Linear Programming (LP)

It is mathematical technique designed for the allocation of scarce (Limited) resources among
competing activities in the best possible (i.e. optimal) way.

It is programming because we move from one feasible solution to another feasible solution until
the best possible solution is obtained.

Assumptions

(1) Linearity
The decision variables in a given situation generate straight lines when graphed.
(2) Divisibility
Decision variables can take on fractional values. e.g. 9.8 employees is accepted as a
solution.
(3) Certainty
All parameters in a given situation are known with certainty and also remain constant
during the period under consideration. (Price/unit, cost/unit)
(4) Non- negativity
No decision variable should take on a negative value.
Formulation of Linear Programming Problem
This is in three parts, namely
(1) Objective Function
It is a mathematical statement of what management wishes to achieve. In industry and
commerce the objective may be maximization of contribution, profit or revenue or
minimization of cost.
(2) Constraints
These are limitations on available resources stated mathematically in the form of
inequalities. The limitation can be in terms of budgets, labour, raw materials, markets,
social acceptability, legal requirements or contracts.
(3) Non-Negativity Constraints
They limit the solution to positive (and meaningful) answers only. That is, no decision
variable should take on a negativity value.

Methods of Analysis

Linear programming problems are analysed using graph or algebra. Algebra is used when the
problem involves two or more decision variables. Graphical method is used when the problem
involve only two decision variables.

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Graphical Solution

Graph the constraints and identify a region common to all constraints. This region is termed the
Feasibility Region and contains all feasible solutions to the problem.

Obtaining an Optimal (Best) Solution

Theoretically, we draw a family of lines of equal contribution (i.e. Iso-Contribution lines) or

lines of equal profit (iso-profit lines) or lines of equal cost (i.e. iso- Cost lines). The point beyond
which such a line leaves the feasible region completing provides the optimum solution to the
problem.

In practice, we identify the coordinates of the vertices (corners) of the feasible region and
substitute these in turn, in the objective function.

For maximization problem, the vertex, that provide the highest objective function value gives the
optimum solution.

For minimization problem, the vertex that provides the smallest objective function value gives
the optimum solution.

SOLUTION OF LINEAR PROGRAMMING PROBLEM

Any solution always involves the following four stages:

(1) Identifying the relevant variables in the problem.

(2) Expressing the objective function.
(3) Stating the constraints (limitation) and non-negativity constraints.
(4) Solving the problem.
Example 1

A calculator company produces a scientific calculator and a graphing calculator. Long-term

projections indicate an expected demand of at least 100 scientific and 80 graphing calculators
each day. Because of limitations on production capacity, no more than 200 scientific and 170
graphing calculators can be made daily. To satisfy a shipping contract, a total of at least 200
calculators must be shipped each day.

If each scientific calculator sold results in a GHȼ2 loss, but each graphing calculator produces a
GHȼ5 profit, how many of each type should be made daily to maximize net profits?

The question asks for the optimal number of calculators, so my variables will stand for that:

x: number of scientific calculators produced

y: number of graphing calculators produced

The revenue relation will be my optimization equation: R = –2x + 5y. So the entire system is:

2
 R = –2x + 5y, subject to:
100 < x < 200
80 < y < 170
y > –x + 200

The feasibility region graphs as:

When you test the corner points at (100, 170), (200, 170), (200, 80), (120, 80), and (100, 100),
you should obtain the maximum value of R = GHȼ 650 at (x, y) = (100, 170). That is, the
solution is "100 scientific calculators and 170 graphing calculators".

Example 2
A firm uses three types of factor input, namely labour, capital and raw material in producing two
products, X and Y. Each unit of X contributes 2 Ghana cedis to profit whereas each unit of Y
contributes 3 Ghana cedis to profit. To produce one unit of X requires one unit of labour, one unit
of capital and two units of raw material. To produce one unit of Y requires one unit of labour,
two units of capital, and one unit of raw material. The firm has 50 units of labour, 80 units of
capital, and 80 units raw material available.
Required:
(a) Formulate the linear programming model
(b) Find the feasible output combination of products X and Y which will maximize profit
for the producer.
(c) What is the value of total profit at this combination?

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Solution

Resource Labour Capital Raw material Contribution

per unit
X 1 1 2 2
Y 1 2 1 3
Amount Available 50 80 80

Maximize: Z = 2x + 3y

Subject to:

X + y ≤ 50 Labour

X + 2y ≤ 80 Capital

2x + y ≤ 80 Raw material

X ≥ 0, y≥ 0 Non-negativity

In order to get the coordinates, we change the inequality to equality sign.

X + y = 50 x + 2y = 80 2x + y = 80

If x =0 If x =0 If x =0

Y =50 2y =80, y =40 y =80

If y =0 If y =0 If y =0

X =50 x = 80 x = 40

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Point Coordinates (x,y) Contribution , z= 2x +3y
O (0,0) 0
A (0,40) 120
B (20,30) 130
C (30,20) 120
D (40,0) 80

B: 2(20) + 3(30) = 40+ 90 =130

C: 2(30) + 3(20) = 60+60 = 120

D: 2(40) + 3(0) = 80 + 0 = 80

The output that will maximize profits for the producer:

X =20 units

Y = 30 units

The maximum profit at the optimum output combination is 130 Ghana cedis.

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Question 3

A manufacturer produces tables (X) and desks (Y). Each table requires 2.5 hours for assembling
(A), 3 hours for buffing (B), and 1 hour for crating (C). Each desk requires 1 hour for
assembling, 3 hours for buffing, and 2 hours for crating. The firm can use no more than 20 hours
for assembling, 30 hours for buffing, and 16 hours for crating each week. Its profit margin is 30
Ghana cedis per table and 40 Ghana cedis per desk.

Required:

(a) Formulate the firm’s linear programming problem.

(b) Find the output mix that will maximize the firm‘s weekly profits.
(c) Find the maximum profit.

Let x = Number of X units produced

Let y= Number of Y units produced

Resource Assembling Buffing Crating Profit per unit

x 2.5 3 1 30
y 1 3 2 40
Amount 20 20 16
Available

Maximize: z = 30x + 40y

Subject to:
2.5x +y ≤ 20 Assembling
3x +3y ≤ 20 Buffing
x+ 2y ≤ 16 Crating
x ≥ 0, y≥ 0 Non-negativity

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Example 4
A company manufactures a liquid detergent. The detergent is manufactured from two basic
ingredients which are both a mixture of appropriate chemicals: Mix A and Mix B. the detergent
which is packaged in five liter bottles are sold to two separate markets: household market aimed
at individual consumers and the industrial/commercial market aimed at large organization such
as hospitals, hotels, local authorities.
For the house hold detergents, each five liter bottle requires four liters of Mix A and one liter of
Mix B, whereas the corresponding composition of industrial / commercial detergent is two liter
of Mix A and 3 liters of Mix B.
On the weekly basis, the company has supplies of not more than 20,000 liters of Mix A available
and 15,000 of mix B. In addition, the plastic containers in which the detergents are sold are
limited in supply. The company buys these containers from a specialist supplier, who can supply
no more than 4,000 containers a week for the household detergent and 4,500 a week for
industrial/commercial detergent.
The company’s accountant has been able to estimate the profit contribution of each detergent;
household detergent contributes GHȼ3 per five liters bottle produced and industrial/commercial
contributes GHȼ2.50.
The proprietor’s problem is to determine, on weekly basis, the combination of two detergents
that should be produced for maximum profit.

(a) Formulate this problem in terms of determining the profit- maximizing combination of
the two detergents, on a weekly basis.
(b) Solve the problem graphically
(c) Which constraints are binding?
(d) Determine the slack materials
(e) Interpret your answers obtained in (d) above

Let x = Number of household detergent produced

Le y = Number of industrial /commercial detergent produce
It is the maximum problem

Type Mix A Mix B Contributing

per unit
X 4 1 3
Y 2 3 2.50
Available 20,000 15000
resource
These constraints are not part of mix A and mix B
X ≤4000
Y ≤4500

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1. Maximize

Z =3x + 2.5y
Subject to
4x + 2y 20,000 Mix A constraint

x + 3y 15000 Mix B constraint

x 4000 product x

y 4500 product y
x, y ≥ 0 Non-negativity
In order to draw the graph and determine the feasible region, we change inequality to
equality sign.
Mix A
4x + 2y = 20,000
y=0
4x + 2(0) =20,000
4x = 20,000
4 y 20, 000

4 4
x = 5000
Coordinates (5000,0)
When x=0 to determine y-intercept
4x + 2y = 2000
4(0) + 2y = 20000
2 y 20, 000

2 2
y = 10,000
Coordinate (0, 10,000).
For mix B
x + 3y = 15000
When y = 0 to determine x – intercept
x + 3(0) = 15000
0+3y=15,000
3 y 15000

3 3
y = 5000
Coordinates (0,500)

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Coordinates (4000,0)

Coordinates (0,4500)

Title: Linear Programming

Scale 2cm to 200 units on the x-axis
2cm to 100 unit on the y –axis

2000

000

0,00

500
4x+2y

500
=
2 0,00
0

000

000
x =4000
000
B = (1300,4500)
(0,4500) C = (300,4000) y =4500
500

Fessible
500
Region

000 D =(4000,200)
x+
3y
10,00 =1
50
00
E =(4000,0)
x
(20,10) 200 400 600 8 00 10 ,0 00 12 00 0 1 40 00 1600 18000

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To determine the optional value

Point Coordinates Z = 3x + 2.5y

A A(0,4500) 11250
B B(1300,4500) 15,150
C C(3000,4000) 19,000
D D(4000,2000) 17000
E E(4000,0) 12000
0 0(0,0) 0
A (0,4500) B(1300,4500)
Z = 3x + 2.5y Z = 3(1300) + 2.5 (4500)
= 3(0) + 2.5 (4500) = 3900 + 11250
= 0 + 11250 = 15150
= 11250

C (3000,4000) D(4000, 2000)

Z = 3(3000) + 4000(2.5) Z = 3(4000) + 2.5 (2000)
= 9000 + 10,000 = 12000 + 5000
= 19,000 = 17000

E (4000,0)
Z = 3(4000) + 2.5 (0)
= 12000 + 0
= 12000

The optimal values are, x = 3000 units and y=4000 units which gives a maximum profit of
Z=GH¢19,000.

C. The constraints are

x

y
The binding constraints are
4x + 2y 20,000

x + 3y 15000

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To determine the shadow price, we increase the right hand value of binding constraint y one
and re-calculate the x and y-values and substitute the values into the object function.
For mix A
4x + 2y = 20001 1
x + 3y = 15000 2 Multiply equation 2 by 4 we want to eliminate x from the
equation

4x + 12y = 60,000 4
4x + 2y = 20001 3
Equation 4 – Equation 3

y = 3999.9
Put y = 3999.9 into equation 2 in order to find x .
x + 3y = 15000
x + 3(3999.9) = 15000
x + 11999.7 = 15000
x = 15000 – 11999.7
x = 300.3
we substitute x and y values into the objective function Z =x+2.5y
Znew = 3(3000.3) + 2.5 (3999.9)
= 900.9 + 9999.75
Change in objective function value or shadow price for mix A
= Z new – Z old
Znew = 19,000.65
Zold = 1900
Shadow price = 1900.65 – 19000
= 0.65
Shadow price = GH¢ 0.65
For mix A

For mix B
We increase the right hand value by one
X+ 3y = 15001 1
4x + 2y = 20000 2
We want to eliminate x from the equation
We multiply equation 1 by 4.
4x + 12y = 60004 4
4x + 2y = 20000 3
Equation 4 – Equation 3

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 y = 4000.4
put y = 400.4 into equation 1 in order to determine x
x + 3y = 15001
x + 3(4000.4) = 15001
x + 12001.2 – 12001.2
x= 2, 999.8
we substitute x = 2999.8 and y = 4000.4 into the objective functions.
Znew = 3(2999.8) + 2.5 (4000.4)
= 8999.4 + 10001
= 19000.4
Show price for mix B = Znew – Zold
= 19000.4 – 19000
= GH¢ 0.4
e. The proprietor would be willing to pay GH¢ 0.65 for addition unit for mix A and GH¢ 0.4
for mix B.

Question 2
A special steel manufacturer produces two types of steel, g1 and g2. Type (g1) requires 2
hours of melting, 4 hours of rolling, and 10 hours of cutting. Type (g2) requires 5 hours of
melting, 1 hour of rolling and 5 hours of cutting. Forty hours are available for melting, 20
hours for rolling, and 60 hours for cutting. The profit margin for type 1 is 24 Ghana cedis
and for type 2 is 8 Ghana cedis.
Required:
(a) Formulate the firm’s linear programming problem.
(b) Find the output mix that will maximize the firm’s weekly profits.
(c) Find the maximum profit.
(d) Which of the resources are binding and which ones are non-binding?
(e) Find the shadow prices of the binding resources.
Question
A farmer can produce yams (X) or maize (Y) with his resources. He makes a net profit of 70
Ghana cedis per acre on yam (X) and 100 per acre on maize. He draws up the following
summary statement of his resources and input equipment:
Requirement per acre:

Resource Yams (X) Maize (Y) Amount Available

Labour 12man days 3 man days 1,080 man days
Equipment 3 machine days 5 machine days 450 machine days
Land 1 acre 1 acre 100 acre

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Required:
(a) Formulate the linear programming problem for the farmer
(b) Find the number of acres he should devote to each product in order to maximize total net
profit
(c) What is his net profit in this situation?

