CHAPTER ONE

LINEAR EQUATIONS AND THEIR APPLICATIONS

Chapter objective

This chapter aims at discussing the basic characteristics of linear equation and its applications.
After completing this unit you will be able to:

 Understand basic concepts of linear equations and functions.

 List characteristics of linear equations
 Develop acquaintance of graphic representation of linear equations.
 Compute and formulate slope and equation of a line.
 Systematically apply the linear equation algebra and geometry in solving real world
situations.
 Develop acquaintance of developing cost, revenue and profit function of both
manufacturing and merchandise enterprises
 Conduct the break even analysis for both manufacturing and merchandising business.
 Compute market equilibrium point

1. Introduction

In our everyday life, there are various types of decisions that need mathematical
supported knowledge. Managers will make many managerial decisions that need much
investigation and analyses which need the skill and knowledge of mathematics. So, this chapter
has a general purpose of familiarizing managers with the algebra and geometry of linear
equations and functions in two variables, that is, equations and functions whose graphs in
a coordinate plane are straight lines; their importance and applications in business area and
management.

1.1 Definitions, Concepts and Characteristics of Linear equations

Linear equations are equations whose terms are a constant times one variable to the first degree.
Linear equations are mathematical statements that indicate two algebraic equations which are
equal. Algebraic equations are those that are linked by mathematical operations (+, - , X, or ÷).

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Linear equation is an equation with one degree and whose graph is straight line and whose slope
is constant through the line.

1.1.1 General form of linear equations

Linear equations with two variables

A linear equation with two variables X and Y has the standard form:

. Where A, B and C are real numbers and A & B cannot both equal zero.

Linear equation with two variables

A linear equation involving two variables X and Y has the standard form:

Ax + By = C - - - - - - - - - - - - - - - (1.1)

Where A, B and C are real numbers and A and B cannot both equal zero

Examples of Linear equations with two variables;

1.
2.
3.
4. 2x + 5y = -5
5. –x + ½ y = 0
6. 2s – 4t = - 2
7. 2k +2 = 5n
The following are examples of equations which are not linear:
1. 2x + 3xy = 7 2. X2 + Y + 3x = 16
3. X1/2+ 2y=8 4. 2x + 3xy – 4y = 10
5.
Exercise: identify linear equations among the following
a)
b)
c)
d)√ √
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Linear Equations with n Variables

Linear equations involving n variables have the following general form:

=b

Linear equation involving n variables X1, X2, X3 … Xn has the general form:

a1X1 + a2X2 + a3 x3 + . . . + an xn = b . . . ……………………. (1.2)

Where; a1, a2, a3 . . . and b are real numbers and not all a1, a2, a3 . . . an equal Zero.

And this is called standard form of a line.

Each of the following is an example of a linear equation involving more than two variables:

1. 3x1 – 2x1 + 5x3 = 0

2. –x1 + 3x2 – 4x3 + 5x4 – x5 + 2x6 = -80
3. 5x1 – x2 + 4x3 + x4 – 3x5 + x6 – 3x7 + 10x8 – 12x9 = 1250

1.1.2 Characteristics of Linear Equations

i. Linear equations have variables with only one degree (power)

ii. The product of two variables should not avail in the linear equations
iii. The graphs of linear equations are straight line
iv. All coefficients of the linear equations should be different from zero

1.2 Linear Function

Linear functions are the relationship between dependent and independent variables. 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 = 0.25x + 20,000 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
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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.

So generally the linear function can be expressed as:

y = m x + b. And this is called slope intercept form of a line.

y- Is the dependent variable

x- Is the independent variable

b- Is the Y intercept (the value of y when the value of x is 0)

m- Is the slope which is computed by dividing change in the dependent variable over change in
the independent variables.

Where,

1.2.1 Dependent and Independent Variables

As we discussed in the previous topics, the relationship between y and x expressed by y = mx +

b is called a functional relationship, because for each value of x, there is one and only one
corresponding value for y. Notice that the expression states that y is in terms of x and we connote
this by saying y is a function of x. If we write; y is equal to an expression involving x and
constants, then x is called the independent variable and is plotted on the horizontal axis. Which
means the value of y depends upon what value we assign to x. in other way of saying the
movement of y depends on the movement of x, and for that reason y is called the dependent
variable, which is plotted on the vertical axis. Thus, when we plot points, the values of x can be
chosen independently, but the corresponding values of y depend on the values chosen for x.

For example, XYZ manufacturing Company produces shoes using inputs such as leathers, labors,
etc. Therefore, the firm incurs costs which are varying with the level of shoes produced.

The dependent variable in this case is total production cost because it is increasing with number
of Shoes produced whereas the independent variable in this example is the number of shoes
produced.

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1.2.2 Slope

The other important term in linear function is Slope. Slope is defined as the rate of change in the
dependent variable for a unit change in the independent variable. Any straight line, with the
exception of vertical lines, can be characterized by its slope.

Numerically, the slope of a straight line is the ratio of the rise (or fall) to the run between two
points on the line, where rise or fall is the vertical separation and the run is the horizontal
separation of the two points.

( ) =

The slope of a line is quantified by a real number and can be computed by dividing the change in
the dependent variable(Y) by the change on the independent variable (X). The sign of the slope
(number) indicates whether the line is rising or falling. The magnitude (absolute value) of the
slope indicates the relative steepness of the line. The slope tells us the rate at which the value of
y changes relative to changes in the value of x. the larger the absolute value of the slope, the
steeper the angle at which the line rises or falls.

Example: compute the slope of a line connecting points located at (2, 4) and (5, 12).

Solution:

Example: compute the slope of a line segment connecting two points (5, 8) and (10,-12)

Solution:

Forms of a slope of a line

The slope of a line can take four forms. Namely;

A. Positive slope: a line with a positive slope rises from left to right or runs uphill. In such cases
we can say that there is a direct relationship between the two variables.

 For such a line the value of y increases as x increases (or y decreases as x decreases).

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 Y-axis

X-axis

Figure: Positive sloped lines

B) Negative slope: it implies that there is an inverse relationship between the two variables:
dependent and independent
 A line having a negative slope falls from left to right, or runs downhill, and for such a
line the value of y decreases as x increases (or y increases as x decreases).

X-axis

Figure: Negative sloped lines Y-axis

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C) Zero slope: this implies that there is no relationship between x and y. a line having a zero
slope is horizontal

 As „x‟ increases or decreases „y‟ stays constant

Y-axis

X-axis

Figure: Zero sloped lines

D) Undefined slope: this is the case of vertical lines (x=k); x is constant regardless of value y.

Y-axis

X-axis

Figure: Undefined sloped lines

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1.2.3 Intercepts

Intercepts: here we have two types of intercepts y-intercept and x-intercepts.

 The x-intercept of an equation is the points where the graph crosses the x-axis.
 The y-intercept is the point where the graph of the equation crosses the y-axis.
 Algebraically, the y-intercepts represent the order pair found by setting=0

Example: determine the y-intercept and x-intercept of the following equations.

a) b)
Solution:
a)
b) ⁄

Horizontal and vertical lines

 Horizontal line74s are lines parallel to the x-axis having zero slope and the form y=c,
where c is non-zero constant
 Vertical lines are lines parallel to the y-axis having undefined slope and the form x=k,
where k is any nonzero constant. The value of y changes regardless of the value of x.

Parallel and perpendicular lines

 If two lines and are parallel, then their slope is equal.

 Let the slope of be and the slope of be .thus, parallel to if and only if

Example: identify parallel and perpendicular lines

a){

b){

If two slant lines are perpendicular, the slope of one is the negative reciprocal of the slope of the
other. Therefore, example “a” is stands for parallel lines and “b” is stands for example of
perpendicular lines.

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1.3 Graphing two variable Equations

A linear equation involving two variables has a graph which is a straight line in two dimensions.
In order to graph this type of linear equation, you only need to:

i) Identify the coordinates of any two points which lie on the line,
ii) Connect the two points with a straight line, and
iii) Extend the straight line in both directions as far as necessary or desirable for your purposes.
The coordinates of the two points are found by identifying any two members of the solution
set.

Example:

The graph of the equation 4y = -2x + 16 is found by first identifying any two pairs of values for x
and y which satisfy the equation.

Solution:

Step 1: identify the coordinates of any two points

Letting x = 0 the corresponding value for y is 4 and letting y = 0 results in x = 8. Thus, (0, 4) and
(8, 0) are two members of the solution set and their graphical representation is indicate by the
two points in Fig 1.1.

Step 2: Connect the two points with a straight line

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Step 3: Extend the straight line in both directions as far as necessary or desirable for your
purposes.

2 4 6 8

1.4 Determining a straight line equation

i) Slope and intercept: initially by identifying slope (m) and y-intercept i.e. (0, b), you
will simply substitute in the basic simple linear equation formula

Where, b - y intercept and m slope

Example: determine the equation of the straight line which has a slope -5 and y intercept at (0,
15)
Solution:
Exercise: compute the equation of straight line which has slope 4 and y-intercept at (0, 10).

ii) Slope and one point

Example1: given the slope of a straight line is -2 and one point lying on the line is (2, 8), find
the equation.
Solution:
( )

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Exercise 1: if the slope of a straight line is zero and one point lying on the line is (5,-30), find
the equation.

3) Two points

Example 2: the following points are given (-2, 4) and (4, 6), find the equation.
Given:

Required: determine linear equation

Solution:
1st compute slope (m): ( )
nd
2 compute for linear equation: ( )
( ( ))

Exercise: determine the linear equation of a line run between (-3, 3) and (1, 6)
1.5 Applications of Linear Equations

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 five
application areas of linear equations. These are the
i) Linear cost – output relations analysis
ii) Linear revenue – output relation analysis
iii) Linear profit - output relation analysis and
iv) Break –even analysis
v) Equilibrium point analysis

In this particular section, we will consider these application areas to some detail for
manufacturing and merchandising businesses.
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 1.5.1 Manufacturing Businesses
Manufacturing firms are those businesses engaged in production of goods and services from the
resources available for them. To produce goods and services, these firms incur cost in the form
of variable and fixed costs. As the result the summation of variable and fixed costs make up total
manufacturing (production costs). The manufacturing firms incur the costs to make profit which
is the result of the difference between total revenue (the money collected form sell of goods and
services) and total cost (total money flowing out for the acquisition of resources).

A. Linear Cost Functions

Organizations are concerned with costs because they reflect money flowing out of the
organization. These out flows usually pay for salaries, raw materials, suppliers, rent, heat,
utilities, and so forth. Accountants and economists often define total cost in terms of two
components: total variable cost and total fixed cost.

Fixed costs are costs that have to be met no matter how much or how little of the commodity are
produced; that is they do not depend on the level of production.

Examples of fixed costs are rents, interest on loans and bonds and management salaries these
costs are expenditure that the company should incur irrespective of the production level.
Variable costs are costs that depend on the level of production (that is on the amount of
commodity produced); material costs and labor costs are examples of variable costs. The
movement of these costs is determined by the movement of output produced by the organization.
If the output level is high these costs are expected be high and if the output level is low these
costs are expected be low. In another way of saying there is direct relationship between variable
cost and output level.

