j ÷ m
j = Annual nominal interest rate
m = Interest/ conversion periods per year
n = Number of annuity payments / deposits (also, the number of compounding
periods)
P = Present value of ordinary annuity

Example: A person recently won a state lottery. The term of the lottery is that the winner
will receive annual payments of birr 18,000 at the end of this year and each of the

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following 4 years. If the winner could invest money today at the rate of 6% per year
compounded annually, what is the present value of the five payments?

Solution:
R = Annual payments of Birr 18,000
Term of the annuity = t = this year and the following 4 years = 5 years
i = 6% = 0.06 (since the conversion period per year is annual)
n=5
Present value of payments = P = ?

1  (1  i )  n 
P  R 
 i 
1  (1  0.06) 5  1  (1.06) 5 
P  18,000   18,000 
 0.06   0.06 
P = Birr 75,822.55

4.3.10. Mortgage Payments and Amortization

Another main area of application of annuities in to real world business situations in
general and financial management practices in particular is mortgage amortization or
payment. Mortgage payment is an arrangement whereby regular payments are made in
order to settle an initial sum of money borrowed from any source of finance. Such
payments are made until the outstanding debt gets down to zero. An individual or a firm,
for instance, may borrow a given sum of money from a bank to construct a building or
undertake something else. Then the borrower (debtor) may repay the loan by effecting
(making) a monthly payment to the lender (creditor) with the last payment settling the
debt totally.

In mortgage payment, initial sum of money borrowed and regular payments made to settle
the respective debt relate to the idea of present value of an ordinary annuity. Along this
line, the expression for mortgage payment computation is derived from the present value
of ordinary annuity formula. Our intention in this case is to determine the periodic
payments to be made in order to settle the debt over a specified time – period.
Hence, we know that

1  (1  i )  n 
P  R 
 i 

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Now, we progress to isolate R on one side. It involves solving for R in the above present
value of ordinary annuity formula. Hence, multiply both sides by the interest rate i to
obtain:
P i = R [1 – (1 + i) –n]

Further, we divide both sides by [1 – (1 + i) –n] and the result will be the mathematical
expression or formula for computing mortgage periodic payments as follows.

 i 
R  P n 
1  (1  i ) 
Where, R = Periodic amount of an annuity
i = Interest per conversion period which is given by j ÷ m
j = Annual nominal interest rate
m = Interest or conversion periods per year
n = the number of annuity payments/deposits (number of compounding
periods)
P = Present value of an ordinary annuity

Example: Emmanuel purchased a house for Birr 115,000. He made a 20% down
payment with the remaining balance amortized in 30 years mortgage at annual interest
rate of 11% compounded monthly.
a. Find the monthly mortgage payment?
b. Compute the total interest.

Solution:

1. Total cost of purchase = Birr 115,000

Amount paid at the beginning (Amount of down payment) = 20% of the total cost
= 0.2 x 115,000 = Birr 23,000
Amount Unpaid or Mortgage or Outstanding Debt = 115,000 – 23,000
= Birr 92,000
t = 30 years
j = 11% = 0.11 , m = 12 , i = 0.11 ÷ 12 = 0.00916
n = t x m = 30 x 12 = 360 months

The periodic payment R = ?

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  i 
R  P n 
1  (1  i ) 

= 92,000 (0.009523233)
R = Birr 876.14

 0.00916 
R  92,000 360 
1  (1  0.00916) 
b. Total Interest = (R x n) – P
= 876.14 x 360 – 92,000
= Birr 223,409.49

Over the 30 years period Emmanuel is going to pay a total interest of Birr 223,409.49,
which is well more than double of the initial amount of loan. Nonetheless, the high
interest can be justified by the fact that value of a real estate is usually tend to increase
overtime. Therefore, by the end of the term of the loan the value of the real estate (house)
could be well higher than its purchase cost in addition to owning a house to live in for the
30 years and more.

