Handout

Mathematics for Finance, for Accounting and Finance 4th year summer students
UNIT ONE
LINEAR EQUATIONS
Unit Introduction
In the face of changing business environment, organizations encounter diverse set of
problems and challenges as well as prospects. Consequently, managers are expected to make
appropriate decisions and take actions that enable the organization take advantages and
overcome difficulties. In making such decisions and actions, one may be required to apply
mathematical tools and quantitative techniques. Correspondingly, it is not uncommon to face
so many cases demanding the application of mathematics of linear algebra and geometry in
making a viable decision that enhance the achievement of organizational objectives. In other
words, there are various subjects of decision of which relation to one another is at least
approximated and explained by linear equations, for instance, sales volume can be linearly
related to advertisement expense. The same holds true between output level and number of
employees engaged on some activity and cost of production. Furthermore, demand for and
supply of a given product can be well approximated and explained by a linear equation. In
such real business instances, the concept and interpretative application of linear equations
have a considerable importance.
Cognizant to the above fact, we need to be well acquainted with the fundamentals of linear
equations algebra and geometry as related to its business application. This chapter, therefore,
is dedicated to our study of linear equations. To this end, the unit is organized in to two
sections. In the first section, you will learn about basic concepts of linear equations and their
graphic representation and then you will proceed to the application of mathematical concepts
of linear equations in solving business problems.
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Complied by Gudata A.
Basic Concepts of Linear Equations and Functions
An equation is a statement of equality, which shows two mathematical expressions are equal.
Equations always involve one or more unknown quantities that need to be solved. Among the
different types of equations, linear equation is the one that we are going to deal with in some
detail. Linear equations are equations whose terms1 are a constant times a variable to the first
power. Accordingly, equations that can be transposed to the form,
a1 x1+ a2 x2+ …+ an xn = c
are said to be linear equations.
Where, a1, a2, a3, … an and c are constants

x1, x2, x3, …xn are variables (unknown quantities)
a1 x1, a2x2, … an xn and c are the terms of the equation (terms of a linear
equation represent the parts separated by plus, minus, and equal signs)
As it occurs in many business application cases, a linear equation may involve two variables,
x and y, and constants a, b, and c in which case the equation relating x and y takes the form,
ax+by=c
The following are all examples of linear equations.
2x + 3y = 9, 3x – 9y + z = 23, 4y + 7.5x – 11 = 14
On the other hand, 4xy + 7x = 8 is not a linear equation because the tem 4x y is a product of a
constant and two variables. Likewise 5x 2 + 3y = 25 is not linear because of the term 5x 2
which is a constant times one variable to the second – power.
Example 1.1
Assume that Ethiopian Electric Power Corporation charges Birr 0.55 per kilowatt-hour
consumed and a fixed monthly charge of Birr 7 for rent of electric meter. If y is the total
monthly charge and x is the amount of kilowatt-hours consumed in a given month, write the
equation for y in terms of x.
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Solution
The total monthly charge will be, 0.55 times the number of monthly KWh consumption plus
Birr 7 for meter rent.
Thus, using the symbols given,
y = 0.55x + 7
The equation of this example is linear with two variable x and y. In such linear equations, we
need to note that the constants can be positive or negative, and can be fractions when graphs
of these equations is plotted it will be a straight line. This is the reason for the term equation.
Linear Functions: functional relationship refers to the case where there is one and only one
corresponding value of the dependent variable for each value of the independent variable.
The relationship between x and y as expressed by
y = 0.55x + 7.
is called a functional relationship since for each value of x (independent variable), there is a
single corresponding value for y (dependent). Thus if we write y as expression involving x
and constants x is called the independent variable, then the value of y depends upon what
value we may assign to x and as a result it is called the dependent variable. Therefore, a
linear function refers to a linear equation, which does have one corresponding value of
dependent variable for each value of the independent variable.
Exercise 1.1
Suppose that a car rent company charges Birr 65 per hour a car is rented. In addition, Birr 150
for insurance premium. Write the equation for the total amount charged by the company in
terms of the hours the car is rented.
Graph of a Linear Equation
Linear equations in two variables can be plotted on a coordinate plane with two dimensions.
Such equations have graphs that are straight lines. This means that the graph of the
relationship between the variables takes the form of a straight line. Any straight-line graph
can be sketched by plotting just two points which satisfy the linear equation and then joining
them with a straight line.
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Exercise 1.2
Find two coordinate points that satisfy the equation 3x + 4y = 24. Then, using the two
coordinate points plot the graph of the given function.
1Linear Cost – Output Relations Analysis
As of the very beginning, we aimed at developing our understanding on the interpretative
application of linear equations in business. Consequently, our interest and purpose in this
section is to learn how we can approximate and relate the mathematical terminology and
technique of linear equations in addressing real world business issues. In dealing, we are
going to consider three application areas of linear equations. These are the linear cost –
output relations analysis, break – even analysis, and market equilibrium analysis. In this
particular section, we will consider these application areas to some detail.
In order to grasp the concept of linear cost output relations, let us consider the relationship
among different types of cost on the following a coordinate plane.
Total
cost I Total cost line
G VC
H
Variable
cost (VC)
F Total cost (TC)