These two components must be added to determine total cost.

TOTAL COSTS = VARIABLE COSTS + FIXED COSTS

Assumption of linear cost function

 Constant unit variable cost – the variable cost for each unit is the same regardless of the
number of units produced (implies constant returns to scale or no economies or diseconomies
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 of scale). This assumption ignores the possibility that the elements of the production process,
laborers or machines, may become more efficient as the number of units produced increases
or that buying raw materials in large quantities may result in quantity discounts which in turn
may lower the variable cost per unit produced.
 All cost involved in the production of goods and services is known
 Fixed cost remains constant over a relevant range
Based on the above assumptions case the total variable costs are proportional to the amount of
commodity produced. If V denotes the variable cost per unit, then the total variable costs of
producing Q units of commodity is VQ. If fixed costs are Fc, then the total cost, C (Q), of
producing Q units is given by

Total cost equation

Total cost = Total variable cost + Total fixed cost

TC or C (Q) = TVC + TFC

TC or C (Q) = V Q + TFC

Where V = is variable cost per unit – unit variable cost.

Q = is the amount of production

TC or C(Q) = is the total cost

Example 1:

The variable cost of processing 1kg of coffee beans is $ 0.50 and the fixed costs per day are
$300.

a. Give the linear cost equation.

b. Draw its graph.
c. Find the cost of processing 100 kg of coffee beans in one day.

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Given: v= $0.50 and TFC =$300

Solution

a) If TC represents the cost in (in dollars) of processing Q kg of coffee beans per day, then
according to the linear function model we have

TC = VQ + FC

Where v is variable cost per unit and Fc is fixed costs per day

V = $0.5 per unit and FC = $300.

Therefore TC = 0.5Q + 300

b) To sketch the graph of TC = 0.5Q + 300, let us first find two points on it using the concept of
intercepts.

 If Q =0, then TC =300. i.e, (0, 300)

 If TC =0, then Q =- 600. i.e (-600, 0)

Thus two points satisfying cost equation, TC = 0.5Q + 300 are (0, 300) and (-600, 0).

Plotting these two points and joining them by a straight line, we obtain the graph. Note that the
relevant portion of the graph lies totally in the first quadrant because x and y are both
nonnegative quantities.

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c) Substituting Q = 100 in the equation C (Q) = 0.5Q + 300 we get

TC = 0.5 (100) + 300

TC = 350. Thus the cost of processing 100kgs of coffee beans per day will be $ 350.

Example 2

If the total factory cost (y) of making X units of a product is given by y = 3x + 20, and if 50 units
are made,

A) What is the variable cost (VC)?

B) What is the total cost (TC)?
C) What is the variable cost per unit (VC/unit)?
D) What is the average cost per unit (AC/ unit)?
E) What is the marginal cost of the 50th unit?
Solution

Given, total cost = y = 3x + 20

x = Units produced
x = 50 Units
A) Variable cost is the cost that varies with the level of production and it can be obtained by
multiplying the slope or the marginal cost with the number units produced (x).
That is, VC = m x = 3*50 = Birr 150

B) TC is the sum of fixed cost and variable cost. In the equation given y =3x + 20, the term
3x represent the VC and the constant 20 is the fixed cost. Thus
TC = y = 3x+20 = 3(50) + 20 = 150 + 20 = Birr 170

C) Variable cost per unit = vc / unit = vc / x = 150 / 50 = Birr 3

D) AC is given by total cost divided by Number of units produced. Thus,
AC/ unit = TC/ x = (VC+FC)/ x = (150 + 20) / 50 = 170 / 50 = Birr 3.40
E) The slope of a linear equation is equal to the marginal cost of any given level of
production thus, MC = 3.

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In alternative approach, MC is the extra (additional) cost of producing one more unit of output.
Thus, the marginal cost of producing the 50th unit is equal to the additional cost in producing the
50th unit.

( ( ) ) ( ( ) )

B. Linear Revenue Functions

The money which flows in to an organization from either selling products or providing services
is often referred to as revenue. The most fundamental way of computing total revenue from
selling a product (or service) is:

Total revenue = (price) (quantity sold)

An assumption in this relationship is that the selling price, p is the same for all units sold Q. If a
firm sells a product, where Q equals the number of units sold of a product and P equals the price
of a product Q, then total revenue function is:

TR or R(Q)= PQ

Example: A firm sells a single product for $ 65 per unit.

a. Construct the revenue function in terms of quantity sold, Q.

b. Plot the graph.
c. What is the total revenue (TR) of selling 200 units of output?

Solution

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a. If the selling price equals $ 65 per unit, total revenue is computed by using the function
TR = P Q
TR = 65Q
b. To plot the graph of R (Q) = 65Q; let Q = 0 then R (Q) = 0 (0, 0) is the point on line
Y = 65x. And letting Q = 20 we get R (Q) =1300. This means (20, 1300) is also on the line y
= 65x. Therefore, show these points on Q plane and connect them by a straight line.
Total Revenue

c. insert 200 in to the equation TR= 65(200) = 13,000

C. Linear profit functions

Profit (Π) for an organization is the difference between total revenue and total cost. Stated in
equation form, Profit = Total revenue – Total cost

Π = TR – TC

When total revenue exceeds total cost, profit is positive. In such cases the profit may be referred
to as a net gain, or net profit. When total cost exceeds total revenue profit is negative and it may
be called a net loss or deficit. When both total revenue and total cost are linear functions of the
same variable, the profit function is also a linear function of the same variables. That is if Total
Revenue = TR and Total cost = TC profit is defined as

Π = TR – TC

Π (Q) = P(Q)- VQ-TFC

Π (Q)= (P-V)Q-TFC

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Example: A firm sells a single product at $65 per unit. Variable costs per unit are $20 for
materials and $27.50 for labor. Annual fixed costs are $ 100,000.

a. Construct revenue, cost & profit functions in terms of quantities produced and sold.
b. Show graphically the equations.

Solution

a) If the product sells for $65 per unit, total revenue is computed by using the function
TR = 65Q
Similarly, total annual cost is made up of material costs, labor costs and fixed costs:
C (Q) = 20Q + 27.5 Q + 100,000
TC = 47.5Q + 100,000
Thus the profit function is computed as
Π = R (Q) – TC
Π = 65Q – (47.5Q + 100,000)
Π = 17.5 Q – 100,000
b) Graph of Revenue and Cost Functions

D. Break Even Model

In this section we will discuss break even models, a set of planning tools which can be, and has
been, very useful in managing organizations. One significant indication of the performance of
the companies is reflected by the so called “bottom line” of the income statement for the firm
that is how much profit is earned! Break even analysis focuses upon the profitability of a firm.

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Of specific concern in break-even analysis is identifying the level of operation or level of output
that would result in a zero profit. This level of operation or output is called the break-even point.
The break-even point is a useful reference point in the sense that it represents the level of
operation at which total revenue equals total cost. Any changes from this level of operation will
result in either a profit or a loss. Break-even analysis is valuable particularly as a short term
planning tool when firms are contemplating expansions such as offering new products or service.
Similarly, it is useful in evaluating the pros and cons of beginning a new business venture. In
each instance the analysis allows for a projection of profitability.

Assumptions

 The selling price per unit of output is constant.

 The variable cost for producing one unit is known and constant.
 The periodic fixed cost is constant in relevant range
 Price per unit of output is greater than the variable cost per unit of output.

The break-even point may be expressed in terms of

 Volume of output (or level of Activity)

 Total dollar sales
 Percentage of production capacity.
Let us now drive a formula for breakeven point or Q*.

TR = TC. Sine TR =PQ and TC =VQ +FC ,

PQ = VQ + FC
PQ* = VQ* + FC
PQ* – VQ* = FC
Q* (P - V) = FC

( )

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Example 1

A group of engineers is interested in forming a company to produce smoke detectors. They have
developed a design and estimate that variable costs per unit, including materials, labor, and
marketing costs, are Br.22.50. Fixed costs associated with the formation, operation, and
management of the company and the purchase of equipment and machinery total Br.250,000.
They estimate that the selling price will be Br.30 per detector.

a. Determine the number of smoke detectors which must be sold in order for the firm to break
even on the venture.
b. Preliminary marketing data indicate that the firm can expect to sell approximately 30,000
smoke detectors over the life of the project if the detectors are sold for Br.30 per unit.
Determine expected profits at this level of output.
Solution

a. The total revenue function is represented by the equations

R (Q) = 30Q
The total cost function is represented by the equation
TC = 22.50Q + 250,000
The break-even condition occurs when total revenue equals total cost, or when
TR =TC
For this problem the break-even point is computed as
30Q* = 22.50Q* + 250,000
7.50Q* = 250,000
Q* = 33,333.33 units
The alternative approach is to first write the profit function and set it equal to zero as follows:
P (Q) = R (Q) – C (Q)
= 30 – (22.50Q + 250,000)
= 7.50Q – 250,000
Setting the profit function P (Q) equal to 0, we have
7.50Q*– 25,000 =0
7.50Q* = 250,000

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 Q* = 33,333.33 units
Our conclusion is that given the assumed cost and price parameters (values), the firm must sell
33,333.33 units in order to breakeven.
b. With sales projected at 30,000 smoke detectors,
π= 7.5(30,000) – 25,000 = 225,000 – 250,000 = -25,000
This suggests that if all estimates hold true-price, cost and demand- the firm can expect to lose
Br.25, 000 on the venture.
To further our understanding of break-even analysis, let us consider the following break-even
chart.

Exercise:

Q1) If a firm sales a single product at $65 per unit; variable costs per unit are $20 for materials and
$27.50 for labor and annual fixed costs are $100000, then

a) Construct revenue, cost and profit functions in terms of quantities of product

produced or sold
b) Show graphically the equations.

Q2) for a watch maker the cost of labor and materials per watch is $15 and the fixed costs are
$2000 per day. If each watch sell for a $20, how many watches should be produced and sold be
produced and sold each day to guarantee that the business break even? Show graphically the
BEP.

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 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 0
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):
 TC = v q + FC
 TR = p q
 Average Revenue (AR) = TR ÷ Q = PQ ÷ Q = P
 Average Variable Cost (AVC) = v Q ÷ Q = v = Slope (m)
 Average Fixed Cost (AFC) = TFC ÷ Q
 Average Cost = TC ÷ Q = AVC + AFC
 Profit (  ) = TR – TC
1.5.2 Merchandising (retail) businesses

Retailers are businesses engaged in buying and reselling of goods and services. These firms
purchase products and resell them at a price, that is, presumably above the cost.

