B Maths Slides

ANTHONY WISHES YOU BEST OF LUCK
Session Goals
At the end of the session, you should be able to understand:
 Functions
 What is a function
 The role of a function
 Example functions in business and economics
 Differentiation of a function
 Differentiating from the First Principle
 Rules of differentiation
 Single function
 Two or more functions of the same variable
 The Quotient Rule
A. Afful-Dadzie 1
Rate of Change and the Derivative
When two (or more ) variables say 𝑥 and 𝑦 are related to each other by a function y = 𝑓(𝑥), there is always an
interest in changes in one variable to a change in the other variable.
When the variable 𝑥 changes from 𝑥0 to 𝑥1 , the change is measured by the difference 𝑥1 − 𝑥0 . Using the
symbol ∆ to denote the change, then:
∆𝑥 = 𝑥1 − 𝑥0
We use 𝑓(𝑥𝑖 ) to denote the value of the function 𝑓(𝑥) when 𝑥 = 𝑥𝑖
e.g. Given 𝑓 𝑥 = 5 + 𝑥 2 ,
𝑓 0 = 5 + 02 = 5 and 𝑓 2 = 5 + 22 = 9.
When 𝑥 changes from an initial value of 𝑥0 to a new value (𝑥0 + ∆𝑥), the function 𝑦 = 𝑓(𝑥) also changes from
𝑓(𝑥0 ) to 𝑓(𝑥0 + ∆𝑥).
The change in 𝑦 per unit of change in 𝑥 is represented by the difference quotient
∆𝑦 𝑓 𝑥0 + ∆𝑥 − 𝑓(𝑥0 )
=
∆𝑥 ∆𝑥
Thus the difference quotient can be calculated if we know the 𝑥0 and ∆𝑥.
A. Afful-Dadzie 2
Rate of Change and the Derivative
Example:
Given 𝑦 = 3𝑥 2 − 6,
𝑓 𝑥0 = 3 𝑥0 2 − 6 , and 𝑓 𝑥0 + ∆𝑥 = 3 𝑥0 + ∆𝑥 2 −6
∆𝑦 𝑓 𝑥0 + ∆𝑥 − 𝑓(𝑥0 ) 3 𝑥0 + ∆𝑥 2 − 6 − (3 𝑥0 2 − 6) 6𝑥0 ∆𝑥 + 3 ∆𝑥 2
= = = = 6𝑥0 + 3∆𝑥
∆𝑥 ∆𝑥 ∆𝑥 ∆𝑥
∆𝑦
can be evaluated for known values of 𝑥0 and ∆𝑥.
∆𝑥
∆𝑦
For example, for 𝑥0 = 5 and ∆𝑥 = 2, ∆𝑥 = 6 ∗ 5 + 3 ∗ 2 = 36.
This means, on average, when 𝑥 changes from 5 to 7, the change in 𝑦 is 36 units per unit change in 𝑥
A. Afful-Dadzie 3
The Derivative
Most times, we are interested in the rate of change of 𝑦 when ∆𝑥 is very small.
∆𝑦
In such cases, it is possible to obtain ∆𝑥 by dropping all terms of ∆𝑥 in the difference quotient formula.
∆𝑦
For example, in the last example, if ∆𝑥 is very small, then ∆𝑥 ≈ 6 ∗ 5 = 30
∆𝑦 ∆𝑦
The smaller the value of ∆𝑥 , the closer is the approximation of ∆𝑥 to the true ∆𝑥.
As ∆𝑥 approaches zero (meaning that it get closer and closer to, but never really reaches zero) 6𝑥0 + 3∆𝑥 will
approach 6𝑥0 .
∆𝑦
Symbolically, this statement is expressed as ∆𝑥 → 0 or ∆𝑥 → 0 or by the equation
∆𝑦
lim = lim 6𝑥0 + 3∆𝑥 = 6𝑥0
∆𝑥→0 ∆𝑥 ∆𝑥→0
The symbol lim is read: “The limit of ….. as ∆𝑥 approaches 0.

∆𝑥→0
∆𝑦
If as ∆𝑥 → 0, the limit of the difference quotient ∆𝑥 exists, that limit is identified as the derivative of the
function 𝑦 = 𝑓(𝑥).
A. Afful-Dadzie 4
Derivative of a function 𝒇
Slope of a tangent line to a curve
𝑓 𝑧 −𝑓(𝑎)
Slope of line 𝑃𝑄 = 𝑚𝑃𝑄 = 𝑧−𝑎
Let 𝑍 = 𝑎 + ℎ
𝑓 𝑧 −𝑓(𝑎)
Then 𝑚𝑃𝑄 = ℎ
As 𝑄 moves along the curve toward 𝑃, 𝑧 approaches 𝑎. This also means ℎ → 0
The slope of a tangent line at point (𝑎, 𝑓 𝑎 ) is given as the limiting value of the slope:
𝑓 𝑧 − 𝑓(𝑎) 𝑓 𝑎 + ℎ − 𝑓(𝑎)
𝑚𝑡𝑎𝑛 = lim = lim
𝑧→𝑎 𝑧−𝑎 ℎ→0 ℎ
Therefore the concept of the slope of a curve is the geometric version of the concept of derivative
A. Afful-Dadzie 5
Derivative of a function 𝒇
The derivative of a function 𝑓 is the function denoted by 𝑓′ which is defined by:

𝑓(𝑧) − 𝑓(𝑥) 𝑓(𝑥 + ℎ) − 𝑓(𝑥)
lim = lim = 𝑓′(𝑥)
𝑧→𝑥 𝑧−𝑥 ℎ→0 ℎ
provided the limit exist.
If 𝑓′(𝑎) can be found, the original function 𝑓 is said to be differentiable at 𝑎, and 𝑓′(𝑎) is called the
derivative of 𝑓 at 𝑎 or the derivative of 𝑓 with respect to 𝑥 at 𝑎.
The process of finding the derivative is called Differentiation.
Example:
If 𝑓 𝑥 = 𝑥 2 , find the derivative of 𝑓
′
𝑓(𝑥 + ℎ) − 𝑓(𝑥) 𝑥 + ℎ 2 − 𝑥2 𝑥 2 + 2𝑥ℎ + ℎ2 − 𝑥 2
𝑓 𝑥 = lim = lim = lim
ℎ→0 𝑧−𝑥 ℎ→0 ℎ ℎ→0 ℎ
2
′
2𝑥ℎ + ℎ ′
ℎ(2𝑥 + ℎ)
𝑓 𝑥 = lim = 𝑓 𝑥 = lim = lim (2𝑥 + ℎ) = 2𝑥
ℎ→0 ℎ ℎ→0 ℎ ℎ→0
Common Notations of a derivative of a function:

𝑑𝑦 𝑑
, 𝑓(𝑥), 𝑦′, 𝐷𝑥 𝑦, 𝐷𝑥 (𝑓 𝑥
𝑑𝑥 𝑑𝑥
A. Afful-Dadzie 6
Rules of Differentiation
1. Constant Function Rule
The derivative of a constant 𝑦 = 𝑓 𝑥 = 𝑘 is zero. Note that since the derivative is a function of 𝑥, different
𝑑𝑦
= 0 or
𝑑𝑘
= 0 or 𝑓 ′ 𝑥 =0 values of 𝑥 may result in different values for the derivative.
𝑑𝑥 𝑑𝑥
Other expressions as below are correct Example: 𝑓′ 𝑥 4 = 4𝑥 3
𝑑 𝑑 𝑑
𝑦= 𝑓 𝑥 = 𝑘 =0 At 𝑥 = 1, 𝑓 ′ 1 = 4.
𝑑𝑥 𝑑𝑥 𝑑𝑥 At 𝑥 = 2, 𝑓 ′ 2 = 4 ∗ 23 = 32
Prof?
3. Generalized Power-Function Rule
2. Power-Function Rule
The derivative of a power function 𝑦 = 𝑓 𝑥 = 𝑥 𝑛
𝑑𝑦 𝑑 𝑛 For a function 𝑓 = 𝑐𝑥 𝑛
′
=𝑓 𝑥 = 𝑥 = 𝑛𝑥 𝑛−1 𝑑𝑦
The derivative 𝑑𝑥 = 𝑐𝑛𝑥 𝑛−1
𝑑𝑥 𝑑𝑥
Example: Find the derivative of 𝑦 = 𝑥 4 Example: 𝑓 = 5𝑥 3
𝑑𝑦 𝑓 ′ 𝑥 = 5 ∗ 3𝑥 2 = 15𝑥 2
= 4𝑥 4−1 = 4𝑥 3
𝑑𝑥 Example: 𝑦 = 4𝑥 −3
1
Example: Find the derivative of 𝑦 = 𝑥 4 𝑑𝑦
= 4 ∗ −3𝑥 −4 = −12𝑥 −4
1
Note that 𝑦 = 𝑥 4 = 𝑥 −4 . 𝑑𝑥
𝑑𝑦 4
Therefore, 𝑑𝑥 = −4𝑥 −4−1 = −4𝑥 −5 = − 𝑥 5
A. Afful-Dadzie 7
Rules of Differentiation Involving two or more functions of the same variable
1. Sum-Difference Rule 2. Product Rule
The derivative of a function 𝑦 = 𝑓 𝑥 ± 𝑔(𝑥) Given the function 𝑦 = 𝑓 𝑥 ∗ 𝑔(𝑥), the derivative of 𝑦 is
𝑑 𝑑 𝑑 expressed as:
𝑓 𝑥 ±𝑔 𝑥 = 𝑓 𝑥 ± 𝑔 𝑥 = 𝑓 ′ 𝑥 + 𝑔′(𝑥) 𝑑 𝑑 𝑑
𝑑𝑥 𝑑𝑥 𝑑𝑥 𝑓 𝑥 𝑔 𝑥 = 𝑓 𝑥 𝑔(𝑥) + 𝑔(𝑥) 𝑓 𝑥 =
𝑑𝑥 𝑑𝑥 𝑑𝑥
Example: Find the derivative of the function

𝑓 𝑥 𝑔′ 𝑥 + 𝑔 𝑥 𝑓′(𝑥)
𝑦 = 3𝑥 3 + 2𝑥 2 + 𝑥
𝑑𝑦 𝑑 𝑑 𝑑
= 3𝑥 3 + 2𝑥 2 + 𝑥 Proof:
𝑑𝑥 𝑑𝑥 𝑑𝑥 𝑑𝑥
𝑑𝑦 𝐹′ 𝑥
= 9𝑥 2 + 4𝑥 + 1 𝑓 𝑥 + ℎ − 𝑓(𝑥) 𝑓 𝑥 + ℎ 𝑔 𝑥 + ℎ − 𝑓 𝑥 𝑔(𝑥)
𝑑𝑥 = lim = lim
ℎ→0 ℎ ℎ→0 ℎ
Example: Find the derivative of the total-cost function
𝐶 = 𝑄3 − 4𝑄2 + 10𝑄 + 75. Add and subtract 𝑓 𝑥 𝑔(𝑥 + ℎ)
𝑑𝐶 𝑓 𝑥 + ℎ 𝑔 𝑥 + ℎ − 𝑓 𝑥 𝑔 𝑥 + 𝑓 𝑥 𝑔 𝑥 + ℎ − 𝑓 𝑥 𝑔(𝑥 + ℎ)
= 3𝑄2 − 8𝑄 + 10 lim
ℎ→0 ℎ
𝑑𝑄 Regroup
𝑓 𝑥 + ℎ − 𝑓 𝑥 𝑔 𝑥 + ℎ + 𝑓 𝑥 [𝑔 𝑥 + ℎ − 𝑔 𝑥 ]
lim
ℎ→0 ℎ
A. Afful-Dadzie 8
Rules of Differentiation Involving two or more functions of the same variable
𝑓 𝑥+ℎ −𝑓 𝑥 𝑔 𝑥+ℎ 𝑓 𝑥 [𝑔 𝑥+ℎ −𝑔 𝑥 ]
lim + lim
ℎ→0 ℎ ℎ→0 ℎ
𝑓 𝑥+ℎ −𝑓 𝑥 𝑔 𝑥+ℎ [𝑔 𝑥+ℎ −𝑔 𝑥 ] 𝑓 𝑥
lim ∗ lim + lim ∗ lim
ℎ→0 ℎ ℎ→0 ℎ ℎ→0 ℎ ℎ→0 ℎ
𝑔 𝑥+ℎ
If 𝐹 is differentiable, then 𝐹 is continuous, ⇒ lim ℎ = 𝑔(𝑥) and so
ℎ→0
′ ′
𝐹 𝑥 = 𝑓 𝑥 𝑔 𝑥 + 𝑓 𝑥 𝑔′(𝑥)
Example: Find the differential of the function F 𝑥 = (𝑥 3 + 3𝑥)(4𝑥 + 5)

Let 𝑓 𝑥 = 𝑥 3 + 3𝑥 and 𝑔 𝑥 = 4𝑥 + 5. Then,
𝑓 ′ 𝑥 = 3𝑥 2 + 3 and 𝑔′ 𝑥 = 4
𝐹 ′ 𝑥 = 𝑥 3 + 3𝑥 ∗ 4 + 4𝑥 + 5 ∗ 3𝑥 2 + 3
𝐹 ′ 𝑥 = 4𝑥 3 + 12𝑥 + 12𝑥 3 + 15𝑥 2 + 12𝑥 + 15
𝐹 ′ 𝑥 = 16𝑥 3 + 15𝑥 2 + 24𝑥 + 15
Example:
2 1
𝑑𝑦 −
Find 𝑑𝑥 if 𝑦 = 𝑥 3 + 3 𝑥 3 + 5𝑥
25 2 1 −2 −
4
Ans: 𝑥 3 + 𝑥 3 − 𝑥 3 + 15
3 3
Example: Given 𝑦 = (𝑥 + 2)(𝑥 + 3)(𝑥 + 4), what is 𝑦′
Let 𝑦1 = (𝑥 + 2)(𝑥 + 3), and 𝑦2 = 𝑥 + 4
𝑦 ′ = 𝑦1′ 𝑦2 + 𝑦1 𝑦2′
A. Afful-Dadzie 9
The Quotient Rule

𝑑 𝑓(𝑥) 𝑔 𝑥 𝑓′ 𝑥 −𝑓 𝑥 𝑔′(𝑥) Relationship between Marginal cost and Average-cost
𝑑𝑥 𝑔(𝑥)
= 2
𝑔 𝑥
Suppose Total-cost function is 𝐶 = 𝐶(𝑄)
𝐶 𝑄
Proof: Then Average-cost function is: 𝐴𝐶 = for 𝑄 > 0
𝑄
If 𝐹 𝑥 = 𝑓 𝑥 /𝑔(𝑥), then 𝐹 𝑥 𝑔 𝑥 = 𝑓(𝑥)
The rate of change of 𝐴C wrt 𝑄 is given as:
By the product rule, 𝑓 ′ 𝑥 = 𝐹 ′ 𝑥 𝑔 𝑥 + 𝑔′ 𝑥 𝐹 𝑥 𝑑 𝐶 𝑄 [𝐶 ′ 𝑄 ∗𝑄−𝐶 𝑄 ∗1] 1 𝐶 𝑄
Rearranging, = = 𝑄 [𝐶 ′ 𝑄 − ]
𝑑𝑄 𝑄 𝑄2 𝑄
′
𝑓 ′ 𝑥 − 𝑔′ 𝑥 𝐹(𝑥) Then
𝐹 𝑥 = 𝑑 𝐶 𝑄 𝐶 𝑄
𝑔(𝑥) ≥ 0 iff 𝐶 ′ 𝑄 ≥
𝑑𝑄 𝑄 𝑄
But 𝐹 𝑥 = 𝑓(𝑥)/𝑔(𝑥) 𝑑 𝐶 𝑄 𝐶 𝑄
𝑓′ 𝑥
𝑔′ 𝑥 𝑓 𝑥
− 𝑔𝑥
≤ 0 iff 𝐶 ′ 𝑄 ≤
𝑓′ 𝑥 𝑔 𝑥 −𝑓 𝑥 𝑔′(𝑥) 𝑑𝑄 𝑄 𝑄
⇒ 𝐹′ 𝑥 = = 2 Since the derivative 𝐶′(𝑄) is the marginal-cost function,
𝑔(𝑥) 𝑔 𝑥
𝐶 𝑄
and is the Average-cost function, the economic
𝑄
4𝑥 2 +3
Example: Given 𝐹 𝑥 = , find 𝐹′(𝑥) meaning of the two iff relationship is that:
2𝑥−1
The slope of the AC curve will be positive, zero, or
Example: Marginal Revenue negative if and only if the marginal-cost function lies
1000 1000 1000 above, intersect, or below the AC curve
If 𝑝 = 𝑞+5
Revenue (r) = 𝑞+5
𝑞= 𝑞+5
𝑑𝑟 5000 𝑑𝑟
= At 𝑞 = 45, 𝑑𝑞 = 2
𝑑𝑞 𝑞+5 2
A. Afful-Dadzie 10
Relationship between Marginal cost and Average-cost
Chart Title
140
120
𝑀𝐶 = 3𝑄2 − 24𝑄 + 60
100
80
60
40
20 A𝐶 = 𝑄2 − 12𝑄 + 60
0
1 2 3 4 5 6 7 8 9 10
MC AC
A. Afful-Dadzie 11
The Quotient Rule
𝑑 𝑓(𝑥) 𝑔 𝑥 𝑓′ 𝑥 −𝑓 𝑥 𝑔′(𝑥) The consumption Function
= 2
𝑑𝑥 𝑔(𝑥) 𝑔 𝑥 The consumption function expresses a relationship
between the total national income 𝐼 and the total national
Proof: consumption 𝐶. That is: 𝐶 = 𝑓(𝐼)
If 𝐹 𝑥 = 𝑓 𝑥 /𝑔(𝑥), then 𝐹 𝑥 𝑔 𝑥 = 𝑓(𝑥) The marginal propensity to consume, is defined as the
By the product rule, 𝑓 ′ 𝑥 = 𝐹 ′ 𝑥 𝑔 𝑥 + 𝑔′ 𝑥 𝐹 𝑥 rate of change of consumption with respect to income. i.e.
Rearranging, derivative of 𝐶 wrt 𝐼.
𝑓 ′ 𝑥 − 𝑔′ 𝑥 𝐹(𝑥) Marginal propensity to consume = 𝑑𝐶/𝑑𝐼
𝐹′ 𝑥 = If savings 𝑆 is the difference between income 𝐼 and
𝑔(𝑥)
But 𝐹 𝑥 = 𝑓(𝑥)/𝑔(𝑥) consumption 𝐶, then 𝑆 = 𝐼 − 𝐶
𝑔′ 𝑥 𝑓 𝑥
𝑓′ 𝑥 −
and
𝑔 𝑥 𝑓′ 𝑥 𝑔 𝑥 −𝑓 𝑥 𝑔′(𝑥)
⇒ 𝐹′ 𝑥 = = 2 The derivative of 𝑆 wrt to 𝐼 is the marginal propensity to
𝑔(𝑥) 𝑔 𝑥
save, which is expressed as:
𝑑𝑆 𝑑 𝐼 𝑑 𝐶 𝑑𝐶
4𝑥 2 +3 = − =1−
Example: Given 𝐹 𝑥 = , find 𝐹′(𝑥) 𝑑𝐼 𝑑𝐼 𝑑𝐼 𝑑𝐼
2𝑥−1
Example:
Example: Marginal Revenue 5(2 𝐼3 +3)
If the consumption function is 𝐶 = ,
determine
1000 1000 1000 𝐼+10
If 𝑝 = 𝑞+5 Revenue (r) = 𝑞= the marginal propensity to consume and the marginal
𝑞+5 𝑞+5
𝑑𝑟
=
5000
At 𝑞 = 45, 𝑑𝑞 = 2
𝑑𝑟 propensity to save when 𝐼 = 100.
𝑑𝑞 𝑞+5 2
A. Afful-Dadzie 12
Session Goals
 Chain Rule
 The generalized Power Function
 Differentiation of special functions
 Partial Differentiation
A. Afful-Dadzie 1
Differentiation
CHAIN RULE
Suppose 𝑦 is indirectly related to 𝑥, and 𝑢 directly related to both 𝑥 and 𝑦.
𝜕𝑦
Then, one can find by applying the chain rule:
𝜕𝑥
𝑑𝑦 𝑑𝑦 𝑑𝑢
= ∙
𝑑𝑥 𝑑𝑢 𝑑𝑥
The name ‘chain’ comes from the fact that the formula could be extended to
any length as long as a feasible relationship exist.
𝑑𝑦 𝑑𝑦 𝑑𝑢 𝑑𝑚 𝑑𝑘 𝑑𝑝
For example, = ∙ ∙ ∙ ∙ .
𝑑𝑥 𝑑𝑢 𝑑𝑚 𝑑𝑘 𝑑𝑝 𝑑𝑥
A. Afful-Dadzie 2
Differentiation: Chain Rule
Example:
Differentiate the function 𝑦 = (𝑥 3 − 1)7 with respect to 𝑥
Solution
Let 𝑥 3 − 1 = 𝑢
𝑑𝑢 𝑑𝑦
= 3𝑥 2 , and = 7𝑢6
𝑑𝑥 𝑑𝑢
𝑑𝑦
= 7(𝑥 3 − 1)6
𝑑𝑢
𝑑𝑦
= 7(𝑥 3 − 1)6 ∗ 3𝑥 2
𝑑𝑥
A. Afful-Dadzie 3
Example- Marginal Revenue Product

Rate of change with respect to number of employees
 A manufacturer determines that m employees will produce a total of q units per
day where; 𝑞 = (10𝑚2 + 1)2 . Let 𝑟 be revenue. If demand equation for the
𝑑𝑟
product is 𝑝 = 1000 − 5𝑞, determine (the rate of change of revenue with
𝑑𝑚
respect to change in number of employees also termed marginal revenue
product).
A. Afful-Dadzie 4
Solution
Revenue = price × quantity
𝑟 𝑞 = 1000 − 5𝑞 𝑞
𝑟 𝑞 = 1000𝑞 − 5𝑞2
𝑑𝑟 𝑑𝑟 𝑑𝑞
= ⋅
𝑑𝑚 𝑑𝑞 𝑑𝑚
𝑑𝑟
o = 1000 − 10𝑞
𝑑𝑞
𝑑𝑟
= 1000 − 10(10𝑚2 + 1)2
𝑑𝑞
𝑑𝑞
o = 2 10𝑚2 + 1 ∗ 20𝑚 = 40𝑚(10𝑚2 + 1)
𝑑𝑚
𝑑𝑟
= [1000 − 10 10𝑚2 + 1)2 40𝑚 10𝑚2 + 1
𝑑𝑚
𝑑𝑟
= 40,000𝑚 10𝑚2 + 1 − 400𝑚 10𝑚2 + 1 3
𝑑𝑚
A. Afful-Dadzie 5
THE GENERALIZED POWER FUNCTION (CHAIN RULE)
Given the function 𝑦 = (𝑥 𝑛 + 1)𝑝 , the derivative with respect to 𝑥

can be obtained using the general formula:
𝑑 𝑎 𝑎−1
𝑑𝑢
𝑢 = 𝑎𝑢 ⋅
𝑑𝑥 𝑑𝑥
Note that this generalized approach is in fact the chain rule where
𝑑𝑦
= 𝑎𝑢𝑎−1 .
𝑑𝑢
A. Afful-Dadzie 6
DIFFERENTIATING SPECIAL FUNCTIONS
 Given a function such as 𝑦 = 𝐼𝑛𝑥, the general form of
the derivative is:
𝑑 1 𝑑𝑢
𝐼𝑛𝑢 = ⋅
𝑑𝑥 𝑢 𝑑𝑥
Examples:
Find y’ if 𝑦 = 𝐼𝑛𝑥
Solution
𝑑𝑢
let 𝑢 = 𝑥, then =1
𝑑𝑥
𝑑𝑦 1 𝑑𝑢 1
= ⋅ = ⋅1
𝑑𝑥 𝑢 𝑑𝑥 𝑥
A. Afful-Dadzie 7
Find y’ if 𝑦 = 𝑙𝑛(𝑥 2 + 5)2
Solution
Let 𝑢 = 𝑥 2 + 5 2
𝑑𝑢
= 2 𝑥 2 + 5 2𝑥
𝑑𝑥
𝑑𝑦 1
= ∗ 2(𝑥 2 + 5)2𝑥
𝑑𝑥 (𝑥 2 +5)2
𝑑𝑦 4𝑥
= 2
𝑑𝑥 𝑥 + 5
Another approach for this problem is to know that according to laws of
𝑑𝑦
logarithms, 𝑦 = 𝑙𝑛(𝑥 2 + 5)2 = 2𝑙𝑛(𝑥 2 + 5). Then, if 𝑢 = 𝑥 2 + 5, =
𝑑𝑥
4𝑥
𝑥 2 +5
A. Afful-Dadzie 8
Find y’ if 𝑦 = 𝐼𝑛(𝑥 2 + 2)−1
Solution
𝑑𝑢
Let 𝑢 = 𝑥 2 + 2 −1 . Then = −1 ∗ 𝑥 2 + 2 −2 ∗ 2𝑥
𝑑𝑥
𝑑𝑦 1 1
= =
𝑑𝑢 𝑢 𝑥 2 +2 −1
𝑑𝑦 1 2 −2
= 2 −1
⋅ −1(𝑥 + 2) ∗ 2𝑥
𝑑𝑥 (𝑥 + 2)
𝑑𝑦 2
−2𝑥 −2𝑥
= 𝑥 +2 . 2 2
= 2
𝑑𝑥 (𝑥 + 2) 𝑥 +2
Or simply let 𝑦 = −1 𝑙𝑛 𝑥 2 + 2 so that 𝑢 = 𝑥 2 + 2.

