PAPER NO.

CI12

CERTIFIED INVESTMENT
AND FINANCIAL ANALYSTS
(CIFA)

SECTION ONE

FINANCIAL MATHEMATICS

STUDY NOTES

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CONTENT

2.1 Introduction to financial mathematics

- Nature and scope of finance; financing, investment, management of working capital and
profit sharing (dividend policy) decisions
- Relationship between finance and other disciplines; finance and economics, finance and
accounting, finance and mathematics
- Purpose of financial modeling

2.2 Financial algebra

- Simultaneous and quadratic equations

- Developing financial equations
- Developing finance functions
- Interactive graphs; graphing financial functions
- Overview of calculator operations: turning on and off the calculator, selecting second
functions, setting calculator formulae, clearing calculator memory, mathematical
operations, memory operations, memory operations, using worksheets

2.3 Time value of money and interest rate mathematics

- Concept of interest rates and inflation

- Simple interest
- Compound interest
- Continuously Compound interest
- Present values
- Basics of capital budgeting
- Loan amortization
- Time value of money and amortization worksheets, entering variables in amortization
worksheets, entering cash inflows and outflows, generating amortization schedules
- Cash flow worksheets; calculator worksheet variables for both even and uneven and
grouped and grouped cash flow, entering, deleting, inserting and computing results
- Depreciation worksheets; depreciation worksheet variables, entering data and computing
results
- Other worksheets: percentage change/compound interest worksheets, interest conversion
worksheets, profit margin worksheets, break-even worksheets, memory worksheets

2.4 Financial forecasting

- Need for financial forecasting

- Techniques of financial forecasting: statistical and non-statistical methods
- Time series components and analysis

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 - Share valuation
- Fixed income model for bonds and construction of yield curve
- Regression and correlation
- Use of financial calculators in regression and correlation models, entering data,
computing the results and interpretation

2.5 Financial calculus

- Introduction calculus
- Differentiation; ordinary and partial derivatives
- Integration
- Application of calculus to solve financial problems relating to maximization of returns
and minimization of costs

2.6 Descriptive statistics

- Measures of central tendency; mean, mode, median

- Measures of relative standing; quartiles, deciles, percentiles
- Measures of dispersion; range, mean deviation, variance, standard deviation, coefficient
of variation
- Statistical worksheets; statistical worksheet variables, computing statistical results and
interpretation

2.7 Probability Theory

- Relevance of probability theory

- Events and probabilities
- Probability rules
- Random variables and probability distributions
- Binomial random variables
- Expected value
- Variance and standard deviation
- Probability density function
- Normal probability distribution
- Stochastic functions
- Application of probability to solve business problems

2.8 Index numbers

- Purpose of index numbers

- Construction of index numbers
- Simple index numbers; fixed base method and chain base method

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 - Weighted index numbers; Laspeyre‘s, Paashes‘s, Fisher‘s ideal and Marshall-
Edgeworth‘s methods
- Limitations of index numbers

2.9 Emerging issues and trends

CHAPTER

CHAPTER ONE
Introduction to financial mathematics………………………………………..………………5

CHAPTER TWO
Financial algebra……………………………………………….……………….……………12

CHAPTER THREE
Time value of money and interest rate mathematics………………….…......…….………32

CHAPTER FOUR
Financial forecasting…...........................................................................................................59

CHAPTER FIVE
Financial calculus………………………………………………………….………...……….85

CHAPTER SIX
Descriptive statistics…............................................................................................................96

CHAPTER SEVEN
Probability Theory………………………………………………………………….………125

CHAPTER EIGHT
Index numbers……………………………………………………………………...………150

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 CHAPTER ONE

INTRODUCTION TO FINANCIAL MATHEMATICS

Nature of financial decision

Financial decisions are those made by financial managers of a firm. It‘s broadly classified into
two.

a) Managerial decision
b) routine decision

Managerial decisions
These are Decisions that require technical skills, planning and expertise of a financial manager.

It‘s classified into four:

1) Financing decision

It involves looking for finance to acquire assets of the firm and may include:

- Issue of ordinary shares

- Long term loan
- Preference shares

2) Investment decision

It‘s the responsibility of a financial manager to determine whether acquired funds should be
invested in order to generate revenue. Financial manager must do a proper appraisal of any
investment that may be undertaken.