A. Cost functions of Retailers

Suppose that an item that cost (purchased at) $ 130 is priced to sell at $200. The Mark up the
difference between selling price (retail price) and purchasing cost is $ 70. That is

Mark up = Retail (selling prices) - Purchasing Costs

Purchasing Cost = $130

Retail price = $200
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 Mark up= Retail price –purchasing cost
= 200 – 130
= $70
From manager‟s view point the dollar (Birr) amounts of mark up on numerous individual
items, which will vary widely, are not very useful in planning and controlling operations. What
is useful is the overall mark up percentage on all items.
For comparability in different items, Markup is viewed in one of two ways:

1) As a function of the cost, and

2) As a function of retail price
In the current example the mark up as the function of cost is

On the other hand, in financial statements accountants use the concept of margin which is the
markup percentage on retail price. Margin is the percentage of mark up as of retail price.
In our example this is:

This means that 35 percent of the retail price of $200 is margin and the other 65 percent of
$200 which 0.65(200) = $130 is the purchasing cost (cost of goods sold).
We now suppose that the company in our illustration uses a margin of 35 percent on all items it
purchases, so that if the firm sells $x worth of merchandise (goods and services), 35 percent of
this amount is margin and 65 percent is cost. Thus, Purchasing cost (cost of goods sold) = 0.65
x.
Total variable cost is the sum of purchasing cost which is the significant cost of merchandising
firms and additional variable costs which is variable costs incurred by retailers except
purchasing cost. That is:

Total variable costs = Purchasing Costs + Additional Variable costs

Continuing our example, if the company incurs selling expenses, which it budgets at 10 percent
of the volume of sales (x), that is selling expense (additional variable costs) = 0.1x if the
company budgets fixed expense at $12,000:

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 Thus for example at a sales volume (total revenue) of $60,000 cost will be:
Y (TC) = 0.75 (60,000) +12,000
Y (TC) = 57,000
And profit before taxes will be:
∏ = TR -TC
60,000 – 57,000
∏= $3000
Driving the Break-Even Level of Sales
Let us symbolize some important components of the formula. Thus, consider the
equation
y = m x + b, where y = represent the total cost
m = represent the variable cost per dollar of sales
x = represent the sales volume (Revenue)
m x = total variable cost
b = the fixed cost
As we have considered in the former case, at breakeven revenue is equal to cost. That
is, y = x. Further, at break – even, the amount of dollar sale is equal to the cost, thus the
break – even level of sales (xe) is equal to y and x.
Therefore, y = x = xe
Then at the break-even point, y and x can be substituted by xe in the equation of
y = mx + b.
Accordingly, xe – m (xe) = b. Now let us solve for xe.
xe = m(xe) + b
xe – m (xe) = b
xe (1 – m) = b
( )
( ) ( )

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 Thus, is the expression for Break Even level of sales
( )

Or,
( )

Example
Suppose that in making a budget for next year‟s operations top management of Hirmata
Business Group has set a sales goal of Birr 200,000 per week. Margin is to be 45% of retail
price and other variable cost is estimated at Birr 0.05 per birr of sales. Fixed cost is projected at
Birr 56,000.
a. What is the linear sales-cost equation?
b. What is the breakeven volume of sales in birr per week?
c. What is the company‟s profit if sales goal is attained?
d. What is the company‟s profit if it sells merchandise that worth Birr 100,000?
e. Plot the company‟s cost-sales model.
Solution
Given values, Margin = 45% = 0.45
Other variable cost = 0.05 per birr of sales
Fixed cost (b) = birr 56,000
Sales goal (Revenue R) = Birr 200,000
x = the monetary (dollar) amount of sales (sales volume)
In addition, if margin is given as 45% the remaining 55% or 0.55 represent the cost. Thus, the
variable cost per birr of sales is equal to m = (100 % - margin percentage) + other variable cost
= (100% - 45%) + 0.05.
Taking these values, we can solve out the problem
The equation y = m x + b
y = 0.6 x + 56.000 = 0.55 + 0.05 = 0.60
Break-even volume of sales

Page | 25
For any amount of sales volume (Revenue) greater than birr 140,000 profit will be attained. At
the targeted level of sale, the profit will be obtained as follows.
Profit = Revenue – Cost
= 200,000 – (0.06x200,000 + 56,000)
= Birr 24,000
Profit if the sales volume (revenue) is birr 100,000.
Profit (A) = R – C
= 100,000 – (m x + b), since cost (c) or y = mx + b
= 100,000 – (0.6 (100,000) + 65,000)
= 100,000 – (60,000 + 56,000)
= 100,000 – 116,000
= (Birr 16,000)
Hence, at sales volume of birr 100,000 the company incurs a loss of Birr 16,000.
Graph of cost – sales model or break – even chart

Page | 26
Exercise: A company expects fixed cost of $36000 margin is to be 52% of retail and variable
cost in addition to cost of goods sold (purchasing cost) is estimated at $0.07 per birr of sales.

a. write the equation relating cost and sales

b. find the break-even point
c. what will be the net profit before taxes on sales of $75000
d. make a break even chart

1.6 Market Equilibrium

Linear demand functions

 A demand function is mathematical relation expressing the way in which the quantity
demanded of an item varies with the price charged for it.
 The relation between these two variables, quantity demanded and price per unit, is
usually inversely (negatively) related.
 The relationship that specifies the amounts of a particular commodity that consumers are
willing to buy at various price levels is called the law of demand.

Where,
P-the price per unit of commodity;
Q- Quantity demanded;
m- Changes in amounts of quantity demanded due to change in a birr/$ of commodity prices
(the value of m is negative); and
b- is constant.
Example 1: a buyer can buy 20 electric shavers at $25 per shaver, but he can buy 30 shavers if
he charges $20 per shaver. Determine the demand equation, assuming it is linear.
Given:

Page | 27
Required: Determine Demand equation
Solution

Then ( )
( )

Linear supply functions

 A supply function relates market price to the quantities that supplies are willing to
produce and sell.
 The implication of supply functions is that what is brought to the market depends upon
the price people are willing to pay.
 The relation between these two variables, quantity supplied and price per unit, is usually
directly (positively) related.
 A relation specifying the amount of any commodity that manufacturers (sellers) can make
available in the market at various prices is called the law of supply.

Where,
P-the price per unit of commodity;
- Quantity supplied;
m- Changes in amounts of quantity supplied due to change in a birr/$ of commodity
prices (the value of m is positive); and
b- is constant.

Example 1: a dealer can sell 20 electric shavers at $20 per shaver, but he can supply for sell 30
shavers if the market price is changed to $25 per shaver. Determine the demand
equation, assuming it is linear.

Page | 28
Given

Required: Determine Demand equation

Solution

Then ( )
( )

Market Equilibrium
Market is said to occur at a price when the quantity demand is equal to the quantity supplied.

Q
Supply

Equilibrium
point

Demand

Hint: at equilibrium point,

Page | 29
Example: determine the equilibrium price ( ) and equilibrium quantity ( ) for the following
demand and the supply laws
( )
( )
Solution:

( )

Coming to equilibrium price ( ), insert into demand or supply equation given above.
Therefore;
( )

Q Supply:

P=3Q+5

𝑃𝑜 =17 Equilibrium
point

Demand

P=-2Q+25

P
𝑄𝑜 =4

Exercise: if the demand and supply equations are respectively,

Determine the values of Q and P at market equilibrium and draw the graphs.

Page | 30
 CHAPTER TWO
MATRIX ALGEBRA AND ITS APPLICATION
2.1 Basic Concepts
A matrix is a rectangular array of numbers, parameters, or variables each of which has a
carefully ordered place and rules applied for it. It is any rectangular form of numbers arranged in
rows and columns which is enclosed by large bracket , - or brasses ( ) subject to certain rules
of operation. It is customary to enclose the elements of a matrix in parentheses, brackets, or
braces to signify that they must be considered as a whole and not individually.
Matrices are generally denoted by bold face capital letters such as: A, B or C. The numbers
(parameters or variables) which form the array are referred to as the entries or elements of the
matrix. The elements in any horizontal line form a row and those any vertical line form a column
of the matrix.
A matrix is further characterized by its dimension. The dimension or order indicates the number
of rows and the number of columns contained within the matrix. If a matrix has m rows and n
columns, it is said to have dimensions , which is read “m by n”.

Matrices are widely applied in the representation of linear equations and systems of linear
equations, solving system of a linear equations, input output analysis, Markov Chain Analysis.

2.1.1 General form

Matrix a containing elements has the general form:

A=

( )

Example: Determine the dimension of the following matrix

A=( )

Solution: 4x3 or 4 by 3

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Example: determine the size (order or dimension) of the following matrices.

A=. / B=( +

C=( ) D=( )

Solution:

 Matrix A contains 2 rows and 3 columns (2 by 3)

 Matrix B contains 3 rows and 1 column (3 by 1)
 Matrix C contains 1 row and 4 columns (1 by 4)
 Matrix D contains 1 row and 1 column (1 by 1)

2.1.2 Type of Matrices

Based on their dimension (order), matrices are classified in to the following types:

A. Vector Matrix: A vector is a matrix having only one row or one column. These matrices can
also be referred to as row and column matrices.
A row matrix: is a matrix that has only one row and can have many columns.
E.g. , -
A column matrix: is a matrix with only one column and can have many rows.

E.g. [ ]

B. Square matrix: is a matrix with equal number of rows and columns.

E.g.

0 1 [ ]

C. Diagonal matrix: is a square matrix where it‟s all non- diagonal elements are zero.
E.g.

0 1 [ ]

Page | 32
D. Scalar matrix: a square matrix is called a scalar matrix if all its non- diagonal elements are
zero and all diagonal elements are equal.

0 1 [ ]

E. Unit matrix (Identity matrix): is a type of diagonal matrix where its main diagonal
elements are equal to one while the other elements equal to Zero.
E.g.

0 1 [ ]

F. Null matrix (zero matrix): a matrix is called a null matrix if all its elements are zero.

E.g. 0 1

G. Equal Matrix: two matrices are equal, if and only if, they have the same order and each
entry in one matrix is identical with the corresponding entry of the other matrix. For two
matrices to be equal, they must be of the same size and have all the same entries in the same
places.
E.g.

0 1 0 1

H. Symmetric matrix: a matrix is said to be symmetric if A = At.

E.g. [ ]

N.B: Every scalar matrix is a diagonal matrix; whereas a diagonal matrix need not be a scalar
matrix. Every unit matrix is a scalar matrix; whereas a scalar matrix need not be a unit matrix.

Page | 33
2.2 MATRIX OPERATIONS AND PROPERTIES
1. Matrix Equality: two matrices are said to be equal if and only if they have the same
dimension and corresponding elements of each matrix are equal.

E.g. 0 1 0 1 0 1

 A ≠ B; A = C; B ≠ C.

2. Transpose of a Matrix: If the rows and columns of a matrix are interchanged the new
matrix is known as the transpose of the original matrix. If the original matrix is denoted by
A, the transpose is denoted by A or At. Transposition means interchanging the rows or
columns of a given matrix. That is, the rows become columns and the columns become
rows.

E.g 2 3

The transpose of matrix , denoted by is given as:

{ }

The dimension of A is changed from 2x3 to 3x2.

