Mathematics Revision

Overview

This unit provides a revision of some simple mathematical concepts that are useful in
Finance. Topics include solving equations involving algebra, logarithms, and
exponential functions.


Learning Objectives

After completing this unit, you should be able to:

Solve simple algebraic equations by:
- Adding,
- Subtracting,
- Multiplying,
- Dividing.
Interpret and use summation notation.
Solve exponential equations.
Solve logarithmic equations.


Practical Applications

The material developed in this unit provides a grounding in the mathematical
concepts and techniques needed in Finance. These techniques provide the basis for
computing the present and future value of cash flows, and have applications to the
valuation of financial instruments (such as stocks and bonds) and real investment
projects.












Unit 0

Section 1: Basic Algebra



Overview

This section demonstrates how to solve simple equations involving unknown
variables. There are many applications in Finance in which the problem can be
summarised in the form of a mathematical equation. To solve these equations, we
need to be able to manipulate these equations using some simple rules of algebra.


Manipulating Mathematical Formulas

Mathematical formulas are used in many different fields to describe the relationship
between variables. For example, we can use a mathematical formula to describe the
relationship between temperature measured in degrees Fahrenheit and degrees
Celcius. Well represent the Fahrenheit temperature by F and the Celcius
temperature by C. The mathematical relationship between these variables is:

9
32
5
F C
| |
= +
|
\ .
.

When we know the value of one variable, we can substitute this value into the
equation and then solve the equation to find the value of the other variable. For
example, suppose we know that water boils at 100 degrees Celcius and we want to
know the corresponding temperature in degrees Fahrenheit. We simply substitute
the value 100 for C:

9
100 32
5
180 32
212.
F
| |
= +
|
\ .
= +
=


So, we conclude that water boils at 212 degrees Fahrenheit.

Conversely, we may know that paper burns at 451 degrees Fahrenheit. What is the
equivalent temperature in degrees Celcius? In this case, we substitute 451 for F :

9
451 32
5
C
| |
= +
|
\ .
.



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Mathematics Revision
Now, we need to manipulate this equation to isolate the unknown, C. In this
equation, we have the left-hand side equal to the right-hand side. The idea is to
manipulate the equation, preserving the equality of each side, but isolating the
unknown. If we perform the same operation on each side of the equation, well
preserve the equality. These operations include the following:

1. add the same value or number to both sides of the equation;
2. subtract the same value or number from both sides of the equation;
3. multiply both sides of the equation by the same value or number, or
4. divide both sides of the equation by the same value or number.

All these operations preserve the equality between the left and right hand sides of
the equation because we do the same thing to both sides. If the original expressions
were equal, the new expressions are equal.

So lets start manipulating our equation:
9
451 32
5
C
| |
= +
|
\ .
. Here we have two
expressions that are equal, 451 on the left-hand side and
9
32
5
C
| |
+
|
\ .
on the right-
hand side. Our goal is to isolate C on the right. First, we deal with the +32. To
do this, we subtract 32 from both sides, preserving the equality because we perform
the same operation on both sides:

9
451 32 32 32
5
9
419 .
5
C
C
| |
= +
|
\ .
| |
=
|
\ .


Next, note that on the right-hand side we are dividing by 5. To remove this term
from the right, we need to multiply by 5. Of course, we need to do this to both sides
to preserve the equality:

9
419 5 5
5
2,095 9 .
C
C
| |
=
|
\ .
=


Finally, note that on the right-hand side we are multiplying by 9. To remove this
term well divide (both sides) by 9:

2,095 9
9 9
232.78 .
C
C
=
=


So, paper burns at 451 degrees Fahrenheit or 232.78 degrees Celcius.

0-3
Unit 0
Summary

Our strategy in solving a mathematical equation is to try to isolate the unknown on
one side of the equation. We do this by manipulating the equation, and the general
principle is that whatever we do to one side of the equation, we must also do to the
other. If we perform the same operation on both sides of the equation, we preserve
the equality.


Worked Example: Manipulating Mathematical Formulas

Solve the equation:
4 8
2
2
x
x
+
= + 6 for x.

In this case, we have the unknown, x, appearing on both sides of the equation.
Here, our strategy will be to simplify the expression by getting rid of any fractions,
and then collect all terms involving x on one side of the equation.

First note that the equation is complicated because the left-hand side involves a
fraction. Lets start by removing this fraction. Since we are dividing by 2 on the left,
we can multiply (both sides, remember) by 2:

( ) (
4 8
2 2 2 6 2
2
4 8 4 12.
x
x
x x
+
= +
+ = +
)


Note that we have to multiply the whole right-hand side by two. This involves
multiplying both terms on the right by two. Next, we collect all the terms that
involve the unknown (x) to one side of the equation. We can do this by moving the
4x term from the right-hand side to the left. Since we are adding 4x on the right, we
need to subtract 4x. Again, we must do this to both sides of the equation:

4 8 4 12 4 4
4 4 12.
x x x x
x
+ = +
+ =


Next, we want to isolate the term involving the unknown. To do this we need to
remove the 4 that we are adding to the left-hand side. This involves subtracting 4
from both sides:
4 4 4 12 4
4 8.
x
x
+ =
=






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Mathematics Revision
The final step is to divide both sides by 4 to be left with x by itself on the left-hand
side:

4 8
4 4
2.
x
x
=
=


After solving an equation, we should be able to take our answer and substitute back
into the original expression, just to confirm that were right. In this case, we can
plug x=2 back into our original expression:

4 8
2 6
2
4 8 2
2 2 6
2
20
4 6
2
10 10.
x
x
+
= +
+
= +
= +
=





Section 2: Summation Notation



Overview

In Finance, we often need to find the sum of a number of quantities. For example,
we might want to sum the returns of a number of stocks or the present values of a
number of cash flows. The Greek letter sigma, represented by the symbol , is
used as mathematical short hand for the sum of. This section demonstrates how
this symbol is used.

The Rules of Summation

To explain how summation notation is used, we consider an accounts clerk who has
generated a list of customers whose payments are 90 days or more overdue.
Suppose that there are six customers on the list and the amount each one owes is
represented by x
1
, x
2
,, x
6
.

The chief accountant has asked the clerk to find the total amount owed by these
customers. In other words, the clerk must find:

1 2 3 4 5
x x x x x x + + + + +
6
.

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Unit 0
Using the symbol, we can write this sum as:

6
1 2 3 4 5
1
i
i
x x x x x x x
=
= + + + + +
6
4
.

In this notation, there is a sequence of numbers to be added. The first term in the
sequence is denoted below the , and the last term is denoted above the . If we
wanted to add only customers 2, 3, and 4, for example, we would write:

4
2 3
2
i
i
x x x x
=
= + +

.

There are four rules to keep in mind when using this summation notation. In the
remainder of this section, well introduce each of these rules in the context of a fully-
worked illustration. For all of these examples, lets assume that the amounts owed
by our six customers are:

Customer 1 2 3 4 5 6
Amount ($000) 5 4 7 8 6 10

In this example, the total amount owed is:

6
1
5 4 7 8 6 10 $40
i
i
x
=
= + + + + + =

.


Rule 1:
Multiplying each of the values by a constant results in the sum being
multiplied by the same constant:

1 1
n n
i i
i i
kx k x
= =
=

.

Suppose the credit manager decides to let these customers pay half of what they
owe. Customer 1, for example, now has to pay only (
1
/
2
)5,000 = $2,500. In general
terms, instead of paying x
i,
each customer only has to pay (
1
/
2
)x
i.
In terms of our rule
above, we have k=
1
/
2
. Now there are two ways to proceed. First, we can multiply
every term by
1
/
2
and then find the sum:

6
1
1 1 1 1 1 1 1
5 4 7 8 6
2 2 2 2 2 2 2
2.5 2.0 2.5 4 3 5 20.
i
i
x
=
| | | | | | | | | | |
= + + + + +
| | | | |
\ . \ . \ . \ . \ . \
= + + + + + =

10
|
|
.





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Mathematics Revision
Alternatively, since we already know the sum of all the payments is 40, we can just
multiply this by
1
/
2
:

6 6
1 1
1 1 1
40 20.
2 2 2
i i
i i
x x
= =
= = =



Rule 2:

I f we add a constant, k, some n times, the sum we obtain is:

1
... .
n
i
k k k k n k
=
= + + =

For example, if the credit manager offers to reduce each of these debts by $2,000 if
the debtors pay within a month, the total cost to the firm is:

6
1
2 2 2 2 2 2 2 6 2 $12
i =
= + + + + + = =

.
.
.


Rule 3:

When we are finding the sum of a number of terms in brackets, we must
first evaluate each of the bracketed terms and then find the sum.

Suppose you need to figure out how much will be collected from these six debtors if
each debt is reduced by $2. The sum of the values collected is:

( )
6
1
2 (5 2) (4 2) (7 2) (8 2) (6 2) (10 2)
i
i
x
=
= + + + + +

We must first evaluate each of the bracketed terms and then we can find the sum:

( )
6
1
2 3 2 5 6 4 8 $28
i
i
x
=
= + + + + + =

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Unit 0
Rule 4:

If we have two sets of values, x
1
, x
2
,,x
n
and y
1
, y
2
,,y
n,
and we want to
find the sum of all of these values, there are two ways to proceed. We can
find the sum of all the x terms and the sum of all the y terms and then add
these two sums together, , or we can find the sum of the x and
y terms for each of the n observations and find the sum of these n terms,
. Both approaches produce the same result:
1 1
n n
i
i i
x
= =
+
i
y
)
1
n
i
i =

1
(
n
i i
i
x y
=
+

1 1
( )
n n
i i i
i i
x y x y
= =
+ = +

.

In our accounts payable example, the values y
1
, y
2
,,y
n
might represent interest
charges on the overdue accounts. The sum of the x
i
and y
i
values would represent
the total of the original debt (the xs) plus accrued interest (the ys) for each
customer.

Suppose the company has a policy of charging 1% interest for overdue payment.
The value of each debt will be the principal payment plus the 1% interest charge:

( )
6
1
(5 0.05) (4 0.04) (7 0.07) (8 0.08) (6 0.06) (10 0.1)
$40.40.
i i
i
x y
=
+ = + + + + + + + + + + +
=

Alternatively, we could find the sum of the debts (which we know is 40) and the sum
of the interest payments and add these two sums. The total interest to be paid is:
6
1
0.01 5 0.01 4 0.01 7 0.01 8 0.01 6 0.01 10 0.40.
i
i
y
=
= + + + + + =

Therefore, the grand sum is:

6 6
1 1
40 0.40 40.40.
i i
i i
x y
= =
+ = + =





Worked Example: Summation Notation

Below is the daily rainfall in Seattle for a particular week:

Day 1 2 3 4 5 6 7
Amount (mm) 5 30 120 10 0 0 190

Let x
i
for represent the rainfall on each of the seven days. 1, 2, ... ...,7 i =

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Mathematics Revision
We can use summation notation to compute the total rainfall over the week. If we
want to find the total rainfall, we need to add the daily rainfall for each of the seven
days (i.e., x
1
+x
2
++ x
7
).

If E represents the rainfall over the whole week, we have:

1 2 3 4 5 6
E x x x x x x x = + + + + + +
7
.

This equation can be written using summation notation:

7
1
5 30 120 10 0 0 190 355.
i
i
E x
=
=
= + + + + + + =

Section 3: Exponential Functions



Overview

There are many cases in Finance that require the use of exponential functions.
Whenever we are computing compound interest, for example, well be raising at
least one term to some power. In fact, there are very few financial equations that
do not involve some sort of exponential function, so its very important to be familiar
with this type of function. This section provides the various mathematical rules that
are used in evaluating exponential functions and shows how to manipulate and solve
them.


The Rules of Exponential Functions

An exponential function is one that involves something being raised to a power.
Consider, for example, the following equation:

5
2 2 2 2 2 2 32 = = .

Here we have 2 to the power of 5. The value of the power, or 5, is called the
exponent and the number that is multiplied together, or 2, is called the base.
Another example is:

3
2 2 2 2 8 = = .

0-9
Unit 0
In the remainder of this section, we introduce a number of general rules that apply
to exponential functions.

Rule 1:

When multiplying exponential functions with the same base, we add the
exponents:

y
)
y
8.
x y x
a a a
+
= .

Suppose we want to find the product of 2
5
and 2
6
. We can write this as:

( ) (
5 6
11
2 2 2 2 2 2 2 2 2 2 2 2 2
2
2,048.
=
=
=


Rule 2:

When an exponential function is itself raised to a power, the two powers
can be multiplied:

( )
y
x x
a a

= .

For example, if we want to find the cube of 2
5
. We can write this as:

( )
3
5 15
2 2 32,76 = =

Note also that:

( ) ( )
3
3
5 3
2 2 2 2 2 2 32 32,768. = = =

Rule 3:

When the power is negative, we take the reciprocal:

1
x
x
a
a

= .

Suppose we are asked to evaluate 2
-3
. Our rule suggests that:

3
3
1
2 .
2

=



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Mathematics Revision
Next, we can expand the denominator:

3
3
1 1
2 .
2 2 2 8 2

= = =

1


Rule 4:

When the power is a fraction, the denominator (bottom) of the fraction is
taken as the root. When the denominator is 2, we take the square root.
When the denominator is 3, we take the cubed root, and so on. I n general:

x
y
x y
a a =

Consider the expression
1
2
4 . This can be evaluated as follows:

1
2 1
2
4 4 = = 2.

Rule 5:

Any number raised to the power 0 is just 1:

0
1 a = .

Consider, for example, the product of 2
1
and 2
-1
. From the rules that are outlined
above:

1 1
1
2 2 2 1
2

= = .
.


We can also evaluate this as:

1 1 1 1 0
2 2 2 2 1

= = =



Solving Equations that Involve Exponential Functions

There are many applications of exponential functions in Finance and we can use the
rules developed above to solve these equations.

Suppose you put a sum of money (say $PV) in the bank and you want to know its
accumulated value after n years if the interest rate is r% per year. This accumulated
value can be computed using the following formula:

(1 )
n
n
FV PV r = +

0-11
Unit 0
where: FV
n
= the final balance in the account after n periods,
PV = the original principal invested,
r = the interest rate per period,
n = the number of periods.

Well look at how this formula is derived in some detail later, but for now, suppose a
bank guarantees that a $100 investment today will double in value over the next ten
years. We want to compute the implied rate of interest. In this case, we have:

10
(1 )
200 100(1 ) .
n
n
FV PV r
r
= +
= +


Since we need to solve for r, we want to isolate r on one side of the equation. The
first step is to remove the 100 from the right-hand side. Since we are multiplying by
100 on the right, we divide both sides by 100:

10
10
200 100(1 )
100 100
2 (1 ) .
r
r
+
=
= +


Now we need to remove the exponent from the right-hand side. Here we use the
rules we developed above. The general principle is that when trying to remove
an exponent from one side of the equation, we raise both sides of the
equation to the reciprocal of the power we are trying to remove. In this
case, were trying to remove the power of 10 from the right-hand side, so we raise
both sides to the power of 1 . 0
10
1
= :

0.1
0.1 10
2 (1 ) r ( = +

.

Now we can use Rule 2 above to simplify the right-hand side we need to multiply
the exponents:

0.1
0.1 10
10 0.1
1
2 (1 )
1.071773 (1 )
(1 )
(1 ).
r
r
r
r

( = +

= +
= +
= +


Finally, we subtract one from each side:

( )
1.071773 1 1 1
0.071773 ,
r
r
= +
=


and note that the implied interest rate is 7.1773% p.a.


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Mathematics Revision
Worked Example: Exponential Functions

Your bank now guarantees that a $100 investment today will triple in value over the
next twelve and a half years. We want to compute the implied rate of interest. In
this case, we have:

12.5
(1 )
300 100(1 ) .
n
n
FV PV r
r
= +
= +


Since we need to solve for r, we want to isolate r on one side of the equation. The
first step is to remove the 100 from the right-hand side. Since we are multiplying by
100 on the right, we divide both sides by 100:

12.5
12.5
300 100(1 )
100 100
3 (1 ) .
r
r
+
=
= +


Now we need to remove the exponent from the right-hand side. In this case, were
trying to remove the power of 12.5 from the right-hand side, so we raise both sides
to the power of 08 . 0
5 . 12
1
= :

0.08
0.08 12.5
3 (1 ) r ( = +

.

Now we can use Rule 2 above to simplify the right-hand side we need to multiply
the exponents:

0.08 12.5 0.08
3 (1 )
1.091867 (1 ),
r
r

= +
= +


in which case the implied interest rate is 9.1867% p.a.




Section 4: Logarithmic Functions



Overview

This section reviews the key concepts relating to logarithmic functions. The rules
reviewed in this section have applications in determining how long it will take to
repay borrowed funds, given a particular loan repayment schedule.

0-13
Unit 0
The Rules of Logarithmic Functions

Rule 1:

The log of a times b is equal to the log of a plus the log of b:

( ) ( ) (
ln ln ln ab a b = +
)
)
.

For example:

( ) ( ) (
ln 4 5 ln 4 ln 5 = + .

Note that:

( ) ( )
ln 4 5 ln 20 2.995, = =

and that:
( ) ( )
ln 4 ln 5 1.386 1.609 2.995. + = + =

Rule 2:

The log of a divided by b is equal to the log of a minus the log of b:

( ) ( )
ln ln ln
a
a b
b
| |
=
|
\ .
.

For example:

( ) ( )
4
ln ln 4 ln 5
5
| |
=
|
\ .
.

Note that:

( )
4
ln ln 0.8 0.223,
5
| |
= =
|
\ .


and that:

( ) ( )
ln 4 ln 5 1.386 1.609 0.223. = =

Rule 3:

The log of a raised to the power c is equal to c times the log of a:

( ) ( )
ln ln
c
a c = a .
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Mathematics Revision
For example:

( ) ( )
2
ln 4 2ln 4 = .

Note that:

( ) ( )
2
ln 4 ln 16 2.772, = =

and that:

( )
2 ln 4 2 1.386 2.772. = =


Using Logarithmic Functions in Finance

We know from above that if you put a sum of money (say $PV) in the bank for n
years at r% per year, the accumulated value can be computed as:

(1 )
n
n
FV PV r = + .

Now suppose that we want to know how long it will take for a $1,000 investment to
double in size when invested at a rate of 8% per year. In this case, we have:

(1 )
2,000 1,000(1 0.08) .
n
n
n
FV PV r = +
= +


Now, we need to solve the equation in which the unknown variable is the exponent.
The first step is to remove the 1,000 from the right-hand side by dividing both sides
of the equation by 1,000:

2,000 1,000(1 0.08)
2,000 1,000(1 0.08)
1,000 1,000
2 1.08 .
n
n
n
= +
+
=
=


Now, when the exponent is the unknown, taking logs will help to solve the equation.
Once again, whatever we do to one side of the equation we must also do to the
other:
( ) ( )
ln 2 ln 1.08
n
(
=

.

Applying Rule 3 from above allows us to re-write the equation as:

( ) ( )
ln 2 ln 1.08 n = .
0-15
Unit 0
Evaluating the log terms yields:

0.69314 0.07696n = .

Finally, we divide both sides by 0.07696:

0.69314
0.07696
9.01.
n
n
=
=


That is, it takes a little over nine years to double your money at 8% p.a.



Worked Example: Logarithmic Functions

Suppose you have $500 to invest and you want to know how long it will take for this
amount to triple in size if the appropriate interest rate is 10% p.a.

We know the formula for calculating the future value is:

(1 )
n
n
FV PV r = + .

Substituting the relevant values into the formula yields:

1,500 500(1 0.10)
n
= + .

Simplifying this equation, we have:

1,500
1.10
500
3 1.10 .
n
n
=
=


Taking the logarithm of both sides of the equation gives:

( ) ( )
ln 3 ln 1.10
n
= .

Applying Rule 3 gives us:

( ) ( )
ln 3 ln 1.10 n = .

We can shift the term, l , to the left hand side of the equation:
(
n 1.10
)

( )
( )
ln 3
ln 1.10
n = .

0-16
Mathematics Revision
Now this expression can be evaluated as:

1.0986
0.0953
11.53 years.
n
n
=
=



0-17