𝑑𝑦 1 −2𝑥
Then, = −1 ∗ ∗ 2𝑥 =
𝑑𝑥 𝑥 2 +2 𝑥 2 +2
A. Afful-Dadzie 9
 Given a function such as 𝑦 = 𝑒 𝑥 , the general form of the derivative

is:
𝑑 𝑢 𝑢
𝑑𝑢
𝑒 =𝑒 ⋅
𝑑𝑥 𝑑𝑥
 Given a function such as 𝑙𝑜𝑔2 𝑥, the general form of the derivative is:
𝑑 1 𝑑𝑢
(log 𝑏 𝑢) = ⋅
𝑑𝑥 𝐼𝑛𝑏 𝑢 𝑑𝑥
A. Afful-Dadzie 10
Find y’ if 𝑦 = 𝑒 𝑥
Solution
𝑑𝑢
Let 𝑢 = 𝑥. Then =1
𝑑𝑥
𝑑𝑦 𝑢
𝑑𝑢
=𝑒 ⋅ = 𝑒𝑥 ⋅ 1 = 𝑒𝑥
𝑑𝑥 𝑑𝑥
(𝑥 2 +1)2
Find y’ if 𝑦 = 𝑒
Solution
𝑑𝑦 (𝑥 2 +1)2
=𝑒 ⋅ 2 𝑥 2 + 1 2𝑥
𝑑𝑥
𝑑𝑦 (𝑥 2 +1)2
=𝑒 ⋅ 4𝑥(𝑥 2 + 1)
𝑑𝑥
A. Afful-Dadzie 11
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
Elasticity =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒
Let 𝑄 = 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦, and 𝑃 = 𝑃𝑟𝑖𝑐𝑒

𝑑𝑄
% change in 𝑄 =
𝑄
𝑑𝑃
% change in P=
𝑃
𝑑𝑄/𝑄 𝑑𝑄 𝑃 𝑑𝑄 𝑃
Elasticity = = =
𝑑𝑃/𝑃 𝑄 𝑑𝑃 𝑑𝑃 𝑄
When 𝑄 is expressed as function of 𝑃, then the elasticity becomes a

function of price.
𝑑𝑄 𝑃
Elasticity =
𝑑𝑃 𝑄 𝑝 A. Afful-Dadzie 12
Example:
The demand function for a product is 𝑞 = 𝑝2 − 40𝑝 + 400, where 𝑞 > 0. Find
the point elasticity of demand η(p)
Solution
(a)
𝑑𝑞 𝑝
η 𝑝 = ∗ Solution
𝑑𝑝 𝑞(𝑝) (b)
𝑑𝑞
= 2𝑝 − 40
𝑑𝑝 When 𝑝 = 15
𝑝
η 𝑝 = 2𝑝 − 40 ∗ 2 2(15)2 − 40(15)
𝑝 − 40𝑝 + 400 η 𝑝 = 2
15 − 40 15 = 400
2𝑝2 − 40𝑝 η 𝑝 = −6
η 𝑝 = 2
𝑝 − 40𝑝 + 400
A. Afful-Dadzie 13
Session Goals
 Relative Extrema
 Necessary condition for a relative extrema
 Sufficiency condition for a relative extrema
 Extreme Value Theorem
A. Afful-Dadzie 1
Differentiation
RELATIVE EXTREMA
 A function 𝑓 is said to be increasing on an interval 𝐼 when, for any two numbers 𝑥1 , 𝑥2 in 𝐼, if 𝑥1 < 𝑥2 , then
𝑓(𝑥1 ) < 𝑓(𝑥2 )
 A function 𝑓 is said to be ↓ on an interval 𝐼 when, for any two numbers 𝑥1 , 𝑥2 in 𝐼, if 𝑥1 < 𝑥2 , then 𝑓(𝑥1 ) >
𝑓(𝑥2 )
A. Afful-Dadzie 2
Differentiation: Relative Extrema
Another approach to determine whether a curve is increasing or decreasing within an
interval is to apply differentiation which is quite simple and is based on the following rule.
Rule 1:
Let 𝑓 be differentiable on the interval (𝑎, 𝑏) if, 𝑓 ′ 𝑥 > 0 for all 𝑥 in (𝑎, 𝑏), then 𝑓 is
increasing on (𝑎, 𝑏).
If, however, 𝑓′(𝑥) < 0 for all 𝑥 in 𝑎, 𝑏 , then 𝑓 is decreasing on (𝑎, 𝑏)
A. Afful-Dadzie 3
Example:
2 3
Given the function 𝑦 = 18𝑥 − 𝑥 . Determine whether the function is
3
increasing or decreasing within the intervals (−2,1) and (4,7) on the 𝑥 axis.
Soln:
The graph of the function is as shown below:
In practice:
For this example, think of 𝑦 as revenue
and 𝑥 as quantity. Then, we are looking
at the range of quantities at which
revenue is increasing or decreasing
A. Afful-Dadzie 4
𝑓 ′ 𝑥 = 18 − 2𝑥 2
When 𝑥 = −2 ⇒ 𝑓 ′ −2 = 18 − 2(−2)2 = 10 > 0
When 𝑥 = 1
𝑓 ′ 1 = 18 − 2 = 16 > 0.
Thus 𝑓 is ↑ on the interval 𝐼 = (−2,1)
When 𝑥 = 4
𝑓 ′ 4 = 18 − 2(4)2 = −14 < 0
When 𝑥 = 7
𝑓 ′ 4 = 18 − 2(7)2 = −80 < 0
Thus 𝑓 is ↓ on the interval 𝐼 = (4,7)
A. Afful-Dadzie 5
Relative Maxima and Relative Minima
The highest and lowest points are called points of relative extremum (i.e. the curve is
locally maximum or minimum).
A. Afful-Dadzie 6
Rule 2: Necessary condition for relative Extrema
At the local (relative) minima or maxima, also called relative extremum, 𝑓 ′ (𝑥) = 0.
Rule 2 however cannot tell exactly whether the point 𝑥 where 𝑓 ′ 𝑥 = 0 is indeed a
maximum or minimum. We need another rule to help us establish that.
Rule 3: Sufficiency (Second derivative) test for relative extrema
Suppose 𝑓 ′ 𝑎 = 0
 If 𝑓′′(𝑎) < 0, then 𝑓 has a relative maximum at 𝑎.
 If 𝑓′′(𝑎) > 0, then 𝑓 has a relative minimum at 𝑎.
Where 𝑓′′(𝑎) is the second derivative of 𝑦 at 𝑎.
A. Afful-Dadzie 7
Example:
Given the function, 𝑦 = 2𝑥 2 − 𝑥 4 ,
a. find the points at which 𝑓(𝑥) is either minimum or maximum (i.e. points of the relative extrema).
b. Indicate whether a relative extremum from question is a relative maximum or minimum.
Solution.
a.
𝑓 ′ 𝑥 = 4𝑥 − 4𝑥 3 = 4 𝑥 − 𝑥 3 = 4𝑥 1 − 𝑥 (1 + 𝑥)
𝑥 = 0, 𝑥 = 1, 𝑥 = −1
Thus, points 𝑥 = 0, 𝑥 = 1, and 𝑥 = −1 are relative extrema.
b. To establish whether 𝑓(𝑥) attains minimum or maximum values at these extrema, we apply rule 3.
𝑓 ′′ 𝑥 = 4 − 12𝑥 2
At 𝑥 = 0, 𝑓 ′′ 0 = 4 − 0 = 4 > 0 → 𝑚𝑖𝑛𝑖𝑚𝑢𝑚
At 𝑥 = 1, 𝑓 ′′ 1 = 4 − 12 = −8 < 0 → 𝑚𝑎𝑥𝑖𝑚𝑢𝑚
At 𝑥 = −1, 𝑓 ′′ −1 = 4 − 12 = −8 < 0 → 𝑚𝑎𝑥𝑖𝑚𝑢𝑚
A. Afful-Dadzie 8
Practical Example
80−𝑞
Suppose price is given as 𝑝 = , 0 ≤ 𝑞 ≤ 80, where 𝑞 is number of unit of products.
4
a. At what value of 𝑞 will maximum revenue be attained?
b. What is this maximum revenue?
Solution:
Revenue= Price × Quantity
(80 − 𝑞)
𝑟 𝑞 = 𝑞
4
80𝑞 − 𝑞 2
𝑟 𝑞 =
4
At the quantity where maximum revenue is attained, 𝑟 ′ 𝑞 = 0, and 𝑟′′(𝑞) < 0
A. Afful-Dadzie 9
a. 𝑟 ′ 𝑞 = 80 − 2𝑞
80 − 2𝑞 = 0 ⇒ 𝑞 = 40
Given the nature of the revenue function, then at quantity 𝑞 = 40, revenue could be
minimum or maximum.
To establish whether revenue is maximum or minimum at 𝑞 = 40 we use the 2nd derivative
test.
𝑟 ′′ 𝑞 = −2 < 0
Thus 𝑞 = 40 is a quantity level which generate the maximum revenue possible.
80 40 −402
b. Revenue = = 400
4
Note: In essence, this is one of the reasons why you had to learn differentiation so as to solve
practical problems as the one above.
A. Afful-Dadzie 10
Extreme-Value Theorem
Definition: If a function 𝑓 is continuous on a closed interval 𝑎, 𝑏 , then the function

has both a maximum value and a minimum value on that interval 𝑎, 𝑏 .
Note that one should guarantee that:
a. the function is continuous
b. the function is being analyzed in a closed interval
The symbol 𝑎, 𝑏 implies a closed interval and includes the endpoints 𝑎 and 𝑏
whereas (𝑎, 𝑏) implies an open interval and excludes the endpoints 𝑎 and 𝑏.
The implication of the above definition is that, the max or min points could occur at
the end points since the interval is closed.
A. Afful-Dadzie 11
Procedure to find absolute extrema for a function 𝑓 that is

continuous on 𝑎, 𝑏
Steps:
1. Find the critical (relative extrema) values of 𝑓.

2. Evaluate the 𝑓(𝑥) at the end points 𝑎 and 𝑏 and the critical
values in (𝑎, 𝑏).
3. The maximum value of 𝑓 is the greatest of the values found in
the step 2 and the minimum value of 𝑓 is the least of the values
found in step 2
A. Afful-Dadzie 12
Example:
80−𝑞
Given 𝑝 = 0 ≤ 𝑞 ≤ 80,
4
where 𝑞 = no. of units, 𝑝 = price per unit. At what value of 𝑞 will maximum revenue be
attained? What is this maximum revenue?
Solution:
Revenue = price * quantity
80 − 𝑞 1 2
( )𝑞 = 20𝑞 − 𝑞
4 4
At the quantity where maximum revenue is attained, marginal revenue = 0. That is,
𝑑𝑟
= 0.
𝑑𝑞
𝑑𝑟 ′ 1
= 𝑟 𝑞 = 20 − 𝑞 = 0 ⇒ 𝑞 = 40
𝑑𝑞 2
𝑟 ′′ 𝑞 < 0
Therefore 𝑞 = 40 is a relative maximum revenue value
A. Afful-Dadzie 13
However, since the analysis is being carried over a closed interval, we need to verify
the endpoints to be sure that 𝑞 = 40 indeed yields the absolute maximum revenue.
At 𝑞 = 0, 𝑞 = 40 and at 𝑞 = 80
𝑟 0 =0
1
𝑟 40 = 20 40 − 40 2 = 400
4
1
𝑟 80 = 20 80 − 80 2 = 0
4
Thus, the maximum revenue is attained at 𝑞 = 40.
A. Afful-Dadzie 14
APPLICATIONS OF RELATIVE MAXIMUM AND MINIMUM
Example 1: Minimizing Average Cost
𝑞2
Suppose 𝐶 is the total cost of producing 𝑞 units of a product where, 𝑐 𝑞 = + 3𝑞 + 400.
4
- At what level of output 𝑞 will average cost per unit be minimum?
- What is this minimum value?
Solution
Let 𝐴𝐶 and 𝐶 be the average cost and total cost resp.
𝑞2
𝐶 + 3𝑞 + 400 𝑞 400
𝐴𝐶 = ⇒ 4 = +3+
𝑞 𝑞 4 𝑞
- At the quantity where average cost is minimum, 𝐴𝐶 ′ 𝑄 = 0
1
𝐴𝐶 (𝑄) = − 400𝑞−2
′
4
A. Afful-Dadzie 15
1
⇒ − 400𝑞−2 = 0
4
1 400
⇒ −
4 𝑞2
⇒ 𝑞 2 = 1600
⇒ 𝑞 = ±40
⇒ 𝑞 = 40 (since can’t have negative 𝑞)
To confirm whether 𝐴𝐶 is minimum at 𝑞 = 40, the 2nd derivative test is applied.
- 𝐴𝐶 ′′ 𝑄 = 800𝑞−3
⇒ 800𝑞−3 > 0
Therefore minimum average cost occurs at 𝑞 = 40
The value of the minimum average cost at 𝑞 = 40 is then:
40 400
𝐴𝐶 = +3+ = 23
4 40
A. Afful-Dadzie 16
Example 2: Maximizing TV Cable Company Revenue
The Vista TV Cable Company currently has 100,000 subscribers who each are paying a
monthly rate at GH¢40.00. A survey conducted reveals that there will be 1000 more
subscribers for each GH¢0.25 decrease in rate. At what rate will maximum revenue be
achieved and how many subscribers will there be at this rate?
Solution:
Revenue = Price × Quantity or Revenue = Rate × Number of subscribers
Let 𝑥 be the number of times rate is decreased. As an example, if we decrease the rate
by 0.25, followed by 0.25, and followed by another 0.25 so that the rate is (40-3*0.2),
then 𝑥 = 3.
∴ Rate =40 − 0.25𝑥
Number of subscribers = 100000 + 1000𝑥
So at any 𝑥, revenue = 40 − 0.25𝑥 (100000 + 1000𝑥)
= 4000000 + 15000𝑥 − 250𝑥 2
A. Afful-Dadzie 17
At the maximum revenue, marginal revenue = 0
𝑑𝑟
= 𝑟 ′ 𝑥 = 15000 − 500𝑥
𝑑𝑥
⇒ 15000 − 500𝑥 = 0
⇒ 15000 = 500𝑥 ⇒ 𝑥 = 30
From the 2nd derivative test, 𝑟 ′′ 𝑥 < 0.
Thus, at 𝑥 = 30, a ‘relative’ maximum revenue is attained.
However, note that 0 ≤ 𝑥 ≤ 160. That is, the TV company can choose to set 𝑥 = 0
(meaning, no reduction) or set 𝑥 = 160 (i.e. charge nothing). We thus have to test the
revenue particularly at 𝑥 = 0 since it is obvious revenue is zero at 𝑥 = 160
𝑟 0 = 4𝑀 and 𝑟 30 = 4𝑀 + 15000 30 − 250 30 2 = 4.225𝑀 > 4𝑀
Thus maximum revenue is attained when the current rate is reduced 30 times.
Therefore maximum revenue = 4000000 + 15000 30 − 250(30)2 = 𝐺ℎ₵ 4,225,000
A. Afful-Dadzie 18
Example try
 Bani Hostels has available 170 rooms. When the rent is GH¢2,100, all rooms
will be rented out. However, there will be 4 unoccupied rooms for every
GH¢40.00 increase in the rent charged. If the cost of running the hostel is a
fixed cost of GH¢100,000 and a variable cost of GH¢880.00 per an occupied
room, what is the rent charge that will maximize Bani Hostel’s profit and
what will be the number of rooms that should be made available for rent?
A. Afful-Dadzie 19
Example
 Suppose 𝑛 is the number of recipient of a healthcare benefit, after 𝑡 years, where 𝑛 is in
𝑡3
thousands of elderly people and given as 𝑛 = − 6𝑡 2 + 32𝑡, 0 ≤ 𝑡 ≤ 12. At what
3
values of 𝑡 will the number of elderly receiving benefits start to fall?
 Solution:
𝑑𝑛
= 𝑡 2 − 12𝑡 + 32
𝑑𝑡
𝑡 2 − 12𝑡 + 32 = 0
𝑡 2 − 4𝑡 − 8𝑡 + 32 = 0
𝑡 𝑡−4 −8 𝑡−4 =0
𝑡−8 𝑡−4 =0
𝑡 = 8, 𝑡 = 4
−𝑏± 𝑏2 −4𝑎𝑐
Note: You could also use the quadratic equation formula, say 𝑡 = to find 𝑡.
2𝑎
A. Afful-Dadzie 20
Session Goals
 Differentials and Integral
 The Indefinite Integral
 Integration
 Elementary Integral formulas
 Integration with Initial Conditions
 Power Rule for Integration
 The Definite Integral
A. Afful-Dadzie 1
Integration
Differentials
Given 𝑦 = 𝑓(𝑥), the derivative is given as:
𝑑𝑦
= 𝑓′(𝑥)
𝑑𝑥
𝑑𝑦 = 𝑓 ′ 𝑥 𝑑𝑥
𝑑𝑦 is the differential of 𝑦, (that is, the infinitesimal change in 𝑦 due to an infinitesimal
change in 𝑥).
Integration says that if we were to add up all the 𝑑𝑦, the result should be equal to 𝑦.
That is 𝑦 = 𝑑𝑦 = 𝑓 ′ 𝑥 𝑑𝑥
Where the symbol is called the integral sign.
Let 𝑓 ′ 𝑥 = 𝐹 𝑥
𝑦= 𝑑𝑦 = 𝐹 𝑥 𝑑𝑥
A. Afful-Dadzie 2
Integration
The Indefinite Integral
Given a function 𝑓, if 𝐹 is a function such that 𝐹 ′ 𝑥 = 𝑓 𝑥 , then 𝐹 is an anti-
derivative of 𝑓.
Example 1
Let 𝑓 𝑥 = 2𝑥 and 𝐹 𝑥 = 𝑥 2
𝐹 ′ 𝑥 = 2𝑥 = 𝑓(𝑥)
Then we can conclude that 𝐹 𝑥 = 𝑥 2 is the anti-derivative of 𝑓 𝑥 = 2𝑥. Intuitively,
if we were to perform the opposite of differentiation on 𝑓(𝑥), we will get 𝐹 𝑥 .
Example 2
Let 𝑓 𝑥 = 2𝑥 and 𝐹 𝑥 = 𝑥 2 + 5
𝐹 ′ 𝑥 = 2𝑥 = 𝑓(𝑥)
Thus, 𝐹 𝑥 = 𝑥 2 + 5 is the anti-derivative of 𝑓 𝑥 = 2𝑥
A. Afful-Dadzie 3
Integration
Example 3
Let 𝑓 𝑥 = 2𝑥 and 𝐹 𝑥 = 𝑥 2 − 4
𝐹 ′ 𝑥 = 2𝑥 = 𝑓(𝑥)
Again, 𝐹 𝑥 = 𝑥 2 − 5 is the anti-derivative of 𝑓 𝑥 = 2𝑥.
Examples 1, 2 and 3 implies that 𝑓 𝑥 = 2𝑥 could have many anti-derivatives.