Properties of the Transpose

The following properties are held for the transpose of a matrix:

 Property 1: (At)t =A
 Property 2: (aA)t = aAt, where (a) is a scalar (at = a)
 Property 3: (A+B)t = At + Bt
 Property 4: (AB)t = BtAt
3. Addition and Subtraction of Matrices
Two matrices A and B can be added or subtracted if and only if they have the same order, which
is the same number of rows and columns. That is, the number of rows of matrix A is equal to the
number of rows of matrix B, and the number of columns of matrix A is equal to the number of
columns of matrix B. Two matrices of the same order are said to be conformable for addition and

Page | 34
subtraction. The sum and subtraction of two matrices of the same order is obtained by adding
together or subtracting corresponding elements of the two matrices.
If A= (aij) and B= (bij), then C = A+B is the matrix having a general element of the form; C ij = aij
+ bij. D = A-B → Cij = aij - bij .

Example 1:

[ ] [ ] 0 1

Required: compute A+B, A+C

Solution

A+B = [ ] [ ] [ ]

A+C is impossible because they have not same order (dimension).

Properties of matrix addition

 Commutative law: A+B = B+A

 Associative law: (A + B) + C = A + (B + C)
 Existence of identity: A+ 0 = 0 + A = A.
NB: The subtraction (difference) of two matrices of the same order is obtained by subtracting
corresponding elements.

 A-B ≠ B-A, thus matrix subtraction is not commutative.

 (A-B) –C ≠ A- (B-C) ; matrix subtraction is not Associative.
Example 2: Anbessa shoe manufacturer makes black, white and brown shoes for children,
women and men. The production capacity (in thousands of pairs) at the Finfine plant is given by
the following matrix:

The production at Adama plant is given by

Page | 35
Required: Given the matrix representing the total production of Finfine plant and Adama plant,
find total production of each type of shoes in both plants.
Solution:

A=( +

B=( +

A+B=( +

Note: Two matrices can be added or subtracted if and only if they have the same dimension.
4. Matrix Multiplication
Two matrices A and B can be multiplied together to get AB if the number of columns
in A is equal to the number of rows in B.

A B

mxn n x s

Inner dimension

Outer dimension

If two matrices have the same inner dimension, then we can get the product of the matrices. The
resulting matrix will have a dimension equal to the outer dimensions of the two matrices. There
are two types of matrix multiplication: multiplication by a scalar and multiplication by a
matrix.
Page | 36
Properties of matrix multiplication
Property 1: The distributive law is valid in matrix multiplications.
A (B+C) = AB + AC
(B+C)A = BA + CA
Property 2: The associative law is valid in matrix multiplication.
(AB)C = A(BC) = ABC
Property 3: If I is an identity matrix, then;
AI = IA =A
In general, as long as the order of the matrix is maintained, matrix multiplication is associative,
but matrix multiplication is not commutative except for:
a) The multiplication of a matrix with an identity matrix;
i.e. A.I = I. A =A
b) The multiplication of a matrix with its inverse;
i.e., A.A-1 = A-1.A = I

i) Scalar multiplication: scalar is a real number/constant number. The product is found by

multiplying each element in the matrix by the scalar.
Example: if K is a scalar and A is the 3x2 matrix below, then find the scalar
multiplication.

A=( +

( + = ( +

ii) Inner product :let A=( ) be 1xn row matrix and B=( , be

an nx1 column matrix, then we shall define inner products of corresponding elements of
A and B then finding the sum of all n of these products, i.e. A.B=

Note: the inner product is defined if and only if row and column vectors contain the same
number of elements.

Example 1: Consider the following vectors: A=( ) and B=. /, then find inner products

Page | 37
Solution:
(5)(4) + (-2) (6) = (8)

Example 2: Given the following vectors: L=( ) N=( )

Required: Find inner products of LN.

Solution:( ) ( ) ( ) ( ) ( )
Example 3: Interest at the rates of 0.06, 0.07 and 0.08 is earned on respective investments of
$3000, $2000 and $4000.
a) Express the total amount of interest earned as the product of a row vector by a column vector.
b) Compute the total interest by matrix multiplication.

iii) Matrix Multiplication :assume that a matrix A having dimension is to be

multiplied a matrix B having dimension
1. The matrix product AB is defined if the number of columns of A equals the number of
rows of B, or if =
2. If the multiplication can be performed (i.e. = ) the resulting product will be a
matrix having dimension =
Example 1: here given are matrix A and B.ew

0 1 0 1

Required: find
i) AB and
ii) BA
Solution (i)
Page | 38
AB
1st check for equality of their inner dimension (i.e. = )

2nd multiply elements in each row of first matrix with corresponding elements in each
column of the second matrix.
( ) ( ) ( ( ) ( ) ( )
[ ] 0 1
( ) ( ) ( ) ( ) ( ) ( )
Solution (ii)
BA
1st check for equality of their inner dimension (i.e. = )

Example 2: suppose that a firm manufactures two products: I and II, by using different amounts
of the three raw materials: P, Q and R. let the units of raw materials used for the two products be
given by the following matrix.

Product Raw Materials

P Q R
I 3 2 4
II 2 5 1

Suppose the firm produces these two products at two plants X and Y. let the costs of the raw
materials per unit at the two locations X and Y be given by matrix B.

Raw materials Plants

X Y
P 10 12
Q 8 7
R 6 5
Required: determine the total costs of raw materials for two
products at the two plants: X and Y.

Given: 0 1 [ ]

Page | 39
1st check for equality of their inner dimension (i.e. = )

2nd multiply elements in each row of first matrix with corresponding elements in each
column of the second matrix.

0 1*[ ]

( ) ( ) ( ) ( ) ( ) ( )
[ ] 0 1
( ) ( ) ( ) ) ( ) ( )

Page | 40
Page | 41
 5. Inverse of a Matrix
In scalar algebra, the inverse of a number is that number which, when multiplied by the original
number, gives a product of 1. Hence, the inverse of x is simply 1/x; or in slightly different
notation, ( ). In matrix algebra, the inverse of a matrix is that which, when multiplied by the
original matrix, gives an identity matrix. The inverse of a matrix is denoted by the superscript “-
1”. The relationship between a matrix A and its inverse (denoted by ) is that the product of A
and ), in either order, results in the identity matrix or
Note that: A matrix must be square to have an inverse, but not all square matrices have an
inverse. The necessary and sufficient condition for a square matrix to possess its inverse is that
/A/ ≠ 0.

Remark:
1. A matrix A is to be invertible or nonsingular if it has an inverse. If A does not have an
inverse, then it is said to be a singular matrix.
2. It can be shown that the inverse of any nonsingular matrix is unique, i.e., if A has an
inverse at all then it has only one inverse.
Example: verify that matrix B is the inverse of matrix A

A=. / B=. /

AB= . /. / = . /

Determining the Inverse of a matrix

There are two common approaches. These are:
1. By multiplying with its inverse and results I matrix
Example: change the following matrix in to an inverse

A=. /

Solution: . /( * =. /

Page | 42
 2. Gauss – Jordan Inversion
It is a technique to compute (find) the inverse of a matrix, procedures to compute the inverse of a
square matrix
1. Write the given matrix at the left
2. Augment an identity matrix that has the same dimension as the given matrix at the right
3. Apply row operations to the two matrices until the left matrix becomes an identity matrix
Row operations may include;
(a) Multiplication or division of a row by a non-zero constant
(b) Addition of a multiplication of one row to a multiple of another row
(c) Inter changing two rows

Page | 43
Page | 44
Page | 45
2.3 MATRIX APPLICATIONS IN SOLVING SYSTEM OF LINEAR EQUATIONS

2.3.1 MATRIX REPRESENTATION OF LINEAR EQUATION

Under this subtopic, we try to address how to rewrite a given linear equation by matrix form. To
write linear equation in matrix form it is important to identify that there are three terms such as
coefficients, variables and constant values. Therefore, while to represent linear equation by
matrix, there are three matrices namely, matrix for coefficients, for variables and for constant
(right hand side) values. When linear equations represented by matrix, the matrix uses for
representing variables and constant values are column matrices (column vector) whereas,
coefficients are represented by row matrix if a given linear equation is only one. in case of

Page | 46
multiple linear equations, coefficients are represent by matrix which its row is equal with number
of linear equations.
If, a linear equation of the form
Whereas;
- are coefficients
- are variables
– is constant value
Then it is represented by matrix as follow:
Coefficient variables constant

( ) ( )

( )
If, a linear equation of the form:

Then it is represented by matrix as follow:

Coefficients variables constant

( ) ( ) ( )

Example 1: The expression 3 +5 -4 = 25can be represented as follows:

Solution:
Coefficients variables constant

( ) ( +

Page | 47
Example 2: consider the following linear and represent by matrix form:

Solution:
Coefficients variables constant

. / . / . /

Example 3: express the following system of equations in a matrix form:

Solution:

{ }

Coefficients variables constant

( +4 5 ( +

Example 5:
A dealer of color television sets has five 26 inch sets, eight 20 inch sets, four 18 inch sets and ten
12 inch sets. The 26 inch sets is sold for $650 each, the 20 inch sets is sold for $550 each, the 18
inch sets is sold for $500 each and the 12 inch sets is sold for $300 each. Express the total selling
price of his television stock as the product of two matrices
Solution:
Coefficients variables constant

Total selling price=( )( )

Exercise 1: express the following system of equation in matrix form:

Page | 48
2.3.2 Approaches to Solve Linear Equations Using Matrix

A. Elimination Method
 It is a special type of elimination procedure
 The procedure begins with the original system of equations and transforms it using row
operations in to an equivalent system from which the solution may be read directly

{ → {

B. Inverse Method
There are common steps to be followed:
Step 1: Write the expanded form
Step 2: Find the inverse of the coefficient matrix
Step 3: Multiply the inverse by the constant matrix
Example: consider the system of equations

Required: Solve the above given linear equation using inverse method.
Solution:
Step 1: Write the expanded form

. / . / . /

Step 2: Find the inverse of the coefficient matrix

i) Augment coefficient matrix with equal dimension identity matrix

0 | 1

ii) Convert coefficient matrix in to identity matrix using row operation. Convert diagonal
elements in to 1 and off-diagonal elements in to 0.
 Start with converting the first diagonal element (2) in to 1 by multiplying its row the
reciprocal (inverse) of 2. (i.e,
* | + * | +
 Then convert other element in same column with 2 into 0 by -4R1 +R2

Page | 49
 R2 New= -4R1+R2 = 2 | 3 * | + * | +

Then,

0 | 1

 Continue with convert the second diagonal element (7) in to 1 by multiplying its row the
reciprocal (inverse) of 7.
(i.e, * | + * | +
 Then convert other element in same column with 7 into 0 by 3/2R2 +R1.

