NATIONAL UNIVERSITY OF SCIENCE AND TECHNOLOGY

DEPARTMENT OF INSURANCE AND ACTUARIAL SCIENCE

QUANTITATIVE ANALYSIS FOR BUSINESS [CIN 1106]

LECTURE NOTES
 LINEAR PROGRAMMING

A mathematical tool that ensures the OPTIMAL utilization of resources.

The function of most organization is to transform the resources available to them, e.g. raw materials,
components, machine time and labour into products and/or services

To do this the organization has to decide how much of each product or service to supply whilst staying
within the bounds imposed by limits on these resources.

Most organisations seek to do this in such a way as to make a profit as large as possible or costs as small
as possible (the optimal utilization of resources)

Linear Programming is a way of modeling this type of management decision problem.

In general Linear Programming can be applied to any environment where activities compete for the use
of limited resources.

Linear Programming Maximisation Problem/Model

The general form is:

Objective Function : Max z = c1x1 + c2x2 + … + cnxn

Subject to:

Constraints : a11x1 + a12x2 + … + a1nxn ≤ b1

a12x1 + a22x2 + … + a2nxn ≤ b2

: :

am1x1 + am2x2 + … + amnxn ≤ b3

Non-negativity Constraint: xij ≥ 0

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1. A boy wants to start a small business selling drinks to NUST students. His mother says he cannot sell
more than 4 litres of drinks. The boy sells lemonade and fruit juice. He sells the lemonade for $2 per
litre and fruit juice for $1.50 per litre. The lemonade uses 30 lemon slices per litre and 1kg of sugar
per litre. The fruit juice uses 10 lemon slices and 2kgs of sugar per litre. The boy’s mother has only
90 lemon slices and 6kgs of sugar. Write a linear programming for the problem.
2. A manufacturer makes motorized and manual hand trucks in a factory that is divided into 2 shops.
Shop 1 which performs the basic assembly operation must work 5 hours on each motorized hand truck
but only 2 hours on each manual hand truck. Shop 2 performs finishing operations and must work 3
hours on each motorized and manual hand truck it produces. Because of the limited number of workers
and machines, shop 1 has 180 hours available per week and shop 2 has 135 hours available per week.
If the manufacturer makes a profit of $300 on each motorized hand truck and $200 on each manual
hand truck. Write a linear programme to maximize profit.
3. A manufacturer makes wooden desks (X) and table (Y). Each desk requires 2,5 hours to assemble, 3
hours for buffing and 1 hour to crate. Each table requires 1 hour to assemble, 3 hours to buff and 2
hours to crate. The firm can do only up to 20 hours of assembling, 30 hours of buffing and 16 hours
of crating per week, profit is $3 per desk and $4 per table. Formulate a linear programming problem
that maximizes profit.

Linear Programming Minimisation Model

The general form is:

Objective Function : Min z = c1x1 + c2x2 + … + cnxn

Subject to:

Constraints : a11x1 + a12x2 + … + a1nxn ≥ b1

a12x1 + a22x2 + … + a2nxn ≥ b2

: :

am1x1 + am2x2 + … + amnxn ≥ b3

Non-negativity Constraint: xij ≥ 0

Examples

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1. A small petroleum company owns 2 refineries. Refinery 1 costs $2 000 per day to operate and it can
produce 400 barrels of high-quality oil, 300 barrels of medium-grade oil and 200 barrels of low-grade
oil each day. Refinery 2 is newer and more modern. It costs $25 000 per day to operate and it can
produce 300 barrels of high-grade oil, 400 barrels of medium grade oil and 500 barrels of low grade
oil each day. The company has orders totaling 25 000 barrels of high-grade oil, 27 000 barrels of
medium-grade oil and 30 000 barrels of low-grade oil. How many days should it run each refinery to
minimize its costs and still refine enough oil to meet orders?

There are 2 methods for finding the optimal solution:

i) Graphical Method
ii) Simplex Method

THE GRAPHICAL METHOD

Given the following linear programming model

Max z = 2x1 + 3x2

Subject to: x1 + x2 ≤ 100

4x1 + 8x2 ≤ 500

x1 , x 2 ≥ 0

Constraint Intercepts
x1 x2
x1 + x2 = 100 0 100
100 0
4x1 + 8x2 = 500 0 62.5
125 0
x1 + x2 = 100
4x1 + 8x2 = 500
1 1 100
4 8 500

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x1 = 75

x2 = 25

Now test the corners of the Feasible Region (FR) in the objective function and select the one that
maximizes z.

Example:

Given the following linear programming model, find the optimal solution.

i) Minimize C = 2x1 + 3x2

Subject to: x1 + x2 ≥ 100

4x1 + 8x2 ≥ 500

x1 , x 2 ≥ 0

ii) Maximize Z = 5x + 8y
Subject to: 2x + y ≤ 15
x + y ≤ 15
2x + 3y ≤ 18
x,y≥0

THE SIMPLEX METHOD

Steps that are taken to solve a linear programming problem using the simplex method are as follows:

1. Convert each inequality in the set of constraint to an equation by adding slack variables.
2. Create the initial simplex table
3. Select the pivot column which is the column with the most negative value element in the last row
4. Select the pivot row which could be the row with the smallest positive ratio
5. Use the ERO to calculate new values for pivot row so that the pivot element is 1
6. Using ERO to make the number in the pivot column equal to zero (0) except and the pivot number. If
all entries in the bottom row are zero or positive then you have reached the optimal solution.

Terms Definition:

Pivot Column – this is a column of the table representing the variable to be entered.
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Pivot Row – is the row of the table representing the leaving variable to be entered.

Pivot Number – is the element at the intersection of the pivot row and the pivot column.

Max Z = 70x1 + 50x2

4x1 + 3x2 ≤ 240

2x1 + x2 ≤ 100

x1 , x 2 ≥ 0

Converting the constraints into slack variables

Z = 70x1 + 50x2 + OS1 + OS2

4x1 + 3x2 + S1 = 240

2x1 + x2 + S2 = 100

x1 , x2 , S1 , S2 ≥ 0

Rewrite the objective function QF

Z = -70x1 - 50x2 - OS1 - OS2 = 0

Initial Table

Basic x1 x2 S1 S2 Solution Ratio

S1 4 3 1 0 240 = 60 R1 = R1 – 4R2

S2 2 1 0 1 100 = 50 Leaving Variable (Pivot Row)

R2 = R2

Z -70 -50 0 0 0 R3 = R3 + 70R2

Pivot Column

Entering Variable

Second Table

Basic x1 x2 S1 S2 Solution Ratio

S1 0 1 1 -2 40 40

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 x1 1 1 0 1 50 100 R2 = R2 - R1
2 2
Z 0 -15 0 35 3500 R3 = R3 + 15R1
Third Table

Basic x1 x2 S1 S2 Solution Ratio

x2 0 1 1 -2 40
x1 1 0 1 3 30
−
2 2
Z 0 0 15 5 4100

x1 = 30

x2 = 40

Z = 4100

THE TRANSPORTATION PROBLEM

The transportation problem seeks to minimize the total shipping cost of transporting goods from m sources to n
destinations, where the unit shipping cost from each source to each destination is known. The network
representation of a transportation problem with 2 sources and 3 destinations as follows:

2 sources 3 destinations

S1 D1

D2

S2 D3

To solve the transportation problem, it is required that the sum of supplies at the sources equal to the sum of
the demands at the destination.

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If the total supply is greater than the total demand, a dummy destination is added where demand is equal to the
excess supply and shipping cost from all sources are zero, similarly if total supply is less than total demand a
dummy source is added.

The 2 methods used to solve the transportation problem are:

i. North-West Corner Method

ii. Least Cost Method

Example:
Formulate a linear programming model for the following transportation problem and solve using the North West
corner method and the least cost method.

a) North West Corner Method

D1 D2 D3 Total Supply
S1 25 15 25 30 20

S2 30 20 40 10 35 30 10

Total Demand 25 0 45 70 10 80

Linear Programming Formulation

Let xij represent the amount of goods shipped from source to the destination Z cost

Minimise Z = 15x11 + 30x12 + 20x13 + 30x21 + 40x22 + 35x23

Subject to:

Supply constraints

x11 + x12 + x13 ≤ 50

x21 + x22 + x23 ≤ 30

Demand constraints

x11 + x12 = 25

x21 + x22 = 45

x31 + x32 = 10

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Non-negativity constraints

x11 , x12 , x13 , x21 , x22 , x23 > 0

Total Cost = 25(15) + 25(30) + 20(40) + 10(35)

= $2275

b) Least Cost Method

D1 D2 D3 Total Supply
S1 25 15 15 30 10 20 150
15 15 15
S2 30 30 40 35 30

Total Demand 25 30 100 80

Total Cost = (25*15) + (30*15) + (10*20) + (30*40)

= $2225

Dummy Situation

Unbalanced Transportation Problem/Model

In some instances it is possible that the total amount demanded does not match the total supply.

This can occur if there is either excess demand or excess supply.

Excess Demand

We introduce a dummy source (i.e. a fictitious factory) which caters for the excess demand.

The amount shipped from the dummy source to a destination represent the quantity shortage at the
destination.

It is necessary to specify the costs associated with the dummy source.

There are 2 situations to consider:

Part A

Since the source does not exist, no shipping from the source would occur, so the unit transportation cost
can be set to 0.

Part B

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 Alternatively, if a penalty cost, say P, is incurred for every unit of unsatisfied demand, then the unit
transportation cost should be set equal to the unit penalty cost.

INDEX NUMBERS

These are devices used to measure changes in an economic variable over time. The most common one is
one that measures price changes.

a) ONE ITEM INDEX NUMBERS

i. One-item-price-index/ price relative index

This index compares the price change for one item over two or more periods. The formula for its
calculation is:

= 100

Where: is the price relative index

is the unit price of an item in the current period

is the unit price of an item in the base period

Example:
If the price of a TV set was $200 last month, and $330 this month, and suppose last month is the base
period, then:

$330
= 100 = 165
$200

This means that from last month, the price of bread has gone up by 65%.

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ii. One-item-quantity-index/ quantity relative index

This index compares the quantity change for one item over two or more periods. The formula for its
calculation is:

= 100

Where:
is the quantity relative index

is the quantity in the current period

is the quantity in the base period

Example:
If Elisha bought 24 bottles of wine for his birthday party in 2004, and 36 bottles of wine in 2006, the
quantity index for wine (a single item) would be:

= 100 = 150. Therefore the quantity of wine has gone up by 50%.

b) UNWEIGHTED AGGREGATIVE INDICES

The word “aggregative” suggests the “summation” and this relates to the summation of a number of
prices for the current period, which is then compared to the summation of the prices in the base year.
Which means we are now considering several items at a go, rather than one item.

i. The unweighted aggregative price index

∑
= 100
∑

Where is the unweighted aggregative price index

ii. The unweighted aggregative quantity index

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 ∑
= 100
∑

Where:
Where is the unweighted aggregative quantity index.

NB: The base period is usually assigned the value of 100, i.e. the base period has an index of 100.
Example:
During 2004 and 2005, a senior bachelor bought the following quantities of rice, sugar and mealie meal:
2004 2005
Price/kg Quantity (kg) Price/kg Quantity (kg)
Rice $200 20 $400 30
Sugar $250 40 $600 50
Mealie Meal $50 80 $125 90
TOTAL (Σ) $500 140 $1,125 170

[2004=100]
(That is 2004 is the base year)
To compute the unweighted aggregative price and quantity indices we proceed thus:
$1125
= 100 = 225
$500
Thus there is an increase by 125% in aggregate prices from 2004 to 2005.
$170
I = x 100 = 121.43
$140
Thus the aggregate quantity consumed in the current year is 21.43% higher than in the base year.

c) WEIGHTED AGGREGATIVE INDICES

i. The Laspeyres Price Index

This is a base year quantity-weighted index. It seeks to compare base year quantitiesat current year
prices to base year quantities at base year prices.
∑
= 100
∑

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 ii. The Laspeyres Quantity Index

Prices are now kept constant and the quantities vary. It seeks to compare base year prices at current year
quantities against base year prices at base year quantities.
∑
= 100
∑

iii. The Paasche Price Index

This compares the price of the new quantities against the old and the new prices.
∑
= 100
∑

iv. The Paasche Quantity Index

This compares quantities of the new prices against the old and the new quantities.
∑
= 100
∑

FISCHER`S IDEAL INDEX

The geometric average of Laspeyres and Paasche`s price indices is called Fischer`s price index. It uses
both current year and base year quantities as weight. This index corrects the positive bias inherent in the
Laspeyres index and corrects the negative bias inherent in the Paasche index.

Fischer`s price index is also a weighted aggregative price index because it is an average of two weighted
aggregative indices.

The computational formular for the Fischer ideal price index is:

∑ ∑
= 100
∑ ∑

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 CALCULUS

In business, we often deal with scenarios that involve the interplay of two or more variables, in which case
the variables could either be dependent or independent. The movement in one variable could have an
adverse, favourable or no effect at all, on the other variable(s). The behavior of each variable in a business
context will translate to either a loss or a profit or breaking-even, hence the need to study relationships
among variables. In this course, we will look at relationships between two variables and later consider
relationships among several variables.

The most basic relationship in business is that of quantity sold and profit. Depending on the product or
service in question, there’s often a direct relationship between these two variables. As the quantity sold
increases, it is expected that profit will also increase. However, profit may be capped by the fact that it

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could be impossible to increase quantity beyond a certain point. Under what circumstances would it be
impossible to increase quantity? What strategies can a business manager employ to increase quantity?
Remember, the whole idea in business is to make profit. There are several variables that affect profit e.g.
cost of sales, price, market share, etc. hence the need to constantly watch the behavior of each of these
variables. The manager would need constant feedback on these relationships in order to make decisions
that result in a profit at the end of the day.

In this section, we wish to ascertain the extent to which a change in one variable affects the other (bi-
variate case) or where a change in one of several variable effects other variables (multi-variate case). Thus,
where a company or organization can model its costs, profits, revenue, productivity etc., the effect of
increasing or decreasing the volume of units produced and sold on total cost, total profit or total revenue
can be assessed using calculus techniques. This enables the company executive can decide on the basis of
a computation, whether a decision to increase or reduce the volume or number of units produced and sold
would be beneficial and determine the quantitative effect of such a decision on cost, profit or revenue.

Calculus provides the best technique for studying rates of change. It involves two processes, namely
differentiation and integration. Differentiation is process used to calculate the gradient of a curve, i.e. the
rate of change. Integration is the opposite process to differentiation and is often used to find the area under
a curve.

DIFFERENTIATION

Using the differentiation technique, we are able to find the average rate of change along a portion of the
curve as well as the instantaneous rate of change at any point on the curve.

Average Rate of Change

This is the rate of change of a function between any two points along the curve. It is abbreviated as ARC
henceforth.

Given a function ( ), a change in the value of the function attributed to a change in the value of ,
from to + , as shown below:

( + )

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 ( )

∆ (delta i.e. change in )

The average rate of change (ARC) is simply the gradient of the slope.

( )
ARC =

( ) ( )
=

Example 4.1:

A company has determined that the total cost (in dollars) of manufacturing units of a product is given
by:

C( ) = + 0.5 + 5000 0≤ ≤ 150

Determine the ARC in total cost as the number of units of products manufactured is increased from 60 to
65.

Solution 4.1:

= 60 + = 65

( )
Therefore, ARC =

( ) ( )
=

. ( ) [ . ( ) ]
=

= $125.50

Therefore, the total cost of production would increase by an average of $125.50 for each of the 5 additional
units (above 60).

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Example 4.2:

If we wish to analyse several possible changes in production level, it would be advantageous to develop a
general function describing the average rate of change in total cost beginning at any specific production
level and involving any specified change in production level .

( ) ( ) ( )
=

( ) . ( ) [ . ]
=

= 2 + + 0.5

Try for = and + =

Solution 4.2:

Finding ∆ , + = 65

Then, 60 + = 65

Therefore, = 5

Since = 2 + + 0.5

Then, = 2(60) + 5 + 0.5

=$ .

Exercise

Find the equation describing the ARC from = to = + for each of the following functions
and evaluate the ARC over the intervals specified.

1. ( )=4 +7 a) from x=3 to x=5

b) from x=6 to x=10

2. ( ) = 10 – – a) from x=0 to x=2

b) from x=1 to x=3

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3. ( )= a) from x=1 to x=3

b) from x=1 to x=4

Instantaneous Rate of Change

It is a rate of change of a function not over an interval of finite length but at a point. It is abbreviated as
IRC henceforth.

The Delta Process

This is a step-by-step procedure for finding the IRC of a function f. The steps are:

1. Compute ( + ) by substituting ( + ) for in the defining rule of the function

2. Compute the difference ( + ) – ( ) and simply the expression. The result is ( )
3. Divide ( ) by
4. Take the limit of ( )/ as → 0, if the limit exists.

Example 4.3:

Use the Delta process to find the expression that describes the IRC of ( ) =

( +∆ )− ( )=( +∆ ) −

( + ∆ ) − ( ) = ( + ∆ )( + ∆ ) −

( + )− ( )= +2 + ( ) –

∆ ( ) = 2 ∆ + (∆ )

( ) ( )
=

= 2x + Δx

( )
Therefore, lim =2
→

Example 4.4:

Use the delta process to derive the function of the instantaneous rate of change for the following:

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1. f(x) = 2x2 + 5
2. f(x) = 3x2
3. f(x) = x2 – 1
4. f(x) =

5. f(x) = 2x2 + 3x + 1

DIFFERENTIATION

The Derivative

The derivative of a function f is that function, commonly denoted f ′′ , whose function value of any x in the
domain of f is given by:

( )
′( ) = lim , if the limit exists
Δ →0

Notation

, ′ , ′( ) , y′ , ,

If the derivative function is to be evaluated at any specific x = a; it may be denoted as:

x=a

The process of determining the derivative of a function is termed differentiation.

The limit as → 0, (read it as: the limit as delta approached 0) may exist for some values of x of a
function and fail to exist for others.

At each x where this limit does exist, the function is said to be differentiable.

For a derivative to exist at a specific value of x, the function must be smooth and continuous at the point.

The continuity requirement dictates that there can be neither a point missing nor a vertical gap nor an
infinite discontinuity in the function at that point.

NB: If a function is not continuous at a point, it cannot have a derivative at that point.

Differentiability also requires that the function must be smooth at the point x = a

The smoothness requirement dictates that there can be no abrupt change in direction at x = a and no sharp
corners at x = a.

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 a x a x

′( ) does not exist because is not continuous at .

a x a x

′( ) does not exist because is not smooth at .

RULES OF DIFFERENTIATION
Rule 1

The derivative of a constant function is zero.

If ( ) = , where k is any constant, then ′( ) = 0

Example 4.5:

( ) ( )
If ( ) = 5; we have ′( ) = lim
→

= lim
→
5

= 0

Rule 2

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The derivative of a variable raised to the constant power , where is any real number and ≠ 0, is equal to
the power multiplied by the variable raised to the power − 1

( )
If ( ) = , then =

Example 4.6:

Find the derivatives of:

a) ( ) = √
b) ( ) =
c) ( )=
d) ( )=
e) ( ) = 1000
f) ( ) = −1 000 235

Rule 3

The derivative of a constant times a function is the constant times the derivative of the function if it exists.

If ( ) = ( ); then ′( ) = ′( )

Example 4.7:

Find the derivatives of:

a) ( )=5
b) ( )=7

c) ( )= −

d) ( ) = 2√ − 11 √

Rule 4

The derivative of the sum (or difference) of 2 functions is the sum (or difference) of their respective derivatives if
these derivatives exist separately.

If ( ) = [ ( ) ± ℎ( )], then ′( ) = [ ’( ) ± ℎ′( )]

Example 4.8:

a) A factory is dumping chemical waste into a stream such that the total quantity of waste G (in tons)
having been dumped into the stream after t weeks is given by:

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 ( ) = 0.1 2 + 1.5

At what rate is the amount of waste increasing at the end of 3 weeks?

b) A firm has estimated that L workers on a production line will produce Q units per day where:

( ) = 80 − 0.1
At what rate is the output increasing when 100 employees are engaged?

Rule 5: The Product Rule

If ℎ( ) = ( )· ( ) then, ℎ’( ) = ′( ) ( ) + ( ) ′( )

Example 4.9:

Find the derivative of ℎ( ) = (2 2 + 4 )( 2 + 5 ) and

ℎ( ) = (3 + 1)(3 ) and
ℎ( ) = √ (7 − 2 √ + 5 − 9)

Rule 6: The Quotient Rule

( ) ( ) ( ) ( ) ( )
If ℎ( ) = ( )
then, ℎ′( ) = [ ( )]

Example 4.10:

Find the derivative of ℎ( ) = and

ℎ( ) = and
√

Rule 7: The Chain Rule

If ℎ( ) = [ ( )] , then, ℎ′( ) = [ ( )] − 1 · ′( )

Example 4.11:

If h(x) = [4x2 + 6x]5 , find the first derivative of h.

(
Find the derivatives of, ℎ( ) =
ℎ( ) = (5√ )(7 −3 )

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CURVE SKETCHING

Stating intervals along the number line

[a,b] a≤x≤b

(a,b] a<x≤b

(-∞,a) -∞< x < a

(a,∞) a<x<∞ etc.

Steps to Curve Sketching

1. Take the derivative

2. Set the derivative = 0 and solve for x

Example:

Make a rough sketch of ( ) =

We know that, ′( ) = 2

Equate derivative to zero, 2 =0

Solving for gives, =0

This means that the graph of turns at the point when =0

NB: For any quadratic equation, we consider the coefficient of the term where the unknown has a power
of 2. If that coefficient is positive, then the graph will be facing upward, which means that there is a
minimum point. If the coefficient is negative, the graph will be facing downward which means that there
is a maximum point.

This can be proved through differentiation. Find the derivative of the function at any point to the right of
the turning point as well as any point to the left. Consider the symbols of the derivatives. Below is a
summary of this exercise for the function ( ) =

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-ve slope 0 +ve slope

Minimum is at x = 0

Therefore minimum value of is (0) = 0 = 0

y = x2

f is decreasing at (-∞ , 0) and increasing at (0 , +∞)

NB: When we have several minimum values, these are known as minima

The equivalent for a function with a maximum value, the plural is maxima

These minima and maxima are ‘extreme values’

Example:

Sketch the following graphs:

1. ( ) = −
2. ( ) = – 18 + 12

MARGINAL ANALYSIS

The word marginal is used in economics to refer to the impact of one additional (extra) unit of output on
other economic variables. As we have seen already, differentiation allows us to observe the effect of
infinitely small changes in the independent variable on the dependent variable, ( ). With this in mind,
we are going to analyse the effects of marginal changes to cost, revenue and profit functions.

When given the total cost, total revenue and total profit functions, once differentiated we will obtain
marginal cost, marginal revenue, marginal profit functions.

The relationship between Cost and Revenue Functions

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The Relationship between Unit Price and Quantity

Suppose that p is the unit price and q is the quantity or number of units produced, then total revenue is
modeled as:

= (unit price x quantity produced and sold)

Generally, R(x) is used in place of , which would be the total revenue generated from the sale of x units.

C(x) would then be the total cost associated with the production and sale of x units of product.

= −

( )= ( )− ( )

This then sets the stage for marginal analysis.

Marginal Cost

It refers to be extra or incremental cost of producing an additional unit of output.

If ( ) = during some specified period of time, then:

′( ) = x, i.e. the rate of change in total cost with respect to

an incremental change in the level of output.

Example 4.:

A manufacturer of automobile wheels finds that its total cost of producing units of product is given
by:

( ) = 0.001 − 0.21 + 40 + 1000

Determine the marginal cost when the level of production is = 50

NB: Remember that the constant term in the cost function represents fixed costs, the costs that do not vary
with the quantity produced. For example, the fixed costs in this function are $1 000. All terms that have
give us the variable costs of this manufacturer.

Solution

′( ) = 0.003 − 0.42 + 40

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When x = 50

′(50) = 0.003(50 ) − 0.42(50) + 40

=$ .

This is the cost of producing the 51st unit (approximately).

Compare with doing the computation the long method which is not examinable in this course.

In general, ′( ) ≈ ( + 1) − ( )

(50) = (51) − (50)

(50) ≈ (0.001 ∗ 51 − 0.21 ∗ 51 + 40 ∗ 51) − (0.001 ∗ 50 − 0.21 ∗ 50 + 40 ∗ 50

(50) ≈ 2626.441 − 2600

(50) ≈ $26.44

NB: You may use the long method only to test your answer but it is not examinable.

Marginal Revenue

This is the amount of revenue generated by the sale of an additional unit of output.

R(x) = Total Revenue realized from the sale of units of a product.

R′(x) = Marginal Revenue

Example 4.:

The revenue, in dollars, realized by a firm when units of a product are produced and sold is given by:

( ) = 15 − 0.01

Determine the marginal revenue function and evaluate marginal revenue when x = 400

Marginal Profit

This is the amount of profit earned at the sale of an additional unit of output.

