CHAPTER -3 MATRIX ALGEBRA AND ITS

APPLICATIONS
A matrix is a rectangular array of numbers, parameters, or

variables each of which has a carefully ordered place

within the matrix.
The numbers (parameters or variables) are referred to as
elements of the matrix.
It is customary to enclose the elements of a matrix in
parentheses, brackets, or braces to signify that they must be
considered as a whole and not individually.
 Cont..
A matrix is any rectangular form of numbers
arranged in rows and columns.
Columns of a matrix are numbered from top to
the bottom &
Rows of a matrix are numbered from left to
right. Matrices are used to represent and
manipulate data in a structured way, making it
A general matrix of order m x n is written as:
a11 a12............... a1n
A= a 21 a22 ............... a 2n

am1 a m2....................amn
If a matrix has m rows and n columns thus, m by n is called order (dimension) of a matrix
In matrix A, the subscript numbers represents the row and the column on which an entry (member) is located. On the
matrixA , from the above example;
a11 means, ‘a’ is located on the first row and first column of matrix A,
a21 means ‘a’ is located on the second row and first column of matrix A,
amn means ’a’ is located on the mthrow and nthcolumn.
 Example:

a11 a12 a13

A= a 21 a22 a 23
a31 a 32 a33
Here A is a general matrix composed of 3x3 = 9 elements,
3x3 arranged in three rows and three columns.
The elements all have double subscripts which give the address or placement of the element in the matrix; the first
subscript identifies the row in which the element appears and the second identifies the column. For instance
a23 is the element which appears in the second row and the third column and a32 is the element which appears in the
third row and the second column.
  Dimensions and Types of Matrices

Dimension of a matrix is defined as the number of rows and columns.

Based on their dimension (order), matrices are classified in to the following types:
 Vector Matrix: - Matrices with only one row or one column. These matrices can also be referred to
as row and column matrices.
A row matrix: is a matrix that has only one row and can have many columns.
E .g.A = 2 5 7 is a row matrix of order 1x3.
A column matrix: is a matrix with only one column and can have many rows.
E.g. B = 1
2
6 is a column matrix of dimensions 3x1
  Square matrix: is a matrix with equal number of rows and columns.
1 4 3
E.g. D = 2 6 2 2 5
3 8 ; E= 8 6 9
 Diagonal matrix: is a square matrix where it’s all non- diagonal elements are zero.
E.g. x= 2 0 0
0 6 0 is a diagonal matrix of order 3x3.
0 0 11
 Unit matrix (Identity matrix): is a type of diagonal matrix where its main diagonal elements are
equal to one while the other elements equal to Zero.
1 0 0
E.g. B = 0 1 0
0 0 1 -
 Scalar matrix: a square matrix is called a scalar matrix if all its non- diagonal elements are zero and
all diagonal elements are equal.
E.g. Y = 2 0 Z= 6 0 0
0 2 0 6 0
0 0 6
 Null matrix (zero matrix): a matrix is called a null matrix if all its elements are zero.
0 0 0
E.g. A= 0 0 0
0 0 0

 Equal Matrix: two matrices are equal, if and only if, they have the same order and each entry in one
matrix is identical with the corresponding entry of the other matrix. For two matrices to be equal,
they must be of the same size and have all the same entries in the same places.
E.g. Y = 1 2 Z= 1 2
3 4 3 4
 Cont.…

 t
Symmetric matrix: a matrix is said to be symmetric if A = A .

E.g. A = 8 2 1
2 3 4
1 4 5
N.B: Every scalar matrix is a diagonal matrix; whereas a diagonal matrix need not be a scalar matrix. Every unit
matrix is a scalar matrix; whereas a scalar matrix need not be a unit matrix.
 MATRIX OPERATIONS AND PROPERTIES
 Matrix equality: two matrices are said to be equal if and only if they have the same dimension and
corresponding elements of each matrix are equal.
3 0 3 -4 3 0
E.g. A= 1 -4 B= 1 0 C= 1 -4
a. A ≠B; A = C; B ≠C.

 Transpose of a matrix: If the rows and columns of a matrix are interchanged the new matrix is known as the
transpose of the original matrix. If the original matrix is denoted by A, the transpose is denoted by A or At.
Transposition means interchanging the rows or columns of a given matrix. That is, the rows become columns and
the columns become rows.
E.g B=3 5 6 9
0 11 13 8
6 8 3 4
The transpose of matrix B, denoted by B' or Bt is given as:
3 0 6
Bt = 5 11 8
6 13 3
9 8 4
The dimension of B is changed from 3x4 to 4x3.
4x3.

A= 1 3 A = 1 0 2
0 4 3 4 8 (2x3)
2 8 (3x2)
Properties of the transpose
The following properties are held for the transpose of a matrix:
 Property 1: (A ) =A
tt
 Addison and subtraction of matrices: Two matrices A and B can be added or subtracted if and only if they have
the same order, which is the same number of rows and columns. That is, the number of columns of matrix A is
equal to the number of columns of matrix B, and the number of rows of matrix A is equal to the number of rows
of matrix B. Two matrices of the same order are said to be conformable for addition and subtraction. The sum
and subtraction of two matrices of the same order is obtained by adding together or subtracting corresponding
elements of the two matrices.
If A= (aij) and B= (bij), then C = A+B is the matrix having a general element of the form; Cij = aij + bij. D = A-B → Cij
= aij - bij .
Example:
A= 2 0 B= 3 6
-5 6 4 1