Summary

The following are some of important formula that deal with mathematics of finance.
 Simple Interest
= Pin
 Future Value Of A Simple Interest
= P (1 + i n)
 Compound Amount
= P (1 + i) n

 Present Value Of A Compound Amount

= F (1 + i) –n

 Maturity Value Of Ordinary Annuity (Fn)

 (1  i) n - 1
Fn  R  
 i 

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  Sinking Fund Payment Formula

 i 
R  Fn  
 (1  i)  1
n

 Present Value Of Ordinary Annuity

1  (1  i )  n 
P  R 
 i 
 Mortgage Payments and Amortization

 i 
R  P n 
1  (1  i ) 

Self-test 4.3. Dear learners, the following questions concerns annuities, try to solve
yourself.

1. A person deposits Br. 400 a month for four years into 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?
2. 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?
3. 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?

4.4. Summary

The following are some of important formula that deal with mathematics of finance.
 Simple Interest
= Pin
 Future Value Of A Simple Interest
= P (1 + i n)

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  Compound Amount
= P (1 + i) n

 Present Value Of A Compound Amount

= F (1 + i) –n

 Maturity Value Of Ordinary Annuity (Fn)

 (1  i) n - 1
Fn  R  
 i 

 Sinking Fund Payment Formula

 i 
R  Fn  
 (1  i)  1
n

 Present Value Of Ordinary Annuity

1  (1  i )  n 
P  R 
 i 

 Mortgage Payments and Amortization

 i 
R  P n 
1  (1  i ) 

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 4.5. Review questions

1. If money worth 14% compounded semi-annually, would it be better to discharge a

debt by paying Birr 500 now or Birr 600 eighteen months from now?
2. A bank states that the effective interest on savings accounts that earn continuous
interest is 10%. Find the nominal rate.
3. If you borrow Br. 1, 000 from Commercial Bank of Ethiopia for 1 year to pay at 6%
interest rate your tuition fee. Find the simple interest and the maturity value of the
loan.
4. What is the present value of a loan that will amount to Br. 5, 000 in 5 years if money
is worth 3% compounded semi-annually? \\
5. How much should be deposited in an account paying 10% compounded quarterly in
order to have a balance of Br. 10, 000 ten (10) years from now? What would be the
amount of compound interest after 10 years?
6. A small boy at the age of 10 drops 0.25 cents into a Jar each day. At the end of each
month (30 days months) he deposits this amount at Dashen Bank that pays 5% interest
compounded quarterly. If he makes the deposit without interruption, how much will
the boy have at the age of 20?
7. Hiwot deposits Br. 1, 000 at the end of every 3 months period in to an account for 5
years which earn 10% interest compounded quarterly and then her deposits are
changed to Br. 500 monthly for the next 5 years which earn 12% interest compounded
monthly. How much is the account by the end of the time period considered?
8. ABC Company purchased a delivery truck on credit from XYZ which requires a
payment of Br. 400, 000 plus 5% interest compounded annually at the end of 5 years.
The Company plans to set up a sinking fund to accumulate the amount required to
settle the debt.
Required:
A. Find the total debt at the end of the 5 year.
B. What should be the monthly deposit into the fund be if the account pays
15% interest, compounded monthly?
9. If Br. 10, 000 is invested at 8% compounded:
A. Annually
B. Semi Annually
C. Quarterly