E
D FC FC
Fixed cost (FC)
D
A
B C Number of units (Q)
Fig. 1.2.1 Classification of costs
Definitions
Fixed cost is a cost component that does not change with the number of units produced. The
variable cost is a cost component that varies with the number of units produced. Then at each
level of production, total cost is the summation of fixed cost and variable cost. Marginal cost
is the additional cost incurred in producing one more unit of output.
Observations
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Assume that total manufacturing cost and the number of units produced are linearly related.
The total cost originates from the fixed cost line because of zero level of production the total
cost will be equal to the fixed cost (see the above figure (Fig 1.2.1)). Accordingly,
- Fixed costs (FC) = AD = BE = CF
- The segment BG is the Total Cost (TC) of producing AB units of outputs.
- The segment CI is the TC of producing AC units of outputs.
- The segment AD is the TC of producing zero units of outputs.
- The ratio
- Marginal cost is given by change in TC divided by change in Quantity (Q). Thus,
Marginal cost (MC) = = VC per unit.
- Therefore, marginal cost and VC/unit are the considered as the slope of TC line and
they are constant as long as total cost and quantity produced are linear.
- When TC ÷ Q = Average cost per unit (AC).
- Unlike MC and VC per units, AC per unit is not constant although cost and quantity,
produced are linearly related.
Example
Given the total cost function C = 5Q + 10 and if 10 units are produced, find TC, AC, MC, FC
and VC per unit.
Solution
i. TC = 5(10) + 10 = 60
ii. AC = Total cost of producing 10 units = 60 ÷ 10 =6
Number of units produced
=>Suppose, if 5 units were produced,
TC = 5(5) + 10 = 35.
In this case, AC = 35 ÷ 5 = 7. Therefore, the AC is not constant.
iii. MC = is the same as the slope of the equation. Thus MC = 5
iv. FC = the fixed cost remains constant at any level of production. Thus, 10 is the
fixed cost.
v. VC/unit = Variable cost ÷ Number of units
= 5(Q) = 5(10) = 5
Q 10
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Exercise
If total factory cost, y, of making x units of a product is y = 10x + 500 and if 1,000 units are
made:
a. What is the variable cost?
b. What is the total cost?
c. What is the variable cost per unit?
d. What is the marginal cost of the last unit made?
Break – Even Analysis
Break-even analysis is an economic theory that states that profits arise from the excess of
total revenue over total cost.
This is, Profit = Total Revenue – Total Cost
In the application of break-even analysis, there are two important concepts we need to
distinguish. These are the break-even point and break-even chart. The break-even point
(BEP) is the volume or level of output resulting in neither a loss nor a profit. It is a point at
which revenue and cost are equal. The break-even chart is a convenient means of graphically
describing the relationship between cost and revenues at different levels of output.
In business concept, we have two cases of applying break-even analysis based on the type of
business activity under consideration. The first case is break-even analysis for manufacturing
companies. The other is for retail businesses. The distinction between the two cases is that
manufacturing companies usually state their cost equation in terms of quantity (output) as
their business involves producing and selling. In such a case, the break-even point is
commonly computed in terms of output level. On the other hand, as retail businesses are
concerned with purchase and sell of merchandise, they state their cost equation in terms of
revenue, which is the same as the Birr (dollar) volume of sales. Thus, the break-even point is
commonly computed in terms of break-even level of sales (dollar sales volume).
Break-Even Analysis for Manufacturing Businesses
In this case, we shall consider a manufacturer who produces q units of a product and sells the
product at a price of p per unit. In proceeding, let us specify the symbols to be used in our
study of the case before hand.
C = total cost of producing and selling q units
q = number of units produced and sold
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v = variable cost per unit made (assumed to be constant)