However, 𝑓 𝑥 must have exactly one anti-derivative. To overcome the problem of
having 𝑓 𝑥 having multiple anti-derivatives, we will add a constant 𝑐 to the anti-
derivative 𝐹(𝑥).
A. Afful-Dadzie 4
Integration
Integration
In essence we have 𝑦 = 𝑓 𝑥 𝑑𝑥 = 𝐹 𝑥 + 𝑐
Elementary Integration Formulas
1. 𝑘𝑑𝑥 = 𝑘𝑥 + 𝑐, where 𝑘 and 𝑐 are constants
E.g. 2𝑑𝑥 = 2𝑥 + 𝑐
𝑥 𝑎+1
2. 𝑥 𝑎 𝑑𝑥 = +𝑐
𝑎+1
𝑥 3+1 𝑥4
E.g. 𝑥 3 𝑑𝑥 = +𝑐 = +𝑐
3+1 4
1 𝑑
3. 𝑥 −1 𝑑𝑥 = 𝑑𝑥 = 𝐼𝑛𝑥 + 𝑐 (remember (𝐼𝑛𝑥)?)
𝑥 𝑑𝑥
A. Afful-Dadzie 5
Integration
4. 𝑒 𝑥 𝑑𝑥 = 𝑒 𝑥 + 𝑐
5. 𝑘𝑓 𝑥 𝑑𝑥 = 𝑘 𝑓 𝑥 𝑑𝑥 , where 𝑘 is a constant
2 2 𝑥3
E.g. 2𝑥 𝑑𝑥 = 2 𝑥 𝑑𝑥 = 2 +𝑐
3
6. 𝑓(𝑥) ± 𝑔(𝑥) 𝑑𝑥 = 𝑓 𝑥 𝑑𝑥 ± 𝑔 𝑥 𝑑𝑥
E.g. 𝑥 2 − 2𝑥 𝑑𝑥 = 𝑥 2 𝑑𝑥 − 2𝑥𝑑𝑥
𝑥3
= − 𝑥2 + 𝑐
3
Example: Find the integral (𝑥 2 + 2𝑥)𝑑𝑥

𝑥3
Solution: 𝑦 = + 2𝑥 + 𝑐
3
A. Afful-Dadzie 6
Integration
Integration with Initial Conditions

To obtain the actual value of 𝑐 in the integration formula will require some
initial knowledge (or condition) about the function under study.
Example 1
Suppose 𝑓 𝑥 = 𝑥 2 + 𝑐 and that at 𝑥 = 1, 𝑓 1 = 4. Then
𝑓 1 ⇒ 12 + 𝑐 = 4
⇒𝑐=3
Thus, the actual function is 𝑓 𝑥 = 𝑥 2 + 3
A. Afful-Dadzie 7
Integration
Example 2
If 𝑦 is a function of 𝑥 such that 𝑦 ′ = 𝑑𝑦/𝑑𝑥 = 8𝑥 − 4 and
𝑦 2 = 5, find 𝑦.
𝑑𝑦 = 8𝑥 − 4 𝑑𝑥
𝑦 = 4𝑥 2 − 4𝑥 + 𝑐
𝑦 2 ⇒ 4(2)2 −4 2 + 𝑐 = 5
⇒ 16 − 8 + 𝑐 = 5
⇒𝑐 =5−8
⇒ 𝑐 = −3
∴ 𝑦 = 4𝑥 2 − 4𝑥 − 3
A. Afful-Dadzie 8
Integration
Example 3:
Finding the demand function from Marginal Revenue
The Marginal Revenue function for a manufacturer’s product is
𝑑𝑟
= 2000 − 20𝑞 − 3𝑞 2 . Find the unit price 𝑝(termed the demand function).
𝑑𝑞
Solution:
𝑟 𝑞 = 2000 − 20𝑞 − 3𝑞2 𝑑𝑞 = 2000𝑞 − 10𝑞2 − 𝑞 3 + 𝑐
Although we are not given any initial condition, note that in practice when
𝑞 = 0, 𝑟 0 = 0.
Thus, 𝑐 = 0, and 𝑟 𝑞 = 2000𝑞 − 10𝑞2 − 𝑞 3
Price = revenue /quantity
𝑟 𝑞
𝑝= = 2000 − 10𝑞 − 𝑞 2
𝑞
A. Afful-Dadzie 9
Integration
Example 4
Given weekly fixed cost as Ghc 4000, find the weekly total cost when the marginal cost function is:
𝑑𝑐
= 0.000001 0.002𝑞 2 − 25𝑞 + 0.2 , where 𝐶 is total cost of producing 𝑞 units of products per
𝑑𝑞
week. What is the cost of producing 𝑞 = 10,000?
Solution
3 2
0.002𝑞 25𝑞
𝐶 𝑞 = 0.000001 0.002𝑞 2 − 25𝑞 + 0.2 𝑑𝑞 = 0.000001( − + 0.2𝑞 + 𝑐1
3 2
In this case, when 𝑞 = 0, 𝑐 = 4000. That is, the fixed cost is incurred whether production occurs
or not.
⇒ 𝑐1 = 4000 and
0.002 3 25 2
𝐶 𝑞 = 0.000001( 𝑞 − 𝑞 + 0.2𝑞 + 4000
3 2
At 𝑞 = 10,000
𝐶 10,000 = 𝐺ℎ𝑐 5416.667
A. Afful-Dadzie 10
Integration
Power Rule for Integration

We’ve learnt that the integral of a power function in the form 𝑥 𝑎 , where 𝑥 is a
𝑥 𝑎+1
variable is given as: 𝑥𝑎 𝑑𝑥 = +𝑐
𝑎+1
For more general power functions, say for instance, (𝑥 + 1)20 𝑑𝑥, applying the
rule above may not work because the (𝑥 + 1) is a function and not a variable.
When this happens, one option is to transform the original integral into the form
𝑥 𝑎+1
of the integral 𝑥𝑎 𝑑𝑥 = + 𝑐 , and work backwards after the integration.
𝑎+1
A. Afful-Dadzie 11
Integration
Example.
Find (𝑥 + 1)20 𝑑𝑥
Solution:
𝑑𝑢
Suppose we let 𝑢 = 𝑥 + 1. Then, =1
𝑑𝑥
𝑑𝑢 = 𝑑𝑥
When all instances of 𝑥 are replaced with 𝑢, then (𝑥 + 1)20 𝑑𝑥 =
20 𝑢21
𝑢 𝑑𝑢 = +𝑐
21
After the integration, we can replace back all instances of 𝑢 with 𝑥.
(𝑥+1)21
⇒ (𝑥 + 1)20 𝑑𝑥 = + 𝑐 because 𝑢 = 𝑥 + 1
21
A. Afful-Dadzie 12
Integration
Example:
2𝑥 3 +3𝑥
Find 𝑑𝑥
𝑥 4 +3𝑥 2 +7
Let 𝑢 = 𝑥 + 3𝑥 2 + 7
4
𝑑𝑢
= 4𝑥 3 + 6𝑥
𝑑𝑥
3 𝑑𝑢
𝑑𝑢 = 2 2𝑥 + 3𝑥 𝑑𝑥 ⇒ = 2𝑥 2 + 3𝑥 𝑑𝑥
2
2𝑥 3 +3𝑥 1 1
Replacing all instances of 𝑥 with 𝑢,⇒ 𝑑𝑥 = 𝑑𝑢
𝑥 4 +3𝑥 2 +7 2 𝑢
1 1 1
𝑑𝑢 = ln 𝑢 + 𝑐
2 𝑢 2
After the integration, we can replace back all instances of 𝑢 with 𝑥.
2𝑥 3 +3𝑥 1
⟹ 𝑑𝑥 = ln 𝑥 4 + 3𝑥 2 + 7 + 𝑐
𝑥 4 +3𝑥 2 +7 2
A. Afful-Dadzie 13
Integration
Example:
Example: Find (𝑥 2 + 1)𝑒 (𝑥 3 +3𝑥)
𝑑𝑥
2
Find 𝑒 𝑥 2𝑥𝑑𝑥 Let 𝑢 = 𝑥 3 + 3𝑥
2 𝑑𝑢
Let 𝑢 = 𝑥 = 3𝑥 2 + 3
𝑑𝑥
𝑑𝑢 𝑑𝑢 = 3 𝑥 2 + 1 𝑑𝑥
= 2𝑥
𝑑𝑥 𝑑𝑢
𝑑𝑢 = 2𝑥𝑑𝑥 = 𝑥 2 + 1 𝑑𝑥
3
∴ 𝑒 𝑢 𝑑𝑢 = 𝑒 𝑢 + 𝑐 1 𝑢
1 𝑢
𝑒 𝑑𝑢 = 𝑒 + 𝑐
3 3
𝑥 2
⇒ 𝑒 +𝑐 1 (𝑥 3 +3𝑥)
⇒ 𝑒 +𝑐
3
A. Afful-Dadzie 14
Integration
Other Examples of Integration

Find 2𝑥 − 3 2 (𝑥 + 1)2 𝑑𝑥
For a problem like this where the power is of small number, it is advisable to expand
the function. In this instance, 2𝑥 − 3 2 (𝑥 + 1)2 = 4𝑥 4 − 4𝑥 3 − 11𝑥 2 + 4𝑥 + 9.
Then,
4 5 11 3
(4𝑥 4 − 4𝑥 3 − 11𝑥 2 + 16𝑥 + 9)𝑑𝑥 = 𝑥 − 𝑥 − 𝑥 + 2𝑥 2 + 9𝑥 + 𝑐
4
5 3
A. Afful-Dadzie 15
Integration
The Definite Integral
Given a function 𝑦 = 𝑓(𝑥) (e.g. say, 𝑦 is a cost function and 𝑥 is quantity),

the area under the curve between the interval [𝑎 𝑏] is given as:
𝑏 𝑏
𝑎
𝑓 𝑥 𝑑𝑥 = 𝐹 𝑥 + 𝑐 𝑎 = 𝐹 𝑏 − 𝐹(𝑎)
A. Afful-Dadzie 16
Integration
Example
2
Find 1 𝑥 + 2 𝑑𝑥
We know that
1 2
𝑥 + 2 𝑑𝑥 = 𝑥 + 2𝑥 + 𝑐
2
2
Thus, 1
𝑥 + 2 𝑑𝑥 = 0.5 ∗ 22 + 2 ∗ 2 − 0.5 ∗ 11 + 2 ∗ 1 = 3.5
Example:
1
Find 0 𝑥 2 + 𝑥 𝑑𝑥
1 3 1 2
𝑥2 + 𝑥 𝑑𝑥 = 𝑥 + 𝑥 + 𝑐
3 2
1 1 1 1 1 5
Thus, 0
𝑥 2 + 𝑥 𝑑𝑥 = ∗ 13 + ∗ 12 − 0 = + =
3 2 3 2 6
A. Afful-Dadzie 17
Integration
Practical example
𝑑𝑐
A manufacturer’s marginal cost function is = 0.6𝑞 + 𝑐. If production is currently set
𝑑𝑞
at 𝑞 = 80 𝑢𝑛𝑖𝑡𝑠 per week, how much more would it cost to increase production to 100
units per week?
Solution
100
𝐶= 0.6𝑞 + 2 𝑑𝑞
80
𝐶 = 0.3𝑞2 + 2𝑞 + 𝑐 100 80
= 0.3(100)2 + 2(100) − 0.3(80)2 + 2(80)
𝐶 = 1120
∴ The manufacturer would need an additional cost of 1120 to increase quantity from
80 units to 100units.
A. Afful-Dadzie 18
Session Goals
 Integrating a function via approximating techniques
 The Importance of Approximating Techniques for integration
 The Trapezium Rule
 The Simpson’s Rule
A. Afful-Dadzie 1
Integration
APPROXIMATE INTEGRATION
Sometimes, it is difficult to integrate a function using the techniques we’ve learnt so far.
2 𝑥2 𝑥 2
For example, it will take a considerable effort to find 0
𝑒 𝑑𝑥 . Below is the curve 𝑒
between the interval 𝑥 = 0 and 𝑥 = 2.
The area under the curve
f(x) between this interval is
60 equivalent to the integral
50 2 𝑥2
0
𝑒 𝑑𝑥.
40
30
Therefore, if it’s too difficult to
y
2 𝑥2
20 integrate 0
𝑒 𝑑𝑥, we could
10 take a short-cut by rather
0
0 0.5 1 1.5 2 2.5
finding the area under the
x
curve.
A. Afful-Dadzie 2
Integration
The problem we face using this approach is that the shape under
the curve might not be a nice one with an already established
formula for finding the area, like say, a triangle, rectangle, sphere,
etc.
In an attempt to still find the area, some scholars proposed
dividing the area into sub areas with some triangle, some
rectangle etc.
We will look at one approach to finding the area under a curve
using a trapezoid.
A. Afful-Dadzie 3
Integration by approximation
TRAPEZIUM RULE
1
The area of a trapezium is given as: (A) = ℎ(𝑓1 + 𝑓2)
2
Given a curve as shown below, we could divide the area

under the curve into a number of trapezoids of equal
base, find the area of each trapezoid, and sum them
together to get an approximate area under the curve.
Note the emphasis on ‘approximate’. There will inevitably
be some left over areas that won’t be covered by the
trapezoids.
A. Afful-Dadzie 4
𝑏−𝑎
The equal interval ℎ = , where 𝑛 is the number of trapezoids, and 𝑎 and 𝑏 are the ends.
𝑛
1
Area = ℎ[ 𝑓 𝑎 + 𝑓 𝑎 + ℎ + 𝑓 𝑎 + ℎ + 𝑓 𝑎 + 2ℎ + 𝑓 𝑎 + 2ℎ + 𝑓 𝑎 + 3ℎ +
2
(𝑓 𝑎 + 3ℎ + 𝑓 𝑎 + 4ℎ + ⋯ + 𝑓 𝑎 + 𝑛 − 2 ℎ + 𝑓 𝑎 + 𝑛 − 1 ℎ + 𝑓 𝑎 + 𝑛 − 1 ℎ + 𝑓(𝑏)]
1
Area = ℎ[𝑓 𝑎 + 2𝑓 𝑎 + ℎ + 2𝑓 𝑎 + 2ℎ + 2𝑓 𝑎 + 3ℎ + ⋯ + 2𝑓 𝑎 + 𝑛 − 1 ℎ + 𝑓 𝑏 ]
2
1
Area = ℎ[𝑓 𝑎 + 2[𝑓 𝑎 + ℎ + 𝑓 𝑎 + 2ℎ + 𝑓 𝑎 + 3ℎ + ⋯ + 𝑓 𝑎 + 𝑛 − 1 ℎ ] + 𝑓 𝑏 ]
2
A. Afful-Dadzie 5
Example:
1 1
Find 𝑦 = 0 1+𝑥 2
𝑑𝑥
Solution
The actual answer is 0.785, however, this integral is not that easy to find. We could
approximate the area under the curve using the trapezoid rule.
1
The function from 𝑥 = 0 to 𝑥 = 1 is as shown below:
1+𝑥 2
1.1
1
0.9
0.8
y
0.7
0.6
0.5
0.4
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
x
A. Afful-Dadzie 6
Finding the area under the curve using 10 trapezoids of equal base ℎ
1−0
ℎ= = 0.1
10
𝑥 1 1
𝑦= 𝑘𝑖 ∗
1 + 𝑥2 1 + 𝑥2
0 1 1
0.1 0.99 2*0.99 =1.98
0.2 0.96 2*0.96 = 1.92
0.3 0.91 2*0.91 = 1.82
0.4 0.86 2*0.86 = 1.72 0.1
∴ 𝐴𝑟𝑒𝑎 = 15.68
0.5 0.8 2*0.8 = 1.6 2
0.6 0.74 2*0.74 = 1.48 𝐴𝑟𝑒𝑎 = 0.784
0.7 0.67 2*0.67 = 1.34
0.8 0.61 2*0.61 = 1.22
0.9 0.55 2*0.55 = 1.1
1.0 0.5 0.5
Sum = 15.68
A. Afful-Dadzie 7
2 𝑥2
Example: Try the trapezoid rule for 0
𝑒 𝑑𝑥
SIMPSON’S RULE (Using the parabola)

We can also approximate the area under a curve using a parabola instead of a trapezoid.
This is called the Simpson’s rule. The sum of the areas of all parabolas under the
Simpson’s rule is given as:
ℎ
Area = [𝑓 𝑎 + 4𝑓 𝑎 + ℎ + 2𝑓 𝑎 + 2ℎ + 4𝑓 𝑎 + 3ℎ + 2𝑓 𝑎 + 4ℎ + ⋯ +
3
2𝑓 𝑎 + 𝑛 − 2 ℎ + 4𝑓 𝑎 + 𝑛 − 1 ℎ + 𝑓(𝑏)
𝑏−𝑎
𝑤ℎ𝑒𝑟𝑒; ℎ =
𝑛
𝑛 must be even
A. Afful-Dadzie 8
Example: REVENUE
Use the Simpson’s rule to approximate the total revenue received from the
production of 80 units of a product if the values of the marginal revenue
𝑑𝑟
function are as follows:
𝑑𝑞
Q units 0 10 20 30 40 50 60 70 80
𝑑𝑟
10 9 8.5 8 8.5 7.5 7 6.5 7
𝑑𝑞
Solution:
80 − 0 Ai= 189
ℎ= = 10
8
ℎ 10
Area = × 𝐴𝑖 = × 189
Ai 1 × 10 4× 9 2× 8.5 4× 8 2× 8.5 4× 7.5 2× 7 4× 6.5 1×7 3 3
10 36 17 32 17 30 14 26 7 Area = 630
Example: Use the Simpson’s rule to find
2 𝑥2
𝑒 𝑑𝑥 and
∴ total revenue received from
0
1 1
𝑑𝑥
the production is 630 9
0 1+𝑥 2 A. Afful-Dadzie
Producer and Consumer Surpluses
For any 𝑑𝑞 quantity below 𝑞0 , there is a consumer surplus of 𝑝1 − 𝑝0 𝑑𝑞

For any 𝑑𝑞 quantity below 𝑞0 , there is a producer surplus of 𝑝0 − 𝑝2 𝑑𝑞
The total consumer and producer surpluses are given as:
𝑞0
Consumer Surplus = 0
𝑝1 − 𝑝0 𝑑𝑞
𝑞0
Producer Surplus = 0
𝑝0 − 𝑝2 𝑑𝑞
A. Afful-Dadzie 10
Example:
The demand function for a product is 𝑝 = 100 − 0.05𝑞, where 𝑝 is the price per unit for
quantity 𝑞. The supply function is 𝑝 = 10 + 0.1𝑞. Determine the consumer and producer
surplus under the market equilibrium.
At equilibrium, 100 − 0.05𝑞 = 10 + 0.1𝑞 ⇒ 0.15𝑞 = 90
⇒ 𝑞0 = 600 and 𝑝0 = 10 + 0.1 ∗ 600 = 70
𝑞 600
Consumer Surplus = 0 0 𝑝1 − 𝑝0 𝑑𝑞 = 0 100 − 0.05𝑞 − 70 𝑑𝑞
100 − 0.05𝑞 − 70 𝑑𝑞 = 30𝑞 − 0.025𝑞2 + 𝑐

600
100 − 0.05𝑞 − 70 𝑑𝑞 = 30 ∗ 600 − 0.025 ∗ 6002 − 0 = 9000
0
𝑞0 600 600
Producer Surplus = 0
𝑝0 − 𝑝2 𝑑𝑞 = 0
70 − (10 + 0.1𝑞) 𝑑𝑞 = 0
60 − 0.1𝑞 𝑑𝑞
60 − 0.1𝑞 𝑑𝑞 = 60𝑞 − 0.05𝑞2 = 𝑐

600
60 − 0.1𝑞 𝑑𝑞 = 60 ∗ 600 − 0.05 ∗ 6002 − 0 = 18,000
0 11
A. Afful-Dadzie
Session Goals
 Decision Variables
 Objective Functions
 Constraints
 Linear Equations and Inequalities
 Mathematical formulation using decision variables, objective functions and
constraints
A. Afful-Dadzie 1
INTRODUCTION TO MATHEMATICAL MODELING
 A business mathematical model is a mathematical representation of a worded

business problem.
 For business problems amenable to mathematical representation, a
mathematical equivalent (or formulation) of the problem enables richer
analysis than the worded equivalent due to its clear and concise form of
representation.
 The first step of any mathematical formulation is the definition of so-called
‘decision variables’.
A. Afful-Dadzie 2
Step 0: Define the decision variable
Example 1
Imagine you have Ghc 10,000 to invest in two assets. Your concern is how much to invest in
asset 1 and asset 2. It could be anything, depending on other information at hand.
For instance, you could put Ghc 1000 in asset 1 and Ghc 9000 in asset 2. You could also
(depending on other information) decide to put Ghc 6000 in asset 1 and Ghc 4000 in asset The
number of ways of the division could be endless (assuming no other information exist).
Instead of thinking of all the possible allocations, we will rather let 𝑥1 , be a variable
representing the amount of money invested in asset 1 and 𝑥2 , the variable representing the
amount invested asset 2.
Then, 𝑥1 + 𝑥2 ≤ 10,000.
The symbol ≤ reflect the fact that it is possible less than Ghc 10,000 could be invested in
the two assets. A. Afful-Dadzie 3
Example 2
A company manufactures products A and B using machine 1 and machine 2.
Suppose machine 1 is available 60 hours per week, machine 2 is available 80 hours per week. In
addition, to produce a unit of product A would require 2 hours on machine 1 and 4 hours on
machine 2, whereas a unit of product B would require 1 hour on machine 1 and 2 hours on
machine 2. In a problem such as this, the challenge is to decide how many of product A and
product B to produce taking into consideration the limitations on the availability of machine 1
and machine 2.
Solution
Let 𝑥𝐴 and 𝑥𝐵 be the variable representing the number of unit of product A and product B respectively
to produce per week. Whatever 𝑥𝐴 and 𝑥𝐵 are, the total hours spent on machine 1 cannot exceed 60
hours per week and the total hours on machine 2 cannot exceed 80 hours per week.
Using the defined variables, a mathematical model for the limitations could be written as:
Alternatively, 2𝑥𝐴 + 𝑥𝐵 ≤ 60
4𝑥𝐴 + 2𝑥𝐵 ≤ 80
A. Afful-Dadzie 4
Step 1: Mathematical Formulation
After defining the necessary variables, the other information regarding a worded
problem statement would then be translated into its equivalent mathematical form
with the help of decision variables (e.g. the representation of the variables in
example 2 above). This is generally accomplished using a combination of equations,
inequalities and functions. For this course, we will limit ourselves to only:
- Linear equations
- Linear inequalities
- Linear or multi linear functions
We will call the symbols {=, <,>, ≤, ≥,} found at the right-hand-side (RHS) or
left-hand-side (LHS) in the linear equations and inequalities Restrictions,
Constraints or Limitations.
A. Afful-Dadzie 5
Linear equation
A linear equation is of the form:
𝒂𝟏 𝒙𝟏 + 𝒂𝟐 𝒙𝟐 + 𝒂𝟑 𝒙𝟑 + ⋯ + 𝒂𝒏 𝒙𝒏 = 𝒃
Where 𝒂𝒊 is a coefficient/ parameter, 𝒃 is a parameter, and 𝒙𝒊 is a variable.
Linear equations are one of the tools used in translating a worded business problem
into a mathematical form for analysis.
Example:
A company earns a before tax of GH¢100,000. It has agreed to contribute 10% of its
after tax profit to the Red Cross Relief Fund. It must pay a regional tax of 5% of its
profit (after the Red Cross donation) and a state tax of 40% of its profit (after the Red
Cross donation and regional tax). How much does the company pay in regional tax,
state tax and Red Cross donation?
A. Afful-Dadzie 6
Solution
To answer the question, we will first translate the worded problem into an equivalent
mathematical form.
Step 0:
Let R and S be variables representing the amounts paid for regional tax and state tax
respectively.
Also, let C be the contribution to the Red Cross.
Step 1:
After tax profit = 100000 – (S+R)
C= 0.1(100000 –S – R)
R= 0.05(100000 – C)
S= 0.4(100000 –C – R)
The three linear equations together does represent the worded problem above. Thus, there are
three equations and three unknown variables of C, R and S. Solving the three equations leads
to S=35736.680, R=4702.194, and C=5956.113.
A. Afful-Dadzie 7
Example
The Smith Company would like to know the total sales units that are required for the
company to earn a profit of GH¢150,000 if the unit selling price is GH¢50, the
variable cost per unit is GH¢25, and the total fixed cost is GH¢500000.
Solution
Step 0:
Let q be the variable representing the number of sales units required to achieve a
profit of GH¢150,000.
Profit = Revenue – Total Cost
Revenue = unit selling price x sales units = 50q
Total cost = total variable cost + total fixed cost = 500000 + 25q.
A. Afful-Dadzie 8
Therefore, mathematically,
Profit = 50q – (500000 + 25q).
If we want to achieve a profit of GH¢150,000, we must have:
150,000 = 25q – 500000
Then we can solve for that q that will results in GH¢150,000 profit. Rearranging,
we have:
25q = 650000 ⇒ q= 26,000
So, the number of required sales units is 26,000 units.
A. Afful-Dadzie 9
Example
The XYZ manufacturing company has a total fixed cost of GH¢1200, a variable
cost per unit of GH¢2, and a total revenue function for selling q units of product
as R(q) =100√q. Determine the break-even quantity of XYZ Manufacturing
Company. What should be the quantity if a profit of Ghc 150,000 is desired?
Solution
At break-even, Total Cost = Total Revenue
Let ‘q’ represent quantity
Total Cost = Fixed Cost + Variable Cost
Total Cost = 1200 + 2q
Total Revenue = 100√q
A. Afful-Dadzie 10
At the break-even point, total revenue equals total cost. Thus:

1200 + 2q = 100√q
(1200 + 2q)2 = (100√q)2
1,440,000 + 4800q + 4q2 = 10000q
4q2 – 5200q + 1,440,000 = 0
q= 400; q=900
Thus, maximum profit is achieved at quantity of either 400 or 900
Now, to attain a profit of Ghc 150,000, Total Revenue – Total = 150,000.