2+3 0+6 5 6

A+B = -5+4 6+1 = -1 7

1 5 10 2
If A= 6 7 B=
8 9 8 6

A+B is not defined, since orders of A and B are not the same
Properties of matrix addition
a. Commutative law: A+B = B+A
b. Associative law: (A + B) + C = A + (B + C)
c. Existence of identity: A+ 0 = 0 + A = A.
NB:The subtraction (difference) of two matrices of the same order is obtained by subtracting corresponding elements.
 A-B ≠ B-A, thus matrix subtraction is not commutative.
 (A-B) –C ≠ A- (B-C); matrix subtraction is not Associative.
  Matrix Multiplication
Two matrices A and B can be multiplied together to get AB if the number of columns in A is equal to the number of
rows in B

A B

nx s
mxn

Inner dimension
Outer dimension

a. If two matrices have the same inner dimension, then we can get the product of the matrices. The resulting matrix
will have a dimension equal to the outer dimensions of the two matrices. There are two types of matrix
multiplication: multiplication by a scalar and multiplication by a matrix.
i. Scalar multiplication: in this type of multiplication, we multiply the scalar by each element of the given matrix.
3 4 0

E.g. If B = 1 2 5
3 4 1

3 4 0 15 20 0
(5). B = (5) 1 2 5 = 5 10 25
3 4 1 15 20 5
Properties of matrix multiplication
Property 1: The distributive law is valid in matrix multiplications.
A (B+C) = AB + AC
(B+C)A = BA + CA
Property 2: The associative law is valid in matrix multiplication.
(AB)C = A(BC) = ABC
Property 3: If I is an identity matrix, then;
AI = IA =A
In general, as long as the order of the matrix is maintained, matrix multiplication is associative, but matrix
multiplication is not commutative except for:
 The multiplication of a matrix with an identity matrix;
i.e. A.I = I. A =A
 The multiplication of a matrix with its inverse;
i.e., A.A-1 = A-1.A = I
Example:
a. Interest at the rates of 0.06, 0.07 and 0.08 is earned on respective investments of $3000, $2000 and $4000.
1. Express the total amount of interest earned as the product of a row vector by a column vector.
2. Compute the total interest by matrix multiplication.
Solution:
Given: Let the interest rate matrix be I and investment matrix be B.
1) I = 0.06 0.07 0.08 (1x3 3000
B= 2000
4000 (3x1)
 Total interest = (Interest rate matrix) (Investment matrix) = I.B.
3000
I.B = 0.06 0.07 0.08 2000
4000
= (0.06x 3000) + (0.07x2000) + (0.08x4000) Total interest = 640 (1x1)
= $ 640
Example 2: Let a firm manufacturing office furniture finds that it has the following variable
costs, in dollars
Desk Chair Table Cabinet
50 20 15 25 Material
V= 30 15 12 15 Labor
30 15 8 20 Overhead
That is, the manufacture of each desk requires materials costing $50, labor costing $30, and overhead of $30. Each
chair requires material costing $20, and so on.
An order for 5 desks, 6 chairs, 4 tables, and 12 cabinets has just been received. This information is organized in a
column vector, as

5 Desks
Q= 6 Chairs
4 Tables
12 Cabinets
The total material, total labor, and total overhead cost associated with filling this order can be computed as follows:
50 20 15 25 5 730 Material
C = VQ= 30 15 12 15 6 = 468 Labor
30 15 8 20 4 512 Overhead
 1) TG Furniture Factory (3F) produces three types of executive chairs namely A, B and C. The
following matrix shows the sale of executive chairs in two different cities.
Executive chairs
A B C
C1 400 300 200
Cities
C2 300 200 100 (2x3)

If the cost of each chair (A, B and C) is Birr 1000, 2000 and 3000 respectively, and the selling price is Birr 1500,
3000 and 4000 respectively;
a. Find the total cost of the factory for the total sale made.
b. Find the total profit of the factory.
Solution:
Given: Let the quantity matrix be q
Let the price matrix be p
Let the unit cost matrix be v;
1. 400 300 200 1500 1000
q = 300 200 100 p= 3000 V = 2000
4000 3000
 Total cost = (unit cost) (Quantity)
= 400 300 200 1000
300 200 100 2000
3000

= 1,600,000
1,000,000
Total cost = Birr 1,600,000 + Birr 1,000,000 = Birr 2,600,000
  Total profit =Total Revenue - Total Cost
b)
Total Revenue = (price) (quantity)

400 300 200 1500

= 300 200 100 3000 .
4000
2,300,000
= 1,450,000
Total Revenue = Birr 2,300,000 + Birr 1,450,000 = Birr 3,750,000
Profit = Birr 3,750,000 – Birr 2, 600,000
= Birr 1,150,000
 Inverse of a Matrix
 In scalar algebra, the inverse of a number is that number which, when
multiplied by the original number, gives a product of 1.
 Hence, the inverse of x is simply 1/x; or in slightly different notation, x -1.
 In matrix algebra, the inverse of a matrix is that which, when multiplied by the
original matrix, gives an identity matrix.
 The inverse of a matrix is denoted by the superscript “-1”. Hence, AA -1 = A-1A
= I.
•Note that: A matrix must be square to have an inverse, but not all square matrices
have an inverse. The necessary and sufficient condition for a square matrix to
possess its inverse is that /A/ ≠ 0.
•Finding the inverse of a matrix requires the concept of row operations to be
performed. The row operations are the following:
  Multiply or divide a row by a non- zero constant;
If A = 2 3
6 9 multiply row one (R1) by -2 to get matrix B.
Then, B = -4 -6
a. 9
Divide row two (R2) by 3 to get matrix C. Then, matrix
C= 2 3
2 3
 Add a multiple of one row to another row;
If A = 1 2 multiply R1 by 2 and add to R2 to get matrix x.
3 4
Matrix X = 1 2
5 8
•N.B: The first row elements in the original matrix become second row elements in the new
matrix and vice versa.
•The most important methods to find inverse of a given matrix is the Gauss- Jordan Inversion
method
•GAUSS – JORDAN INVERSION
•It is a technique to compute (find) the inverse of a matrix, procedures to compute the inverse
of a square matrix
•1. Write the given matrix at the left `
•2. Augment an identity matrix that has the same dimension as the given matrix at the right
•3. Apply row operations to the two matrices until the left matrix becomes an identity matrix
•
Row operations may include;
(a) Multiplication or division of a row by a non-zero constant
(b) Addition of a multiplication of one row to a multiple of another row
(c) Inter changing two rows
Example- find the inverse of A using the Gauss- J ordan method.
A = 3 2
1 1
Solution
Steps:
1st: write the given matrix at the left and the corresponding identity matrix at the right;
3 2 1 0
= 1 1 0 1
N.B: corresponding identity matrix for 2x2 matrix is of dimension 2x2.