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 D. What can you observe from your answers in A, B and C
What is the amount after 5 years?
10. Assume you won a lottery and you want to deposit/ invest your money in the
following to investment alternatives. Investment A which pays 15% compounded
monthly and B that pays 14% compounded semiannually, which is the better
investment, assuming other things are the same.
11. An investor has an opportunity to invest in two investment alternatives A and B which
pays 15% compounded monthly, and 15.2% compounded semi-annually respectively.
Which investment is better investment, assuming all else equal?
12. Mr. Kebede has a savings goal of Br. 100, 000 which he would like to reach 15 years
from now. During the first 5 years he is financially able to deposit only Br. 1000 each
quarter into the savings account. What must his quarterly deposit over the last 10 (ten)
years be if he is to reach his goal? The account pays 10% interest, compounded
quarterly.
13. What is the present value of an annuity that pays Br. 500 a month for the next five
years if money is worth 12% compounded monthly?
14. If you have Br. 100,000 in an account that pays 6% compounded monthly and I you
decide to withdraw equal monthly payments for 10 years at the end of which time the
account will have a zero balance, how much should be withdrawn each month?
15. Andinet and Florence are looking to purchase a home. They found one that they like
that costs Birr 150,000. They can get a 30-year mortgage at 9% and plan to make a
down payment of 20% of the selling price.
A. What will be their monthly mortgage payment?
B. When Andinet and Florence go to the bank, they are offered an annual percent
rate of 6% if they take a 15-year loan rather than one for 30 years. Andinet and
Florence are skeptical because they can't afford to make twice the payment
calculated for 30 years. In actual fact, how much would their payment be if they
repaid the mortgage in 15 years?
C. Andinet is 25 years old and wants to be a millionaire by the time he is 50. He is
planning to put aside a sum of money at the end of each year sufficient to
accumulate a million Birr in 25 years using an interest rate of 10%. How much
must he put aside?
D. Considering your answer in part c above, suppose Andinet can only put aside Birr
10,000 per year. How high a rate of return must he realize to achieve his goal?
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Chapter Five: Elements and Applications of Calculus

Chapter Objectives
Dear learners, at the end of this chapter you should be able to:
 Understand Differential Calculus
 Understand Limits and Continuity of a function:
 Understand and compute Derivative
 Demonstrate how to apply Differential calculus in business
 Understand integral calculus and the basic rules for integration
 Demonstrate how to apply integral calculus in business

5.1. Introduction to Calculus

Dear learner! What do calculus mean? Why we study calculus? __________________

________________________________________________________________________

It is a dried fact that the application of concepts of calculus in the business arena
specially; in marginal analysis and optimization problems is paramount. In this part of the
module, basic concepts in calculus to be seen include: concept of limit and continuity,
derivatives, definite and indefinite integration, Calculus is branch of mathematics
and their major application areas in business; concerned with the study of such
typically, marginal analysis, optimization concepts as the rate of change of
one variable quantity with respect
problems and area functions.
to another, the slope of a curve at a
prescribed point, the computation
Calculus is the branch of mathematics that of the maximum and minimum
concerns itself with the rate of change of one values of functions, and the
quantity with respect to another quantity. calculation of the area bounded by
curves.
Calculus is a mathematical tool to solve
problems in business, economics and other areas which mainly rely about changes. There
are two types of calculus: Differential calculus and Integral calculus.

5.2. Differential Calculus

It is one aspect of calculus that measures the rate of change in one variables as another
variable changes. It broadens the idea of slope. There are two core concepts which lie
down the foundation for differential calculus. These are: Limits and Continuity.

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 A function: if for every value of a variable x, there corresponds exactly one and only one
value of the variable y, we call y is a function of x, written as:
Y = f(x).
Limits: the limit of f(x) as x c is ℓ which is written as ; lim (x) = ℓ, if and only if
x c

the functional value f(x) is close to the single real number ℓ, whenever x is close to but
not equal to c ( on either side of c).

Example-1:
For the function f(x) =x2 + 2, find the limit of f(x) as x approaches 1.

Solution:

X 0.8 0.9 0.99 0.999 1 1.0001 1.001 1.01 1.1

2
f(x)=x +2 264 2.81 2.9801 2.998 3.0002 3.002 3.021 3.21
ℓ- = 3 ℓ+ = 3
lim f(x) = 3
x1

Example-2:
For the function f(x) = /x/, find;
X
a. lim f(x) b. lim f(x)
x 2 x 0

Solution:

X 1.9 1.99 1.999 2 2.001 2.001 2.01

f(x)=/x/ 1 1 1 1 1 1
x
ℓ- = 1 ℓ+ = 1
Thus; lim f(x) = 1
x1

b.
X -0.999 -0.99 -0.9 0 0.0001 0.001 0.01 0.1
f(x)=// -1 -1 -1 1 1 1 1
x
ℓ- = -1 ℓ+ = 1
ℓ-≠ ℓ+ → So, lim f(x) doesn’t exist.
x 0

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Limit Theorems:

1. If k is any constant , lim k = k

xa

E.g. lim 10 = 10
x5

lim c = c
a b

2. lim kf(x) = k lim f(x)

xa xa

E.g. lim 3x2 = 3( lim x2) = 3(a2) = 3a2

xa xa

3. lim (f(x) +g(x)] = lim f(x) + lim g(x)

xa xa xa

E.g. lim (x2-2+3) = lim x2 – 2 lim x + lim 3

xa xa xa xa
2
= a -2a +3
4. lim [f(x).g(X) ] = ( lim f(x) ] ( lim g(x) ]
xa xa xa

E.g. lim (x+3)(X-2) = [ lim (x+3) ] [ lim (x-2)

x 2 x 2 x 2

= [5] [0]
=0

5. lim [f(x)n] =[ lim f(x)n]

xa xa

E.g. lim (x-1)5 = [ lim (x-1)]5 =25 = 32

x3 x3

6. If lim f(x) = L and lim g(x) = m, then;

xa xa

a, If m0, then lim [f(x)/g(x) ] = L/m

b. If m = 0 and L  0, the lim [f(x)/g(x)] = doesn’t exist
c. If m = 0 and L = 0, then f(x) and g(X) have a common factor and the limit can be
evaluated after employing the process of cancellation.

Continuity of a Function:

Definition: a function f is continuous at the point x = c if:

1. lim f(x) → exists
2. f(c) is defined
3. lim f(x) = f(c)

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Example:

Using the definition of continuity, discuss the continuity of the function f(x) = x2-4
x-2
at c =1 and c = 2

Solution:

At c =1, lim f(x)

x1

X 0.9 0.99 0.999 1 1.0001 1.001 1.01 1.1

f(x) = x2-4 2.9 2.99 2.999 3.0001 3.001 3.01 3.1
x-2
ℓ- = 3 ℓ+ = 3
lim f(x) =3 lim f(x) exists
x1 x1

f(1) =1 -4 = 3 → f(c) is defined

2

1-2
lim f(x) = 3 = f(1)
x1

Therefore; f(x) = x2-4 is continues at c =1

x-2
At c = 2
X 1.9 1.99 1.999 2 2.0001 2.001 2.01 2.1
F(x) 3.9 3.99 3.999 4.0001 4.001 4.01 4.1
ℓ =4
-
ℓ+ = 4
lim f(x) = 4 It exists
x 2

f(2) =22-4 = 4-4 = 0= ¢

2-2 0 0
lim f(x)  f(c) →4¢
x 2

Therefore; f(x) is not continuous at c = 2.

Derivatives:

Definition: for y = f(x) we define the derivative of f at x, denoted by f′′(x) to be;

f′(x) = lim f(x) = lim f(x+x)- f(x)
x 0 x x 0 x

Example-1
Find f′(x) for f(x) = 2x +4
f(x) = lim f(x+ x) –f(x)
x 0 x

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 1st → find f(x) =
f(x) = f(x+x)-f(x)
= [2(x+x) +4] – (2+4)]
= 2+2x+4-2x-4
f(x) = 2x
2 nd
find the limit: f′(x) = lim f(x)
x 0 x
= lim 2x
x 0 X
f′(x) = 2
Example-2

For the function f(x) = 4x-x2 find f′(x)

f′(x)= lim f(x+x) – f(x)
x 0 x
1 → find f(x) = 4(x+x)-(x+x)2- (4x-x2)
st

x x
= 4x+4x-x2 – 2xx -x2-4x+x2
x
= x (4-2x-x)
x
= 4-2x-x
2 → find the limit of the resulting function
nd

f′(x) = lim f(x) = lim 4-2x-x

x 0 x x 0
′
f (x) = 4-2x

Rule of differentiation:

1. A constant function rule

If f(x) = c then f′(x) = 0
E.g. If f(x) = 5 then f′(x) = 0

2. The power rule

The derivative of the power function is the power times the function raised the power
minus one.
If f(x) = axn, then f′(x) = anxn-1
E.g. If f(x) = x5, then f′(x) = 5x5-1 = 5x4
If f(x) =3x3, f′(x) =33x3-1 = 9x2