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 = –

( )= ( )– ( )

′( ) =

Example 4.:

The profit function of a firm is given by:

( ) = −0.1 2 + 80 − 5000, where is the number of units of the product produced or sold and
( ) is profit in dollars.

i) Determine the marginal profit function.

ii) Evaluate marginal profit at x = 300 and interpret it fully.

NB: in the relationship: P(x) = R(x) – C(x), taking the derivatives of both sides gives

′( ) = ′( ) − ′( )

To maximize profit, we set ′( ) = 0

0 = ′( ) − ′( )

Hence, ′( ) = ′( )

i.e. Marginal Revenue = Marginal Cost when profit is maximum.

Example 4.

A monopoly faces the demand schedule = 460 − 2

and the cost schedule = 20 + 0.5

How much should it sell to maximize profit?

Solution:

= = (460 − 2 )

( ) = 460 − 2

We are given that, ( ) = 20 + 0.5

27 | P a g e
Now find ( ) ′( ), and the equate them.

Total Cost, Average Cost and Marginal Cost

Let ( )=

( )
c( ) = NB: small letter c represents average cost

To find the minimum average cost, we must take the derivative of ( ) and set it equal to zero and solve
for (the number of units that must be produced and sold to minimize average cost).

( )
Using the quotient rule to differentiate, c( ) =

[ ( )∙ ] [ ( )∙ ]
we obtain, ′( ) =

( ) ( )
( )= =0 (then numerator must be 0)

therefore, ’( ) − ( )=0

( )
which means that, ′( ) =

It has been shown that the average cost is minimum when MC = AC

Therefore, MC = MR = AC when average cost is minimum or when profit is maximum.

Example 4.

When will average variable cost be at its minimum value for the following TC function:

= 40 + 82 − 6 + 0.2

Solution:

Find the MC by differentiating TC

Then find AC by dividing VC by

Equate the two functions and solve for

Exercise

28 | P a g e
 1. If = 0.5 − 3 + 25 + 20, derive functions for
a)
b)
c) The slope of the
2. What is special about if = 25 + 0.8 ?
.
3. If = 65 + , what is when = 25. Interpret your results fully.

PARTIAL DERIVATIVES
Partial derivatives are used to analyse the effect of changes in multi-variate cases. What is the effect on
the dependent variable of changes in one of the several independent variables ceteris paribus, i.e. while
the other independent variables are held constant? For example, given that income (GDP) is a function of
consumption, investment, government expenditure and net exports, we might want to assess the extent to
which income responds to changes in investment hence the need to hold consumption, government
expenditure and net exports constant.

There are several applications of partial derivatives in economics, namely elasticity of demand, marginal
utility, marginal product of capital, marginal product of labour, marginal rate of substitution and Euler’s
theorem. In this course we will only apply partial derivatives in production and cross-price elasticity of
demand.

Quite often we have to assess the effect of charges in one of the several independent variables on the
dependent variable. For a function such as ( , ) each of the variables, and can be varied
independently of the other. One variable may be set at some fixed value and the other variable allowed to
vary in order to study the net effect of changes on the dependent variable.

Notation:

( , ) ( , ) etc.

The differentiation rules used previously are used here, but for one variable at a time, all other variables
temporarily being treated as constants.

Example 4.:

( , )=3 + +5

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 =3+ = +5

Exercise

Find the partial derivatives of

( , , )= +5 + 10 +4

( , ) = 10 +6 + 10

Example 4.:

The number of units of output for a firm (in units per day) depends of the number x of units of labour used
on that day and the number y of units of machine time that are used. The production function is given by:
( , )= +6 + 1.5

i) Find the marginal productivity of labour when 40 units of labour and 50 units of machine time are
used:
(40,50) = 2(40) + 6(50) = 380

i.e. if labour units used were held constant at 40, while the number of machine time units was
increased from 50 to 51, the total output would be increased by approximately 390 units.

ii) Find the marginal productivity of machine time when 40 units of labour and 50 units of machine
time are used.

COMPLEMENTARY AND SUBSTITUTE GOODS

When studying cross price elasticity of demand in economics, we encounter complementary and substitute
goods. The former are goods that are jointly consumed and the latter are alternatives to each other.
Basically, cross-price elasticity of demand measures the responsiveness of the quantity demanded of one
good to a change in price of the other. For example, how does a change in car prices affect the demand
for bicycles? How does a change in bread prices affect the demand for margarine?

Given a quantity demanded function expressed in terms of the prices of the goods;

if < 0 and < 0

then goods A and B are complementary goods.

30 | P a g e
However, if > 0 and > 0

Then goods A and B are substitutes are competitive.

Example:

1. If = ( , )

= 800 − +5

and = ( , )

= 400 + 3 − 15

Determine if goods A and B are substitutes or complementary.

DECISION-MAKING IN BUSINESS

The business environment is dynamic and competitive. It is imperative for a business manager to stay ahead of
the pack or constantly adapt to change. This entails making decisions in the shortest possible time. Therefore, it
is vital to collect relevant information in order to make a smart decision and a good business decision for that
matter. Information sources are varied and the manager need only concern him/herself with the relevant
information. It is important to know what information is required to make a capital investment versus and such
information will be different from that required for an operations decision.

Foreknowledge and superior forecasting techniques will enable the manager to use the relevant and most
updated information to make a good business decision. However, most business decisions are taken under
circumstances where the manager has limited information and/or is uncertain of all possible outcomes.

Several strategies and techniques have been developed by scholars from all over the world in an attempt to make
decision making easier and prompt. Technological advancements in this regard include management information
systems and applications software that can be adapted to suit different business environments.

Decision-making techniques used in business include the break-even analysis, preference matrix, decision trees,
expected value among other decisions theory models. In this course we are going to look at the Break-even
Analysis and Expected Value Criterion.

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 BREAK-EVEN ANALYSIS

This is an accounting cost-volume analysis tool which considers the costs and revenue of a project or product and
attempts to find the point where total costs are equal to the total revenue. This point shows the number of units
that should be produced and sold in order to cover the total costs of the business and it follows that the actual
number of units produced should be higher than this number in order to make a profit. Total costs are a product
of fixed costs and variable costs. Fixed costs are cost that the business will incur before and in order to engage in
actual production. Fixed costs (FC) do not vary with the quantity of units produced e.g. rent, fixed telephone
charges etc. Variable costs per unit (VC) are costs that vary directly with the quantity of goods produced e.g. the
more units we produce the more man hours, raw materials etc. are required. The total variable cost (TVC) is the
product of variable costs and quantity. Fixed costs plus variable costs give us the Total Costs (TC). The selling price
per unit should be know before the analysis can be performed so that we can calculate the Total Revenue (TR) by
multiplying the selling price (P) by the quantity sold (Q).

In its simplest form, the break-even point is given by: =

Which can also be expressed as: × = +

The break-even analysis is useful in that:

 It tells us if the estimated sales volume will enable the firm to break-even, i.e. neither make a loss nor profit.
 It helps us compute the amount of fixed costs that will enable us to break-even using current prices and unit
costs.
 It enables to calculate the amount of variable costs that will enable the business to break-even using current
prices and unit costs.
 It also reveals the effect of prices on the break-even volume
 Non-linear break-even analysis gives a range within` which the company should maintain the quantity
produced in order to make profit. If the volume produced falls outside this range the business will make a loss

The break-even point can be found by using the arithmetic method or the graphical method.

LINEAR BREAK-EVEN ANALYSIS

This analysis is used when the profit function is linear, i.e. there are no exponents (powers). This is the simplest
form of break-even analysis.

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 =

which can also be expressed as: = +

Since = ∗ and = ∗

it follows that: ∗ = +( ∗ )

making the subject of the formula =

Example:

A business manager wants to find the break-even quantity of a new product which is expected to sell at $10 per
unit. The fixed costs are $20 000 and the variable costs are $1.50 per unit.

Arithmetic Approach

= 20 000

= 1.50

= 10

Therefore, =
.

= 2352.941

This means that the manager should produce 2 353 units in order to break-even. If the manager decides to
produce fewer than 2 353 units, the company will make a loss and if more units are produced, a profit will be
realized.

Graphical Approach

Plot the TR, TFC and TC graphs on the same axis i.e. y-axis for Money ($) and x-axis for Quantity (Q). The point of
intersection of TR and TC is the breakeven point. Read the quantity, or x-coordinate of that point as the final
answer. The y-coordinate gives the price at which the business will break-even.