2nd : Interchange R1 and R2;

3 2 1 0 1 1 0 1
1 1 0 1 3 2 1 0
3rd: M ultiply R 1 by -3 and add the result to R 2;
-3 R 1 = -3 -3 0 -3
+
R2 = 3 2 1 0
0 -1 1 -3
The resulting matrix is given by:
1 1 0 1
0 -1 1 -3

4th: Simply add R 2 entries to R 1 entries;

R2 = 0 -1 1 -3
+
R1 = 1 1 0 1
1 0 1 -2
The resulting matrix is given by:
1 0 1 -2
0 -1 1 -3

5th: M ultiply R 2 by -1;

(-1) (R 2) = 0 1 - 1 3
The resulting matrix is given by;
1 0 1 -2
0 1 -1 3
Thus; the inverse matrix A, denoted by A -1 is given as:
A-1 = 1 -2
-1 3
Check! A.A =A . A =I
- 1 - 1

= 3 2 1 -2 1 0

1 1 -1 3 = 0 1
Example: Find the inverse of 2 2 3
B= 0 1 1
4 0 3

The resultant matrix is given by:

1 0 0 3/ 2 -3 -1/ 2
0 1 0 2 -3 -1
0 0 1 -2 4 1

Thus; 3/ 2 -3 -1/ 2
B -1 = 2 -3 -1
-2 4 1
 MATRIX APPLICATIONS
SOLVING SYSTEM OF LINEAR EQUATIONS

A system of linear equations can be solved by the

following two basic methods using matrix a
algebra:
a)The inverse method
b)The Gauss-Jordan method
A) The Inverse Method:
It is used to find the solution of linear equations when the number of equations is equal to the
number of variables (i.e. for square matrices only).
Consider the following system of linear equations:
a11x1+ a12x2+ a13x3 = b1
a21x1+ a22x2+ a23x3 = b2
a31x1 + a32x2+ a33x3 =b3
These equations can be expanded as:
a11 a12 a13 x1 b1
a21 a22 a23 . x2 = b2
a31 a32 a33 x3 b3
Matrix of coefficient column vector of column vector of
(A) Variables (x) constants (B)
 Therefore; AX = B
If we multiply the above equation by A-1, we get (A-1A) (x) = A-1B
 Cont..
If we find the inverse, we multiply it by vector B, and
the outcome will be the solution.
In total, in using the inverse method to find the solution
of linear equations:
1st Find the inverse of the coefficient matrix.
2nd Multiply the inverse with the column vector of
constants.
Example:
Solve the following equations using the inverse method.
a) 2x1 + 3x2 = 17
x1+ 2x2 =10
b) x+2y-3Z=11
3x+2y+Z=1
2x+y - 5Z=11
 Solution :
For a)

The resultant matrix is given by:

1 0 2 -3
0 1 -1 2
Thus, the inverse of the coefficient matrix is:
2 -3
-1 2
3rd Multiply the inverse by the constant matrix;
X= A-1B
X1 = 2 -3 17 = 4
X2 -1 2 10 3 Therefore, X1 = 4 and X2 = 3.
 Solution :
For b)
b) 1st write the expanded form;

1 2 -3 X 11
3 2 1 Y = 1
2 1 -5 Z 11

The final resultant matrix is given by:

1 0 0 -11/ 26 7/ 26 4/ 13
0 1 0 17/ 26 1/ 26 -5/ 13
0 0 1 -1/ 26 3/ 26 -2/ 13
3rd Multiply the inverse (A-1) with the constants matrix (B); i.e. X=A-1B;
X -11/ 26 7/ 26 4/ 13 11

Y = 17/ 26 -7/ 13 -5/ 13 * 1

Z -1/ 26 3/ 26 -2/ 13 11
x -1

y = 3 So, x = -1, y= 3, and z = -2.

z -2
 B)The Gauss-Jordan Method:

This method works through several operations to reduce a given

matrix of coefficients of a system equation in to an identity
matrix.
It is used to find the solution of linear equations:
i) When the number of equations (m) is equal to the number of
variables (n); i.e. m = n.
ii) When the number of equations (m) is greater than the number
of variables (n); i.e., m>n.
iii) When the number of equations (m) is less than the number of
variables (n); i.e., m<n.
It applies the concept of row operations both on the
coefficient matrix (A) and the column vector of constants (B)
in order to convert them to an identity matrix (I) and the
 Cont...
That is, (A/B)row operations (I/S)
Number of equations (m) equals number of variables (n)
The intention to convert (A/ B) to (I/ S) when the number of equations (m) equals the number of
variables (m) will result in:
 Unique solution if the coefficient matrix has an inverse.
 An infinite solution if the elements in the last row are all zeros including the constants’
column.
 No solution if there is a row that is all zeros except in the constants’ column.
 Example-1:
Solve the following system of two equations:
2x1 + 3x2= 5
x1 + x2 = 3

