MATHEMATICS OF

MANAGEMENT
ALGEBRA
1. ALGEBRA: Algebraic principles enable us to examine relationships among those quantities.
For example, given the price of a commodity and an understanding of the relationship
between price and demand, algebraic techniques allow us to compute the demand for that
commodity. We can also use algebra to determine the monthly production quantity needed
to break even — that is, to have monthly revenues just cover monthly operating costs.

 The notation q = g(p) might mean, for example, that demand q is determined from
the price p by the function g.
 The expression y = f(x) is used to indicate that the value of the dependent
variable y is determined from the variable x by the function f.
 A function of one variable of the form f(x) = ax + b is called a linear function. Here a
and b are simply numbers (called constants). In short, a function of a single variable
is linear if x is multiplied by a constant

First is a linear equation because one variable growth depends on the other variable
growth. The second graph is not variable because it divides the other variable so it isn’t
linear.

To express the dependence of a dependent variable on more than one independent variable, you
need to use a multivariate function. For example, if y depends on the independent variables x1, x2,
and x3, you can write y = f(x1, x2, x3). 
CARTESIAN COORDINATES: USE OF COORD GEO IN MANAGEMENT
 2 VARIABLES
 In business, you often have two variables or unknowns (call them x and y) that are related by
two equations. To find the values of the unknowns, you must find the values of x and y that
satisfy both equations.
 In finance class, you will have to solve linear equations to use the arbitrage approach for
determining the price of put and call options and of other securities.

INEQUALITIES 2 VARIABLES

In several of your courses (probably operations, economics, and quantitative methods), you will have to graph
the set of points satisfying a linear inequality in two variables of the form ax + by ≤ cx + dy or ax + by ≥ cx + dy.
Here a, b, c, and d are constants, and x and y are variables. To graph the set of points satisfying such a linear
inequality, you add the same amount to both sides of the inequality until all the variable terms are on the left side
and all the constant terms are on the right side. Then the inequality looks like a'x + b'y ≤ c' or a'x + b'y ≥ c', where
a', b', and c' are constants.

POLYNOMIAL EQUATION

A polynomial is a function in the form f(x) = a  + a x + a x  + ... a x , where n is a positive integer. The highest
0 1 2
2
n
n

power of x with a nonzero coefficient is called the degree of the polynomial. A straight line is a first-degree
polynomial. A second-degree polynomial is called a quadratic function, and a third-degree polynomial is called
a cubic function. For example, f(x) = 2x  + x + 1 is a quadratic function, and f(x) = 2x  - x  + 2x is a cubic
2 3 2

function.
Polynomial functions are often used in economics to represent the cost of producing x units or the profit
associated with charging a price x. Polynomial functions are evaluated just like any other function. Just
remember that x  (x to the nth power) means x multiplied by itself n times. For example, 3  = 81, 2  = 8, etc. For
n 4 3

example, suppose Gregory Clooney works at Smalltown Bagels (STB). If the cost in dollars of baking x bagels is
given by c(x) = 10 + 0.001x  + 0.2x, what is the cost of baking 100 bagels? Simply evaluate c(100) = 10 +
2

0.001(100)  + 0.2(100) = 10 + 0.001(10,000) + 20 = $40.

2

POWERS AND EXPONENTS

POWER FUNCTIONS:
A function of the form y = f(x) = axn, where a is a constant, is known as a power function. (In most business
applications, a > 0, so let's assume that here.) If n > 1, then the graph of the power function will show the
function is increasing, and the graph will get steeper. For example, in y = 2x2, n = 2 and the graph is as follows:

A power function is a function with a single term that is the product of a real
number, a coefficient, and a variable raised to a fixed real number. (A number that
multiplies a variable raised to an exponent is known as a coefficient.) As an example,
consider functions for area or volume. The function for the area of a circle with
radius r is
A(r)=πr2 

and the function for the volume of a sphere with radius R is

v (r)=4/3 πr3 

Relation of POWER FUNCTION AND COST CURVES: LEADS TO POWER CURVES

COST CURVES: A cost curve represents the relationship between output and the
different cost measures involved in producing the output. Cost curves are visual
descriptions of the various costs of production. In order to maximize profits firms
need to know how costs vary with output, so cost curves are vital to the profit
maximization decisions of firms.
Cost curves where f(x) = the cost of producing x units are often described by the sum of
power functions and a constant. For example, f(x) = x2 + 3x + 2 might represent the cost of
producing x units.

POWER CURVES AND DIMINISHING RETURNS

Diminishing returns, also called law of diminishing

returns or principle of diminishing marginal productivity,
economic law stating that if one input in the production of a
commodity is increased while all other inputs are held fixed, a point
will eventually be reached at which additions of the input yield
progressively smaller, or diminishing, increases in output.

If 0 < n < 1, the graph of the power function will show that the function increases as x increases, but
the graph eventually gets flatter. For example, for the power function f(x) = 2x.5, n = .5, and the graph
is as follows
Often a power curve with 0 < n < 1 is used to model the response to a marketing effort, because the response to
a marketing effort usually exhibits diminishing returns. For example, f(x) = 2x  might represent the number of
.5

units (in thousands) sold of a drug when x hundred sales calls to physicians are made.

POWER CURVE AND DEMAND CURVE RELATION

The demand curve is a graphical representation of the relationship between the price of a

good or service and the quantity demanded for a given period of time. In a typical
representation, the price will appear on the left vertical axis, the quantity demanded on the
horizontal axis.

If n < 0, the power curve will decrease as x increases, but the graph eventually gets flatter.
For example, the graph of f(p) = 1000p-.5 is as follows:
A power curve with n < 0 often represents demand curve. For example, f(p) = 1000p-.5 might
be the demand (in thousands of days of therapy) if a price of p dollars is charged for a
prescription.