R1 New= 3/2R2 +R1= * | + * | + 2 | 3

Then,

[ | ]

Therefore, the inverse of coefficient matrix is [ ]

Step 3: Multiply the inverse by the constant matrix

. / [ ] . / . /

Therefore, x = 5 and y = 1
C. Gaussian Method
Step 1: Write the expanded form
Step 2: write the system of linear equations in augmented form (i.e., in the form of A/B, where A
is coefficient matrix and B is a constant matrix).
Step 3: applying elementary row operations to change or transform the coefficient matrix in to
identity matrix.
The row operations are:
i. Inter changing two rows
ii. Multiplying or dividing a row by a non-zero constant.
iii. Adding (subtracting) a constant multiple of one row to another.
Step 4: after reducing the values in to identity, determine the values.

Page | 50
Example 1:
3x+7y = 27
2x + 5y = 19
Required: Solve the above given linear equation using Gaussian matrix
Solution:
Step 1: Write the expanded form

. / . / . /

Step 2: write the system of linear equations in augmented form (i.e., in the form of A/B, where
A is coefficient matrix and B is a constant matrix).

0 | 1

Step 3: applying elementary row operations to transform the coefficient matrix in to identity
matrix.
 Convert the first diagonal element (3) into 1 and other in same column (2) into 0.
 Convert the first diagonal element (3) into 1 by multiplying its row (R1) with
the invers of the first diagonal element (3). * | +

* | +
 Convert other in same column (2) into 0 by adding the opposite of 2 after
multiplied with .( )

{ | } * | + * | +

Then; [ | ]

 Convert the second diagonal element (1/3) into 1 and other in same column (7/3) into 0.
 Convert the second diagonal element (1/3) into 1 by multiplying its row (R2)
with the invers of the second diagonal element (1/3).
2 | 3 * | +

 Convert other in same column (7/3) into 0 by adding the opposite of 7/3 after
multiplied with .( )

2 | 3 * | + * | +

Then; 0 | 1

Page | 51
Step 4: after reducing the values in to identity, determine the values.
Therefore, the value of X =2 and Y =3.
Exercise 1: consider the system of equations and solve it

Answer:
Exercise 2: solve the following system of linear equation

Answer:

2.3.3 SPECIAL APPLICATION AREAS OF MATRIX

Markov Chain Analysis

Definition- Markov analysis is the process of determining future occurrences depending on

present occurrences. It is a continuous process by which an outcome at each stage is determined
from the previous outcome by applying a certain fixed proportion.
There are two important data of the model:
a) The set of transition probabilities, and
b) The current or initial state
Based on these inputs, the model makes two predictions:
i. The probability of the system being in any state at any given time (i.e., state probability).
ii. The long run or steady state or equilibrium probability.
The Markov model is based on the transitional probability describing a situation that changes
between two stages. The first occurs at time (t-1), and the second stage takes place at time (t). In
other words, the current probability of a certain state depends on the probability of the immediate
preceding state only.
The Markov model has various applications in business and economics. For example, it can be
applied to a model where customers are buying products from two different stores and where
managers are interested in knowing how these customers change stores or continue buying from

Page | 52
the same store over the long run. Also, the Markov model can be applied to a situation where
people migrate from region to region between time (t-1) and (t).
States, Stages and Transitional Probabilities
Imagine the following table of probabilities:

The table reveals some technical concepts. The first concept is the state concept such as state 1,
2, and so forth, which means that the system is in a certain category or condition. For example; it
is sunny today (stage t-1) and will be cloudy tomorrow (Stage t). The second concept is the stage
concept. The table shows that there are two stages; stage t-1 and stage t. This means that if stage
t-1 represents yesterday, stage t represents today (or a future day). Similarly, if stage t-1
represents the month of May, stage t indicates the month of June (or a future month). The third
concept is the transition probabilities, Pij. Pij, i =1, 2….n and j =1, 2….n, which represent the
probabilities that the system will change from state i to state j during stage t. For example, P12
reflects the probability that the system will change from state 1 to state 2 during stage t. Similarly
p23 reflects the probability that the system will change form state 2 to state 3 during stage t. In
fact, this is the reason why the probability matrix P, where

is called the transition matrix which is a stochastic matrix, is a square matrix of dimension nxn
with the following properties:
i. All the elements Pij must be between 0 and 1 (i.e. pij ≥0), and

Page | 53
ii. The sum of each row must equal 1.
The fourth technical concept that the table of probabilities provides is the concept of a system. In
Markov analysis, the system consists of all the states along with their transition probabilities,
provides is the concept of a system. In Markov analysis, the system consists of all the states
along with their transition probabilities, Pij.
Example:
Assume a weather record showing that it will be sunny to tomorrow with a probability of 70
percent if it is sunny today; otherwise it will be cloudy tomorrow if it is sunny today. Also, the
record shows that the probability that it will be cloudy tomorrow 50 percent of the time if it is
cloudy today; otherwise it will be sunny tomorrow if it is cloudy today. The task is to formulate
the transition probability matrix, taking in to consideration the two states of sunny and cloudy.
The transition probability is shown below. The table reveals two stages: today (t-1) and
tomorrow (t). The transition probabilities reflect two states: Cloudy and sunny.
Tomorrow
Sunny Cloudy
Today Sunny 0.70 0.30
Cloudy 0.50 0.50
As can be seen, each entry of the transition matrix is between zero and one, and each entry can
be described as follows.
The probability 0.70 represents the probability that it will be sunny tomorrow if it is sunny today.
The probability of 0.30, which is ( ) reflects the probability that it will be cloudy
tomorrow if it is sunny today. The probability of 0.50 represents the probability that it will be
sunny tomorrow if it is cloudy today. The entry, 0.50, represents the probability that it will be
cloudy tomorrow if it is cloudy today.
Stated differently, these transition probabilities are actually conditional probabilities. If S
represents the event sunny, and C represents the event cloudy, then given that the state cloudy
has occurred today, the probability of being sunny tomorrow (or P(S/C) is equal to 0.50; this is
called a conditional probability. Similarly, P(C/C) is the conditional probability of cloudy
tomorrow given it is cloudy to day, which is equal to 0.50.
The transition (conditional) probabilities can be described by probability trees. Given that it is
sunny today, the probabilities that it will be sunny or cloudy tomorrow are 0.70 and 0.30,
respectively, as shown in the following:
Page | 54
 Sunny
0.7

0.30
Cloudy
Sunny
Given the state that it is cloudy today, the probabilities that it will be sunny or cloudy tomorrow
are 0.50 and 0.50 respectively, and this is shown below:

Sunny

0.50

Cloudy 0.50 Cloudy

The transition probabilities for the above problem are shown in the following transition diagram:

Example:

Assume that a market is shared by two cigarette brands namely Rothmans and Nyala. The
Ethiopian Tobacco Corporation conducted a market survey and has concluded the following
information about the proportion of smokers who stay with the same brand or change brands in
consecutive months.
 Of the smokers who bought Rothmans last month, 80% buy it again and 20 percent
change to Nyala this month.
 Of the smokers who bought Nyala last month, 40% buy it again and 60% change to
Rothmans this month. If for a sample of 1000 smokers, 400 buy Rothmans and 600 buy
Nyala in the first month of observations, what figure can we expect for the second, third
and fourth months?

Page | 55
 Remarks:
 The elements in the main-diagonal indicate brand loyalty.
 The elements in the off-diagonal indicate shifting of customers.
 The rows indicate the proportion of those retained and lost by a given brand.
 The column elements indicate the proportion of customers retained and gained by a
given brand.
Let R  represents Rothmans
N  represents Nyala
 The expected figure in the second month:
(Current state) (Transition probabilities)
R N R N R N
= 400 600 R 0.8 0.2 = 680 320
N 0.6 0.4
 The expected figure in the third month:
= State of second month. Transition probabilities
R N R N R N
= 680 320 R 0.8 0.2 = 736 264
N 0.6 0.4
 The expected figure in the four month:
= Third month state probability = Transition probabilities
R N R N R N

= 736 264 R 0.8 0.2 = 747 253

N 0.6 0.4

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Markov Chain Formula:
Where;
Vij(n) = Vij(n-1) p Vij(n) = the state probability at the nth period
Vij(n-1) = the state probability at the (n-1)th period
P = the transition probability

Taking the above example, if we continue the process; the state probabilities for the following
consecutive months will be:
Month Rothmans Nyala
5…………………………..….749.44 250.56
6………………………… ….749.888 250.112
7……………………………..749.9776 250.0224
8……………………………..749.99552 250. 00448
9……………………………..749.999104 250.0008964
Pre-multiplying P with ( 750 250 ) gives us:
750 250 0.8 0.2 = 750 250  Steady state probability
0.6 0.4
Note: Finding the steady state probability using the above pre-multiplication of the rounded
figure is cumbersome and time taking.
In reality, it is very difficult to find the steady state transition matrix by multiplying the P matrix
by itself many times. The alternative approach for finding the steady state matrix is to do the
following: S=SP
For the steady state matrix (S) of two states only, we have:
S1 S2 P11 P12 = S1 S2
P21 P22
For the above example, P= 0.8 0.2 ;
0.6 0.4
Then; S1 S2 . 0.8 0.2 = S1 S2
0.6 0.4
After performing the required multiplication, we obtain;
-0.2S1+ 0.6 S2 = 0 ……………..e1
The sum of the rows in the state vector
0.2 S1+ (-0.6 S2) = 0…………..…..e2
equals 1.
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 S1 + S2 = 1 ……....……..e3
This is a system of three equations but two unknowns. As the first two equations are linearly
dependent, one of the equations has to be dropped. Assume, the second equation is dropped, the
system becomes;
-0.2S1 + 0.6 S2 = 0 Solve simultaneously!
S1+S2 =1
Multiply the second equation by 0.2;
-0.2S1 + 0.6 S2 = 0
Solve simultaneously!
0.2S1 + 0.2S2 = 0.2
0+0.80S2 = 0.2
S2 = = 0.25
Then, substituting S2 = 0.25 in to any one of the equations, S1 = 0.75.
Therefore; (S1 S2) = (0.75x1000 0.25x1000) = (750 250), which is the steady state vector.
Example:
The market for a particular product is shared by three department stores: X, Y and Z. A market
survey has produced the market transition table below which describes the proportion of
customers who buy at the same store again or change stores in consecutive months.
From/To X Y Z
X 0.6 0.2 0.2
Y 0.1 0.6 0.3
Z 0.2 0.6 0.2
Required:
a. Find the share of the market which each store would command at the steady state
b. If the sample of 4000 people is assumed to be customers of the three stores, calculate the
number of customers who used each store at the steady state.
Solution:
a) Let V1, V2 and V3 represent the steady state vector;
At the steady state: (V1 V2 V3) * (P) = (V1 V2 V3)
Then, 0.6 0.2 0.2
(V1 V2 V3) 0.1 0.6 0.3 = (V1 V2 V3)
0.2 0.6 0.2