Solution for the above Questions

1 0 4
0 1 -1
As can be seen through several operations, we reduce the coefficient
matrix in to an identity matrix of dimension 2x2. The last column of
the above matrix is the solution for x1 and x2, respectively.
 Example- 2 X + Y =2
2X + 2Y =4
• …………………………………………………………………

The resultant matrix is given by:

1 1 2
0 0 0 ↔ Infinite solution since the last row entries are all zeros.
Notice that, no row operations can convert matrix A in to an identity matrix. So, no further
operation is required. The bottom row entries (all being zero) indicate the case of an infinite
solution.
Example-3 :
X+Y+Z=4
5X-Y+7Z=25
2X-Y+3Z=8
……………………………………………………………………………………………………
…………………………………………………………………………………………………….

The resultant matrix is:

1 0 4/3 29/4
0 1 -1/3 -5/6
0 0 0 -5/2 ↔ No solution

You have noticed that bottom row entries are all zeros except the constants’ column (which is -
5/ 2) resulting in no solution case
 ii) Number of equations (m) greater than number of variables (n)
The intention to convert  A / B  → I / S  will result either in:

1. An n by n identity matrix above m-n bottom rows that are all zeros,
giving the unique solution.
2. A row that is all zeros except in the constants’ column indicating that
there are no solutions.
3. A matrix in a form different from (1) and (2) indicating an unlimited
solution.
Example-1
2x1 -3x2 = 6
x1 +5x2 = 29
3x1 - 4x2 = 11
Solution:
1st → write the expanded form;
2 -3 x1 6
= 1 5 . = 29
3 -4 x2 11

2nd→ Apply row operations;

2 -3 6
1 5 29
3 -4 11

…………………………………………………………...

 4R2+R3;
1 0 9
0 1 4 ↔ Unique solution
0 0 0 Thus; x1 = 9, and x2 = 4
 iii) Number of equations (m) less than number of variables (n)
The attempt to convert matrix (A/B)  (I/S), when m
<n, will result either in:
1. A row which is all zeros except in the constant
column, indicating that there are no solutions.
2. A matrix in a form different from (1), indicating that
there are unlimited number of solutions.
Example;
4x1+ 6x2- 3x3= 12

6x1+9x2- 9/2x3= 20
 Cont.…
Solution:
1st→ 4 6 -3 12
6 9 -9/ 2 20
2nd→R1/ 4;
1 3/ 2 -3/ 4 3
6 9 -9/ 2 20
3rd→-6R1+R2;

1 3/ 2 -3/ 4 3
0 0 0 2 ↔ No solution case!
 Solving Word Problems
Steps:

1. Represent the unknown quantities by letters.

2. Translate the quantities from the statement of the

problem and form an algebraic expression; then, set

up an equation.

3. Solve the equations for the unknowns.

4. Check the findings as per the statement in the

problem.
 Example-1
A manufacturer produces two products p and q. Each unit of

product p requires in its production 20 units of raw material A

and 10 units of raw material B whereas each unit of product q

requires 30 units of raw material A and 50 units of raw material

B. There is a limited supply of only 1200 units of raw material A

and 950 units of raw material B. How many units of P and q can

be produced if the manufacturer is to exhaust the supply of raw

materials (to operate at full capacity).

 Cont.…
Solution:
Given: Raw materialsType of Products Availability
P q
A 20 30 1200
B 10 50 950
Step-1: Let x and y represent the number of units of product
P and q to be produced respectively at full capacity.
Step 2:Formulate the equations:
Raw material A: 20x+30y =1200  2x+3y =120
Raw material B: 10x+50y = 950  x+5y = 95
Step 3: Solve the equations:
 Cont..
Expanded form:
2 3 x = 120
1 5 . y 95
(A/ B) (I/ S)
2 3 120
1 5 95
 Interchange R1and R2;
1 5 95

.................................................................................

1 0 45
0 1 10
x = 45  x = 45 units
y 10 y = 10 units
Step -4: Cross- Checking
 20x+30y =1200 10x+50y = 950
20(45)+30(10) =1200 10(45)+50(10)=950
1200 =1200 950 = 950
 Example -2
Attendance records indicated that 1600 people attended a football
game and the total ticket receipt was 2800 birr. The admission price
was 1.50 birr for students and 2.50 birr for others. Determine the
number of students and non-students who attended the game.
Solution:
Given: Attendants Total
Students Non-students receipt
Admission price ……. 1.50 birr 2.50 birr 2800 birr
Number of People - - 1600
Step -1: Let S and N represent the number of students and non –
students who attended the same respectively.
Step- 2: Develop the equations;
Number of people: S+N = 1600
Receipt : 1.50 S+ 2.50 N = 2800
 Cont..
Step- 3: Apply the Gaussian method;
1 1 . S = 1600
1.5 2.5 N 2800
  A / B → I / S 

1 1 1600
1.5 2.5 2800
 -1.5 R1 + R2 ;
1 1 1600
0 1 2800

 -R2 + R1 ;
1 0 1200 Number of students(S) = 1200.
0 1 400 Number of non-students (N) = 400
 END OF THE CHAPTER
THANKYOU INADVANCE!!!
 CHAPTER- 4