Thus,
100√q – (1200 + 2q) = 150,000.
One can then solve for q.
A. Afful-Dadzie 11
Linear Inequalities
Linear inequalities are of the form:
𝒂𝟏 𝒙𝟏 + 𝒂𝟐 𝒙𝟐 + 𝒂𝟑 𝒙𝟑 + ⋯ + 𝒂𝒏 𝒙𝒏 ≤ 𝒃
𝒂𝟏 𝒙𝟏 + 𝒂𝟐 𝒙𝟐 + 𝒂𝟑 𝒙𝟑 + ⋯ + 𝒂𝒏 𝒙𝒏 ≥ 𝒃
Where 𝒂𝒊 is a coefficient/ parameter, 𝒃 is a parameter, 𝒙𝒊 is a variable, and the symbols ‘≤
, ≥ ‘ stand for ‘less-than or equal-to’ and ‘greater-than or equal-to respectively.
Familiar Words and their equivalent symbols

At least/ not less than ≥
At most/ not more than ≤
Exactly/ should be/ Must be=
A. Afful-Dadzie 12
Examples:
1. A person wishes to invest GH¢20,000 in two enterprises so that total returns for the
year would be at least GH¢1,440. One enterprise pays 6% annually; the other has
more risks and so pays 8% annually. How much must be invested in each
enterprise?
Solution
Step 0:
Let x1, x2 be the amount invested in enterprises 1 and 2 respectively.
Step 1:
x1 + x2 = 20,000 ( equation for total amount)
0.06x1 + 0.08x2 ≥ 1,440 (equation for total returns)
A. Afful-Dadzie 13
Functions
In business, objectives are mostly modeled using functions. Notable business
objective functions includes:
1. Profit function
2. Cost function
3. Revenue function
4. Time function
5. Distance function
A. Afful-Dadzie 14
Example
1. A bank is attempting to determine where its assets should be invested during the
current year. At present, GH¢500,000 is available for investment in bonds, home
loans, auto loans and personal loans. The annual rate of return on each type of
investment is known to be: bonds 10%; home loans 16%; auto loans 13%; and
personal loans 20%. To ensure that the banks portfolio is not too risky, the bank’s
investment manager has placed the following three restrictions on the bank’s
portfolio:
a. the amount invested in personal loans cannot exceed the amount invested in bonds;
b. the amount invested in home loans cannot exceed the amount invested in auto loans;
c. no more than 25% of the total amount invested may be in personal loans.
The bank’s objective is to maximize the annual return on its investment portfolio.
Formulate a mathematical model to help the bank achieve its objectives.
A. Afful-Dadzie 15
Solution
Step 0:
Let x1, x2, x3, and x4 be the amounts invested in bonds, home loans, auto loans and
personal loans respectively.
Step 1:
Objective function – Maximization
0.1x1 + 0.16x2 + 0.13x3 +0.2x4
Constraints/Restrictions/limitations
x1 + x2 + x3 + x4 ≤ 500,000
x4 ≤ x1
x2 ≤ x3
x4 ≤ 0.25(500,000)
x1 ≥ 0, x2 ≥ 0, x3 ≥ 0, x4 ≥ 0 (non-negativity constraints)
A. Afful-Dadzie 16
The last part of the mathematical formulation is very important since if we

don’t add this, we are implicitly assuming one can invest a negative
amount, which is not possible.
**Students will lose lots of marks for not adding the non-negativity
constraints for problems that seem obvious negative amount is not possible.
A. Afful-Dadzie 17
The final formulation would then be:

Max 0.1x1 + 0.16x2 + 0.13x3 +0.2x4
s.t
x1 + x2 + x3 + x4 ≤ 500,000
x4 ≤ x1
x2 ≤ x3
x4 ≤ 0.25(500,000)
x1 ≥ 0, x2 ≥ 0, x3 ≥ 0, x4 ≥ 0
Where ‘s.t’ stands for ‘subject to’.
That is, we want to achieve the objective of maximizing total annual returns taking into
account (or subject to) the constraints presented. This form of mathematical formulation
where a linear objective is subject to a set of linear constraints is known as ‘Linear
programming’ or ‘linear optimization’.
We will see how we can solve such problems in UGBS 301 (Quantitative Methods)
A. Afful-Dadzie 18
Session Goals
 The purpose of index numbers
 Calculate indices for changes in the value of a variable
 Change the base of an index
 Use simple aggregate and mean relative indices
 Calculate aggregate indices using base-weighting and current-weighting
A. Afful-Dadzie 1
Indices
 An index is a number that compares the value of a variable at any

given point in time with its value at a fixed reference point.
 The fixed reference point is usually called “Base period” and the
associated value is called the “Base value”.
 In business, an index measures percentage (%) change in the value of

some commodity cover a period of time.
A. Afful-Dadzie 2
Indices
Simple Index Number Construction
Suppose the price of a 330ml can of coke was GH¢2.0 in January, GH¢2.2 in February and
Ghc 2.8 in March, then;
2.2−2.0
⇒% increase from Jan-Feb = × 100 = 10%
2.0
The price of 330ml can of coke increased (↑) by 10% from January to February.
2.8−2.0
⇒% increase from Jan-March = × 100 = 40%
2.0
The price of 330ml can of coke increased (↑) by 10% from January to February and by 40%
from January to March.
In index number form, the 10% (and 40%) increase (↑) is added to the base 100 giving 110
(and 140). So, the price index of 330ml can of coke in March was 140 (relative to January).
NB: Any increase (↑) or decrease (↓) must be related to some time period, otherwise, it is
meaningless. A. Afful-Dadzie 3
Indices
Index Number Notation for Price and Quantity

Throughout this lecture, we will let
P0 ≡ Price at the base time point
Pn ≡ Price at some other time point
Q0 ≡ Quantity at base time point
Qn ≡ Quantity at some other time point
Ip, Iq will be the price index and quantity index respectively.
Then
𝑝𝑛
Ip for any time period n = × 100% ;
𝑝0
𝑞𝑛
Iq for any time period n = × 100%
𝑞0
A. Afful-Dadzie 4
Indices
Example:
The price of a quantity of a product A from 2010 to 2014 is as follows. Using
the year 2010 as the base year, calculate the price index from 2010 to 2014.
Year 2010 2011 2012 2013 2014

Price 50 60 55 65 70
50 60 55 65 70
Index × 100% × 100% × 100% × 100% × 100%
50 50 50 50 50
= 100 = 120 = 110 = 130 = 140
A. Afful-Dadzie 5
Indices
An Index Relative
An Index Relative (sometimes called “relative”) is the name given to an index number
which measures the change in a single distinct commodity.
Example
2013 2014
Item
Price (P0) No Sold (Q0) Price (P0) No Sold (Q0)
Video recorder GH¢500 40 GH¢542 28
30 inch television GH¢410 25 GH¢465 42
For Video Recorder;

542
Price Index (Ip) = × 100% = 108.4
500
28
Quantity Index (Iq) = × 100% = 70
40
For 30 inch television;

465
Price Index (Ip) = × 100% = 113.4
410
42
Quantity Index (Iq) = × 100% = 168
25
A. Afful-Dadzie 6
Indices
Fixed and Chain-based Relative Indices
Indices are usually expressed relative to a ‘fixed’ reference time point.
On rare occasions however, indices could be expressed such that the reference
time point for the current period is the immediate past period.
When this is the case, the relative index is described as chain-based.
The next example illustrate the difference between fixed and chain-based relative
indices.
A. Afful-Dadzie 7
Indices
Example
Month Jan Feb(base) March April May June

Production 4563 4245 4841 4644 5290 5156
Fixed Base 4563 100% 114% 109% 124.6% 121.5%
Relative × 100%
4245
Index = 107%
Chain Base — 4245 4841 4644 5290
× 5156
Relative × 100% 4644
4563 4245 4842 100% =113.9 5290
Index = 99% × 100% × 100% × 100%
= 114% = 95.9% = 97.5%
Note: The rest of the lecture will use only fixed based relative indices approach.
A. Afful-Dadzie 8
Indices
Comparing Values at Different Times
𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛 𝑝𝑛
Index at period n = Ipn = =
𝑏𝑎𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑝0
𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑚 𝑝𝑚
Index at period m = Ipm = =
𝑏𝑎𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑝0
𝑝𝑛 𝑝𝑚
Thus =
𝑝0 𝑝0
𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑚

That is, =
𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑚
A. Afful-Dadzie 9
Indices
Example:
The table below shows the monthly index for sales of an item.
Month 1 2 3 4 5 6 7
Index 121 112 98 81 63 57 89
(a) If sales in month 3 amounted to 240 units, what was the sales value in month 8?
𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑚𝑜𝑛𝑡ℎ 8 𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑚𝑜𝑛𝑡ℎ 3
=
𝑖𝑛𝑑𝑒𝑥 𝑖𝑛 𝑚𝑜𝑛𝑡ℎ 8 𝑖𝑛𝑑𝑒𝑥 𝑖𝑛 𝑚𝑜𝑛𝑡ℎ 3
240
Sales in month 8 = ∗ 109 = 267
98
A. Afful-Dadzie 10
Indices
Percentage Change Period
Period 1 2 3 4 5
Index 100 120 142 108 135
At period 2, there is a 20 point increase (↑) over the index at period 1.

% change point = index at point t0 – index at point t1
A. Afful-Dadzie 11
Indices
Changing Base Period
Reasons for Changing Base Period

1. Changing circumstances: an index should be reset whenever there is a significant
change that makes comparison with earlier periods meaningless.
2. An index becomes too large- say an index rises to 5000 then a 10% increase (↑) raises
it by 500 points, which is a huge jump, then a jump of from 100 to 110.
Disadvantages
Changing the base period introduces discontinuity that makes comparison over periods
more difficult.
A. Afful-Dadzie 12
Indices
Changing the Base of a Fixed Base Relative
Note that for any period, the following must hold
𝑣𝑎𝑙𝑢𝑒 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛
𝑜𝑙𝑑 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛 =
𝑜𝑙𝑑 𝑏𝑎𝑠𝑒 𝑣𝑎𝑙𝑢𝑒
𝑛𝑒𝑤 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛 =
𝑛𝑒𝑤 𝑏𝑎𝑠𝑒 𝑣𝑎𝑙𝑢𝑒
Thus,
𝑜𝑙𝑑 𝑏𝑎𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 =
𝑜𝑙𝑑 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛
𝑛𝑒𝑤 𝑏𝑎𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 =
𝑛𝑒𝑤 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛
A. Afful-Dadzie 13
Then
Indices
𝑜𝑙𝑑 𝑏𝑎𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑙𝑑 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛 𝑛𝑒𝑤 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛
= =
𝑛𝑒𝑤 𝑏𝑎𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑣𝑎𝑙𝑢𝑒 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛 𝑜𝑙𝑑 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛
𝑛𝑒𝑤 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛
Similarly for say, period 𝑚
𝑜𝑙𝑑 𝑏𝑎𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑛𝑒𝑤 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑚
=
𝑛𝑒𝑤 𝑏𝑎𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑙𝑑 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑚
It is easy to see then that
𝑛𝑒𝑤 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛 𝑛𝑒𝑤 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑚
=
𝑜𝑙𝑑 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛 𝑜𝑙𝑑 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑚
Therefore, between an old and new indices, the formula below holds:
𝑜𝑙𝑑 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛 𝑛𝑒𝑤 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛
=
𝑜𝑙𝑑 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑚 𝑛𝑒𝑤 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑚
A. Afful-Dadzie 14
Indices
Example 1
The following are indices relative to a base year of 1975. Suppose the base year is to change to
year 2004, calculate the new indices using the new base year.
Since, year 2004 is the new base year, then new index at year 2004 = 100.
Let 𝑥𝑡𝑛𝑒𝑤 be the new index at year 𝑡 and 𝑥𝑡𝑜𝑙𝑑 be the old index at year 𝑡. Then,
𝑥4𝑜𝑙𝑑 𝑥4𝑛𝑒𝑤
= 𝑛𝑒𝑤
𝑥5𝑜𝑙𝑑 𝑥5
𝑥4𝑛𝑒𝑤
Therefore, 𝑥5𝑛𝑒𝑤 = 𝑥5𝑜𝑙𝑑 ∗
𝑥4𝑜𝑙𝑑
Using 2004 index as the base, the new indices are as shown in row 2 of the table below.
Year 2004 2005 2006 2007 2008 2009 2010
Old index
324 351 377 384 391 404 428
(1975=100)
New index 324 351 377 384 391 404 428
× 100 × 100 × 100 × 100 × 100 × 100 × 100
(2004=100) 324 324 324 324 324 324 324
= 100 = 108.3 = 116.4 = 118.5 = 120.7 = 124.7 = 132.1
A. Afful-Dadzie 15
Indices
Example 2:
The following indices monitor the annual profits of Tigo Company Ghana.
Year 1 2 3 4 5 6 7 8
Index 1 100 140 168 199 230
Index 2 100 125 142 160
a. If the company had not changed to index 2, what values would index 1 have in years 6 to
8?
b. What values does index 2 have in years 1 to 4?
c. If the company made a profit of GH¢5M in year 3, how much did it make in other years?
Assume year 1 and year 5 as the base year for index 1 and index 2 respectively.
A. Afful-Dadzie 16
Indices
Solution
230
a. 𝑦𝑒𝑎𝑟 = 𝑖𝑛𝑑𝑒𝑥 2 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 ×
100
230
𝑦𝑒𝑎𝑟 6 ⇒ 125 × = 287.5
100
230
𝑦𝑒𝑎𝑟 7 ⇒ 142 × = 326.6
100
230
𝑦𝑒𝑎𝑟 8 ⇒ 160 × = 368
100
100
b. 𝑦𝑒𝑎𝑟 ⇒ 𝑖𝑛𝑑𝑒𝑥 1 𝑜𝑓 𝑦𝑒𝑎𝑟 ×
230
100
𝑦𝑒𝑎𝑟 1 ⇒ 100 × = 43.5
230
100
𝑦𝑒𝑎𝑟 2 ⇒ 140 × = 60.9
230
100 100
𝑦𝑒𝑎𝑟 3 ⇒ 168 × = 73.0𝑦𝑒𝑎𝑟 4 ⇒ 199 × =86.5
230 230
value in year n value in year m
c. You can use the formula = to answer c
index in year n index in year m
A. Afful-Dadzie 17
Indices
Indices for More Than One Variable
Sometimes an entity (eg. Company) might be involved in more than one commodity.
In such a case, an interest could center on composite index to represent the company.
There are two ways of generating a composite index in such a case;
1. Mean (Average) Relative Index
2. Simple Aggregate Relative Index
𝐾
sum of separate indices 𝑎𝑡 period n 𝑖=1 𝐼𝑛𝑖
Mean Relative Index at a period n = =
number of indices 𝐾
𝐾
sum of value in period 𝑖=1 𝑉𝑛𝑖
Simple Aggregate Relative Index at a period n = = 𝐾 𝑉
sum of value in base period 𝑖=1 0𝑖
Where 𝐼𝑛𝑖 is the individual index at period 𝑛 for commodity 𝑖, 𝑉𝑛𝑖 and 𝑉0𝑖 are the
values for commodity 𝑖 at period 𝑛 and base period respectively. 𝐾 is the number
commodities present
A. Afful-Dadzie 18
Indices
Example
Year 2013 2014 2015 Fixed indices
Item Price Price Price 2014 2015
Coffee 62
×
64
× 100=116.6
55p 62p 64p 55 55
100 =112.7
Tea 32
×
30
×
28p 32p 30p 28 28
100 =114.3 100 =107.1
Hot Chocolate 74 50
×
72p 74p 50p 72 × 100
100 =102.8 72
= 69.4
Relative Mean 112.7 + 114.3 + 102.8 116.6 + 107.1 + 69.4
Index 3 3
= 109.9 = 97.7
Simple Aggregate 62 + 32 + 74 64+30+50
× 100 ×
Relative Index 55 + 28 + 72 55+28+72
= 108.38 100 =92.9
NB: Using 2013 as the base year. A. Afful-Dadzie 19

Indices
Disadvantages of the Mean/Simple Aggregate Index

1. Suppose the price of a loaf of bread was GH¢2 in year 1 and GH¢2.40 in year 2; also
the price of a ton of butter was GH¢2800 in year 1 and GH¢3000 in year 2,
3000+2.4
Simple Aggregate Index for year 2 = × 100% = 107.15%
2800+2
Suppose we were to ignore the value for bread, then
3000
Simple Aggregate Index for year 2 = × 100% = 107.14%
2800
The two index values are almost the same, implying butter has virtually no influence on
the composite index. This is one of the shortcomings of the simple aggregate index
technique.
A. Afful-Dadzie 20
Indices
The Mean Relative index however does not suffer from this shortcoming and must
be used in such circumstances (i.e. when there are huge differences between the
values for the various commodities).
For example, using the mean relative index, we have:
𝐾
sum of separate indices at period 𝑛 𝑖=1 𝐼𝑛𝑖
Mean Relative Index at a period n = =
number of indices 𝐾
2.4
Index for bread at year 2 = ∗ 100% = 120
2
3000
Index for butter at year 2 = ∗ 100% = 107.14
2800
120+107.14
Mean Index for year 2= = 113.57
2
In this case, the two commodities contribute fairly to the mean index of 113.57
A. Afful-Dadzie 21
Indices
2. Mixing of Units
Sometimes, two or more commodities might be in different units which might
result in a meaningless/un-interpretable composite index.
Example: Suppose in 2014, 5000kg of steel and 1000 gallons of diesel were sold,
and in 2015, 6000kg of steel and 1200 gallons of diesel were sold. According to
simple aggregate index,
5000𝑘𝑔+1000𝑔
Simple Aggregate Index for year 2015 = × 100%
6000𝑘𝑔+1200𝑔
The value obtain from the resulting composite index is meaningless as we are
mixing Apples and Oranges.
A. Afful-Dadzie 22
Indices
WEIGHTED INDICES
Importance Weight
Often, a commodity or an aspect of a commodity could be more
important relative to another commodity.
In this case, the manufacturer may want to place more emphasis (or
weight) on the most important commodity.
This weight must be taken into account when calculating the indices.
A. Afful-Dadzie 23
Indices
Take the example in the table below. Commodity A has a price of 2 but sold 20,000 units
whereas commodity B’s price is 1000 but sold only 2.
Basing a simple aggregate index on price/quantity will yield result that ignores the size of
quantity or price.
When emphasis is on price, commodity B is more important than commodity A. The
opposite is true when emphasis is on quantity.
Thus, when one is after price index, the quantity values could be used as weights.
Similarly, when quantity index is desired, the price values could be used as weights.
Price Quantity
A 2 20,000
B 1000 2
A. Afful-Dadzie 24
Indices
Weighted Indices
The above reasoning leads to a modification of the previous indices for more than one variable:
a. Weighted Mean (Average) Relative Index
𝑛
𝑖=1 𝑊𝑖 𝐼𝑛𝑖
𝐼𝑊𝑀 = 𝑛 𝑊
𝑖=1 𝑖
where, Wi = weight factor for commodity i

Ini = index for commodity i at period n
b. Weighted Aggregate Index

𝑛
𝑖=1 𝑊𝑖 𝑉𝑛𝑖
𝐼𝑊𝐴 = 𝑛 𝑊 𝑉 × 100%
𝑖=1 𝑖 0𝑖
where, Wi = weight factor for commodity I; Vni = value for commodity i at time n
V0i = value for commodity i at base time period
A. Afful-Dadzie 25
Indices
Example
Item Year 1 Year 2