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After matrix multiplication, we obtain the following;
0.6V1+ 0.1V2 + 0. 2V3 = V1  -0.4V1+ 0.1V2 +0.2V3 = 0………..e1
0.2V1+ 0.6V2 + 0.6V3 = V2  0.2V1-0.4V2 +0.6V3 = 0 ………..…e2
0.2V1 + 0.3 V2 + 0.2V3 = V3  0. 2V1+ 0.3V2 - 0.8V3 = 0……….e3
V1+ V2 + V3 =1........................................................................e4
Equate e1and e4
-0.4V1 + 0.1V2 +0.2V3 = 0
X (0.4)
V1+V2+V3 =1
- 0.4V1+ 0.1V2 + 0.2V3 = 0
0. 4V1 + 0.4V2 + 0.4V3 = 0
0.5V2 + 0.6V3 = 0.4..................................e5
Equate e2 and e4
0.2V1-0.4V2 +0.6V3 = 0
X (-0.2)
V1+ V2 + V3 = 1
0.2V1 -0.4V2 + 0.6V3 = 0
-0.2V1- 0.2V2- 2V3 = -0.2
-0.6V2 + 0.4V3 = -0.2..................................e6
Equate e5and e6
X(0.6) 0.5V2 + 0.6V3 = 0.4
-0.6V2 + 0.4V3 = -0.2
0.3V2+0.36V3+ = 0.24
-0.3V2 + 0.2V3 = -0.1
0.56V3 = 0.14
V3 = = 0.25

Substitute V3 = 0.25 in e6;

Then, -0.6 V2 + 0.4V3 = -0.2  -0.6V2 + 0.4 (0.25) = -0.2
-0.6V2 =-0.3
V2 = = 0.50
Substitute V2 = 0.5 and V3 = 0.25 in e4;
Then; V1 +V2 +V3 =1  V1 +0.50+0.25 =1

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 V1=1-0.75= 0.25
(V1 V2 V3) = (0.25 0.5 0.25)  Steady state vectors
b) Total number of people = 4,000
 Customers of store x at the steady state = 0.25x 4000 = 1,000
 Customers of store y at the steady state = 0.5x 4000 = 2,000
 Customers of store z at the steady state = 0.25x 4000 = 1,000
Example: Presently three food processing firms X, Y and Z hold 5000, 3000 and 2000
customers of the market in coffee .there are 10000 consumers of coffee and nobody stops
consuming. The three firms simultaneously introduce new brands of coffee. With the
introduction of new brands in one year, the following occurs
A. X retains 60% of its customers and loses 20% to Y and 20% to Z
B. Y retains 60%of its customers and loses 30% to X and 20% to Z
C. Z retains 60% of its customers and loses 10% to X and 20% to Y
Required:
I. What share of the will each firm have at the end of the two years
II. Determine the number of customers of firm Z in the long run
Solution:

Transition matrix (P) =( +

I. ( )( + ( )

( )( + ( )

II. Equilibrium number of customers

( )( + ( )

⁄
( + ⁄
( ⁄ )
Therefore,
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 CHAPTER THREE
LINEAR PROGRAMMING
3.1 Introduction
Mathematical model involves optimization of a certain function, called the objective function,
subject to certain constraints. This model is known as Linear Programming (LP).
Linear Programming (LP) is defined as a mathematical modeling technique useful for economic
allocation of “scarce” or “limited” resources, such as labor, material, machine, time, warehouse,
space, capital, etc. to several competing activities such as products, services, jobs, new
equipment, projects etc, on the basis of a given criterion of optimality.
Linear programming is a method of obtaining an optimal solution or programme (say, product
mix in a production problem), when we have limited resources.
LP involves optimization of the objective function, subject to certain constraints.

3.2 Components of Linear Programming Model

The general structure of LP model consists of three basic elements or components.

1. Decision variables (Activities): - are physical quantities whose optimal numerical values
indicate the solution of the problem. The activities (also called the decision variables) are usually
denoted by X 1, X 2, .... X n. . The values of these activities represent the extent to which each of

these is performed. E.g. the number of units of a product to manufacture by using limited
resources such as personnel, machinery, money, material, etc. In an LP model all decision

variables are continuous, controllable, and non-negative. i.e. x1  0, x2  0,.... xn0.

2. Objective function: is the goal or objective of a management stated as intent to maximize or
minimize some important quantity such as profits and costs. Optimize (Maximize or
Minimize) Z= C1 X 1  C2 X 2  ....  Cn X n

Where Z is the measure of performance variable, which is the function of X 1, X 2, .... X n.

quantities C1, C2, ....Cn are parameters that represent the contribution of a unit of the respective

variables X 1, X 2, .... X n. to the measures of performance Z. The optimal value of the given

objective function is obtained by the graphical method or simplex method.

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3. Constraints: - are limitations or restrictions imposed by the operating environment. There are
always certain limitations (or constraints) on the use of resources, e.g. labor, Machine, Raw
material, space, money, etc.
4. None Negativity constraint: - the values of the decision variables can‟t be negative.

3.3 Formulation of Linear Programming Model

The steps for formulating the linear programming are:

 Identify the decision variables to be determined and assign symbols to them.
 Identify all the restrictions or constraints in the problem and express them as linear
equations or inequalities of decision variables.
 Identify the objective or aim and represent it also as a linear function of decision
variables.
In general terms, a linear programming problem (or model) with n decision variables and m
constraints can be stated in the following form:
Find the values of decision variables X 1, X 2, .... X n. so as to: -

Optimize (Maximize
or Minimize) Z = C1 X 1  C2 X 2  ....  Cn X n Objective Function
Subject to : a11x1 + a12x2 + . . . + a1nxn ( ≤,=,  ) b1
a21x1 + a22x2 + . . . + a2nxn ( ≤ , =,  ) b2
. . . .

am1x1 + am2x2 + . . . amnxn ( ≤, =,  ) bm Constraints

x1, x2 . . . , xn ≥ 0 Non-negativity
constraint
Maximization problem

Example 2.1: - A company manufactures two products X and Y, which require the following
resources. The resources are the capacities of machines denoted as , , and . The
available capacities are 50, 25 and 15 hours respectively in the planning period (a week). Product
X requires 1 hour of machine and 1 hour of . Product Y requires 2 hours of , 2 hours of
machine and 1 hour of . The profit contribution of products X and Y are 5 and 4 Birr
respectively. Formulate Linear Programming Problem
Solution
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1st Determine DV:
Product Symbol
X
Y
2nd Determine the constraints
Types of Resources/ Utilization of Resources Resources
Restriction Availability

0 2 50
1 2 25
1 1 15
3rd Identifying the Objective Function
It is the issue of profit contribution of X and Y.
Therefore;
(Optimization)
Then the formulated LPP is
Objective function
Subject to

Constraints

Non-negativity
Exercise: A firm is engaged in producing two products, A and B. Each unit of product A
requires 2 kg of raw material and 4 labour hours for processing, whereas each unit of product B
requires 3 Kg of raw material and 3 hours of labour, of the same type. Every week, the firm has
an availability of 60 kg of raw material and 96 labour hours. One unit of product A sold yields
Birr 40 and one unit of product B sold gives Birr 35 as profit. Formulate LPP

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Minimization Problem

Example 2:
Suppose the only foods available in your local store are potatoes and steak. The decision about
how much of each food to buy is to made entirely on dietary and economic considerations. We
have the nutritional and cost information in the following table:

Required: Formulate the LPP

Solution
1st Determine DV:
Products Symbols
Potatoes
Steak
2nd Determine constraints
Items in the Package Quantity of items in each Minimum requirements
package

Carbohydrates 3 1 8
Vitamins 4 3 19
Proteins 1 3 7

Therefore the constraints are:

3X1 + X2 ≥8
4X1+ 3X2 ≥ 19
X1+ 3X2 ≥7
3rd Identify the objective function.
The issue is securing the stated nutrients at least cost. That implies that minimization of costs.

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Therefore,
= $25X1 + $50X2
Therefore, the formulated LPP is:
= $25X1 + $50X2
S.to:
3X1 + X2 ≥8
4X1+ 3X2 ≥ 19
X1+ 3X2 ≥7
X1, X2 ≥0
3.4 Solving Linear Programming Problems (LPPs)
There are two approaches to solve LPPs
1. The Graphical Approach
2. The Simplex Algorism (Algebraic Method)
3.3.1 The Graphic Solution Method
To use the graphic method, the following steps are needed:
Step 1: Formulate LPP if not formulated
Step 2: Draw a graph including all the constraints based on intercepts
Step 3: Identify the feasible region
Step 4: Obtain a point on the feasible region that optimizes the objective function
Step 5: Compute the optimal solution
Example 1:
= 40x1 + 35x2 Profit
Subject to: -
2x1 + 3x2≤ 60 Raw material constraint
4x1 + 3x2 ≤ 96 Labor hours constraint
X1, X2 ≥ 0 Non-negativity restriction

Required: solve the above LPP using graphical method.

Step 1: formulate LPP (it is already formulated)
Step 2: Draw a graph including all the constraints based on intercepts:
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 → 2x1 + 3x2≤ 60; compute x1 and x2 intercepts.
→ If ; coordinate (0,20)
 Whereas, if ; coordinate (30,0)
→ 4x1 + 3x2 ≤ 96; compute x1 and x2 intercepts.
 If ; coordinate (0, 32)
 Whereas, if 24; coordinate (24,0)
 Draw a graph of these two constraints using the coordinates

Step 3: Identify the feasible region (common region for both constraints)

Step 4: Obtain a point on the feasible region that optimizes the objective function

Corners Coordinates
A (0, 0)
B (0, 20)

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C (18, 8) *
D (24, 0)
Step 5: Compute the optimal solution

Corners Coordinates = 40x1 + 35x2

A (0, 0) $0
B (0, 20) $700
C (18, 8) $1000
D (24, 0) $960
Interpretation of the result: The maximum profit is ( ) which is resulted by
producing 18 and 8.
Example 2:
= 25X1 +30X2
St:
20X1 + 15X2 > 100
2X1 +3X2 > 15
X1, X2 > 0
Required: Solve the above given LPP using Graphical method
Solution
Step 1: formulate LPP (it is already formulated)
Step 2: Draw a graph including all the constraints based on intercepts:
→ 20X1+15X2 ; compute x1 and x2 intercepts.
 If ; coordinate (0, 20/3)
 Whereas, if ; coordinate (5, 0)
→ 2X1+3X2 15; compute x1 and x2 intercepts.
 If ; coordinate (0, 5)
 Whereas, if ; coordinate (7.5, 0)
 Draw a graph of these two constraints using the coordinates

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Step 3: Identify the feasible region (common region for both constraints)

Step 4: Obtain a point on the feasible region that optimizes the objective function
Corners Coordinates
A (0, 20/3)
B (2.5, 3.33)
C (7.5, 0)