Price ($) Total Revenue

Profits

33 | P a g e
 Total Costs

BE Price

Total Fixed Costs

Losses

BE Quantity Quantity

NB: Always round-up to the nearest whole number when using the break-even approach.

There is unlimited profit in this scenario as the graph is open-ended at the top, after the break-even quantity has
been exceeded. If the company produces below the break-even quantity, then it will incur losses as much as TC
exceeds TR.

Deciding between 2 Alternatives

If the company has 2 mutually exclusive new products, projects or other business options, a decision has to be
made as to which one the company will engage in since it cannot take up both options. For example, deciding
between outsourcing or producing in-house. The break-even analysis will help the manager decide which option
to take by identifying the quantity at which the total costs of each of these options is equal. The forecast volume
will then be used to determine the option with lower costs for that quantity.

1− 2
Arithmetic Approach - − =
2− 1

The substitute the forecast volume into each cost function and select the option with lower total costs.

Graphical Approach - plot the TC graphs of the two options on the same axis. The break-even point is the point of
intersection of the two graphs. Then plot the vertical line representing the expected demand (forecast volume)
and this line must touch both TC graphs. By observation, identify the option with a lower cost at that volume and
chose that option.

Costs ($) Total Cost for Product A

Total Costs for Product B

34 | P a g e
 Break-Even Expected Quantity
Quantity Demand

Product B has a lower cost of production at the expected demand level hence it must be chosen over product A
since the company seeks to minimize costs.

It follows that if the expected demand falls below the break-even quantity, then both products are unprofitable
for the company. The expected demand is only meaningful if it lies to the right of the break-even point.

Example:

A firm has the choice of 2 machines; machine A will give a fixed cost of $20 plus $1 per unit for 100 items produced.
Machine B, on the other hand, has no fixed costs but will incur variable costs at a rate of $1 multiplied by the
square often number of hundreds of items produced. At what output does machine A become cheaper than
machine B?

Exercise:

At what point should a manager be indifferent about buying special uniforms for staff from a supplier or have the
staff make them?

Buy Make
Fixed Costs $0 $300 000
Variable Costs $9 $7

NON-LINEAR BREAK-EVEN ANALYSIS

It is common for the profit function to be given in the form of a quadratic function. In this case, the arithmetic and
graphical methods can be used to determine the break-even point. The non-linear break-even analysis not only
shows the point at which the company starts making profit but also the cut-off point for making profit.
Arithmetically, the equation will be solved to give us 2 different quantities, the lower being the strict break-even

35 | P a g e
point and the higher being the break-even cut-off. To find the point of maximum profit we must find the maximum
point of the profit function and substitute that quantity into the profit function.

The graphical method will give a parabola which is open downward and would cut the break TC graph at 2 points.

Price ($)

Total Costs

Total Revenue

BE Price Total Fixed Costs

Strict BE BE Cut-off Quantity

Since the TR graph is a parabola, it cuts the TC graph at 2 point, the lower being the strict break-even point.

If the manager decides to produce more units that the second point, the break-even cut-off, then the company
will start making losses. The non-linear break-even point therefore gives a range of quantity to be produced in
order to make a profit unlike the linear breakeven which only gives us a single point and unlimited profit potential
for the firm or limited loss potential. The profits are maximized at the turning point of the parabola, i.e. the
distance furthest from the TC graph.

If the manager decides to produce a quantity that is greater than the breakeven cut-off point, then the firm will
make losses. The same is true if the level of production is below the strict break-even point.

Example:

= 9.99

= 45 000 + 6.99

Find the break-even quantity if:

a) Overheads increase by 15%

b) Costs increase by $1.50 per item
c) The selling prices increases to 11.99

Exercise:

36 | P a g e
 1. A firm has analysed its sales and probability and found that its profit can be expressed as:
= −100 + 100 − 5
where is profit ($000s) and is the number of units sold (in 000s)
It has also been found that its costs are:
= 100 + 2
where is costs ($000s)
a) Obtain a third equation showing the firm’s revenue, TR.
b) Using a graph, determine the number of units the firm should sell to maximize profit
c) What will the firm’s costs be at the profit-maximising level of sales.
d) At what quantity should the firm stop production?
2. A firm finds that the demand for its products is given by:
= 1 000 − 5
where is the number of units demanded by customers and is the selling price per unit
a) Construct a graph for a price between 0 and 200.
b) Comment on the shape of the graph. Why does the line slope downwards?
c) If we define revenue as the quantity sold multiplied by the price, obtain an equation for revenue.
d) Draw a graph of this revenue equation.
e) What price should the firm charge in order to maximize revenue?
3. A firm has fixed costs of $500 and a variable cost of 50c per item. It sells its product at a price of 80c per
item, regardless of the number sold. Draw a graph to find the point at which the firm beaks even.
4. The average unit production cost for a run of 6000 units is $5. The variable production cost consists of the
cost of raw materials ($2.50 per unit) and wages ($1.50 per unit). The item sells for $6.50 was the run of
6000 units less than or higher than the break-even point?
5. Sales of an item are slower than expected. Lowering the selling price is likely to increase sales and hence
output. The manager refuses to do this since output has not yet reached the break-even point. Why is his
reasoning faulty?

EXPECTED VALUE CRITERION

There are three distinct decision-making environments in business namely decision making under certainty, under
uncertainty and under risk. Decision-making under certainty refers to a scenario where the possible outcomes are

37 | P a g e
known for certain and the manager needs to simply choose the one that is most favourable. Decision-making
under uncertainty refers to a scenario where the probabilities of the possible outcomes are unknown. However,
in decision-making under risk the probabilities are known. In this course we will focus on the expected value which
uses given and known probabilities to either maximize gains or minimize losses in a risky environment.

Let us assume that a business manager needs to decide to produce one of 2 mutually exclusive strategic
alternative e.g. products, plants, etc. Mutually exclusive means that it is impossible to engage in both alternatives
simultaneously; you can only adopt one alternative at a time. The manager has 3 options, produce either product
A or product B or produce neither. The decision has to be made after taking into consideration all possible states
of nature e.g. the market could be favourable or unfavourable. The probabilities of the different states of nature
(all possible outcomes of a random variable) should add up to 1. (Hint: always verify that the sum of all
probabilities in a problem is equal to one). Further, the manager needs to have the estimated payoffs for each
alternative under each of the given market conditions.

The expected value is a weighted sum of all possible payoffs for each alternative strategy.

= [( 1 )×( 1 )]
+ 2 × 2
+ 3 × 3 +⋯
+[ × ]

where is the last state of nature

Once the information has been tabulated, it will be possible to compute the expected values per strategy as
shown below:

State of Nature
Favorable Market Unfavourable Market Expected Value
ALTERNATIVE ($) ($) ($)
Product A 200 000 -180 000
Product B 100 000 -20 000
Do nothing 0 0
Probabilities 0.50 0.50

38 | P a g e
To find the expected value for each product, we follow the expected value formula:

( ) = (200 000 ∗ 0.50) + (−180 000 ∗ 0.50) = 10 000

( ) = (100 000 ∗ 0.50) + (−20 000 ∗ 0.50) = 40 000

( ℎ ) = (0 ∗ 0.50) + (0 ∗ 0.50) = 0

Fill in the EV column with these solutions.

Decision Criterion: Select the alternative with the highest Expected Value.

In this case, the manager will select to produce Product B because it has the highest EV of the 3 alternatives at
hand. In the case, the manager seeks to maximise income. It is very important to understand the question in order
to respond appropriately. Pay close attention to what is being asked.

NB: The probabilities always relate to the different states of nature.

Example:

An investment manager has 4 possible investment avenues; namely gold, bonds, stocks and a savings account.
The manager must choose the investment alternative that will earn his client the largest return given the following
states of nature (projections of market movements):

( ) = 0.225

( ) = 0.315

( ℎ ) = 0.275

( ) = 0.095

( )=

a) Find the probability of a large fall in the market.

b) Given the following pay-offs, as the client, how much do you stand to lose if the investment manager opts
for gold instead of stocks?
Large Rise Small Rise No Change Small Fall Large Fall
Gold -100 100 200 300 0
Bonds 250 200 150 -100 -150
Stocks 500 250 100 -200 -600

39 | P a g e
 Savings Account 60 60 60 60 60
c) Which alternative has the highest pay-off?
d) Under what circumstances would a client opt for a savings account?

Exercise:

1. The Campus Bookstore manager wishes to determine the number of QAB textbooks to order for next
semester’s class. The manager has come up with 3 possible alternatives 280, 340 or 400 textbooks. The
manager has been reliably informed that the university could offer 2, 3, 4 or 5 QAB classes next semester.
After making some calculations, the manager arrived at this pay-off table showing profit under each of
the 4 states of nature.
State of Nature
2 classes 3 classes 4 classes 5 classes
ALTERNATIVE offered offered Offered offered
280 2800 2720 2640 2480
340 2500 3100 3320 3160
400 2200 2800 3400 4000
Probability 0.1 0.4 0.3 0.2

Determine the number of textbooks that the manager should purchase in order to maximize the store’s
expected profit.
2. A local retailer must decide whether or not to introduce a special candy bar for Christmas. The following
table shows the pay-offs as determined by management.
State of Nature
10 000 units sold 40 000 units sold 70 000 units sold
ALTERNATIVE
Introduce new candy -100 000 50 000 150 000
bar
Do not introduce -20 000 -20 000 -20 000

a) Given that the probabilities of selling 10 000 and 70 000 units are 0.34 and 0.185 respectively, find
the probability of selling 40 000 units.

40 | P a g e
 b) Using the Expected Value criterion, determine if the company should introduce the candy bar for
Christmas.
3. A local athlete, Gumede, is being considered by Zeus Apparel for 3 endorsement alternatives; namely Plan
I, II and III. Under Plan I, Gumede will work exclusively for Zeus Apparel, under Plan II he will work for

Zeus semi-exclusively and in Plan III he will be a Zeus-sponsored athlete. Zeus management has prepared
the following pay-off table which shows the profits and losses that could accrue to the company under
each plan. The states of nature are the potential outcomes facing the athlete at the Olympic Games as
these have a direct bearing on endorsement profits for Zeus, based on previous advertising campaigns
involving Olympic medal winners.
State of Nature
ALTERNATIVE Gold Medal Silver Medal Bronze Medal No Medal

Plan I 100 000 20 000 10 000 -20 000

Plan II 60 000 40 000 20 000 -5 000

Plan III 15 000 10 000 5 000 0

Further, sports experts have predicted that Gumede has a 35% chance of winning gold, 22% for silver and
17% for bronze.
a) Calculate Gumede’s probability of not winning a medal at the Olympic Games.
b) Construct an Expected Value table and complete it showing the expected values for each
endorsement plan.
c) Which endorsement plan should Zeus management select?

41 | P a g e
 FINANCIAL MATHEMATICS

This is a branch of mathematics that deals with computations in banking and finance. Several mathematical
concepts are used in these disciplines e.g. decomposing functions, asymptotic functions, percentages, to name a
few.

TIME VALUE OF MONEY

You must be familiar with the phrase, ‘A dollar today is worth more than a dollar tomorrow’.

This is because money has a value that is relative to time. As a supplier, you wish to be paid cash today rather than
accept credit, a promise to make a payment in the future. That is why credit comes with interest, the price of the
opportunity cost of foregoing the use of the more a valuable dollar today. Hence money has a present value and
a future value based on the interest rates being charged.

Interest

It is the price or cost of using borrowed money or a reward for making an investment.

In any economy, there are surplus and deficit unit. A surplus unit is a person or institution or company that has
excess funds they do not require for use in the near future hence they wish to save. A deficit unit is the person or
institution or company that is need of funds and therefore they wish to borrow. Interest is the reward earned by
a surplus unit when they lend. Interest is the amount paid by the deficit unit for using borrowed funds.

42 | P a g e
Interest rates are set by the monetary authority, i.e. the Reserve Bank of Zimbabwe in our case. They are given in
the Monetary Statements as determined by the Monetary Committee. The interest rates are a tool that is used to
control money supply. High interest rates generally deter investment while low interest rates encourage
investment and consumer spending. The interest rates affect the demand for interest-sensitive commodities such
as consumer durables e.g. household furniture, cars etc.

Simple Interest
Simple Interest is the interest paid only on the initial investment. This means that throughout the loan period, the
interest calculation will be based on the principal amount. In other words, the principal is not combined with the
interest in the first period to form the principal for the next period.

( )=

where: P = principal (original loan amount)

r = annual rate of interest

t = time in years

Example 6.1: Invest $2000 for 5 years at 1,5% per annum

Year 1 : Interest = $2000 x 1.5% x 1 = $30 A = $2000 + $30 = $2 030

Year 2 : Interest = $2000 x 1.5% x 2 = $60 A = $2000 + $60 = $2 060

Year 3 : Interest = $2000 x 1.5% x 3 = $90 A = $2000 + $90 = $2 090

Year 4 : Interest = $2000 x 1.5% x 4 = $120 A = $2000 + $120 = $2 120

Year 5 : Interest = $2000 x 1.5% x 5 = $150 A = $2000 + $150 = $2 150

We can see that the interest earned is increasing by $30 per annum since it is based on a constant principal
amount. Consequently, the amount attained at the end of the investment period, A, is also increasing by $30 per
annum.

The following formulae will help handling any simple interest calculation.

Interest = Principal * Rate * Time

A = Principal + Interest

A = P + Prt

43 | P a g e
where: A = Amount received at the end of the investment period

Example 6.2:

Suppose you invest $1000 at 10% per annum for 5 years, how much money will you receive at the end of the 5
years?

A = P + Prt simplifying the RHS gives

A = P(1 + rt)

A = $1000 (1 + (0.1*5))

= $1500

Compound Interest
Interest is said to be compound interest if it is calculated based on the principal and interest earned in previous
periods. It is often called interest on interest. For example, the interest earned in the 1st period is added to the
principal before calculating the interest for the 2nd period.

Example 6.3: Invest $2 000 for 5 years at 1,5% per annum

Year 1: A = P(1 + )

= $2 000(1 + 0.015)

= $2 030

Year 2: A = P(1 + )

= 2 030(1+ 0.015)

= $2 060.45

Year 3: A = P(1 + )

= 2 060.45(1 + 0.015)

= $2 091.36

44 | P a g e
Year 4: A = P(1 + )

= 2 091.36(1 + 0.015)

= $2 122.73

Year 5: A = P(1 + )

= 2 122.73(1 + 0.015)

= $2 154.57

Example 6.4:

Suppose an amount P is invested at compound interest % per annum for ‘ ’ interest periods. Find the sum or
amount at the end of the 1st year, second year, third year …….. th
year.

Solution:

End of year 1

S1 = P(1 + )

= P+P

= P(1 + )

End of year 2

S2 = P(1 + ) + P(1 + )

= P(1 + )2

End of year 3

S3 = P(1 + )2 + P(1 + )

= P(1 + )3

End of year

45 | P a g e
 = ( + )

Making the subject of the formula, (NB: ignore the subscript of S)

= (1 + )

Log ( ) = (1 + )

=
( )

Introducing Present and Future Values

When dealing with compound interest, the amounts A and Sn are often called the future value, FV. It represents
the total amount accrued after earning compound interest over several periods. Basically, a future value is any
amount that will be received or paid at a future date that is not today. The principal amount P is regarded as the
present value, PV, meaning that it is the amount available at the inception of the loan or investment. The present
value is the amount owed or paid today or now.

The future value for compound interest is therefore:

FV = PV(1 + )

where: (1 + ) is the compound factor.

In order to obtain the Future Value, we must be given some Present Value and a rate of interest, , in order to
compound (accumulate) interest going forward in time.

PV = ( )

PV = FV(1 + )

where: (1 + ) is the discount factor.

In order to obtain the Present Value, we must be given some Future Value and a rate of interest, , in order to
discount (reverse the growth process) going backward in time.

46 | P a g e
Frequency of Compounding

Compound interest depends on the number of interest periods. This means that interest will be earned per
interest period. If annually, then the interest period is 1 year, which means that interest will be earned once a
year.

However, if interest is compounded monthly, it means that there are 12 interest periods in a year. Therefore,
interest will be calculated at the end of each month. This also depends on the investment period. If the investment
period is one year, there will be 12 interest periods but if the investment period is half a year, there will be 6
interest periods. Furthermore, if the investment period is 10 years, there will be 120 interest periods, meaning
that interest will be calculated 120 times throughout the investment period.

The formulae are given as follows:

Annually

FV = (1 + )

Semi-Annually

FV = (1 + )

Quarterly

FV = (1 + )

Monthly

FV = 1+

times a year

FV = 1+ NB: divide the interest and multiply the years by

Two-Years

FV = PV(1 + 2( ))

-years

47 | P a g e
FV = PV(1 + ( )) NB: multiply the interest and divide the years by

Continuously

FV =

Example 6.5:

1. A man invests $2000 (principal) at 10% (compound interest) per annum for 2 years. Find the future value.

Solution:

FV = PV(1 + )

FV = 2000 x (1 + )2

= 2000 x (1 + 0.1)2

= $2 420.00

2. How long will it take $6000 to double if interest is 16% compounded annually.

= (1 + )

Log ( ) = (1 + )

n = ( )

= ( . )

= 4.678 years

3. Given $5000 invested at 16% per annum compounded interest for 2 years, find the Future Value for each of
the following compounding frequencies:
i) Annually
ii) Semi-annually
iii) Quarterly
iv) Monthly
v) Daily

48 | P a g e
vi) Continuously

FV = 1+

In this case, our present value, = $5 000

our rate of interest, = 16% . .
the investment period, =2 , time in years.

i) Annually
FV = PV(1 + )
= 5000(1 + 0.16)2
= $6 728

ii) Semi-annually

FV = PV(1 + )2n
.
= 5000(1 + )2(2)

= 5000(1.08)4
= $6 802.44

iii) Quarterly
.
FV = PV(1 + )4(2)

= 5000(1 + 0.04)8
= $6 842.85

iv) Monthly

FV = PV(1 + )12n
.
= 5000(1 + )12(2)

= $6 871.10

v) Daily (always assume a 365-day year in this course)

49 | P a g e
 FV = PV(1 + )365n
.
= 5000(1 + )365(2)

= $6 885.16

vi) Continuously

FV =

= 5000e0.16*2

= $6 885.64

This example demonstrates that the interest earned depends on the frequency of compounding or the number of
interest periods. The higher the frequency of compounding, the higher the future value.

Effective Rate of Interest

if we want to compare two or more different interest rates offered by different investment banks, it is necessary
to be able to standardize their different rates. We can achieve this by using the effective rate which is also known
as the annual percentage yield. The effective rate is the simple interest rate that would produce the same
accumulated amount in 1 year as the nominal rate compounded times in a year.

It is calculated as follows:

Effective Rate =

( )
=

= [(1 + ) – 1]

E.R. = (1 + ) – 1 = (1 + ) –1

but = 1 at all times when finding the effective rate of interest.

Example 6.6: Bank A offers 17.5% converted quarterly and Bank B offers 17.5% converted half yearly. Which
bank should you invest in?

.
Bank A = (1 + )4*1 – 1

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 = 0.1868 x 100

= 18.68%

.
Bank B = (1 + )2*1 – 1

= 0.1827 x 100

= 18.27%

A prudent investor will choose bank A since it has a higher effective rate of interest. The actual interest earned in
bank A is higher than that in bank B.

Example 6.7: find the effective rate of interest corresponding to a nominal rate of 8% per year compounded:

a) Annually
b) Semi-annually
c) Quarterly
d) Monthly
e) Daily

Solution:

E.R. = (1 + ) – 1 = (1 + ) –1

a) Annually (1 + 0.08) − 1 = 0.08 i.e. 8%

.
b) Semi-annually (1 + ) − 1 = 0.0816 i.e. 8.16%
.
c) Quarterly (1 + ) − 1 = 0.08243 i.e. 8.24%
.
d) Monthly (1 + ) − 1 = 0.0829995 i.e. 8.3%
.
e) Daily (1 + ) − 1 = 0.08327757 i.e. 8.33%

Exercise

a) Which investment earns the most?

i) A certificate of deposit paying 7.25% compounded semi-annually
ii) A government bond paying 7.2% compounded quarterly.
iii) A savings account paying 7.15% compounded daily.

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 Present Value and Future Value
So far we have concentrated on compounding which leads us to the future value given some present value. Now
we want examine the relationship between present and future values more closely, by finding present values.

FV = PV(1 + )

where: (1 + ) is the compound factor.

PV = ( )

PV = FV(1 + )

where: (1 + ) is the discount factor.

The process of finding the present value is often called discounting while that of finding future values is called
compounding. The solution to example 6.3 can be shown using a timeline at follows:

amount $2 000 $2 030 $2 060.45 $2 091.36 $2 122.73 $2 154.57

Time =0 =1 =2 =3 =4 =5

Time = 0, represents today and $2 000 is the present value.

The timeline shows that at the going interest rate, an investor should be indifferent between $2 000 now and $2
091.36 in 3 years’ time.

The future value of $2000 in 3 years’ time at an interest rate of 1.5% p.a. is $2 091.36

Consequently, the PV of $2 091.36 to be received in 3 years at 1.5% p.a. is

= (1 + )

= 2 09136(1 + 0.015)

= $2 000.00

Some investors often wish to accumulate a specific amount by a certain future date. This is often the case with
parents who want to save for their children’s university requirements. Hence they need to know how much they
should invest today in order to meet that target at a future date.

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Example 6.

Mr. and Mrs. Nkomo wish to start a university fund for their daughter who is 3 years old. They expect to have
accumulated $22 000 in savings when their daughter turns 18. How much should they invest today if the interest
rate is 8.25% per annum compounded semi-annually?

Solution:

= 22 000

.
Since 8.25% is equivalent to , then = 0.0825

Time in years is given by: 18 − 3 = 15

= ( + )

. ∗
= ( + )

=$ .93

Therefore, Mr. and Mrs. Nkomo need to invest $6 542.93 today in order to obtain $22 000 in 15 years’ time.

Testing Your Answer

You can always verify if your answer is correct by using the FV formula to compound your PV as shown below:

= (1 + ) we know that our PV is correct if and only if the FV we obtain in this test is $22 000.

. ∗
= 6542.93(1 + ) = 22 000.00 certainly our answer for the PV is correct!

You can perform this test for the FV as well by substituting your answer into the PV formula.

Example 6.

How much money should be deposited into a bank account that earns interest at 5.79% p.a. in order to accumulate
$500 000 in 8 years given that the interest is compounded:

a) Annually
b) Semi-annually

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 c) Quarterly
d) Monthly
e) Daily
f) Continuously

Solution:

a) = 500 000(1 + 0.0579) = $318 722.75

. ∗
b) = 500 000(1 + ) = $316 709.92

c) $315 679.83
d) $314 984.05
e) $314 644.94
f) = the answer is $314 633.38

We can conclude that the higher the frequency of compounding, the lower the present values. There is an
inverse relationship between the PV and the number of interest periods.

Mid-term Interest Rate changes

So, what happens when the interest rate changes during the investment period? We’re going to consider an
example where the interest rate changed twice before the maturity date of the investment.

A young couple, the Kudus, are keen to renovate their house in 12 years’ time. They’ve taken up an endowment
policy with a leading life insurer and they hope to raise a minimum of $35 000. When they signed up for the policy
3 years ago, the interest rate was 7.34% p.a. The central bank has since announced a downward revision by 250
basis points. Some analysts believe that the monetary committee was rather too drastic in its approach and they
project that the interest rates will be raised by 300 basis points 24 months from today. Assume that the projections
are realized as stated above.

a) What was the present value of $35 000, receivable in 12 years’ time, three years ago?
b) Using your answer in (a), how much is in the endowment policy today? [Hint: assume you’re calculating
on the last day of the 3rd year of investment].
c) How much will be in the endowment policy at the end of the next 2 years?
d) How much will the couple withdraw at the maturity date, assuming there are no deductions?
e) If interest rates had not changed, how much would they have withdrawn on the maturity date?

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 f) Comparing your answers in (d) and (e), would you say the interest rate changes worked in favour of or
against the couple?

Solution

ANNUITIES

An annuity is a series of equal payments that are made at the end of equal intervals of time, e.g. monthly or
quarterly or annually etc. These payments are made over a period of time e.g. monthly rentals payments for 1
year. A good example of an annuity is when a pensioner pays equal monthly instalments towards his retirement
fund; those equal (regular) monthly payments form a series called an annuity. Also, when the pensioner receives
his pension benefits monthly after retirement, those equal monthly payments also constitute an annuity. In the
former case, the pensioner is saving towards some target future value and in the latter he is receiving payments
from a lump sum (present value). The lump sum is first considered a future value until he retires and it becomes
a present value from which regular monthly payments are made. It is expected that the pensioner’s payment
before retirement are far less than the monthly amount received after retirement.

Annuities can be grouped into 2 distinct categories: ordinary annuity and annuity due.

ORDINARY ANNUITY
If the payments are made at the end of each period, the annuity is referred to as an ordinary annuity.