108 | P a g e
3. The sum and difference rule
The derivative of the sum or difference of two functions is the derivative of the first
function plus or minus the derivative of the second function.
If f(x) = u(x) + v(x), then f′(x) =u′(x) + v′ (x)

E.g. f(x) = 3x+8 , f′(x) =3+0= 3

f(x) = 4x-x2 ; f′(x) = 4-2x

4. The product rule

The derivative of the product of two functions is the first function times the derivative
of the second function plus the second function times the derivative of the first.
If f(x) = u(x). (v(x)) then;
f′(x) =u(x). v′(x) + v(x) .u′(x)
E.g. f(x) = 3x2 (4x-1), the f′(x) =
3x2(4) + (4x-1) (6x)
= 12x2 +24x2-6x
= 36x2-6x
5. The quotient rule;
The derivative of the division of two functions is the denominator times the derivative
of the numerator minus the numerator times the derivative of the denominator over
the denominator square.
If f(x) = u(x), then;
V(x)
f′(x) = v(x) .u′(x) – u(x). v′(x)
[V(x)] 2
If f(x) = x2/2x-1
f′(x) = (2x-1)(2x) –(x2)(2)
(2x-1)2
= 4x2-2x-2x2
4x2-4x+1
= 2x2-2x
(2x-1)2

Application of Differential Calculus to Marginal Analysis:

The word marginal refers to rate o f change→ that is a derivative.

Let x be the number of units of a product produced
Total cost function → C(x)
Total revenue function→ R(x)

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Total profit function→ P(x) = R(x) –C(x)
Marginal cost function → C′(x)
 Marginal cost is the rate of change in total cost per unit change in production at an
output level of x-units.
 Marginal revenue function→ R′(x)
 Marginal profit function→ P′(x) = R′(x) - C′(x)
 Average cost→ č(x) = C(x)
x
 Marginal average cost→ č′ (x)
 Average revenue → Ř(x) = R(x)
x
 Marginal average revenue→ Ř′(x
 Average profit → Pˉ (x) =P(x)
x
 Marginal average profit → Pˉ′(x)

Example-1
A company manufactures and sells x transistor radios per week. Its weekly cost and
demand equations are:
C(x) = 5000 +2x
P = 10 – x find
1000
a) Production level that maximizes revenue and the maximum revenue.
b) The production level that maximizes profit and the maximum profit.
c) The MR and MC at the profit maximizing output level.
d) The average cost per unit if 1000 radios are produced.
e) The marginal average cost at a production level of 1000 radios and interpret the
result.

Solution:

a) R(x) = P.X = (10-x) (x)

1000
2
R(x) 10x- x
1000
R(x) = 10 –x =0
5000
10= x → x = 5000 units
500

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R′(x) = -1/5000; R′(x) <0 x= 5000 units is the revenue maximizing output level.
Maximum revenue is at x = 5000 units
R(x) = 10x – x2
1000
R(5000) =10(5000)- (5000)2
1000
= Birr 25000
b) P(x) = R(x) – C(x)
[10x- x2 ]- [5000+2x]
1000
= 10x –x2 - 5000-2x
1000
P(x) = 8x-x2 - 5000
1000
P′(x) 8-2x = 8-x
1000 500
8-x= 0
500
8= x
500
x = 4000 units
P″(x) = -1 P″(x)<0 x = 4000 units is the profit maximizing output level
500
At x = 4000 units P(x) = 8x-x2 - 5000
1000
= 8(4000) - (4000)2-5000
1000
= Birr 11,000
c) C′(x) = 2 production cost increases by birr 2 at each level of out put
R′(x) = 10- 2x = 10-x
1000 500
At x = 4000 units
R′(x) = 10 -4000 = 10-8 =2 birr
500
At each level of output TR increases by birr 2
At the profit maximization; MR = MC, i.e. 2 Birr

d) x =1000 radios;
 Average cost č(x) = C(x)
x
= 5000 +2x
x

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 At x = 1000 radios; č(x) = 5000 +2(1000)
1000
= 7 Birr
e) Marginal average cost = č′(x)
MAC = - 5000
x2
č′(x) = - 5000 = -0.005 Birr
(1000)2

Interpretation: At a production level of 1000 units a unit increase in production will

decrease average cost by approximately 0.5 cents or by 0.005 Birr.