Step 5: Compute the optimal solution

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3.4.2 Simplex (Algebraic) Method of Solving LPPs
LP model is a mathematical model which is used to allocate scarce organizational resources so as
to achieve optimization, i.e., either profit maximization or cost minimization.
Remember all that we graph constraints by treating them as equality. Likewise in simplex
algorism, to convert the inequality constraints into equality, we introduce slack or surplus
variables.
In economic terminology slack variables represent unused capacity and surplus variables
represent excess amount and the contribution associated with them in zero.
A. Solving maximization problem
The simplex procedure for a maximization problem with all “≤” constraints of the following
steps:
STEP-1- Write the LP model in a standard form (conversion of constraints and the objective
function).
When all the constraints are written as equalities, the LPP is said to be in a standard form.
Applying the slack variables to standardize:
a1X1 + a2X2 +---------------------+anXn ≤ b
Standardize: a1X1 + a2X2 + --------------+ anXn + S1 = b
 Every variable in the model must be represented in the objective function
 Since slacks don‟t provide any real contribution to the objective, each slack variable is
assigned a coefficient of zero in the objective function.
Example: - Z max = 60X1 + 50X2
S.t: 4X1 + 10X2 ≤ 100
2X1 + X2 ≤ 22
3X1 + 3X2 ≤ 39
X1, X2 ≥ 0
Standardize; the non-negativity quantity be added to the left side increases to RHS value (slacks)
Z max = 60X1 + 50X2 + 0S1 + 0S2 + 0S3
S.t: 4X1 + 10X2 + S1 + 0S2 + 0S3 = 100
2X1 + X2 + 0S1 +S2 + 0S3 = 22
3X1 + 3X2 + 0S1 + 0S2 + S3 = 39
X1, X2, S1, S2, S3 ≥ 0
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STEP-2- Develop the initial tableau (finding an initial feasible solution)
 List the variables across the top of the table and write the objective function coefficient of
each variable just below it.
 There should be one row in the body of the table for each constraint, list the slack
variables in the bases column, one per row.
 In the Cj column enter the objective function coefficient of zero for each slack variable
 Compute values for row Zj
 Compute values for row Cj-Zj, where Cj is coefficient of variable j in the objective
function.

Initial feasibility S1 = 100

S2 = 22 obtained by equating row variables zero
S3 = 39
X1 = 0 and X2 = 0 decision variables
Zmax = 0 Profit
STEP-3- Developing subsequent tables (choosing the entering and leaving variables)
 Identify the entry variable that has a largest positive value in the Cj– Zj row.

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  Identify the leaving variable, using the coefficient or substitution rates in the entering
variable column dived each one in to the corresponding quantity value, however, don‟t
divide by a zero or a negative value. The smallest non negative ratio that results indicate
which leave the solution.
STEP-4- Find unique vectors for the next basic variable using row operations on the pivot
element.
STEP-5- If all Cj-Zj row values are zeros and negatives, you have reached optimality.
simplex solution in a maximization is optimal if the Cj – Zj consists entirely of zeros and
negative numbers, i.e. there is no positive values in the bottom row.
½ R2 = newR2 = 1 ½ 0 ½ 0 11
-4 R2 + R1 = new R1 = 0 8 1 -2 0 56
-3R2 +R3 = new R3 = 0 3/2 0 -3/2 1 6

2/3 R3 = 0 1 0 -1 2/3 4 new R3

-1/2 R3 + R2 = 1 0 0 1 -1/3 9 new R2
-8R3 + R1 0 0 1 6 -16/3 24 new R1

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Here, all Cj-Zj row values are zeros and negatives, you have reached optimality. Optimum
solution is at X1 = 9, X2 = 4 and S1 = 24 and the amount of profit is $740.

Example -2- Z max = 9X1 + 9X2

S.t: 6X1 + 3X2 ≤ 42
4X1 + 5X2 ≤ 40
Solution: - Standardization Z max = 9X1 + 9X2 + 0S1 + 0S2
S.t: 6X1 + 3X2 + S1 + 0S2 = 42
4X1 + 5X2 + 0S1 + S2 = 40
X1, X2 S1, S3 ≥ 0

1/6 R1 = 1 ½ 1/6 0 7 new R1

-4R1 +R1 = 0 3 -2/3 1 12 new R2

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1/3R2 = 0 1 -2/9 1/3 4 = New R2
-1/2R2 + R1 = 1 0 5/18 -1/6 5 = New R1

Thus, all Cj-Zj row values are zeros and negatives, you have reached optimality. Optimum
solution is at X1 = 5 & X2 = 4 and the amount of profit is $81.

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B. Solving Minimization Problems
It is similar to maximization problem except
 The selection of variable to enter the solution (pivot Colum) is based on the most/largest
negative value in the Cj-Zj row (net evaluation row).
 Addition of the coefficient +M to standardize the problem in the OF.
 Have at least one artificial variable for the OF and each constraint
 Subtraction of the surplus
Why the big +M method is used? Since it is easy to visualize that an initial solution doesn‟t exist
if we let X1 and X2 each equal to zero, we get S1 and S2 with negative constraints which are not
feasible as it violates the non-negativity constraints restriction. To provide an initial feasible
solution, we add an artificial variable in to the model in which has not tangible relationship with
the decision with the decision program.

Example: - Z min = 3X1 + 4X2

S.t: 2X1 + 3X2 ≥ 90
4X1 + 3X2 ≥ 120
where; X1 X2 ≥ 0
Solution:-
Standardization: Zmin = 3X1 + 4X2 +0s1+0S2 + MA1 +MA2
S.t 2X1 + 3X2 – S1 -0S2 +A1 +0A2 = 90
4X1 + 3X2 – 0S1-0S2 +0A1 +A2 = 120
X1, X2, S1, S2, A1, A2 ≥ 0

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¼ R2 = 1 ¾ 0 -1/4 0 30 = new
R2
-2R2 +R1= 0 3/2 -1 ½ 1 30 = new
R1

2/3 R1 = 0 1 -2/3 1/3 20 =

newR1
-3/4 R1 + R2 = 1 0 ½ -1/2 15 =

new R2

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Since all the numbers in the index row (Cj – Zj row) are either zero or positive, the optimal
solution has been arrived or realized and the solution is given as; X1 = 15 and X2 = 20 and its
minimum cost is = $125.

Example - A chemical company produced two types of compounds, A and B. The following
table gives the units of ingredients X1 and X2 per kg of compounds A and B as well as minimum
requirements of X1 and X2 and cost per Kg of A and B. Using the simplex method, find the
quantities of A and B which would give a supply of X1 and X2 at a minimum cost?

Solution:- The OF is to minimize cost. Thus; Z min = 4X1 + 6X2

S.t: X1 + 2X2 ≥ 80
3X1 + X2 ≥75 X1, X2 ≥ 0 Standardization: 4X1 + 6X2 +0S1 +0S2 +MA1+MA2
S.t: X1 + 2X2 –S1-0S2 + A1 +0A2 =80
3X1 + X2 – 0S1 –S2 +0A1 +A2 =75
X1, X2, S1, S2, A1, A2 ≥ 0

Page | 76
Page | 77
Since all the numbers in the index row (Cj – Zj row) are either zero or positive, the optimal
solution has been arrived or realized. Therefore, optimality is found at X1 = 14 , X2 = 33 and the
minimum cost is = 254

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 CHAPTER FOUR
MATHEMATICS OF FINANCE
4.1 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 rationale
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.

4.2 SIMPLE INTEREST AND DISCOUNTS

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 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.

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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.
4.2.1 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.
Simple interest formula:
The computation of simple interest is based on the following formula.
I = p *i* n
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

ii. Weeks, then

iii. Days, then

a. Exact interest

b. Ordinary simple interest

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Maturity value (future value) represents the accumulated amount or value at the end of the time periods
given. Thus,
Future value (F) = Principal (P) + Interest (I)
Example 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,
F=P+I
Then, substitute I = P* i* n in the expression to obtain
F = P + P*i*n
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.

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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) = P*i*n = 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 = p*i*n
In the case, n represents all quarters within 5 years. That is,
n = Number of years x 4 = 5x4 = 20
Then, Interest (I) = Pin = 10000 x 0.02 x 20 = Birr 4000
Exercise
1. Suppose, a small handicraft enterprise has requested a two year loan of Birr 6500 from the commercial
Bank of Ethiopia. If the bank approves the loan at an annual interest rate of 7.5%,
b. What is the simple interest on the loan?
c. What is the maturity value of the loan?
2. If the above loan (exercise 5.1) is offered at a rate of 21% and is due in 3 months, what is the maturity
value of the loan?
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:
Given: P = Birr 300, I = Birr 28, i = 3%
Required: n = ?
Then; I = P*i*n, now solve for n in this formula.

Solution 2
Given: P=Birr 150, I=Birr 20.25, n=4.5 years
Required: the rate of interest (i)=?

Then;

Solution 3
Given: I = Birr 38.50, n =2 years i = 3.5% per year
Required: Principal (P)
We can find out the value of P* i*n the same manner with the above examples a follows.

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I = p*i*n, solve for P

Thus, Birr 550 is required to produce interest of Birr 38.5 in 2 years at 3.5% rate.
4.2.2 Ordinary and Exact Interest
In computing simple interest, the number of years or time, n, can be measured in days. In such case, there
are two ways of computing the interest.
i. The Exact Method: if a year is considered as 365 days, the interest is called exact simple interest. If the
exact method is used to calculate interest, then the time is
n = number of days / 365
ii. The Ordinary Method (Banker’s Rule): if a year is considered as 360 days, the interest is called
ordinary simple interest. The time n, is calculated as
n = number of days/ 360
Example
Find the interest on Birr 1460 for 72 days at 10% interest using,
a. The exact method
b. The ordinary method
Solution
Given a) P=1460 b) P=1460
P = Birr 1460 n=72/365 n= 72/360
n = 72 days i= 0.1 i=0.1
i = 10% = 0.1 I=Pin =1460*72/365*0.1=28.8 I=Pin= 1460*72/365*0.1=29.2

4.2.3 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 + P*i*n
F = P (1+ i*n)
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.