Suppose an amount is deposited into an interest earning account. Find at amount of money that will be in the
account the end of the 1st, 2nd, 3rd, … , nth period.

The following shows the growth of the investment.

Y1 Y2 Y3 Y4 Yn-1

FV = R + R(1 + i) + R(1 + i)2 + R(1 + i)3 + … + R(1 + i)n-1

( )
Sn =

where: A=R , ratio = 1 + I , year = nth

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 [( ) ]
FV = ( )

[( ) ]
=

The present value of an ordinary annuity measures the value today of a series of regular payments occurring at
regular intervals in the future.

PV = + + +…+
( ) ( ) ( ) ( )

[( )
]
( )
=

[( )
]
( )
PV =

After simplifying, the formula will be:

[ ( ) ]
PV =

Example 6.:

1. Find the future value of an ordinary annuity of $2000 for 5 years if interest is 12% compounded annually.

Solution:

[( ) ]
FV =

[( . ) ]
=
.

= $12 705.69

2. Find the future value of an ordinary annuity of $2000 for 5 years if interest is 12% compounded quarterlly.

Solution:

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 [( ) ]
FV =

. ( )
[ ]
= .

[( . ) ]
=
.

= $53 740.75

3. Find the present value of an annuity of $5000 for 2 years if interest is 16% compounded semi-annually.

Solution:

[ ( )
]
PV =

[ .
( )
= .

= $16 560.63

4. An annuity will pay $8 000 at the end of each year for 5 successive years, the first payment being 12 months
from the initial purchase date. What is the maximum price any rational investor would pay for such an annuity
if the opportunity cost of capital is 10%?
5. KFC Bulawayo will start paying a $5 000 franchising fee beginning next year. If a fund earning 8.33%
compounded annually is set aside from which payments will be made, what should be the size of the
fund to guarantee annual payments of $5 000 for the next seven years?
6. Blue deposits $100 at the end of each month into an account that pays 5.24% compounded monthly.
After three years, she puts the accumulated amount into a certificate of deposit paying 7.5%
compounded quarterly for two-and-a-half years. Thereafter, she puts the money into a 90-day
certificate of deposit paying 6.82% annually. When the certificate matures, how much money would
have Blue accumulated?

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 ANNUITY DUE
An annuity due is the annuity in which all the cash flows occur at the beginning of the period e.g. rent
payments.

Typically, an annuity due, such as rent, is paid at the beginning of the month.

Computation of the future value and presents values of annuity due requires the cash flows of one
additional period beyond an ordinary annuity.

PV annuity due = PV ordinary annuity x (1+ i)

[ ( ) ]
= ∗ (1 + )

FV annuity due = FV ordinary annuity x (1 + i)

[( )
= ∗ (1 + )

Example 6.

a) What would you pay for an annuity that promises to pay $450 a year for the next 10 years given an
interest rate of 8%?
b) An annuity will pay $1 740 a year for the next 5 years with the first payment starting now. Capital
can be invested elsewhere at an interest of 14%. Is $6 000 a reasonable price to pay for this annuity.
c) What would be a reasonable price to pay for a pension plan which guarantees to pay $200 at the
beginning of every month for the next 2 years if you can earn 1.2% a month on your bank deposit
account?

Exercise:

i. Find the future value of an annuity of $2000 for 2 years if interest is converted quarterly.
ii. How long will it take $14 000 to double if interest is 10% per annum compounded semi-annually
iii. You have a savings plan whereby $1000 is deposited in an account at the end of the year at an
annual rate of 5%. What is the value of your investment at the end of 10 years?

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 PERPETUITIES
A perpetuity is an annuity with an infinite life. This means that it will go on and on being paid out forever. A good
example are irredeemable preference shares of a company. Often, such preference shares have a fixed contractual
pay-out which is due at regular intervals e.g. semi-annually, annually or bi-annually. We will not attempt to find
the future values of perpetuities as that is a mammoth task. In this course, we will be required to find the present
values of perpetuities.

The formula for finding the present value of a perpetuity is:

Example 6.

The director of a company has been offered preference shares that earn $5 000 annually as part of his revised
compensation package. The interest rate is currently at 4.98% pa. what is the present value of the perpetuity?

5 000
=
0.0498

= $100 401.61

What if the perpetuity was paid out,

a) Semi-annually
b) Bi-annually

Solution:

a) =

b) =

Exercise:

a) An investment opportunity involves an initial outlay of $50 000 and gives a $5 000 annual return,
starting in 12 months’ time and continuing indefinitely. Capital can be invested elsewhere at 8%. Is this
worth considering?
b) What would be the maximum price you would pay for a perpetual annuity that will pay $900 per annum,
starting in 12 months’ time, given an interest rate of 15%?

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 c) What should be the interest rate for a perpetuity that has a present value of $40 000 and a perpetual
stream of payments of $1 500 semi-annually?

AMORTIZATION

When banks finance houses, they often do so by issuing amortised loans called mortgages. The buyer will pay the
bank a stream of equal payments for a long time, often more than 20 years, in regular intervals e.g. monthly. This
certainly makes houses affordable to most people.

An amortised loan is a loan that is paid off in equal payments. Therefore, the loan payments are an annuity.

In an amortised loan, the present value can be thought of as the amount borrowed as shown below:

[ 1 − (1 + ) ]
=

where: = amount borrowed

= interest rate per period

= amount that is to be paid back per period

= number of periods the loan will run for,

Amortised Loan

Taking the PV formula, we make the subject to obtain the following:

R =
( )

Example:

Suppose you plan to get a $9 000 loan from a furniture dealer at 18% and interest with annual payments
that you will pay off in over 5 years. What will your annual payment be on this loan?

Construct the appropriate amortization schedule.

PV = 9000

i = 0.18

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n = 5 years

R = ( )

.
=
( . )

= $2 878.00

Year Amount Owed Annuity payment Interest Portion of Repayment of Outstanding

Principal at the (2) Annuity (3) Principal (4) Balance (1)-(4)
beginning of the [(2) – (3)]
year (1)

1 9000 2878 1620 1258 7742

2 7742 2878 1393.56 1484.44 6257.56
3 6257.56 2878 1126.36 1751.64 4505.92
4 4505.92 2878 811.07 2066.93 2438.99
5 2438.99 2878 439.00 2438.99 0

Column 1 is the outstanding loan balance at the beginning of each period

Column 2 is the annuity (fixed instalment) paid at the beginning of every period

Column 3 is the interest due on the outstanding amount (9000 * 0.18 = 1620)

Column 4 is the portion of the annuity (fixed instalment) that is paid towards the principal

Column 5 is the outstanding loan balance at the end of each period

We can observe the following from the table:

 the size of each payment (instalment) remains the same however the interest payment declines
each year as the outstanding balance declines as more of the principal is repaid.
 most of the instalment in the early years goes towards interest rather than the principal.

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Exercise:

a) A man takes a loan of $10 000 and agrees to amortise both capital and interest over a period of
3 years if interest is 17% converted semi-annually find his regular payment and construct the
appropriate amortisation schedule.
b) What are the monthly payments on a repayment mortgage of $60 000 taken out for 25 years if
the monthly rate of interest is 0.75%? Construct an amortization schedule for the first 5 years of
this mortgage. What is the outstanding amount after 5 years?

SINKING FUND

A fund that is set up for the purpose of accumulating income to meet a certain future commitment is called a
sinking fund if it is made up of a stream of regular payments at regular intervals.

First, we take the formula for finding the Future Value of an ordinary annuity (assuming the payments are made
at the end of each period):

[(1 + ) − 1]
=

Then we make the subject of the formula:

=
(1 + ) − 1

Example 6.

The owner of Best Hardware has decided to set up a sinking fud for the purpose of purchasing a truck in 2 years’
time. The truck could cost $43 000. If the fund earns 10% interest per annum compounded quarterly, determine
the size of each instalment that should be aid into the fund.

Exercise

i. How much should we invest monthly at 16% compounded monthly if we wish to have R500 000
in 4 years’ time to replace plant and machinery?
ii. Janet wishes to send her son to Oxford University in England. She hopes that he will start at
university after his 18th birthday. At that time, she would like to have $240 000 available to cover
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 all expenses. She’s planning on making payments into her son’s account on his 1st birthday. If the
account pays 7.25% compounded semi-annually, how much should she deposit at each birthday
to achieve her goal.
iii. How long does it take to save $1 000 000 if you placed $25 per month into an account paying
8.41% compounded monthly?

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