Price (P0) Price (Pn) Weight (Wi)
A 20 24 6
B 55 51 4
C 63 84 1
D 28 34 8
a. Calculate the Weighted Mean Price Index

b. Calculate the Weighted Aggregate Price Index
A. Afful-Dadzie 26
Indices
Solution:
In this example, item D is considered the most important, followed by A, B
and C with respective weights of 8,6,4,1.
a 𝑰𝒏𝒊 𝑾𝒊 𝑰𝒏𝒊
A 24 6 × 120 = 720
20 × 100% = 120%
B 51 4 × 92.73 = 370.92
55 × 100% = 92.73
C 84 1 × 133.33 = 133.33
63 × 100% = 133.33
D 34 8 × 121.43 = 971.44
28 × 100% = 121.43
Total 2195.69
2195.69
𝐼𝑊𝑀 = = 115.56%
19
A. Afful-Dadzie 27
Indices
b
𝑾𝒊 𝑷𝒏𝒊 𝑾𝒊 𝑷𝟎𝒊
A 6 × 24 = 144 6 × 20 = 120
B 4 × 51 = 204 4 × 55 = 220
C 1 × 84 = 84 1 × 63 = 63
D 8 × 34 = 272 8 × 28 = 224
Total 704 627
704
𝐼𝑆𝐴 = × 100% = 122.20%
627
A. Afful-Dadzie 28
Indices
SPECIAL INDICES
Laspeyres Indices (Base-weighted Index)
This is a special case of a weighted aggregate index which uses base time period
value as weight. It is commonly associated with price and quantity.
Laspeyres Price Index: This uses base period quantity as the weight.
Laspeyres Quantity Index: This uses base period price as the weight.
Finding Laspeyres Price Index:

𝑛
𝑖=1 𝑞0𝑖 𝑝𝑛𝑖
𝐿𝑝 = 𝑛 𝑞 𝑝
𝑖=1 0𝑖 0𝑖
Finding Laspeyres Quantity Index:
𝑛
𝑖=1 𝑝0𝑖 𝑞𝑛𝑖
𝐿𝑞 = 𝑛 𝑝 𝑞
𝑖=1 0𝑖 0𝑖
A. Afful-Dadzie 29
Indices
Example
Item P0 Pn Q0 Qn
A 10 15 95 100
B 20 25 4 2
95 ∗ 15 + 4 ∗ 25
𝐿𝑝 = ∗ 100 = 148
95 ∗ 10 + 4 ∗ 20
10 ∗ 100 + 20 ∗ 2
𝐿𝑞 = ∗ 100 = 100
10 ∗ 95 + 20 ∗ 4
A. Afful-Dadzie 30
Indices
Paasche (Current-weighted) Indices
This is a special case of the weighted aggregate indices which uses current time period
values as the weight for the index. It is commonly associated with price and quantity.
Paasche Price Index uses current time period quantities as weight.
Paasche Quantity Index uses current time period price as weight.
Finding Paasche Price Index:
𝑛
𝑖=1 𝑞𝑛𝑖 𝑝𝑛𝑖
𝑃𝑝 = 𝑛 𝑞 𝑝
𝑖=1 𝑛𝑖 0𝑖
Finding Paasche Quantity Index:
𝑛
𝑖=1 𝑝𝑛𝑖 𝑞𝑛𝑖
𝑄𝑞 = 𝑛 𝑝 𝑞
𝑖=1 𝑛𝑖 0𝑖
A. Afful-Dadzie 31
Indices
Example
A company buys four products with the following features;
Number of units Price paid per unit

Item Year 1 Year 2 Year 1 Year 2
A 20 24 10 11
B 55 51 23 25
C 63 84 17 17
D 28 34 19 20
a. Calculate the base-weighted price and quantity index.

b. Calculate the current-weighted price and quantity index.
A. Afful-Dadzie 32
Indices
Solution:
a.
20 × 11 + 55 × 25 + 63 × 17 + 28 × 20
𝐿𝑝 = × 100% = 105.15%
20 × 10 + 23 × 55 + 63 × 17 + 28 × 19
10 × 24 + 23 × 51 + 17 × 84 + (19 × 34)
𝐿𝑞 = × 100% = 113.66%
10 × 20 + 23 × 55 + 17 × 63 + (19 × 28)
b.
24 × 11 + 51 × 25 + 84 × 17 + 34 × 20
𝑃𝑝 = × 100% = 104.59%
24 × 10 + 51 × 23 + 84 × 17 + 34 × 19
11 × 24 + 25 × 51 + 17 × 84 + (20 × 34)
𝑃𝑞 = × 100% = 113.05
11 × 20 + 25 × 55 + 17 × 63 + (20 × 28)
A. Afful-Dadzie 33
Session Goals
 Simple and Compound Interest
 Time value of money and compound interest
 The relationship between present and future cash values
 Single Amount
 Stream of cash flows
 Uniform
 Arithmetic gradient
 Geometric gradient
 Cash flows in perpetuity
A. Afful-Dadzie 1
Introduction Financial Mathematics
A. CASHFLOW DIAGRAM
It is the inflow and outflow of money over a period of time.
Tools used to represent Cash flow
Cash flow diagram
A. Afful-Dadzie 2
Cash flow table
A cash flow table lists the period and the corresponding cash in a table. However,
unlike a cash flow diagram, it doesn’t show whether cash is received at the
beginning or at the end of the period.
Example:
Depict the following cash flows of a company on a cash flow diagram.
Year 1 2 3 4 5 6 7
Cash -100M -10M 10M 15M 40M 40M 50M
a. When money is paid out/received at the beginning of the year?

b. When money is paid out/received at the end of the year?
A. Afful-Dadzie 3
Solution
a.
A. Afful-Dadzie 4
A. INTEREST AND INTEREST RATES
Suppose the principal (P) is the current amount of money and I is the interest
earned over a time period n. If Pn is the amount of money attained at period n,then:
Interest (I) at period 𝑛 = 𝑃𝑛 − 𝑃0
The business world however, prefers the use of ‘interest rate’ which is the
percentage of the interest earned over the principal than ‘interest’.
Let 𝑖 be interest rate. Then:
𝐼
𝑖= × 100%
𝑃0
Thus, Interest (I) = 𝑃0 × 𝑖
Types of Interest
- Simple Interest (for very short-life projects and usually smaller interest rate)
- Compound Interest
A. Afful-Dadzie 5
Simple Interest Compound Interest

Beginning Ending Beginning
Year Interest Interest Ending amount
amount amount amount
0 P 0 P P 0 P
1 𝑃 P×𝑖 P + P𝑖 𝑃 P×𝑖 P + P𝑖 = 𝑃(1 + 𝑖)
𝑃 1+𝑖 +𝑃 1+𝑖
2 P + P𝑖 P×𝑖 P + 2P𝑖 𝑃(1 + 𝑖) 𝑃 1+𝑖 ∗𝑖
∗𝑖 =𝑃 1+𝑖 2
2 2 𝑃 1+𝑖 2+𝑃 1+𝑖 2
3 P + 2P𝑖 P + 3P𝑖 𝑃 1+𝑖 𝑃 1+𝑖 ∗𝑖
∗𝑖 =𝑃 1+𝑖 3
3 3
4 P + 3P𝑖 P + 4P𝑖 𝑃 1+𝑖 𝑃 1+𝑖 ∗𝑖 𝑃 1+𝑖 3+𝑃 1+𝑖 3
∗𝑖 =𝑃 1+𝑖 4
… … … … … … …
𝑛−1 𝑃 1 + 𝑖 𝑛−1
𝑃 1+𝑖
n P + (n − 1)P𝑖 P + nP𝑖 𝑃 1+𝑖 𝑛−1 + 𝑃 1 + 𝑖 𝑛−1 ∗ 𝑖
∗𝑖
=𝑃 1+𝑖 𝑛
A. Afful-Dadzie 6
For ‘Simple’: Total Interest =𝑛𝑃𝑖
𝑖= interest rate
𝑃= Beginning amount
𝑛= time period
Total amount (simple interest) after period 𝑛 = 𝑃 + 𝑛𝑃𝑖
For compound: Total Interest =𝑃(1 + 𝑖)𝑛 − 𝑃
𝑃=Present value
𝑖=interest rate
𝑛= future value
Total amount after period 𝑛 = 𝑃(1 + 𝑖)𝑛
Thus compound interest is the interest earned not only on the original principal, but also
on all interests earned previously. In other words, at the end of each year, the interest
earned is added to the original amount (principal) and the money is reinvested.
The formula, 𝐹 = 𝑃(1 + 𝑖)𝑛 is at the heart of many calculations in finance.
A. Afful-Dadzie 7
Time Value of Money
Time value of money expresses the purchasing power of money at a given period. For
example, suppose you can buy one ball of Ga kenkey this year for GH¢1.00. Do you think
the same ball of Ga kenkey would go for GH¢1.00 next year?
In another example, imagine a neighbor borrows your block making machine for her
construction business. Do you think it’s fair for her to return the machine to you next year
without any compensation because she is a friend?
Three major economic factors should be considered here which is all related to ‘time
value of money’.
1. Opportunity cost: You missed the chance of making money from the machine within
the year. In other words, you could have earned some interest had you sold your
machine and put the money in a savings account.
A. Afful-Dadzie 8
2. Depreciation: The machine would be older next year and probably less productive
compared to this year.
3. Inflation: The price of the machine might be higher next year than it is this year.
If one considers all three factors above, then it is not fair for the neighbor to return the
machine next year without any compensation.
This course will consider only factor 1 and will primarily consider cases involving an
individual/entity and the bank.
A. Afful-Dadzie 9
Relationship between the Present and Future value of a single amount of money
Let 𝑃 and 𝐹 be the present (current time period) and future (i.e. time period 𝑛)
value of a single amount assuming interest rate will remain at 𝑖 within the period
considered. Then, 𝑃 and 𝐹 are related by the formula: 𝐹 = 1 + 𝑖 𝑛
Note that this formula is for a single amount, and 𝑛 is the number of periods
from the future period to whatever present time in mind.
Usually, the present is time zero. However, there will be instances where for
purposes of calculation sake one could assume say, time period 3 as the present,
and later consider time period 3 as the future to be taken to time zero. This will
become clear later.
A. Afful-Dadzie 10
Example 1
Find the present value of the cash flow shown above when 𝑖 = 5%.
𝑛 𝐹
𝐹 = 𝑃(1 + 𝑖) ⇒ 𝑃 = 𝑛
(1+𝑖)
For the future amount Ghc 3000 at period 2, it has to move back two time periods to the
3000
present (period zero). Thus, 𝑛 = 2 and therefore 𝑃0 = 2
(1+0.05)
2000
However, for the future amount Ghc 2000 at period 1, 𝑛 = 1 and therefore 𝑃0 =
(1+0.05)1
2000 3000
The total present value of the cash flow above is: 𝑃0 = + = 4625.85
(1+0.05)1 (1+0.05)2
In other words, you are indifferent between receiving Ghc 4625.85 today and receiving
Ghc 2000 in year one and Ghc 3000 in year 3 if interest rate were to remain at 5% per year.
A. Afful-Dadzie 11
Example 2
Find the present value of the cash flow shown below if interest rate (𝑖) is 10% per year.
Year Cash
1 2000
2 5000
3 0
4 -2000
5 3000
Solution
2000 5000 0 2000 3000

𝑃𝑇 = + + − +
(1+0.1)1 (1+0.1)2 (1+0.1)3 (1+0.1)4 (1+0.1)5
𝑃𝑇 = 6447.15
A. Afful-Dadzie 12
Types of Cash Flows
1. Uniform Cash Flows
For uniform cash flows, the amount of cash inflow or outflow is the same each time
period. This is shown in the figure below.
It useful to find a shortcut to solving time value of money problems particularly when a
clear pattern exist in the cash flow. The reason being that when 𝑛 is large (say 𝑛 = 200),
it will be too tedious to compute 𝑃 one by one for each cash flow using the formula 𝑃 =
𝐹 1 + 𝑖 −𝑛 .
The following takes you through the development of a shortcut formula for uniform cash
flows.
A. Afful-Dadzie 13
Let 𝑃 be the present value of the uniform cash flows above. Then:
𝐴 𝐴 𝐴 𝐴 𝐴 𝐴
𝑃= 1
+ 2
+ 3
+⋯+ 𝑛−2
+ 𝑛−1
+
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖)𝑛
1 1 1 1 1 1
𝑃=𝐴 1 + 2 + 3 + ⋯+ 𝑛−2 + 𝑛−1 + 𝑛 ⇢ 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛 1
(1+𝑖) (1+𝑖) (1+𝑖) (1+𝑖) (1+𝑖) (1+𝑖)
In what follows, we seek a shortcut to find 𝑃 such that unlike equation (1) above which
requires 𝑛 computations, only 1 computation would be needed to find 𝑃.
To do this, first form Equation (2) by dividing Equation (1) by 1 + 𝑖
𝑃 1 1 1 1 1 1
=𝐴 2 + 3 + 4 +⋯+ 𝑛−1 + 𝑛 +
1+𝑖 (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖)𝑛+1
⇢ 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛 2
A. Afful-Dadzie 14
Next, subtract equation (2) from equation (1): 𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛 (1) − 𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛 2 .
By cancelling out like terms, we have:
𝑃 1 1
𝑃− =𝐴 1
−
1+𝑖 (1 + 𝑖) (1 + 𝑖)𝑛+1
Note that the emphasis is on finding 𝑃. Therefore, we rearrange to make 𝑃 the subject.
𝑃 1+𝑖 −𝑃 𝐴 1
= 1−
1+𝑖 1+𝑖 (1 + 𝑖)𝑛
1 𝐴 1
𝑃⋅𝑖 =𝐴 1− 𝑛
𝑃 = 1−
(1 + 𝑖) 𝑖 (1 + 𝑖)𝑛
𝑨 (𝟏 + 𝒊)𝒏 − 𝟏
𝑷= 𝒏
⇢ 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛 3
𝒊 (𝟏 + 𝒊)
A. Afful-Dadzie 15
Thus, the present value of a continuous uniform cash flow that begins at the end of
period 1 to end of period 𝑛 is as shown in equation (3).
In general, equation (3) can be used to find the present value of a continuous uniform
cash flow that begins at any period (not necessarily at period one). The present value 𝑃
occurs one period before the occurrence of the first uniform value. Also, 𝑛 in the
formula is equal to the number of uniform cash flows.
Note also that since 𝐹 = 𝑃 1 + 𝑖 𝑛 , we can find the future value of all uniform cash
flows by simply replacing 𝑃 with that from equation (3). Then:
𝐴 (1 + 𝑖)𝑛 − 1 𝑛
𝐹= 𝑛
1+𝑖
𝑖 (1 + 𝑖)
𝑨
𝑭 = (𝟏 + 𝒊)𝒏 − 𝟏 ⇢ 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛 4
𝒊
A. Afful-Dadzie 16
Example 1:
In this example, we test the power of the shortcut.
Find the net present value of the cash flow shown below with 𝑖 =5%.
Alternative 1: Brute-force approach

5000 5000 5000 5000 5000 5000
⇒ 𝑃𝑇 = + + + + + = 25378.46
(1+0.05)1 (1+0.05)2 (1+0.05)3 (1+0.05)4 (1+0.05)5 (1+0.05)6
Alternative 2: Using the shortcut.

5000 (1+0.05)6 −1
𝑃𝑇 = = 25378.46
0.05 (1+0.05)6
It is clear that when 𝑛 is large, the shortcut is more convenient.

A. Afful-Dadzie 17
Example 2
The government of Ghana is to receive an amount of GH¢10,000 for the next
100 years. If interest rate is assumed to remain at 10% per year throughout
the 100 years, find the net present value of all the cash flows.
⇒ 𝑛 = 100; 𝑖 = 2%; 𝐴 = 10,000

10,000 (1+0.02)100 −1
𝑃𝑇 = = 𝐺𝐻¢430,983.52
0.02 (1+0.02)100
A. Afful-Dadzie 18
Example 3
Find the net present value of the cash flow shown above when 𝑖 =5%.
Solution: First, we can find the present value of the uniform cash flows in period 2.
5000 (1 + 0.05)3 − 1
⇒ 𝑃2 = 3
= 13616.20
0.05 (1 + 0.05)
𝑃2 then becomes the future value at period 2 whose present is sought at period 0. Thus
13616.20
𝑃0 = 2
= 12,350.33
(1 + 0.05)
A. Afful-Dadzie 19
Example 4
You borrowed GH¢10,000 from EcoBank at an interest rate of 10% to be
repaid in 5 years. What is the equal amount to be saved each year in order to
repay the loan in full at the end of 5 years?
𝐴 (1+𝑖)𝑛 −1
⇒ 𝑃 = 𝐺𝐻¢10,000; 𝑖 = 10%; 𝑛=5 𝑃=
𝑖 (1+𝑖)𝑛
𝑃⋅𝑖(1+𝑖)𝑛 10000⋅0.1(1+0.1)5
𝐴= =
(1+𝑖)𝑛 −1 (1+0.1)5 −1
𝐴 = 2637.97
A. Afful-Dadzie 20
Example 5
Find the net present value of the cash flow below. Assume 𝑖 = 5%.
Find the net present value of the cash flow shown above. Assume 𝑖 = 5%.
2000 (1+0.05)3 −1
⇒ 𝑃0 𝑓𝑟𝑜𝑚 3 = = 5446.5
0.05 (1+0.05)3
4000 (1+0.05)4 −1
𝑃4 𝑓𝑟𝑜𝑚 8 = = 14183.8
0.05 (1+0.05)4
𝑃4 𝑓𝑟𝑜𝑚 8 + 𝐴4 = 21183.8
21183.8
𝑃0 𝑓𝑟𝑜𝑚 4 = = 17247.96
(1+0.05)4
𝑁𝑃𝑉 = 𝑃0 𝑓𝑟𝑜𝑚 3 + 𝑃0 𝑓𝑟𝑜𝑚 4
𝑁𝑃𝑉 = 5446.5 + 17247.96 = 22694.46
A. Afful-Dadzie 21
1. Arithmetic Gradient Cash Flow

This is a type of periodic payment where payment at period 𝑡 is always increased by
a constant amount 𝑘 over the payment at period 𝑡 − 1.
The diagram below depicts the arithmetic gradient cash flow. It is obvious the cash
flow can be divided into 2 parts: a uniform part with an amount A, and a gradient
part that start two periods from period 0 increasing by 𝑘 each period after.
A. Afful-Dadzie 22
Let 𝑃𝐴 and 𝑃𝐾 respectively be the present value of the uniform and gradient part. Also, let
𝑃𝑇 be the total present value of the arithmetic cash flow. Then:
𝑃𝑇 = 𝑃𝐴 + 𝑃𝐾
We want a shortcut to compute 𝑃𝑇 .
𝑃𝐴 can be found using equation (3). Therefore, our focus is on 𝑃𝐾 .
𝑘 2𝑘 3𝑘 4𝑘 𝑛−2 𝑘 𝑛−1 𝑘
𝑃𝐾 = 2
+ 3
+ 4
+ 5
+ ⋯+ 𝑛−1
+
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖)𝑛
⇢ 𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛 1
Form equation 2 by doing: 𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛 1 × 1 + 𝑖
𝑘 2𝑘 3𝑘 4𝑘 𝑛−2 𝑘 𝑛−1 𝑘
𝑃𝐾 ⋅ 1 + 𝑖 = 1
+ 2
+ 3
+ 4
+ ⋯+ 𝑛−2
+
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖)𝑛−1
A. Afful-Dadzie 23
Do Equation 2 – Equation 1
𝑃𝐾 1 + 𝑖 − 𝑃𝐾
𝑘 𝑘 𝑘 𝑘 𝑘 𝑘 𝑛𝑘
= 1 + 2 + 3 + 4 +⋯+ 𝑛−1 + 𝑛 −
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖)𝑛
1 1 1 1 1 1 𝑛𝑘
𝑃𝑘 ⋅ 𝑖 = 𝑘 + + + +⋯+ + −
(1 + 𝑖)1 (1 + 𝑖)2 (1 + 𝑖)3 (1 + 𝑖)4 (1 + 𝑖)𝑛−1 (1 + 𝑖)𝑛 (1 + 𝑖)𝑛
The first part of the right-hand-side is similar to the equation that led to the shortcut of equation
(3) when 𝐴 is replaced with 𝑘.
Therefore, the equation above reduces to:
𝑘 (1 + 𝑖)𝑛 − 1 𝑛𝑘
𝑃𝑘 ∗ 𝑖 = −
𝑖 (1 + 𝑖)𝑛 (1 + 𝑖)𝑛
A. Afful-Dadzie 24
𝑘 𝑘 (1+𝑖)𝑛 −1
Factor out 𝑃 ∗ 𝑖= −𝑛
1+𝑖 𝑛 𝑘 (1+𝑖)𝑛 𝑖
𝑘 (1 + 𝑖)𝑛 − 1 − 𝑛 ∗ 𝑖
𝑃𝑘 ∗ 𝑖 =
(1 + 𝑖)𝑛 𝑖
𝑘 (1 + 𝑖)𝑛 − 𝑛 ⋅ 𝑖 − 1
𝑃𝑘 ∗ 𝑖 = 𝑛
[ ]
(1 + 𝑖) 𝑖
𝒌 𝒏 − 𝒏 ⋅ 𝒊 − 𝟏]
𝑷𝒌 = 𝟐 [(𝟏 + 𝒊)
𝒊 (𝟏 + 𝒊)𝒏
Note:
1. In general, 𝑃𝑇 = 𝑃𝐴 ± 𝑃𝐾 . Where the sign changes to (−) when the gradient
part is decreasing. Also, once we have the present value, the future value can be
obtained through 𝐹 = 𝑃 1 + 𝑛
2. 𝑃𝐾 occurs two period to the first gradient series.
A. Afful-Dadzie 25
Example 1
Find the present worth of a cash flow that begins with GH¢3000 in the first period and
increases by GH¢500 per period for 10 years with interest of 5%.
𝐴 = 3000; 𝑘 = 500; 𝑖 = 5%; 𝑛 = 10
𝐴 (1 + 𝑖)𝑛 − 1
𝑃𝐴 =
𝑖 (1 + 𝑖)𝑛
3000 (1+0.05)10 −1 𝑘
= = 23165.20𝑃𝑘 = (1 + 𝑖)𝑛 − 𝑛 ⋅ 𝑖 − 1
0.05 (1+0.05)10 𝑖 2 (1+𝑖)𝑛
500
= (1 + 0.05)10 − 10 0.05 − 1 = 15826.02
0.052 (1+0.05)10
𝑃𝑇 = 23165.20 + 15826.02 = 38991.
A. Afful-Dadzie 26
Example 2
The income from Precious Metal Mining Corporation has been decreasing uniformly for
four years.
If income in year 1 was GH¢300,000 and it decreased by GH¢30,000 per year to year 4,
what is the present worth of income stream at 5% per year?
⇒
𝑃𝑇 = 𝑃𝐴 − 𝑃𝑘
300,000 (1 + 0.05)4 − 1
𝑃𝐴 = 4
= 1063785.15
0.05 (1 + 0.05)
30000 4 − 4 0.05 − 1 = 153084.36
𝑃𝑘 = (1 + 0.05)
0.052 (1 + 0.05)4
𝑃𝑇 = 1063785.15 − 153084.36 = 910700.79
A. Afful-Dadzie 27
1. Geometric Gradient Cash Flow
This is similar to that of the arithmetic gradient cash flow except that payment at
period 𝑡 is always increased by 𝑔% of the payment at period 𝑡 − 1. That is:
𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡 = 1 + 𝑔% [𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑡 − 1)]

The total present value of such cash flows (uniform plus gradient part) is given as:
𝒏
𝟏+𝒈
𝟏− 𝟏+𝒊
𝑷𝑻 = 𝑨 ; 𝑤ℎ𝑒𝑛 𝑔 ≠ 𝑖
𝒊−𝒈
𝒏
𝑷𝑻 = 𝑨 ; 𝑤ℎ𝑒𝑛 𝑔 = 𝑖Where; 𝑔 = growth rate (rate of increase)
𝟏+𝒊
𝑖 = interest rate
A. Afful-Dadzie 28
Example
The academic fees of the University of Ghana (UG) is set to increase by 10% per year for
the next 4 years. You are a first year student and the fee is GH¢1,000 this year. Your
guardian would be travelling for a while and would like to deposit an amount today in a
fund that would be sufficient to pay the total of your tuition for the four years. How much
should your guardian deposit today if the fund pays interest rate of: a. 10% and b. 5%
Solution
a. 𝐴 = 1000; 𝑔 = 10%; 𝑖 = 10%; 𝑛=4
4
𝑃𝑇 = 1000 = 3960.40
1 + 0.1
b. 𝐴 = 1000; 𝑔 = 10%; 𝑖 = 5%; 𝑛=4

4
1 + 0.1
1−
𝑃𝑇 = 1000 1 + 0.05 = 4090.37
0.05 − 0.1
A. Afful-Dadzie 29
1. Uniform Cash Flow in Perpetuity
When 𝑛 is forever (e.g. and endowment fund), equation (3) which is

the present value of all future cash flows reduces to
𝑨
𝑷=
𝒊
A. Afful-Dadzie 30
Session Goals
 Amortization and sinking fund
 Amortization and sinking fund schedule
 Nominal and effective interest rates
 Effective interest rate and Nominal interest rate
 Continuous compounding
 Inflation adjusted interest rates
A. Afful-Dadzie 1
Amortization Annuity
Amortization annuity is one way of repaying money borrowed over a certain period of time.
- Each payment accounts for both repayment of capital and interest.
- Debt is said to be amortized if this payment method is adopted.
This is popular for repayment of loans by banks and mortgages.
Since amortization annuity assumes equal payment each period, the present value of the equal
payment amount can be determined using the shortcut formula for finding present value of uniform
cash flows given as:
𝐴 (1+𝑖)𝑛 −1
𝑃= where; A = Annuity
𝑖 (1+𝑖)𝑛
P = Principal/ debt amount at the beginning; 𝑖 = interest rate
Rearranging, the equal payment amount is:
𝑃 × 𝑖(1 + 𝑖)𝑛
𝐴=
(1 + 𝑖)𝑛 − 1
A. Afful-Dadzie 2
Amortization Schedule
An amortization schedule is a period to period specification of the debt left to be paid.
For each period, it shows;
i. Amount of debt outstanding at the beginning of the period.
ii. Interest paid on outstanding debt
iii. Annual payment
iv. Amount of principal repaid (optional)
v. Outstanding debt (optional)
Note that:
Amount of principal repaid = annual payment – Interest paid on outstanding debt.
In other words, part of the annual payment has to be used into paying interest on debt
before using the rest to pay off part of the debt.
A. Afful-Dadzie 3
Example
1. Kojo has gone for a loan of GH¢100,000 to start a new business. The loan is to be
paid in equal installments over 10 years at an annual interest rate of 25%. What is
the amount Kojo must pay the bank each year in order to pay down the loan fully
at the end of 10 years?
Solution
P = GH¢100,000
n = 10 ; 𝑖 = 25%
𝑃 × 𝑖(1 + 𝑖)𝑛
𝐴=
(1 + 𝑖)𝑛 − 1
100000 × 0.25(1.25)10
𝐴=
1.2510 − 1
𝐴 = 28,007.26 ∴ Kojo must pay GH¢28,007.26 annually for 10 years to fully
repay the loan A. Afful-Dadzie 4
Amortization Schedule
Most investors are always interested in the periodic cash flows and how loans are paid
off or savings accrue over time. An amortization schedule is meant to do just that.
A debt of GH¢10,000 with interest of 5% per year is amortized by equal annual
payment over the next 6 years.
a. Find the value of each payment.
b. Construct an amortization schedule for the loan.
Solution
P = GH¢10,000
n=6 ; 𝑖 = 5%
𝑃 × 𝑖(1 + 𝑖)𝑛 10000 × 0.05(1.05)6
𝐴= 𝑛
= 6
= 𝐺𝐻¢1970.17
(1 + 𝑖) − 1 1.05 − 1
A. Afful-Dadzie 5
b. Amortization Schedule
Period Beginning Interest paid at Annual Principal repaid Outstanding debt
Amount the end of period payment
A B C D E
0 E 𝑖% of A Annual C-B A-D
5 1970.17 – 500 =
1 10,000 × 10,000 1970.17 10,000 – 1470.17 =8529.83
100 1470.17
= 500
5 1970.17 – 426.5 = 8529.83 – 1543.68 =
2 8529.83 × 8529.83 1970.17
100 1543.68 6986.15
= 426.5
5 1970.17 – 349.3 = 6986.15 – 1620.86 =
3 6986.15 × 6986.15 1970.17
100 1620.86 5365.29
= 349.3
5 1970.17 – 268.26 = 5365.29 – 1701.91 =
4 5365.29 × 5365.29 1970.17
100 1701.91 3663.38
= 268.26
5 1970.17 – 183.17 =
5 3663.38 × 3663.38 1970.17 3663.38 – 1787.0 = 1876.38
100 1787.0
= 183.17
5 1970.17 – 93.82
6 1876.38 × 1876.38 1970.17 0.03≈0
100 =1876.35
= 93.82
A. Afful-Dadzie 6
Sinking Fund
When a series of uniform payments are made into a fund that pays interest at 𝑖%
per period, they accumulate to a total capital in the future.
- The accumulated future capital is called sinking fund.
- The capital payments made each period are annuities.
A sinking fund is an annuity invested in order to meet future commitment.
Sinking Funds are used for;
 Repayment of debts due in the future
 Providing/saving funds to purchase new assets in future when existing assets
are fully depreciated.
A. Afful-Dadzie 7
Sinking Fund Schedule

A sinking fund schedule shows for each year;
For debt
 Outstanding amount
 Interest paid
 Equal payment period
For fund
 Equal payment per period
 Interest earned
 Amount in full
A. Afful-Dadzie 8
Example
1. A company borrowed GH¢46,000 which is compounded at 15% per
year to finance a new production line. The debt will be discharged at
the end of 5 years with regular annual equal payment into a sinking
fund which pays 11.25% per year.
a. Calculate the annual payment into the fund.
b. Construct a sinking fund schedule assuming that the first payment into
the fund is made at the end of the first year.
A. Afful-Dadzie 9
Solution
a.
Future amount: Total cost of loan at the end of year 5.
𝐹 = 𝑃(1 + 𝑖)𝑛 ; where P = GH¢46,000 n = 5𝑖 = 15%
𝐹 = 46,000(1.15)5 = 𝐺𝐻¢92,522.43
Annuity for future amount: Annual savings to pay down the loan at the end
of year 5.
𝐴 𝐹⋅𝑖
𝐹= (1 + 𝑖)𝑛 −1 𝐴= ; where F = GH¢92,522.43 n=5
𝑖 (1+𝑖)𝑛 −1
𝑖 = 11.25%
92,522.43 ⋅ 0.1125
𝐴= 5
𝐴 = 𝐺𝐻¢14782.68
(1.1125) − 1
A. Afful-Dadzie 10
b. Sinking fund schedule
Period Total amount in fund Interest paid at the end Annual Total amount in fund at the end of
at the beginning of period Payment period
period
1 0 0 14782.68 14782.68
11.25 14782.68 +1663.05 + 14782.68
2 14782.68 × 14782.68 14782.68
100 =31228.41
= 1663.05
11.25 31228.41 + 3513.2 + 14782.68 =
3 31228.41 × 31228.41 14782.68
100 49524.29
= 3513.2
11.25 49524.29 + 5571.48 + 14782.68 =
4 49524.29 × 49524.29 14782.68
100 69878.45
= 5571.48
11.25 92552.46 ≈ 925552.43
5 69878.45 × 69878.45 14782.68
100
= 7861.33
A. Afful-Dadzie 11
Nominal and Effective Interest Rates
Interest rates quoted by banks and financial institutions are typically in nominal form
which may or may not be the true interest rate one would earn if interest is
compounded at time periods different from that of the quoted nominal rate.
For instance, a bank could quote a rate of 12% per year compounded monthly. This is
shown in the figure below where there are 12 periods for the number of compounding
in a month.
This means, although the rate is quoted per year, interest is actually calculated or
paid out every month. The true interest rate per year (termed the Effective Interest
Rate) in this case, should be slightly higher than that of the quoted rate.
A. Afful-Dadzie 12
Definitions
Nominal Interest Rate:
This is the rate usually quoted by banks and lenders. It is determined by multiplying the
compounding period’s rate by the number of periods per year. Thus, if interest rate is 1% per
month, the nominal rate would be 1*12 = 12% per year. This leads to the formula:
𝑟
Nominal Interest Rate for shorter period =
𝑚
Nominal Interest Rate for longer periods (𝑟)
Number of shorter periods within the longer period (𝑚)
In most cases, the longer period is a year, the shorter period is the compounding period,
thereby yielding:
𝑟 Nominal Interest Rate per year (𝑟)
Nominal Interest Rate for compounding period =
𝑚 Number of compounding periods within the year (𝑚)
A. Afful-Dadzie 13
Effective Interest Rate (annual equivalent rate - AER).
This is the total (and the true) interest rate paid on a loan. It is sometimes also taken for the term
Annual Percentage Rate (APR).
To obtain the effective interest rate, note that if one invest an amount 𝑃 today, if market is fair, there
should be no discrimination between receiving interest say, monthly and waiting till the end of the year.
That is, if one waits till a year, the amount 𝑃 should grow to 𝐹𝑦 = 𝑃(1 + 𝑖𝑒𝑓𝑓 )1 at the end of the year.
If however, one prefers to be paid interest at a period less than a year, the total amount of at the end of
𝑟 𝑚
the year (assuming she is paid interest 𝑚 times within the year) will be 𝐹𝑚 = 𝑃 1 +
𝑚
For there to be no discrimination, we must have:
𝐹𝑦 = 𝐹𝑚
𝑟 𝑚
𝑃(1 + 𝑖𝑒𝑓𝑓 ) = 𝑃 1 +
𝑚
𝑟 𝑚 𝑟 𝑚
1 + 𝑖𝑒𝑓𝑓 = 1 + ⇒ 𝑖𝑒𝑓𝑓 = 1 + −1
𝑚 𝑚
A. Afful-Dadzie 14
Thus, when interest is compounded at periods shorter than a year, the

effective interest rate earned over a year is given by the formula:
𝑟 𝑚
∴ Effective interest rate (𝑖𝑒𝑓𝑓 ) = 1 + −1
𝑚
Where 𝑟 is the nominal rate per year (usually quoted by banks) and 𝑚
is the number of times interest is quoted within a year.
A. Afful-Dadzie 15
Example
Suppose a rate of 12% is given for a period of one year, calculate the effective interest rate
if interest is compounded monthly.
⇒ 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 12%
12%
⇒ 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ = = 1%
12
Number of compounding period within a year 𝑚 = 12
Then: 𝑖𝑒𝑓𝑓 = 1 + 0.01 12 − 1
𝑖𝑒𝑓𝑓 = 1.1268 − 1 = 0.1268 = 12.68%
Notice that 12.68% > 12%. Thus what actually one earns in interest is higher than what is
quoted by the financial institution. This also means, if one borrows money from the bank,
the true interest to be paid to the bank could be higher than the annual quoted interest rate if
the bank requires that interest is compounded in a period less than a year.
A. Afful-Dadzie 16
Example
1. A visa credit card issued through Chase Bank carries an interest rate of 1% per month
compounded monthly on the unpaid balance.
a. Calculate the effective interest rate per semi-annual period.
b. If the card’s interest rate is stated at 3.5%per quarter, find the effective semi-annual and
annual interest rates.
Solution
a. Compounding done monthly
𝑟
= 1% 𝑚 = 6
𝑚
𝑟 𝑚
𝑖𝑒𝑓𝑓 = 1 + −1
𝑚
𝑖𝑒𝑓𝑓 𝑓𝑜𝑟 6 𝑚𝑜𝑛𝑡ℎ𝑠 = 1 + 0.01 6 − 1 = 6.152%
Note: If nominal interest rate is compounded yearly, then both nominal and effective are the same.
If the compounding period is shorter than one year then ieff will always be greater than the nominal rate per year.
A. Afful-Dadzie 17
b. For semi-annual (i.e. 6 month)

𝑟
= 3.5% 𝑚 = 2 (𝑛𝑜 𝑜𝑓 𝑞𝑢𝑎𝑡𝑒𝑟𝑠 𝑖𝑛 6 𝑚𝑜𝑛𝑡ℎ𝑠)
𝑚
𝑖𝑒𝑓𝑓 𝑓𝑜𝑟 6 𝑚𝑜𝑛𝑡ℎ𝑠 = (1 + 0.035)2 − 1 = 7.1%
For yearly,
𝑚 = 4 𝑛𝑜 𝑜𝑓 𝑞𝑢𝑎𝑡𝑒𝑟𝑠
𝑖𝑒𝑓𝑓 𝑓𝑜𝑟 1 𝑦𝑒𝑎𝑟 = (1 + 0.035)4 − 1 = 14.57%
A. Afful-Dadzie 18
Example
One of your clients has asked for your advice concerning GH¢100M which he
wishes to invest for 5 years. The two alternative investments are to use a Bank
account where the 36% per year rate is compounded monthly or a savings fund
where the 40% per year rate is compounded annually.
i. Calculate the size of each fund at the end of 5 years.
ii. Calculate the effective annual interest rate of the Bank Account investment.
iii. Advice your client on the basis of your calculations.
A. Afful-Dadzie 19
Solution
𝑟 = 36%
𝑟 36%
= = 3%
𝑚 12
𝑖𝑒𝑓𝑓 = (1 + 0.03)12 − 1 = 42.58%
i. 𝐹 = 𝑃(1 + 𝑖)𝑚
Bank;
𝐹 = 100𝑀(1 + 0.03)60 = 𝐺𝐻¢589,160,310.4 ( if using monthly interest rate)
𝐹 = 100𝑀(1 + 0.4258)5 = 𝐺𝐻¢589,241,127.5 (if using yearly interest rate)
Saving;
𝐹 = 100𝑀(1 + 0.4)5 = 𝐺𝐻¢537,824,000
ii. 𝑖𝑒𝑓𝑓 = (1 + 0.03)12 − 1 = 42.58%
iii. Based on the calculations above, the Bank account investment yields more benefits than the
Savings fund investment hence this friend should invest hid GH¢100M into the Bank Account.
A. Afful-Dadzie 20
Nominal and Effective Interest Rate
Continuous Compounding
When interest is compounded continuously, then the future value of a
current amount P over 𝑡 periods is: 𝑃𝑒 𝑟𝑡 . Thus, to ensure fairness,
𝑡
𝑃𝑒 𝑟𝑡 = 𝑃 1 + 𝑖𝑒𝑓𝑓
Therefore,
𝑒 𝑟 = 1 + 𝑖𝑒𝑓𝑓
𝑖𝑒𝑓𝑓 = 1 − 𝑒 𝑟 .
A. Afful-Dadzie 21
Example
a. For an interest rate of 18% per year compounded continuously, calculate
the effective monthly and annual interest rates.
b. An investor requires an effective return of at least 15%. What is the
minimum annual nominal rate that is acceptable for continuous compounding?
a. The nominal monthly rate is 𝑟 = 18%/12 or 0.015 per month.

Then the effective monthly rate is:
𝑖𝑒𝑓𝑓 = 𝑒 𝑟 − 1 = 𝑒 0.015 − 1 = 1.511%
Similarly, the effective annual rate using per year is
𝑖𝑒𝑓𝑓 = 𝑒 𝑟 − 1 = 𝑒 0.18 − 1 = 19.72%
A. Afful-Dadzie 22
b.
𝑒 𝑟 − 1 = 0.15
𝑒 𝑟 = 1.15
ln 𝑒 𝑟 = 𝑙𝑛1.15
𝑟 = 13.976%
Note: Can find effective rate using the spreadsheet formula: EFFECT(nominal_rate, compounding frequency)
A. Afful-Dadzie 23
Inflation adjusted interest rate
Example
Suppose Ghs 2500 is invested at a nominal rate of interest of 5% per
annum. Calculate the amount accumulated at the end of 10 years if interest
is calculated (a) annually, (b) 4 times annually, (c) 52 times per year, (d)
continuously.
A. Afful-Dadzie 24
For a real interest rate of 𝒊% per year and an inflation rate of 𝒇% per
year, the inflation-adjusted interest rate 𝒊𝒇 is given as:
𝒊𝒇 = 𝒊 + 𝒇 + 𝒊𝒇
A. Afful-Dadzie 25
Joey is one of several winners who shared a lottery ticket. There are three plans
offered to receive the after-tax proceeds.
Plan 1: $100,000 now.
Plan 2: $15,000 per year for 8 years beginning 1 year from now.
Plan 3: $45,000 now, another $45,000 four years from now, and a final
$45,000 eight years from now.
Joey, a quite conservative person financially, plans to invest all of the proceeds
as he receives them. He expects to make a real return of 6% per year. Use the
8-year time frame and an average inflation of 4% per year to determine
which plan provides the best deal.
A. Afful-Dadzie 26
Session Goals
 Payback period
 Net Present Value
 Equal lifespan
 Unequal lifespan
 IRR
A. Afful-Dadzie 1
Capital Investment Appraisal
Often times, since money is limited and there may be a number of competing
investment/project alternatives, one is compelled to select the projects whose capital outlay
is within budget and also offer the best return. This lecture presents techniques for analyzing
and selecting business projects/investments.
Capital Investment is a project which (for this course) consists of;

1. An initial outlay of capital (C0)
2. A set of estimated cash inflows and outflows over the life of the project
3. Optionally, a resettlement figure, which might be caused by resale of a plant or a cash
settlement to clear any liabilities incurred.
Often times, since money is limited and there may be a number of competing
investment/project alternatives, one is compelled to select the projects whose capital outlay
is within budget and also offer the best return. This lecture presents techniques for analyzing
and selecting business projects/investments.
2
A. Afful-Dadzie
Techniques of Investment Appraisal
1. Payback Period
 Non discounted, 𝑖 = 0% (No time value of money)
 Discounted, 𝑖 > 0% (Time value of money)
 Annuity ( Equal Periodic Payments)
2. NPV (Net Present Value)
 Equal Lifespan
 Non-equal Lifespan
 Annuity Worth
 LCM
3. IRR (Internal Rate of Return)
A. Afful-Dadzie 3
Payback Period
Given 𝐶𝑘 as the cash flow in period 𝑘,
𝑛
When interest rate is zero, Payback period (𝑛) = 𝐶0 − 𝑘=1 𝐶𝑘 ≤ 0
𝑛 𝐶𝑘
When 𝑖 > 0%, Payback period (𝑛) = 𝐶0 − 𝑘=1 1+𝑖 𝑘 ≤0
The Payback Period for the case of 𝑖 = 0% can be easily calculated using the formula below:
𝐵
𝑇𝑝 = 𝐴 +
𝐶
where 𝑇𝑝 is the payback period, A is the last period with the negative cumulative cash flow.
B is the absolute value of the cumulative cash flow at the end of the period A.
C is the total cash flow during the period immediately after A.
Note: Unlike when 𝑖 = 0% (i.e. non discounting), when 𝑖 > 0%, cash flows should be discounted to their
present values before the formula above is applied.
A. Afful-Dadzie 4
Example
Find the Payback period for the investment with the following cash
flow assuming
a. 𝑖 = 0%; Year Cash flow

b. b. 𝑖 = 10% 0 -50000
Assuming 360 days in a year. 1 20000
2 20000
3 17000
4 14000
A. Afful-Dadzie 5
Solution
a. First find the cumulative cash flow for
each year
Year Cash Flow Cumulative
𝑖 = 0%
Cash flow
𝐵
𝑇𝑝 = 𝐴 + 0 -50000 -50000
𝐶
1 20000 -30000
10000 2 20000 -10000
𝑇𝑝 = 2 + × 360 𝑑𝑎𝑦𝑠
17000 3 17000 70000
𝑇𝑝 = 2 + 211.7 𝑑𝑎𝑦𝑠 4 14000 21000
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 𝑖𝑠 2 𝑦𝑒𝑎𝑟𝑠 𝑎𝑛𝑑 211.7 𝑑𝑎𝑦𝑠.

A. Afful-Dadzie 6
b. First find the cumulative Present Value of each period
𝑖 = 10% Year Cash flow Present Value Cumulative
𝐵 PV
𝑇𝑝 = 𝐴 +
𝐶 0 -50000 -50000 -50000
1 20000 20000 -31818.18
2516.9 = 18181.82
𝑇𝑝 = 3 + × 360 𝑑𝑎𝑦𝑠 1.1
9562.19
2 20000 20000 -15289.25
𝑇𝑝 = 3 + 94.7 𝑑𝑎𝑦𝑠 = 16528.93
1.12
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 𝑖𝑠 3 𝑦𝑒𝑎𝑟𝑠 𝑎𝑛𝑑 94.7 𝑑𝑎𝑦𝑠.
3 17000 17000 -2516.9
3
= 12772.35
1.1
4 14000 14000 7045.29
4
= 9562.19
1.1
A. Afful-Dadzie 7
Example
A company has to choose either Machine A or Machine B. The following are the
cash flows for both machines. Which of the two machines should be chosen based
on discounted payback period if interest is a. 0%, and b. 15%? Assume 360 days in a
year.
Year Machine A Machine B
0 -50,000 -45,000
1 25,500 12,500
2 24,500 15,500
3 17,000 21,000
4 14,000 38,000
A. Afful-Dadzie 8
a
Cum Cash Cum Cash
Year Machine A flow for A Machine B flow for A
0 -50,000 -50,000 -45,000 -45,000
1 25,500 -24,500 12,500 -32,500
2 24,500 0 15,500 -17,000
3 17,000 17,000 21,000 4,000
4 14,000 31,000 38,000 42,000
For 𝑖 = 0%, Payback period for Machine A is end of year 2.