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 ( )
Example
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: n in ordinary method = Number of days / 360 = 90 /360, n = 0.25; F = the amount repaid = Birr
870.19 and i = 9 ½% = 9.5% = 0.095
Required: The amount borrowed which is the same as simple present value, P.
Then; = 870.19 / (1+ (0.095 x 0.25))
( )

P = 870.19 ÷ 1.024 = Birr 849.795

2. Given: F = Birr 645, n = 2.5 years, i = 3% = 0.03
Then;
P = F/ 1+ in = 645/ 1+ (0.03 x 2.5) = 645/1.075 = Birr 600
4.3 COMPOUND INTEREST
As it has been highlighted earlier, compound interest raters for the case where interest earned during the
earlier periods also earn interest during the later period. If, instead of being paid when due, the interest an
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).
The Compound Interest Formula
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: ( )
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
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A period, for this purpose, can be any unit of time. If interest is compounded annually, a year is the
appropriate compounding or conversion or interest period. If it is compounded monthly, a month is the
appropriate period. It is important to know that the number of compounding period/s within a year is/are
used in order to find the interest rate per compounding periods and it is denoted by i in the above formula.
Consequently, when the interest rate is stated as annual interest rate and is compounded more than once a
year, the interest rate per compounding period is computed by the formula:
i = j / m,
where j is annual quoted or nominal interest rate
m number of conversation periods per year or the compounding periods per year
n = m x t, where t is the number of years
Example 1:
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
Given: 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 ( ) ( ) ( )
Example 2:
An individual accumulated Birr 30,000 ten years before his retirement in order to buy a house after he is
retried. If the person invests this money at 12% compounded monthly, how much will be the balance
immediately after his retirement?
Solution
Given: P = Birr 30,000, t = 10 years, i = 12% = 0.12
m = compounded monthly = 12
i = j / m = 0.12 / 12 = 0.01
n = m x t = 12 x 10 = 120 and what is required is the Future Value F.
Then, F ( ) ( ) ( )

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Having the understanding of how compound interest works and computation of future value, in
subsequent example, we will consider how to determine the number of periods it will take for P birr
deposited now at i percent to grow to an amount of F birr.
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.
Future value is obtained by compounding technique and the expression ( ) is called compound
factor. On the other hand, present value is obtained by discounting techniques and the expression
( ) 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
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?
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 = ( ) ( ) ( )
(b) Given: 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
We are required to find Present Value P.
Then; ( ) ( ) ( )

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2. Given: 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?

( ) ( ) ) ( )
4.4 ANNUITIES
Annuity refers to a sequence or series of equal periodic payments, deposits, withdrawals, or receipts made
at equal intervals for a specified number of periods. For instance, regular deposits to a saving account,
monthly expenditures for car rent, insurance, house rent expenses, and periodic payments to a person
from a retirement plan fund are some of particular examples of annuity.
Payments of any type are considered as annuities if all of the following conditions are present:
i. The periodic payments are equal in amount
ii. The time between payments is constant such as a year, half a year, a quarter of a year, a month etc.
iii. The interest rate per period remains constant.
iv. The interest is compounded at the end of every time.
Annuities are classified according to the time the payment is made. Accordingly, we have two basic types
of annuities.
i. Ordinary annuity: is a series of equal periodic payment is made at the end of each interval or period. In
this case, the last payment does not earn interest.
ii. Annuity due: is a type of annuity for which a payment is made of the beginning of each interval or
period.
It is only for ordinary annuity that we have a formula to compute the present as well as future values. Yet,
for annuity due case, we may drive it from the ordinary annuity formula. To proceed, let us first consider
some important terminologies that we are going to use in dealing with annuities.
i. Payment interval or period: it is the time between successive payments of an annuity.
ii. Term of annuity: it is the period or time interval between the beginning of the first payment period and
the end of the last one.
iii. Conversion or interest period: it is the interval between consecutive conversions of interest.
iv. Periodic payment/rent: it is the amount paid at the end or the beginning or each payment period.
v. Simple annuity: is the one in which the payment period and the conversion periods coincides each
other.
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Following the above basic overview about annuities, we shall progress to deal with practical business
problems, which relate with determining the maturity and present values of annuities with specific
application cases.
4.4.1 Sum of Ordinary Annuity: Maturity Value
Maturity value of ordinary annuity is the sum of all payments made and all the interest earned therefrom.
It is an accumulated value of a series of equal payments at some point of time in the future. Suppose you
started to deposit Birr 1000 in to a saving account at the end of every year for four years. How much will
be in the account immediately after the last deposit if interest is 10% compounded annually?
In attempting this problem, we should understand that the phrase at the end of every year implies an
ordinary annuity case. Likewise, we are required to find out the accumulated money immediately after the
last deposit which also indicates the type of annuity. Further, the term of the annuity is four years with
annual interest rate of 10%. Thus, we can show the pattern of deposits diagrammatically as follows.

The first payment earns interest for the remaining 3 periods. Therefore, the compound amount of it at the
end of the term of annuity is given by,
( ) ( )
In the same manner, the second payment earns interest for two periods (years). So,
( )
The 3rd payment earns interest for only one period. So,
( )
No interest for the fourth payment since it is made at the end of the term. Thus, its value is 1000 itself. In
total, the maturity value amounts to Birr 4641.
This approach of computing future value of ordinary annuity is complex and may be tiresome in case the
term is somewhat longer. Thus, in simple approach we can use the following formula for sum of ordinary
annuity (Future Value).

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 ( )
6 7

Where, n = the number of payment periods

i = interest rate per period
R = payment per period
Fn = future value of the Annuity or sum of the annuity after n periods
Now, let us consider the above example. That is,
R = Birr 1000 i = 0.1 and n = 4
( ) ( )
6 7 6 7

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

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

R = 1000, j = 6% = 0.06 , m = semi-annual = twice a year

i = 0.06 ÷ 2 = 0.03
n=4
F4 = ?
( ) ( )
0 1 0 1

2. R = Birr 50
t = 6 years
m = quarterly = 4 times a year
n = t x m = 6 x 4 = 24 quarters

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j = 6% = 0.06
i = j ÷ m = 0.06 ÷ 4 = 0.015
( ) ( )
0 1 0 1

Interest = Maturity Value - Sum of Deposits = Maturity value - (24 (50)) = F24 -1200 = 1431.68 - 1200 =
Birr 231.68
4.4.2 Ordinary Annuities: Sinking Fund Payments
A sinking fund is a fund into which periodic payments or deposits are made at regular interval to
accumulate a specified amount (sum) of money in the future to meet financial goals and/or obligations.
The equal periodic payment to be made constitute an ordinary annuity and our interest is to determine the
equal periodic payments that should be made to meet future obligations. Accordingly, we will be given
the Future Amount, F, in n period and our interest is to determine the periodic payment, R. Then it is
computed as follow.

[ ]
( )
Then, is the sinking found formula:
Where, R = Periodic payment amount of an annuity
i = Interest per period which is given by j ÷ m
j = Annual nominal interest rate
m = Number of conversion periods per year
n = Number of annuity payment or deposits (also, the number of compounding
periods)
F = Future value of ordinary annuity
In general, a sinking fund can be established for expanding business, buying a new building, vehicles,
settling mortgage payment, financing educational expenses etc.
Example
1. A corporation wants to establish a sinking fund beginning at the end of this year. Annual deposits will
be made at the end of this year and for the following 9 years. If deposits earn interest at the rate of 8% per
year compounded annually, how much money must be deposited each year in order to have 12 million
Birr at the time of the tenth deposit? How much interest will be earned?
2. Assume in the previous example that the corporation is going to make quarterly deposits and that
interest is earned at the rate of 8% per year compounded quarterly. How much money should be deposited
each quarter? How much less will the company have to deposit over the 10-year period as compared with
annual deposits and annual compounding.

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Solution
1. Future level of deposit desired = Fn = Birr 12 million
Term of the annuity = t = 10 years
Conversion periods = m = annual = 1
n = t x m = 10 x 1 = 10 annuals
j = 0.08
i = j ÷ m = 0.08 ÷ 1= 0.08
R = the amount to be deposited each year to have 12 million at the end of the 10th year = ? Then to obtain
the value of R, we shall use the formula for sinking fund.

[ ] [ ]
( ) ( )
R = Birr 828,353.86
On the other hand, the amount of interest, I, is obtained by computing the difference between the maturity
value (Fn = 12,000,000) and the sum of all periodic payments made. Thus,
I = Fn - R (10) = 12,000,000 – 823,353.86 (10) = 12,000,000 – 8,283,538.6 = Birr 3,716,461.4.
2. This is the continuation of the previous example. Thus,
Fn = Birr 12,000,000
t = 10 years
m = Quarterly = 4 times a year
n = m x t = 4 x 10 = 40
j = 8% = 0.08
i = j ÷ m = 0.08 ÷ 4 = 0.02

[ ] [ ]
( ) ( )
R = Birr 198,668.94
In further computation to determine the difference in amount of deposit by changing the length of the
conversion period, we see that as compared with the first case of annual conversion period, in the
quarterly conversation scheme, the corporation will deposit R (10) minus R (40) less over the term of the
annuity.
Thus, R (10) – R (40) = Birr 828,353.86 (10) – 198,668.96 (40) = 8,283,538.6 – 7,946,758.4 = Birr
336,780.2

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

Where, R= Periodic amount of an annuity

i = Interest per period which is given by j ÷ m
j = Annual nominal interest rate
m = Interest/ conversion periods per year
n = Number of annuity payments / deposits (also, the number of compounding
periods)
P = Present value of ordinary annuity
Example
A person recently won a state lottery. The term of the lottery is that the winner will receive annual
payments of birr 18,000 at the end of this year and each of the following 4 years. If the winner could
invest money today at the rate of 6% per year compounded annually, what is the present value of the five
payments?
Solution
R = Annual payments of Birr 18,000
Term of the annuity = t = this year and the following 4 years = 5 years
i = 6% = 0.06 (since the conversion period per year is annual)
n=5
Present value of payments = P = ?
( ) ( )
[ ] 6 7

4.5 Mortgage Payments and Amortization

Another main area of application of annuities in to real world business situations in general and financial
management practices in particular is mortgage amortization or payment. Mortgage payment is an
arrangement whereby regular payments are made in order to settle an initial sum of money borrowed from
any source of finance. Such payments are made until the outstanding debt gets down to zero. An

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individual or a firm, for instance, may borrow a given sum of money from a bank to construct a building
or undertake something else. Then the borrower (debtor) may repay the loan by effecting (making) a
monthly payment to the lender (creditor) with the last payment settling the debt totally.
In mortgage payment, initial sum of money borrowed and regular payments made to settle the respective
debt relate to the idea of present value of an ordinary annuity. Along this line, the expression for mortgage
payment computation is derived from the present value of ordinary annuity formula. Our intention in this
case is to determine the periodic payments to be made in order to settle the debt over a specified time –
period.
Now, we progress to isolate R on one side. It involves solving for R in the above present value of
ordinary annuity formula. Hence, multiply both sides by the interest rate i to obtain:
, ( ) -
Further, we divide both sides by , ( ) - and the result will be the mathematical expression or
formula for computing mortgage periodic payments as follows.

[ ]
( )
Where, R = Periodic amount of an annuity
i = Interest per conversion period which is given by j ÷ m
j = Annual nominal interest rate
m = Interest or conversion periods per year
n = the number of annuity payments/deposits (number of compounding periods)
P = Present value of an ordinary annuity
Example
1. Emmanuel purchased a house for Birr 115,000. He made a 20% down payment with the remaining
balance amortized in 30 years mortgage at annual interest rate of 11% compounded monthly.
a. Find the monthly mortgage payment?

b. Compute the total interest.

2. Assume you borrowed Birr 11,500 from a bank to finance construction of a swimming pool and agreed
to repay the loan in 60 monthly equal installments. If the interest is 1.5% per month on the unpaid
balance,
a. How much is the monthly payment?

b. How much interest will be paid over the term of the loan?

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

[ ] [ ]
( ) ( )
R = Birr 876.14
b. Total Interest = (R x n) – P
876.14 x 360 – 92,000
= Birr 223,409.49

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