COBB DAUGLAS PRODUCTION FUNCTION

A Cobb-Douglas production function models the relationship between production output

and production inputs (factors). It is used to calculate ratios of inputs to one another for
efficient production and to estimate technological change in production methods

In economics and econometrics, the Cobb–Douglas production function is a particular

functional form of the production function, widely used to represent the technological
relationship between the amounts of two or more inputs (particularly physical capital and
labor) and the amount of output that can be produced by those inputs.
In economics, a production function gives the technological relation between quantities of
physical inputs and quantities of output of goods. 

The Cobb-Douglas production function uses exponents and is commonly used to

model how the number of units produced depends on two inputs (usually K =
capital and L = labor). The Cobb-Douglas function is expressed as f(K, L) = KaL1-a,
where 0 < a < 1.

For example, if Tina spends K dollars buying supplies for lemonade and

works L minutes making lemonade, she can produce
f(K, L) = K3/4L1/4 glasses of lemonade. This function is a special case of the Cobb-
Douglas production function, with “A” having the value 3/4. Using Tina's Cobb-
Douglas function, suppose that she spends $81 on supplies and 16 minutes
making lemonade.
 She can then produce f(81, 16) = (81)3/4(16)1/4. Using Rule 4, (81)3/4 = (811/4)3. When
n is an integer, x1/n is simply nx√ .
Thus, (81)1/4 = 481−−√ = 3, and (81)3/4 = 33 = 27. Similarly, (16)1/4 = 416−−√ =
2. Thus, f(81, 16) = 27 × 2 = 54 glasses of lemonade.

Incidentally, the U.S. economy is thought to follow a Cobb-Douglas production

function with a = 0.3.

INVERSE FUNCTIONS

What Is an Inverse Demand Curve? With an inverse demand curve, price

becomes a function of quantity demanded. This means that changes in the
quantity demanded lead to changes in price levels, which is the inverse of
a demand curve.

Suppose that demand q is a function of price. That relationship is frequently

expressed as q = f(p). Often in economics class you will instead need to find p as a
function of q or p = g(q). Such a function g is called the inverse function (or, in this
case, the inverse demand curve) of f.

FINDING INVERSE DEMAND CURVES

Jennifer has just gotten a job cooking at the local, independently owned OutaBurger fast food restaurant.
The restaurant's estimated daily demand for milk shakes is expressed as q = f(p) = 400 - 10p, where p is
the price of milk shakes in dollars.

So far you have seen demand curves graphed with p on the x axis and q on the y axis. Economists,
however, usually graph q on the x axis and p on the y axis. To do that, you must solve for p as a function
of q. First, isolate all terms that include p on one side of the equation and solve for p. Add -400 to both sides
of q = 400 - 10p to get q - 400 = -10p. Then divide both sides of this equation by -10 to get -q/10 + 40 = p.
To graph this function set p equal to 0 in order to find the q-axis intercept: (400, 0). Then set q equal to 0 to
find the p-axis intercept: (0, 40). The graph of the inverse demand function is as follows:

PERCENTAGES AND CORPORTATE GROWTH

Companies often set their growth targets in terms of percentage growth. For
example, suppose that Smalltown Bagels's sales during the current year (2012) are
$3 million. Its goal is to grow sales revenues by 20% per year. What revenues does
the company need to generate during each of the next two years?

To grow by 20% during 2013, STB needs revenues to increase by (0.2) × 3 = $.6
million, for a target of $3.6 million.

Then, to grow by 20% during 2014, assuming revenues of $3.6 million in 2013, STB
will need to increase revenues by (0.2) × (3.6) = $.72 million, for a 2014 target of 3.6
+ 0.72 = $4.32 million.

Note that meeting the 20% growth target for 2014 required more revenue growth
than was needed to meet the 20% growth target for 2013. That's because the
revenue figure was larger in 2013 than in 2012, and 20% of a bigger number is
bigger than 20% of a smaller number. Many new companies (such as Cisco and
Microsoft in their early years) grow at high rates such as 30% a year. Once these
companies become large, however, it is hard for them to continue growing at 30% a
year because 30% of the current revenue will be much larger than 30% of the
company's initial revenue level.

ELASTICITY OF DEMAND

In your marketing and managerial economics classes, you will surely discuss pricing.
When a business determines what price to charge for a product, it must look at how
sensitive the demand for the product is to the product's price. The concept
of Elasticity of Demand helps a business understand the relationship between a
product's price and demand.

Elasticity of demand is illustrated in Figure 1. Note that a change in price results in a

large change in quantity demanded. An example of products with an elastic demand
is consumer durables. These are items that are purchased infrequently, like a
washing machine or an automobile, and can be postponed if price rises.

ELASTIC AND INELASTIC DEMAND

If E < -1, the demand for a product is said to be elastic; if E > -1, the demand for a
product is said to be inelastic. If product demand is elastic, a small increase in price
will decrease revenue; if product demand is inelastic, a small increase in price will
increase revenue. Conversely, if product demand is elastic, a small decrease in price
will increase revenue; if product demand is inelastic, a small decrease in price will
decrease revenue.

A CONSTANT ELASTICITY DEMAND CURVE

As we have seen, demand elasticity varies greatly along a linear demand curve.
Economists often like to model demand with a function that
exhibits constant elasticity. If demand q=ap-b (for an example, see "The Power
Curve as a Demand Curve" page in the Powers and Exponents: Power Function
section), then it can be shown that for any price, demand elasticity equals -b. For
example, if we model daily demand for lasagna dinners by q=1000p-2, then the
demand elasticity is -2. This means that for any price, a 1% increase would reduce
demand by 2%. Of course, if b < -1, then demand is elastic while if -1 < b < 0, then
demand for lasagna is inelastic.

 IF ELASTIC THEN E>1 IF INELASTIC THEN E<1

 The formula is to calculate the percentage diff in quantity/ percentage

difference in price.

 Then if we get the result as >1 then it is elastic if not then inelastic if =1 then
unit elastic.