FC = fixed cost (constant amount)
P = Selling price per unit
R = total revenue received, which is equal to sales volume in terms of dollar or birr.
The cost function then is given by:
C = v q + FC ……………………. (1)
and,
Revenue = Price per unit x Number of units sold
R = p q …………………………… (2)
Thus, if the manufacture is to break – even on operations, which is to neither incur loss nor
earn profit, revenue (2) must equal cost (1).
That is, at break – even

p q = v q + FC …………………… (3)
You may now solve equation (3) for the production volume q;
p q = v q + FC
p q – v q = FC
q (p – v) = FC
Thus, the Break – Even Quantity denoted by qe, is given by;
To further our understanding of break-even analysis, let us consider the following break-even
chart.
Revenue/ cost
Profit (R > C)
Revenue
BEP
Variable cost
R= p qe and
FC
C = v qe + FC
Loss Fixed cost (FC)

(R < C)
0 Number of units (q)

qe
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Fig 1.2.2 Break Even Point (BEP) and other points

Observations: From the above break – even chart, we observe certain important points.
i. As such, the total revenue line passes through the origin and hence has a y-
intercept of zero while the total cost line has a y – intercept which is equal to the
amount of the fixed cost.
ii. The fixed cost line which is parallel to the quantity axis (x – axis) is constant at all
levels of output.
iii. To the left of the break – even point the revenue line is found below the cost line
and hence any vertical separation indicates a loss while to the right the opposite is
true.
iv. The total variable cost, which is the gap between the total cost and the fixed cost
line increases as more units are produced.
v. Important linear cost – output expressions (equations):
 C = v q + FC
 R=pq
 Average Revenue (AR) = R ÷ q = p q ÷ q = p
 Average Variable Cost (AVC) = v q ÷ q = v = Slope (m)
 Average Fixed Cost (AFC) = FC ÷ q
 Average Cost = C ÷ q = AVC + AFC
 Profit ( ) = R – C
Example 1
A book company produces children’s books. One time fixed costs for Little Home are birr.
12,838 that includes fees to the author, the printer, and for the building. Variable costs
amount to birr. 14.50 per book the books are then sold to bookstores around the country at
birr. 39.00 each. How many books must be printed and sold to break-even?
Solution
Given, v = birr. 14.50
FC = birr. 12,838
p = birr. 39
Let q = the number of books printed and sold
Thus, C = v q + FC
C = 14.5q + 12,838 is the cost equation.
The revenue (R) is also given by,
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R=pq
= 39q
Then to obtain the quantity of books to be printed and sold to break-even, you need to equate
the R and C equations.
39q = 14.5q + 12,838
39q – 14.5q = 12838
24.5q = 12838
q = 12838/24.5
q = 524 books must be printed and sold to break – even.
Example 2
A manufacture has a fixed cost of Birr 60,000 and a variable cost of Birr 2 per unit made and
sold at selling price of Birr 5 per unit. Required:
a. Write the revenue and cost equations
b. Computer the profit, if 25,000 units are made and sold
c. Compute the profit, if 10,000 units are made and sold
d. Find the breakeven quantity
e. Find the break-even birr volume of sales
f. Construct the break-even chart
Solution
Given the values,
FC = Birr 60,000 , v = Birr 2 , p = Birr 5
a. Revenue equation = p q
R = 5q
Cost equation = v q + FC
C = 2q + 60,000
b. Level of production = q = 25,000 units

Thus, R= 5q = 5 x 25,000
R = Birr 125,000
Likewise, C = v q + FC
C = (2 x 25,000) + 60,000
C = 50,000 + 60,000 = Birr 110,000
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Then, Profit = R – C
= 125,000 – 110,000
= Birr 15,000
c. Level of production = q = 10,000 units

Thus, R = 5q = 5 x 10,000
R = Birr 50,000
Likewise, C = v q + FC
= 2 (10,000) + 60,000
= Birr 80,000
Then, Profit = R – C
= 50,000 – 80.000
= (Birr 30,000)
The manufacturer losses Birr 30,000 at 10,000 units level of production.
d. The break-even quantity is given by;
Units are required to be produced to
break-even on operation.
e. The break – even birr volume of sales can be simply obtained by substituting the
break – even quantity in the revenue (R) equation. This is,
R = 5q
Substituting qe in place of q will result in,

R = p qe = 5 x 20,000
R = Birr 100,000
f. In sketching break – even chart, first we need to find x – and y – interests for both the
revenue and cost equations. To this end, considering the cost equation, C = 2q +
60,000 we can obtain; the y – intercept (at q = 0) = FC = Birr 60,000.
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g. Therefore, the cost equation arises from the point 60,000 on the y- axis (cost and
revenue axis). Alternatively, in a simple way, the total cost line starts at the point of
fixed cost.
On the other hand, the graph for the revenue originates from the origin because the
revenue at zero production level is zero. Further, the two lines crosses each other at
the BEP which has a coordinate of (20,000, 100,000), the 20,000 units on the quantity
axis (x – axis) and Birr 100,000 on cost revenue axis (y – axis).
Revenue/ cost
(in Birr)
Revenue
Break – Even Point

(20,000, 100,000)
60,000 Profit
Total Cost
100,000
Loss
FC
Fig 1.2.3 Solved example of BEP
Note: The BEP coordinate

0 is given by (qe, p qe)
qe = 20,000 Number of units (q)
Exercise
Suppose a company has a fixed cost of Birr 35,000 and a variable cost of Birr 1.75 per unit
for its products. Let us further consider that selling price is Birr 2.70 per unit.
a. Write the revenue and cost equations of the company.
b. At what level of output is the company break-even?
c. What is the amount of revenue when the company produces 300,000 units?
d. Plot the break-even chart and show the break-even point.
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UNIT TWO
INTRODUCTION TO LINEAR PROGRAMMING
A large number of decision problems faced by a business manger involve allocation of
resources to various activities with the objective of increasing profits or decreasing costs, or
both. When resources are in excess, no difficulty is experienced. Nevertheless, such cases are
very rare. Practically in all situations, the managements are confronted with the problem of
scarce resources. Normally, there are several activities to perform but limitations of either of
the resources or their use prevent each activity from being performed to the best level. Thus,
the manger has to take a decision as to how best the resources be allocated among the various
activates.
The decision problem becomes complicated when a number of resources are required to be
allocated and there are several activities to perform. Rule of thumb, even of an experienced
manger, in all likelihood, may not produce the right answer in such cases. The decision
problems can be formulated and solved as mathematical programming problems.
Defining Linear Programming Model

Linear Programming (LP) is a mathematical process that has been developed to help
management in decision-making involving the efficient allocation of scares resources to
achieve a certain objective. Diagrammatically,
Scares To be allocated to:

Resource
Resource
constraints
Objectives Constraints
Non-negativity
Constraints
Optimization
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Maximization Minimization
Fig 3.1.1 Linear Programming Model
LP is a method for choosing the best alternative from a set of feasible alternatives.
Requirements to Apply Linear Programming
To apply LP, the following conditions must be satisfied. These will be discussed next:
a. There should be an objective that should be clearly identified and measurable in
quantitative terms. Example, maximization of sales, profit, and minimization of costs etc.
b. The activities to be included should be distinctly identifiable and measurable in
quantitative terms.
c. The resources of the system which are to be allocated for the attainment of the goal
should also be identifiable and measurable quantitatively. They must be in limited supply.
These resources should be allocated in a manner that would trade off returns on
investment of the resources for the attainment of the objective.
d. The relationship representing the objective and the resource limitation considerations
represented by the objective function and the constraint equations or inequalities,
respectively, must be linear in nature.
e. There should be a series of feasible alternative courses of actions available to the
decision-maker that is determined by the resource constraints.
When these stated conditions are satisfied in a given solution, the problem can be expressed
in algebraic form called linear programming problem (LPP), and then solved for optimal
decision. We first illustrate the formulation of linear programming problems and then
consider the method of their solution.
Formulation of Linear Programming Model
Problem Modeling: The Maximization Case
Problem Formulation or Modeling is the process of translating the verbal statement of a
problem in to mathematical statements. Formulating model is an art that can only be
measured with practice and experience. Even though every problem has certain unique
features, most problems have common features. Therefore, some general guidelines for
model formulation are helpful. Next, you will have the illustration of some general guidelines
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by developing mathematical model for some given problems. Consider the following
example.
Example
A firm is engaged in producing two products, A and B. Each unit of product A requires two
Kgs of raw material and four labor hours for processing whereas each unit of product B
requires three kg of raw material and three hours of labor of the same type. Every week the
firm has an availability of 60 kgs of raw material and 96 labor hours. One unit of product A
sold yields Birr 40 and one unit of product B sold yields Birr 35 as profit.
Formulate this problem as a linear programming problem to determine as to how many units
of each of the products should be produced per week so that the firm can maximum the profit.
Assume that there is no marketing constraint so that all that is produced can be sold.
The objective function: the first major requirement of linear programming problem (LPP) is
that we should be able to identify the goal in terms of the objective function. This function
relates mathematically the variables with which we are dealing in the problem.
For our problem, the goal is the maximization of profit, which would be obtained by
producing (and selling) the products A and B. If we let x 1 and x2 represent the number of units
produced per week of the products A and B respectively, the total profit, Z, would be equal to
40 x1 +35x2 is then, the objective function, relating the profit and the output level of each of
the two items. Notice that the function is a linear one. Further, since the problem calls for a
decision about the optimal values of x1 and x2, these are known as the decision variables.
The constraints: As has been laid, another requirement of linear programming is that the
resources must be in limited supply. The mathematical relationship which is used to explain
this limitation is inequality. The limitation itself is known as a constraint.
Each unit of product A requires 2 kg of raw material while each unit of product B needs 3 kg.
The total consumption would be 2x 2 and 3x2, which cannot be the total the availability of 60
kg every week. We can express this constraint as 2x 1 and 3x2 < 60. Similarly, it is given that a
unit of A requires 4 labor hours for its production and one unit of B requires 3 hours. With an
availability of 96 hours a week, we have 4 x 1 and 3x2 < 96 as the labor hour's constraint. It is
important to note that for each of the constraint, inequality rather than equation has been
used. This is because the profit maximizing output might not use all the resources to the full
leaving some unused, hence the < sign. However, it may be noticed that all the constraints are
also linear in nature.
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Non-negativity Condition: Quite obviously, x1 and x2, being the number of units produced,
cannot have negative values. Thus both of them can assume values only greater than or equal
to zero. This is the non-negativity condition, expressed symbolically as x1 > 0 and x2, > 0.
Now we can write the problem in complete form as follows.
Maximize Z = 40 X1 + 35 X2, Profit
Subject to
2X1 + 3X2 < 60 Raw material constraint
4X1 + 3X2 < 96 Labor hours constraint
X1, X2, > 0 Non-negativity restriction
Assumptions Underlying Linear Programming

A linear programming model is based on the assumptions of proportionality, additively,
continuity, certainty, and finite choices. These are explained here next.
1. Proportionality: A basic assumption of linear programming is that proportionality exists
in the objective function and the constraint inequalities. For example, if one unit of a
product is assumed to contribute Birr 10 toward profit, then the total contribution would
be equal to 10x1 where x1 is the number of units of the product. For 4 units, it would equal
Birr 40 and for 8 units it would be Birr 80, thus if the output (and sales) is doubled, the
profit would also be doubled. Similarly, if one unit takes 2 hours of labor of a certain
type, 10 units would require 20 hours, 20 units would require 40 hours….and so on. In
effect, then, proportionality means that there are constant returns to scale and there are no
economies of scale.
2. Additively: Another assumption underlying the linear programming model is that in the
objective function and constraint inequalities both, the total of all the activities is given by
the sum total of each activity conducted separately. Thus, the total profit in the objective
function is determined by the sum of the profit contributed by each of the products
separately. Similarly, the total amount of a resource used is equal to the sum of the
resource values used by various activities.
3. Continuity: It is also an assumption of a linear programming model that the decision
variables are continuous. Therefore, combinations of output with fractional values, in the
context of production problems, are possible and obtained frequently. For example, the
best solution to a problem might be to produces 5¾ units of product B per week.
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Although in many situations we can have only integer values, but we can deal with the
fractional values, when they appear.
4. Certainty: A further assumption underlying a linear programming model is that the
various parameters, namely, the objective function coefficients, the coefficients of the
inequality/equality constraints and the constraint (resource) values are known with
certainty. Thus, the profit per unit of the product, requirements of materials and labor per
unit, availability of materials, labor etc. are given and known in a problem involving
these. The linear programming is obviously deterministic in nature.
5. Finite Choices: A linear programming model also assumes that a limited number of
choices are available to a decision maker and the decision variables do not assume
negative values. Thus, only non-negative levels of activity are considered feasible. This
assumption is indeed a realistic one. For instance, in the production problems, the output
cannot obviously be negative, because a negative production implies that we should be
above to reverse the production process and convert the finished output back in to the raw
materials!
Solution Approaches to LPPs
Now we shall consider the solution to the linear programming problems. They can be solved
by using graphic method or by applying algebraic method, called the Simplex Method. The
graphic method is restricted in application – it can only be used when two variables are
involved. Nevertheless, it provides an intuitive grasp of the concepts that are used in the
simplex technique. The simplex method, whereas is the mathematical technique of solving
linear programming problems with two or more variables.
Graphical Solution to Linear Programming Problems
Steps in Graphic Method of Linear Programming Problems
To use the graphic method, the following steps are needed:

i. Identify the problem – determine the decision variables, the objective function,
and the constraints.
ii. Draw a graph including all the constraints and identify the feasible region.
iii. Obtain a point on the feasible region that optimizes the objective function –
optimal solution.
iv. Interpret the results.
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Note: Graphical LP is a two-dimensional model.
The Maximization Problem

This is the case of Maximize Z with inequalities of constraints in < form.
Example 3
Consider two models of color TV sets; Model A and B, are produced by a company to
maximize profit. The profit realized is birr. 300 from A and birr. 250 from set B. The
limitations are
a. Availability of only 40 hrs of labor each day in the production department,
b. A daily availability of only 45 hrs on machine time, and
c. Ability to sale 12 set of model A.
How many sets of each model will be produced each day so that the total profit will be as
large as possible?
Resources used per unit

Constraints Model A Model B Maximum Available
(x1) (x2) Hours
Labor Hours 2 1 40
Machine Hours 1 3 45
Marketing Hours 1 0 12
Profit birr. 300 birr. 250
Solution
1. Formulation of mathematical model of LPP
Max Z=300X1 +250X2
St:
2X1 +X2< 40
X1 +3X2< 45 LP Model
X1 < 12
X1, X2 >0
2. Convert constraints inequalities into equalities
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2X1 + X2 = 40
X1 + 3X2 = 45
X1 = 12
3. Draw the graph by finding out the x– and y–intercepts
2X1 +X2 = 40 ==> (0, 40) and (20, 0)
X1 +3X2 = 45 ==> (0, 15) and (45, 0)
X1 = 12 ==> (12, 0)
2X1 +X2 = 40
X1 , X2 = 0
X2
X1=0
40 X1=12
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B X1 +X2 = 45
Feasible C(12, 11)

Region X2=0
D X1
A 12 20 45
Fig. 3.1 Graphical Solution of LPP. (Maximization Problem)
4. Identify the feasible area of the solution which satisfies all constrains. The shaded region
in the above graph satisfies all the constraints and it is called Feasible Region.
5. Identify the corner points in the feasible region. Referring to the above graph, the corner
points are in this case are:
A (0, 0), B (0, 15), C (12, 11) and D (12, 0)
6. Identify the optimal point.
Corners Coordinates Max Z = 300 X1 +250X2
A (0, 0) birr. 0
B (0, 15) birr. 3750
C (12, 11) birr. 6350 (Optimal)
D (12, 0) birr. 3600
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7. Interpret the result. Accordingly, the highlighted result in the table above implies that 12
units of Model A and 11 units of Model B TV sets should be produced so that the total
profit will be birr. 6350.
Example 2
A manufacturer of Light Weight mountain tents makes two types of tents: REGULAR tent
and SUPER tent. Each REGULAR tent requires one labor-hour from the cutting department
and 3 labor-hours from the assembly department. Each SUPER tent requires 2 labor-hours
from the cutting department and 4 labor-hours from the assembly department. The maximum
labor hours available per week in the cutting department and the assembly department are 32
and 84 respectively. Moreover, the distributor, because of demand, will not take more than 12
SUPER tents per week. The manufacturer sales each REGULAR tents for birr. 160 and costs
birr. 110 per tent to make. Where as SUPER tent ales for birr. 210 per tent and costs birr. 130
per tent to make.
Required:
a. Formulate the mathematical model of the problem
b. Using the graphic method, determine how many of each tent the company should
manufacture each week so as to maximize its profit?
c. What is this maximum profit assuming that all the tents manufactured in each week
are sold in that week?
Solution
1. The LP Model:
Labor Hours per Tent Maximum Labor-hours

Department Available per Week
REGULAR (X1) SUPER(X2)
Cutting department 1 2 32
Assembly department 3 4 84
Selling price per tent birr. 160 birr. 210
Cost per tent birr. 110 birr. 130
Profit per tent birr. 50 birr. 80
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The distributor will not take more than 12 SUPER tents per week. Thus, the manufacturer
should not produce more than 12 SUPER tents per week.
Dear student, please formulate the mathematical model based on the information in the above
table before going to the solution part.
Let X1 = The No of REGULAR tents produced per week.

X2 = The No of SUPER tents produced per week.
X1 and X2 are called the decision variables.
…… Cutting department constraint

LP Model
…… Assembly department constraint
……. Demand constraint
…… Non-negativity constraints
2. The Corners and Feasible Solution:
Corners Coordinates Max Z=50 X1 +800X2

A (0, 0) birr. 0
B (0, 12) birr. 960
C (8, 12) birr. 1360
D (20, 6) birr. 1480
E (28, 0) birr. 1400
3. The Interpretation:
The manufacturer should produce and sale 20 REGULAR tents and 6 SUPERS tents to get a
maximum weekly profit of birr. 1480.
UNIT THREE
20
MATHEMATICS OF FINANCE
Introduction
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 value of one birr today is not the same after
a year. Suppose, if you deposit Birr 1000 at a bank for some period, you will find the sum
grows to a higher sum at the time of withdrawal. The rational behind is that the banks
reinvest the deposits received at some other profitable ventures and hence, it is using
depositors’ money. As a result, it pays interest on depositors’ money as compensation. Thus,
in one way or another as value of money changes overtime we find a difference between the
present and future value of money. In sum, the difference arises because a rational being is
assumed to invest/use money available on productive activity that result in a higher future
sum and, the difference between the present and future value of money is referred to as time-
value of money.
Mathematics of finance has an important implication in organizations as transactions and

business dealings are mostly pecuniary. Such matters as lending and borrowing money for
various purposes, leasing materials, accumulating funds for future use, sell of bonds are some
of the cases that involves the concept of time value of money, Likewise, finance mathematics
is equally important in our personal affairs. For example, we might be interested in owning a
house, in financing 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 unit. In doing so, the unit is organized in to three main
sections. The first section advances to our study of simple interest and discounts. We further
explore about compound interest and annuities in the second and third sections respectively.
Dear student, do you have any concept of interest? Please try to define what interest is?
Basic Concepts
In business, we usually pay some money for using services and goods. Such payments go by
various names. For instance, the money we pay for hiring a taxi is known as fair. The amount
we pay for education is called tuition fee. Likewise, the cost we pay for electric consumption
commonly called electric charge. Back to our case, we also incur cost in using money for a
certain period. This cost is referred to as interest. Thus, interest is the payment made for use
21
of the principal (money) or a fee, which is paid for having the use of money. The amount of
money that is borrowed or lent or invested or money available at hand at the beginning is
called the principal and denoted by P. Interest is usually paid in proportion to the principal
and the period of time over which the money is used. The percent of the principal that is
charged for the use of the principal for a unit of time is called the rate of interest (interest
rate, i). The length of time for which the principal is borrowed, lent or invested is called the
time or term of the loan and commonly how symbolized by n. The future or maturity value,
which is also denoted by F, is the sum of the principal and all the interest earned.
Based on computation of the respective interest, there are two types of interests. These are,
i. Simple interest: it is the return on a principal amount for one time period.
ii. Compound interest: it is the return on a principal amount for two or more time period,
assuming that the interest for each time period is added to the principal amount at the
end of each period and earns interest on all subsequent periods.
The Simple Interest

Interest that is paid solely on the amount of the principal P is called simple interest. Simple
interest is usually associated with loans or investments that are short term in nature. In
addition, it is always computed based on the original principal.
The Simple Interest Formula:

The computation of simple interest is based on the following 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
22
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
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 1
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 = p i n
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,
23
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
Example 2
A person “lends” Birr 10,000 to a corporation by purchasing a bond from the corporation.
Simple interest is computed quarterly (four times a year) at a rate of 2% per quarter, and a
check for the interest is mailed each quarter to all bondholders. The bonds expire at the end of
5 years, and the final check includes the original principal plus interest earned during the last
quarter. Compute the interest earned each quarter and the total interest, which will be earned
over the five-year life of the bonds.
Dear student, please try to solve the problem before going to the solution part.
Solution
Given values in the problem, P = Birr 10,000 i = 2% per quarter n = 5 years
Required:
Interest per quarter and interest over the five-year periods
Interest per quarter (one quarter) = Pin
= 10000 x 0.2 x 1
= Birr 200
There, at each quarter the interest earned on Birr 10,000 is Birr 200.
Interest over the five year period = pin

In the case, n represents all quarters with in 5 years. That is,
n = Number of years x 4
24
= 5x4 = 20
Then, Interest (I) = Pin
= 10000 x 0.02 x 20 = Birr 4000
Solution for P, i and n
Dear students, in the computation of simple interest we might be required to find out the
value of the principal, interest rate and the time period in some cases. Such computation for
P, i and n is simply made by driving the formula for the unknown values from the formula we
have used for simple interest.
Example 3
1. How long must one leave Birr 300 invested in order to learn Birr 28 interest at 3% per
year?
2. At what rate will Birr 150 produce interest of Birr 20.25 in 4.5 years?
3. What principal is required to produce interest of Birr 38.50 in two year at 3.5 % per year?
Solution
1. The question involves determining the time period which is enough to earn an interest of
Birr 28 on Birr 300.
The given values in the problem are P = Birr 300 I = Birr 28 i = 3% and n = ?
I = Pin, now solve for n in this formula.
n= I = 28 = 28 = 4 years
Pi 300 x 0.30 9
2. Given values in the problem
P=Birr 150
i=Birr 20.25
n=4.5 years
The required value is the rate of interest.
I = pin, Solve for i
i=I = 20.25 = 20.25 = 0.03 or 3%
25
Pn 150x4.5 675
3. Given values in the problem
I = Birr 38.50
n =2 years
I = 3.5% per year
Required: Principal (P)
We can find out the value of P In the same manner with the above examples a follows.
I = pin, solve for P
P = Birr 550
Thus, Birr 550 is required to produce interest of Birr 38.5 in 2 years at 3.5% rate.
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 5
26
1. 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 %?
2. What is the present value of Birr 645 due in 2 ½ years if the interest rate is 3%? What
is the simple discount?
Solution
1. Given values in the problem,
n in ordinary method = Number of days / 360
= 90 /360
n = 0.25
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.
= 870.19 / (1+ (0.095 x 0.25))

P = 870.19 ÷ 1.024
P = Birr 849.795
2. Given values in the problem,
F = Birr 645
n = 2.5 years
i = 3% = 0.03
P = F/ 1+ in
P = 645/ 1+ (0.03 x 2.5)
P = 645/1.075
P = Birr 600
27
Compound Interest
The Compound Interest and Its Formula
As it has been highlighted earlier, compound interest involves the case where interest earned
during the earlier periods also earns interest during the later period. If, instead of being paid
when due, the interest as investment is added to the principal and the sum is used as new
principal, we say that compound interest is being used. Under this procedure, the interest for
each period is added to the principal for purpose of computing interest for the next period.
The sum to which the principal and interest on it grow during the period is called the maturity
or accumulated value of the principal. The difference between the compound amount and the
principal is called compound interest. The sum that is invested is called the present value or
the principal. The time interval between the date on which the principal was invested and the
date on which it is repaid is called the term of the investment (loan).
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, 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:
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
28
Example 7
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
Present Value of a Compound Amount
As we have considered in the simple interest case and as extended in the compound amount
as well, 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)
29
n
Future value is obtained by compounding technique and the expression (1 + i) is called
compound factor. On the other hand, present value is obtained by discounting techniques and
-n
the expression (1 + i) is referred to as the compound discount factor. The formula for
present value of compound amount is simply derived from compound amount formula by
solving for P.
Examples 11
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 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)
30
= 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
p = ? but P = Fn (1 + i)-n
= 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
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
31
Amount of compound interest = Birr 207,510
32

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Mathematics for Finance, for Accounting and Finance 4th year summer students

In the face of changing business environment, organizations encounter diverse set of

mathematical tools and quantitative techniques. Correspondingly, it is not uncommon to face

have a considerable importance.

Basic Concepts of Linear Equations and Functions

Where, a1, a2, a3, … an and c are constants

Graph of a Linear Equation

F Total cost (TC)

- Marginal cost is given by change in TC divided by change in Quantity (Q). Thus,

Marginal cost (MC) = = VC per unit.

Break-Even Analysis for Manufacturing Businesses

v = variable cost per unit made (assumed to be constant)

That is, at break – even

Thus, the Break – Even Quantity denoted by qe, is given by;

Loss Fixed cost (FC)

0 Number of units (q)

Fig 1.2.2 Break Even Point (BEP) and other points

b. Level of production = q = 25,000 units

c. Level of production = q = 10,000 units

d. The break-even quantity is given by;

Units are required to be produced to

Substituting qe in place of q will result in,

Break – Even Point

Fig 1.2.3 Solved example of BEP

Note: The BEP coordinate

Defining Linear Programming Model

Scares To be allocated to:

Fig 3.1.1 Linear Programming Model

Assumptions Underlying Linear Programming

Steps in Graphic Method of Linear Programming Problems

To use the graphic method, the following steps are needed:

Note: Graphical LP is a two-dimensional model.

The Maximization Problem

Resources used per unit

2. Convert constraints inequalities into equalities

Feasible C(12, 11)

Fig. 3.1 Graphical Solution of LPP. (Maximization Problem)

Corners Coordinates Max Z = 300 X1 +250X2

B (0, 15) birr. 3750

C (12, 11) birr. 6350 (Optimal)

D (12, 0) birr. 3600

Labor Hours per Tent Maximum Labor-hours

Profit per tent birr. 50 birr. 80

Let X1 = The No of REGULAR tents produced per week.

X1 and X2 are called the decision variables.

…… Cutting department constraint

2. The Corners and Feasible Solution:

Corners Coordinates Max Z=50 X1 +800X2

C (8, 12) birr. 1360

D (20, 6) birr. 1480

E (28, 0) birr. 1400

Mathematics of finance is concerned with the analysis of time-value of money. The

Mathematics of finance has an important implication in organizations as transactions and

The Simple Interest

The Simple Interest Formula:

ii. Weeks, then

Or, using alternative approach,

Interest over the five year period = pin

Solution for P, i and n