Self-test 5.1.
A certain manufacturing company has the following information: Average total cost is
given by the equation:
č(q) = 0.5q -500+ 5000 and,
q
The demand function is:
P = 2500-0.5q
A. Find the firm’s: i. Total profit function ii. Marginal cost function iii. Marginal average
cost function
B. Find the quantity level that: i. maximizes total revenue ii. Maximizes total profit iii.
Minimizes total cost
C. Find the firm’s: i. Maximum revenue ii. Maximum profit
D. Find the price level that leads to maximum: i. Revenue ii. Profit

5.3. Integral Calculus

Integral Calculus - which deals with the problem of finding a quantity, given that we
know the rate at which it is changing.

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).

Indefinite Integral: Given F(x) which is the anti-derivative of f(x), the indefinite integral
of f(x) is defined to be:

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f(x) dx = F(x) +C,

Where;
 = the integral symbol
f(x) = the integrand (the function to be integrated)
F(x) = the integral (the outcome of integration)
C = the constant of integration
dx = indicates the variable to be integrated

The rules of integration:

1. A constant function rule;

If f(x) = k
f(x)dx = (k)dx = kx0+1 + C = kx+C
0+1
E.g. If f(x) = 5
f(x) dx = (5)dx = 5x0+1 + C = 5x+C
0+1

2. The power rule

If f(x) = xn
f(x) dx = (xn)dx = xn+1 + C
n+1
5
E.g. If f(x) = x ;
f(x)dx = (x5)dx = x5+1 + C = x6 + C
5+1 6

3. A constant times a function rule;

If f(x) = axn
(x)dx = (axn)dx = a(xn)dx = a(xn+1) + C
n+1

E.g. If f(x) = 3x3

f(x)dx = (3x3)dx = 3(x3)dx = 3(x3+1)+ C
3+1
= 3/4x4+C

4. The sum and difference rule

If f(x) =g(x) ± h(x)
f(x)dx = [g(x) ± h(x)]
=g(x)dx ± (h(x)dx

113 | P a g e
E.g. If f(x) = 5x+9
f(x)dx = (5x+9)dx = (5x)dx+ (9)dx
= 5x1+1 + 9x0+1
1+1 0+1
= 5/2 x2 + 9x + C

5. The product rule

If f(x) = (ax+b)n
f(x)dx = (ax+b)n = (ax+b)n+1 + C
a(n+1)
E.g. If f(x) =(x+2) = f(x)dx = (x+2)2dx
2

= (x+2)2+1 + C = (x+2)3+ C
(2+1) 3

6. The quotient rule;

If f(x) = g(x) + h(x)
k(x)
f(x)dx = (g(x)dx + (h(x))dx
k(x) k(x)
3
E.g. If f(x) = 8+x
x2
f(x)dx =(8 )dx + (x3)dx
x2 x2
(8x-2)dx + (x)dx
= 8x-2+1 = x1+1 + C
-2+1 1+1
-1 2
= 8x +x + C
-1 2
= -8x +1/2x2 + C
-1

= -8/x+x2 + C
2
Indefinite integral for finding total functions:

Example: The function describing the marginal cost of producing a product is given by
f(x) = x+100, where x is the number of units produced, determine the total cost function if
the total cost of producing 100 units is birr 40 000.

Solution:

C(x) = f(x)dx= f(x) = x+100

(x+100)dx = x1+1 +100x0+1 + C

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 1+1 0+1
2
x + 100x+ C
2
2
C(x) =1/2x + 100 x +c (fixed cost)
2
40,000 = ½(100) +100(100) + C
40,000 = 5000+ 10,000+ C
40,000 = 15000+ C
40,000 -15000 = C
C = 25000 Birr
Therefore; C(x) = ½x2+100x+25,000

Self-test 5.2.

Dear student, attempt this question. The marginal revenue function for a company’s
product is given by f(x) = 50,000-x, where x is the number of units produced. Develop the
total revenue function if revenue is zero when no units are produced and sold.