LOGARITHMS

Logarithms are convenient tools that reduce a multiplication problem to an addition

problem. They also simplify problems involving exponents to much simpler
multiplication problems. Logarithms may be used in your economics and finance
courses, where you'll need them to properly price put and call options

LOGARITHM DEFINITION

Assuming a positive number b, the logarithm of a number x to the base b is the

power to which b must be raised to result in the number x— i.e., the logarithm of x to
the base b is c if bc = x. In this case, we write Logb x = c. For example, the logarithm
of 100 to the base 10 is 2, because 100 is 10 squared. The logarithm of 1048576 —
the number of rows supported in Excel 2007 — to the base 16 is 5, because
1048576 is 16 raised to the 5th power. (Base 16, or hexadecimal, is commonly used
in computer science and can often be used in describing the characteristics of
computer applications.)

In business, b is usually set equal to 10 or to e, which is a number that is

approximately 2.7182. When b = e, rather than Loge, Ln is used and the base is
omitted. Therefore, Loge x = c and Ln x = c are considered equivalent statements.
The logarithm of a number x to base e is often called the natural logarithm of x.

RULES INVOLVING LOGARITHM:

 Rule 1: Logb x + Logb y = Logb x*y.

 For example, Log10 100,000 = Log10 (100*1000) = Log10 100 +
Log10 1000 = 2 + 3 = 5. Since 105 = 100,000, we know that
Log10 100,000 = 5 and that Rule 1 is valid for this example.
 Rule 2: Logb x - Logb y = Logb x/y.
For example, Log10 10,000/100,000 = Log10 10,000 - Log10 100,000 =
4 - 5 = -1. Since 10-1 = .1 = 10,000/100,000, we know that Rule 2 is
valid for this example.
 Rule 3: Logb xc = c*Logb x.
For example, to find Log10 1005, we can use b = 10, x = 100, and c = 5
and find that
Log10 1005 = 5 * Log10 100 = 5*(2) = 10.
Since Log10 1005 = Log10 (102)5 = Log10 1010 = 10, we see that Rule 3
is valid for this example.

USING EXCEL TO COMPUTE LOGARITHMS

There are three Excel functions that are often used in business to compute
logarithms.

 LOG10(x) returns Log10 x.

 Log(x,b) returns Logb x. Of course, Log(x,10) would return Log10 x.

 Ln(x) returns the natural logarithm of x. Therefore, we use the Ln function to
compute natural logarithms.

WORD PROBLEMS INVOLVING LOGARITHM

 INDEX NUMBERS

CONSUMER INDEX

The Consumer Price Index (CPI) is a measure that examines the weighted average

of prices of a basket of consumer goods and services, such as transportation, food,
and medical care. It is calculated by taking price changes for each item in the
predetermined basket of goods and averaging them.

 Essentially, an index number indicates the percentage change in a quantity, relative

to a base level that is assigned a value of 100. 

the base year currently used for the CPI is 1982 and that the CPI for 1982 = 100. In
effect, the CPIs in the above table are relative to the 1982 base-level CPI. For
example, the 2007 CPI is 2.02416 times as high as it was in 1982.

CHANGING THE BASE YEAR

If you were to keep 1982 as the base year and if inflation were to continue,
eventually the CPI might become a large number such as 500. In such cases, you
can change the base year to a more recent year in order to prevent the price indexes
from becoming too large. If the government decides to use 2000 as the base year,
what would the CPIs be for the years 2004 through 2008? Since the CPI for 2000 is
168.8, simply scale all the listed CPIs relative to 168.8 rather than 100. For example,
the 2005 CPI would be 100 x (190.7/168.8) = 1.13. The CPIs for the years 2000
through 2008, relative to the base year of 2000, are listed to the right

CALCULUS

INTRODUCTION TO DIFFERENTIAL CALCULUS

In the algebra chapter, you learned that a straight line has the same slope at every point on it.
For example, at every point on y = 2x + 1, the slope is 2. Therefore, whenever x increases by
1, y increases by 2.

A nonlinear function, on the other hand, does not have a consistent slope. For example, the
graph of y = x2 (below) shows that for values of x that are less than zero, the function
decreases as x increases, so the slope of the curve is negative; for values of x that are greater
than zero, the function increases as x increases, so the slope of the curve is positive.
Differential calculus is primarily concerned with rigorously defining the slope of a function
and computing the slope of that function at any point on it.

A branch of mathematics concerned with determining the slope of a function at any point.
Knowledge of differential calculus enables us to easily maximize and minimize functions and
also graph complicated functions.

WHY CARE ABOUT DIFFERENTIAL CALCULUS

In business, you often need to figure out how to maximize or minimize a function. For
example, Smalltown Bagels may want to identify what price will maximize its profit from
selling bagels. The local electronics store may want to identify the order quantity for digital
cameras that minimizes the sum of annual ordering and inventory costs. In many business
situations, the maximum or minimum value of a function is the point at which the slope of the
curve is zero.

The first graph below shows that the maximum value of y = -x2 + 6x + 5 occurs at x = 3. That
is also the point at which the curve has a slope of zero.

Similarly, in the second graph, the minimum value of y = x2 - 6x + 5 occurs at x = 3, again
where the slope is zero. The next section will more rigorously define the slope of a function
for a given value of x.
HOW TO DEFINE THE SLOPE OF A FUNCTION
 TANGENT LINES

If a line touches 2 points on the function then it is a secant, but if it touches one point it is a
tangent.

TANGENT LINES AND SIGN OF A FUNCTION SLOPE

In the animation below, tangent lines along a function's graph are shown progressively for
different points on the graph. Where the slope of the tangent line is positive, the line is shown
in green; where the slope is negative, the line is shown in red; where the slope is zero, the line
is shown in black.

The point where the function shifts from increasing values of y to decreasing values of y (or
from decreasing values of y to increasing values of y) is where the slope of the tangent line
equals zero — i.e., where the tangent line is horizontal. In a subsequent section, you will
learn how to find this point for specific types of functions that are of interest in business.
 RULES OF COMPUTING DERIVATIVES

Given y = f(x), let dy/dx denote the derivative, or slope, of f(x). Sometimes the derivative of a

function is denoted as y' or f'(x). Now you will learn several rules that, when used in concert,
allow you to determine the derivatives of many important functions, particularly polynomials.
Keep in mind that if f'(x) > 0, the function is increasing at x, and that if f'(x) < 0, the function
is decreasing at x.
EVALUATING AND INTERPRETING A FUNCTIONS DERIVATIVE

A function's derivative is itself a function and may be evaluated for any value of x. For
example, recall the function given at the beginning of this section, y = x2. If f(x) = x2, then f'(x)
= 2x. Of course, f'(2) = 2(2) = 4. Therefore, the slope of y = x2 at the point where x = 2 is 4.
That implies that if you increase x from a value of 2 by a small amount (Δx), then f(x) will
increase by approximately 4Δx. For example, if you increase x from 2 to 2.1 (Δx = 0.1), you
can estimate that f(x) will increase by 4(0.1), or 0.4, to a value of 4.4.

Of course, f(x) actually increases to f(2.1) = 2.12 = 4.41. Thus, your estimate that f(x) will
increase by 0.4 is off by only 0.01

CONCAVE AND CONVEX FUNCTIONS:

A function is concave for a value x if f"(x) (2nd derivative of x) is less than or equal to 0. A

function that is concave for all values of x (such as y = -x2) is referred to as a concave
function. More intuitively, a function is concave if for all values of x the slope of the function
is non-increasing.

A function is convex for a value x if f"(x) (2nd derivative of x) is greater than or equal to 0. A

function that is convex for all values of x (such as y = x2) is referred to as a convex function.
More intuitively, a function is convex if for all values of x the slope of the function is non-
decreasing.
 FINDING THE SECOND DERIVATIVE

The second derivative of a function y = f(x) is denoted by f"(x), y'', or d2y/dx2. To find

a function's second derivative, simply take the derivative of the first derivative.

Consider y = x2. You already know that for this function, y' = f'(x) = 2x. Therefore, y"
= f"(x) = 2. The second derivative is a constant because the first derivative, y = 2x, is
linear (it always has a slope of 2).

Consider another example: f(x) = x3 - x2. Then f'(x) = 3x2 - 2x, and f''(x) = 6x - 2.

When a function's second derivative is positive, the function's first derivative is

increasing; when a function's second derivative is negative, the function's first
derivative is decreasing. Thus, for y = x2, the first derivative is always increasing
because y" = 2, which is greater than zero. For y = x3 - x2, f"(x) = 6x - 2 is positive
when x > 1/3 and negative when x < 1/3. Therefore, f'(x) is increasing for x > 1/3
and f'(x) is decreasing for x < 1/3.
 MAXIMIZING AND MINIMIZING FUNCTIONS

Learnt how to find the maximum and minimum points using the concave and convex
methods and understanding the second derivatives and first derivatives.

INFLECTION POINTS
 STATISTICS

The analysis of data is crucial to business. In finance class, you will analyze returns
on stocks and other investments. In your operations and marketing classes, you will
analyze monthly demand for products that are being sold. This section of the course
begins by introducing you to the basics of data analysis.

SUMMATION

USING SUMMATION NOTATION TO EXPRESS THE AVERAGE

SKEWNESS AND MEASURES OF CENTRAL TENDENCY

SKEWNESS: A measure of a data set's asymmetry. A skewness value near 0 indicates a data
set with a symmetric histogram. A skewness value greater than +1 indicates that a data set is
positively skewed. A skewness value less than -1 indicates that a data set is negatively skewed.
ABOVE IS THE EXCEL SKEW FUNCTION AND WHAT IT REPRESENTS
RELATION BETWEEN MEAN MEDIAN AND SKEWNESS

RULE OF THUMB AND OUTLINERS

COVARIANCE AND CORRELATION AND ALSO CAUSATION
COVARIANCE

A measure of linear association between two data sets that depends on the units in which each
data set is measured.

CORRELATION

A unit free measure of linear association between two data sets.

COVARIANCE CLEAR DEFINITION:

Given n points (x , y ), (x , y ), ...(x , y ), the covariance between data sets X and Y is given by
1 1 2 2 n n

Suppose that X and Y tend to go up and down together. That is, when X is larger than average, then Y is
usually larger than average and when X is smaller than average, then Y is usually smaller than average. Then
most of the terms in the numerator of our covariance formula will be positive and the covariance will be
positive. Conversely, suppose that when X is larger than average, then Y is usually smaller than average and
when X is smaller than average, then Y is usually larger than average. Then most of the terms in the
numerator or our covariance formula will be negative and the covariance will be negative. Therefore,
if X and Y "covary" in the same direction, their covariance will be positive, whereas if X and Y covary in
opposite directions, their covariance will be negative.

In summary, a positive covariance indicates that X and Y tend to go up or down together whereas a

negative covariance indicates that X and Y tend to move in opposite directions (relative to their
averages). Note that covariance only measures the strength of a linear relationship and is not useful
for detecting nonlinear relationships between variables. Therefore, covariance is a measure of linear
association between two variables.
CALCULATING COVARIANCE:

CORRELATION DEFINTION AND FORMULA AND ITS ACTUAL METHODOLOGY

 PROBABILITY
Experiment: Drawing, dicing, tossing these are experiments
Sample Space: Consists of all the possible outcomes from the experiments
Events: Getting 7 when 2 dice are rolled is an event, it is a subset of sample space

Mutually Exclusive events:

A group of events is considered mutually exclusive if the occurrence of any one event in the
group precludes the occurrence of any other event in the group. For example, if you toss two
dice, these two events — E 1 = dice totaling 7 and E 2 = dice totaling 11 — are mutually
exclusive because if the dice total 7, they cannot also total 11.
COMPLEMENTARY EVENTS:
Let E be any event. The complement of the event E (written E−−) is the event that E does not occur. Note that E
and E−− are mutually exclusive because the occurrence of either event precludes the occurrence of the other
event. Together, E and E−− make up the whole sample space, so P(E or E−−) = 1 = P(E) + P(E−−). Rearranged,
the equation is P(E) = 1 - P(E−−). Therefore, if you can find the probability of E−−, you can easily find the
probability of E as well.

CONDITIONAL PROBABILITY
New information often changes your expectation about the probability that a particular event will occur. For
example, you may initially think that your college football team has an 80% chance of beating its archrival. But
if you learn that your star quarterback is injured and will miss the game, you would probably reduce your initial
estimate.

Given two events, A and B, the conditional probability of A occurring, if B has already occurred, is expressed as
P(A|B). In the college football example, let A = the event of beating your archrival team and B = the event that
your quarterback is injured. Your assumptions are expressed as P(A) = .80 and P(A|B) < .80.

INDEPENDENT EVENTS:

For n events, E , E , ... E , suppose that you want to know the chance that a subset of the n events will
1 2 n

occur. If, for any subset of n events, you can find the probability that all those events will occur
by multiplying the probabilities of the individual events in the subset, then the events E , E , ...
1 2

E  are independent.
n

For example, two events E  and E  are independent if and only if P(E  and E ) = P(E ) × P(E ).
1 2 1 2 1 2

Three events E , E , E  are independent if and only if all of the following are true:
1 2 3
 P(E  and E ) = P(E ) × P(E ),
1 2 1 2

P(E  and E ) = P(E ) × P(E ),

1 3 1 3

P(E  and E ) = P(E ) × P(E ),

2 3 2 3

P(E  and E  and E ) = P(E ) × P(E ) × P(E ).

1 2 3 1 2 3

To appreciate the underlying logic, assume that the events E  and E  are independent. Then, P(E  and E ) =
1 2 1 2

P(E ) × P(E ). Dividing both sides of that equation by P(E ) yields P(E1andE2)P(E2)=P(E1) .

1 2 2

The left side of this equation is identical to the right side of the basic equation for conditional probability, and
so it is equal to P(E |E ). Therefore, two events are independent if and only if P(E |E ) = P(E ). Similarly, two
1 2 1 2 1

events E  and E  are independent if and only if P(E |E ) = P(E ). In short, two events are independent if and
1 2 2 1 2

only if the knowledge that one event has occurred does not change the estimate of the probability that the
other event will occur.

Knowing that the events in a set are independent of one another allows you to determine the probability that
any subset of the events will occur simply by multiplying the probabilities of the individual events.

Efficient Market Hypothesis

The belief that all information about a stock's future price is embedded in the stock's current price.

RANDOM VARIABLES:

A random variable is simply a function that associates a numerical value with every point in an
experiment's sample space. Here are some examples:

 If you toss three coins, you might define a random variable X as the number of heads tossed
(random variables are usually written in bold).

Consider an experiment in which you toss three coins and define the random variable X as the number of
heads tossed. Let's now toss the three coins. Two heads come up, so the random variable X = 2. On a
second try, no heads come up, so the random variable X = zero.
 DISCRETE RANDOM VARIABLES:

A random variable can be classified as either discrete or continuous. It is considered discrete if it can take
on a finite number of values such as 0, 1, 2, 3, and so on. Here are some examples of discrete random
variables:

 If you are told that at most ten new casinos will open in Nevada during the next year, this
discrete random variable can assume the values 0, 1, 2, ...10.
 Let X be the random variable representing the number of new casinos to open in Nevada
during the next year. When you toss two dice, their total is a discrete random variable that
can assume the values 2, 3, 4, ...12.

EXPECTED VALUE:

f you perform an experiment a great many times, the expected value of a random variable is the "average
value" of the random variable that you can expect. The expected value of a discrete random variable is
found simply by multiplying each value of the random variable by its probability and then adding up the
products. Let E(X) be the expected value of X. Assume that the random variable assumes n values x , x , ...
1 2

x . (Note that the actual values assumed by a random variable are written in lowercase.) Let the value
n

x  occur with probability p . Then,

i i

E(X)=∑i=1npixi

For example, toss a die and define a random variable X as the toss result. This random variable is equally
likely to be 1, 2, 3, 4, 5, or 6, so P(X = 1) = P(X = 2) = P(X = 3) = P(X = 4) = P(X = 5) = P(X = 6) = 1/6. Then,
E(X) = (1/6)(1) + 1/6(2) + (1/6)(3) + (1/6)(4) + (1/6)(5) + (1/6)(6) = 21/6 = 3.5.

Thus, if you repeatedly toss a die, on average you will get 3.5 dots. Note that the expected value of a
random variable need not be a possible value of a random variable.

HOW TO EXPECT PROFIT IN A BUSINESS BASED ON THIS EXPECTED

VALUE CONCEPT USED IN MBA:
A spin of a roulette wheel is equally likely to result in 0, 00, 1, 2, ... 36. Thus, each number has a 1/38
chance of occurring. Suppose that Vivian bets on a single roulette number at a casino. If her number comes
up, she earns $35 in profit; if her number does not come up, she loses $1. What is the expected profit on
such a $1 bet? Let X = the profit on a $1 bet. Whatever number is bet on has a 1/38 chance of coming up.
Therefore, P(X = 35) = 1/38 and P(X = -1) = 37/38. The expected profit is simply

(1/38)(35) + (37/38)(-1) = -2/38 = -.053, or -5.3 cents.

In other words, on average, Vivian can expect to lose 5.3 cents of every dollar bet, or 5.3% of her total
stake.
 VARIANCE OF RANDOM VARIABLE:

CONTINUOUS RANDOM VARIABLES:

A continuous random variable can assume an infinite number of values and is defined over an interval or
intervals of values. Here are some examples of continuous random variables:

 The height of a randomly selected Smalltown adult man is a continuous random variable that
can theoretically assume any value between 0 inches and, say, 96 inches.
 The time it takes Tina to swim 100 yards in Nevada's statewide high school swimming
championship is a continuous random variable that can assume any value in the range 45
seconds to, say, 75 seconds.
 The return on a share of Company A's stock is a continuous random variable that can
assume any value between -100% and, say, 300%.

INTERVAL OF PROBABLE POINTS IS IMPORTANT IN CONTINOUS RANDOM BUT NOT A

SINGLE POINT:

When a die is tossed, there is a 1/6 probability that a three comes up. If you measure the height of a randomly
selected Smalltown adult man, what is the chance that he is exactly 6 feet tall? This probability must be zero,
because to be exactly 6 feet tall, someone's height must be precisely 72.000000000000000000000000000
(infinite number of 0s!) inches. The chance of being exactly that height is, for all intents and purposes, zero.
Therefore, for most continuous random variables, each possible value has a zero probability. You can ask,
however, what the probability is that a person stands between 71.99 and 72.01 inches tall. It is not zero. Let's
now discuss how to calculate probabilities for continuous random variables.
PROPERTIES OF PROBABILITY DENSITY FUNCTION

A PDF has the following properties:

 It is always nonnegative.
 The height of a PDF for a value x of a continuous random variable represents the relative
likelihood that the random variable assumes a value near x.
 In the above example on men's heights, the PDF is largest at 69 inches, so the most likely
height of a Smalltown adult man is 69". It's also clear that the PDF value at 64" is
approximately half that at 69". Therefore, roughly half as many Smalltown adult men are
about 64" tall as are about 69" tall.
 In the example on flour use, the fact that all PDF values between 150 and 200 pounds are
the same means that any value in that range is equally likely to occur.
 The total area under the PDF must equal 1. For example, the PDF for flour use corresponds
to a rectangle with a base of 50 and a height of 0.02. Its area, therefore, is (0.02)(50) = 1.
 The probability of an event involving a continuous random variable corresponds to the area
under the PDF. The total probability of all possible outcomes must equal 1, in line with the
total area of 1 under the PDF.
NORMAL RANDOM VARIABLE:

PROPERTIES OF NORMAL RANDOM VARIABLE:

The normal random variable has several important properties:

 A normal random variable assumes a mean value μ.

 A normal random variable has a variance of σ  and a standard deviation of σ.
2

 There is a 68% chance that a normal random variable assumes a value within σ of the
mean, a 95% chance that it assumes a value within 2σ of the mean, and a 99.7% chance
that it assumes a value within 3σ of the mean. For example, IQs are normally distributed with
a mean of μ = 100 and standard deviation of σ = 15. Thus,
 68% of people have IQs between 100 - 15 and 100 + 15 (i.e., 85 to 115).
 95% of people have IQs between 100 - 2(15) and 100 + 2(15) (i.e., 70 to 130).
 99.7% of people have IQs between 100 - 3(15) and 100 + 3(15) (i.e., 55 to 145).
 The normal PDF is symmetric about the mean: It looks the same to the left of the mean as it
does to the right. For example, recall that IQs are normally distributed with a mean of μ = 100
and a standard deviation of σ = 15. The symmetry of the normal random variable implies that
for any x > 0, roughly as many people have IQs near 100 + x and 100 - x. For example, the
chance that a person has an IQ near 90 is equal to the chance that a person has an IQ near
110. The chances that a person has an IQ near 80 or near 120 are also equal to each other.
FINANCE
NPV: NET PRESENT VALUE

 The value of a sequence of cash flows expressed in today's dollars.

EXAMPLE OF NPV:
In Smalltown, Sarah Lopez Clooney's client Bernie Griffin runs a small lawn care business
called Lawns Are Us. Bernie's company has two investments under consideration. Investment
1 requires Bernie to invest $10,000 today and $14,000 two years from now. Investment 1 will
pay Bernie $24,000 one year from now. Investment 2 requires that Bernie invest $6000 today
and $1000 two years from now. Investment 2 will pay Bernie $8000 one year from now.
Bernie's naive answer is that Investment 2 is better because its total cash flow of $1000
exceeds Investment 1's total cash flow of $0. Sarah points out to Bernie that he is ignoring the
time value of money. That's why she gets paid the big bucks!

NPV FOR EXCEL: Excel's NPV function has the syntax =NPV(rate, range of cash flows),
where rate is the interest rate per period. The NPV function requires that cash flows be
received at regularly spaced intervals. The Excel NPV function also assumes that the first
cash flow occurs one period from today. If the first cash flow occurs today, you should
separate out that cash flow and apply the NPV function to the remaining cash flows. Please
refer to the file NPV.xlsx.
IRR: INTERNAL RATE OF RETURN
The rate of return that makes the Net present value (NPV) of a sequence of cash flows equal
to 0. Some streams of cash flows have multiple IRR's while other streams of cash flows have
no IRR.

The problem with using NPV to compare investments is that it is difficult to come up with an
appropriate discount rate. The advantage of instead using Internal Rate of Return (IRR) is
that you do not need to determine a discount rate. The IRR of a sequence of cash flows is
simply any discount rate that makes the NPV of the sequence of cash flows equal zero.
Usually, a sequence of cash flows has a unique IRR. If a sequence of cash flows has an IRR
of, say, 12%, the sequence of cash flows is earning 12% per period on the money invested.
Most of the time, ranking projects by IRR gives you a good idea of the relative merits of
different investments (exceptions are discussed later).
Let's suppose Bernie is trying to decide whether to invest in a new lawn mower or a fertilizer
spreader for his business. Each of the two pieces of equipment sells for $200, but they are
associated with different future cash flows. In this section, we will explore the implications of
this in terms of IRR.

EXCEL IRR FUNCTIONS

Excel's IRR function can be used to compute the IRR of a sequence of regularly spaced cash flows. To ensure
that the IRR function finds an answer, use the syntax =IRR(range of cash flows, guess). "Guess" means a guess
for the IRR of the cash flow sequence; you should let it range between -90% and, say, 100%.
 PAYBACK PERIOD
The payback period refers to the amount of time it takes to recover the cost of
an investment. Simply put, the payback period is the length of time an
investment reaches a break-even point.
The desirability of an investment is directly related to its payback period.
Shorter paybacks mean more attractive investments.

Payback Period = Initial investment / Cash Flow per year

Corporate finance is all about capital budgeting. One of the most important
concepts every corporate financial analyst must learn is how to value different
investments or operational projects to determine the most profitable project or
investment to undertake. One way corporate financial analysts do this is with
the payback period.
But there is one problem with the payback period calculation: Unlike other
methods of capital budgeting, the payback period ignores the time value of
money (TVM)—the idea that money today is worth more than the same
amount in the future because of the present money's earning potential.

FUTURE VALUE:

When computing NPV, you try to determine the value of a sequence of cash flows in today's dollars. Often you
also want to assess the value of dollars received today in terms of future dollars. For example, if you invest
$10,000 in your retirement account today and earn 10% annually on that investment, how much money will you
have in Year 10? The value of a cash flow moved forward in time is the cash flow's future value. In this section,
you will learn that the future value of a single cash flow is easy to determine.

Under the assumption of a given rate of return, future value measures the value of a cash flow
moved forward in time. For example, if we earn 8% per year on our investment the future value of
$100 in two years would equal 100(1.08) . 2

Future value (FV) is the value of a current asset at a future date based on an

assumed rate of growth. The future value is important to investors and
financial planners, as they use it to estimate how much an investment made
today will be worth in the future. Knowing the future value enables investors to
make sound investment decisions based on their anticipated needs. However,
external economic factors, such as inflation, can adversely affect the future
value of the asset by eroding its value.
Determining the FV of an asset can become complicated, depending on the
type of asset. Also, the FV calculation is based on the assumption of a stable
growth rate. If money is placed in a savings account with a guaranteed
interest rate, then the FV is easy to determine accurately. However,
investments in the stock market or other securities with a more volatile rate of
return can present greater difficulty.
 ANNUITY
Annuities are contracts issued and distributed (or sold) by financial institutions
where the funds are invested with the goal of paying out a fixed income
stream later on. They are mainly used for retirement purposes and help
individuals address the risk of outliving their savings. Upon annuitization, the
holding institution will issue a stream of payments at a later point in time.

The present value of the total sequence of cash flows:

 PERPETUITY
A perpetuity is a security that pays for an infinite amount of time. In finance,
perpetuity is a constant stream of identical cash flows with no end. The
formula to calculate the present value of a perpetuity, or security with
perpetual cash flows, is as follows:
THE PRESENT VALUE OF PERPETUITY FOR A N TIME SERIES CASH
FLOW

BUT IT IS SIMPLY CALCULATED AS C/R as 1/r(1+r)^N gives just decimal

values which can be neglected so just calculate the C/R which is the cash flow
divided by discount rate.
Suppose that Vivian's annual payment of $10,000 is guaranteed to go on
forever. That is, at times 1, 2,... Vivian receives $10,000. Assume that r = .
10. What is the present value of this perpetuity? In this example, C =
10,000 and r = .10. Therefore, the present value of this annuity is simply
10,000/.1 = $100,000. By the way, no single function in Excel can value a
perpetuity. Of course, you could let the number of periods in the PV
function grow large to approximate the value of a perpetuity, but it is
much easier just to use the formula C/r.

GORDON GROWTH MODEL(GGM) (GET TO KNOW WHETHER A STOCK

OR COMPANY IS UNDERVALUED OR OVER VALUED)
The Gordon Growth Model (GGM) is used to determine the intrinsic value of a
stock based on a future series of dividends that grow at a constant rate. It is a
popular and straightforward variant of the dividend discount model (DDM).
The GGM assumes that dividends grow at a constant rate in perpetuity and
solves for the present value of the infinite series of future dividends. Because
the model assumes a constant growth rate, it is generally only used for
companies with stable growth rates in dividends per share.
The three key inputs in the model are dividends per share (DPS), the growth
rate in dividends per share, and the required rate of return (RoR).
1. DPS: Dividends per share represent the annual payments a
company makes to its common equity shareholders, 
2. Growth rate in DPS:  the growth rate in dividends per share is
how much the rate of dividends per share increases from one
year to another
3. ROR: The required rate of return is a minimum rate of return
investors are willing to accept when buying a company's stock,
and there are multiple models investors use to estimate this rate.

2 IMPORTANT LIMITATIONS FOR GGM:

1. The main limitation of the Gordon growth model lies in its assumption of
constant growth in dividends per share. It is very rare for companies to show
constant growth in their dividends due to business cycles and unexpected
financial difficulties or successes. The model is thus limited to firms showing
stable growth rates.
2. The second issue occurs with the relationship between the discount factor
and the growth rate used in the model. If the required rate of return is less
than the growth rate of dividends per share, the result is a negative value,
rendering the model worthless. Also, if the required rate of return is the same
as the growth rate, the value per share approaches infinity.

BEST CALCULATIONS FOR GGM:

The value of a growing perpetuity is simply C/(r − g). Note that when g is 0, the
expression simplifies to the familiar formula for a perpetuity, C/r. For example, let's
assume that the Happytail Vet Clinic generated $150,000 in profit last year. If you
assume that its profits will grow 8% per year and you discount future profits at
10%, what is the value of all future profits?

Since Happytail generated $150,000 last year, C = $150,000(1.08) = $162,000. Given

that g = .08 and r = .10, the stream of cash flows generated by Happytail beginning
one year from now would have a total value of $162,000/(.10 − .08) = $8,100,000.
Therefore, the estimated value of all future profits generated by Happytail is $8.1
million. Note that if Happytails's profits were not growing at all, you would have
obtained a much smaller value for future profits of $1.62 million.
 CONTINOUS COMPOUND INTEREST
Continuous compounding is the mathematical limit that compound interest can
reach if it's calculated and reinvested into an account's balance over a
theoretically infinite number of periods. While this is not possible in practice,
the concept of continuously compounded interest is important in finance. It is
an extreme case of compounding, as most interest is compounded on a
monthly, quarterly, or semiannual basis.
EFFECTIVE INTEREST RATE:
The Effective Annual Interest Rate is an important concept that describes the
true interest rate associated with an investment or loan. The most important
feature of the Effective Annual Interest Rate is that it takes into account the
fact that more frequent compounding periods will lead to a higher effective
interest rate. For instance, suppose you have two loans which each have a
stated interest rate of 10%, in which one compounds annually and the other
compounds twice per year. Even though they both have a stated interest rate
of 10%, the Effective Annual Interest Rate of the loan that compounds twice
per year will be higher. 
 ZERO COUPON BONDS

Companies and governments often raise money by selling bonds to investors. Investors pay corporations
money today, and in return the investors receive cash flows in the future. A zero coupon bond pays cash at one
point in the future. For example, suppose that Sarah buys each of her children a $100 thirty-year savings bond.
Each bond pays $100 to the holder 30 years from the time of purchase. The $100 is called the face value of the
bond.

Zero coupon bond: A bond that pays the owner a single payment of the date the bond matures
FACE VALUE

The amount of money (excluding coupons) paid to a bondholder on the bond's maturity date. The
face value is usually a round number such as $100 or $1000.

To raise money, the Smalltown city government might sell a $1000 ten-year bond at 8%. Ten years is
the maturity of the bond. Such a bond will pay its $1000 face value at maturity. Also, each year (including the
year of maturity) the bond pays 8% of the face value ($80) as a coupon. Ten years from now, the bond pays the
coupon and the $1000 face value for a total of $1080.

PRESENT VALUE OF A ZERO COUPON BOND

PRESENT VALUE OF BOND WITH ANNUAL COUPONS

PRICING A BOND WITH SEMI ANNUAL COUPONS:

CALCULATING THE YIELD OF A BOND: THE R VALUE

YIELD OF BOND WITH COUPONS:

 COMPOUNDED AVERAGE GROWTH RATE

Investors often have historical data on the annual stock returns or revenue growth of a company and want
to distill these data down to a single number. For example, suppose that famous actress Betty Spears is
one of Sarah's high-profit investment clients. Sarah is considering investing Betty's money in the national
coffee chain Fourbucks. The annual returns on Fourbucks stock during the last four years are -50%, + 60%,
-50%, and +60%. To summarize these data, you might use the average return over the last four years,
which is −50+60−50+604=5% . This calculation

illustrates that if Sarah invests Betty's money in Fourbucks, assuming that the past is representative of the
future, Betty might expect to earn a return of 5% per year. You will soon see that Fourbucks is not that good
an investment!

WE SHOULD NOT CALCULATE THE AVERAGE PERCENTAGE WHICH WILL NOT

GIVE US THE ACCURATE ESTIMATION OF THE PRESENT PROFIT OR LOSS FOR
THE WHOLE PERIOD OF LOSSES AND PROFIT.
The per period rate of growth that describes the rate at which an investment would have
grown if it grew at a steady rate. For example, if a company's profits have a five year
CAGR of 6%, then $1 invested in the company for five years would grow to 1.06 . 5

This is CAGR.

OPTION PRICING THEORY:

OPTIONS:
Options are financial instruments that are derivatives based on the value of
underlying securities such as stocks. An options contract offers the buyer the
opportunity to buy or sell—depending on the type of contract they hold—the
underlying asset. Unlike futures, the holder is not required to buy or sell the
asset if they choose not to.

 Call options allow the holder to buy the asset at a stated price within a
specific timeframe.
 Put options allow the holder to sell the asset at a stated price within a
specific timeframe.

DERIVATIVES: A derivative is a financial security with a value that is reliant

upon or derived from, an underlying asset or group of assets—a benchmark.
The derivative itself is a contract between two or more parties, and the
derivative derives its price from fluctuations in the underlying asset.

The most common underlying assets for derivatives are stocks, bonds,
commodities, currencies, interest rates, and market indexes. These assets are
commonly purchased through brokerages.

SECURITY: The term "security" refers to a fungible, negotiable financial

instrument that holds some type of monetary value. It represents an
ownership position in a publicly-traded corporation via stock; a creditor
relationship with a governmental body or a corporation represented by owning
that entity's bond; or rights to ownership as represented by an option.

Option Contract: An options contract is an agreement between two parties to

facilitate a potential transaction on the underlying security at a preset price,
referred to as the strike price, prior to the expiration date.
Models used to price options account for variables such as current market
price, strike price, volatility, interest rate, and time to expiration to theoretically
value an option. Some commonly used models to value options are Black-
Scholes, binomial option pricing, and Monte-Carlo simulation.
STRIKE PRICE: The strike price is the price at which a derivative can be
exercised, and refers to the price of the derivative’s underlying asset.  In a call
option, the strike price is the price at which the option holder can purchase the
underlying security.  For a put option, the strike price is the price at which the
option holder can sell the underlying security. 

ITM: In the money" (ITM) is an expression that refers to an option that

possesses intrinsic value. ITM thus indicates that an option has value in a
strike price that is favorable in comparison to the prevailing market price of the
underlying asset:

 An in-the-money call option means the option holder has the opportunity

to buy the security below its current market price.
 An in-the-money put option means the option holder can sell the
security above its current market price.