Question
Adom Tool Company (ATC) is a privately held firm that competes in the
consumer and industrial market for construction tools.It only produces wrenches
and pliers. Wrenches and pliers are made from steel, and the process involves
molding the tools on a molding machine and then assembling the tools on an
assembly machine. The data below are the production summary of ATC:

Wrenches Pliers Availability

Steel (lbs) 1.5 1.0 27,000 lbs/day
Molding Machine 1.0 1.0 21,000 hours/day
(hours)
Assembling 0.3 0.5 9,000 hours/days
Machine (hours)
Demand Limited 15,000 16,000
(tools/day)
Contribution to 13 10
Earnings (Gh /
1000 units)

If ATC would like to plan for the daily production of wrenches and pliers at its plant
so as to maximize the contribution to earnings:
(a) How many wrenches and pliers should ATC plan to produce per day in order to
maximize the contribution to earnings?
(b) What would be the total contribution to earnings from this plan?
(c) Which resources would be most critical in this plan?
MINIMIZATION PROBLEM
The procedure for solving a minimization problem by linear programming is the same
as that for a maximization problem except that:
 The minimum value for the objective function will involve a line which is
feasible but nearest to the origin and therefore the lowest value.
 The feasible region will reflect inequalities of the greater than or equal to
variety (≥).
Example
A travel company operates two types of vehicles A and B. Vehicle A can carry
40 passengers and 30 tons of baggage; vehicle B can carry 60 passengers but

13
 only 15 tons of baggage. The travel company is contracted to carry at least
960 passengers and 360 tons of baggage per journey. If vehicle A cost 10
Ghana cedis to operate per journey and vehicle B costs 12 Ghana cedis to
operate per journey , what choice of vehicles will minimize the total cost per
journey?
Solution
Let x=Number of vehicle A type
Let y= number of vehicle B type

Resource Passenger Baggage Cost per unit

x 40 30 10
y 60 15 12
Amount 960 360
Available

Minimize: z = 10x + 12y

Subject to:
40x + 60y ≥ 960 Passenger
30x + 15y ≥ 360 Baggage
x≥ 0, y≥ 0 Non- negativity

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Point Coordinates Total cost, z=10x +12y
E (0,24) 288
F (6,12) 204
G (24,0) 240

The company will minimize its total costs by providing 6 vehicles of type A and 12
vehicles of type B per journey. It will cost the company 204 Ghana cedis.
Question 3
A farmer decides to purchase fertilizer containing three nutrients, A, B and C to
spread on his field. The minimum needs are 160 units of A, 200 units of B, and 80
units of C.
There are two popular brands of fertilizer on the market: Fast Grow, costing 4000 a
bag, contains 3 units of A, 5 units of B and 1 unit of C. Easy Grow , costing 3000 a
bag contains 2 units of each nutrient. If the farmer wishes to minimize his cost while
maintaining the nutrients required how many bags of each brand should he buy?

A B C Cost per bag

x 3 5 1 4000
y 2 2 2 3000
Amount of 160 200 80
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 Resources
available

Binding and Non-binding Constraints

A constraint that provides an optimum solution to a linear programming problem is
known as Binding constraint.
A constraint is said to be binding or active if it satisfied equality sign at the optimal
solution. It is also referred to as the scarce resource and every scarce resource has a
shadow price or imputed cost.
A constraint is said to be Non-binding or inactive if it satisfied with strict inequality at
the optimal solution.
Example:
The firm that uses 3 types of factors: Labour, Capital and Raw Material in producing
products X and Y.
Required:
What factors are binding and which ones are non-binding?
Solution
The constraints are:
Labour X + Y ≤ 50
Capital: X + 2Y ≤ 80
Raw Material: 2X + Y ≤ 80

The optimal solution:

X = 20, Y = 30
Labour Constraints
Substituting X and Y values:
20 +30 = 50
This means that all the labour resources available are utilized. Therefore, it is a
binding constraint.
Capital Constraint:
Substituting X and Y values:
20 + 2(30) = 20 + 60 = 80
Capital is also a binding constraint.
Raw material
Substituting values for X and Y:
2(20) +30 =70 < 80
This implies that raw material is non-binding because not all of the 80 units available are
used. Only 70 units (out of the 80) are used.
Notes:
(1) In a production process where raw material is not used must be discarded after the
batch of production then 10 units of raw material will be discarded.

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 (2) Capital and labour are scarce resources while raw material is not scarce.

SHADOW PRICE
Is the price that management will be prepared to pay for any additional unit of a scarce
resource available? It may also be explained as the amount by which total contribution
would increase for every additional unit of a scarce resource made available.

For example
For our maximization problem:
(i) Identify the scarce resources
(ii) Find the shadow prices of the resources
Solution
At the optimum point:
X +y ≤ 50 Labour constraint
X + 2y ≤ 80 Capital constraint
The scarce resources are labour and capital
Determination of Shadow price
Labour hour
Increase labour unit by one hour, then solve for the new coordinates.
X + y =50+1
X + y = 51----------(1)
X +2y=80-----------(2)
Solving them simultaneously,
X=22, y=29
Z = 2x +3y

Znew= 2(22) +3(29)

= 44 +87
=131
Increase in Z = 131-130
=1
The amount by which total cost will increase when we increase labour unit by one is one
Ghana cedi.
Shadow price of labour is one Ghana cedi.
Question 1
A company manufactures two products X and Y. the products are processed in two
departments – electrical and assembly. Each day 48 man-hours are available in
electrical workshop: the corresponding time for assembly is 54 man-hours. Product X
requires 72 minutes in electrical workshop and 54 minutes in assembly: the
corresponding times for product Y are 24 and 36 minutes respectively. The marketing

17
 manager does not think that he can sell more than 75 per day of product Y. It is
therefore, decided not to produce more than 75 of product Y per day.
The variable costs per unit of product X and Y together with the selling prices are given
below:

X Y
Material costs (GHȼ) 35 15
Labor costs (GHȼ) 16 8
Selling price (GHȼ) 75 35

(a) Formulate this as a linear programming problem

(b) Represent graphically and shade feasible region
(c) Find the number of products X and Y that should be made to maximize
contribution
Find also the maximum contribution.
(d) If the cost of materials of product X were to increase to GHȼ47, and assuming
that all other prices and cost remained the same, what effect would this have on
your results in pact (c)?
2.
A production line can be set up to produce either product X or Y. To produce 1 unit of
X, 30 minutes of labor, 2lbs of material and 3 minutes of testing time are required.
Similarly, to produce 1 unit of Y, 15 minutes of labor, 4lbs of material and 4 minutes
of testing time are required.
In any one week, only 30 hours of labor and 280lbs of material are available, and
owing to cost and availability, the testing equipment must be used for at least 4 hours.
Also, because of existing orders, at least 20 units of product X must be produced. The
contribution from each unit of X produced is GHȼ12 and each unit of Y is GHȼ9.

(a) Formulate the situation as a linear programing problem.

(b) Draw a graph to represent this problem and identify the feasible region.
(c) Use the graph to obtain the weekly production that will maximize contribution
and calculate the resulting contribution.
(d) Calculate the percentage utilization of the available labor.
(e) The union is pressing for an overtime wage rate of GHȼ 20 per minute above the
wage rate for labor. Justify whether the management of the company finds this a
profitable possibility or not.
3.
The Fertilizer Development Unit of the Ministry of Food and Agriculture makes a
fertilizer using two chemicals that provides nitrogen, phosphate and potassium. A
pound of chemical ingredient A contributes 10 ounces of nitrogen and 6 ounces of
phosphate, while a pound of chemical ingredient B contributes 2 ounces of nitrogen,

18
 6 ounces of phosphate and 1 ounce of potassium. Chemical ingredient A costs GHȼ
3.00 per pound and chemical ingredient B costs GHȼ 5.00 per pound. Currently, the
Units puts 4 pounds of each type of chemical ingredient it should put into the bag of
fertilizer to meet the minimum requirements of 20 ounces of nitrogen, 36 ounces of
phosphate and 2 ounces of potassium, whiles minimizing cost
(a) Formulate a linear programming model for this problem.
(b) Draw a graph of the problem.
(c) Using your graph, determine the optimum quantity of each type of chemical
ingredient that the Unit should put into a bag of fertilizer.
(d) What is the minimum cost?
(e) Find the cost savings, if any, that the Unit can make by switching from its current
policy of making the fertilizer to your recommendation policy.
4.
A Pharmaceutical Company produces a drug from two ingredients X and Y. Each
ingredient contains the same three antibiotics A, B and C in different proportions.

One gram of ingredient X contributes 3 units of antibiotic A and one gram of ingredient Y
contributes 1 unit of antibiotic A. The drug requires not more than 60 units of antibiotic
A. At least, 40 units of antibiotic B are required for the drug and one gram of each
ingredient contributes one unit of antibiotic B. At least 120 units of antibiotic C are
required for the drug and one gram of ingredient X contributes 2 units of antibiotic C and
one gram of ingredient Y contributes 6 units of antibiotic C.

The cost for a gram of ingredient X is GHȼ80 and the cost for a gram of ingredient Y is
GHȼ50. The company wants to determine the number of grams of each ingredient that
must go into the drug in order to meet the antibiotic requirements at the minimum cost.

a. Formulate a linear programming model for this problem.

b. Draw a graph of the problem, and identify the feasible region.
c. Using the graphical method determine, for the company, the quantity of each type of
ingredient that must go into the drug in order to meet the antibiotic requirements at
the minimum cost.
d. State the minimum cost.
e. What are the values of the slack or surplus variables?

Financial Mathematics

1. Introduction:

This chapter begins by introducing the differences between simple and compound interest,
formulae for their calculations are given and some of their applications. The chapter also describes the

19
techniques of present value and how it can be applied to cash flow in order to find their worth in today’s
money values, and annuity (techniques associated with fixed payment overtime).

2. Interest:

An interest is earned on money invested and paid on money borrowed. Interest can be in the form of
simple or compound when money is invested over a number of years.
Some terms used in business mathematics calculations:
Principal Amount (P): The amount of money that is lent or invested is called the principal.
It might be an amount about to be invested or loaned. It may refer to the original value or cost of the plant
or machinery. For instance if a company is considering to take a loan of say GHȼ20.000, this will be
referred to as the principal amount borrowed.
Accrued amount (A).this term is applied generally to a principal amount after some time has elapsed for
which interest has been calculated and added. It is quite common to qualify A exactly according to time
elapsed. Thus A1, A2, A3, would mean the amount accrues at the end of 1 st, 2nd, and 3rd years and so on.
The company referred to (a) above might owe, say, an accrued amount of GHȼ22,000 at the end of the 1st
year, if no repayment had been made prior to this time.

Rate of interest (i/r): The interest rate specifies the rate at which interest accumulates. The interest rate is
typically stated as a percentage of the principal per period of time, for example, 18 percent per year.

Number of time period: The number of time period over which amount of money are being invested or
borrowed is normally denoted by the symbol n. Although n is usually a number of years, it could
represent other time periods, such as a number of quarters or months.

Differences between simple interest and compound interest

Simple interest: Interest that is paid solely on the amount of the principal is called simple interest. Simple
interest is usually associated with loans or investments which are short-term in nature.
The computation of simple interest is based on the following formula:
Formula for amount accrued (simple interest)
S.I == Pin= Principal x interest rate per time period x number of time periods.
Accrued Amount (A) = P + Pin = P (1 + in)

Accrued Amount formula:

An = P (1 + rn)

Where An = Accrued amount

P= Principal amount

r= interest rate per year

n= number of year

Example 1: what will be the simple interest if GHȼ 1000 is invested at the rate 5% simple
interest per annum (p.a)

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Solution
S.I = Pin, P = GH₵ 1000, I = 5/100 = 0.05, n = 1

S.I =1000 * 0.5 * 1 = GHȼ 50

Example 2: if GHȼ 3000 is invested at a simple interest rate of 9.5% over a period of 5 years. What will
be the accrued amount (A) of the investment?

Solution

A = P (1+ni)

P = GH₵ 3000, r = 95/100 =0.95, n = 5 years

A = 3000 [1+ (0.95 * 5)]

= 3000 (1.475)

= GH₵ 4425

Example 1
A credit union has insured a 3-year loan of GHȼ5000. Simple interest is charged at a rate of 10
percent per year. The principal plus interest is to be repaid at the end of the third year?
Using the formula I= pin, we get p = GHȼ5000, I = 0.10 per year, and n = 3 years.
Therefore, I= 5000x 0.10x 3
I = GHȼ1,500
The amount to be repaid is the principal plus the accumulated interest, or
A=P+I
A = 5000 + 1500
A = GHȼ6,500

Assignment
A person “lends” GHȼ10,000 to a corporation by purchasing a bond from the corporation.
Simple interest is computed quarterly at a rate of 3 percent per quarter, and a check for the
interest is mailed each quarter to all bondholders. The bonds expire at the end of 5 years, and the
final check includes the original principal plus interest earned during the last quarter. Compute
the interest earned each quarter and the total interest which will be earned over the 5-year life of
the bonds.