Definite integral:

Definition: If f(x) is a continuous function on the interval [a, b], the definite integral of
b
f(x) is defined as 
a
f (x)dx = F(b) –F(a)
Where

F(x) = the anti-derivative for f(x)

F(b) = the upper limit
F(a) = the lower limit
F′(x) = f(x)

A definite integral has a single numerical value associated with it and can be obtained
through the indefinite integral by using the following steps.
Step-1: get the indefinite integral of the function
Step-2: substitute the value x = a in the indefinite integral
Step-3: substitute x = b in the indefinite integral
Step-4: subtract the numerical value obtained in Step 2 from step 3 and the result gives
the definite integral value of the function between the limits x = a x = b.

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Example
If marginal revenue is given by:
F(q) = 200-6q , what extra total revenue is obtained by increasing sales (q) from 15 to
20?
Solution:
20 20
Extra revenue =  15
f(q)dq = 
15
(200-6q)dq
= 200q – 6q1+1 + C
1+1
= [200(20) -3(20)2+ C] - [200(15) -3(15)2+C]
= 2800+C- 2325 – C
= Birr475

5.4. Summary

The major formulas for application of concept of calculus in marginal analysis and
optimization problems include the following.
- Marginal cost is the rate of change in total cost per unit change in production at an
output level of x-units.
- Marginal revenue function→ R′(x)
- Marginal profit function→ P′(x) = R′(x) - C′(x)
- Average cost→ č(x) = C(x)
x
- Marginal average cost→ č′ (x)
- Average revenue → Ř(x) = R(x)
x
- Marginal average revenue→ Ř′(x
- Average profit → Pˉ (x) =P(x)
x
- Marginal average profit → Pˉ′(x)

  f(x) dx = F(x) +C
b
 a
f (x)dx = F(b) –F(a)

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 5.5. Review Questions

1. One million Birr is deposited in to a savings account for 1 year at 12%

compounded quarterly. If interest is added at the end of each quarter. Find the
account's balance for each quarter. Where is the graph discontinuous?
2. The profit, P (in millions of Birr), gained from selling x (in thousands) units of a
product is given by: P(x) = -0.1x2+4x-30 [10<x<30]
a. Find the average rate of change of profit with respect to x.
b. Determine the average rate of change of profit with respect to x as x changes
from x=12 to x=15.
c. Interpret your result.
3. A small machine shop manufactures drill bits that are used in petroleum industry.
The shop manager estimates that the total daily cost (in Birr) of producing X bits
is C(x) = 1,000 + 25x – 0.1x2.
a. Find the daily average cost if x units are produced.
b. Find the average cost per unit if 10 drill bits are produced.
c. Find the marginal average cost function.
d. Find the marginal average cost if 10 drill bits are produced, and interpret the
results.
4. From past experience, an apple grower knows that if the apples are harvested now,
each tree will yield on average 130 pounds and the grower will sell the apples for
Birr 0.64 per pound. However, for each additional week that the grower waits
before harvesting, the yield per tree will increase by 5 pounds, while the price per
pound will decrease by Birr 0.02. How many weeks should the grower wait before
harvesting the apples in order to maximize the sales revenue per tree? What is the
maximum sales revenue per tree?
5. 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.
6. A truck carrying natural gas gets stuck at a low underpass and leaks natural gas at the rate
of L'(t) = 10t +20 cubic feet per minute, where t denotes time (in minutes) elapsed since
the gas first began leaking.
a. Find the total amount of natural gas that has leaked during the first five minutes.
b. Find the total amount of natural gas that has leaked during the first 10 minutes.

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 c. Find the total amount of gas that has leaked during the fifth minute.
d. Find the total amount of gas that has leaked during the sixth minute
e. If the amount of natural gas that the truck was carrying was 5,100 cubic feet, how many
minutes will be elapsed before the truck is empty?
7. The annual profit of a certain hotel is given by
P(x, y) = 100x2 +4y2 +2x +5y + 100,000

Where x is the number of rooms available for rent and y is the monthly advertising
expenditures. Presently, the hotel has 90 rooms available and is spending Birr 1000 per month
on advertising.
a) If an additional room is constructed in an unfinished area, how will this affect
annual profits?
b) If an additional Birr is spent on monthly advertising expenditures, how will this
affect profit?
7. The revenue, z, derived from selling x units of calculators and y units of adding machines is
given by the function
Z = f(x, y) = -x2 + 8x - 2y2 + 6y + 2xy + 50
a) How many calculators and adding machines should be sold in order to maximize sales
revenue?
b) What is the maximum sales revenue?