Payback period for Machine B is 2+4/21000*360 days = 2 years and 291 days
Thus, pick Machine A since it has the shortest payback period
A. Afful-Dadzie 9
b.
Cum Cash Cum Cash
Year Machine A flow for A Machine B flow for A
0 -50,000 -50,000 -45,000 -45,000
1 25,500 -27,826 12,500 -34,130
2 24,500 -9,301 15,500 -22,410
3 17,000 1,877 21,000 -8,602
4 14,000 9,882 38,000 13,124
For 𝑖 = 15%, payback period for Machine A is: 2+9301/1700*360 days = 2 years and
197 days.
Payback period for Machine B is: 3 + 8602/3800 *360 days = 3 years and 81 days. So,
decision is to go for Machine A.
A. Afful-Dadzie 10
Payback Period for Equal Periodic Payment

𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶0
 When 𝑖 = 0%, 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = =
𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝐴
 When 𝑖 > 0%, 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 𝑖𝑠 𝑡ℎ𝑒 𝑒𝑎𝑟𝑙𝑖𝑒𝑠𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑎𝑡 𝑤ℎ𝑖𝑐ℎ
𝐴 1+𝑖 𝑛−1
𝐶𝑜 − 𝑛
≤0
𝑖 1+𝑖
where 𝐶0 is initial the capital outlay.
A. Afful-Dadzie 11
Example
A company is evaluating the following mutually exclusive projects at an interest rate
of a) 0% and b) 10% per annum
Project 1 Project 2
GHS GHS
Initial Cost 150000 80000
Annual Benefits 20000 15000
Project life (years) 20 13
i. What is the payback period for project 1 and project 2 at 0% interest rate?
ii. What is the discounted payback period for both projects at 10%?
iii.Which project should be selected based on i) and ii) above?
A. Afful-Dadzie 12
Solution
i. when 𝑖 = 0%
𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶0
𝑇𝑝 = =
𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝐴
150000
For Project 1: 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 = = 7.5 𝑦𝑒𝑎𝑟𝑠
20000
80000
For Project 2: 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = = 5.3 𝑦𝑒𝑎𝑟𝑠
15000
ii. when 𝑖 = 10%

𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 𝑖𝑠 𝑡ℎ𝑒 𝑒𝑎𝑟𝑙𝑖𝑒𝑠𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑎𝑡 𝑤ℎ𝑖𝑐ℎ
𝐴 1+𝑖 𝑛−1
𝐶𝑜 − ≤0
𝑖 1+𝑖 𝑛
For Project 1;
20000 1.1 14 −1
at 𝑛 = 14; 150000 − = 2666.25 𝑤ℎ𝑖𝑐ℎ 𝑖𝑠 𝑛𝑜𝑡 ≤ 0
0.1 1.114
20000 1.1 15 −1
at 𝑛 = 15; 150000 − = −2121.59 < 0
0.1 1.115
Therefore the payback period is year 15 13
A. Afful-Dadzie
For Project 2;
15000 1.1 7 −1
at 𝑛 = 7; 80000 − = 6973.71 𝑤ℎ𝑖𝑐ℎ 𝑖𝑠 𝑛𝑜𝑡 ≤ 0
0.1 1.17
1.1 8 −1
at 𝑛 = 8; 80000 − = −23.89 < 0
1.18
Therefore the payback period is year 8
iii. Based on the solutions above, Project 2 should be selected since in both
situations, it has the shorter payback period.
A. Afful-Dadzie 14
NB: The payback period has some disadvantages.

- It ignores cash flow after the payback period.
- The default approach of i=0% ignores time value of money.
An advantage of the payback period technique could be that;
- it helps reduce risk due to shorter time to recover initial outlay.
A. Afful-Dadzie 15
Net Present Value (NPV)
Net Present value (NPV) is a technique that finds the sum of the present values of all cash
flows for each competing alternatives. As long as the NPV ≥ 0, the investment is
worthwhile.
𝑛 𝐶𝑘
𝑁𝑃𝑉 = 𝑘=1 (1+𝑖)𝑘 − 𝐶0 When;
NPV ˃ 0, project or investment is profitable
NPV = 0, breakeven (return on investment or project is the same as return from the bank
or risk free investments)
NPV = 0 implies that your required return has been met exactly. So for example if you
wanted a return of 20% on your investment, you have achieved it if NPV=0
NPV ˂ 0 project or investment is not profitable. For a firm, it means the investment adds
no value to the firm.
A. Afful-Dadzie 16
Example 1
A company has to choose either Machine A or Machine B. The following
are the cash flows for both machines.

0 -50,000 -45,000
1 25,500 12,500
2 24,500 15,500
3 17,000 21,000
4 14,000 38,000
Assume Machine A has a scrap value of GH¢5,000 and Machine B, a scrap

value of GH¢4,000. Which of the two machines would be chosen based on NPV
if interest rate is 20% per annum?
A. Afful-Dadzie 17
Solution
𝑛
𝐶𝑘
𝑁𝑃𝑉 = 𝑘
− 𝐶0
(1 + 𝑖)
𝑘=1
25,500 24,500 17,000 14,000 + 5,000
𝑁𝑃𝑉𝐴 = + 2
+ 3
+ 4
− 50,000 = 𝐺𝐻¢7264.66
1.2 1. 2 1. 2 1. 2
12,500 15,500 21,000 (38,000 + 4,000)
𝑁𝑃𝑉𝐵 = + 2
+ 3
+ 4
− 45,000 = 𝐺𝐻¢8587.962
1.2 1. 2 1. 2 1. 2
Based on NPV, Machine B would be chosen.
A. Afful-Dadzie 18
NPV and unequal life projects/investments
Example
A company is evaluating the following mutually exclusive projects.
Project 1 Project 2
GH¢ GH¢
Initial Cost 200,000 100,000
Annual Benefits 26,000 21,000
Project Life (years) 16 10
Which project should be selected based on NPV at 6% per year?
A. Afful-Dadzie 19
Solution
𝐴 (1+𝑖)𝑛 −1
𝑁𝑃𝑉 = − 𝐶0 For Project 1;
𝑖 (1+𝑖)𝑛
26,000 (1.06)16 −1
𝑁𝑃𝑉1 = − 200,000 = 𝐺𝐻¢62,753.28
0.06 (1.0616
For Project 2;
21,000 (1.06)10 −1
𝑁𝑃𝑉2 = − 100,000 = 𝐺𝐻¢54,561.83
0.06 (1.0610
Based purely on NPV, Project 1 should be selected.
A. Afful-Dadzie 20
Note: When evaluating two or more projects or investments, choose the project or
investment with the highest NPV in terms of revenue and choose the project or
investment with the least NPV in terms of cost.
Example
Your company is evaluating two projects with the following information:
Project 1 requires an investment of GHS 500,000, an annual revenue of GHS 80,000
starting in year 2 and increasing by GHS 2,000 per year till the end of the project.
Project 2 requires an investment of GHS 300,000, an annual revenue of GHS 50,000
starting in year 3 and increasing by 8% per year till the end of the project.
Calculate the NPV for both projects if the lifespan for both project is 14 years and the
interest is 10% per year.
A. Afful-Dadzie 21
Solution
For Project 1
𝑁𝑃𝑉 = 𝑃𝐴 + 𝑃𝐾 − 𝐶0
where 𝑃𝐴 is the present value of the annual revenue (80,000)
𝑃𝐾 is the present value of the increase (2,000)
𝐴 1+𝑖 𝑛−1 80000 1.1 13 − 1

𝑃𝐴 = 𝑛
= 13
= 568268.50
𝑖 1+𝑖 0.1 1.1
𝐾 1+𝑖 𝑛 −𝑛𝑖−1 2000 1.1 13 − 13 0.1 −1

Also, 𝑃𝐾 = = = 66754.39
𝑖2 1+𝑖 𝑛 0.12 1.1 13
∴ 𝑃𝐴 + 𝑃𝐾 = 568268.50 + 66754.29 = 635022.89

A. Afful-Dadzie 22
But 𝑃𝐴 + 𝑃𝐾 is the present value at year 1 so find the present value at year 0
635022.89
Present value at year 0 = = 577293.54
1.1
Therefore 𝑁𝑃𝑉 = 577293.54 − 500000 = 77293.54
For Project 2
𝑁𝑃𝑉 = 𝑃𝑇 − 𝐶0
1+𝑔 𝑛 1.08 12
1− 1+𝑖 1−
𝑃𝑇 = 𝐴 = 50000 1.1 = 494083.49
𝑖−𝑔 0.1 − 0.08
But 𝑃𝑇 is the present value at year 2 so find the present value at year 0
494083.49
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑦𝑒𝑎𝑟 0 = 2
= 408333.46
1.1
𝑇ℎ𝑒𝑟𝑒𝑓𝑜𝑟𝑒 𝑁𝑃𝑉 = 408333.46 − 300000 = 108333.36.
A. Afful-Dadzie 23
Example
A company has to choose either Machine A or Machine B. The following
are the cash flows of both machine.

0 -50000 -45000
1 25500 12500
2 24500 15000
3 17000 21000
4 14000 38000
Which of the two machines would be chosen based on NPV if interest rate
is 10% per annum? A. Afful-Dadzie 24
Solution
𝑛
𝐶𝑡
𝑁𝑃𝑉 = 𝑡
− 𝐶0
1+𝑖
𝑡=1
For Machine A;
25500 24500 17000 14000

𝑁𝑃𝑉 = + 2
+ 3
+ 4
− 50000 = 15764.29
1.1 1.1 1.1 1.1
For Machine B;
12500 15500 21000 38000

𝑁𝑃𝑉 = + 2
+ 3
+ 4
− 45000 = 20905.68
1.1 1.1 1.1 1.1
A. Afful-Dadzie 25
Annual worth Approach
The Annual worth Approach of the Net Present Value is usually used when the lifespan
of the projects or investment are different. When this is the case, using the NPV
approach will introduce biasness in the selection process.
In calculating for the Annual worth of each project or investment, first find the NPV of
the project or investment and use it to find for the annual worth of the project or
investment.
𝐴 1+𝑖 𝑛 −1
That is, if 𝑃 =
𝑖 1+𝑖 𝑛
𝑃𝑖 1 + 𝑖 𝑛
⇒𝐴=
1+𝑖 𝑛−1
A. Afful-Dadzie 26
Example
A company is evaluating the following mutually exclusive projects.
Project 1 Project 2
GH¢ GH¢
Initial Cost 200,000 100,000
Annual Benefits 26,000 21,000
Project Life (years) 16 10
Which project should be selected based on NPV at 6% per year?
A. Afful-Dadzie 27
Solution
𝐴 (1+𝑖)𝑛 −1
𝑁𝑃𝑉 = − 𝐶0 For Project 1;
𝑖 (1+𝑖)𝑛
26,000 (1.06)16 −1
𝑁𝑃𝑉1 = − 200,000 = 𝐺𝐻¢62,753.28
0.06 (1.0616
For Project 2;
21,000 (1.06)10 −1
𝑁𝑃𝑉2 = − 100,000 = 𝐺𝐻¢54,561.83
0.06 (1.0610
Based purely on NPV, Project 1 should be selected.
A. Afful-Dadzie 28
Annual worth approach
𝐴 (1+𝑖)𝑛 −1 𝑃∗𝑖∗ 1+𝑖 𝑛
𝑃= ⇒ 𝐴=
𝑖 (1+𝑖)𝑛 (1+𝑖)𝑛 −1
For Project 1; P=62753.28, n=16

62753.28∗0.06
𝐴= (1.06)16 −1
= 𝐺𝐻¢6209.57
1.0616
For Project 2; P=54,561.83, n=10
54,561.83∗0.06
𝐴= (1.06)10 −1
= 𝐺𝐻¢7413.20
1.0610
Based on the annual worth approach, Project 2 should be selected.

A. Afful-Dadzie 29
The IRR is the true interest rate earned on an investment over the course of its
economic life.
𝑛 𝐶𝑘
IRR is that rate 𝑖∗ at which 𝑁𝑃𝑉 = 𝑘=1 (1+𝑖 ∗ )𝑘 − 𝐶0 = 0
𝑛 𝐶𝑘
That is, 𝑘=1 1+𝑖 ∗ 𝑘 = 𝐶0
That is, taking time value of money into account, the IRR is the maximum rate of
return that an investment is able to recover the initial capital outlay of 𝐶0 .
Most organizations have an established minimum returns that any investment must
meet. This is usually termed, the Minimum Acceptable Rate of Return (MARR).
For such organizations, it is only when the IRR>=MARR, would the potential
investment merit consideration.
A. Afful-Dadzie 30
Thus the following rules apply when using the IRR:

When IRR ˃ MARR, investment is profitable
When IRR = MARR, investment add no value to the investor and so investor is
indifferent.
When IRR<MARR, investment is not worthwhile
When comparing two or more projects, the first condition for any project to merit
consideration is for it to have IRR >=MARR. For those projects meeting this
criterion, select the project with the maximum IRR.
That is, suppose project 1 and project 2 have IRR1 > MARR and IRR2 > MARR
respectively, and are mutually exclusive. If IRR2 > IRR1 then select project 2.
A. Afful-Dadzie 31
Calculating Internal Rate of Return using Interpolation
1. Graphic Approach
The graphical approach requires that one first select an interest rate 𝑖1 and calculate
its corresponding net present value 𝑁𝑃𝑉1 for the point (𝑖1 , 𝑁𝑃𝑉1 ), and again 𝑖2 and
its associated 𝑁𝑃𝑉2 , for the point (𝑖2 , 𝑁𝑃𝑉2 ). The point at which the line passing
through these two points touches the x-axis is the IRR.
A. Afful-Dadzie 32
Algebraic Approach
The algebraic approach makes use of interpolation and can be understood through the graph
above when finding the slope.
For any line with two points (𝑥1 , 𝑦1 ) and (𝑥2 , 𝑦2 ), the slope 𝑚 is given as:
𝑦1 −𝑦2
𝑚=
𝑥1 −𝑥2
It can be observed that the slope of the line above that the slope of the line is:
𝑁1 −𝑁2 𝑁1 −0
𝑚= or 𝑚 = . Thus,
𝑖1 −𝑖2 𝑖1 −𝐼𝑅𝑅
𝑁1 −𝑁2 𝑁1 −0
=
𝑖1 −𝑖2 𝑖1 −𝐼𝑅𝑅
Rearranging, we get:
𝑁1 − 𝑁2 𝑖1 − 𝐼𝑅𝑅 = 𝑁1 (𝑖1 − 𝑖2 ) ⇒ 𝑁1 𝑖1 − 𝑁1 𝐼𝑅𝑅 − 𝑁2 𝑖1 + 𝑁2 𝐼𝑅𝑅 = 𝑁1 𝑖1 − 𝑁1 𝑖2
𝑁2 − 𝑁1 𝐼𝑅𝑅 = 𝑁2 𝑖1 − 𝑁1 𝑖2
𝑁2 𝑖1 − 𝑁1 𝑖2 𝑁1 𝑖2 − 𝑁2 𝑖1
𝐼𝑅𝑅 = =
𝑁2 − 𝑁1 𝑁1 − 𝑁2
Note: The accuracy of IRR is high when one of the 𝑁1 and 𝑁2 is positive and the other negative.
A. Afful-Dadzie 33
Example
A company has to choose either Project 1 or Project 2. The following are the cash
flows for both machines.
Year Project 1 Project 2
0 -50,000 -45,000
1 25,500 12,500
2 24,500 15,500
3 17,000 21,000
4 14,000 38,000
Find the Internal Rate of Return of both projects.
A. Afful-Dadzie 34
Solution
Project 1
25,500 24,500 17,000 14,000
+ + + − 50,000
(1+𝑖)1 (1+𝑖)2 (1+𝑖)3 (1+𝑖)4
when 𝑖 is 10%
25,500 24,500 17,000 14,000
+ + + − 50,000 = 15764.29
(1.1)1 (1.1)2 (1.1)3 (1.1)4
when 𝑖 is 20%
25,500 24,500 17,000 14,000
+ + + − 50,000 = 4853.4
(1.2)1 (1.2)2 (1.2)3 (1.2)4
𝑖1 = 10%, 𝑁1 = 𝐺𝐻¢15764.29
𝑖2 = 20%, 𝑁2 = 𝐺𝐻¢4853.4
15764.29 0.2 −4853.4(0.1)
𝐼𝑅𝑅1 = = 0.244 = 24.4%
15764.29−4853.4
A. Afful-Dadzie 35
Project 2
12,500 15,000 21,000 38,000
+ + + − 45,000
(1+𝑖)1 (1+𝑖)2 (1+𝑖)3 (1+𝑖)4
when 𝑖 is 10%
12,500 15,000 21,000 38,000
+ + + − 45,000 = 20,905.68
(1.1)1 (1.1)2 (1.1)3 (1.1)4
when 𝑖 is 20%
12,500 15,000 21,000 38,000
+ + + − 45,000 = 6658.95
(1.2)1 (1.2)2 (1.2)3 (1.2)4
𝑖1 = 10%, 𝑁1 = 𝐺𝐻¢20,905.68; 𝑖2 = 20%, 𝑁2 = 𝐺𝐻¢6658.95

20905.68 0.2 −6658.95(0.1)
𝐼𝑅𝑅2 = = 0.247 = 24.7%
20905.68−6658.95
A. Afful-Dadzie 36
Capitalized Cost Investments
When the investment is for a very long period of time.
𝐴 1+𝑖 𝑛 −1
If 𝑃 =
𝑖 1+𝑖 𝑛
𝐴
When n is infinite (say n > 100 years) ⇒ 𝑃 =
𝑖
Example
Construction of a hydroelectric dam will take 12 years and will cost GHS 8m in each of
those years. Net revenue from selling electricity is expected to be GHS 8m starting in year
13 and continuing at the same amount in perpetuity (forever).
Calculate
i. The maximum rate of return needed to recover the project's investment (i.e IRR)
ii. The NPV for 𝑖 = 3%.
A. Afful-Dadzie 37
Solution
i. For IRR, NPV = 0.

NPV is essentially revenue minus cost.
𝑁𝑃𝑉 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐶𝑜𝑠𝑡
Let 𝑃𝐴𝑐 be the sum of the present values of all cost incurred, and𝑃𝐴𝑅 , the sum of the present
value of all revenue to be accrued. Then:
𝐴 1+𝑖 𝑛−1
𝐶𝑜𝑠𝑡: 𝑃𝐴𝑐 = 𝑤ℎ𝑒𝑟𝑒 𝑖 = 𝐼𝑅𝑅
𝑖 1+𝑖 𝑛
8 1+𝑖 12 −1
𝑃𝐴𝑐 =
𝑖 1+𝑖 12 A. Afful-Dadzie 38
𝐴
Revenue: 𝑃𝐴𝑅 = 𝑤ℎ𝑒𝑟𝑒 𝑖 = 𝐼𝑅𝑅
𝑖
8
𝑃𝐴𝑅 𝑎𝑡 𝑦𝑒𝑎𝑟 12 = . This value in year 12 should be taken to the start of the project at zero.
𝑖
8 1
𝑃𝐴𝑅 𝑎𝑡 𝑦𝑒𝑎𝑟 0 = ×
𝑖 (1+𝑖)12
8 1 8 1+𝑖 12 −1
Therefore 𝑁𝑃𝑉 = × − =0
𝑖 (1+𝑖)12 𝑖 1+𝑖 12
8 1 8 1+𝑖 12 −1
⇒ × =
𝑖 (1+𝑖)12 𝑖 1+𝑖 12
1= 1+𝑖 12 −1 ⇒ 1+𝑖 12 =2
1 1
1 + 𝑖 = (2) 12 ⇒ 𝑖= 2 12 −1
𝑖 = 0.0594 = 5.94%
The rate of return for the investment is 5.94%
A. Afful-Dadzie 39
Session Goals
At the end of the session, you should be able to:
 Understand the rules of probability and how to assign or determine
probability for each possible outcome of an event.
 Understand the concepts of random variables and probability distribution
 Understand and calculate Expectation (ie. mean or average) of a random
variable
 Understand and calculate Standard deviation and Coefficient of Variation of
a random variable.
 Understand the role of Coefficient of variation in business
A. Afful-Dadzie 1
Making Decision Under Uncertainty
Introduction to Probability
Most times, one would have to make a decision before observing the outcome. For
example, invest in a business today and attain profit/loss tomorrow; plan electricity
generation capacity today in anticipation of next year’s demand which is uncertain;
toss a coin, the result is uncertain and could be “Head” or “Tail”. There is a some
level of uncertainty surrounding the outcome of each of the examples above. The
uncertainty makes the decision process challenging.
 How can one make better decisions in such an uncertain environment?
 This is done with the help of probabilities.
A probability gives a measure of uncertainty. That is, the probability of an event is a

measure of its likelihood or chance of occurrence.
A. Afful-Dadzie 2
Statistical Experiment
A Statistical Experiment can be described as any situation, specifically set up or
occurring naturally.
All Statistical Experiments have three things in common;
1. The experiment can have more than one possible outcomes
2. Each possible outcome can be specified in advance
3. The outcome of an experiment depends on chance, e.g. tossing a dice (possible
outcomes≡{1,2,3,4,5,6})
4. After the experiment is performed, only one of the possible outcomes will occur
irrespective of the prior probabilities or chances.
A. Afful-Dadzie 3
Outcomes of an Experiment
An outcome set of an experiment is the specification of all possible distinct results (i.e.
outcomes) of the experiment when it is performed.
E.g. Toss a coin;
- Outcome set = {Head, Tail}
After tossing however, only “Head” or “Tail” and not both will be realized.
Tossing a dice
- Outcome set = {1,2,3,4,5,6}
Playing the lottery
- Outcome set = {Win or Lose}
Playing soccer
- Outcome set = {Win or Draw or Lose}
A. Afful-Dadzie 4
Statistical Event
An event is any subset of a given outcome set of an experiment that is of
interest. Thus, after performing the experiment, the event may or may not occur.
Example: Suppose the experiment is tossing a dice.
Outcome set = {1,2,3,4,5,6}
What are the chances that 2 or 3 might show up?
Event set = {2, 3}
Mutually Exclusive Events
Two events of the same experiment are mutually exclusive if their respective
event sets do not overlap. In other words, when event 1 occurs, event 2 cannot
occur.
A. Afful-Dadzie 5
Independent Events
Two events, A and B, are independent if the outcome of one of the event in no
way affects the outcome of the occurrence (or not) of the other.
Measuring/Estimating Probabilities
Empirical (Relative Frequency) Probabilities: Given an event E, denote the
probability of E by P(E), then,
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑤𝑎𝑦𝑠/𝑡𝑖𝑚𝑒𝑠 𝑒𝑣𝑒𝑛𝑡 𝐸 𝑐𝑎𝑛 𝑜𝑐𝑐𝑢𝑟 𝑖𝑛 𝑡ℎ𝑒 𝑒𝑥𝑝𝑒𝑟𝑖𝑚𝑒𝑛𝑡
𝑃 𝐸 =
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑜𝑠𝑠𝑖𝑏𝑙𝑒 𝑜𝑢𝑡𝑐𝑜𝑚𝑒𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑒𝑥𝑝𝑒𝑟𝑖𝑚𝑒𝑛𝑡
A. Afful-Dadzie 6
Example
The economy of Ghana has always been Excellent, Good, O.K., or Bad. The following
table is a breakdown of the number of times the economy was either Excellent, or Good,
or O.K., or Bad in the last 50 years.
Economy Number of
times
Excellent 5
Good 25
O.K. 10
Bad 10
Total 50
What is the probability that next year the economy will be Excellent, Good, O.K. or Bad?
A. Afful-Dadzie 7
Solution
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑡𝑖𝑚𝑒𝑠 𝐸𝑥𝑐𝑒𝑙𝑙𝑒𝑛𝑡 𝑜𝑐𝑐𝑢𝑟𝑠 5
𝑃 𝐸𝑥𝑐𝑒𝑙𝑙𝑒𝑛𝑡 = = = 0.1
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑃𝑜𝑠𝑠𝑖𝑏𝑙𝑒 𝑜𝑐𝑐𝑢𝑟𝑒𝑛𝑐𝑒𝑠 50
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑡𝑖𝑚𝑒𝑠 𝐺𝑜𝑜𝑑 𝑜𝑐𝑐𝑢𝑟𝑠 25
𝑃 𝐺𝑜𝑜𝑑 = = = 0.5
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑜𝑠𝑠𝑖𝑏𝑙𝑒 𝑜𝑐𝑐𝑢𝑟𝑒𝑛𝑐𝑒𝑠 50
10 10
𝑃 𝑂. 𝐾. = = 0.2𝑃 𝐵𝑎𝑑 = = 0.2
50 50
Probability = 0 ⇒means the event will never occur