INTRODUCTION
MATHEMATICS OF FINANCE
 Mathematics of finance is concerned with the analysis of time-value
of money.
 The fundamental premise behind such analysis is the concept that
entails the value of money changes overtime.
 Putting it in simple terms, the value of one birr today is not the
same after a year.
 Suppose, if you deposit Birr 1000 at a bank for some period, you will
find the sum grows to a higher sum at the time of withdrawal.
 The rationale behind is that the banks reinvest the deposits received at
some other profitable ventures and hence, it is using depositors’ money.
 As a result, it pays interest on depositors’
money as compensation.
 Thus, in one way or another as value of money
changes overtime we find a difference between
the present and future value of money.
 In sum, the difference arises because a rational
being is assumed to invest/use money available
on productive activity that result in a higher
future sum and, the difference between the
present and future value of money is referred to
as time-value of money.
 Mathematics of finance has an important implication
in organizations as transactions and business
dealings are mostly pecuniary(financial matters).
 Such matters as lending and borrowing money for
various purposes, leasing materials, accumulating
funds for future use, sell of bonds are some of the
cases that involves the concept of time value of
money, Likewise, finance mathematics is equally
important in our personal affairs.
 For example, we might be interested in owning a house, in
financing our educational fees, having a car, having enough
retirement funds etc.
 All these cases and others involve financial matter.
 In doing so, the unit is organized in to three main sections.
 The first section advances to our study of simple interest and, We
further explore about compound interest and annuities in the
second and third sections respectively
 SECTION ONE: - SIMPLE INTEREST

 Dear student, do you have any concept of interest? Please try

to define what interest is?

 In business, we usually pay some money for using services and

goods. Such payments go by various names.
 For instance, the money we pay for hiring a taxi is known as fare.
 The amount we pay for education is called tuition fee.
 Likewise, the cost we pay for electric consumption commonly
called electric charge.
 Back to our case, we also incur cost in using money for a certain
period.
 This cost is referred to as interest.
 Thus, interest is the payment made for use of the principal (money)
or a fee, which is paid for having the use of money.
 The amount of money that is borrowed or lent or invested or money
available at hand at the beginning is called the principal and denoted
by P.
 Interest is usually paid in proportion to the principal and the period of
time over which the money is used.
 The percent of the principal that is charged for the use of the principal
for a unit of time is called the rate of interest (interest rate, i).
 The length of time for which the principal is borrowed, lent or invested
is called the time or term of the loan and commonly how symbolized
by n(t).
 The future or maturity value, which is also denoted by F, is the sum of
the principal and all the interest earned.
Based on computation of the respective interest,
there are two types of interests. These are,

i. Simple interest: it is the return on a principal

amount for one time period.
[Link] interest: it is the return on a principal
amount for two or more time period, assuming that
the interest for each time period is added to the
principal amount at the end of each period and
earns interest on all subsequent periods.
 4.1.1 Simple Interest
 Interest that is paid solely on the amount of the principal P is called
simple interest.
 Simple interest is usually associated with loans or investments that are
short term in nature.
 In addition, it is always computed based on the original principal.
Simple interest formula:
The computation of simple interest is based on the following formula.
I = p i n(t) Where, I = Simple interest (in dollars or birr)
P = Principal (in dollar, or birr) and
i = Rate of interest per period (the annual simple
interest rate)
n(t) = Number of years or fraction of one year
 In computing simple interest, any stated time period such as months,
weeks or days should be expressed in terms of years. Accordingly, if the
time period is given in terms of,
i. Months, then
n= Number of months
12
ii. Weeks, then
n= Number of Weeks
52
iii. Days, then
a. Exact interest
n= Number of days
365
b. Ordinary simple interest
n= Number of days
360
Maturity value (future value) represents the accumulated amount or value
at the end of the time periods given. Thus,
 Future value (F) = Principal (P) + Interest (I)
 Example 4.1

 A credit union has issued a 3 year loan of Birr

5000. Simple interest is charged at a rate of 10%

per year. The principal plus interest is to be repaid

at the end of the third year.

a. Compute the interest for the 3-year period.

b. What amount will be repaid at the end of the third

year?
 Solution
Given values in the problem
3 – Years loan = Principal = Birr 5000
Interest rate = i = 10% = 0.1
Number of years (n) = 3 years
a. I = p i n
I = 5000 x 0.1 x 3
I = Birr 1500
b. The amount to be repaid at the end of the third
year is the maturity (future) value of the specified
money (Birr 5000).
Accordingly, F = P + I
F = 5000 + 1500
F = Birr 6500
Or, using alternative approach,
F=P+I
Then, substitute I = P i n in the expression to obtain
F = P + Pin
F = P (1 + in)
Consequently, using this formula we can obtain
F = 5000 (1+ (0.1x3)
F = 5000 x 1.3
F = Birr 6500
 Example 4.2
A person “lends” Birr 10,000 to a corporation by
purchasing a bond from the corporation. Simple
interest is computed quarterly (four times a year) at a
rate of 2% per quarter, and a check for the interest is
mailed each quarter to all bondholders. The bonds
expire at the end of 5 years, and the final check
includes the original principal plus interest earned
during the last quarter. Compute the interest earned
each quarter and the total interest, which will be
earned over the five-year life of the bonds.
Dear student, please try to solve before going to the solution part.
Solution
Given values in the problem, P = Birr 10,000 i = 2% per quarter n = 5
years

Required: Interest per quarter and interest over the five-year periods
Interest per quarter (one quarter) = Pin
= 10000 x 0.2 x 1
= Birr 200
There, at each quarter the interest earned on Birr 10,000 is Birr 200.