Answer for Review Questions

1.a. Answer: Birr 1,030,000, 1,060,900, 1,092,720, and 1,125,508.81.
b. Answer: The graph is discontinuous at the end of the first, second,
third and fourth quarters.
2. a. Answer:-0.2x - 0.1x+4
b. Answer: Birr 1,300,000
c. Answer: As x changes from x=12, 000 to x= 15,000, an additional unit
sold yields Birr 1,300, on the average
3.
C ( x) 1,000  25x  0.1x 2 1,000
a. C ( x)    0.1x  25 
x x x
1,000
b. C (10)  0.1(10)  25   Birr 124
10

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 dC ( x) 1,000
c. C ' ( x)   0.1  2
dx x
1,000
d. C ' (10 )  0.1    Birr 10 .10
(10 ) 2
A unit increase in production will decrease the average cost per unit by
approximately Birr 10.10 at a production level of 10 units.
4, Let x be the number of weeks the grower waits. The sales revenue per tree is given
by R = number of pounds per tree * price per pound
R(x) = (130+5x) (0.64 - 0.02x)
Critical values
Using the product rule we find
R'(x) = (130+5x) (-0.02) + (0.64 - 0.02x) (5)
= 0.6 - 0.2x
0 = 0.6 - 0.2x
0.6 = 0.2x
x=3
Test for absolute extrema (Second derivative test)
R"(x) = -0.2 <0
Absolute maximum is at x = 3
R (3) = [130 +5(3)] [0.64 - .2(3)]
= 145 * 0.58
= Birr 84.10
5. 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
= -6x/2 + 750x + C P(x) = -3x2+750x-20,000
1. a. Answer: 225 cubic feet
b. Answer: 700 cubic feet
c. Answer: 65 cubic feet
d. Answer: 75 cubic feet
e. Answer: 30 minutes

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7. a. Answer: Birr 18,002
b. Answer: Birr 8,005
8. Critical points
a) we first calculate fx and fy, as follows:
fx = -2x + 8 + 2y
fy = -4y + 6 + 2x

Setting fx and fy equal to 0, we have

0 = -2x + 8 + 2y
0 = -4y + 6 + 2x
Solving for this linear system for x and y, we obtain x = 11 and y = 7. Thus, the only
critical point is (11, 7).
Second derivative test
We calculate fxx = -2, fyy = -4, and fxy = 2.

Since the partial critical point is (11, 7), then

A = f (11, 7) = -2
B = f (11, 7) = -4
C= f (11, 7) = 2.
AB – C2 = -2(-4) - 22 = 4
Since AB – C2 > 0 and A < 0, then, according to the second derivative test, a relative
maximum occurs at (11, 7). Thus, in order to maximize revenue, x = 11 calculators
and y = 7 adding machines must be sold.
b) The maximum sales revenue is
Z = f (11, 7) = - (11)2 + 8(11) – 2(7)2 + 6(7) + 2(11) (7) + 50 = Birr 115.

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References
Text Book:
• Bowen Earl. Mathematics with applications in Business and Economics, 10th.
1987
Reference Books
 Salezman S. A. etal. Mathematics for Business. 8th Ed. 2007, Pearson
Publishing limited.
 Nelda W. Roueche and Virginia H. Graves. Business Mathematics, 6th ed,
1993, Prentice Hall Limited
 Ronald E. Larson and Bruce H. Edwards. Finite Mathematics with Calculus,
1991
 Ann j. Hughes. Applied Mathematics: For Business, Economics, and the social
Science, 1983.
 Barnett Raymond A. and Ziegler Michael R. Essentials of College Mathematics
for business and Economics, life science and social science. 3rd Ed. 1989

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