Compound Interest: Under this procedure, the interest is reinvested. The interest earned each period
added to the principal for purposes of computing interest for the next period.

Formula for amount accrued (compound interest)

I = Pi

21
 A1 = P + Pi = P (1 + i) factorizing

I2 = P (1+ i) i

A2 = P (1+ i) + I2

A2 = P (1 + i) + P (1 + i) i factorizing

A2 = P (1 + i) 2

Similarly A3 = P (1 + i) 2 (1 + i)

= P (1 + i) 3

A4 = P (1+ i) 4

So for An = P (1 + i) n

Accrued amount formula (compound interest)

An = P (1 + i) n

Where An = accrued amount at the end of the n th year

P = Principal amount

i/r = interest rate per year

n = number of years

What will be the value of GH₵ 450 compounded at 12% for 3 years?
Solution
An = P (1 + i) n
P = 450; I = = 0.12 and n = 3

A = 450 (1 + 0.12)3 = 450 (1.12)3 = GHȼ632.2176

Example 2

Suppose that GHȼ1000 is invested in a savings bank which earns interest at a rate of 8 percent per
year compounded annually. If all interest is left in the account, what will the account balance be
after 10 years?
Solution

22
A  p (1  r ) n
A 1000(1  0.08)10
A 1000(1.08)10
A 2158.924997
A = GHȼ2158.924997

Note on previous formula:

The above formula can be transpose to make P the subject as follows:

P= or P = A (1 + i) n

If the interest is given in daily, monthly or quarterly

Then we would have: An = P (+ i/f) nf
Where An = accrued amount
P = Principal
f = frequency of compounding
i/r = interest rate per year
n = number of years

Example
A long-term investment of GHȼ250,000 has been made by a medium-size company. The interest
rate is 12 percent per year, and interest is compounded quarterly. If all interest is reinvested at the
same rate of interest, what will the value of the investment be after 8 years?

23
 nf
 r
A  p 1 
 f 
f 4
n 8
r 0.12
p 250, 000
8x4
 0.12 
A 250, 000  1  
 4 
32
A 250, 000  1.03
A 643770.6889
A= GHȼ643770.6889

Example
GHȼ 100 is subjected to interest at 12% , compounded quarterly, what is the accrued interest
after 1 year?
Solution

A = P (1 + ) nf P = 100, i = 0.12 , n = 1, f = 4

A = 100 (1 + ) 1*4 = 100 (1.03) 4 = ₵112.55

I = A- P
I = 112.5-100
I = GHȼ12.55

Effective Annual Interest Rate

This is the interest rate that would give the same yield if compounded only once per year.

24
Interest rates are typically stated as annual percentages. The stated annual rate is usually referred
to as the nominal rate. We have seen that when interest is compounded semiannually, quarterly,
and monthly, the interest earned during a year is greater than if compounded annually. When
compounding is done more frequently than annually, an effective annual interest rate can be
determined. This is the interest rate compounded annually which is equivalent to a nominal rate
compounded more frequently than annually.
To calculate for the effective interest rate (ieff) , the formula is given by:
Also known as Actual percentage rate (APR).
ieff = (1 + i/f) f – 1
Where ieff = effective interest rate
f= frequency of compounding
I= interest rate per year
Example
A man purchases a house from a real estate developer at GHȼ 300m. He pays GHȼ 100m cash
and takes out a 10 year mortgage for the remainder from the Home Finance Company at 36% per
annum interest, compounded monthly.
i. What is the effective annual rate of interest?
f
 r
ii. I eff  1    1
 f 

12
iii. Ieff =

12
Ieff =
Ieff = (1.03)12 – 1
Ieff= 1.425760887 – 1
Ieff= 1.425760887 x 100%
Ieff= 42.576%

Example
A company has decided to set up a fund for its employees with an initial payment of GHȼ 2,500
which is compounded 6 months, half yearly over a 4 year period at 24% p.a. calculate
(i) the size of the fund
(ii) the effective annual interest rate
Solution:

P = 27,500 n= 4 A=?

f=2 i = 24%

25
 i/f = 24/2 = 12% = 0.12; nf = 4*2 = 8

But A = P (1+i/f) nf

Substituting we have

A = 27500 (1 + 0.12) 8

= 27500 (1.12) 8

= 27500 (2.47596)

= GHȼ6189.9097941

Accrued amount =6189.9097941

i. ieff = (1+i/f) f – 1
= (1+0.12)2 – 1
= (1.12)2 – 1
= 0.2544 x100%
= 25.44%

Example

Your company has decided to set up a fund for its employers with an initial payment of GHȼ 275m which
is compounded six monthly over a four-year period at 24% per annum.
a) Calculate the size of the find at the end of the 4 years.
b) Calculate the effective annual interest rate
c) Total interest earned
Solution

a) P = 275, n=4 r=24%

r 24%
 12% 0.12
f 2

nf 2 x 4 8
nf
 r
A  p 1 
 f 

Substituting, A = 275 (1.12)8 = 275 (2.4760)

A = GH¢680.9m

Total amount of interest earned = 680.9 - 275

= GH¢405.9
f
 r
I eff  1    1
 f 
= (1 + 0.12)2 - 1

26
 = 1.2544 - 1 = 0.2544
Or = 25.44%
That is if you use 25.44% to work interest once in a year A = P (1 + r) n will give you the same
answer.
Example
A principal amount accrued to GHȼ 8500 if it is compounded at 14.5% over 6 years. Find the
value of this original amount.
Solution

P= A = 8500; i= = 0.145; n=6

P= = = GH¢3772.12

Annuity fund and Sinking fund.

(a) An annuity is a sequence of fixed equal payments (or receipt) made over a uniform time
intervals.
(b) A sinking fund can be defined as an annuity invested in order to meet a known commitment
at some future date.
3. Types of annuity fund and sinking fund
(a) The annuity or sinking fund may be paid at the end of the payment interval or ‘in
arrears’ and will begin and end on a fixed date.
(b) The annuity or sinking fund may be paid ‘in advance’ of the interval.
4. Formula for annuity fund and sinking fund
(a) Annuity/ sinking fund ‘in arrears’:

S =a[ ]

Where S = sinking fund

a = annuity
i = interest rate
n = number of years
(b) Annuity/ sinking fund ‘in advance’:

S = a (1+ i) [ ]

Where S = sinking fund

a = annuity

27
 i = interest rate
n = number of years

Amortization annuity
If an amount of money is borrowed over a period of time, one way of paying the debt is
by repaying amortization annuity. This consists of a regular annuity in which each
payment account for both repayment of capital and interest. The debt is said to be a
mortised if this method is used.
Amortization payment formula

P=a[ ]

Where P = amount borrowed

a = annuity
i = interest rate

n = number of years

Also the amount borrowed, ‘P’ is equal to the net present value of the annuity payment of ‘a’ over
the period of the debt.

i.e. P =

Question on Amortization
A District Assembly has purchased a piece of equipment for its income –generating project at a
cost of GHȼ40,000. It is anticipated that this equipment will be replaced after five years of use.
The equipment is purchased with a five year loan, which is compounded annually at 20 percent.
(i) Determine the size of the equal annual payments.
(i) Produce an amortization schedule for the five equal annual repayments of the
loan.
Solution

28
   1  r  n  1
p a  n 
 r  1  r  
p 40, 000 as the principal amount, rate (r) =20%, r=0.2 and n=5
  1+0.2  5  1 
40000=a  5
 0.2  1  0.2  
  1.2  5  1 
40000 a  5
 0.2  1.2  
  1.48832  
40000 a  
 0.497664 
40000 2.99061214a
40000
a 13375.18813
2.99061214

Amortization schedule (YLITAO)

year Loan Interest Total amount Annual Outstanding

payment Balanced

1 40000 8000 48000 13375.18813 34624.81187

2 3462.81187 6924.961374 41549.77424 13375.18813 28174.58611

3 28174.58611 5634.917222 33809.50333 13375.18813 20434.3152

4 20434.3152 4086.86304 24521.17824 13375.18813 11145.99011

5 11145.99011 2229.198022 13375.18813 13375.18813 0

Example
A man purchases a house from a real estate developer at GHȼ300m. He pays GHȼ100m
cash and takes out a 10 year mortgage for the remainder from the Home Finance
Company at 36% per annum interest, compounded monthly.

i. What is the effective annual rate of interest?

ii. What will his annual mortgage payment be?

29
 iii. How much interest will he pay during the 10 years?

Solution

Total cost = GH¢ 300m

Down payment = GH¢ 300m
Loan = GH¢ 200m
n = number of years
n = 10 years
r = 36% = 0.36
f = 12
f
 r
I eff  1    1
 f 
12
Ieff = -1
= (1.36)12 – 1
= 1.425760887 – 1
= 1.425760887 x 100%
= 42.576%
Ieff = 43%

i. Amortization

P=

a =?
r = 36% = 0.36
n = 10 years
f = 12
p = GH¢200m

Substituting the values

200 = a

30
200 = a

200 = a

200 = a

200 = a

200 = a (32.37302261

a = 6.17798

The annual repayment is = GH¢ 6.17798

ii. Total payment = 6.17798 x 120

= 741.3576

Total interest to be paid = 741.3576 – 200

= GH ¢ 541.3576

Question
A manufacturing company intends to purchase a new equipment costing GHȼ300m. The money
required to buy the equipment is to be provided as a loan by the company’s bankers. The agreed
rate of interest is 24% per annum, compounded annually. The loan is repayable in full with
interest at the end of five years.
To provide for this eventual repayment, the board of Directors of the company has decided to set
aside, equal annual amount, at the beginning of each year, and invest in the a fund which will
earn 30 percent per annum interest, with interest compounded annually.
i. Determine the annual payment into the fund which will be sufficient to repay the
loan in five years
ii. Construct a sinking fund schedule.

The loan, P = 300, Interest rate, r=24%=0.24

31
Number of years, n=5

Value of loan in 5 years, A=P(I+r)n

Substituting the values

A = 300 (1+0.24)5

A = 300(1.24)5

A = 300(2.931625062)

A = 879.4875187

A = 879.49

Sinking Fund

a=?, s=?, n=5 years, Interest rate, r=30%=0.3

Payment in advance

s = a(1 +r)

s = a(1 +0.3)

s = a(1.3)

s = a(1.3)

s = a(1.3)

s = a (1.3)(9.0431)

For the sinking funds to pay for the loan in 5years then, we equate the values of the loan in five
years to sinking fund value.

11.75603 a = 879.49

32
a = 74.81181998

Equal annual payment = GHȼ74.81

ii. Construct a sinking fund schedule for payment in advance (YLITBATIS)

Year Loan Interest Total Balance Annual Total Interest Sinking

Amt. payment
GH¢

1 300 72 372 - 74.81 74.81 22.44 97.25

2 375 89 4.61 97.25 74.81 172.06 51.62 233.68

3 416 111 572 223.68 74.81 298.49 89.55 388.04

4 572 137 709 388.04 74.81 462.85 738.86 60.171

5 709 170 879 601.71 74.81 676.52 202.96 879.48

The sinking figure is the same as that of the five years accrued amount GH¢879

Question

(a) A company has purchased a piece of equipment for its production department at a cost of
GHȼ37,500 on 1st August 2008. It’s anticipated this piece of equipment will be replaced after
5 years of use on 1/08/2013. This equipment is purchased with a 5 year loan which is
compounded annually at 20%.

i. Determine the size of the annual equal payment.

ii. Display an amortization table to show the amount of outstanding and interest of each
year on the loan.