Interest over the five year period = pin

In the case, n represents all quarters with in 5 years. That is,
n = Number of years x 4
= 5x4 = 20
Then, Interest (I) = Pin
= 10000 x 0.02 x 20 = Birr 4000
Remark

 The interest rate of 2% is given as at a quarterly rate. Hence, in

computation of the interest we shall not change it in to annual rate.

 As long as the interest rate is provided in the desired time interval, we

shall not make adjustment on the rate given as well as the period.

 Yet, if conversion from one time interval to another is demanded, we

have to be consistent.

 For example, in the above example the i = 2% is for a quarter. The

yearly rate will be 2x4 = 8%. By using this annual rate, we can

compute the total interest as follows.

I = Pin

= 10000 x0.08 x 5 = Birr 4000

Exercise 4.1
1. Suppose, a small handicraft enterprise has requested
a two year loan of Birr 6500 from the commercial
Bank of Ethiopia. If the bank approves the loan at an
annual interest rate of 7.5%,
[Link] is the simple interest on the loan?
[Link] is the maturity value of the loan?
2. If the above loan (exercise 5.1) is offered at a rate of
21% and is due in 3 months, what is the maturity
value of the loan?
Principal (P) = Birr 6500
Annual Interest Rate (R) = 7.5%
Time (T) = 2 years
1. Simple Interest on the loan:
Simple Interest (SI) = P x R x T / 100
= 6500 x 7.5 x 2 / 100 = Birr 975
2. Maturity Value of the loan:
Maturity Value = P + SI
Maturity Value = 6500 + 975 = Birr 7475
Now, let's calculate for the second scenario where the loan is offered
at a rate of 21% and is due in 3 months:
Given: Annual Interest Rate (R) = 21%
Time (T) = 3 months = 3/12 years = 0.25 years
1. Maturity Value of the loan:
Simple Interest (SI) = P x R x T / 100
SI = 6500 x 21 x 0.25 / 100 = Birr 341.25
Maturity Value = P + SI
Maturity Value = 6500 + 341.25 = Birr 6841.25
Therefore, the maturity value of the loan in the second scenario is
Birr 6841.25.
 SECTION TWO: COMPOUND INTEREST
 As it has been highlighted earlier, compound interest raters for the
case where interest earned during the earlier periods also earn
interest during the later period.
 If, instead of being paid when due, the interest an investment is
added to the principal and the sum is used as new principal, we say
that compound interest is being used.
 Under this procedure, the interest for each period is added to the
principal for purpose of computing interest for the next period.
 The sum to which the principal and interest on it grow during the
period is called the maturity or accumulated value of the
principal.
 The difference between the compound amount and the principal
is called compound interest.
 The sum that is invested is called the present value or the
principal.
 The time interval between the date on which the principal was
invested and the date on which it is repaid is called the term of the
investment (loan).
 4.2.1 The Compound Interest Formula

 If an amount of money, P, earns interest compounded at a

rate of I percent per period it will grow after n periods to the

compound amount F, and it is computed by the formula:

Compound amount formula: Fn = P (1 + i) n

Where, P = Principal

i = Interest rate per compounding periods

n = Number of compounding periods (number of periods in

which the principal earn interest)

F = Compound amount
 A period, for this purpose, can be any unit of time.

 If interest is compounded annually, a year is the appropriate

compounding or conversion or interest period.

 If it is compounded monthly, a month is the appropriate period.

 It is important to know that the number of compounding period/s

within a year is/are used in order to find the interest rate per

compounding periods and it is denoted by i in the above formula.

 Consequently, when the interest rate is stated as annual interest rate

and is compounded more than once a year, the interest rate per

compounding period is computed by the formula:

i = j / m, where j is annual quoted or nominal interest rate

m number of conversation periods per year or

the

compounding periods per year

n = m x t, where t is the number of years

2. Compound Interest:
Compound interest takes into account not only the initial
principal amount but also the accumulated interest over time. The
formula for compound interest is:
Compound Interest = Principal x (1 + Rate)^Time - Principal
 Example 4.

Assume that we have deposited Birr 6000 at

commercial Bank of Ethiopia which pays interest of
6% per year compounded yearly. Assume that we
want to determine the amount of money we will have
on deposit (our account) at the end of 2 years (the
first and second year) if all interest is left in the
savings account.
 Solution
Give values in the problem,
P = Birr 6000, j = 6% = 0.06, t = 2 years
m = compounded annually = i.e. only once
n=mxt =1x2 = 2
i = j / m = 0.06 / 1 = 0.06
Then, the required value is the maturity or future
value
F = P(1 + i )n
= 6000 (1 + 0.06)2
= Birr 6000 (1.06)2
= Birr 6741.6
 Exercise 4.8

An individual accumulated Birr 30,000 ten

years before his retirement in order to buy a
house after he is retried. If the person
invests this money at 12% compounded
monthly, how much will be the balance
immediately after his retirement?
 Solution

Given values, P = Birr 30,000 , t = 10 years , i = 12% = 0.12

m = compounded monthly = 12

i = j / m = 0.12 / 12 = 0.01

n = m x t = 12 x 10 = 120 and what is required is the Future Value

F.

Then, F = P (1 + i) n

= 30,000 (1.01)120

= 30,000 (1.01)120
 Cont.
• Having the understanding of how compound interest
works and computation of future value, in
subsequent example, we will consider how to
determine the number of periods it will take for P
birr deposited now at i percent to grow to an
amount of F birr.
 4.2.2 Present Value of a Compound Amount
 As we have considered in the simple interest case and as
extended in the compound amount as well, future (maturity)
value is the value of the present sum of money at some future
date (time).
 Conversely, present value (or simply principal) is the current
birr or dollar value equivalent of the future amount.
 It is the sum of money that is invested initially and that is
expected to grow to some amount in the future at a specified
rate.
 Cont..
If we put the present and future (maturity) values on a continuum as shown below, we can
observe that they are inverse to one another. And, future value is always greater than the
present value or the principal since it adds/ earns interest over specified time-period.

