LESSON - 02

LINEAR AND NON LINEAR FUNCTIONS

1. Linear Functions
2.1 What is Linear Function
Linear function has the form

𝑦 = 𝑓(𝑥) = 𝑏 + 𝑚𝑥

Where,

𝑚 is the slope/ rate of change of 𝑦 with respect to 𝑥

𝑏 is the vertical intercept/ value of 𝑦 when 𝑥 = zero

Notice that if the slope is 0, we have 𝑦 = 𝑏, a horizontal line.

A Linear equation is an algebraic equation in which each term is either a constant

or the product of a constant and (the first power of) a single variable. Linear
equations can have one, two, three or more variables. A common form of a linear
equation in the two variables 𝑥 and 𝑦 is

𝑦 = 𝑚𝑥 + 𝑏

Where 𝑚 and 𝑏 designate constants (the variable 𝑦 is multiplied by the constant

1, which as usual is not explicitly written). The set of solutions of such an equation
forms a straight line in the plane, which is the origin of the name "linear". In this
particular equation, the constant 𝒎 determines the slope or gradient of that
line; and the constant term 𝒃 determines the point at which the line
crosses the y-axis.

Consider the function 𝑦 = 𝑎𝑥, 𝑥 є 𝑅

In this case, є is to denote that 𝑥 is an element of Real numbers (𝑅).

Where 𝒂 is any real number, is graphed in figure 1.1. In (a) of the figure the
parameter a is positive, and in (b) it is negative.

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 Figure 1.1: linear functions

The reason for calling this function linear is obviously that its graph is a straight
line. The steepness of the line is determined by the absolute value of 𝒂. Taking
two 𝑥- values, we can write,

𝑦1 = 𝑎 𝑥1

𝑦2 = 𝑎 𝑥2

Implying that 𝑦2 – 𝑦1 = 𝑎 (𝑥2 – 𝑥1 )

Or 𝑎 = 𝑦2 – 𝑦1 / 𝑥2 – 𝑥1 = ∆𝑦 /∆𝑥

Where, ∆𝑦 is read as ”the change in 𝑦” and likewise for ∆𝑥. The ratio ∆𝑦/∆𝑥 is called
the slope of the line and so 𝑎 is the slope coefficient. Note that the line 𝑦 = 𝑎𝑥 is
fully determined once a chosen.

In equation 1, 𝑦 is often referred terminology as the Dependent variable and 𝑥

as the Independent variable. This terminology suggests that often we will have
a particular causality in mind when writing down the relationship between
variables, Such as, a change in 𝑥 causes a change in “𝑦”. For instance, consider
the relationship between sales and advertising. Advertising is one of the factors
which determine sales and hence sales are known as a dependent variable while
advertising becomes an independent variable.

When both 𝑥 and 𝑦 can serve as dependent or independent variables (i. e. where
the causation is unknown or unimportant), we can write the equations as an

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Implicit functions:

𝑓 (𝑥, 𝑦 ) = 0

The line so far has passed through the origin. We can displace them, so that
their position changes but not their slope, by adding the intercept term, 𝑏 € 𝑅.

Thus, if we write

𝑦 = 𝑎𝑥 + 𝑏 𝑥€𝑅

Then, since 𝑦 = 𝑏 when = 0 , the line cuts the y – axis at 𝑏 , as figure 1.2 shows
varying 𝑏 generates a whole family of parallel lines.

0 x

Figure 1.2 Linear function with a positive

intercept
We can express the same idea in the implicit form as

𝑎1 𝑥 + 𝑎2 𝑦 − 𝑐 = 0,

𝑥, 𝑦 € 𝑅

𝑎2 𝑦 = 𝑐 − 𝑎1 𝑥

𝑦 = 𝑐/𝑎2 − 𝑎1 𝑥/𝑎2

−𝑎1
Where we now have 𝑚 = 𝑎2
. Varying with 𝑎1 and 𝑎2 fixed again generate a family

of parallel. Setting 𝑦 = 0 allows us to obtain the intercept of the line on the 𝑥 axis
simply as 𝑐/𝑎2

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Example: 1

Find the slope of the following linear function. 𝑦 = 2𝑥 + 3

In this case, firstly, you can find any two coordinates of the function by applying
values to the function.

Let’s take 𝑥= 0

Then, 𝑦 = 3.

What you have to do is just to substitute the assumed value to the given function.