Probability = 1 ⇒ means the event will surely/always occur
Probability between 0 and 1 ⇒ measures the likelihood of chances that the event will
occur
*Probability can never be outside the range 0 to 1
A. Afful-Dadzie 8
Example
Below is a table of ages of students attending a summer camp. If a student is randomly
picked from a darkened room containing all the students, what are the chances that the
student picked is aged 25 – 29?
Age of student Frequency/Number Present

10 – 14 4
15 – 19 8
20 – 24 5
25 – 29 2
30 - 34 1
2
⟹ 𝑃 25 − 29 = = 0.1
20
A. Afful-Dadzie 9
Rules of Probabilities (Students should read this on their own)
 Addition Rule
 Multiplication Rule (In particular independent)
 Complement Rule
 Conditional Probability
 Bayes Rule
In all, given an outcome set x = {x1, x2, x3, …, xn} with respective probabilities
P = {P1, P2, P3, …, Pn}, the following must hold for the probabilities;
0 ≤ 𝑃𝑖 ≤ 1 ⩝𝑖
𝑛
𝑖=1 𝑃𝑖 =1
Given an event E with probability P(E), P(Ē) = 1 – P(E)
Note: The rules will be covered in depth in UGBS 301: Quantitative Methods.
A. Afful-Dadzie 10
Random Variable
A Random Variable, usually written Xi, is a variable whose possible values are a
numerical outcome of a random phenomenon.
Types of Random Variables

1. Discrete Random Variables
- May take on only a countable number of distinct values such as 1, 2, 3, 4.
- If a random variable can take only a finite number of distinct values, then, it
must be discrete.
2. Continuous Random Variables
- A variable which can take on infinite number of possible values.
- Continuous Random Variables are usually measurements like height, weight,
pressure, etc.
A. Afful-Dadzie 11
Probability Distribution
A Probability Distribution of a Random Variable describes the chances of the
occurrence of the possible outcomes of the random variable. That is, it lists for
each outcome, the probability of occurrence.
Example:
1. Tossing a dice
Outcome = {1, 2, 3, 4, 5, 6}
1 1 1 1 1 1
Probability ={ , , , , , } Probability Distribution
6 6 6 6 6 6
A. Afful-Dadzie 12
X1 X2 X3 X4 X5
Electricity Demand Next Year (MW)
1800 2200 2500 2800 3000
Probability (X) 0.2 0.1 0.35 0.3 0.05
Probability
0.4 X3
X4
0.3 X1
P(X)
0.2 X2
0.1 X5 Probability
0
1800 2200 2500 2800 3000
Demand
Both the table and the graph depicts the same information: The probability distribution of electricity
demand next year.
 Demand next year is uncertain among these five events.
 A demand of 2500 is highly probable and a demand of 3000 is least probable.
13
A. Afful-Dadzie
Expectation (Mean) of a Random Variable

Given a random variable 𝑋 = {𝑥1 , 𝑥2 , 𝑥3 , … , 𝑥𝑛 } with respective probabilities
𝑃 = {𝑃1 , 𝑃2 , 𝑃3 , … , 𝑃𝑛 }, the expectation/mean of the Random Variable 𝑋 is given as:
𝑛
𝐸 𝑋 = 𝑃𝑖 𝑋𝑖 = 𝑃1 𝑋1 + 𝑃2 𝑋2 + 𝑃3 𝑋3 + ⋯ + 𝑃𝑛 𝑋𝑛
𝑖=1
Example:
X1 X2 X3 X4 X5
Electricity Demand Next Year (MW) 1800 2200 2500 2800 3000
Probability (X) 0.2 0.1 0.35 0.3 0.05
Find the expectation for the Electricity Demand data

𝐸 𝑋 = 0.2 1800 + 0.1 2200 + 0.35 2500 + 0.3 2800 + 0.05 3000 = 2445
A. Afful-Dadzie 14
Variance of a Random Variable

Given a Random Variable 𝑋 = {𝑥1 , 𝑥2 , 𝑥3 , … , 𝑥𝑛 } with respective probabilities 𝑃 =
{𝑃1 , 𝑃2 , 𝑃3 , … , 𝑃𝑛 }, the variance of 𝑋 is given as
𝑛
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑋 = 𝑃𝑖 (𝑋 − 𝑋𝑖 )2 = 𝑃1 (𝑋 − 𝑋1 )2 + 𝑃2 (𝑋 − 𝑋2 )2 + 𝑃3 (𝑋 − 𝑋3 )2 + ⋯ + 𝑃𝑛 (𝑋 − 𝑋𝑛 )2
𝑖=1
where 𝑋 is the expectation of the Random Variable 𝑋

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 = 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒(𝑋)
NB: In practice, a smaller standard deviation implies lesser uncertainty.
A larger standard deviation implies greater uncertainty
A. Afful-Dadzie 15
Example:
Using the illustration above (Electricity Demand),
𝑉𝑎𝑟 𝑑𝑒𝑚𝑎𝑛𝑑
= 0.2(2445 − 1800)2 + 0.1(2445 − 1200)2 + 0.35(2445 − 2500)2
+ 0.3(2445 − 2800)2 + 0.05(2445 − 3000)2 = 292475
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑑𝑒𝑚𝑎𝑛𝑑 = 292475
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑑𝑒𝑚𝑎𝑛𝑑 = 540.8096
A. Afful-Dadzie 16
Coefficient of Variation (Measure of Risk)

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 (𝑋) 𝜎(𝑋)
𝐶𝑜𝑉 𝑋 = =
𝐸𝑥𝑝𝑒𝑐𝑡𝑎𝑡𝑖𝑜𝑛 (𝑋) 𝐸 (𝑋)
COV is very useful when comparing two random variables of seemingly

different scale. The COV in a sense is similar to the idea of normalization.
A. Afful-Dadzie 17
Example
The economy of Ghana could be Excellent, Good, O.K. or Bad next year with respective
probabilities 0.2, 0.5, 0.2 and 0.1. The table below gives the respective returns of an
investment next year. Economy Return
Excellent 25%
Good 15%
O.K. 10%
Bad -10%
The economy of the United States next year will also be excellent, good, O.K. or Bad with
respective probabilities and returns of 0.5, 0.3, 0.15 and 0.05; 10%, 3%, 1% and 0.5%.
1. Find the expected returns of GH¢100,000 investment in both Ghana’s economy and the
United States’ economy.
2. Quantify the risk associated with the investment.
3. Which country is more economically viable to invest taking risk into account?
18
A. Afful-Dadzie
1&2
For Ghana
𝑋𝐸𝑥𝑐𝑒𝑙𝑙𝑒𝑛𝑡 = 0.25 × 100,000 = 25,000
𝑋𝐺𝑜𝑜𝑑 = 0.15 × 100,000 = 15,000
𝑋𝑂.𝐾. = 0.10 × 100,000 = 10,000
𝑋𝐵𝑎𝑑 = −0.10 × 100,000 = −10,000
𝑛
𝐸 𝑋 = 𝑃𝑖 𝑋𝑖 = 𝑃1 𝑋1 + 𝑃2 𝑋2 + 𝑃3 𝑋3 + ⋯ + 𝑃𝑛 𝑋𝑛 𝐸 𝑋
𝑖=1
= 0.2 25000 + 0.5 15000 + 0.2 10000 + 0.1 −10000 = 13500
A. Afful-Dadzie 19
𝑉𝑎𝑟 𝑋
𝑛
= 𝑃𝑖 (𝑋 − 𝑋𝑖 )2 = 𝑃1 (𝑋 − 𝑋1 )2 + 𝑃2 (𝑋 − 𝑋2 )2 + 𝑃3 (𝑋 − 𝑋3 )2 + ⋯ + 𝑃𝑛 (𝑋 − 𝑋𝑛 )2
𝑖=1
𝑉𝑎𝑟 𝑋
= 0.2(13500 − 25000)2 + 0.5(13500 − 15000)2 + 0.2(13500 − 10000)2 + 0.1(13500
− −10000 )2 = 85250000
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 = 85250000 = 9233.09
9233.09
𝐶𝑜𝑉 = = 0.68
13500
A. Afful-Dadzie 20
For US
𝑋𝐸𝑥𝑐𝑒𝑙𝑙𝑒𝑛𝑡 = 0.1 × 100,000 = 10,000
𝑋𝐺𝑜𝑜𝑑 = 0.03 × 100,000 = 3,000
𝑋𝑂.𝐾. = 0.01 × 100,000 = 1,000
𝑋𝐵𝑎𝑑 = 0.005 × 100,000 = 500
𝑛
𝐸 𝑋 = 𝑃𝑖 𝑋𝑖 = 𝑃1 𝑋1 + 𝑃2 𝑋2 + 𝑃3 𝑋3 + ⋯ + 𝑃𝑛 𝑋𝑛 𝐸 𝑋
𝑖=1
= 0.5 10000 + 0.3 3000 + 0.15 1000 + 0.05 500 = 6075
𝑛
𝑉𝑎𝑟 𝑋 = 𝑃𝑖 (𝑋 − 𝑋𝑖 )2 = 𝑃1 (𝑋 − 𝑋1 )2 + 𝑃2 (𝑋 − 𝑋2 )2 + 𝑃3 (𝑋 − 𝑋3 )2 + ⋯ + 𝑃𝑛 (𝑋 − 𝑋𝑛 )2
𝑖=1
A. Afful-Dadzie 21
𝑉𝑎𝑟 𝑋
= 0.5(6075 − 10000)2 + 0.3(6075 − 3000)2 + 0.15(6075 − 1000)2 + 0.05(6075 − 500)2
= 15956875
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 = 15956875 = 3994.61

3994.61
𝐶𝑜𝑉 = = 0.66
6075
3. Thus U.S edges Ghana slightly.
A. Afful-Dadzie 22
Session Goals
At the end of the session, you should be able to:
 Understand and apply the decision tree technique
A. Afful-Dadzie 1
Decision Trees
Decision Trees Conventions
In a Decision Tree consist of:
1. Square nodes and circle nodes
- Where a square node represents a decision point/time
- A circle node represents uncertain events with possible outcomes
2. Branches
- Where a branch coming out of a square node is an alternative
- Where a branch coming out of a circle node is a possible outcome of an uncertain event
3. Each branch coming out of a circle node has an assigned probability

 The sum of probabilities of all branches out of a particular circle node must be 1
4. Monetary value (profit, revenue, etc.) earned after making a particular decision
(alternative) are placed at the end of the branch coming out of a node.
2
A. Afful-Dadzie
Decision Trees
5. Costs incurred for making a particular decision are typically placed on the
branch coming out of the node.
6. Decision at any point in time is based on the “Expected Monetary Values”
(EMV).
7. If a problem is based on profit, then select decision with the highest EMV.
8. Solution to the entire problem is based on a so-called “ Folding back
process”.
9. Time moves from left to right.
10. Branches out of a node are assumed yet to occur. Branches into a node are
assumed to have already occurred.
A. Afful-Dadzie 3
Decision Trees
Sequential Decision Trees
 If a decision situation requires a series of decisions, then a decision tree becomes
the best method for decision analysis.
 A sequential decision tree illustrates a situation requiring a series of decisions.
Decision: Branches with the greatest expected value are selected.

A. Afful-Dadzie 4
Decision Trees
Determining the best decision by using a decision tree involves computing
the expected value at each probability node or circle.
𝐸𝑉 𝑛𝑜𝑑𝑒 6 = 0.8 ∗ 3𝑀 + 0.2 ∗ 700𝑘 = $2.54𝑀

𝐸𝑉 𝑛𝑜𝑑𝑒 7 = 2,300𝑘 ∗ 0.3 + 1,000𝑘 ∗ 0.7 = $1,390𝑘
𝐸𝑉 𝑛𝑜𝑑𝑒 4 = max($2,540𝑘 − 800𝑘, $450𝑘)
𝐸𝑉 𝑛𝑜𝑑𝑒 5 = max($1,390𝑘 − 600𝑘, $210𝑘)
𝐸𝑉(𝑛𝑜𝑑𝑒 2) = .60($2,000,000) + .40($225,000) = $1,290,000
𝐸𝑉(𝑛𝑜𝑑𝑒 3) = .60($1,740,000) + .40($790,000) = $1,360,000
𝐸𝑉 𝑛𝑜𝑑𝑒 1 = max($1,290𝑘 − 800𝑘, $1,360𝑘 − 200𝑘)
A. Afful-Dadzie 5
Decision Trees
Asempa Asa Oil Company is trying to decide whether to market a fuel additive which, it
claims, will improve fuel consumption. Unfortunately, there are a number of competitors
in the market who are also working on a similar product and Asempa Asa Oil Company
knows that if it decides to market the product it will face stiff competition from the other
oil companies. Asempa Asa Oil Company has the option of starting the whole project
with a market research survey to see if motorists would purchase the product or
without a market research survey.
If the Company decides not to carry out a market research survey, it will market the
product or sell the rights to the product. If it goes ahead and markets the product, it
estimates that the probability that sales will be high is only 0.2. When the product is
marketed, sales would be either high or low.
A. Afful-Dadzie 6
Decision Trees
If Asempa Asa Oil Company carries out a market research survey, there is a 0.43 probability
that the survey will be favourable. The Company can decide either to market the product
or sell the rights to the product whatever the results of the survey. If the outcome of the
survey is favourable, there is a 0.35 probability that sales will be high if the product is
marketed. Additionally, if the outcome from the survey is unfavourable, there is a 0.09
probability that sales will be high if the product is marketed. A market research survey will
cost the Company GH¢0.70m.
At any stage, if the sales of the product are high, the Company will make a profit of
GH¢20m and if the sales are low, the Company will lose GH¢2m.
Also, at any stage, if the Company decides to sell the rights to the product, the Company will
make a profit of GH¢4m.
A. Afful-Dadzie 7
Decision Trees
a. Draw the decision tree for this problem.

b. As a financial analyst, hired by the Company, recommend a course of action to
the Oil Company with reasons.
c. The Consulting Firm that carried out the market research survey has indicated
that the probability of a favourable outcome from the survey was erroneously
given as 0.43. If the correct probability of a favourable outcome from the
survey is now given as 0.30, will this affect your recommendation in (b) above?
A. Afful-Dadzie 8
Decision Trees
A. Afful-Dadzie 9
Decision Trees
b)
Node D
Expected profit = 20m x 0.09 – 2m x 0.91 = 1.8m – 1.82m = - GHC 0.02M
Node C
Sell rights: expected profits = GHC 4m
Market product: expected profits = -GHC 0.02M
DECISION: sell rights for a higher expected profit of GHC 4m
Node F
Expected profit = 20m x 0.35 – 2m x 0.65 = 7m – 1.3m = GHC 7m
Node E
Sell rights: expected profits = GHC 4m
Market product: Expected profit = GHC 5.7m
Decision: Market product for a higher expected profit of GHC 5.7m
A. Afful-Dadzie 10
Decision Trees
Node B
Expected profit = 4m 0.57 + 5.7m x 0.43 = 2.28m + 2.451m = GHC 4.731m
Node H
Expected profit = 20m x 0.2 -2m x 0.8 = 4m -1.6m = GHC 2.4m
Node G
Sell rights: expected profit = GHC 4m
Market product: expected profit = GHC 2.4m
Decision: sell rights for a higher expected profit of GHC 4m
Node A
No market survey: expected profit = GHC 4m
Conduct market survey: expected profit = 4.731m – 0.7m = GHC 4.031m
Decision: conduct a market survey for a higher expected profit.
11
A. Afful-Dadzie
Decision Trees
Recommendation:
Conduct a market survey, if the survey proves unfavourable; sell the rights to the product.
On the other hand, if it proves favourable, market the product for a higher expected profit.
A. Afful-Dadzie 12
Decision Trees
C.
Node B
2.8m + 1.71m = GHC 4.51m
Node A
No market survey: expected profit = GHC 4m
Conduct market survey: expected profit = 4.51m – 0.7m = GHC 3.81m
Decision: don’t conduct a market survey for a higher expected profit of GHC 4m by
selling the rights. So yes, the recommendation is now changed.
A. Afful-Dadzie 13

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The symbol lim is read: “The limit of ….. as ∆𝑥 approaches 0.

The derivative of a function 𝑓 is the function denoted by 𝑓′ which is defined by:

Common Notations of a derivative of a function:

1. Sum-Difference Rule 2. Product Rule

Example: Find the derivative of the function

Example: Find the differential of the function F 𝑥 = (𝑥 3 + 3𝑥)(4𝑥 + 5)

The Quotient Rule

Example- Marginal Revenue Product

THE GENERALIZED POWER FUNCTION (CHAIN RULE)

Given the function 𝑦 = (𝑥 𝑛 + 1)𝑝 , the derivative with respect to 𝑥

Or simply let 𝑦 = −1 𝑙𝑛 𝑥 2 + 2 so that 𝑢 = 𝑥 2 + 2.

 Given a function such as 𝑦 = 𝑒 𝑥 , the general form of the derivative

Let 𝑄 = 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦, and 𝑃 = 𝑃𝑟𝑖𝑐𝑒

When 𝑄 is expressed as function of 𝑃, then the elasticity becomes a

If, however, 𝑓′(𝑥) < 0 for all 𝑥 in 𝑎, 𝑏 , then 𝑓 is decreasing on (𝑎, 𝑏)

Where 𝑓′′(𝑎) is the second derivative of 𝑦 at 𝑎.

Definition: If a function 𝑓 is continuous on a closed interval 𝑎, 𝑏 , then the function

Procedure to find absolute extrema for a function 𝑓 that is

1. Find the critical (relative extrema) values of 𝑓.

Examples 1, 2 and 3 implies that 𝑓 𝑥 = 2𝑥 could have many anti-derivatives.

Example: Find the integral (𝑥 2 + 2𝑥)𝑑𝑥

Integration with Initial Conditions

𝑟 𝑞 = 2000 − 20𝑞 − 3𝑞2 𝑑𝑞 = 2000𝑞 − 10𝑞2 − 𝑞 3 + 𝑐

Power Rule for Integration

Other Examples of Integration

Given a function 𝑦 = 𝑓(𝑥) (e.g. say, 𝑦 is a cost function and 𝑥 is quantity),

Given a curve as shown below, we could divide the area

SIMPSON’S RULE (Using the parabola)

For any 𝑑𝑞 quantity below 𝑞0 , there is a consumer surplus of 𝑝1 − 𝑝0 𝑑𝑞

100 − 0.05𝑞 − 70 𝑑𝑞 = 30𝑞 − 0.025𝑞2 + 𝑐

60 − 0.1𝑞 𝑑𝑞 = 60𝑞 − 0.05𝑞2 = 𝑐

 A business mathematical model is a mathematical representation of a worded

At the break-even point, total revenue equals total cost. Thus:

Now, to attain a profit of Ghc 150,000, Total Revenue – Total = 150,000.

Familiar Words and their equivalent symbols

The last part of the mathematical formulation is very important since if we

The final formulation would then be:

 An index is a number that compares the value of a variable at any

 In business, an index measures percentage (%) change in the value of

Index Number Notation for Price and Quantity

Year 2010 2011 2012 2013 2014

For Video Recorder;

For 30 inch television;

Fixed and Chain-based Relative Indices

Indices are usually expressed relative to a ‘fixed’ reference time point.

When this is the case, the relative index is described as chain-based.

Month Jan Feb(base) March April May June

Comparing Values at Different Times

𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑚

At period 2, there is a 20 point increase (↑) over the index at period 1.

Changing Base Period

Reasons for Changing Base Period

NB: Using 2013 as the base year. A. Afful-Dadzie 19

Disadvantages of the Mean/Simple Aggregate Index

where, Wi = weight factor for commodity i

b. Weighted Aggregate Index

Item Year 1 Year 2

a. Calculate the Weighted Mean Price Index

Finding Laspeyres Price Index: