Nelson Mandela University

Methods of Finance

Lecture notes for module STAV101

Student Version
Contents
1. Chapter 1
1.1. Introduction
1.2. Simple Interest
1.3. Additional Examples on Simple Interest
1.4. Compound Interest
1.5. Additional Examples on Compound Interest
1.6. Nominal and Effective Interest Rates
1.7. Additional Examples on Nominal and Effective Interest Rates
1.8. Equivalent Effective Interest Rates
1.9. Continuous Compounding
1.10. Changes in Interest Rates
1.11. Net Present Values (NPV)
1.12. Internal Rate of Return (IRR)
2. Chapter 2
2.1. Introduction
2.2. Simple Annuities
2.3. Additional Examples of Simple Annuities
2.4. Complex Annuities
2.5. Additional Examples of Complex Annuities
3. Chapter 3
3.1. Moving Money through Time
3.2. Simple Loans
3.3. Additional Examples of Simple Loans
3.4. Loans and Amortization Tables
3.5. Missed Payments
3.6. Changes in Interest Rates
3.7. Missed Payments and Changes of Interest Rates
3.8. Depreciation and Sinking Funds
3.9. Growing Annuities
3.10. Perpetuities and Growing Perpetuities
4. Chapter 4: Linear Programming
4.1. Plotting a Linear Function on a 2-d Graph
4.2. Introduction to Linear Programming (LP)
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4.3. Solutions to LP Models
4.4. Formulating an LP Model
4.5. Higher Order Models
4.6. Sensitivity Analysis

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1. Chapter One
1.1 Introduction

The time value of money is an important concept in modern day society. It is almost certain that at some
stage during a person’s adult life they will either borrow money from someone or lend money to someone.
When an institution lends money they expect the money to be repaid in full together with an additional
amount which is agreed upon when granting the loan. This additional amount is called interest.

In South Africa loans can be secured from banks and a number of microlending organizations. All these
loans are subjected to interest rates that can either be fixed or variable over a set period of time.

Basic Concepts and Notation

Present value, Pv.
The capital or principal amount is quite often referred to as the present value (Pv). We define the present
value as the amount of money at the beginning point in time when we are looking forward in time and want
to know something about the value of the amount of money sometime in the future.
Future value, Fv.
The accumulated amount when the capital and interest is to be repaid is often some value in the future. We
will refer to the future value (Fv) as the amount of money at the end point in time when we are looking
backward in time and want to know something about the value of the amount of money in the past.
Interest, I.
Interest (I) is the amount of money paid by a borrower to a lender for the use of an amount of money that is
commonly referred to as the capital or principal (P) amount.
Number of interest periods, n.
The duration of a loan is split into the number of interest period’s (n) for which the principal amount is
borrowed.
Rate of interest, i.
The rate of interest (i) is the percentage of the capital, which will constitute the interest for one period. A
number of different interest rates will be introduced throughout this text so it is crucial to understand the
meaning of interest rate and ensure you are familiar with the notation used.
Per annum, p.a.
Interest rates are calculated at regular intervals. One common unit of measurement for an interval period is
per annum or per year.
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1.2 Simple Interest

Simple interest calculations are used to introduce the concept of the time value of money. It is important to
realize that this is a simplified version of what generally happens in the real world. The interest, I, for a sum
of money, the Pv, invested for n periods at an interest rate of i % per period is given by:
I = Pv  i  n
The Fv of the money invested is determined by:
Fv = Pv + I
In interest calculations one is normally required to know at least three quantities. The concepts are best
introduced by means of an example.

Example 1
A person requires a loan of R1000 and is able to repay the loan after two years. Assuming a bank is willing to
lend the person the R1000 but requires the person to pay an additional amount, the interest, when repaying
the loan. Determine how much should be repaid assuming the agreed interest rate is 12% per annum (p.a.).

To illustrate this problem we introduce the concept of a time diagram. It is important to understand how to
use a time diagram as this concept will be used throughout this text.

Time Diagram

T0 T1 T2

Pv Fv

We can refer to the R1000, which is borrowed today, as the Pv of the loan and the amount to be repaid in two
years time as the Fv of the loan. In the time diagram we place Pv at T0 and Fv at T2, where T0 denotes the
present time period and T2 denotes the time period when the loan is to be repaid in two years. As you can see
the value of the loan “moves” through two (yearly) time periods. We denote the rate of interest per period as i
= 12% p.a. and the number of interest periods, n = 2 years. It is important at this stage to check that interest
rate and number of interest periods have units that coincide. In this example they are both years.

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Solution
Pv = 1000
n = 2 years
i = 12 % per annum = 0.12 p.a.
Fv = ?
I=?

Fv = Pv + I = Pv + ( Pv  i  n)

Fv = Pv(1 + i  n)
Fv = 1000(1 + 0.12  2)
Fv = R1 240

Example 2
A person requires a loan of R1000 and is able to repay the loan after 18 months. Assuming a bank is willing
to lend the person the R1000, determine how much should be repaid when the interest rate is 12% per annum.

Solution
Pv = 1000
n = 18 months = 1.5 years
i = 12 % per annum = 0.12 p.a.
Fv = ?

Fv = Pv(1 + i  n)
Fv = 1000(1 + 0.12  1.5)
Fv = R1 180

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1.3 Additional Examples on Simple Interest
Example 3
Given that an investor pays R200 interest at an interest rate of 10% per annum. Determine the amount repaid
if the duration of the loan was
(a) 3 years
(b) 9 months

Part (a) Part (b)

Fv = R866.67 Fv = R2 866.67

Note: Always remember to quote monetary values to the correct number of decimal places. In most monetary
examples the final answer can be reported to two decimal places. Only round off the final answer, as some
problems will require a number of calculations. It is also important to include the units for any answer you
calculate. Answers without units are meaningless.

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Example 4
Determine the interest an investor earns if the future value of his investment is R2000, the interest rate is
16% p.a. and the investment period is 5 years.
Fv = 2000
i = 16 % p.a. = 0.16 p.a.
n = 5 years

I = R888.88

Example 5
What is the rate of interest per annum for an investment of R5000 when six months later it is valued at
R6000?
Pv = 5000
Fv = 6000
n = 6 months = 0.5 years
i = ? % p.a.

i = 0.4000 = 40.00 % p.a.

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Example 6
A part time student would like to do a course in statistics. The course costs R980 but the student only has
R800. Assuming the student invests her money at a financial institution offering an interest rate of 18% p.a.,
how long before the student earns enough to enroll for the statistics course?
Pv = 800
Fv = 980
i = 18 % p.a. = 0.18 p.a.
n = ? years

n = 1.25 years = 15 months

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1.4 Compound Interest
To determine the value of an investment most businesses use compound interest instead of simple interest.
Compound interest is the method of calculating interest periodically and then adding the interest to the initial
capital. This procedure results in capital growth as the interest periods increase. To illustrate the procedure of
how one’s capital grows, a period-by-period procedure is shown in table 1. This period-by-period procedure
is a simple method that shows how a compound interest formula for n periods is developed:

Table 1: Development of Compound Interest Formula

Value at beginning of General formula for

Period Definition: Fv = Pv + I
period Fv

Fv1 = Pv + I1
1 Pv Fv = Pv(1 + i)
= Pv + Pvi(1)

Fv2 = Pv + I1 + I2

= Fv1 + Fv1i(1)
2 Fv1 Fv = Pv(1 + i)2
= Fv1(1 + i)
= Pv(1 + i)(1 + i)
Fv3 = Pv + I1 + I2 + I3

= Fv2 + Fv2i(1)
3 Fv2 Fv = Pv(1 + i)3
= Fv2(1 + i)
= Pv(1 + i)(1 + i)(1 + i)

And so on until the nth period

Fvn = Pv + I1 + I2 + I3 + … + In

= Fv(n – 1) + Fv(n – 1)i(1)

n Fv(n – 1) Fv = Pv(1 + i)n
= Fv(n – 1)(1 + i)
= Pv(1 + i)(1 + i)(1 + i) … (1 + i)

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The general formula for compound interest calculations is given by:

Fv = Pv (1 + i ) n

Where n is the number of interest periods and i is the interest rate for the compounding period. The time units
of the number of interest periods and the compounding period must coincide. A simple example is an interest
rate that is compounded annually and the number of interest periods are calculated in years. Similarly if
compounding is said to be monthly we would need to convert n into the number of months before using the
compound interest formula.

Example 7
A person requires a loan of R1000 and is able to repay the loan after two years. Assuming a bank is willing to
lend the person the R1000, determine how much should be repaid assuming the interest rate is 12% per
annum compounded annually.

Solution
Pv = 1000
i = 12 % p.a. compounded annually = 0.12 p.a. (c.a.)
n = 2 years
Fv = ?

Check: Interest rate; compounded annually: Number of interest periods; years. Periods coincide, we can use
the compound interest formula.
Fv = Pv (1 + i ) n

Fv = 1000 (1 + 0.12 ) 2
Fv = R1 254.40

If we compare this to example 1 we will see that compound interest yields a higher return for the bank.

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1.5 Additional Examples on Compound Interest
Example 8
Determine the interest an investor earns if the future value of his investment is R2000, the interest rate is
16% p.a. compounded annually and the investment period is 5 years.
Fv = 2000
i = 16 % p.a. (c.a.) = 0.16 p.a. (c.a.)
n = 5 years
I=?

I = R1 047.77

Example 9
What is the rate of interest per annum for an investment of R5000 when six months later it is valued at
R6000? Note: If the compounding period is not given, you should always assume that compounding is
annual.
Pv = 5000
Fv = 6000
n = 6 months = 0.5 years
i = ? % p.a. (c.a.)

i = 44.00% p.a.

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Example 10
A part time student would like to do a course in statistics. The course costs R980 but the student only has
R800. Assuming the student invests her money at a financial institution offering an interest rate of 18% p.a.
compounded annually, how long before the student earns enough to enroll for the statistics course?
Pv = 800
Fv = 980
i = 18 % p.a. (c.a.) = 0.18 p.a. (c.a.)
n = ? years

n = 1.2261…years 14.7 months

Compare this result with example 6.

The student is now able to start the course ~ 0.3 months earlier as the investment yields the necessary return
sooner.

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The Sharp EL – 738 financial calculator (prescribed for this text) can perform routine compound interest
operations in financial mode.

The calculator is now in financial mode and routine interest calculations can be performed. Follow the step-
by-step procedure below to perform calculations for some of the examples previously shown.

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Calculator check:

Refer to Example 7
Pv = 1000
i = 12 % p.a. compounded annually = 0.12 p.a. (c.a.)
n = 2 years
Fv = ?

1000 PV

12 1/Y

2 N

comp FV -1254.4

To report this result it is important to write the answer with the correct units and correct number of decimal
places i.e. the Fv = R1 254.40

Note: The built in financial formula requires one of Pv or Fv to be negative. The calculator formula is
programmed in this way as most financial calculations indicate either an inflow or outflow of money.
Traditionally money flowing out is negative (-) and money flowing in is positive (+). You can decide for
yourself how to use the built in formula, just so long as the answers reported are consistent with the problem.

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Refer to Example 9
Pv = 5000
Fv = 6000
n = 6 months = 0.5 years
i = ? % p.a.

-5000 Pv

6000 Fv

0.5 N

comp 1/Y 44

i = 44.00 % p.a.

Refer to Example 10
Pv = 800
Fv = 980
i = 18% p.a. (c.a.) = 0.18 p.a. (c.a.)
n = ? years

800 Pv

-980 Fv

18 1/Y

comp N 1.22612

n = 1.2261 years

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The difference between simple and compound interest can easily be seen by the comparisons in the following
table:

Simple Interest Compound Interest

R1000 for 10 years @ 15% p.a. R1000 for 10 years @ 15% p.a.(ca)

n Future Value n Future Value

1 R 1,150.00 1 R 1,150.00
2 R 1,300.00 2 R 1,322.50
3 R 1,450.00 3 R 1,520.88
4 R 1,600.00 4 R 1,749.01
5 R 1,750.00 5 R 2,011.36
6 R 1,900.00 6 R 2,313.06
7 R 2,050.00 7 R 2,660.02
8 R 2,200.00 8 R 3,059.02
9 R 2,350.00 9 R 3,517.88
10 R 2,500.00 10 R 4,045.56

Initially the change is “small”, however as time moves on, the difference between simple and compound
interest becomes considerably more noticeable, i.e. much better return on investment. From this illustration it
is obvious that the time value of money is crucial for any future investment decisions.

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1.6 Nominal and Effective Interest Rates
The examples used so far have either assumed or stated that compounding occurs annually. All we’ve had to
do is convert the number of interest periods, n, to years and then apply the compound interest formula. In
many cases encountered in business, compounding occurs at different time periods. Common examples are
monthly compounding, daily compounding and continuous compounding. Common practice among lending
institutions is to quote an annual rate of interest and then state the compounding period. A simple example
would be an institution quoting an interest rate of 12% per annum compounded monthly.

It is now necessary to define the quoted annual rate of interest as the nominal rate of interest and this will be
denoted by the symbol j. If the interest rate compounding period is not per annum, the real (or effective) rate
of interest per annum will be different from the nominal rate of interest. We denote the effective rate of
interest when interest is compounded in periods of less than a year as im, where m is the number of
compounding periods per annum. This allows us to determine the effective (or real) rate of interest at the end
of every compounding period. The relationship between im and j is by definition given as:

j
im =
m

Where j = the nominal rate of interest with units per annum

im = the effective rate of interest per compounding period m
m = the number of compounding periods per annum

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Example 11 (from example 7)
A person requires a loan of R1000 and is able to repay the loan after two years. Assuming a bank is willing to
lend the person the R1000, determine how much should be repaid assuming the interest rate is 12% per
annum compounded monthly.

Solution
j
Pv = 1000 im =
m
12
j = 12% p.a. compounded monthly = 0.12 p.a. (c.m.) i12 =
12
n = 2 years = 24 months i12 = 1% per month effective

Fv = ?

Check: Interest rate; compounded monthly: Number of interest periods; years. Convert n to coincide with
the compounding period before using the compound interest formula.

Fv = Pv (1 + i12 ) n

Fv = 1000 (1 + 0.01) 24 = R1 269 .7346 ...

Fv = R1 269.73

Compare this result with example 7. In example 7 the Fv = R1 254.40 when compounding was annual, by
compounding monthly the Fv has increased by approximately R15. This indicates that as compounding
periods become more frequent the Fv increases. It is important at this stage to understand the difference
between nominal and effective interest rates.

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1.7 Additional Examples on Nominal and Effective Interest Rates
Example 12
Determine the interest an investor earns if the Fv of his investment is R2000, the interest rate is 16% p.a.
compounded quarterly and the investment period is 5 years.
Fv = 2000
j = 16% p.a. (c.q.) = 0.16 p.a. (c.q.)
i4 = j/4 = 16/4 = 4% per quarter effective
n = 5 years = 20 quarter years
I=?

I = R1 087.23

Compare this result with example 8.

If you are the investor which of the two interest rates would you prefer?

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Example 13
If compounding occurs monthly, at what rate of interest per annum must money be invested so as to double
itself in 5 years?
Pv = ?
Fv = 2Pv
n = 5 years = 60 months
j = ? % p.a. (c.m.)
i12 = ? % p.m. effective

j = 13.9433 % p.a. (c.m.)

Example 14
How long will it take R1000 to accumulate to R2000 at 15% p.a. compounded monthly?
Pv = 1000
Fv = 2000
j = 15 % p.a. (c.m.) = 0.15 p.a. (c.m.)
i12 = 1.25 % p.m. effective = 0.0125 p.m. effective
n = ? months

n = 55.7976… months  4.65 years

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1.8 Equivalent Effective Interest Rates
The effective rates discussed so far are automatically determined from the compounding period. Often an
investor would like to compare effective rates for different compounding periods. Two procedures are
possible to contrast this problem. Option one necessitates two interest calculations whilst option two
compares effective rates for the same compounding periods. An equivalent effective rate for any
compounding period can be determined from the effective rate automatically determined from the nominal
rate using the formula below.

(1 + i p ) p = (1 + im ) m

The equivalent effective interest rate denoted by ip has p compounding periods per annum and is determined
from the effective interest rate, im which has m compounding period per annum. For example, the nominal
interest rate, j, will be equal to the equivalent annual effective interest rate if the compounding period is
annual.

Example 15
A student has R1000 that she would like to invest for three years. Two competing lending institutions offer
the following interest rates; Company A offers 14% per annum compounded quarterly whilst company B
offers 13.2 % per annum compounded monthly. In which of the two companies should the student invest to
maximise her return?
Solution 1
Pv = 1000
n = 3 years = 12 quarter years = 36 months
Company A Company B
j = 14% p.a. (c.q.) j = 13.2% p.a. (c.m.)
i4 = 3.5% p.q. effective i12 = 1.1% p.m. effective

Fv = Pv (1 + im ) n Fv = Pv (1 + im ) n

Fv = 1000 (1 + 0.035 )12 Fv = 1000 (1 + 0.011) 36

Fv = R1 511.06 Fv = R1 482.66

Investing in company A maximises the students return after the 3 year period.

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Solution 2
A direct comparison of effective interest rates (those with the same period units) is an alternative technique
proposed. The formula for the equivalent effective interest rate is rearranged to make ip the subject of the
formula. Although any effective interest rate (with the same period units) can be compared, it is common
practice to compare equivalent effective annual interest rates. Therefore each investment options annual
effective rate, i1, is determined and direct comparisons are possible.

(1 + i p ) p = (1 + im ) m

i p = (1 + im ) p − 1
m

i1 = (1 + im ) − 1
m

Company A Company B
i1 = (1 + 0.035 ) − 1 i1 = (1 + 0.011) − 1
4 12

i1 = 14.7523 % p.a. effective i1 = 14.0286 % p.a. effective

The effective annual interest rate for company A is better than company B. The student should invest with
company A to maximise her return.

Example 16
If the equivalent effective annual rate is 17.5% p.a., find the nominal rate per annum when compounding is
monthly.
i1 = 17.5 % p.a. effective
i12 = ? % p.m. effective

j = imm = i1212

i1 = (1 + im ) − 1
m

i12 = 12 1 + i1 − 1

i12 = 12 1 + 0.175 − 1
i12 = 1.3529…% p.m. effective

j = im  m = 1.3529  12

j = 16.2357 % p.a. (c.m.)

23
Using the financial calculator to calculate annual effective interest rates, EFF, from nominal rates:
(See example 15)
Choose the best investment option:

A: j = 14% p.a. (c.q.) or B: j = 13.2% p.a. (c.m.)

A: To find i1:

4 ,
(x,y)
14 2nd F EFF 14.7523… = 14.75% pa effective

B: To find i1:

,
12 (x,y) 13.2 2nd F EFF 14.0286… = 14.03% pa effective

The first value entered is the number of compounding periods, and then the nominal interest rate, EFF gives
the annual equivalent effective interest rate.

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1.9 Continuous compounding
In previous examples it has been shown that when the number of compounding periods for a fixed present
value and fixed nominal interest rate are increased, the computed future value increases. What happens if the
number of compounding periods increase to such an extent that we can think of compounding as continuous?
To answer this question we consider an example where the number of compounding periods keeps
increasing.

Example 17
Determine the future value of R1000 invested for one year at 12% p.a. when compounding is
a) Annual Fv = 1000 (1 + 0.12)1 = R1120 .00

b) Monthly Fv = 1000 (1 + 0.01)12 = R1 126 .83

c) Daily Fv = 1000 (1 + 0.12 365 ) 365 = R1 127 .47

d) Hourly Fv = 1000(1 + 0.12 365  24)36524 = R1127.50

It is intuitively obvious that as the compounding periods become more frequent, the Fv increases. Initially the
Fv increases sharply but then a tapering off effect is observed. It seems appropriate at this stage to wonder if
there is a maximum Fv that will be attained as the number of compounding periods increase. This maximum
can be derived theoretically but for the purposes of this course it is only necessary to be able to use the results
of this derivation. The formula below is the solution to the derivation to determine the value of an investment
when compounding is continuous:

Fv = Pve jn

where e is the mathematical constant e = 2.7182818…

j is the nominal interest rate per annum and
n is the number of yearly interest periods

For this simple illustration, the future value of R1000 invested for one year when compounding is continuous
is

Note that this result (rounded to decimal places) is the same result as for hourly compounding in part d).

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Beyond the scope of this module (but for information)
The number “e” is an irrational number determined from the summation of factorial terms.

0.000001 1.000
1 2.000
2 2.250
3 2.370
4 2.441
5 2.488
6 2.522
7 2.546
8 2.566
9 2.581
10 2.594
100 2.705
1000 2.7169
10000 2.7181
100000 2.7183

As n gets larger, the value increases but is approaching a limit. The limit is never reached, but if we are
working with numbers which can be rounded off, then a rounded off result is possible.

26
Example 18
Find the present value of R500 invested at a nominal rate of 15% p.a. for one year if compounding is
continuous.
Solution
Fv = 500
Pv = ?
n = 1 year
j = 15 % p.a. (c.c.)

A formula for the equivalent effective annual rate of interest can be derived by equating two compound
interest formulas and after rearranging is given as:

i1 = e j − 1

Example 19
An investor doubles her money when investing for 4 years if compounding is continuous. Find the nominal
and annual effective interest rate for the investment.

Fv = Pve jn
 Fv 
ln e jn = ln   Note: ln ex = x
 Pv 
 Fv  ln (2 Pv Pv)
jn = ln   j=
 Pv  4
j = 17.3286…% p.a. (c.c.)
i1 = e j − 1

i1 = e 0.1732... − 1
i1 = 18.9207 % p.a. effective

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1.10 Changes in Interest Rates
It is common for interest rates to change over an investment period. When dealing with problems like this it
is best to use a time diagram to indicate how money moves through time. In cases like this it is important to
think of the Fv of money as some value ahead of the point in time we are working from, in this case the point
in time we are working from would be represented as the Pv.

Example 20
A person deposits R500 in a savings account on 1 January 2016. The account pays interest of 15% p.a.
effective. On 1 July 2016 the interest rate changes to 12% p.a. compounded monthly. On 1 July 2017 the
interest rate changes to a nominal rate of 14% p.a. with continuous compounding. Determine the value of this
investment on the first day of November 2018.

Solution
We consider this problem as three compound interest problems. Let T0 be the point in time when the R500 is
deposited on 1 January 2016. For this problem we show the time period as months, thus from 1 January 2016
to 1 July 2016 we move from T0 to T6, a period of 6 months. This is illustrated on the diagram by the first
arrow. The second problem is shown for the period 1 July 2016, T6, to 1 July 2017, T18, a period of 12
months. The third part of the problem is shown from T18 to T34, the 16-month period from 1 July 2017 to 1
November 2018.

Time Diagram

1/1/16 1/7/16 1/7/17 1/11/18

T0 T6 T18 T34
i1 = 15% p.a. eff i12 = 1% p.m. eff j = 14% p.a. (c.c.)

FvT6 = PvT6 FvT34

FvT18 = PvT18
500

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T0 to T6
n = 6 months = 0.5 years
i1 = 15 % p.a. effective

T6 to T18
We can now think of the investment as worth R536.19… at T6 and use this value for the Pv as we move
forward in time.
n = 12 months
i12 = 1 % p.a. (c.m.)

T18 to T34
n = 16 months = 1.3333… years
j = 14 % p.a. (c.c.)
Fv = Pve jn

This investment is worth R728.19 on 1 November 2018. It is worthwhile to comment at this stage that this
problem can be solved many different ways, the end result should always be the same.

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EVALUATION METHODS OF MULTIPLE TRANSACTION CASH FLOW STREAMS

Multiple transaction cash flow streams describe investments where money is invested at different time
periods, and return on the investment could take place at different time periods. Investors need to decide
whether it is a better option to invest in such a project or to rather place the money in a bank. This section
introduces two methods that can be used to assess such scenario’s.

1.11 Net Present Values (NPV)

A businessman providing capital will want a good return from the money invested. Some method of
comparing the capital outlay with the expected return is necessary to determine if the investment should
proceed. The net present value (NPV) of a cash flow is a method for evaluating the feasibility of an
investment proposal. The NPV determines the present value of all inflows and outflows achieved by a
proposed investment. When a businessman appraises a project, the incoming amounts are referred to as
inflows and the costs as the outflows. The businessman sets a base date and all the inflows and the outflows
relative to this date are determined. The general base date is the start of the project (T0) and all cash flows
involved are determined relative to this point in time.

Example 21
Suppose an investor is asked to invest R5000 in a project and is informed he can expect risk free returns of
R2000 in eighteen months time and R5000 in three years time. Currently the R5000 is sitting in a savings
account earning interest at 12% p.a. compounded monthly. What conclusion should the investor make based
solely on monetary terms?

Solution
The method used is to determine the NPV of the cash flow and based on the result reach a conclusion.

T0 T18 T36

5000 2000 5000

30
There are two compound interest calculations necessary to solve this problem. Simultaneously we bring the
expected returns back to T0.

NPV = inflows + outflows (with outflows calculated as negatives and inflows as positive)

At T0
NPV = -5000 + 2000(1 + i12)-18 + 5000(1 + i12)-36
NPV = -5000 + 5166.66
NPV = R166.66
As the NPV is positive, a return of more than 12% p.a. compounded monthly is expected. If the investor
chooses to finance the proposal his expected returns for the project will be better than if he left the money in
the savings account.

The criteria based solely on monetary terms for deciding the feasibility of an investment are:
a) If NPV > 0 then accept the investment
b) If NPV < 0 then reject the investment

This was a simple illustration but often there is a number of regular inflow and outflows in a business
scenario. Most financial calculators can perform regular calculations provided the time periods between the
cash flows are the same. It is also essential to ensure that the compounding period of the interest rate is the
same period as the time interval between the cash flows.

Example 22
The time diagram indicates outflows and inflows for a project. Determine the NPV of the project assuming an
interest rate of 15% per period.

Time diagram

T0 T1 T2 T3 T4 T5

-10000 -2000 +5000 -2000 15000

31
First clear any cash flow data:

CFi 2nd F CA

Enter the data:

+/- 10000 DATA

+/- 2000 DATA

5000 DATA

DATA
+/- 2000
DATA
15000

2nd F CASH

ENT
15

(NET_PV= will be displayed)

COMP
−697.15

NPV < 0, reject the project

The NPV for this investment is < 0. Therefore a return of less than 15% per period is expected from this
project.

32
1.12 Internal Rate Of Return (IRR)
The NPV is not the sole method for appraising an investment proposal. An alternative approach is to
compare the expected return for different proposals. This is a little more difficult and the method used is to
determine the internal rate of return (IRR). The IRR is the interest rate per period an investment yields when
the NPV of cash flow is equal to zero. The criteria for deciding the feasibility of an investment are:
a) If IRR > an alternative interest rate per period then accept the investment
b) If IRR < an alternative interest rate per period then reject the investment

Example 23
The time diagram indicates outflows and inflows for a project. Determine the IRR of the project assuming an
alternative investment option could yield an interest rate of 15% per period.

Time diagram

T0 T1 T2 T3 T4 T5

-10000 -2000 +5000 -2000 +15000

Solution
Solving for the interest rate (ip) in the equation below yields the IRR per period. Solving this equation is
difficult, you are welcome to try.

0 = -10000 - 2000(1 + ip)-1 + 5000(1 + ip)-2 – 2000(1 + ip)-3 + 15000(1 + ip)-4

Fortunately numerical methods have been written for most financial calculators, and the Sharp EL738 is one
of them. The solution to this problem is solved computationally.

33
Solution

First clear any cash flow data:

CFi 2nd F CA

Enter the data:

+/- 10000 DATA

+/- 2000 DATA

5000 DATA

+/- 2000 DATA

15000 DATA

2nd F CASH RATE (I / Y) = will be displayed

2nd F CA
(if there is a value other than 0)
COMP
12.88% This is the IRR

IRR < 15% (offered by bank), reject the project.

Thus a return of about 12.88% per period is achieved for this investment option. Of the two investment
options, the one yielding a rate of return of 15% per period would be preferred.
Note: These computations are only possible when the time periods between cash flows are of the same
duration. To compute this problem the calculator also requires an interest rate input, which is used as a
starting point for the numerical technique programmed in the calculator.

34
EXERCISES ON SECTIONS 1.1 – 1.5

1. Calculate the interest and Fv in the following:

Present Value Time Interest Rate

a) R 20 000 2 years 10 % simple interest
b) R 15 000 3 years 8 % compound interest (c.a.)
c) R 25 000 1 year 15 % compound interest (c.a.)
d) R 3 000 3 months 20 % compound interest (c.a.)
e) R 8 000 10 months 18 % simple interest
f) R 3 500 1.5 years 12 % compound interest (c.a.)
g) R 12 000 2 years and 5 months 14 % compound interest (c.a.)
h) R 10 000 20 months 16 % simple interest
i) R 9 000 13 months 10 % compound interest (c.a.)
j) R 15 000 30 months 15 % compound interest (c.a.)

2. A 5 years investment at a simple interest rate of 15% yields R2 925 interest, how much money was
invested?

3. After what time period would a loan of R5 400 at a simple interest rate of 23% have a value of R9 747?

4. What was the simple interest rate if interest on a loan of R69 000 amounted to R30 360 after 2 years?

5. How much money should be invested to yield a total of R11 437.60 after 2 years with compound interest
rate of 16%?

6. At what interest rate must R15 000 be invested if after 3 years a total of R6 073.92 interest is earned?

7. For how long must R12 000 be invested at an interest rate of 9% to yield R15 540.35?

8. a) At what rate of simple interest will R1 000 amount to R10 000 in 10 years time?
b) At what rate of compound interest will R1 000 amount to R10 000 in 10 years time?

35
EXERCISES ON SECTIONS 1.1 – 1.9
1. Calculate the future value in each of the following cases:

Present Nominal Interest Term

Value Rate
a) R10 000 10% p.a. (c.a.) 1 year
b) R12 000 8% p.a. (c. sa.) 5 years
c) R2 500 12% p.a. (c.q.) 3 years
d) R18 000 24% p.a. (c.m.) 3 years
e) R15 000 7% p.a. (c.m.) 2 years

2. Find the present value of R19 046.02 due at the end of 2 years if money is worth 12% compound interest
compounded monthly.

3. At what nominal interest rate must R15 000 be invested to grow to R45 000 over a period of 10 years if
compounding occurs quarterly?

4. How many years will it take R3 000 to grow to R10 000, invested at 13% p.a. (compounded daily)?

5. Which of the three interest rates below would you recommend to an investor who intends investing his
money for 5 years? Motivate your response!
(a) 20% simple interest, (b)16% p.a. (c.a.) or (c) 15% p.a.(c.m.).

6. At what nominal rate of interest must R8 000 be invested to accumulate to R12 000 in 4 years if
compounding occurs quarterly?

7. How long will it take an investment to double itself at a nominal interest rate of 12% if compounding
occurs monthly?

8. Which of the following two options would yield the highest return: Option A: 11% annual interest
compounding quarterly or option B: 10.5% annual interest compounding monthly? (Compare equivalent
effective interest rates.)

9. Calculate the annual equivalent effective interest rate of 15.8% p.a. (cm).

36
10. Calculate the monthly equivalent effective interest rate of 13% p.a. (ca).

11. Calculate the quarterly equivalent effective interest rate of 12.2% p.a. (cm).

12. Calculate the annual equivalent effective interest rate of 8.5% p.a. (cd).

13. Calculate the nominal interest rate if compounding occurs daily and the monthly equivalent effective
interest rate is 1.02%.

14. Calculate the nominal interest rate if compounding occurs quarterly and the annual equivalent effective
interest rate is 9.5%.

15. Determine the best investment option between 14.5% p.a. (cq) and 14.8% p.a. (c.sa) by comparing annual
equivalent effective interest rates.

16. What would a R10 000 investment accumulate to in 4 years at a nominal interest rate of 8.5% p. a. and
compounding is continuous?

17. Find the Pv of R7 627.49 invested at a nominal interest rate of 12% p.a. for 2 years if compounding is
continuous.

18. After 3 years, a R5 000 loan has accumulated interest of R1 000. What was the nominal and the annual
equivalent effective interest rate if compounding is continuous?

19. An investor doubles his money when investing at a nominal interest rate of 11.5% p.a. when
compounding is continuous. For how many years was the money invested?

37
EXERCISES ON SECTIONS 1.10 − 1.12

1. An amount of R15 054 is invested for 3 years at a simple interest rate of 12.3% per annum. A certain
amount of money is added to the investment and the total is invested again for 2 more years at a simple
interest rate of 15% per annum. The value of the money after the 5 years is R29 095. How much money
was added to the initial investment after 3 years?

2. Invest R25 000 for 10 years. For the first 2 years, invest at a simple interest rate of 8% per annum. For the
next 4 years, invest at a compound interest rate of 12% per annum, compounded semi-annually and for
the rest of the time, an annual effective interest rate of 15%. What is the total interest earned?

3. A loan was made for R1 950 from the bank for 5 years at 17% interest per annum (c.m.), after 2 years
R950 was paid back while the interest rate dropped to 15% per annum (c.q.).
a) What is the total paid back after the 5 years?
b) What was the total interest?

4. R20 000 is invested for 10 years at 10% p.a. (c.a.) At the end of the first 3 years a withdrawal was made.
The balance was reinvested for the remaining period at 12% p.a.(c.a.) and yielded an amount of R30 000.
Calculate the amount withdrawn.

5. A supply company offers the owner of a new business R20 000 worth of fixtures on credit. The money is
to be repaid in two payments. The first payment is to be made exactly two years after the credit is
granted and the second payment exactly five years after the credit is granted. Assuming that interest is
calculated at 20% p.a. compounded monthly, find the value of each payment given that the second
payment is to be twice the size of the first.

6. Rx was invested at 8% p.a. compounded monthly. After 4.5 years one quarter of the total accumulated
amount was withdrawn and the rest reinvested at j p.a. compounded annually. In another 9.25 years the
account had increased 1.9 times and stood at R10 141. Find j and x rounded to 2 decimal places.

7. The time diagram indicates outflows and inflows for a project. Determine the NPV of the project
assuming an alternative investment option could yield an interest rate of 12% per period effective. Based
on the NPV, indicate which would be the best option.

T0 T1 T2 T3 T4 T5

−15 000 −5 000 7 500 −1 000 8 000 15 000 38

8. The time diagram indicates outflows and inflows for a project. Determine the IRR of the project
assuming an alternative investment option could yield an interest rate of 10% per period effective.
Based on the IRR, indicate which would be the best option.

T0 T1 T2 T3 T4

−5 000 −1 000 2 000 −3 000 10 000

9. An investor is asked to invest in a project. If he invests R15 000 he can expect risk free returns of
R8000 at the end of year two and R11 000 at the end of year three. An alternative investment option
would yield an interest rate of 12% p.a. effective. Calculate the Net Present Value of the project.

39
2. Chapter 2
2.1 Introduction
When a sequence of equal, regular payments (Pt) are made over time, it is called an annuity. We will
consider two types of annuities that are common to the financial world. A simple annuity is one where the
interval between payments and the interest rate compounding period are the same. A complex annuity is one
where the interval between payments and the interest rate compounding period differ. Examples of annuities
with which most people are familiar include; monthly mortgage bond repayments, regular hire purchase
repayments, regular monthly student loan repayments and regular insurance policy contributions.

Basic Concepts and Notation

Present value, Pv.
In the case of a loan, the Pv of an annuity is the lump sum of money secured which will require a series of
regular, equal payments in the future. The time diagram below indicates a series of five regular, equal
payments made in the future to secure a lump sum, the Pv, at T0.

T0 T1 T2 T3 T4 T5

Pv Pt Pt Pt Pt Pt

The present value of the annuity is the lump sum of money secured one period before the first payment is
made. The payments to be made must be equal and the intervals between payments must be the same.

Payment, Pt.
The payment is the fixed amount of money deposited at each payment period during the annuity.

Number of payments, k.
The number of equal, regular payments made throughout the annuity’s life will be denoted by the term k. In
the Pv time diagram above, k = 5 period payments.

40
Future value, Fv.
The future value of an annuity is the amount of money that has accumulated in an account after a series of
regular, equal payments have been made. The time diagram below indicates a series of five regular, equal
payments made in the past to secure a lump sum, the Fv, at T5.
Note: The Fv is the accumulated amount when the last payment is made.

T0 T1 T2 T3 T4 T5

Pt Pt Pt Pt Pt

Fv

Interest rate, im
The rate of interest, im, of an annuity is the interest rate offered or secured for the annuity.

Payment period
The time interval between the equal, regular payments is the payment period.

Note: The formulas that will be introduced in the next section require that the rate of interest compounding
period and the payment period coincide. This concept is best understood using an example.

41
2.2 Simple Annuities
A simple annuity is one where the payment period and the interest rate compounding period are the same.
An example of a simple annuity is one where payments are made annually and the interest rate is
compounded annually. To illustrate the concept of a simple annuity the following example is presented.

Example 24
Determine the present value of a loan that is repaid by 5 monthly payments of R1000 each when the interest
rate is 18% per annum compounded monthly.

Solution
The size of the loan can be determined by computing five separate compound interest calculations. Each
R1000 payment can be brought back to T0. The sum of these five payments at T0 is the Pv of the loan.

Time diagram

T0 T1 T2 T3 T4 T5

1. P 1000 1000 1000 1000 1000

v

Pv1 = 1000 (1 + 0.015 ) −1

Pv5 = 1000 (1 + 0.015 ) −5

The time diagram illustrates how each Pt is brought back to T0.

42
Tabulated calculations:
Period Pv = Fv(1 + i12 ) − n Pv at T0 Pv formula for each time period

T1 Pv1 = 1000 (1 + 0.015 ) −1 R985.22 Pv = Pt (1 + i12 ) −1

T2 Pv2 = 1000 (1 + 0.015 ) −2 R970.66 Pv = Pt (1 + i12 ) −2

T3 Pv3 = 1000 (1 + 0.015 ) −3 R956.32 Pv = Pt (1 + i12 ) −3
T4 Pv4 = 1000 (1 + 0.015 ) −4 R942.18 Pv = Pt (1 + i12 ) −4
T5 Pv5 = 1000 (1 + 0.015 ) −5 R928.26 Pv = Pt (1 + i12 ) −5

Pv of annuity at T0 R4 782.64 Pv = Pt[(1 + i12 ) −1 + ... + (1 + i12 ) −5 ]

The Pv of the annuity at T0 is the sum of the five interest calculations. This is found to be R4782.64. This
type of problem is tedious and requires a number of calculations that are very similar. The only value which
changes for each calculation is n, the number of interest periods. In each case the value of n increases by 1
period. Clearly for a problem that requires a large number of payments these calculations will require some
type of computing equipment. Fortunately the terms in the “Pv formula for each time period” column form a
geometric series. A theoretical derivation of the solution for the series is unnecessary at this stage. Rather the
general solution is presented for application purposes. In the general case where k payments are made this
series converges to the expression below:

1 − (1 + im ) − k 
Pv = Pt  
 im 

This formula can be used to find the Pv of an annuity if we are given the number of payments, the value of
the payments and the interest rate.

43
Example 25
Determine the present value of a loan, which is to be repaid by 5 monthly payments of R1000 each when the
interest rate is 18% per annum, compounded monthly.
Solution
Pv = ?
Pt = 1000
k = 5 monthly payments
j = 18% p.a. compounded monthly
i12 = 1.5 % p.m. effective

1 − (1 + im ) − k 
Pv = Pt  
 im 

1 − (1 + 0.015) −5 
Pv = 1000 
 0.015 

Pv = R4 782.64

44
Note: Most financial calculators have a built in annuity programme. The solution to this problem should be
cross-checked using a financial calculator:

C/Y = 12

Note: The built in financial formula requires one of PV or PMT to be negative. The calculator formula is
programmed this way as most calculations indicate an inflow or outflow of money. You can decide for
yourself how to use the built in formula, just so long as the reported answers are consistent with the problem.

In this example, the Pv of the annuity at T0 is worth R4782.64.

45
To determine the future value of a simple annuity a similar method is used. The equal regular payments are
all moved forward in time. The sum of the payments at the last period in time is the Fv of the annuity. To
illustrate the concept the following example is presented.

Example 26
Determine the future value of a savings account when 5 monthly deposits of R1000 each are made when the
interest rate is 18% per annum compounded monthly.

Solution
In this example we calculate the Fv of the annuity at T5, the point in time when the last deposit is made. The
total value of the deposits, the Fv, can be determined by performing 5 separate compound interest
calculations

Time Diagram

T0 T1 T2 T3 T4 T5

1000 1000 1000 1000 2. 10

00
Fv

Fv5 = 1000 (1 + 0.015 ) 0

Fv1 = 1000 (1 + 0.015 ) 4

46
Tabulated calculations:
Period Fv = Pv(1 + i12 ) n Fv at T0 Fv formula for each time period

T1 Fv1 = 1000 (1 + 0.015 ) 4 R1 061.36 Fv = Pt (1 + i12 ) 4

T2 Fv2 = 1000 (1 + 0.015 )3 R1 045.68 Fv = Pt (1 + i12 ) 3

T3 Fv3 = 1000 (1 + 0.015 ) 2 R1 030.23 Fv = Pt (1 + i12 ) 2

T4 Fv4 = 1000 (1 + 0.015 )1 R1 015.00 Fv = Pt (1 + i12 )1

T5 Fv5 = 1000 (1 + 0.015 ) 0 R1 000.00 Fv = Pt (1 + i12 ) 0

Fv of annuity at T5 R5 152.27 Fv = Pt[(1 + i12 ) 4 + ... + (1 + i12 ) 0 ]

The Fv of the annuity at T5 is the sum of the five interest calculations. This is found to be R5152.27. Once
again the terms in the “Fv formula for each time period” column form a geometric series. In the general case
where k payments are made this series converges to the expression:

 (1 + im ) k − 1
Fv = Pt  
 im 

This formula can be used to find the Fv of an annuity if we are given the number of payments, the value of
the payments and the interest rate.

Example 27
Determine the future value of a savings account when 5 monthly deposits of R1000 each are made when the
interest rate is 18% per annum compounded monthly.

Solution
Fv = ?
Pt = 1000
k = 5 monthly payments
j = 18% p.a. compounded monthly
i12 = 1.5 % p.m. effective

47
  (1 + im ) k − 1
Fv = Pt  
 im 

 (1 + 0.015)5 − 1
Fv = 1000 
 0.015 

Fv = R5 152.27

The solution to this problem should be cross-checked using a financial calculator:

C/Y = 12

Note: Similarly to the Pv example, the built in financial formula requires one of FV or PMT to be negative.
You can decide for yourself how to use the built in formula, just so long as the reported answers are
consistent with the problem.

It is vitally important to take note that the annuity formulas can ONLY be used at the points in time as shown
on the time diagrams.

Annuities are often deferred in such a way that the first of the series of regular payments only begins at some
time in the future (or distant past). A common example is a hire purchase agreement where the first payment
is made three months after securing the funds for the purchase. The idea of a deferred annuity is best
illustrated using a typical example.

48
Example 28
A final year student borrows R10 000 for study fees from a lending institution at an interest rate of 24% per
annum compounded monthly. The student will only be able to begin the loan repayments exactly 13 months
after the loan is granted. Determine the value of the payments assuming the lending institution would like to
have it repaid in 18 equal monthly installments.

Solution
k = 18 monthly payments
j = 24 % p.a. (compounded monthly)
i12 = 2 % p.m. effective
Pv (at T0) = 10000
Pt = ?

It is best to view this problem using a time diagram. The initial loan is placed at T 0, the first of the regular
payments at T13, the second at T14 and so on until the last payment is made at T30.

Time Diagram

T0 T1 T11 T12 T13 T29 T30

10000 Pt Pt Pt

The two annuity formulas presented thus far, the one for Pv and the one for Fv can only be used at either T12
or T30 respectively. The solution requires we move the value of the loan to either of these time periods before
we can use one of the annuity formulas. This is easy enough as we can move the value of the loan from T 0 to
T12 using the compound interest formula developed in chapter 1. It is then possible to calculate the necessary
payments using an annuity formula.

49
Solution continued:
Move the loan from T0 to T12
n = 12 months

T0 T1 T11 T12 T13 T29 T30

10000 12682.42 Pt Pt Pt

To calculate the Pt from T13 to T30, given the lump sum value at T12 we use the Pv annuity formula with
k = 18 (payment) months
Fvat T12 = Pvat T12 = 12682.42

To settle the debt, the student will need to make 18 equal payments of R845.94 starting 13 months after
securing the loan.

50
2.3 Additional Examples of Simple Annuities
Example 29
Mr Pazi is planning to purchase a holiday home in Port Alfred. A loan of R400 000 is secured at an interest
rate of 21% per annum compounded monthly. The loan is to be amortised by equal monthly payments over
the next 20 years, the first payment falling due one month after securing the loan. Find the value of the
payments.
Solution
Pv = 400 000
j = 21 % p.a. (c.m.)
i12 = 1.75 % p.m. effective
k = 20 × 12 monthly payments = 240 monthly payments
Pt = ?

To settle the debt, Mr. Pazi will need to make 240 monthly payments of R7110.57 each starting one month
after securing the loan.

Note: Something to ponder; Do interest rates fluctuate over the course of a loan?

51
Example 30
Dr van Rooyen is planning to set up a private practice. She requires a loan of R500 000 which is secured
from a local bank at an interest rate of 18% per annum compounded monthly. Her budget allows equal
monthly repayments of R15 000, the first payment falling due exactly 6 months after securing the loan.
Determine the required number of payments.

Solution
Pv (at T0) = 500 000
j = 18 % p.a. (c.m.)
i12 = 1.5 % p.m. effective
k = ? monthly payments
Pt (starting at T6) = 15 000

Move loan to T5

Determine k by rearranging annuity formula

In the interim period we simplify this problem by rounding up k and record an approximated value. In
chapter 3 we will be shown how to find a solution for problems when k is not an integer. To settle the debt,
Dr van Rooyen will need to make approximately 52 monthly payments of R15 000 each starting 6 months
after securing the loan.
This problem can be done using the financial calculator. Practice for yourself how to get the correct answer.

52
There is one shortcoming to the annuity formulas we have used thus far. The value of im cannot be found
using simple algebraic methods. For the purposes of this course it will be adequate to find the rate of interest
using the financial calculator.

Example 31
Find im given
k = 10 period payments
Pv = 500
Pt = 60 per period

Solution

Using the fin calc.

2nd F CA
To clear any other information from previous calculations

2nd F P/Y 12 ENT

ON/C

10 N

500 PV

- 60 Pmt

COMP I/Y

im = 3.4601…% per period … will be displayed.

Note: The calculator requires some time to compute this value.

It would be sufficient to report this answer to two decimal places, i.e. the rate of interest is 3.46 % effective
per period.

53
2.4 Complex Annuities
A complex annuity is one where the payment period and the interest rate compounding period are different.
A common example would be a loan with equal monthly payments and an interest rate with annual
compounding. To solve complex annuity problems we convert them to simple annuities. The procedure
requires finding the equivalent effective interest rate per payment period. The procedure is best illustrated
with an example.

Example 32
Determine the present value of a loan that is repaid by 5 monthly payments of R1000 each when the interest
rate is 18% per annum compounded annually.

Time diagram

T0 T1 T2 T3 T4 T5

3. P 1000 1000 1000 1000 1000

v

Solution
Pv = ?
Pt = 1000
k = 5 monthly payments
j = 18 % per annum (compounded annually)
i1 = 18 % p.a. effective

The compounding period and payment period differ. To use an annuity formula it is necessary to find the
equivalent effective interest rate per payment period, i.e. in this case per month.

i12 = ? % p.m. effective

i p = (1 + im ) p − 1
m

1 1
i12 = (1 + i1 ) 12 − 1 = (1 + 0.18) 12 − 1 = 1.38884303...% p.m. effective

54
In problems such as these it is recommended to use as many decimal places as your calculator will allow. If
one rounds off to soon it can adversely affect the final answer.

1 − (1 + im ) − k 
Pv = Pt  
 im 

1 − (1 + 0.0138884303)−5 
Pv = 1000 
 0.0138884303 
Pv = R4798.24

At T0 the value of the loan that is secured is R4 798.24.

55
Example 33
A final year student borrows R10 000 for study fees from a lending institution at an interest rate of 24% per
annum compounded quarterly. The student will only be able to begin the loan repayments exactly 13 months
after the loan is granted. Determine the value of the payments assuming the lending institution would like to
have it repaid in 18 equal monthly installments.

It is best to illustrate this problem using a time diagram. It is possible to use the Pv annuity formula if we
have the value of the loan at T12.

T0 T1 T11 T12 T13 T29 T30

10000 Pt Pt Pt

Solution
Pv (at T0) = 10000
j = 24 % p.a. (compounded quarterly)
i4 = 6 % p.q. effective
k = 18 monthly payments

Move the loan from T0 to T12

n = 12 months = 4 quarters in a year

T0 T1 T11 T12 T13 T29 T30

10000 12624.77 Pt Pt Pt

56
To calculate the Pt from T13 to T30, given the lump sum value at T12 we find the equivalent effective interest
rate per month and then we can use the Pv annuity formula

Now we can use the Pv annuity formula

To settle the debt, the student will need to make 18 equal payments of R839.23 starting 13 months after
securing the loan.

Note: In example 28 the same problem was illustrated except the interest rate was 24% per annum
compounded monthly. If you were the student which interest rate would you prefer?

57
2.5 Additional Examples of Complex Annuities

Example 34
Mr Pazi is planning to purchase a holiday home in Port Alfred. A loan of R400 000 is secured at an interest
rate of 21% per annum compounded monthly. The loan is to be amortised by equal annual payments over the
next 20 years, the first payment falling due one year after securing the loan. Find the value of the payments.
Solution
Pv = 400 000
j = 21 % p.a. (c.m.)
i12 = 1.75 % p.m. effective
k = 20 annual payments
Pt = ?

Find the equivalent effective interest rate per payment period:

i1 = ? % p.a. effective

To settle the debt, Mr. Pazi will need to make 20 equal, annual payments of R94 038.05 each starting one
year after securing the loan.

58
Example 35
Dr van Rooyen is planning to set up a private practice. She requires a loan of R500 000 which is secured
from a local bank at an interest rate of 18% per annum compounded monthly. Her budget allows equal half
yearly repayments of R80 000, the first payment falling due exactly 6 months after securing the loan.
Determine the required number of payments.

Solution
Pv (at T0) = 500 000
j = 18% p.a. (c.m.)
i12 = 1.5% p.m. effective
k = ? half yearly payments
Pt (starting at T6) = 80 000

Find equivalent effective interest rate per payment period:

Determine k by rearranging annuity formula

To simplify this problem, we will round up k and report an approximated value. To settle the debt, Dr van
Rooyen will need to make approximately ten half yearly payments of R80 000 starting 6 months after
securing the loan.

59
Class exercise:
A vehicle is purchased and financed with a loan that is secured at 14% p.a. (ca). The payments start 6 months
after the purchase is made, and the loan is paid off over 60 months with payments of R2 412.43.
a) Give the effective interest rate per payment period.
b) What was the price of the vehicle when it was purchased?
Solution:
a)

b)
T0
… T5 T6
… Tn

PV0 PMT PMT

FV5 = PV5

60
Exercises: Sections 2.1 – 2.5
1. Calculate the future value of 10 monthly deposits of R2 500, deposited at an interest rate of 14% p.a.
(c.m.)

2. Calculate the future value of 10 monthly deposits of R2 500, deposited at an interest rate of 14% p.a.
(c.q.)

3. A R15 000 loan is to be amortised by 120 equal monthly payments of R270.28. Calculate the nominal
interest rate if compounding occurs monthly.

4. A R175 000 loan is to be amortised by equal monthly payments of R5 034.39 over 5 years. Calculate
the effective annual interest rate if compounding occurs monthly.

5. A loan of R250 000 is to be amortised by equal monthly payments of R6 348.36 at a nominal interest
rate of 18% p.a. (c.m.).
a) What is the effective monthly interest rate?
b) Calculate the duration of the loan.

6. A loan of R8 000 is to be amortised by equal monthly payments over the period of one year at an
interest rate of 15% p.a. (c.q.).
a) What is the effective interest rate per payment period?
b) Calculate the value of the payments.

7. A R75 000 loan is secured at 8% p.a. (c.a.), and will be paid off over 5 years with equal annual
payments. Calculate the value of the payments.

8. A R15 000 loan is secured at 24% p.a. (c.m.). The loan will be amortised over 5 years by equal
quarterly payments.
a) What is the effective interest rate per payment period?
b) Calculate the value of the payments.

9. A loan is secured at 22% p.a. (c.q.) and will be paid of over a period of 20 years by equal quarterly
payments of R42 000. Calculate the original value of the loan.

61
10. A loan is secured at 9% p.a. (c.q.) and will be paid of over a period of 15 years by equal annual
payments of R16 000.
a) What is the effective interest rate per payment period?
b) Calculate the original value of the loan.

11. A loan is secured at 8% p.a. (c.a.) and will be paid of over a period of 5 years by equal monthly
payments of R1 510.73.
a) What is the effective interest rate per payment period?
b) Calculate the original value of the loan.

12. A student is given a R12 000 loan at an interest rate of 12% p.a. (c.m.). The student will be able to
start paying off the loan 13 months after the loan is granted. The loan is to be amortised by 60 equal
monthly payments. Calculate the value of the payments.

13. A vehicle is purchased at a cost of R79 000 (Financing for the full amount is arranged at an interest
rate of 9% p.a. (c.a.)). The customer will be able to start paying R5 000 per month, 4 months after
purchasing the vehicle. Calculate how long it will take to pay off the vehicle.

14. A student is given a R12 000 loan at an interest rate of 12% p.a. (cm). The student will be able to start
paying off the loan 13 months after the loan is granted. The loan is to be amortised by 60 equal
monthly payments. Calculate the value of the payments.

15. A woman buys a 2nd hand car. She agrees to pay R950 per month starting the payments three month
after receiving the car. Find the value of the car when she takes ownership if she makes 48 payments
and if the interest rate is charged at 24% p.a. compounded monthly.

16. A R800 000 home loan is secured at 10% p.a. compounded monthly. Monthly payments of R12 000
are made, but the first payment was made only after three months. Determine the required number of
payments.

62
17. A student has R40 000 available for his studies that will take 4 years to complete. If he invests this
money at 14% p.a. compounded annually, what equal amounts can he withdraw at the beginning of
each month assuming the first withdrawal is one month after securing the investment.

18. Find the initial amount of money that must be invested on a girl’s 10th birthday to provide her with
three consecutive annual payments of R10 000. The first payment is to be made on her 20 th birthday
and interest is calculated at 12% p.a. compounded monthly.

63
3. Chapter 3

3.1 Moving Money Through Time

In principle loans that are encountered in business are similar to annuity problems. Many a loan requires
regular, equal payments over a fixed period of time. Interest rates can be fixed when securing the loan
thereby ensuring the payments to be made are equal. It is not unusual in business circumstances for a
borrower to settle their outstanding debt in a single payment. To determine the amount to be repaid in one
payment requires one to understand how money “moves through time”. This concept is best illustrated by
means of an example.

Example 36
In example 25 the present value of a loan, which was to be repaid by 5 equal monthly payments of R1000
was calculated and found to be R4782.64. The interest rate was fixed at 18% per annum, compounded
monthly. Assuming the person borrowing the money would like to settle the debt just after the third payment
is made, how much should be repaid? This problem can be solved using two methods. In both cases we are
required to “move the value of money” to the point in time where the settlement of debt is to occur.

Solution
Pv = 4782.64
Pt = 1000
k = 5 monthly payments
j = 18% p.a. compounded monthly
i12 = 1.5 % p.m. effective

Method 1 (The retrospective method)

To determine the amount outstanding we need to move the value of the loan to T3. The difference between
the value of the loan at T3 and the value of the payments made prior to and including the payment at T3 is the
amount outstanding at T3. The value of the loan is a single amount and can be moved to T3 using the
compound interest formula developed in chapter 1. The value of the payments prior to and including the
payment at T3 is the future value of the payments made at T1, T2 and T3 respectively. The value of these
equal payments at the point in time, T3, where the settlement of debt is to occur, can be determined using the
future value annuity formula developed in chapter 2. Refer to the time diagram for an illustrative
representation of this problem.

64
Time diagram

T0 T1 T2 T3 T4 T5

4782.64 1000 1000 1000 1000 1000

Value of payment made at T3

 (1 + im ) k − 1
Fv(T3 ) = Pt  
 im 
Fv(T3 ) = Pv (1 + im ) n
Value of loan at T3

Value of the loan at T3

Fv(T3 ) = 4782 .64(1 + 0.015 )3 = R5001 .10

The value of the payments made up to and including the payment at T3

 (1 + 0.015 ) 3 − 1
Fv(T3 ) = 1000   = R3045 .22
 0.015 

The outstanding amount, or outstanding balance is the difference of the value of the loan and the payments
already made.
Outstanding Balance = Value of amount borrowed (at T3) – Value of payments made (at T3)

BT 3 = Fv( amount borrowed ) − Fv( payments made)

 (1 + 0.015 )3 − 1
BT3 = 4782 (1 + 0.015 )3 − 1000  
 0.015 

BT3 = R5001.10 – R3045.22 = R1955.88.

65
Method 2 (The prospective method)
To settle the debt we need to “move the value” of the payments from T4 and T5 backwards in time to T3. The
value of these payments which have yet to be made equates to the outstanding debt. To find the outstanding
debt, we bring the payments from T4 and T5 back to T3. As the two payments are equal, the interest rate is
fixed and we require the combined value one period before the first payment is due, we can use the present
value annuity formula developed in Chapter 2. Refer to the time diagram for an illustrative representation
of this problem.

Time diagram

T0 T1 T2 T3 T4 T5

4782.64 1000 1000 1000 1000 1000

1 − (1 + im ) − k 
Pv = Pt  
 im 

Out. Balance = Value of payments still to be made at T3

Outstanding balance = Value of payments still to be made (at T3)

1 − (1 + 0.015) −2 
BT 3 = Pv(Payments still to be made ) = 1000 
 0.015 

BT3 = R1955.88

The concept that money can “move through time” is important for the rest of work covered. It is also
important to be able to differentiate between a single sum of money moving through time and multiple, equal
and unequal sums of money moving through time. If we need to move a single amount through time, it is
easiest to use the compound interest formula developed in Chapter 1. If we move multiple, equal amounts
through time it is easiest to use one of the annuity formulae developed in Chapter 2.

66
Example 37
In example 29 Mr. Pazi was planning to purchase a holiday home in Port Alfred. The loan of R400 000 was
secured at an interest rate of 21% per annum compounded monthly. The loan was to be amortised by equal
monthly payments of R7110.57 over the next 20 years. The first payment was due one month after securing
the loan. Assuming Mr. Pazi wins the national lottery six years after securing the loan and decides to settle
the debt immediately. Determine the settlement amount if he settles the debt at the same time he makes the
72nd payment.
Solution
Pv = 400 000
j = 21 % p.a. (c.m.)
i12 = 1.75 % p.m. effective

k = 20  12 monthly payments = 240 monthly payments

Pt = R7 110.57

Retrospective method
At T72
Outstanding balance = Value of amount borrowed (at T72) – Value of payments made (at T72)
BT 72 = Fv( amount borrowed ) − Fv( payments made)

BT72 = 1394883.96 – 1010598.86 = R384 285.10

Prospective method
At T72
Outstanding balance = Value of payments made still to be made (at T72)

These two answers differ slightly. Why does this happen? The answer to this question will follow shortly.

67
3.2 Simple Loans
In example 37 we calculated the outstanding balance of a loan using the retrospective and prospective
methods. The answers that were obtained for these two methods differed slightly yet both methods are
correct; one may wonder why this happens? In example 37 the difference was negligible; this difference is a
direct result of the rounding effect when performing calculations of this nature. In other cases the rounding
off can result in huge differences.

Let us return to example 35.

In example 35, Dr van Rooyen was setting up her private medical practice. She required a loan of R500 000,
which was secured from a local bank at an interest rate of 18% per annum, compounded monthly. Her budget
allowed for equal half yearly repayments of R80 000, the first payment fell due exactly 6 months after
securing the loan. The number of payments required to settle the debt was calculated to be 9.818… half-
yearly payments. In this example we chose to round up the number of half-yearly payments to 10. This
would mean that the 10th and final payment to be made would be R80 000. Intuitively we realize that the
necessary payment should be less than R80 000. If you were Dr van Rooyen, would you be willing to pay
more than is necessary? Now that we know how to move money through time it is a simple process to
calculate the actual value of the final payment.

Example 38
Finding the value of a final payment
Find the value of the 10th (and final) payment of Dr van Rooyen’s loan.
Pv (at T0) = 500 000
j = 18% p.a. (c.m.)
i2 = 9.344326392% p.hy. effective
k = 9.818… half yearly payments
Pt (starting at T6) = 80 000

Time diagram

T0 T1 T2 T9 T10

80 000 80 000 80 000 F

500 000

68
Solution
The way to solve this problem is to “move” all the money to a base point in time. The value of the money
borrowed must equal the value of the payments at this base point in time. Let us denote the final unknown
payment as F. The final payment is a single value and can be moved back and forth through time using the
compound interest formula. The equal R80 000 payments can also be moved through time, but only to
points T0 (the PV annuity formula) and T9 (the FV annuity formula). Once one has calculated a single value
for these equal payments this single value can be moved back and forth through time using the compound
interest formula. Finally the last option available is to move the single valued sum of money borrowed back
and forth through time.

Method (move all the payments to T0 and equate this to the value of the loan secured at T0).
At T0
Value of loan = Value of all payments
1 − (1 + im )− k  −n
500 000 = Pv( regular payments) + Pv( final payment ) = Pt   + Fv(1 + im )
 im 

1 − (1 + 0.09344326...)−9  −10
500 000 = 80 000  + F (1 + 0.09344...) = 472978.42 + 0.40929597F
 0.09344326... 
F = 66019.66
The final payment should be R66 019.66. This is noticeably different from the R80 000 initially assumed.

Alternative method (move the value of the loan to T10 and equate this to the value of the payments to T10.)

 (1 + 0.09344326...)9 − 1
500 000(1 + 0.09344...)10 = 80 000 (1 + 0.09344...) + F
1

 0.09344326... 

F = R66 019.66
This is a confirmation of the previous result.

69
3.3 Additional Example of Simple Loans
Example 39
A building contractor secures a loan of R1 000 000 from a financial institution. The institution fixes the
interest rate at 18% p.a. compounded monthly. Loan repayments are to be made monthly starting one month
after the loan is secured. The contractor budgets for monthly payments of R16 100. Determine the number of
monthly payments and the value of the final payment.

Solution
Pv = 1000 000
j = 18% p.a. (c.m.)
i12 = 1.5 % p.m. effective
Pt = 16 100 per month
k = ? monthly payments

Solution
To solve this problem assume all payments to be made equal R16 100. Using this assumption determine the
number of “equal” payments required. Once the number of “equal” payments required is calculated the
contractor can make (k – 1) payments of R16 100 and the kth (and final) payment can be calculated as shown
in example 38.

Finding k, the number of “equal” payments to be made

70
Therefore the contractor is required to make 180 equal payments of R16 100 and a final payment, F which is
less than R16 100.

Finding F, the final payment

At T0
Value of loan = Value of all payments

To settle the loan, the contractor will need to make 180 payments of R16 100 and a final (181 st) payment of
R3 870.28.

71
3.4 Loans and Amortization Tables
For any loan that is secured the payments that are needed to repay the debt consists of two parts. One part of
the payment, Pt, pays off interest, I. The second part of the payment reduces the capital and is referred to as
the principal amount, Prn, of the payment. A simple formula for this is Pt = I + Prn.

All long term loans are easily arranged in a simple spreadsheet format. The sequential nature of a loan is such
that the value of the loan and other terms of interest can be arranged in a column format. One such common
tabular arrangement of a loan is the amortization table. The table is constructed to include the outstanding
balance after each payment is made, and partitions the payment into the interest and principal components.

The solution to setting up a sequential tabular summary is to realize that the interest (I) at any point in time,
is the previous periods present value (Pv) multiplied by the interest rate (i). The question is, what is the
previous periods present value? This is the outstanding balance of the loan.

That is,
I t = Pvt −1  ( i )  (1) = OBt −1  i.

The principal (Prn) is the difference between the payment and the interest. That is, Prnt = Ptt − I t . Thereafter

we recalculate the outstanding balance by deducting the principal from the previous periods outstanding
balance. The remainder is what is still owed.

That is
OBt = OBt −1 − Prnt

Once one has learnt how to find the outstanding balance at any point in time for a loan, it is relatively simple
to determine how much of the following installment pays off interest and how much pays off the capital. To
illustrate this concept we return to examples 25 and 36.

Example 40
In example 25 the present value of a loan, which was to be repaid by 5 equal monthly payments of R1000
was calculated and found to be R4782.64. The interest rate was fixed at 18% per annum, compounded
monthly. In example 36 the person borrowing the money determined that the outstanding balance after the

72
third payment was made was R1955.88. Determine how much of the next payment, the 4th payment, pays off
the interest and how much pays off the capital?
Pv = 4782.64
Pt = 1000
k = 5 monthly payments
j = 18% p.a. compounded monthly
i12 = 1.5 % p.m. effective
BT3 = R1955.88
IT4 = ?
PrnT4 = ?

Time diagram

T0 T1 T2 T3 T4 T5

4782.64 1000 1000 1000 1000 1000

I4
BT3 = R1955.88
Prn4

Solution
Find the interest portion of the 4th payment, I4.
I 4 = Pv3  ( i )  (1) = OB3  i
= 1955.88  0.015
= R 29.34
Find the principal portion of the 4th payment, Prn4.
Prn4 = Pt4 − I 4
= 4782.64 − 29.34
= R970.66
Find the outstanding balance at T4 once the 4th payment has been made.
OB4 = OB3 − Prn4
= 1985.22 − 970.66
= R985.22

73
This process can be continued for each payment and the results displayed as a table. The tabulated results are
the amortization table. This table is ideally suited for loans with equal, regular payments. The individual
formulae for the amortization table are shown below.

Amortization table

Payment no. Reduction on debt

Payment (Pt) Interest (I) Outstanding Balance (B)
(k) (Prn)

--- --- --- --- BT0

Pt 1 I1 = BT0.im Prn1 = Pt – I1 BT1 = BT0 – Prn1
Pt 2 I2 = BT1.im Prn2 = Pt – I2 BT2 = BT1 – Prn2
… … … … …
Pt k-1 Ik-1 = BTk-2.im Prnk-1 = Pt – Ik-1 BTk-1 = BTk-2 – Prnk-1
Pt k Ik = BTk-1.im Prnk = Pt - Ik BTk = BTk-1 - Prnk

Example 41
In example 25 the present value of a loan, which was to be repaid by 5 equal monthly payments of R1000
was calculated and found to be R4782.64. The interest rate was fixed at 18% per annum, compounded
monthly. Prepare an amortization table for this problem.

Amortization table

Payment made Payment no. Reduction on debt Outstanding Balance

Interest (I)
(Pt) (k) (Prn) (B)

0 0 0 0 4782.64
1000 1 71.74 928.26 3854.38
1000 2 57.82 942.18 2912.20
1000 3 43.68 956.32 1955.88
1000 4 29.34 970.66 985.22
1000 5 14.78 985.22 0.00

74
3.5 Missed Payments
It is common during the life span of a loan that a single or multiple payments are missed. In this case some
form of compensation is required to account for the missed payments. A number of scenarios are possible.
• The value of the missed payment can be “added” to the next payment to be made.
• The value of the missed payment can be “added” to the final payment to be made.
• The value of the missed payment can be “added” to the remaining payments to be made.
• The duration of the loan can be increased and the value of the missed payment can be “added” to this
extension period either as a single payment or as multiple payments.
In each case the “adding” requires a different calculation. To determine the value of the missed payment later
in time we need to apply the concept of “moving money through time” to the missed payment. Solutions to
these scenarios are best illustrated using examples.

Example 42
A loan of R10 000 has been secured at an interest rate of 18% p.a. compounded monthly. The loan is to be
repaid by 24 equal monthly installments of R499.24. This scenario is shown below.

T0 T1 T2 T7 T8 T9 T10 T23 T24

10000 499.24 499.24 499.24 499.24 499.24 499.24 499.24 499.24

Assuming payments from T7 to T9 are missed, compensation for these missed payments will be necessary.
This scenario is shown below

T0 T1 T2 T7 T8 T9 T10 T23 T24

10000 499.24 499.24 MP MP MP 499.24 499.24 499.24

75
a) Find the additional amount that must be added to the 10th payment to compensate for the missed
payments.

T0 T1 T2 T7 T8 T9 T10 T23 T24

10000 499.24 499.24 499.24 499.24 499.24 499.24 499.24 499.24

FvT9 of missed pts FvT10 of missed pts

Solution
Find the value of the missed payments at T9

Move this single value from T9 to T10

To compensate for the three missed payments at T7, T8 and T9, a single additional payment of R1543.10 must
be made at T10.

76
b) Find the additional amount that must be added to the final payment to compensate for the missed
payments.

T0 T1 T2 T7 T8 T9 T10 T23 T24

10000 499.24 499.24 499.24 499.24 499.24 499.24 499.24 499.24

FvT9 of missed pts

FvT24 of missed pts

Solution
From (a), the value of the missed payments at T9 is R1520.30

Move this single value from T9 to T24

To compensate for the three missed payments at T7, T8 and T9, a single additional payment of R1900.73 must
be made at T24.

An alternative method for solving (a) and (b) would be to find the value of the missed payments at T 6. It is
then possible to move this single value to T10 and T24 for (a) and (b) respectively. The answers are the same;
the solution is left for the reader to confirm.

77
 c) Find the equal amount that must be added to each of the remaining payments to compensate for the
missed payments.

T0 T1 T2 T7 T8 T9 T10 T23 T24

10000 499.24 499.24 499.24 499.24 499.24 499.24 499.24 499.24

x x x

FvT9 of missed pts

Solution
From (a), the value of the missed payments at T9 is R1520.30

This single value at T9 can be identified as an annuity present value for the equal payments x at T10 to T24 all-
inclusive.

In addition to the R499.24 payments from T10 to T24, fifteen additional equal payments of R113.94 must be
made to compensate for the missed payments.

78
3.6 Changes in Interest Rates
It is common during the life span of a loan that the interest rate changes. In this case two common scenarios
are possible.
• The value of the remaining payments can be increased if the interest rate increases or decreased if the
interest rate decreases.
• The value of the payments can remain the same whilst the number of payments required can be increased
if the interest rate increases or decreased if the interest rate decreases.

Scenario 2 is not as common as scenario 1, for illustration purposes we only consider the case where the
values of the payments are adjusted.

Example 43
A loan of R10 000 has been secured at an interest rate of 18% p.a. compounded monthly. The loan is to be
repaid by 24 equal monthly installments of R499.24. When the 8th payment is made the interest rate increases
from 18% p.a. compounded monthly to 21% p.a. compounded monthly. Determine the value of the new
equal repayments from T9 to T24 all-inclusive. This scenario is shown below.

T0 T1 T2 T7 T8 T9 T10 T23 T24

10000 499.24 499.24 499.24 499.24 499.24 499.24 499.24 499.24

i12 = 1.5% p.m. (eff.) i12* = 1.75% p.m. (eff.)

To solve this problem one needs to find the outstanding balance at T8 and then treat the outstanding balance
as a new loan with a new interest rate.

79
Solution
Finding outstanding balance at T8 using the retrospective method
B = Fv ( amount borrowed ) − Fv ( payments made)

This is shown on the time diagram below. Let x denote the value of the new, equal repayments to be made
from T9 to T24.

T0 T1 T2 T7 T8 T9 T10 T23 T24

10000 499.24 499.24 499.24 499.24 x x x x

i12 = 1.5% p.m. (eff.) i12* = 1.75% p.m. (eff.)

BT8 = R7054.93

Find the new payments, x, using the new interest rate.

To compensate for the change in interest rate, equal, regular payments of R509.36 must be made from T9 to
T24 inclusive.

80
 3.7 Missed Payments and Changes in Interest Rates
It is common during the term of a loan that a payment is missed and the interest rate changes. In this case
several scenarios are possible. Each case must be analyzed separately, solutions to some simple examples are
illustrated below.
Example 44
Returning to example 42 where a loan of R10 000 has been secured at an interest rate of 18% p.a.
compounded monthly. The loan is to be repaid by 24 equal monthly installments of R499.24. Assume
payments from T7 to T9 inclusive are missed and at T8 the interest rate changes to 15% p.a. compounded
monthly. An adjustment for the change of interest rates will be necessary and compensation for the three
missed payments will be required. This scenario is shown below.

Time diagram

T0 T1 T2 T7 T8 T9 T10 T23 T24

10000 499.24 499.24 MP MP MP 499.24 499.24 499.24

Start of loan: i12 = 1.5% p.m. effective

i12 = 1.5% p.m. New rate: i12* = 1.25% p.m.

effective effective

Problems like this must be approached cautiously. There is no single method to solving problems like this,
each individual case may require an alternative solution strategy.

81
 Solution
To compensate for the missed payments and adjust for the new interest rate find the new equal repayments
from the 10th payment onwards.

T0 T1 T2 T7 T8 T9 T10 T23 T24

10000 499.24 499.24 MP MP MP x x x

Start of loan: i12 = 1.5% p.m. effective

i12 = 1.5% p.m. New rate: i12* = 1.25% p.m.

effective effective

Steps to follow:
• Find the outstanding balance one period before the first payment is missed, i.e. at T6.
• Move the outstanding balance to the period where the interest rate changes, i.e. at T8.
• Move the outstanding balance to the last missed payment, i.e. at T9.
• Using the outstanding balance at T9, determine the new equal, x, payments to be made from T10 to T24.

Solution
Find the outstanding balance one period before the first payment is missed, i.e. at T6.
 (1 + i12 )k − 1
BT 6 = Fvloan − Fv paymentsmade = Pv(1 + i12 ) − Pt 
n

 i12 

 (1 + 0.015)6 − 1
BT 6 = 10000(1 + 0.015)6 − 499.24  = 10934.43 − 3110.04 = R7 824.39
 0.15 

Move the outstanding balance to the period where the interest rate changes, i.e. at T8.
FvBT 8 = Pv (1 + im ) n = 7824 .39 (1 + 0.015 ) 2 = R8 060 .88

Move the outstanding balance to the last missed payment, i.e. at T9.
FvBT 9 = Pv (1 + im ) n = 8060 .88(1 + 0.0125 )1 = R8161 .64
*

Using the outstanding balance at T9, determine the new equal, x, payments to be made from T10 to T24.
82
Pt x = Pv 
(
1 − 1 + i *
12 )
−k
 1 − (1 + 0.0125 )−15 
 = 8161 .64   = R 600 .10
*
 i12   0 .0125 

83
3.8 Depreciation and the Sinking Fund Method
Assets like buildings, machinery, vehicles, computers, etc., decrease in value as they age. In recent years, the
rapid advances in computer technology have resulted in a rapid decrease in the value of “old” computers.
There are many methods of assessing the depreciation of an asset, we will cover one such method known as
the sinking fund method. This method requires the establishment of a fund, which is used to replace an asset
at the end of its useful life. Determining the length of its useful life requires knowledge about the asset and is
best left to experts in their respective fields. The concept of a sinking fund is best illustrated using an
example.

Example 45
A laptop computer has been purchased at a cost of R15 000. It is known that the life term of the laptop is four
years and it will then be necessary to replace the asset. It is estimated that to replace the laptop in four years
time will cost R25 000. It is also estimated that the laptop can be sold secondhand for R5 000. Establish a
sinking fund to replace the laptop in four years. Monthly deposits are to be made into the fund and the fund
will earn interest at an interest rate of 12% p.a. compounded monthly.

Time Diagram

T0 T1 T2 T46 T47 T48

Pt Pt Pt Pt Pt
Current: R15 000
Replace: R25 000

Scrap value: R5 000

Solution
To purchase the new asset, the value to be accumulated in the fund is R25 000 – R5 000 = R20 000.
Determine the regular savings deposits necessary for the fund
 (1 + im )k − 1
FvT 48 = Pt  
 im 

84
 −1 −1
 (1 + im )k − 1  (1 + 0.01)48 − 1
Pt = Fv   = 20000   = R326 .68
 im   0.01 

In the previous example we were given the estimated replacement costs and the estimated scrap value of the
asset. Often these estimates are unknown and one is required to estimate them oneself. To determine how to
solve this problem we need to acknowledge that an asset depreciates in value. Compound depreciation is a
common depreciating tool. The principle is similar to compound interest; the difference between compound
interest and compound depreciation is the interest rate used is negative. This concept is best illustrated
using an example.

Example 46
A laptop computer has been purchased at a cost of R15 000. It is known that the life term of the laptop is four
years and it will then be necessary to replace the asset. To replace the laptop in four years time a sinking fund
is to be established. It is expected the asset will depreciate at 25% p.a. effective. The cost of replacing the
laptop will increase at 15% p.a. compounded monthly. Determine the monthly deposits necessary to effect
the replacement. Assume monthly deposits into a savings account earn interest at a rate of 15% p.a.
compounded monthly.
Time Diagram

T0 T1 T2 T46 T47 T48

Pt Pt Pt Pt Pt
Current: R15 000
Replace: Unknown

Scrap value: Unknown

Solution
Find the value of the “old” laptop at T48
Fv = Pv (1 + im ) n = 15000 (1 + (−0.25)) 4 = R 4746 .09

Find the value of the “new” laptop at T48

Fv = Pv (1 + im ) n = 15000 (1 + 0.0125 ) 48 = R 27 230 .32

The value to be accumulated in the fund is R27230.32 – R4746.09 = R22 484.23

85
Determine the regular savings deposits necessary for the fund
−1 −1
 (1 + i m ) k − 1  (1 + 0.0125 )48 − 1
Pt = Fv   = 22484 .23   = R344 .70
 im   0.0125 

To extend the life of certain assets it is common to include maintenance costs in the sinking fund. If the
sinking fund has been constructed in such a way that monthly savings are put aside, it is then possible to
include in the monthly savings a portion which will provide for the maintenance costs of the asset. The
concept of a sinking fund that includes maintenance costs is best illustrated using an example.

Example 47
A transport vehicle has been purchased at a cost of R150 000. It is known that the life term of the vehicle is
six years and it will then be necessary to replace the vehicle. To replace the vehicle in six years time a
sinking fund is to be established. It is expected the asset will depreciate at 20% p.a. effective. The cost of
replacing the vehicle will increase at 12% p.a. compounded monthly. Yearly maintenance costs will be
necessary to ensure the vehicle life term will be no less than six years. The maintenance costs are estimated
to be R2000 per year; the first maintenance will be required exactly one year after the vehicle is purchased
and the last maintenance will be necessary when the vehicle is to be resold. Determine the monthly deposits
necessary to effect the replacement. Assume monthly deposits into a savings account earn interest at a rate of
12% p.a. compounded monthly.
Time Diagram

T0 T1 T12 T60 T71 T72

Pt Pt Pt Pt Pt

Current: R150 000 Pt Maint Pt Maint Pt Maint

Maintenance costs

Replace: Unknown

Resale value: Unknown

Solution
86
Find the scrap value of the “old” vehicle at T72
Fv = Pv (1 + im ) n = 150000 (1 + (−0.20 ))6 = R39321 .60

Find the cost of the “new” vehicle at T72

Fv = Pv (1 + im ) n = 150000 (1 + 0.010 )72 = R307 064 .90

Find the value of the maintenance costs at T72

Noted: Maintenance costs are withdrawn yearly, the interest rate for the savings plan is 12% p.a.
compounded monthly. To use the Fv annuity formula, we need to find i1, the equivalent annual effective
interest rate.

i1 = (1 + i 12 ) − 1 = (1 + 0.01) − 1 = 12 .6825 ...% p.a. effective

12 12

 (1 + im )k − 1   (1 + 0.126825...)6 − 1 
FvT 72 = PtMaint   = 2000   = R16 512.50
 im   0.126825 
   

The value to be “accumulated” in the fund at T72

FvT72 = Replacement costs + Maintenance costs – Resale value = 307064.90 + 16512.50 – 39321.60
FvT72 = R284 255.80.

Determine the regular savings deposits necessary for the fund

−1 −1
 (1 + im )k − 1   (1 + 0.010 )72 − 1 
Pt = Fv   = 284255.80   = R 2714.70
 im   0.010 
   

87
3.9 Growing Annuities
The annuities dealt with so far all require equal, regular payments. There are special cases whereby one
requires an increase in the payment amount to offset the influence of inflation. An example of this would be a
trust fund established to make annual disbursements sometime in the future. These scenarios are easily
addressed using spreadsheets, but are just as easily dealt with using a formula derived from a geometric
series.

Consider the example where each year a trust is expected to make a disbursement. To offset the influence of
inflation the payment each year is increased by a fixed percentage (g). An example of this scenario is shown
in the time diagram.

T0 T1 T2 T3 Tn-1 Tn

Pv Pt Pt(1+g)1 Pt(1+g)2 Pt(1+g)n-2 Pt(1+g)n-1

The present value of this can be found by bring all payments back to To.

−2
(
Pv = Pt (1 + in ) + ( Pt (1 + g ) ) (1 + in ) + Pt (1 + g )
−1 2
) (1 + i )
n
−3
(
+ ... + Pt (1 + g )
n −1
) (1 + i )
n
−n

This sequence converges geometrically and is represented by the equation,

Pt   1 + g  
k

Pv = 1 −    in − g  0.
in − g   1 + in  
 

One can use this formula directly to determine how much should be invested for a fixed period with an
annual growth rate (g), a fixed interest rate (im), and to provide for k annual payments (Pt) in the future.

88
Example 48
A trust is required for a grandchild to enable them to pay for tertiary studies when they reach eighteen. The
trust is structured to allow for annual payment growth of 10% per annum at a fixed interest rate of 12% p.a.
compounded annually. The first payment is due in exactly one year, and the first payment is set at R65 000.
Determine the amount that must be invested in the trust to allow for six payments.

Pv = ?
Pt = R 65 000
g = 10% p.a.
i1 = 12 % p.a. effective
k =6

Before starting this problem, check that the growth rate is less than the effective annual interest rate.

Pt   1 + g  
k

Pv = 1 −   
in − g   1 + in  
 
65000   1 + 0.10  
6

= 1 −   
0.12 − 0.10   1 + 0.12  
= R 333 034.21

Example 49
A trust is established to make five annual disbursements with the first disbursement exactly ten years after
establishment. The trust has secured an investment of R500 000 at a fixed interest rate of 7.5% per annum
compounded annually. To counter future inflationary effects, an annual increase of 5% per payment is
allowed. Determine the value of the fifth payment.

Pv = R500000
Pt = ?
g = 5% p.a.
i1 = 7.5% p.a. effective
k =5

89
Time diagram

T0 T9 T10 T11 T14

Pv Pv Pt Pt(1+g)1 Pt(1+g)4

To do this problem, move the value of the investment to T9, then use the growing annuity formula to
determine the value of the first payment. Thereafter the fifth payment is determined at T14.

At T9: Value of investment

Fv = Pv (1 + in ) = 500000 (1 + 0.075 ) = R958 619.33

n 9

Re-arrange growing annuity formula to determine payment at T9.

−1
  1 + g k 
Pt = Pv ( in − g )  1 −  
  1 + in  
 
−1
  1 + 0.05 5 
= 958619.33 ( 0.075 − 0.05)  1 − 
  1 + 0.075  
 
= R 215 914.86

To determine the fifth payment at T14, we need to consider the growth rate.

PtT 14 = PtT 10 (1 + g )
n −1

= 215914.86 (1 + 0.05)
4

= R 262 445.87

90
3.10 Perpetuities and Growing Perpetuities
At this stage, we have only considered annuity examples which have finite endpoints. We have always
considered that there are a finite or fixed number of payments. A special case to consider would be where
there are an infinite number of payments. In this scenario we are unable to use the existing annuity formulae
as we require k, the number of equal regular payments.

Consider the example where we require the present value of some future payments that are to be made in
perpetuity. The equation for this scenario is:

Pv = Pt (1 + in ) + Pt (1 + in ) + Pt (1 + in ) +
−1 −2 −3

 
 
 
= Pt  (1 + in ) + (1 + in ) + (1 + in ) +
−1 −2 −3

 (1+in )−1 
 1−(1+in )
−1 
 
Pt
=
in

Analogous to this scenario is the case where the future payments grow at an annual growth rate to counter
inflationary effects.

Pv = Pt (1 + in ) + Pt (1 + in ) (1 + g ) + Pt (1 + in )−3 (1 + g )2 +
−1 −2

 
 
 
= Pt  (1 + in ) + (1 + in ) (1 + g ) + (1 + in ) (1 + g ) +
−1 −2 −3 2

 (1+in )−1 
 1−(1+ g )(1+in )
−1 
 
Pt
= in − g  0.
in − g

Both these equations are simple solutions to the infinite series of future payments. The infinite sums form
geometric series which are then simplified to allow calculations for lifetime savings.

Example 50
An employee who is about to retire would like to ensure they receive a monthly pension for the remainder of
their lifetime. At their retirement date, their pension will be provided as a lump sum of R750 000. An
91
insurance broker has secured a fixed interest rate of 9% p.a. compounded monthly. Determine the value of
the payments assuming the first payment is due in one month.

Pt
Pv =
in
Pt = Pv  in = 750000  0.0075 = R5 625

Example 51
The employee realizes that the monthly pension needs to counter the influence of inflationary effects and
decides that a 0.5% per month growth rate per payment is required. Determine the value of the first two
payments.

The first payment

Pt
Pv =
in − g
Pt = Pv ( in − g )
= 750000 ( 0.0075 − 0.0050 )
= R1 875.

The second payment

PtT 2 = PtT 1 (1 + g )
1

= 1875 (1 + 0.005)
1

= R1884.38

92
EXERCISES ON SECTIONS 3.1 – 3.3

1. A loan of R20 000 has been secured at 15% p.a. (c.m.). The loan is to be repaid in 10 equal monthly
installments.
a) Find the value of the monthly payments.
b) Find the balance of the loan if it is settled after the 6th payment is made.

2. A loan of R1 000 has been secured at 20% p.a. (c.m.). The loan is to be repaid in 12 equal monthly
installments.
a) Find the value of the monthly payments.
b) Find the outstanding balance if the loan is settled after the 2nd payment is made.

3. A loan of R300 000 has been secured at 10% p.a. (c.m.). The loan is to be repaid in equal monthly
installments of R3 965.
a) Find the number of payments.
b) Find the value of the last payment.

4. A loan of R500 has been secured at 24% p.a. (c.m.). Monthly repayments to the value of R48 is to be
made.
a) Find the number of payments.
b) Find the value of the last payment.

5. A loan of R1 000 000 is secured at a fixed interest rate of 15% p.a. (c.m.). Monthly repayments to the
value of R25 000 is to be made.
a) Determine the number of payments.
b) Determine the value of the last payment.

EXERCISES ON SECTIONS 3.4 – 3.6

1. A R250 000 loan is to be amortised by equal monthly payments of R2 752.72 over 20 years. The loan
is secured at an interest rate of 12% p.a. (c.m.). Which portion off the 80 th payment pays the interest
and which portion pays off the capital?

93
2. A R500 000 loan is to be amortised by equal monthly payments of R5 241.95 over 15 years. The loan
is secured at an interest rate of 10% p.a. effective. Which portion off the 66th payment pays the
interest and which portion pays off the capital?

3. A loan of R10 000 has been secured at 9% p.a. (c.m.). The loan is to be repaid in 12 equal monthly
installments.
a) Find the value of the monthly payments.
b) Find the value of the last payment.
c) Prepare an amortization table for this problem.

4. A loan of R8 000 has been secured at an interest rate of 10% p.a. (c.m.). The loan is to be repaid in 15
equal monthly installments of R569.58. Assuming payments T10, T11, T12 and T13 were missed:
a) Find the additional amount that must be added to the 14th payment to compensate for the missed
payments.
b) Find the additional amount that should be added to the final payment to compensate for the missed
payments.
c) Find the new value of the remaining payments to compensate for the missed payments.

5. A vehicle costing R130 000 was financed at 15% p.a. (c.m.). 24 Equal monthly payments of R6 303.26
were required. Payments for T10 and T11 were missed. Find the equal amount that must be added to each
of the remaining payments to compensate for the missed payments.

6. A vehicle costing R130 000 was financed at 15% p.a. (c.m.). 24 Equal monthly payments of R6 303.26
were required. After the 10th payment was made, the interest rate changed to 12% p.a. (c.m.). Calculate
the value of the new, equal repayments to be made over the remainder of the time.

EXERCISES ON SECTIONS 3.7 – 3.8

1. A R250 000 loan is to be amortised by equal monthly payments of R2752.72 over 20 years. The loan
is secured at an interest rate of 12% p.a. (c.m.). The payments from T40 to T45 are missed and at T45
the interest rate changes to 15% p.a. (c.m.). Find the value of the payments from T46 in order to pay
the loan off in the same amount of time.

2. A R15 000 loan is to be amortised by equal monthly payments of R380.90 over 5 years. The loan is
secured at an interest rate of 18% p.a. (c.m.). The payments from T20 to T28 are missed and at T25 the

94
 interest rate changes to 15% p.a. (c.m.). Find the value of the payments from T29 in order to pay the
loan off in the same amount of time.

3. A R500 000 loan is to be amortised by equal monthly payments of R5 241.95 over 15 years. The loan
is secured at an interest rate of 10% p.a. effective. The payments from T100 to T108 are missed and at
T100 the interest rate changes to 15% p.a. (c.m.). Find the value of the payments from T109 in order to
pay the loan off in the same amount of time.

4. A R20 000 loan is to be amortised by equal monthly payments of R356.79 over 8 years. The loan is
secured at an interest rate of 15% p.a. (c.q.). The payments from T12 to T19 are missed and at T15 the
interest rate changes to 15% p.a. (c.m.). Find the value of the payments from T20 in order to pay the
loan off in the same amount of time.

5. A vehicle has been purchased for R120 000. In 8 years’ time the vehicle will have to be replaced. To
replace the vehicle a sinking fund needs to be established. It is expected that the vehicle will
depreciate at 20% p.a. effective. The cost of replacing the vehicle will increase by 10% p.a. effective.
Determine the monthly deposits necessary to effect the replacement. Assume the fund earns interest
of 15% p.a. (c.m.)

6. An asset is purchased for R85 000. The asset will need to be replaced in 10 years time. To replace the
asset a sinking fund needs to be established. It is expected that the asset will depreciate at 5% p.a.
effective. The cost of replacing the asset will increase by 10% p.a. effective. Determine the monthly
deposits necessary to effect the replacement. Assume the fund earns interest of 12% p.a. (c.m.).

7. An asset is purchased for R150 000. The asset will need to be replaced in 15 years time. To replace
the asset a sinking fund needs to be established. It is expected that the asset will depreciate at 10%
p.a. effective. The cost of replacing the asset will increase by 5% p.a. effective. Yearly maintenance
costs will be necessary to ensure the asset life term will be no less than 15 years. Maintenance cost
are estimated at R750 per year starting one year after the asset has been purchased and the final
maintenance will be necessary when the asset is to be resold. Determine the monthly deposits
necessary to effect the replacement. Assume the fund earns interest of 16% p.a. (c.m.).

95
Chapter 4: Linear Programming (LP)

4.1 Plotting a Linear Function on a 2-d Graph

A linear function is by definition an equation where each term is a constant or a function of a constant
multiplied by an unknown variable of order one. In school you would have seen the equation, y = mx + c .
This function is a linear equation, where m and c are constants and both y and x are order one. An example of
a non-linear equation is the quadratic function you were introduced to in school, y = a + bx + cx 2 , where the
second x term is raised to the power two. For the rest of this chapter, we only use linear equations (and/or
inequalities), although we increase the dimension of the equation to include n variables. In addition, all
examples require that we restrict use to non-negative variables, that is, all unknown variables are greater than
or equal to zero. Hence we restrict our plot axes to non-negative values when we graph the functions.

Given the equation 2 x1 + 3x2 = 6 , plot this equation on a 2-d graph with x1 on the horizontal axis and x2 along
the vertical axis. To do this we need two points and can then draw a line through the two points as all points
on the line will satisfy the equation. The easiest option is to find these points sequentially. We find the first
point by setting x1 to zero and finding x2. Thereafter we find the second point by setting x2 to zero and finding
x1.
When x1 = 0 Similarly x2 = 0
 2 ( 0 ) + 3 x2 = 6  2 x1 + 3 ( 0 ) = 6
 x2 = 2  x1 = 3

We now have two points, ( 0,2 ) and ( 3,0 ) , which can be plotted on a graph.

We identify the two points on the graph, then draw a

straight line through the points.

96
All students should have encountered this method of plotting in schools. What is sometimes less obvious is
plotting a function with a negative coefficient. On the same graph, with the same axis try plot the linear
equation, 2 x1 − 3x2 = 4 .

97
When x1 = 0 Similarly x2 = 0
 2 ( 0 ) − 3 x2 = 4  2 x1 − 3 ( 0 ) = 4
4  x1 = 2
 x2 = −
3

We now have two points,  0, −  and ( 2, 0 ) , which only allows for the second point to be plotted on the
4
 3

graph above. We can’t see the x2 axis along the horizontal at -4/3. The easiest method is to find an alternative
4
point which does fit on the graph. Consider when x1 = 4  2 ( 4 ) − 3x2 = 4  3x2 = 4  x2 = .
3

We now have two points,  4,  and ( 2, 0 ) , which can be plotted on the graph.
4
 3

Question for the student

If the function was an inequality, would you be
able to identify the region which satisfies the
inequality?
How would you be able to confirm that the
region you’ve identified does indeed satisfy the
inequality?
The answer to these questions will assist you in
the forthcoming sections.

For the remainder of this chapter it is crucial that you are able to draw equations and inequalities on a 2-d
graph. The reason for this will become apparent as we move into finding an optimal solution for a linear
programming model.

98
4.2 Introduction to Linear Programming
Linear programming (LP) is not to be confused with reference to computer science programming. Linear
programming is a mathematical optimisation method that provides algorithms to solve problems formulated
with linear functions. The historical context of LP modelling lies in a field referred to as operations research.

Some History
• Operational Research (OR) is a relatively new field in Science. It started in the 1940’s in the UK. The
main driver for new research was the Second World War. The American Navy quickly took up from
the British and used it for planning and research of military operations.
• The name OR originates from this period. Today we also use the broad term Mathematical
Programming which encompasses both linear and non-linear optimisation.
• After WW2, OR moved into other fields, business, commerce, industry and government and is used
extensively in these fields.
• Within the NMMU statistics Department we’ve developed and published algorithms for team
selection in the sporting domain. This research has been extended to using advanced LP methods to
provide guidance on the relative efficiency of governing institutions in providing service delivery.

OR Problems
OR is considered to be a constrained optimization domain, useful in finding optimal solutions for general
resource allocation problems. The range of applications is enormous but the basic problem is essentially the
same, that of choosing the best (optimal) solution from a large number of alternatives. We restrict this course
to linear constrained optimisation, i.e. linear programming models, but the field of application is extensive.

Examples of OR problems include:

• Allocation Problems: These problems deal with allocation of limited resources in the most efficient
manner (e.g. allocating investment funding to projects to maximise the return on the investment, or
alternatively to minimize the risk of the investment).
• Inventory problems: to provide answers to a simple question: when and how much to order.
• Scheduling problems: Optimal allocation of processes in time and space (e.g. finding the best
examination schedule in a university).

Mathematical Model
• One needs to represent a real process with a mathematical model in order to study it by means of OR.
99
 • A mathematical model is a set of equations, inequalities, functions and other mathematical structures.
• A model is a simplified presentation of the reality.
• If a model is too simple, the essential properties of a real process are ignored and the best solution for
the model may be far from optimum for the real process.
• A too complex model requires more time and effort for design and may be way too difficult for
proper investigation.

Structure of the LP Model: Decision Variables

• Decision variables represent unknown quantities that should be found by the decision-maker.
• In real problems the decision variables are restricted in some way (e.g. in terms of funds, resources or
time).
• When the optimal values of the decision variables are found the LP problem is considered solved.

Structure of the LP Model: Constraints (or Restrictions)

• This component of the LP model represents physical limitations of the real systems.
• The constraints limit the unknown decision variables and other parameters of the model to their
possible permissible values.
• The constraints are represented by means of equations and/or inequalities.
• A set of values of the decision variables which satisfies all the constraints is called a feasible point.
• The set of all feasible points is called a solution space or feasible region.

Structure of the LP Model: Objective Function

• The objective function (OF) is a measure of the effectiveness of the system as a whole.
• In most cases the OF is represented as a linear function of the unknown, decision variables and some
constant. These functions are optimised by either maximising or minimising the equation.
• In the first case the objective of the decision-maker is to maximise the value of the objective function
selecting the decision variables which secure this maximum.
• In this case we say that the objective function is of maximisation type.
• In the second case the objective of the decision-maker is to minimise the value of the objective
function selecting the decision variables which secure this minimum.
• In this case we say that the objective function is of minimisation type.

100
Structure of the LP Model: A Mathematical Example
An example of a linear programming model with one inequality constraint.
Maximise Z = 4 x1 + x2
subject to 2 x1 + 3x2  6
non-neg x1 , x2  0

With elementary logic, by inspection, we can find the solution to this problem. The graphical plot of the
inequality is shown below, the region highlighted identifies the region which is feasible. That is, all points
within this region satisfy the constraint. The problem is to find the optimum solution for the objective
function (Z).

Questions for the student

How would one determine the
optimum by inspection?

Let’s think what would happen if we

added an additional constraint to the
problem.
Would the feasible area increase or
decrease?

It is important to recognise that constraints can be equations, inequalities or a combination of both. It is

however less restrictive if an inequality is used. Think what the feasible region would be if the LP model
above was restricted by an equation rather than an inequality. Which area would satisfy the constraint? The
only feasible region would be all points along the line linking the two boundary points.

101
The General Structure of an LP Model
Consider an LP model with n variables, p constraints and the objective is to maximise a linear function. The
general model can be arranged as

Maximise Z = c1 x1 + c2 x2 + ... + cn xn
Subject to a11 x1 + a12 x2 + ... + a1n xn  b1
a21 x1 + a22 x2 + ... + a2 n xn  b2

a p1 x1 + a p 2 x2 + ... + a pn xn  bp
non-neg x1 , x2 , ... xn  0

with pn to allow for multiple solutions in order to optimise the OF. The terms, ci and aij are assumed

known coefficients for the objective function and constraint equations respectively. In addition, all RHS
values of the constraints, b j , are assumed known. The unknowns are the variables, xi . The general structure

of the LP model is often re-arranged such that the objective function is minimised.

4.3 Solutions to LP Models

There are several methods used to find the optimal solution to an LP model, starting with the basic 2-d
graphical methods (the iso-objective method and the corner point method), to the more advanced higher
dimensional methods of the simplex algorithm, the big M-method, and interior point methods. For the
purposes of this chapter, we restrict ourselves to the graphical methods and a computational approach
available when using solver in Excel.

4.3.1 The Graphical Method: The Iso-objective Method

Example 52
Maximise Z = 1600 x1 + 2000 x2
Subject to 8000 x1 + 9000 x2  100000
x1  8
x2  8
x1 , x2  0

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Drawing the Constraints
Let’s draw the line of the first restriction:
8000x1 + 9000x2 ≤ 100000
if x1 = 0, then x2 = 100000/9000 = 11.11
if x2 = 0, then x1 = 100000/8000 = 12.5

As point (0, 0) satisfies the inequality, so the feasible points will be below the line going through points
( 0, 11.11) and (12.5, 0). The shaded area below the line contains all points satisfying the inequality,
8000 x1 + 9000 x2  100000 .

Let’s draw the lines of the second and third restrictions.

x1 ≤ 8 this is a vertical line. Points to the left of the line are feasible.
x2 ≤ 8 this is a horizontal line. Points below the line are feasible.

The shaded area contains all points satisfying the first, second and third constraints.

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Lastly we need to account for the non-negativity constraints. The shaded area is the solution space for the
problem.

Representing OF and Level Lines

Now when we are done with the constraints we need to represent graphically the objective function. To do so
we set the OF equal to two arbitrary constants.
1600x1 + 2000x2 = 16000
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1600x1 + 2000x2 = 22000
We can see these lines on the following graph.

These lines are called level lines. Any point at a level line secures the same value of the objective function as
any other point on the same line. That is any point on the first line secures an OF value of (R)16 000 and any
point on the second line secures an OF value of (R)22 000 (however the second line does not contain any
feasible points).

Where is the Optimal Point?

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Visual examination of the graph suggests that the feasible point that secures the maximum value of the
objective function is point A, laying on the intersection of the first and third constraints.
• This point is called the optimal point.

To find the coordinates x1 and x2 of the optimal point we need to solve simultaneously the equations of the
first and third constraints (we replace inequalities with equalities).

8000x1 + 9000x2 = 100 000

x2 = 8

From the above we easily get: x1 = 3.5, x2 = 8

• The optimal value of the objective function is:

Z = 1600 × 3.5 + 2000 × 8 = 21 600

Answer: To maximise the OF x1 = 3.5 and x2 = 8. The optimal value of the OF is (R)21 600.

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The Graphical Method: Important Observations
• The graphical method is only applicable if the LP has two decision variables: this rarely happens in
real practical applications.
• The level lines are parallel lines.
• The optimal point will always be found in a corner point of the solution space, where two lines
intersect.
• This is true for any LPP, regardless of the number of variables and/or constraints.
• This conclusion creates the foundation for solving any LP.

4.3.2 The Graphical Method: The Corner Point Method

We now show how to find a solution to a 2-d LP model using the graphical, corner point method.

Example 53
Determine the optimal solution to the LP model
Maximise Z = 200 x1 + 270 x2
Subject to 10 x1 + 8 x2  800
3x1 + 4 x2  360
x2  60
x1 , x2  0

Identify the feasible region as per the method shown in the iso-objective method. The difference is we do not
need to plot level lines, once we have the feasible region, identify each corner point and evaluate the
objective function. The solution which satisfies the optimisation criterion is the optimal solution.

Finding the feasible region

Constraint one, 10 x1 + 8 x2  800 , gives points ( 0, 100 ) and (80, 0 ) .

Constraint two, 3 x1 + 4 x2  360 , gives points ( 0, 90 ) and (120, 0 ) .

Constraint three, x2  60 can be plotted directly.

Non-negativity constraint, x1 , x2  0 , concludes graphical representation.
To find feasible region, determine which area of the equation satisfies the inequality and find the intersecting
region of all constraints. The constraints are illustrated below, and the feasible region of all constraints is
highlighted in the third panel. In the fourth panel, we see that there are four corner points, labelled (a), (B),
(c) and (d).

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Constraint one Constraint one and two

The feasible region for all constraints The four corner points

We evaluate each corner point and thereafter identify the optimal solution.

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Corner points:
(a): (0; 60): P = 200x1 + 270x2 = 0 + 270 (60) = 16 200
(b): (0; 90): P = 200x1 + 270x2 = 0 + 270 (90) = 24 300
(c): (20; 75): P = 200x1 + 270x2 = 200(20) + 270 (75) = 24 250
(d): (32; 60): P = 200x1 + 270x2 = 200(32) + 270 (60) = 22 600

As the problem requires we maximize the OF, the optimal solution is the result with the highest value. This is
achieved at point (b), where x1 = 0, x2 = 90 and the OF = 24300.

Note: A common error is to assume the optimal is at the intersection of constraints 1 and 2. This is NOT
always the case as can be seen from this example.

Hints for students

• Always clearly identify the feasible region.
• Check that your region is feasible against the individual constraints.
• Label your axis and identify your constraints.
• Evaluate all corner points.

Note: The coordinates of point (c) are found by setting the equations for the two lines that cross at (c) equal
to each other:
10 x1 + 8 x2 = 800 and 3x1 + 4 x2 = 360

Multiply the second equation by 2, then subtract the second equation from the first
10 x1 + 8 x2 = 800

6x1 + 8x2 = 720

4 x1 = 80
 x1 = 20

Substitute into one of the original equation to find x2. This gives the value x2 = 75 and point ( 20, 75) .

The coordinates of point (d) are found by setting the equations for the two lines that cross at (d) equal to each
other, i.e. x2 = 60, therefore
10 x1 + 8 x2 = 800  10 x1 + 8 ( 60 ) = 800
 x1 = 32

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4.4 Formulating an LP Model
Arguably the most important part of LP modelling is to take a problem and transform it into mathematical
representation. In the real world, this is what you as students are most likely to encounter. Finding a solution,
using the graphical methods previously shown is to develop the logic, and explain the concepts. However
when you leave university you may encounter problems which you, yourself are expected to transform into
mathematical representation. Unfortunately this is also the most difficult part of LP modelling, and unlike the
algorithms, there is no step-by-step procedure one can follow to formulate a problem. The only advice one
can provide, is that the more you practice, the easier it becomes.

Example 54
A filling station (garage) needs to order petrol and diesel to sell to their clients. The cost of one ton of petrol
is R8 000 and the cost of one ton of diesel is R9 000. The net profit from selling a ton of petrol is R1 600,
and the net profit from selling a ton of diesel is R2 000. Total funds available for the purchase are limited by
R100 000. Due to the reservoir sizes the garage cannot purchase more than 8 tons of each fuel. How much
petrol and how much diesel should be purchased to receive the maximum net profit?

Write down the mathematical problem for the above problem by

1. Identifying the decision variable.
2. Specifying the constraints.
3. Specifying the objective function.

• Decision variables: Let

x1 = the number of tons of petrol that the garage will purchase, and
x2 = the number of tons of diesel that the garage will purchase.

• Constraints/restrictions: There is three restrictions to this problem: Restriction

on the total available funds,
on reservoirs for both diesel and petrol.
Constraint one, we must spend no more than R100 000. In order to formulate the constraint, you must
balance units. The LHS units must be the same as the RHS units. Consider the terms for the constraints,
a11 x1 + a12 x2  R100 000 . We know that the RHS units are # of Rands. We also know that the decision

variables have units of # of tons. This means the coefficients on the LHS must be such that the tons are
cancelled and Rands introduced. That is, units for aij must be Rands/Ton.

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 Consider the following,
a11 x1 + a12 x2 +  100000 .
Units = Rands / ton Units = # of tons Units = # of Rands Units = # of Rands
Units = # of Rands

This equation ensures the units on either side are the same. It is this approach that needs to be adopted for
every constraint, units on either side must be the same.
8000 x1 + 9000 x2  100000

Constraints two and three, we have maximum reservoir sizes of 8 tons.

x1  8000
x2  8000

The non-negativity constraint, ensures practical solutions, i.e. x1 , x2  0 .

• Objective function: Given that the objective is to maximise the profits, we write this function as
Maximise Z = c1 x1 + c2 x2 . As per the constraints, we need to ensure the units on either side of the equation

are the same.

Maximise Z = 1600 x1 + 2000 x2

Summarising the mathematical model for the problem looks as follows:

Maximise Z = 1600 x1 + 2000 x2 , subject to the constraints

8000 x1 + 9000 x2  100000

x1  8000
x2  8000

x1 , x2  0

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4.5 Higher Dimensional Models
Higher dimensional solutions are possible using simplex algorithms developed in the 1940s which have since
been surpassed by the computational efficiencies of the interior point methods developed in the 1990s.
Rather than learning to solve a model using a tedious algorithm, we consider the applications of LP models
using the computational routine available in Solver, an Excel optimisation add-in.

All students have previously used solver in the optimisation of a non-linear, unconstrained function, when
trying to find the interest rate of several functions (refer to practicals two and three). We now use solver to
determine optimal solutions for constrained, linear models and use the solutions to interpret the meaning in
practical applications.

4.5.1 A Computational Solution

Example 55
Consider the problem in 4.3.1, and thereafter formulated in 4.4.
Maximise Z = 1600 x1 + 2000 x2 , subject to the constraints

8000 x1 + 9000 x2  100000

x1  8000
x2  8000

x1 , x2  0

We know the solution to the problem is Z = R 21600, when x1 = 3.5 and x2 = 8.0 .

• We shall solve the problem using an add-in to Microsoft EXCEL called Solver. This add-in, is a small
scale optimiser, which is useful to demonstrate the benefits available to users in order to solve LP models
of higher dimension. Solver is often updated and the computational capacity increased. However the
procedure followed with each update is more or less uniform.

Note: A step-by-step procedure is provided in a practical for this module, ensure you are familiar with the
procedure. What follows below is a more general illustrative version than the practical.

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Setup the spreadsheet

Since we do not know the optimal values for the decision variables, we put in arbitrary values (1 and 1)
• The first formula defines profit (= 1600 × x1 + 2000 × x2)
• The second formula defines the total payment for the decision variables (= 8000 × x1 + 9000 × x2)
• The third (=B6) and fourth (=C6) formulae give the maximum values

Installing Excel Solver

• click the File tab (top left), Options, Add-ins, EXCEL Add-ins, GO
• Tick Solver add-in, click OK (Good idea to also select Analysis ToolPak)
• After this the Solver toolbar will appear on you Data tab

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 • Click on Solver and the following window will open

• Fill in all the necessary entries in the Solver Parameters window.

Tick the box next to “Make Unconstrained Variables Non-Negative”. Select “Simplex LP” as the Solving
Method.

• Click on Solve in the Solver Parameters window.

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 • When choosing “Answer” in the Solver Results window, a more detailed report is generated on a
separate worksheet.

Objective Cell (Max)

Cell Name Original Value Final Value
$D$2 profit 3600 21600

Variable Cells
Cell Name Original Value Final Value Integer
$B$6 x1 1 3.5 Contin
$C$6 x2 1 8 Contin

Constraints
Cell Name Cell Value Formula Status Slack
$D$3 price 100000 $D$3<=100000 Binding 0
$D$4 maxpetrol 3.5 $D$4<=8 Not Binding 4.5
$D$5 maxdiesel 8 $D$5<=8 Binding 0

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Example 56 (Solving a linear model with three decision variables)
A filling station (garage) needs to order petrol, diesel and unleaded petrol to sell to their clients. The cost of
one ton of petrol is R8 000, the cost of one ton of diesel is R9 000 and the cost of one ton of unleaded petrol
is R8 500. The net profit from selling a ton of petrol is R1 600, the net profit from selling a ton of diesel is
R2 000, and the net profit of selling a ton of unleaded is R2 100. Total funds available for the purchase are
limited by R100 000. Due to the reservoir sizes the garage cannot purchase more than 8 tons of petrol, 8 tons
of diesel and not more than 5 tons of unleaded petrol. How much petrol, how much diesel and how much of
unleaded petrol should be purchased to receive the maximum net profit?

Solution:
Define the decision variables. Let:
x1 denote the quantity of petrol that the garage will purchase (in tons),
x2 is the quantity of diesel that the garage will purchase (in tons),
x3 is the quantity of unleaded petrol that the garage will purchase (in tons).

Our mathematical model for the problem looks as follows:

Maximise Z = 1600x1 + 2000x2 + 2100x3

Subject to: 8000x1 + 9000x2 +8500x3 ≤ 100000
x1 ≤ 8
x2 ≤ 8
x3 ≤ 5
x1 ≥ 0, x2 ≥ 0, and x3 ≥ 0

In Excel we have the following:

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Performing similar manipulations the following report is generated:

• The first two tables in the report are obvious, the maximum profit is 23 277.77 (first table)
• The optimal point is x1 = 0, x2 = 6.38 and x3 = 5 (second table)
• The last table gives a summary of all the constraints: binding means that the optimal solution uses the
most extreme possible value of the restriction (e.g. the optimal value of x3 is 5 and it is the limit as per
the fourth restriction).
• Not binding means that the optimal value does not reach the limit of corresponding restriction (e.g.
optimal value of x1 is 0, while it may in fact be as big as 8, as per the second restriction).

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4.6 Sensitivity Analysis
4.6.1 Introduction to Sensitivity Analysis (SA)
After an LP is solved additional analysis of the system may be useful for many practical considerations.
Sensitivity analysis (SA) allows checking:
• How the parameters of the system should be changed to allow better performance of the system.
• What changes in the parameters will not affect the optimality at all.
• Other important observations over the properties of the system (e.g. price elasticity analysis).

SA is a study of how the changes in the coefficients of a linear program affect the optimal solution.
SA helps us determine when:
• A change in the coefficient of the objective function (profit / cost contribution), and
• A change in the right hand side (RHS) value of a constraint (amount of hours allocated)
will affect the optimal solution.

We consider two separate terms in sensitivity analysis. These are defined as the range of optimality and the
range of feasibility.

The Range of Optimality (RoO) allows us to see by how much the profit contribution is allowed to fluctuate,
all else being constant and yet have the current production quantities remain optimal.

The Range of Feasibility (RoF) allows us to see by how much a binding constraint is allowed to fluctuate,
all else being constant, before the constraint becomes non-binding and a new solution is required.

Example 57
A filling station (garage) needs to order petrol, diesel and unleaded petrol to sell to their clients. The cost of
one ton of petrol is R8 000, the cost of one ton of diesel is R9 000 and the cost of one ton of unleaded petrol
is 8500. The net profit from selling a ton of petrol is R1 600, the net profit from selling a ton of diesel is R2
000, and the net profit of selling a ton of unleaded is R2100. Total funds available for the purchase are
limited by R100 000. Due to the reservoir sizes the garage cannot purchase more than 8 tons of petrol and
diesel and not more than 5 ton of unleaded. How much petrol, how much diesel and how much of unleaded
petrol should be purchased to receive the maximum net profit?

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Sensitivity Analysis with Excel:
• Select “Sensitivity” in the “Results” window of the Solver.

• The sheet ”Sensitivity Reports 1” will be generated.

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Interpretation of the Sensitivity Report
• Let’s first look at the top table ”Adjustable Cells”.

• Final Value: this column gives the optimal quantities for the decision variables.
E.g. buy 6.38 tons of diesel and 5 tons of unleaded petrol to obtain maximum profit.
• Objective Coefficients: The profit or cost contribution associated with each decision variable.
E.g. the net profits from selling a ton of petrol, a ton of diesel and a ton of unleaded petrol are R1600, R2000
and R2100 respectively.
• Reduced Cost: for variables which are not part of optimal solution the absolute value of this index
indicates by how much the relevant coefficient of the objective function needs to improve so that this
variable becomes part of the optimal solution. (The reduced cost will only be non-zero if the final
value is zero). For a maximization problem, improve implies that the objective function coefficient
must increase and for a minimization problem it means that the objective function coefficient must
decrease.
E.g. For petrol to be part of the final solution, the net profit from selling a ton of petrol should increase from
R1600 to R1600 + R177.78 = R1777.78.
• Allowable Increase/Allowable Decrease: These two columns give the amount by which each
objective coefficient (profit/cost contribution) is allowed to increase (Allowable Increase) or decrease
(Allowable Decrease) without changing the optimal solution.
The range of optimality for each objective function coefficient is the range of values which the coefficient
can become without changing the values of the decision variables in the optimal solution.
It is an open interval. The sum of the allowable increase and the objective coefficient value will give the
upper limit of the range of optimality. The objective function coefficient value minus the allowable decrease
will be the lower limit of the range of optimality.
E.g. the range of optimality for diesel is (2000 – 200; 2000 + 223.53) → (1800; 2223.53). If the objective
coefficient for diesel changes within these limits, the optimal solution will stay unchanged.
NOTE: Changing the objective coefficients will however change the optimal objective function value.

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Any changes of the objective coefficients outside the range of optimality will imply a change in the optimal
values for the decision variables and the LP must be re-solved.

• Let’s next interpret the Constraints table.

• Final value: the amount of the specific resources actually used.

E.g. to get maximum profit, R100 000 was spent. Also, only 6.39 tons of the reservoir capacity for diesel was
used and the total reservoir capacity of 5 tons for unleaded petrol was used.
• Shadow Price: is the most important. It gives the benefit/loss we get if we change a constraint by one
unit.
E.g. if we improve the value 100 000 (total funds available) by 1 Rand, the profit can increase by R0.22 and
if we increase the funds available by R100, the profit will increase by R22. If we decrease the funds by 1
Rand, the profit will decrease by R0.22.
• Constraint R.H side: This column gives the current values of the constraints (right hand side).
• Allowable Increase/Allowable Decrease: The amount by which the constraint R.H side is allowed to
increase/decrease and yet have the current decision variables in the optimal solution.
The range of feasibility for a constraint R.H side is the range of values that the constraint R.H side can
become without changing which decision variables are in the optimal solution.
E.g. the range of feasibility for funds is (100 000 – 57 500; 100 000 + 14 500) → (42 500; 114 500). If the
available funds fall between these limits, diesel and unleaded petrol will still be in the optimal solution, but
with different (non-zero) final values.

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Exercises on sections 4.1 – 4.6
1. For the following problems, graphically illustrate the feasible regions for the following mathematical
models. Clearly indicate the feasible region, and how you decided that this was the feasible region. Do not
solve the models!
(a ) Minimise 2 x1 + x2 , subject to
3x1 + x2  19
x1 + 4x2  20
3 x1 + x2  9
xi  0

(b) Maximise 2 x1 + x2 , subject to

x1 − 4 x2  6
x1 + 4x2  20
− 2 x1 + 3x2  20
xi  0

(c) Minimise 2 x1 + x2 , subject to

x1 + 2 x2  3
2 x1 + 3x2  15
3x1 + 4x2 = 12
x1  1
x2  3
xi  0

2. Solve the following LP problems, using the corner-point method, the iso-objective method and the
computational method. You should see that the solution is the same irrespective of the method used.
(a) Maximise the LP model
Z = 10 x1 + 2 x2
Subject to
2 x1 + 4 x2  160
4 x1 + x2  180
xi  0 i

(b) Minimise the LP model

Z = 5 x1 + 18 x2
Subject to
2 x1 + x2  100
x1 + 3 x2  120
xi  0 i

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(c) Minimise the LP model
Z = 7 x1 + 2 x2
Subject to
5 x1 + 2 x2  18
3x1 + 2 x2  10
x1 + 2 x2  60
2 x1 + 5 x2  80
xi  0 i

3. Formulate the following LP models without solving them.

(a) A manufacturer makes two products. The first product requires five hours for processing, three hours for
assembling and four hours for packaging. The second product requires two hours for processing, twelve
hours for assembling and eight hours for packaging. The plant has forty hours available for processing, sixty
for assembling and forty eight for packaging. The profit margin for the first product is R7 and R21 for the
second product.
(b) A manufacturer of kitchen units makes two types of units, A and B. It takes 2 days to assemble one unit
1
of type A and 3 days to assemble one unit of type B. This is done in a workshop that is available for only
3
20 days each month. The paint shop can handle a maximum of 8 units per month. At least 2 units of type A
must be produced each month. Units of type A yield a profit of R700 per unit while units of type B yield a
profit of R900 per unit. Maximise the profit.

4. Formulate and solve the following LP models.

(a) A clothing designer has been invited to a fashion show where a variety of suits and dresses will be shown.
She will receive R80 for every suit shown and R60 for every dress shown. Designing a suit takes her 2
hours, while designing a dress takes 4 hours. It will take her seamstress 4 hours to make a suit and 1 hour to
make a dress. She has 160 working hours available before the show, while her seamstress has 180 working
hours available. How many suits and how many dresses should the designer make for the show to maximise
her income?
(b) A farmer wishes to minimize the cost of feeding his 50 camels weekly. There are two types of feed
available, Type A and Type B. Type A costs 60c per kg while Type B costs 100c per kg. Each camel must
receive at least 100 units of energy weekly and at least 120 units of protein weekly. Each kg of Type A
contains 2 units of energy and 1 unit of protein, while Type B contains 1 unit of energy and 3 units of
protein. Use the graphical method to find the most affordable combination of the two types of feed that the
farmer should purchase.

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5. Study the following Sensitivity Report and answer the following questions.

Microsoft Excel 11.0 Sensitivity Report

Adjustable Cells
Final Reduced Objective Allowable Allowable
Cell Name Value Cost Coefficient Increase Decrease
$C$16 Models Sedan 25 0 20000 24000 7058.823529
$D$16 Models Pick-Up 50 0 22000 12000 12000
$E$16 Models Minibus 0 -12000 16000 12000 1E+30

Constraints
Final Shadow Constraint Allowable Allowable
Cell Name Value Price R.H. Side Increase Decrease
$C$21 Steel (tons) Used(LHS) 110 10000 110 10.58823529 36
$C$22 Plastic (tons) Used(LHS) 5 100000 5 0.947368421 1.764705882
$C$23 Wiring (kg) Used(LHS) 11750 0 12500 1E+30 750
$C$26 Time (hours) Used(LHS) 237.5 0 336 1E+30 98.5
$C$24 Upholstery (m2) Used(LHS) 1875 0 2500 1E+30 625
$C$25 Min Pick-Up Used(LHS) 50 0 20 30 1E+30

The objective is to maximise the profit!!!

a) Interpret the reduced cost of the Minibus Models.
b) Calculate the range of optimality (upper and lower limit) for Sedan Models.
c) What amount of steel, plastic and wiring will be used when profits are maximised?
d) If we allocate 3 more tons of steel to the production of the models, will the maximised profit increase
or decrease and by how much?
e) Calculate the range of feasibility (upper and lower limit) for the Plastic constraint.
f) Specify the quantity of the various decision variables that should be produced such that profit is
maximised and calculate the maximum total profit.

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6. Study the following Sensitivity Report and answer the following questions.

Microsoft Excel 11.0 Sensitivity Report

Adjustable Cells
Final Reduced Objective Allowable Allowable
Name Value Cost Coefficient Increase Decrease
Cakes(in 1000) 0.02 0 12 1.33333333 7
Tarts (in 1000) 0.00666667 0 10 14 1

Constraints
Final Shadow Constraint Allowable Allowable
Name Value Price R.H. Side Increase Decrease
Eggs (in 100) 0.08666667 0 36 1E+30 35.9133333
Flour (kg) 5 0.056 5 1.66666667 2.5
Milk (litre) 10 0.00266667 10 10 2.5

The objective is to maximise the profit!!!

a) Interpret the reduced cost of Cakes.

b) Calculate the range of optimality (upper and lower limit) for tarts.
c) Calculate the range of feasibility (upper and lower limit) for the milk constraint.
d) Specify the quantity of the various decision variables that should be produced such that profit is
maximised and calculate the maximum total profit.

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7. Study the following Sensitivity Report and answer the following questions.

Microsoft Excel 11.0 Sensitivity Report

Adjustable Cells
Final Reduced Objective Allowable Allowable
Name Value Cost Coefficient Increase Decrease
Lupine (kg) 214.2857143 0 30 10.83333333 30
Wheat (kg) 0 9.285714286 35 1E+30 9.285714286

Constraints
Final Shadow Constraint Allowable Allowable
Name Value Price R.H. Side Increase Decrease
Protein (kg) 42.85714286 0 35 7.857142857 1E+30
Carbohydrates (kg) 150 42.85714286 150 1E+30 27.5

The objective is to minimise the cost!!!

a) Interpret the reduced cost of Lupine.

b) What amount of protein and carbohydrates will be used when costs are minimised?
c) If we allocate 1 more kg of Protein, will the minimum total cost increase or decrease and by how
much?
d) Specify the quantity of the various decision variables that should be used such that total cost is
minimised and calculate the minimum total cost.

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