Therefore, the coordinate will be (0, 3)

Let’s take another value, 𝑥= 2

Then 𝑦 = 7

Therefore, the coordinate will be (2, 7)

It is to be noted that when you indicate a coordinate, value of the “𝑥” axis has to
be written at first. Now you can find the slope.

Slope = change in 𝑦/ change in 𝑥

Slope = 7 – 3/ 2 – 0

Slope = 2

Now you can see that there is a relationship between the value we obtained as
slope and the coefficient of the given function. Therefore, in case of a linear
function given as 𝑦 = 𝑚𝑥 + 𝑐, coefficient of 𝑥 equals to the slope of the function.

As we discussed earlier, intercept is the value at which the line cuts the 𝑦 axis.

Therefore, in that moment, value of 𝑥 must equal to zero. So, in this example,
intercept is 3 as 𝑦 value is 3 when 𝑥 equals to 0.

Example: 2

Find the intercept and slope of the following linear function 𝑥/3 + 𝑦/4 = 1

𝑥/3 + 𝑦/4 =1

𝑦/4 = -𝑥/3 + 1

𝑦 = -4𝑥/3 + 4 Hence, slope is -4/3 while the intercept is 4.

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2.2 Economic Applications

We assume that the economy is divided into two sectors, household and firms,
firms use resources such as land, capital and labour to produce goods and
services. These resources are known as factor of production and are taken to
belong to households. National income represents the flow of income from firms
to households given as payment for these factor. Households can then spend this
money in one of two ways. Income can be used for the consumption of goods
produced by firms or it can be put into savings. Consumption (C) and saving (S)
are therefore functions of income Y that is:

𝐶 = 𝑓 (𝑌)

𝑆 = 𝑔 (𝑌)

For some appropriate consumption functions 𝑓 and saving functions 𝑔. Moreover,

𝐶 and 𝑆 are normally expected to increase income rises so 𝑓 and 𝑔 are both
increasing functions.

We begin by analyzing the consumption functions. As usual we need to quantify

the precise relationship between 𝐶 and 𝑌. If this relationship is linear then graph
of typical consumption functions is in figure 1.3. It is clear from this graph that if

𝐶 = 𝑎𝑌 + 𝑏

C = aY + b
b

Y
Figure 1.3 - Consumption function

Then 𝒂 > 𝟎 and 𝒃 > 𝟎, the intercept 𝒃 is the level of consumption when there is no
income (that is when Y = 0) and is known as Autonomous consumptions. The
slope 𝒂, is the change in 𝐶 brought about by one unit increase in 𝑌 and known as

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the Marginal Propensity to Consume (MPC). As previously noted, income is
used up in consumption and savings so that 𝑌 = 𝐶 + 𝑆

It follows that only a proportion of the one unit increase in income is consumed.
The rest goes into savings. Hence the slope, “𝑎” is generally smaller than 1 that
is 𝑎 < 1. It is standard practice in mathematics to collapse the two separate
inequalities 𝑎 > 0 and 𝑎 < 1 into the single inequality; 0 < 𝑎 < 1

The relation, 𝑌 = 𝐶 + 𝑆 enables the precise form of the savings functions to be

determined from any given consumption function.

Example: 3

Sketch a graph of the consumption function 𝐶 = 0.6 𝑌 + 10. Determine the

corresponding savings functions and sketch its graph.

The graph of the consumption function 𝐶 = 0.6𝑌 + 10 has intercept 10 and slope
0.6. You can select any two coordinates to sketch this graph.

It passes through (0, 10) since 10 is its intercept. For a second point, let us
choose 𝑌=40 which gives 𝐶=34.

Hence the line also passes through (40, 34). The consumption function is
sketched in following figure 1.4

To find the savings function we use the relation 𝑌 = 𝐶 + 𝑆

This gives;

𝑆 = 𝑌– 𝐶 (subtract C from both side)

= 𝑌 – (0.6𝑌 + 10) (substitute C)

= 𝑌 – 0.6 𝑌 − 10 (multiply out of the brackets)

= 0.4 𝑌 – 10 (collect terms)

The savings function is also linear. Its graph has intercept - 10 and slope

0.4. This is sketched in figure 1.5 using the fact that it pass through (0, -10)
and (25, 0)

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 C
S
C = 0.6 Y + 10
S = 0.4 Y-10

40,34
Y
10 25

Y
Figure 1.4 Figure 1.5

2.3 Market Equilibrium

A Demand equation expresses the relationship between the unit price of the
commodity and the quantity demanded of the commodity. The line graph of the
demand equation is called a Demand curve. In general, the quantity demanded
of a commodity decreases as the commodity’s unit price increases, and vice
versa. Accordingly, a demand function defined by 𝑝 = 𝑓 (𝑄), where 𝑝 measures
the unit price and 𝑄 measures the number of units of the commodity in demanded
question, is generally characterized as a decreasing function of 𝑄: that is 𝑝 = 𝑓 (𝑄)
decreases as 𝑄 increases. Since both 𝑄 and 𝑝 assume only nonnegative values,
the demand curve is that part of the graph of 𝑓(𝑄) that lies in figure 1.6

Figure 1.6

The equation that expresses the relation between the unit price and the quantity
supplied is called a supply equation, and its graph is called a Supply curve. A
Supply function defined by 𝑝 = 𝑓 (𝑄) is generally characterized an increasing
function of 𝑄: that is, 𝑝 = 𝑓 (𝑄) increases as 𝑄 increase. Since both 𝑄 and 𝑝
assume only nonnegative values, the supply curve is that part of the graph
of 𝑓 (𝑄) that lies in figure 1.7.

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 Figure 1.7

When quantity demanded equals to the quantity supplied, that condition is known
as “Market equilibrium”. The quantity produced at market equilibrium is called
the Equilibrium quantity, and the corresponding price is called the Equilibrium
price.

Figure 1.8

Example: 4

You are given a demand and supply equations. Find the equilibrium point.

Demand: 𝑝 = −𝑄 + 6, Supply: 𝑝 = 𝑄 + 3

Quantity demanded = Quantity supplied

−𝑄 + 6 = 𝑄 + 3
2𝑄 = 3
𝑄 = 1.5
If we substitute in supply equation then 𝑝 = 1.5 + 3 = 4.5

Therefore, the equilibrium quantity is 1.5 and the equilibrium price is 4.5

Try Self-Assessment Exercise 1

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2. Non Linear Functions
2.1 Non Linear Functions and Graphs

a) Exponential Function

Previous lessons dealt mainly with exponents, linear and quadratic equation, and
simultaneous equations. Now you will learn an important new function in which a
constant base 𝒂 is raised to a variable exponent 𝑥. It is called an exponential
function and is defined as:

𝑎 > 𝑜 𝑎𝑛𝑑 𝑎 ≠ 1
b) Properties for General Exponential Functions

Given 𝑦 = 𝑎 𝑥 , 𝑎 > 0, 𝒂𝒏𝒅 𝑎 ≠ 1

1. The domain of the function is the set of all real numbers: the
range of the function is the set of all positive real numbers.
i.e., for all 𝒙, even 𝒙 < 𝟎, 𝒚 > 𝟎.

2. For 𝑎 > 1 , the function is increasing and convex; for 0 < 𝑎 < 1,
the function is decreasing and convex.

3. At 𝑥 = 0, 𝑦 = 1, independently of the base.

Example: 5

Given (a) 𝑦 = 2𝑥 and (b) 𝑦 = 2−𝑥 , the above properties of exponential functions
can readily be seen from the tables and graphs of the function.

(a) 𝑦 = 2𝑥

x y

-3 0.125

-2 0.25

-1 0.5

0 1

1 2

2 4

3 8

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 1 𝑥
(b) 𝑦 = 2−𝑥 = ( )
2

x y

-3 8

-2 4

-1 2

0 1

1 0.5

2 0.25

3 0.125

c) Logarithmic Function

Interchanging the variables of an exponential function 𝑓 defined by 𝑦 = 𝑎 𝑥 gives

rise to a new function g defined by 𝑥 = 𝑎 𝑦 such that any ordered pair of numbers
in 𝑓 will also be found in 𝑔 in reverse order.
If 𝑎𝑥 = 𝑏
Then, log 𝑎 𝑏 = 𝑥

Since 𝑎 𝑥 = 𝑏, you can replace b with 𝑎 𝑥 . i.e. log 𝑎 𝑎 𝑥 = 𝑥

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Example: 6
1. 𝐿𝑒𝑡 𝑓(𝑥) = , 𝑡ℎ𝑒𝑛 𝑓𝑖𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓(5).
2. 𝐼𝑓 𝑓(5) 𝑖𝑠 𝑦, 𝑓𝑖𝑛𝑑 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 log 2 𝑦
3. 𝐿𝑒𝑡 𝑔(𝑦) = log 2 𝑦 , 𝑡ℎ𝑒𝑛 𝑓𝑖𝑛𝑑 𝑔(𝑦)

Solution:
1. If 𝑓 (𝑥) = 2𝑥
Then, 𝑓 (5) = 25
= 32

2. Now y = 32
Therefore, if f (a) = m,
And log 2 𝑦 = log 2 32 Then g (m) = a
=5

3. Again If y = 32
g (32) = log 2 32
log 2 25 = 5
g (32) = 5

Example: 7
If f (2) = 4,

Then g (4) = 2; and

if f(3) = 8,

Then g (8) = 3.

The new function g, the inverse of the exponential function f, is called a

logarithmic function with base 𝒂. Instead of = 𝑎 𝑦 , the logarithmic function
with base a is more commonly written,

𝑦 = log 𝑎 𝑥 𝑎>0 𝑎≠1

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𝑦 = log 𝑎 𝑥 is the exponent to which 𝑎 must be raised to get 𝑥. Any positive number
expects 1 may serve as the base for a logarithm. The common logarithm of 𝑥,
written log10 𝑥 or simply 𝑙𝑜𝑔 𝑥, is the exponent to which 10 must be raised to get 𝑥.

d) Properties of Logarithms

For 𝑎, 𝑥 𝑎𝑛𝑑 𝑦 positive real numbers, 𝑛 a real number, and 𝑎 ≠ 1:

1) log 𝑎 𝑥𝑦 = log 𝑎 𝑥 + log 𝑎 𝑦:

In other words log of the product xy equals to the sum of logs of 𝑥 𝑎𝑛𝑑 𝑦.

𝑥
2) log 𝑎 = log 𝑎 𝑥 − log 𝑎 𝑦:
𝑦

In other words log of the division x by y equals to the difference of logs of

𝑥 𝑎𝑛𝑑 𝑦.

3) log 𝑎 𝑥 𝑛 = 𝑛log 𝑎 𝑥:
In other words log of exponential 𝑥 𝑛 equals to the n times the logs of 𝑥.

1
4) log 𝑎 √𝑥 =
𝑛
log 𝑎 𝑥
𝑛

In other words log of the nth root of x equals to the one nth of the logs of 𝑥.

Example: 8

1) 𝑥 = 7 ∗ 2
log 𝑥 = log 7 + log 2
log 𝑥 = 0.8451 + 0.3010
𝑙𝑜𝑔 𝑥 = 1.1461

Now, take the antilog of 1.1461

𝑥 = 14

2) 𝑥 = 18 ÷ 3
log 𝑥 = log 18 − log 3
log 𝑥 = 1.25553 − 0.4771
𝑙𝑜𝑔 𝑥 = 0.77843

Now, take the antilog of 0.77843

𝑥=6

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3) 𝑥 = 32
log 𝑥 = 2 log 3
log 𝑥 = 2(0.4771)
𝑙𝑜𝑔 𝑥 = 0.9542

Now, take the antilog of 0.9542

𝑥=9

4) 𝑥 = √8
3

1
log 𝑥 = log 8
3
1
log 𝑥 = (0.9031)
3
𝑙𝑜𝑔 𝑥 = 0.3010

Now, take the antilog of 0.3010

𝑥=2

Here the values 14, 6, 9 and 2 have been obtained by taking the anti-log of
1.1461, 0.7782, 0.9542, and 0.3010 respectively. This can be done by using a
logarithmic table. It is very efficient to use a scientific calculator and follow
instructions given below.

 Press the button called “SHIFT”.

 Then press button called “log”

 And enter the value, for example, in the example 1 you

have to enter here 1.1161 and
 Press = then you will get 13.999... Then round
the value to nearest whole number and get 14.

Try Self-Assessment Exercise 2

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2.2 Natural exponential and logarithmic functions

a) What is Natural Exponential and Logarithmic Functions

The most commonly used base for exponential and logarithmic functions is the
irrational number 𝒆, expressed mathematically,

𝑥 𝑥2 𝑥3
𝑒𝑥 = 1 + + + … … … … … … ..
1! 2! 3!

Definition of 𝒆:

1 𝑛
𝑒 = lim (1 + ) = 2.71828
𝑛→∞ 𝑛

b) Solving Natural Exponential and Logarithmic Functions

Since natural exponential functions and natural logarithmic are inverses of each
other, one is generally helpful in solving the other. Mindful that ln𝑥 signifies the
power to which “𝑒” must be raised to get 𝑥, it follows that:

1) e raised to the natural log of a constant (a>0), a variable (x>0), or a function

of a variable [f(x)>0] must equal that constant, variable, or function of the
variable:

𝑒 ln 𝑎 = 𝑎 𝑒 ln 𝑥 = 𝑥 𝑒 ln 𝑥 = 𝑓 (𝑥)

2) Conversely, the natural log of e raised to the power of a constant, variable, or

function of the variable:

𝑙𝑛 𝑒 𝑎 = 𝑎 𝑙𝑛 𝑒 𝑥 = 𝑥 𝑙𝑛 𝑒 f( 𝑥) = 𝑓 (𝑥)

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Example: 9
How to get ln24?
5𝑒 𝑥+2 = 120
Press icon “ln”
Solve algebraically for 𝑒 𝑥+2 , Enter 24
Press =
5 𝑥+2 120
𝑒 =
5 5

𝑒 𝑥+2 = 24

Take the natural log of both sides to eliminate “e”

𝑙𝑛𝑒 𝑥+2 = 𝑙𝑛24

𝑥 + 2 = 𝑙𝑛24

𝑥 = 𝑙𝑛24 − 2

Using calculator we can find value of ln24

𝑥 = 3.17805 − 2 = 1.17805

Example: 10
How to get 𝒆𝟑.𝟐
6 ln 𝑥 − 7 = 12.2
Enter 3.2
Solve algebraically for ln 𝑥, Press 𝒆𝒙

6ln 𝑥 = 12.2 + 7

6 ln 𝑥 = 19.2

ln 𝑥 = 19. 2 ÷ 6

ln 𝑥 = 3.2

Set both sides of the equation as exponents of e to eliminate the natural log
expression

𝑒 ln 𝑥 = 𝑒 3.2

𝑥 = 𝑒 3.2

𝑥 = 24.53253

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2.3 Exponential and Logarithmic Functions in Management

a) Interest Compounding

S Final value of investment

P Initial value of investment

i Interest rate per period

n Number of interest periods

At the start:

𝑺 = 𝑷

After 1 period:

𝑺 = 𝑷 + 𝑷𝒊 = 𝑷(𝟏 + 𝒊)

P - Amount at the start of this period

Pi - Amount of interest earned during this period on the starting amount of this
period

P (1+i) - Final value at the end of this period

After 2 periods:

𝑺 = 𝑷 (𝟏 + 𝒊) + 𝑷(𝟏 + 𝒊)𝒊 = 𝑷(𝟏 + 𝒊)(𝟏 + 𝒊) = 𝑷(𝟏 + 𝒊)𝟐

P (1 + i) - Amount at the start of this period, i.e., the final value at the end of
the last period

P (1 + i) i - Amount of interest earned during this period on the starting amount

of this period

P (1 + i)2 - Final value at end of this period

After 3 periods:

𝑺 = 𝑷 (𝟏 + 𝒊)𝟐 + 𝑷(𝟏 + 𝒊)𝟐 𝒊 = 𝑷(𝟏 + 𝒊)𝟐 (𝟏 + 𝒊) = 𝑷(𝟏 + 𝒊)𝟑

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P (1 + i)2 -Amount at the start of this period, i.e., the final value at the end of
the last period

P (1 + i)2i- Amount of interest earned during this period on the starting amount
of this period

P (1 + i)3 - Final value at end of this period

After n periods:

𝑺 = 𝑷 (𝟏 + 𝒊)𝒏

Often the interest per period,𝒊, is expressed in terms of the Annual Percentage
Rate (APR), 𝑟, and the number of interest periods per year, 𝒎.

Under these conditions the interest per period is equal to the annual percentage
rate divided by the number of interest periods per year, as in:

𝒊 = 𝒓/𝒎

This would make the above formula for the final value of an investment after
𝑛 interest periods look like this:

𝑺 = 𝑷 (𝟏 + 𝒓/𝒎)𝒏

Notice that the output, 𝑆, is an exponential function of 𝑛. That is, if we consider

the final value of the investment as a function of the length of time for the
investment, then 𝑛, the length of time for the investment, is in the exponent
position, and this makes 𝑆 an exponential function of 𝑛.

A given principal 𝑃 compounded annually at an interest rate 𝑖 for a given

number of years 𝑛 will have a value 𝑆 at the end of that time given by the
exponential function.

𝑆 = 𝑃 (1 + 𝑖)𝑛

If compounded 𝑚 times a year for 𝑛 years,

𝑖 𝑛∗𝑚
𝑆 = 𝑃 (1 + )
𝑚

If compounded continuously at 100 percent interest for 1 year,

1 𝑚
𝑆 = 𝑃 lim (1 + 𝑚) = 𝑃 (2.71828) = 𝑃. 𝑒
𝑚→∞

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 For interest rates 𝑖 other than 100 percent and time periods 𝑛 other than 1
year,

𝑆 = 𝑃𝑒 𝑖𝑛

For negative growth rates, such as depreciation or deflation, the same formulas
apply, but 𝑖 and 𝑟 are negative.

Example: 11

Find the value of Rs. 100 at 10 percent interest for 2 years compounded:

1. Annually, 𝑆 = 𝑃(1 + 𝑖)𝑛

𝑆 = 100(1 + 0.1)2

𝑆 = 𝑅𝑠. 121

𝑖
2. Semi-annually, 𝑆 = 𝑃(1 + 𝑚)𝑛∗𝑚

0.1 2∗2
𝑆 = 100(1 + 2
)

𝑆 = 100(1 + 0.05)4

𝑆 = 100 (1.2155)

𝑆 = 𝑅𝑠. 121.55

3. Continuously, 𝑆 = 𝑃𝑒 𝑖𝑛

𝑆 = 100𝑒 0.1∗2

𝑆 = 100 (1.2214)

𝑆 = 𝑅𝑠. 122.14

b) Effective vs. Nominal Rates of Interest

Above example given principal set out at the same nominal rate of interest will
earn different effective rates of interest which depend on the type of
compounding. When compounded annually for 2 years, Rs. 100 will be worth
Rs. 121; when compounded semi-annually, S = Rs. 121.55; when compounded
continuously, S = Rs.122.14.

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 To find the effective annual rate of interest 𝑖𝑒 for multiple compounding

𝑖 𝑛∗𝑚
𝑃 (1 + 𝑖𝑒 )𝑛 = 𝑃 (1 + )
𝑚

Dividing by 𝑃 and taking the nth root of each side,

𝑖 𝑚
1 + 𝑖𝑒 = (1 + )
𝑚

𝑖 𝑚
𝑖𝑒 = (1 + ) − 1
𝑚

To find the effective annual rate of interest for continuous compounding:

1 + 𝑖𝑒 = 𝑒 𝑖

𝑖𝑒 = 𝑒 𝑖 − 1

Example: 12

Find the effective annual rate of interest for a nominal interest rate of 10
percent when compounded for 2 years (1) semiannually and (2) continuously.

𝑖 𝑚
1. Semi-annually, 𝑖𝑒 = (1 + ) −1
𝑚

0.1 2
𝑖𝑒 = (1 + 2
) −1

𝑖𝑒 = 1.1025 − 1 = 0.1025 = 10.25%

2. Continuously, 𝑖𝑒 = 𝑒 𝑖 − 1

𝑖𝑒 = 𝑒 0.1 − 1

𝑖𝑒 = 1.10517 − 1 = 0.10517 = 10.52%

c) Discounting

A sum of money to be received in the future is not worth as much as an equivalent

amount of money in the present, because the money on hand can be lent at
interest to grow to an even larger sum by the end of the year. If present market
conditions will enable a person to earn 8 percent interest compound annually, Rs.

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100 will grow to Rs. 108 by the end of the year. And Rs. 108 1 year from now,
therefore, is worth (has a present value of) only Rs. 100 today.

Discounting is the process of the determining the present value 𝑃 of a future sum
of money 𝑆. if under annual compounding

𝑆 = 𝑃(1 + 𝑖)𝑛

𝑆
Then, 𝑃 = = 𝑆(1 + 𝑖)−𝑛
(1+𝑖)𝑛

Similarly, when finding the present value under multiple compounding 𝑃 =

𝑖 −𝑚∗𝑛
𝑆 [1 + ( )] and continuous compounding 𝑃 = 𝑆𝑒 −𝑖∗𝑛 , the interest rate is called
𝑚

the “Discount rate”.

Example: 13

The present value of a 5-year bond with a face value of Rs. 1000 and no coupons
is calculated below; it is assumed that comparable opportunities offer interest
rates of 9 percent under annual compounding

𝑃 = 𝑆(1 + 𝑖)−𝑛

𝑃 = 1000(1 + 0.09)−5

𝑃 = 1000 (0.64993) = 𝑅𝑠. 649.93

Thus, a bond with no coupons promising to pay Rs. 1000 5 years from now is
worth approximately Rs. 649.93 today since Rs. 649.93 at 9 percent interest will
grow to Rs. 1000 in 5 years.

Try Self-Assessment Exercise 4

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