(a) If in (a) above GHȼ3,500 debt is compounded annually at 20% and it is charged on 1st
August 2013, by using a sinking fund method under 5 year equal annual deposit are made
starting 21stJuly 2009 into the fund paid 15% annually.

i. Determine the size of the annual equally deposits into the sinking fund.
ii. Display a table which demonstrates the growth of the loan and sinking fund.
(b) If in (b) above the debt is compounded annually at 20% and it is charged on 1st August
2013, by using a sinking fund method under which 5 equal annual deposit are made
starting 1stAugust 2008 into the fund paid 15% annually.

i. Determine the size of the equal deposit into the fund

33
ii. Display a table which demonstrates the growth of the loan and sinking fund.
Solution:
i. Amount of loan P =37,500; i = 20%; n = 5 years

P=a[ ]

By substituting we have

37,500 =a[ ]

37,500 =a[ ]

37,500 = a (2.9906)

a=

a=12,539

Equal annual deposit = GHȼ12,539

Alternative solution:

P = 37500 a a a a a

0 1 2 3 4 5

Present value of payment =

By substituting we have:

PV of payment =

34
 =a( )

= a (0.8333+ 0.6944 + 0.5787 + 0.482 +0.491)

37,500 = a (2.9906)

37,500 = 2.9906a

a=

= GHȼ12,559

Amortization Schedule (YLITAO)

Year Loan Interest Total Amount Annual Outstanding

of Loan Payment Balance
1 37,500 7,500 45,000 12,539 32,461
2 32,641 6,497 38,953 12,539 26,414
3 26,414 5283 31,697 12,539 19,158
4 19,158 3832 22,990 12,539 10,451
5 10,451 2,090 12,541 12,539 2

(b) i. P = 37,500; i = 0.2 n=5

Accrued amount in 5 years, A, = P (1+ i)n

35
 = 37,500 (1+0.2)5

= 37,500 (1.2)5

= 37,500 (2.4883)
= GHȼ93,311

The value of loan in 5 years = GHȼ93,311

Sinking fund payment ‘in arrears’

S = A; a=? i = 0.15; n = 5

S=[ ]a

By substituting we have:

S=[ ]a

S=[ ]a

S = a (6.7424)
S = 6.7424a
For the sinking fund to pay the loan in 5 years then A = S
→ 93311 = 6.7424a

a=

a = 13,889

Equal annual deposited = GHȼ13,889

ii. Sinking fund schedule (payment in areas) (YLITBITAS)

Year Loan 0.2 Total Balance 0.15 Total Annual Sinking

Interest amount b/f Interest Amount payment Fund
of loan
1 37,500 7,500 45,000 - - - 13,389 13,389

36
 2 45,000 9,000 54,000 13,389 2,076 15,915 13,389 29,745
3 54,000 10,800 64,800 29,745 4,463 34,217 13,389 48,056
4 64,800 12,960 77,760 48,056 7,208 55,264 13,389 69,013
5 77,760 15,552 93,312 69,013 10,365 79,468 13,389 93,309

(d) Sinking fund (payment in advance) when P = 37,500; n = 5; I = 0.2

Then accrued amount in 5 years, A, = P (1+ i)n

A = 37,500 (1+0.2)5

= 37,500 (1.2)5

= 37,500 (2.4883)
= GH₵93,312

Sinking fund:

S = A; a=? i = 0.15; n = 5

S = a (1+ i) [

S = a (1+ i) [ ]

By substituting we have:

S = a (1.15) [ ]

S = a (1.15) (6.424)

S = a (7.7538)

S = 7.7538a

For the sinking fund to pay the loan in five years

S = A = 93312

= 7.7538a

a=

= 12,034

Equal annual payment =GH₵12034

Sinking fund schedule (payment in Advance) (YLIBATIS)

37
 Year Loan 20% Total Balance Annual Total Interest Sinking
Interest amount b/f payment Amount 15% Fund
of loan
1 37,500 7,500 45,000 - 12,034 12,034 1,805 13,389
2 45,000 9,000 54,000 13,389 12,034 25,873 3,881 29,745
3 54,000 10,800 64,800 29,745 12,034 41,788 6,268 48,056
4 64,800 12,960 77,760 48,056 12,034 60,090 9,014 69,013
5 77,760 15,552 93,312 69,104 12,034 81,138 12,171 93,309

Example 2

a) A company has purchased a piece of equipment for its production dept. at a cost of ₵ 375m on
march 1, 20011. It is anticipated that this piece of equipment will be replaced after 5year of use
on March 1, 20016. The equipment is purchased with a 5 – year loan, which is compound
annually at 30%
I. Determine the size of the equal annual payments
II. Display a table which slows the amount outstanding and the interest for each year of the
loan.
b) If in a) the ₵375m debt is compounded annually payment is advance at 30% and discharged on
march, 20011 by using a sinking fund method, under which 5 equal annual deposits are made
starting on march 1, 2012 into the fund paying 24% annually
I. Determine the size of the equal annual deposits into the sinking fund and
II. Display a table which demonstrates the growth of the loan and the sinking fund

c) If in a) the 375m debt is compounded annually at 30% and discharged on march 1, 2011 by using
a sinking fund method under which 5 equal annual deposits are made starting on march 31st,
into the fund paying 24% annually.
I. Determine the size of the equal annual deposits into the sinking fund, and
II. Display a table which demonstrates the growth of the loan and the sinking fund

Amortization formula
Solution
I. P = 375,
n = 5 r=0.3 a =?

38
   1  r  n  1
P a  n 
 r  1  r  

Substituting, we have

375 = a (1.3)5 - 1
0.3(1.3)5

375 = a (2.4356)
= a = 375
II.4356 = ₵ 153.966m this is what we will be paying each year
Total amount of interest to be paid= (154 x 5) - 375

Alternative Solution

P=375 a a a a a

1 2 3 4 5

PV of value deposits

= a + a + a + a + a
1 2 3 4
(1.3) (1.3) (1.3) (1.3) (1.3)5

=a 1 + 1 + 1 + 1 + 1
(1.3)1 (1.3)2 (1.3)3 (1.3)4 (1.3)5

= a (0.7092 + 0.5917 + 0.4552 + 03501 + 0.2693)

= a (2.4355)
. . . 2.4355a = 375

ii) Amortization Table

Year Value of loan ₵ Interest ₵ Total amount Annual Outstanding

of loan ₵ payments ₵ balance ₵
1 375 112.5 487.5 153.966 333.534
2 333.534 100.0602 433.5942 153.966 279.6282
3 279.6282 83.8885 363.5167 153.966 209.5507
4 209.5507 62.8652 272.4159 153.966 118.4499

39
5 118.4499 35.5350 153.5350 153.966 0.0189

B)
P = 375, 2 = 5 r = 0.3
Value of loan in 5 year, a = P(1 + r)n = 375 (1.3)5 = 375 (3.7129)
= ₵ 1392.3375m

Payment in advance

  1  r  n  1
S a  1  r   
 r 
Where a=? r = 0.24, n = 5

Substituting, we have

S = a (1.24) (1.24)5 – 1
0.24
S = a (1.24) (8.0484)

S= 9.98a

For the sinking fund to pay for the loan in 5years

9.98a = 1392.3375
A = 1392.3375
9.98
A = 139.5128

Equal annual deposits = GHȼ139.5128m

a a a a a A = 1392.3375

0 1 2 3 4 5

Sinking fund

S = a (1.24)5 + a (1.24)4 + a (1.24)3 + a (1.24)2+ a (1.24)

S = a (1.245 + 1.244 + 1.243 + 1.242 + 1.24)

S = a (2.9316 + 3642 + 1.9066 + 1.5376 + 1.24)

40
 S = 9.98a

9.98a = 1392.3375

a = 1392.3375 = 139.5128
9.98

Sinking Fund schedule (payment is advance)

years Value of Investmen Total Balance Annual Total Interest Sinking

loan t ₵m amount of b/f ₵m deposite amount ₵m fund ₵m
₵m loan
1 375 112.5 487.5 - 139.5128 139.5128 33.4831 172.9959
2 487.5 146.25 633.75 172.9959 139.5128 312.5087 75.0021 387.5108
3 633.75 190.125 823.875 387.5108 139.5128 527.0236 126.4857 653.5093
4 823.875 247.1625 1071.0375 653.5093 139.5128 793.0221 190.3253 983.3474
5 1071.0375 321.3113 1392.3488 983.3474 139.5128 1122.860 269.4864 1392.346
2 6

A) Payment in arrears

n
Value of loan in 5 year A  p  1  r  = 1392.3375

Sinking fund, S = a (1 + r)n - 1

r

S = a (1.24)5 – 1 = a (8.0484)
0.24
i.e 5 = 8.0484a

For the sinking fund to pay for the loan in 5years,

8.0484a= 1392.3375
8.0484

Or a = 172.9956

i.e equal annual deposits = ₵172.9956m

41
 or

0 1 2 3 4 5

The sinking fund is

S = a (1.24)4 + a (1.24)3 + a (1.24)2 + a (1.24) + a

= a (1.244 + 1.243 + 1.242 + 1.24 + 1)

= a (2.3642 + 1.9066 + 1.5376 + 1.24 + 1)

= a (8.0484)

i.e sinking fund = 8.0484a

years Value Interest Total Balance Interest Total Annual Sinking

of loan ₵m amount b/f ₵m ₵m amount deposits fund
1 172.9959 172.9959
2 172.9959 41.5190 214.5149 172.9959 387.5108
3 387.5108 93.0027 480.5135 172.9959 653.5094
4 653.5094 156.8423 810.5135 172.9959 983.3476
5 1392.3488 983.3476 236.0034 1219.351 172.9959 1392.3469

Q1. a. A man purchases a house from a real estate developer at GHȼ250,000. He pays
GHȼ50,000 cash and takes out a 5 – year mortgage for the remainder from the Home
Finance Company at 40 percent per annum interest, compounded quarterly.

i. What is the effective annual rate of interest?

ii. What will his annual mortgage repayment be?
iii. How much interest will he pay during the 5 years?

42
 b. A manufacturing company intends to purchase a new equipment costing GHȼ50,000.
The money required to buy the equipment is to be provided as a loan by the company’s
bankers. The agreed rate of interest is 20 percent per annum compounded annually. The
loan is repayable in full with interest at the end of 5 years.

To provide for this eventual payment, the Board of Directors of the company has decided
to set aside, equal annual amount at the end of each year, and invested in a fund which
will earn 25 percent per annum interest, with interest compounded annually.

i. Determine the annual payment into the fund which will be sufficient to repay the
loan in five years.
ii. Provide a sinking fund schedule.

1. One of your private clients has asked for your advice concerning GH ȼ5,000 which he
wishes to invest for five years. The two alternatives are to use a Bank Account
Investment where the 24% per annum interest is compounded monthly or a Savings
Fund Investment where the 25% per annum interest is compounded annually.

a) Calculate the size of each investment at the end of the five years.

b) Calculate the effective annual interest rate of the Bank Account Investment.

c) Advise your client on the basis of your calculations.

2. A company plans to buy equipment for GH ȼ12,000.

a) If the equipment is to be purchased with a five-year loan, which is compounded

annually at
15%, produce an amortization schedule for the five equal annual repayments of the
loan.

b) If the GH ȼ12,000 debt, which is compounded annually at 15%, is to be discharged in

five years by a sinking fund method, under which equal annual deposits will be made
at the beginning of each year into a fund paying 10% annually, produce the schedule
for the sinking fund.

c) If the GH ȼ12,000 debt, which is compounded annually at 15%, is to be discharged in

five years by a sinking fund method, under which equal annul deposits will be made

43
 at the end of each year into a fund paying 10% annually, produce the schedule for the
sinking fund.

3. A mortgage of GH ȼ50,000 has to be repaid by equal six-monthly installments over 25

years at an interest rate of 20% per annum compounded six-monthly.

Calculate:

i. the amount of each six-monthly installment payment.

ii. the total amount of interest paid on the loan.

1. a. Your company has recently run short of office accommodation and has had to rent
space nearby for the Marketing Division. The annual rental for these extra premises is
GHȼ30,000 which is payable in advance at the beginning of the year. It is envisaged that
this arrangement will need to continue for six years. The company decides to cover these
circumstances by taking out an annuity at the beginning of the first year at 10 percent
per annum compounded annually.

What is the present value of the six years total rental?

b. Efo Kwaku, the proprietor of Efo and Sons Limited, is faced with the problem of
which of the two mutually exclusive investment projects, Project 1 and Project 2, he
should choose.

Project 1 costs GHȼ5,000 and Project 2 costs GHȼ4,500. Both projects involve the
purchase of an equipment, the useful life of which is four years.

The net cash flows for the two projects are provided in the table below:

Net Cash Flow (GHȼ)

Project Year 1 Year 2 Year 3 Year 4
1 2,550 2,450 1,700 1,400
2 1,240 1,550 2,100 3,800

The equipment bought for Project 1 will have a scrap value of GHȼ500 at the end of its
life, while the equipment bought for Project 2 will have a scrap value of GHȼ400 at the
end of its life.

i. Find the payback period for each project.

ii. Establish the net present value for each project using discount rate of 20%.
iii. Establish the net present value for each project using discount rate of 25%.
iv. Determine the internal rate of return for each project.
44
 v. Using the payback criterion and the internal rate of return criterion advice the
proprietor on the project he should undertake, giving reasons for your choice of project.

Investment Appraisal Techniques

It involves making of long-term planning decisions for investments

Investment Appraisal

Payback Period Discount cash flow

NPV IRR
PAYBACK METHOD

The payback method gives the number of years necessary to recover the initial investment.

Payback Period

Payback period formula

(a) Payback period =

(b) Interpolation method: → this method is used when the cash flow is not uniform.
E.g. (i) a certain project 1 has an initial investment of GHȼ3000 and the following cash
flows:

Year 1 2 3 4 5
Cash flow 1,000 1,500 2,000 1000 500

What is the payback period?

45
 Solution:

Payment period = 2 +

iii. Another project 2 has an initial investment of GHȼ3000 and the following cash flow
below:

Year 1 2 3 4 5 6
Cash flow 200 300 500 1500 2500 3500

Determine the payback period.

Solution:
Payback period = [200+300+500+1500]
= 2500 this means that the cash flows can pay the initial
investment in the 4 year but there will be a fraction in the 5th year.
th

Therefore payback period =4+

Disadvantages of interpolation method

(i) It ignores the time value of money
(ii) It ignores the net cash flow.

NET PRESENT VALUE (NPV)

With the NPV, the cash flows of the investment are discounted by a minimum acceptable
compound annual rate of return.

The investment is judged to be acceptable if the present value of the net cash flows exceeds the
initial investment outlay.

Present Value
Suppose the current investment Rate is 10%, then the present value of GH₵110 in one year time

is

Similarly, the present value of GH₵121 in two year time will be

(a) Formula for present value

46
 P=

Where P = present value

A = amount payable in a year

i = discount rate (as proportion)

n = number of time

(b) The quantity is sometimes known as the present value factor or discount factor.

(c) Formula for present value of an interest - bearing rate

PV=

Where i = proportional borrowing rate

j = proportional discount rate

p = original amount borrowed

n = number of time periods

Net present value (NPV)

(a) Formula for NPV.
NPV = ∑PV - Co
Where NPV = net present value
PV = present value
Co = initial investment

(b) Interpretation of NVP

NPV interpreted loosely in the following ways:
NPV > O project is profitable (i.e. worthwhile)
NPV = O project breaks even
NPV < O project makes a loss (i.e. not worthwhile)

(c) Further interpretation of NVP

47
 NPV > O project earns more than the discount rate
NPV = O project earns the same as the discount rate
NPV < O project earns less than the discount rate

INTERNAL RATE OF RETURN (IRR)

The IRR is the compound interest rate that equates the present value of the future net cash flows
with the initial outlay.

Or in other words the discount rate that gives a NPV = zero

Internal rate of return (IRR)

The internal rate of return of a project is the value of the discount rate that gives NPV of zero.

(a) Formula for IRR

IRR = a + (a-b) [ ]

Where NPV at a = lower discount rate NPV

NPV at b = higher discount rate NPV
a = lower discount rate
b = higher discount rate

(b) Methods of estimating IRR

(i) Interpolation method: This is to estimate between two known values.

NPV Assume a% → NPV = + ve

b% → NPV = - ve

IRR → NPV = 0
+ve
IRR
0
Discount rate
-ve a b c

Fig 1

48
 For instance, discount rate 15% yields an NPV of GH₵14,000; discount rate 17% yields an NPV of
GH₵14,000

NPV
20,000

10,000
Estimate of IRR =16.33%

0 Discount rate
-100000 14 15 16 17 18 19

Fig 2
(ii) Extrapolation: This is to estimate beyond the known values by extension of a curve
or a line.
Assume a% NPV = +ve
b% NPV = -ve
IRR NPV = 0
then will have a graphical estimate of IRR as in figures 3 below.

NPV

+ve
IRR

0
Discount rate
-ve a b

Fig 3

49
Example 5:

Two mutually exclusively projects A and B are being evaluated. Each project has an initial cost
of GHȼ 20. The following cash flows for the two projects are provided.

Cash flow
Year Project A Project B
1 2 10
2 2 10
3 2 10
4 13 5
5 13 5
6 14 5
Also given is a rate of return of 15%. Complete the following for each project.

(a) Payback period

(b) Net present value
(c) Internal rate or returns

Solution:

Taking one project means another is not taken

(a)
(i) Project A

Payback period = 4+ = 4+0.08 = 4.08 years

(ii) Project B
Payback period = 2 years

(b) Net present value (i = 0.15)

Discount Cash Project A Project B

flow (DC F)
Year Cash flow PV Cash flow PV

1 0.8696 2 1.7392 10 8.694

2 0.7561 2 1.512 10 7.561
3 0.6575 2 1.3152 5 6.575
4 0.5718 13 7.4334 5 2.859
5 0.4972 13 6.4636 5 2.486
6 0.4323 14 6.0522 5 2.161
Total - - 24.5156 - 30.3385

50
 For project A, NPV = 24.5156 – 20
= GHȼ4.5156
For project B, NPV = 30.3385 – 20
= GHȼ10.338

(c) Internal rate of return.

Notice that we need to take the interest rate to be 20% which is higher than the former
15% because we want to drag NPV to zero

(I = 0.2) Project A Project B

Year Cash flow PV Cash PV
flow
1 0.8333 2 1.666 10 8.333
2 0.6944 2 1.3888 10 6.944
3 0.5787 2 1.1574 5 5.787
4 0.4823 13 6.2699 5 2.4115
5 0.4019 13 5.2247 5 2.0095
6 0.3349 14 4.6886 5 1.6745
Total - - 20.396 - 27.1597

For project A, NPV = 20.396 – 20 = GHȼ0.396

For project B, NPV = 27.159 – 20 = GHȼ7.1595

Project A:
At 15% NPV = 4.5156
At 15% NPV = 0.396

Project B:
At 15% NPV = 10.3385
At 15% NPV = 7.1595

IRR = a + (b-a) [ ]

Where a = 15% and b = 20%

51
 For project A,

IRR = 0.15 + (0.2 – 0.15) [ ]

= 0.15 + 0.05 ( )

= 0.15 + 0.05 (1.0961)

= 0.2048

For project B,

IRR = 15+ (20 – 15) ( )

= 15+ 5 ( )

= 15 + 16.26

= 31.26%

Therefore, we prefer project B to project A, because it has a higher yield

Two mutually exclusive projects A and B are being evaluated. Each project has an initial cost of
GHȼ 20m. The following cash flow are provided.

Year 1 2 3 4 5 6
Project A 2 2 2 13 13 14
Project B 10 10 10 5 5 5

Also given is discount rate of 15%

a) Compute the ff. for each project

52
 I. Payback period
II. Net present value
III. Internal rate of return
b) In each case, decide on which project you would prefer.

Solution

1) Payback method
Project A
Payback period = 4 + 1
3
= 4 + 0.1 = 4.1yrs
Project B
Decision project B is preferred because it has shorter payback
Payback period = 2years

B) Net present value

R= 20% Project A Project B
Years 1/(1 + r)s Cash flow PV Cash flow PV
1 0.8696 2 1.7392 10 8.696
2 0.7561 2 1.5122 10 7.561
3 0.6575 2 1.315 10 6.575
4 0.5718 13 7.4334 5 2.859
5 0.4972 13 6.4636 5 2.486
6 0.4323 14 6.0522 5 2.1615
24.5156 30.3385

For project A,

NPV = 24.5156 – 20

= 4.5156m
For project B

NPV = 30.3385 - 20 = GHȼ10.3385m

Decision
Project B is preferred since it has a higher NPV
(x) IRR Method

R=20% Project A Project B

year 1/(1 + r); Cash flow PV Cash flow PV
1 0.8333 2 1.6666 10 8.333

53
2 0.6944 2 1.3888 10 6.944
3 0.5787 2 1.1574 10 5.787
4 0.4823 13 6.2699 5 2.4115
5 0.4019 13 5.2247 5 2.0095
6 0.3349 14 4.6886 5 1.6745
20.396 27.1595

For project A
NPV = 20.393 - 20 = GHȼ0.396m

For Project B
NPV = 27.1595 - 20 = GHȼ 7.1595

IRR = a + (b-a) NPV at a

NPV at a - NPV at b

For project A
= 15 + (20 - 15 ) 4.5156
4.5156 – 0.396

IRR = 15 + 5 4.5156 = 15 + 5.48

4.1196 = 20.48%

For Project B

IRR = 15 + (20 - 15) 10.3385

10.3385 - 7.1595

= 15 + 5 10.3385
3.179

= 15 + 16.26
= 31.26%
Conclusion
Project B is project
A firm is considering two mutually exclusive capital project which involves the purchase, use
and final disposal of two machines A and B at the end of the fourth year of purchase.

Initial cost Net Cash Flows

Machine (GHȼ) Year 1 Year 2 Year 3 Year 4

A 5,000 2,550 2,450 1,700 1,400

54
 B 4,500 1,250 1,550 2,100 3,800

The scrap value, at the end four years, of the machine A is GHȼ500 and that of machine B is
GHȼ400.
(a) Using discount rates of 20% and 25%, find the net present value of each
machine.
(b) Choose between the two machines using:
i. The payback method
ii. The net present value method
iii. The interest rate of return method.

. Efo Kwaku, the proprietor of Efo and Sons Limited, is faced with the problem of which of the
two mutually exclusive investment projects, Project 1 and Project 2, he should choose.

Project 1 cost GHȼ5,000 and Project 2 costs GHȼ4,500. Both projects involve the purchase of
equipment, the useful life of which is four years.

The net cash flows for the two projects are provided in the table below:

Net Cash Flow (GHȼ)

Project Year 1 Year 2 Year 3 Year 4
1 2,550 2,450 1,700 1,400
2 1,240 1,550 2,100 3,800

The equipment bought for Project 1 will have a scrap value of GHȼ500 at the end of its life,
while the equipment bought for Project 2 will have a scrap value of GHȼ400 at the end of its life.

vi. Find the payback period for each project.

vii. Establish the net present value for each project using discount rate of 20%.
viii. Establish the net present value for each project using discount rate of 25%.
ix. Determine the internal rate of return for each project.
x. Using the payback criterion and the internal rate of return criterion, advice the
proprietor on the project he should undertake, giving reasons for your choice of project.

55
Differential Calculus

Consider the graph of a function f(x) given below

Y=f (x)

B [x + ∆x, f(x +∆x)]

A (x1 fx)

X ∆ x x + ∆x

Slope of a line AB = change in y = ∆y

Change in x = ∆x
Where ∆ is a Greek letter pronounced DELTA and means a small change

∆y = f (x + ∆x) – f (x)
∆x ∆x

Definition
As B moves towards A, ∆x, diverse in value until such time that its value is almost zero. At
this point, A and B coincide and the line through them touches the curve at only one point.
This line is the tangent line whose slope is the same as the slope of the curve at the point of
contact with the tangent line. The slope of the tangent line is the instantaneous rate of change
dy
of y with respect to x, denoted by where
dx
dy y f  x  x   f  x 
 lim  lim
dx x 0 x x 0 x
Note
Line ∆x 0 means LIMIT as ∆x at as ∆x approaches zero
dy
= f (x) = First derivation of y with respect to x
dx
d2y = = Second derivative of y with respect to x
dx2

56
 Some rules of differentiation

dy
a)  k  0 where k is a constant
dx
dy
e.g. If y = 10, 0
dx

b)
 
d xn
nx n  1
dx
dy
6
6 x 6 1
E.g if y  x , dx
6 x 5
d  x
(c) 1
dx

Example y  x

dy
1
dx

Examples
Differentiate the following

a) Y= 4x3 + 5x2 + 8x + 11

b) Y = 1
x

c) Y = 3√x

Solution
a) y = 4x3 + 5x2 + 8x + 11

dy
 4(3)x 3-1 + 5 (2)x 2-1 + 8x1 + 0
dx
= 12x2 + 10x + 8

b) y = 1 = x  1
x
dy 1
= -1x -1-1 = 2
dx x

Example

57
Find the extrema for the following

Y = x3 – 9x2 + 24x- 19
Solution

Y = x3 – 9x2 + 24x – 19
dy
3 x 2  18 x  24
dx
dy
For extrema, 0
dx
i.e 3x2 – 18x + 24 = 0 factorization (quadratic)

(ax2 + bx + C = 0)
Using the formula

X = -b ± √b2 – 4ac, we have

= (-18± √(-18)2 – 4 (3)(24)
2 (3)

= 18±√324 – 288
6

= 18±√36
6
= 18 ± 6
6

i.e either x = 18 + 6 or x = 18 -6
6 6
X = 24 or x = 12
6 6
We have
X = 4 or x = 2
d 2 y d  dy  d
2
     3 x 2  18 x  24 
dx dx  dx  dx
6 x  18

Where x=4
d2y
6 x  18 6  4   18
dx 2
6  positive

This implies that we have a minimum point, when x =4

y min = x3 - 9x2 + 24x - 19

58
 = 43 – 9 (4)2 +24 (4) - 19
= 64 - 144 + 96 – 19
Y(minimum) =-3

i.e when x = 4 ymin = -3

When x = 2

d2y
= 6x – 18 = 6 (2) – 18 = 12 – 18 = -6
dx 2
= negative

That implies that when x =2 we have a maximum point

y max = x3 – 9x2 + 24x – 14

= 23 – 9(2)2 + 24 (2) – 19
= 8 – 36 + 48 -19
=1
When x =2, Ymax = 1
Some Applications of differential Calculus
a) maximization of profits (minimization of cost)
Let TR represents total revenue
TC represents total cost
Which are functions of output, x
Profit, π = TR – TC
d
For max profit, 0
dx
d d
 TR    TC 
dx dx

Note
d
 TR  = change in total revenue per unit change in output level, representing marginal revenue, MR.
dx

d
 TC  = change in total cost per unit change in output level, representing marginal cost MC
dx

Example 1

a. A company manufactures and sells a product. The demand function for the
product is given by:

59
 where p represents price per unit (in GH₵000)
x represents number of units produced and sold

The company’s management accountant estimates the average cost function

as:

Where AC represents average cost per unit (GH₵000)

X represents number of units produced and sold.

Determine:
i. The level of output at which profit is maximized.
ii. The price per unit that must be charged to achieve this maximum
iii. The output tax per unit that must be imposed on the company to maximize tax
revenue for government.

P = 200-

AC =

= profit

= Total revenue – Total cost

= TR –TC

TR = price unit x quantity produced and sold

TR = P.X

TR =

TR =

60
 =

AC.X = TC

TC = AC.X

TC =

TC =

TC =

Substituting the values into the profit function

Output level that maximize profit

61
x = 140 x 15

x = 2100 unit

Output that maximize profit is x = 2100units

ii. P=

u = 2100unit

Substitute x = 2100 into price function

P=

= 200 – 70

=GH₵ 130

Let t = Tax per unit imposed by government

Total tax = T = tx
Substituting tx into the profit function

π = 140 x -

π = 140 x -

Level of output that maximized profit

=0

Cross multiply
x = 15 (140 –t)
Put x = 2100 – 15t into the total tax
T=tx

62
 T = t(2100-15t)
T = 2100t – 15t2

At output level that maximized tax revenue

t = 70
Example 2
A monopolist’s demand function for her product is P 400  2 x and has average cost function, AC, is
400
AC 0.2 x  4  Where x is the number of units and both P and AC are expressed in cedis
x
Determine:
i) level of output at which profit is maximized
ii) the price at which this occurs
iii) the maximum profits

Solution
a) P = 400 – 2x
AC = 0.2x + 4 + 400
X
Profit, π = TR – TC

TR = price / unit x number of units

= Bx
TC = (400 -2x)x
Or = 400x – 2x2

AC = TC
X
Or TC = Ac . X
= (0.2x + 4 + 400)X
X
i.e TC = 0.2x2 + 4 + 400

π = 400x – 2x2 – (0.2x2 + 4x + 400)

π = 400x – 2x2 – (0.2x2 + 4x + 400)

= 400x – 2x2 – 0.2x2 – 4x – 400

63
 400 x  2 x 2  0.2 x 2  4 x  400
  2.2 x 2  396 x  400
The profit function

d
 4.4 x  396 0
dx
4.4 x 396
396
x 90
4.4

Output level for maximum profit = 90 units

For max profit, MR = MC

d
TR = 400x – 2x2, MR   TR  400  4 x
dx
TC = 0.2x2 + 4x + 400

d
MC   TC  0.4 x  4
dx
For max profit MR = MC

i.e 400 – 4x = 0.4x + 4

396 = 4.4x

Or x = 396 = 90
4.4

b) P = 400 – 2x
When x = 90

P = 400 – 2 (90)
= 400 – 180 = 220

i.e price/unit = GHȼ220

c) π = - 2.2x2 + 396x – 400

= 17820 + 35640 – 400
= GHȼ17,420

64
Example 3
The revenue and cost functions of a pineapple producer are R = 204x –x 2. C = x2 + 4x + 1000 where x is
the output (in units) per month and R and C the total revenue and total cost respectively in cedis.

a) What are the pineapple producers optimum output price per unit and profit before tax
consideration?
b) If a lump sum tax of GHȼ1500 was imposed every month, what would the optimum output
level, price per unit and profit after tax be?
c) If an output tax of GHȼ 40 per unit were imposed, what would be the optimum output level,
price per unit and profit after tax be?
d) What output tax per unit should be imposed to maximized tax revenue?

Solution
R = 204x – x2
C = x2 + 4x + 1000

a) Profit π = TR – TC
= 204x – x2 – x2 – 4x -1000
  2 x 2  200 x  1000

d
 4 x  200
dx
d
For maximum profit 0
dx
x 200
200
x
4
x 50

I.e output level for maximum profit = 50 units

TR = px = 204x – x2
Px = (204 - x)x

Or P = (204 -x)x = 204 –x

X
i.e price / unit p = 204 – x

when x = 50,
p = 204 – 50 = 154
i.e price / unit charged = GHȼ154

π = - 2x2 + 200x – 1000

x = 50
πmax = -2 (50)2 + 200 (50) = 1000
= - 5000 + 10,00 – 100

65
 = 4000
i.e maximum profit = GHȼ 4000

b) Imposition of lump sum tax of GHȼ 1500

π = - 2x2 + 200x – 1000 – 1500
π= -2x2 + 200x – 2500

d
 4 x  200
dx

4x = 200
Or x = 200 = 50
5

i.e output level for maximum profit = 50 units

P = 204 – x
= 204 – 50 = 154
i.e price / unit charged = GHȼ 154

π = - 2x2 + 200x – 2500

When x = 50

π max = 2 (50)2 + 200 (50)- 2500

= - 5000 + 10,000 – 2500
= ₵2500

Before tax After tax

Output level 50 50
Price / unit 154 154
Maximum - profit 4000 2500

From the above table the lump sum tax has no effect on the output. It also has no effect on the
price per unit but has reduced the profit from GHȼ 4000 to GHȼ 2500. It has reduced by the
amount of tax imposed
c) Imposition of output tax of GHȼ 40 per unit

Total tax = 40x

π = - 2x2 + 2000x – 1000 – 40x
π = - 2x2 + 160x – 1000

d
 4 x  160 0
dx
4x = 160
Or x = 160 = 40 units
4

66
P = 204 – x
= 204 – 40 = 164
i.e price / unit charge = GH₵ 164

π = - 2x2 + 160 – 1000

When x = 40
π max = -2 (40)2 + 160 (40) – 1000
= 3200 + 6400 – 1000
= 2200
i.e maximum profit =GH ₵2200

Before tax After tax

Output level 50 50
Price / unit 154 164
Max - profit 4000 2200
By the imposition of output tax, output level has dropped from 50 to 40, profit has also dropped
from 4000 to 2200, but price per unit has increased from 154 to 164 which means the producer
has passed onto the consumer GHȼ10 of the tax.

d) Suppose tax per unit imposed is GHȼt. total tax imposed = tx

π = 2x2 + 200x – 1000 – tx

d
 4 x  200  t
dx
For maximum profit
d
0
dx

4x = 200 – t

200  t
x
4

i.e x = 50 - 1 t
4

Total tax revenue, T is T tx

Substitute for x, T = t (50 – 1 t)

4

T = 50 t – 1 t2
4
dT 1
50  t
dt 2

67
 dT
To maximize tax revenue 0
dt
1
t 50
2
t = 50 x 2 = 100
i.e Tax per unit imposed = GHȼ100

Point Elasticity of demand, e

e = percentage change in demand

Percentage change in price

Supposed demand changes from x1 to x2

. Change in demand, dx = x2 – x1

Percentage change in demand = dx * 1000 = dx * 100

X x

Again, suppose price /unit changes from P1 to P2

Change in price, dp = P2 – P1

Percentage change in price = dp x 100 = dp x100

P p

Substituting, we have
dx
x100
x dx p
e  
dp
x100 x dp
p
Example
A monopolist’s demand function is

P = 400 -2x

Where x is output (in units) P is price per unit (in cedis) find the point elasticity of demand at the
output level that maximize total revenue
Solution
P = 400 -2x

TR = px
= (400 – 2x)x
Or
TR = 400x -2x2
d (TR) =400 – 4x = 0

68
dx
4x =400
X = 400 = 100
4
i.e output level for maximum revenue = 100 units
.: P = 400 - 2x
= 400 – 2 (100)
= 400 – 200 = 200
P =GH ₵200
P = 400 – 2x
dp
 2
dx
dx  1

dp 2
dx p
Substituting into e   , we have
dp x

200  1  200
e   =  =-1
100  2  200

If quantity increases by 1 price falls by 1 or

Price increases by 1 quantity falls by 1
Question 1

A monopolist’s demand function for his product is given by:

p = 400 – 2x

and his average cost function is:

AC = 0.2x + 4 +

Where p represents price per units (in GHȼ)

x represents number of units produced and sold

AC represents average cost per unit (in GHȼ)

(a) Determine:
i. The level of output at which profits is maximized
ii. The price at which this occurs and the maximum profit.
(b) If, as a regulatory device, the government imposes a tax of GHȼ22 per unit on the
monopolist, discuss the effects of the imposition of this output tax per unit.

69
 (c) Determine the output tax per unit that will maximize tax revenue for government
(a) The demand for product A and the demand for product B are each functions of prices of
both A and B. If the demand function for product A and B are given respectively by:

Determine whether A and B are complementary products.

(b) A company has determined that this is a production function is:

Q = 20l k

wherel is the number of man-hours per month and k is the capital (expressed in GHȼper

Month) required for monthly production of Q units of its products.

Determine:

(i) The marginal productivity of labor

(ii) The marginal productivity of capital.

Where l = 512 hours and k = GHȼ256

Question 3

A monopolist is practicing price discrimination in the sale of his product by charging different
prices in two separate markets.

In market A, the demand function is PA = 100 - qA and in market B, the demand function is

PB= 84 - qB, where qA and qB are the quantities sold per week in A and B and PA and PB are the
respective prices per unit in Ghana Cedis.

If the monopolist’s cost function is

C = 600 + 4(qA + qB)

Where C is given in Ghana Cedi,

(i) How much should be sold in each market to maximize profit?

(ii) What selling price per unit would give this maximum profit?
(iii) Find the maximum profit.

70
Question 4

A manufacturer intends to introduce a new revolutionary product on Ghanaian market. At the

business planning stage, her financial analyst estimated the sales of products would be dependent
on the amount of money spent on product development and promotion, according to the
function:

S= 50x y

Where S represents sales (in GHȼ 000)

X represents amount spent on product development (in GHȼ 000)

y represents amount spent on promotion (in GHȼ 000)

If the manufacturer has GHȼ80,000 to spend on development and promotion of products, advise
her on how to allocate the funds between product development and promotion in order to
generate the highest possible sales.

What is the highest sales figure?

Question

Your firm has undertaken an investigation for a client company and has discovered that its total
cost function is given by:

TC = -

Where TC is the total cost (in GHȼ 00)

X is the number of units produced and sold

The total revenue function has also been estimated as:

TR = 200x -

Where TR is the total revenue (in GHȼ 00)

71
 X is the number of units produced and sold.

i. Obtain the profit function

ii. Determine the output level that will maximize profit
iii. Give the price per unit that should be charged for maximum profit
iv. Compute the maximum profit
v. Estimate the price elasticity of demand at the output level that maximizes profit.
Interpret your answer.
vi. Determine the output tax per unit that will maximize tax revenue for government.
vii. If, as a regulatory device, the government imposes a tax of GHȼ22 per unit on the
monopolist, discuss the effects of the imposition of this output tax per unit.

PARTIAL DIFFERENTIATION

Partial differentiation is differentiation involving two or more independent variables.

Eg f = f (x, y, z)
Partial differential of function with respect to x is the differential of function with respect to x
keeping all other independent variables constant, denoted by
F
x
Similarly, partial differential of function with respect to y is the differential of function with
respect to y, keeping all the variables constant
Mathematically, for the function f (x,y),

f f  x  , y   f  x , y 
 lim
 x  x 0 x
f f  x, y  y   f  x, y 
 lim
 y y  0 y

72
Note

f    f   2y
fx  , f xx   
x  x   x   x 2

f   f  2f
fy  , f yy   
y  y   y   x 2

  f  2 f
f xy    
y  x  yx

  f  2 f
f yx   
x  y  xy

Example
Find fx, fxx, fy fyy, fxy, fyx of the following

F = x5 y4 – 3x4y3 + 7x3 + 2y2 – 3xy + 4

Solution
F = x5 y4 – 3x4y3 + 7x3 + 2y2 – 3xy + 4

 f 
f x   = 5x4y4 – 12x3y3 + 21x2 – 3y
 x 

 2 f    f  
f x x  2    = (5x4y4 – 12x3y3 + 21x2 – 3y)
 x  x x
  x


= 20x3y4 - 36x2y3 + 42x

Solution

q A 1000  50 p A  2 PB
q A
2  positive
pB
qB 500  4 PA  20 PB
qB
4  positive
PA
Products A and B are competitive.

Maximum and minimum Points (extrema)

a) Necessary conditions for extrema

73
 f f
0, 0 etc.
x y

Solve the resulting equations for x

b) Sufficient condition for extrema

  2 f    2 f   2 f 
When  2  2      positive
 x   y   xy 

 2 f   2 f 
When  2   positive ,  2   positive
 x   y 
We a have minimum point

 2 f   2 f 
(ii)  2   Negative ,  2   Negative , we have a maximum point
 x   y 

Example

The production function, Q, of a firm is given by

2 3 2 3
Q=0.54 -0.02 + 1.89 -0.09

Where L, K are the amount of labour and capital respectively and Q is quantity of output
production

Find the amount of L and K that will maximize output.

Solution

Q=0.54l2 – 0.02l3 + 1.89 2

- 0.09 3

74
 2
= 1.08 - 0.06 =0

= {1.08 – 0.06 } =0

Either =0 or

1.08 – 0.06 =0

0.06 =1.08

= =18

2
=3.78 – 0.27 =0

= {3.78 – 0.27K} = 0

Either = 0, or 3.78 – 0.27 =0

0.27 = 3.78 or

= = 14

i.e. = 0 or = 18

75
and

= 0 or = 14

= 1.08 – 0.12L

When = 18

= 1.08 – 0.12(18)

=1.8 – 2.16 = -1.08 = Negative

= 3.78 – 0.54

When = 14

=3.78 – 0.54(14)

=3.78 – 7.56

= -3.78 = Negative

1
= = x3

76
 1 13  1
= 3x

= = =

Maximization and Minimization

A necessary condition for extreme

(Maximization and minimization point).

Take and set equal to zero

i.e. =0

Solve the resulting equation for x, called stationary values.

A sufficient condition for extreme

Take and substitute stationary values

If = positive, we have a minimum point.

If = Negative, we have a maximum point.

= -3 +7 +2 -3 +4

77
 = =4 -9 +4 -3

= ={ 4 -9 +4 -3 }

= 12 - 13 +4

= ( )= {5 -12 + 21 -3 }

= 20 - 36 –3

= ( )= {4 -9 +4 –3 }

= 20 - 36 –3

Some Application

Competitive and Complementary Products

Given the demand and for products A and Band their respective price limit

and products A and B are competitive when

= positive, = positive

78
 for complementary product,

= negative, = negative

Example

The following are the demand functions for products A and B respectively

= 1000 - 50 +2

= 500 + 4 - 20

Determine whether A and B are competitive or complementary

i.e =18 and =14 will maximize output, therefore for maximum output

Amount of labour =18

Amount of capital =14

Constrained Optimization

Consider a non-linear function of the form which we wish to maximize

(minimize), subject to the constraints:

etc

We form the lagrangion, , by subtracting multiples, , of the constraints from the original
function.

79
 Take , , , etc.

Solve the resulting equation for , etc.

Note λ, etc are LAGRANGE MULTIPLIERS

Example

A firm has an order for 200units of its products and wishes to distribute their
manufacture between 2 of its plant; plant 1 and plant 2; the total cost function is given by:

C=

Where = output of plant 1

= output of plant 2

How should the output be distributed to minimize cost?

Solution

Minimize C

Subject to

80
Or

ie

Or

Or

Equate ① and ②

81
Or

Substituting ③ into ④

Ie becomes

plant 1 should produce 50 units and

Plant 2 should produce 150 units

Marginal Productivity

Example

A B C company is the manufacturer of a popular product the company has determined that it
productive function is

, where l is the number of man hours per week and k is the capital (expressed in
cm per week) required for a weekly productions of Q times of the product.

Example

Determine the marginal productivity of

I. Labour
II. Capital

82
 For the case when

Solution

When

i.e Marginal Productivity of labour = 0.1

When

83
Example

The production function of a company is given by:

2

Where
Q is the quantity (in units) produces

L is the amount of labour employed

K is the amount of capital employed

The costs to the firm of labor and capital are respectively GH₵2m per unit and GH₵3m per unit.
If the budgetary constraint is GH₵30m, find the amount of labor and capital that will maximize
output. What is this maximum output?

Maximize

Q = 60l + 30k – 212 – 3k2

Subject to
2l + 3k = 30 – Budget constraint
2l + 3k – 30 = 0
Using langrage to maximize
L = 60l + 30k - 2l 2 - 3k 2 -  (2l - 3k - 30)
Differentiating partially with respect to labour capital and, we have
L L
0, 0
l k
L
60  4l  2 0
l
60  4l  2 0
L
30  6k  3 0
k
30  6k  3 0
3 =30-6k
Dividing both sides by 3
 10  2k -----------2
Dividing both sides by 2
 30  2l ---------------1

84
L
 2l  3k  30

 2l  3k  30 0
2l  3k 30 -----------3
Grouping the like terms
 30  2l -------------1
 10  2k ------------2
Combining equation one and equation two, then we have:
Equation 1 = Equation 2
10  2k 30  2l
2l  2k 30  10
2l  2k 20...........4
Using simultaneous equation to eliminate the l from the equation
5k 10
K= 2
Put k = 2 into equation 3
2l + 3k =30
2l + 3(2) = 30
2l + 6 = 30
2l =30-26
2l =24

l 12

Maximum output.
Q=60l + 30 k – 2l2 – 3k2
Substituting l = 12 and k=2 into the output function them we have
Q = 60(12) + 30(2) – 2(12)2 - 3(3)
Q = 720 +60 -288-12
Q= 480units
Question

1. . A manufacturing company has two production facilities that manufacture a product.

Production costs at the two facilities differ because of varying labour rates, type of
equipment, among others. The joint-cost function for the company is:

TC = x12 – 14x1 + x22 – 16x2 + 113

Where

85
 TC is the joint cost in (GHȼ)
x1 is production volume (in units) at facility 1.
x2 is production volume (in units) at facility 2.

The number of units of the product that can be produced at the two facilities is
constrained by the fact that there are only 12 units of the raw material that is used in the
production of the product.

Facility 1 requires 2 units of the raw material per unit produced and
Facility 2 requires 3 units of the raw material per unit produced.
i. Develop a mathematical model that can be used to determine the number of units
to produce at each facility.
ii. Find the solution to your mathematical model to determine the optimal number of
the product to produce at each facility.
iii. Give the minimum joint cost.

Question

. A firm’s profit function is given by

= 600 – 3x2 – 4x + 2xy – 5y2 + 48y
where
x denotes numbers of units of Product X produced
y denotes number of units of Product Y produced
denotes profit (in GHȼ)

The number of units of each product that can be produced in the next planning period is
constrained by the fact that there are only 5 units of an ingredient that is used in the
production of both products, available. One unit of Product X requires 2 units of the
ingredient and one unit of Product Y requires 1 unit of the ingredient.

i. How many units of each product should be produced to maximize profit for the
firm?
ii. Determine the firm’s maximum profit.

86
PROBABILITY THEORY

Definition

An experiment is any operation whose outcome cannot be predicted with certainty. For example,
tossing of a coin or throwing of a die is an experiment since the outcome is not certain.

An experiment is a process that, when performed, results in one and only one of many
observations. Examples of an experiment include rolling a die, flipping a coin, and choosing
a card from a deck of playing cards. These observations are called the outcomes of the
experiment. The collection of all outcomes for an experiment is called a sample space.

Suppose we randomly select two persons from the members of a club and observe whether the
person selected each time is a man or a woman. Write all the outcomes for this experiment. Draw
the tree diagrams for this experiment.


First Second Final
selection selection outcomes

MM
M

M
W MW
M WM
W

W WW
(b)

87
Example: Toss a coin thrice and describe the sample space using a tree diagram

An event is a collection of one or more of the outcomes of an experiment. For example, the
event of rolling an odd number with a die consists of three simple events {1, 3, 5}. An
event with more than one outcome is called a compound event.

There are 2 main definition of probability, namely classical and relative frequency.

Classical (or priori) definition

Suppose there are outcomes favorable to the occurrence of an event and outcomes

unfavorable to the occurrence of the event the total number of possible outcomes is .

The probability that an event occurs (also known as the probability of a success) is denoted by P,
when

Or similarly the probability that an event does not occur (also referred to as the

probability of failure), denoted by q is

88
Or

Properties of classified probability

Properties of classified probability

a) There are 2 mutually exclusive outcomes

b) Outcomes are equally likely
c) Outcomes are collectively exclusive
d) Relative frequency definition

e) Suppose there are successes in independently repeated trials the long term

profitability of a success is the relative frequency, denote by p,

Definitions
Sample Space
The set of all possible outcomes of an experiment e.g. Toss a coin three times.
The sample space is denoted by

(i) Joint Probability

Involves two or more classifications
Eg. Given two events A and B, the probability that they will occur is their joint
probability given by
P(AB), or P(A and B), or P(A ∩ B).

89
 (ii) Marginal Probability
Involves only one classification
Eg. Given two events A and B, the probability that A will occur denoted by P(A)or
probability that B will occur is denoted by P(B) is a marginal probability.

(iii) Conditional Probability involves dependent events. It is the probability that an event will
occur GIVEN THAT (denoted by a forward slash,/) another event has occurred. It is given by

So conditional probability of A given B is

Conditional probability of B given A is

Statistical dependence and independence

Independence
If A and B are independent the occurrence of one does not influence the occurrence of
the others. In this case,

Dependence
If they are dependent, the occurrence of one influences the occurrence of the others.
In this case,
A depends on B

B depends on A

Basics Laws Of Probability

a. Multiplication Law
(i) Independent Events
If A and B are independent events;

90
 (ii) Dependent Events
If A and B are dependent events,

b. Additional Law
(i) If A and B are independent events,

(ii) If A and B are mutually exclusive events,

Bayes’ Theorem
Given a compound event made up of 2 simple mutually exclusive events A and B, and
given another event D, Bayes Theorem states that;

Or

Tree Diagram
It is used to solve a number of probability questions. If it is used to solve pure probability questions, it is
a PROBABILITY TREE. On the other hand, if it is used to make decisions, it is a DECISION TREE.
An example of such a diagram is shown below

Example 1

A company employs 100 persons: 75 men and 25 women. The Accountancy department provides
jobs for 12% of the men and 20% of the women. If a name is chosen at random from the
Accountancy department, what is the probability that she is a woman?

Solution
91
Example 2

A manufacturer purchases two machines A and B. The probability that A will last five years is
4/5 and the probability that B will last 5 years is ¾. Find the probability that

a. Both machines will not last 5 years

b. Only one machine will last 5 years
c. Only machine A will last 5 years
d. At least one machine will last 5 years

Solution

Let:

A = machine A lasts 5 years

B = machine B lasts 5 years

A̕= machine A does not last 5 years

B̕= machine B does not last 5 years

92
 a.

b.

c.

4 1 1
= x 
5 4 5

d.

Example 3

The probability that a construction job will be finished on time is 3/5, the probability that there
will be no strikes is 2/3, and the probability that the job will be finished on time given that there
are no strikes is 4/5. What is the probability that

a. The job will be finished on time and there will be no strike.

b. There will have been no strikes given that the job is finished on time?

Solution

93
Let A = job finished on time

B = no strikes

a.

b.

Example 4

An analyst believes that the stock market has 0.75 probability of going up in the

next years if the economy should do well, and a 0.3 probability of going up if the

economy should not do well during the year. The analyst further believes there is a

0.8 probability that the economy will do well in the coming year.

(a) What is the probability that the stock market will go up next year based on

his assessment?

(b) Given that the stock market will not go up, what is the probability that the

economy will do well next year?

94
 0.75
Mkt going up

Mkt not going up

doing well
0.8 0.25
Economy Mkt going up
0.3
Economynot
doing well
Mkt not going up
0.2
0.7
a.

b.

95
 (a) There are three insurance companies in the Business District in Accra. It is known
from previous records that each year, 2 percent, 5 percent and 3 percent of those
insured by companies A, B and C respectively submit claims. 20 percent of the people
in the community have an insurance policy with company A, 30 percent with
company B and 50 percent with company C.

i. What is the probability that a randomly selected insurance policyholder in the

community did not submit a claim in a certain year?
ii. If a randomly selected policy holder in the community is found to have made a
claim in a certain year, what is the probability that, that person is insured with
company A?

SOLUTION TO THE PROBLEM

Let A=Insurance company A

Let B=Insurance company B

Let C= Insurance company C

P(A) = Probability that the people insured with company A

P(B) = Probability that the people insured with company B

P(C) = Probability that the people insured with company C

96
P(A) = 20%= = 0.2

P(B) = 30% = = 0.3

P(C) = 50%= = 0.5

Let S = those who submitted claims

P(S/A) = probability that those who submitted claims from company A

P(S/B) = Probability that those insured by company B, submit claims

P(S/C) = Probability those insured by company C, submitted claims

P(A) = 2% = 0.2

P(B) = 5% = 0.5

P(C) = 3% = 0.3

0. 02
( S/ A)
P
P(SI/C), 0.98
0.2
A,

B, 0.3 P(S/B), 0.05

P(S I/C
), 0. 95
C,
0.5 P(S /C), 0.0 3

P( S I
/C) ,
0.9
7

97
(i) P(S1) = Probability that a randomly selected insurance policyholder in the
community did not make a claim in a certain year?
P( ) = P( ) + P( ) + P( )
= 0.2 x 0.98 + 0.3 x 0.95 + 0.5 x 0.97
= 0.196 + 0.258 + 0.485
P( ) = 0.966

(iii) P(A/S) =

P(A/S) = 0.1176

Mathematical Expectation

Consider the real values , , … of a discrete random variables x, with respective

probabilities, f( ),f( ),...f( ). In a tabular form we have

Random
variable …………………

Probability
f( ) f( ) f( ) ………………… f( )

98
 The expected value, E( ) and the variance V( ) of the random variable are

E( ) =

V( ) = f( )

NB
The expected value of the random variable is the same as the mean, of the random variable ie

E( ) = where is the Greek letter pronounce MU.

Example 1
A developer of computer games is planning a major investment. The profit from this
investment is a random variable, , where distribution is estimated in the following table

Profit (m) 0 100 150 200

probability 0.1 0.5 0.2 0.2

Find the mean profit and the standard derivation of profit.

Solution√

Mean, E( ) =

Variance, V( ) = f( )

f( ) f( )

0 0.1 0 1440

100 0.5 50 200

150 0.2 30 180

200 0.2 40 1280

99
Ie mean profit, = 120

Variance, V( ) = 310

Standard deviation of profit = = 55.7

Example 2

As the financial analyst of a certain company, you decide which of two new products to
introduce next year. The market research group of the company has given you the following
probability distributions of the net profit of each product.

Product A net profit Product A probability Product B net profit Product B probability
0 0.1 0 0.2

100 0.3 100 0.4

200 0.3 200 0.3

300 0.2 300 0.1

400 0.1

a. Compute the expected value and the standard deviation of net profit in each product.
b. Based on your calculations which product would you introduce if you are risk averse?

Solution

Product A

f( ) f( ) f( )

0 0.1 0 3610

100 0.3 30 2430

200 0.3 60 30

100
 300 0.2 60 2420

400 0.1 40 4410

Therefore, = 190

Standard deviation = √12900 = 113.58

Product B

f( )

0 0.2 0 3380

100 0.4 40 360

200 0.3 60 1470

300 0.1 30 2890

Therefore, = 130

Standard deviation = √8100 = 90

a. For product A,
Expected profit = 190
Standard deviation of profit = 113.58

For product B
Expected profit = 130
Standard deviation of profit = 90

101
b. Co-efficient of variation =

For product A,

Co-efficient of variation =

For product B,

Co- efficient of variation =

Question
As Management Accountant of a certain company you must decide which of the two new
products to introduce next year. Your Research Group has given you the following
probability distributions for the net profits of each product:

PROJECT A PROJECT B

Net Profit P(Net Profit) Net Profit P(Net Profit)

(GH₵000) (GH₵000)

200 0.2 0 0.4

0 0.3 100 0.3

200 0.3 200 0.2

500 0.2 300 0.1

i. Find the expected net profit and standard deviation for each product.
ii. Based on your calculations which product would you introduce assuming
you are risk adverse?

(b) As corporate affairs manager of a company, you are considering two investment
alternatives for expanding the company’s core business. The expansion covers four
metropolitan areas of the country. The net profit for identical periods and probabilities
of success of investment A and B are given the following table.

102
 Investment A Investment B

Net Profit (GH₵) Probability of Net Profit (GH₵) Probability of

Return Return

700 0.4 1,100 0.3

800 0.3 1,200 0.5

900 0.2 1,300 0.1

1000 0.1 1,400 0.1

i. Determine the expected net profit and standard deviation of net profit for
each investment?
ii. Based on your calculation, recommend to the board of directors of the
company, the investment that should be risk averse

Investment A
Let net profit = x

x P(x) xP(x) x-800

x-

700 0.4 280 -100 10,000 4000

800 0.3 240 0 0 0

900 0.2 180 100 10,000 2000

1,000 0.1 100 200 40,000 4000

10000

Expected net profit for investment A is

E(x) = or E(x) = ∑ xp(x)

E(x) = or 800

= 800

103
Variance of A V(x) = ∑ (x- )2P(x)
V(x) 1000
Standard deviation =

S.d =

S.d =
In order to determine the best investment you have to calculate coefficient of variation
coefficient of variation for investment A

C.V=

C.V=

= 0.125%

104
Investment B
Let x=Net profit
P(x) = probability of x

x P(x) xP(x) x-

1,100 0.3 -100 -100 10,000 3000

1,200 0.5 600 0 0 0

1,300 0.1 130 100 10,000 1000

1,400 0.1 140 200 40,000 4000

V(x)=800

Expected net profit for investment B

Standard deviation of investment B
S.d =

S.d =
S.d = 89.44
Coefficient of variation

C.V = x 100%

C.V = x 100%

= 7.45%

iv. Investment B should be chosen because it has smallest coefficient of variation.

105
Normal Distribution

Has a probability density function given by:

Where δ =standard deviation, SD

e = 2.7183

The parameters for the normal distribution are

It is a continuous distribution having the following properties: (a) Its

probability curve is bell-shaped.
(b) Its mean, mode, and median are equal and located at the centre of the
distribution.
(c) It is a unimodal distribution.
(d) The curve is symmetrical about the mean. Thus it has same shape on both sides of a
vertical line drawn through the centre.
(e) The curve never touches the horizontal axis or mathematically it touches at infinity.
(f) The total area under the curve is equal to 1.0.

Properties of the Normal Distribution

a. The normal curve is bell shape

b. The curve is symmetrical about the mean
c. Total area under the normal curve is one (1)

Ie

0.5

0.5

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To be able to use and distribute tables, the normal distribution whose variables x has units to be
converted to the standardized normal whose variable z had no units using the transportation equation.

Where z is the z-size or the standard normal deviation

The long-distance calls made by executives of a private university are normally distributed
with a mean 10 minutes and a standard deviation of 2.0 minutes. Find the probability that a
call:
(a) Lasts between 8 and 13 minutes
(b) Lasts more than 9.0 minutes
(c) Lasts less than 7 minutes.

A standardized normal distribution has mean 1

107
Example
The weekly wages of employees are normally distributed about a mean of 100,000 with a
standard deviation of 10,000
a. Find the probability that an employee having a weekly wage
i. Between 95,000 and 130,000
ii. Over 1200,000
iii. Under 80,000
iv. Between 111,250 and 122,500
b. What is the minimum weekly wage received by 20% of wage earners?

Solution

a. i. between 95,000 to 130,000

0.15 0.4987

95000 100,000 130,000

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 -0.5 0 3

N.B

Area required is the shaded region

P(between 95000 and 150000) = 0.1915 + 0.4987

= 0.6902

Over 112,500

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 100,000 112,500

The shaded region is the required area

0.3 because minimum will be Between x to the mean ie

100,000

0.3

0.2 x 100,00

From the stats table, z with an area of 0.3 = 0.84

Substituting, we have

Therefore minimum wage = 91,600

Example

A firm has a machine which turns metal cylinder plugs. The machine is known to operate with a Standard
deviation of 0.001cm. To turn plugs with a mean diameter of 3cm but the plugs must be within the
tolerance limits of 2.998cm. Diameters are normally distributed

What proportion of the output produced to meet this order would fail to meet the tolerance limits?

110
 a) Any plug that fails to meet the tolerance limits is rejected at a cost of

1000. If the company

produces 100,000 plugs, what is the expected total of rejects?

Solution

Acceptable

2.998 3 3.002 x

-0.2 0 2 z

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{0.5 because under 50,000}

50,000 100,000

When

Iv between 111250 and 122500

0.4878

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 100,000 111,250 132,500

1.13 2.25

When

a.

Therefore

b. Expected number of rejects = 100,000 × 0.0456 = 4560

Expected cost of rejects = 4560 × 1000 = 4,560,000
1. a. A machine packs ‘half-kilo’ bags of flour. The weights of the bags are
normally distributed with mean o.51kg and standard deviation 0.008 kg.
i. What percentage of the bags is underweight?

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 ii. New trade regulations permit at most 5% of bags to be underweight. If the
machine is to comply with regulations, find the lowest value to which the
firm could set the mean weight, if the standard deviation remains unchanged.

iii. To meet the trade regulations in b (ii) above, the company decides to adjust
the machine so as to alter the variability of weights, while leaving the mean
weight at 0.51 kg. What would be the maximum standard deviation of weight
following these adjustments?

2. A firm has a machine, which turns metal cylinder plugs. The machine is known to
operate with a standard deviation of 0.001cm. To meet an order, the machine is set
to turn plugs with a mean diameter of 3cm but the plugs must be within the
tolerance limit of 2.998cm to 3.002cm. Diameters turned are normally distributed.

i. What proportion of the output produced to meet this order would fail
to meet the tolerance limits?

ii. Any plug that fails to meet the tolerance limits is rejected at a cost of
GH₵1,000. If the company produces 100,000 plugs what is the
expected total costs of rejects?

Normal distribution

Mean µ = 0.51kg

Standard deviation, s = 0.008kg

Note: weight of the bag

Z=

Let x = weight of the bag.

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For under weights

x<µ

x = 0.5kg

0.5 0.51 x

0.5 0.51 z

x = 0.5

Z=

Z=

Z= -1.25

P(z<-1.25) = 0.5 – P(0<7≤1.35)

= 0.5 – 0.3944

= 0.1056 x 100%

= 10.56%

Let the lowest value = x

P(z ≤ x) = 0.05

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We need the z – value that correspond with the probability of at most 5 percent

Z= 0.05 0.45

-7 0
-1.64

The Z-value that corresponds with at most 5 percent is Z = -1.64. From the table substituting into
the equation

Cross multiply

-1.64 x 0.008 = x -0.51

-0.01312 = x – 0.51

-0.01312 + 0.51 = x

X = 0.49688

The mean weight should be, x=0.5 or x=0.49688

According to trade regulation the mean weight should be, x=0.49688

Z=

r = ? Z = -1.64, , x = 0.49688

Substituting the values

Cross multiply

-1.648 = -0.01312
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σ = 0.008

σ = 0.008 kg

the maximum standard deviation is

σ = 0.008kg

mean, , standard deviation, σ = 0.0010

Let x = cylinder plugs

Z=
acceptable

-2.998 3 3.002 x
-2. 0 2

When x = 2.998

Z=

Z = -2

When

Z = 3.002

Z=

Z=

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Z=2

From the table

P(0 ≤ z ≤2) = 0.4772

P(0 ≤ z ≤ 2) = 0.4772 + 0.4772

= 0.9544

P(meet tolerance limit) = 0.9544

P(fails to meet limit) = 1 – 09544

= 0.0456

The quantity that fails to meet the tolerance limit = 4.56%

ii. The quantity that fails to meet the tolerance limit = 0.0456 x 100,000

= 4.560

The expected to cost that fail to meet the tolerance limit = 4.4560 x GH¢1000

= GH¢4,560,000

Regression analysis
A regression line can be established between two series of recorded figures such as
expenditure on advertising and volume of sales using the least square method.
i. What is meant by least squares?
ii. What practical use does such a regression line have?

b). A car rental company has a fleet of ten vehicles of similar type. The Management of the
company is investigating the relationship between the monthly cost of maintenance of these
vehicles and their age. The record of maintenance cost and age of vehicle is provided below:

Vehicle 1 2 3 4 5 6 7 8 9 10

Age (month) 5 10 15 20 30 30 30 50 50 60

Maintenance 190 240 250 300 310 335 300 300 350 395
Cost (GH₵)

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 i. Find the least square regression line of maintenance cost on age

ii. Give the practical meaning of the regression equation obtained in (i) above to
a colleague who is not trained in Statistics

iii. Estimated the maintenance cost for a vehicle of this type which is 40 months
old.

iv. Compute the product-moment correlation co-efficient and interpret your

answer.

v. Comment on the reliability of your forecast obtained in (iii) above

Least square mining the sum of the squares of the errors of the regression line
It is used for forecasting
b. It is used to show the relationship between two or more variables
Let x = Age (in month) of the vehicle
Let y = maintenance cost.
Suppose the regression line has equation
Y = a + bx

Where a =

x y xy

5 190 950 25 36100

10 240 2400 100 57600

15 250 3750 225 62500

20 300 6000 400 9000

30 310 9300 900 96100

30 335 10050 900 112225

30 300 9000 900 90000

50 3000 15000 2500 90000

50 350 17500 2500 122500

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60 395 23700 3600 156025

From the table

b=

Substituting

b=

b=

b=

b = 2.7868
b = 2.80

a=

a=

a=

a=

a = 213
Regression equation is:
Y = 213 + 2.8x
ii. when the value is new, x=0 the maintain cost GH¢213
The maintain cost would increase by GH¢2.8 as the car grows older
iii. when x=40

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y = 213 + 2.8 (40)
y = 213 + 112
y = 325
Maintenance cost at age 40 months = GH¢325
iv. Product moment correlation coefficient
n xy   x y
r
 2

n x 2    x  n y 2    y 
2

r=

r=

r=

r=

r= 7444
r = 0.87

Interpretation
There is a strong positive relationship between and the age of the vehicle. As the vehicle
grows older, maintenance cost increases
v. reliability can be obtained by using coefficient of determination = r2
r2 = (0.87)2
r2 = 0.7569 x 100%
The forecast is fairly accurate because age contribute 77% and the rest age due to their
factors

Question

Explain the connection between regression analysis and correlation theory and briefly
indicate how the latter may be measured.

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 b) The Ministry of Local Government set up a committee four years ago when it was
deciding to purchase new office equipment. The following data show the estimated
current value of this office equipment compared with the purchase price provided by
the Entity Committee.

Equipment A B C D E F G H I J

Purchase
Price
(GH₵00) 24 26 21 23 22 19 18 17 15 16

Current
Value
(GH₵00) 35 33 31 29 25 24 23 21 20 19

i. Obtain the equation of the least squares regression line of current value on
purchase price.
ii. Determine the product-moment correlation coefficient and interpret your
answer
iii. Estimate the current value for items of equipment which has purchased
values of GH₵2,000
iv. Discuss the likely accuracy of your estimates in (iii) above.

Question 2

The following data show the output and the expenditure on energy for a firm over a period of 10
months:

Expenditure 102 138 158 172 102 142 184 102 164 192
(GH₵)

Output (000 20 22 25 26 20 23 28 20 25 29
units)

122
(i) Find the least squares regression equation of energy expenditure on output.
(ii) Estimate the energy expenditure if the following month’s output is planned at 30,000
(iii) Calculate the product-moment correlation coefficient

Comment on the reliability of your forecast

123