0 1 2 3 . . . n
Present Value (P) Future Value
(Compound Amount)
Fn n
P  Fn (1  i ) Fn P(1  i) n
(1  i) n
 Cont..
 Future value is obtained by compounding
technique and the expression (1 + i) n
is called
compound factor.
 Present value is obtained by discounting
techniques and the expression (1 + i) -n
is referred
to as the compound discount factor.
 The formula for present value of compound amount
is simply derived from compound amount formula
by solving for P.
 Examples 4.11

1. What is the present value of

a. Birr 5000 in 3 years at 12% compounded annually?
b. Birr 8000 in 10 years at 10% compounded quarterly?
 Solution
Solution
o (a) Given the values, Fn = F 3 = Birr 5000, t = 3 years m = 1 (compounded
annually)
n = t x m =3 x 1 =3
j = 12 % = 0.12
i = j / m = 0.12/ 1 = 0.12 and we are required to find Present Value P.
Thus, P = F n (1 + i) -n
= 5000 (1 + 0.12)-3
= 5000 (1.12-3)
= 5000 (0.7118)
P = Birr 3559

(b) F n = F 40= Birr 8000, t = 10 years , m = quarterly = 4

n = t x m = 10 x 4 = 40 , i = 10% = 0.1 , i = j / m = 0.1 / 4 = 0.025
p =? but P = F n (1 + i)-n
= 8000 (1 + 0.025)-40 = 8000 (1.025) -40
P = Birr 2979.5
 SECTION THREE: ANNUITIES
 Annuity refers to a sequence or series of equal
periodic payments, deposits, withdrawals, or
receipts made at equal intervals for a specified
number of periods.
 For instance, regular deposits to a saving account,
monthly expenditures for car rent, insurance, house
rent expenses, and periodic payments to a person
from a retirement plan fund are some of particular
examples of annuity.
Payments of any type are considered as annuities if all of the

following conditions are present:

i. The periodic payments are equal in amount

ii. The time between payments is constant such as a year, half a year,

a quarter of a year, a month etc.

[Link] interest rate per period remains constant.

iv. The interest is compounded at the end of every time.

Annuities are classified according to the time

the payment is made.

 Accordingly, we have two basic types of annuities.

i. Ordinary annuity: is a series of equal periodic

payment is made at the end of each interval or

period. In this case, the last payment does not earn

interest.

[Link] due: is a type of annuity for which a

 It is only for ordinary annuity that we have a
formula to compute the present as well as
future values.
 Yet, for annuity due case, we may drive it
from the ordinary annuity formula.
 To proceed, let us first consider some
important terminologies that we are going to
use in dealing with annuities.
i. Payment interval or period: it is the time between
successive payments of an annuity.
[Link] of annuity: it is the period or time interval
between the beginning of the first payment period
and the end of the last one.
[Link] or interest period: it is the interval
between consecutive conversions of interest.
[Link] payment/rent: it is the amount paid at
the end or the beginning or each payment period.
v. Simple annuity: is the one in which the payment
period and the conversion periods coincides each
other.
 4.3.1 Sum of Ordinary Annuity: Maturity Value

 Maturity value of ordinary annuity is the sum of

all payments made and all the interest earned there
from.
 It is an accumulated value of a series of equal
payments at some point of time in the future.
 Suppose you started to deposit Birr 1000 in to a
saving account at the end of every year for four
years.
 How much will be in the account immediately after
the last deposit if interest is 10% compounded
In attempting this problem, we should understand that
the phrase at the end of every year implies an ordinary
annuity case.
Likewise, we are required to find out the accumulated
money immediately after the last deposit which also
indicate the type of annuity.
Further, the term of the annuity is four years with annual
interest rate of 10%.
Thus, we can show the pattern of deposits
diagrammatically as follows.
The Present The Future
0 1st 2nd 3rd 4th
1000 1000 1000 1000

Birr 1000
Birr 1100
Birr 1210
Birr 1331
Total Future Value = Birr 4641
The first payment earns interest for the remaining 3 periods. Therefore, the compound amount
of it at the end of the term of annuity is given by,
F = P (1 + i) n = 1000 (1 + 0.1)3 = Birr 1331
In the same manner, the second payment earns interest for two periods (years). So,
F= 1000 (1+0.1)2 = 1210
The 3rd payment earns interest for only one period. So,
F=1000(1+0.1)1 = 1100
No interest for the fourth payment since it is made at the end of the term. Thus, its value is
1000 itself. In total, the maturity value amounts to Birr 4641.
This approach of computing future value of ordinary annuity is complex and may be tiresome in
case the term is somewhat longer. Thus, in simple approach we can use the following formula
for sum of ordinary annuity (Future Value).

 (1  i) n - 1
Fn  R  
 i 

Where, n = the number of payment periods

i = interest rate per period
R = payment per period
F n = future value of the Annuity or sum of the annuity after n periods
 Cont..

Now, let us consider the above example. That is,

R = Birr 1000
i = 0.1 and n =4

 (1  0.1) 4 - 1
F4 1000  
 0.1 

Future Value = Birr 4641

 Example 4.12
1. A person plans to deposit 1000 birr in a savings account at the
end of this year and an equal sum at the end of each following
year. If interest is expected to be earned at the rate of 6% per
year compound semi-annually, to what sum will the deposit
(investment) grow at the time of the fourth deposit?
2. A 12-year-old student wants to begin saving for college. She
plans to deposit Birr 50 in a saving account at the end of each
quarter for the next 6 years. Interest is earned at a rate of 6%
per year compounded quarterly. What should be her account
balance 6 years from now? How much interest will she earn?
 #1 Solution

Solution
 The known values in the problem are,
R = 1000, j = 6% = 0.06 , m = semi-annual = twice a year
i = 0.06 ÷ 2 = 0.03
n =4

 (1  i ) n  1
F4 =? F4 =R  
 i 
 (1  0.03) 4  1
= 1000  
 0.03 

= 1000 (1.03) 4  1 / 0.03 
= 1000 x 4. 183627
F = Birr 4183.63
 #2 Solution
 R = Birr 50
t = 6 years
m = quarterly = 4 times a year
n = t x m = 6 x 4 = 24 quarters
j = 6% = 0.06
i = j ÷m = 0.06 ÷ 4 = 0.015

 (1  0.015) 24  1
F 24 = 50  
 0.015 

= 50 (1.01524  1) 0.015 
F 24 = Birr 1431.68

Interest = Maturity Value - Sum of Deposits

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

Multiply both sides by

i
(1  i ) n  1

That is,

i  (1  i) n  1 i
Fn  n R  
(1  i)  1  i  (1  i) n  1
 Cont..
Then, is the sinking found formula.
 i 
R Fn  n 
 (1  i)  1

Where, R = Periodic payment amount of an annuity

i = Interest per period which is given by j ÷m
j = Annual nominal interest rate
m = Number of conversion periods per year
n = Number of annuity payment or deposits (also, the number of compounding
periods)
F = Future value of ordinary annuity
 Cont..
In general, a sinking fund can be
established for expanding business,
buying a new building, vehicles,
settling mortgage payment,
financing educational expenses etc.
 Example 4.13
1. A corporation wants to establish a sinking fund beginning at the end of this year. Annual
deposits will be made at the end of this year and for the following 9 years. If deposits
earn interest at the rate of 8% per year compounded annually, how much money must
be deposited each year in order to have 12 million Birr at the time of the tenth deposit?
How much interest will be earned?
 # 1 Solution
 Future level of deposit desired = F n = B irr 12 million
Term of the annuity = t = 10 years
Conversion periods = m = annual = 1
n = t x m = 10 x 1 = 10 annuals
j = 0.08
i = j ÷m = 0.08 ÷ 1= 0.08
R = the amount to be deposited each year to have 12 million at the end of the 10th year = ?
Then to obtain the value of R, we shall use the formula for sinking fund.

 i 
R  Fn  n 
 (1  i )  1 

 0.08 
R 12,000,000  10 
 (1  0.08)  1

 0.08 
R 12,000,000  10 
 (1.08)  1

 0.08 
R 12,000,000  
 1.158925 

R = B irr 828,353.86
 Cont..
On the other hand, the amount of interest, I, is obtained by computing the difference between
the maturity value (Fn =12,000,000) and the sum of all periodic payments made. Thus,
I = Fn - R (10)
= 12,000,000 – 823,353.86 (10)
= 12,000,000 – 8,283,538.6
= Birr 3,716,461.4
 4.3.3 Mortgage Payments and Amortization
 Mortgage payment is an arrangement where by regular

payments are made in order to settle an initial sum of

money borrowed from any source of finance. Such

payments are made until the outstanding debt gets down to

zero.

 An individual or a firm, for instance, may borrow a given

sum of money from a bank to construct a building or

undertake something else.

 Then the borrower (debtor) may repay the loan by effecting

(making) a monthly payment to the lender (creditor) with

 In mortgage payment, initial sum of money borrowed and regular
payments made to settle the respective debt relate to the idea of
present value of an ordinary annuity.
 Along this line, the expression for mortgage payment computation
is derived from the present value of ordinary annuity formula.
 Our intention in this case is to determine the periodic payments to
be made in order to settle the debt over a specified time – period.

Hence, we know that

 1  (1  i)  n 
P R 
 i 
 Now, we progress to isolate R on one side. It involves solving for R
in the above present value of ordinary annuity formula. Hence,
multiply both sides by the interest rate i to obtain:
P i = R [1 – (1 + i) –n]
 Further, we divide both sides by [1 – (1 + i) –n
] and the result will
be the mathematical expression or formula for computing
mortgage periodic payments as follows.

 i 
R P   n 
 1  (1  i ) 

Where, R = Periodic amount of an annuity

i = Interest per conversion period which is given by j ÷ m
j = Annual nominal interest rate
m = Interest or conversion periods per year
n = the number of annuity payments/ deposits (number of compounding periods)
P = Present value of an ordinary annuity
 Example 4.16

1 Assume you borrowed Birr 11,500 from a bank to finance

construction of a swimming pool and agreed to repay the loan in 60
monthly equal installments. If the interest is 1.5% per month on the
unpaid balance,
a. How much is the monthly payment?
b. How much interest will be paid over the term of the loan?
1. Amount borrowed = Birr 11,500 = P
n = 60 months
i = 1.5% = 0.015
The interest rate is already given as monthly rate and it is equal to the
interval of compounding and payment periods. Thus, we are not required
to divide it by the number of conversion periods.
a) Monthly Installment Payment R = ?

 i 
R P   n 
 1  (1  i ) 

R = Birr 292.02 per month

[Link] interest paid (I) = (R x n) –

I = (292.02 x 60) –11,500

I = Birr 6021.405
THE END!!!