3) Dividend decision

Dividends are part of the earnings distributed to ordinary shareholders for their investment in the
company. Financial manager has to consider the following:

- How much to pay

- When to pay
- How to pay i.e. cash or bonus issue
- Why to pay

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 4) Liquidity/working capital management decision

Liquidity is the ability of a company to meet its short-term financial obligation when they fall
due.

It‘s the financial managers‟ role to ensure that the company has maintained the required
liquidity and to avoid instances of insolvency.

It‘s also his role to manage the cash position of the firm, inventory position and the amount of
receivables in the company.

Routine decisions

They are supportive to managerial decisions. They require no expertise in executing them. They
are normally delegated to junior staff in finance department. They include:

- issue of cash receipts

- safeguarding the cash balance
- safe custody of important finance document (filing)
- implementation of control system

Financial asset

A financial asset is an intangible asset that derives value because of a contractual

claim. Examples include bank deposits, bonds, and stocks. Financial assets are usually
more liquid than tangible assets, such as land or real estate, and are traded on financial
markets. According to the International Financial Reporting Standards (IFRS), a financial asset is
defined as one of the following:
 Cash or cash equivalent;
 Equity instruments of another entity;

 Contractual right to receive cash or another financial asset from another entity or to
exchange financial assets or financial liabilities with another entity under conditions
 that are potentially favourable to the entity;
 Contract that will or may be settled in the entity's own equity instruments and is either
a non-derivative for which the entity is or may be obliged to receive a variable number
of the entity's own equity instruments, or a derivative that will or may be settled other
than by exchange of a fixed amount of cash or another financial asset for a fixed
number of the entity's own equity instruments.

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Risk and return

Risk
It refers to deviation or variations of the actual outcome from the expected. It‟s the possibility
of things happening than they are expected.
Risk can be measured for either a single or a gap of project (portfolio-collection of securities)

Return
It is the anticipated gain or earnings on any investment. These investments returns could
be positive or negative outcomes.

'Risk-Return Tradeoff'
It‘s the principle that the potential return rises with an increase in risk. Low levels of uncertainty
(low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk)
are associated with high potential returns. According to the risk-return tradeoff, invested money can
render higher profits only if it is subject to the possibility of being lost.
Because of the risk-return tradeoff, you must be aware of your personal risk tolerance when
choosing investments for your portfolio. Taking on some risk is the price of achieving returns;
therefore, if you want to make money, you can't cut out all risk. The goal instead is to find an
appropriate balance - one that generates some profit, but still allows you to sleep at night.

Optimization decisions
These are decisions that maximize returns and minimize risks to an investor.

Relationship between finance and other disciplines

Relationships to Economics:
There are two important linkages between economics and finance. The macroeconomic
environment defines the setting within which a firm operates and the micro-economic
theory provides the conceptual under pinning for the tools of financial decision making.
Key macro-economic factors like the growth rate of the economy, the domestic savings rate, the
role of the government in economic affairs, the tax environment, the nature of external
economic relationships the availability of funds to the corporate sector, the rate of inflation, the
real rate of interests, and the terms on which the firm can raise finances define the environment
in which the firm operates. No finance manager can afford to ignore the key developments in the
macro economic sphere and the impact of the same on the firm.
While an understanding of the macro economic developments sensitizes the finance manager to the
opportunities and threats in the environment, a firm grounding in micro economic principles
sharpens his analysis of decision alternatives. Finance, in essence, is applied micro economics.
For example the principle of marginal analysis – a key principle of micro economics according
to with a decision should be guided by a comparison of incremental benefits and cost is
applicable to a number of managerial decisions in finance.

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 CHAPTER TWO

FINANCIAL ALGEBRA

Function

It‘s the relationship between independent variable and the dependent variable. It consists of
a constant and a variable.

A constant – This is a quantity whose value remains unchanged throughout a particular

analysis e.g. fixed cost, rent, and salary.
A variable – This is a quantity which takes various values in a particular problem

Illustration
Suppose an item is sold at Sh 11 per unit. Let S represent sales rate revenue in shillings and
let Q represents quantity sold.

Then the function representing these two variables is given as:

S = 11Q

S and Q are variables whereas the price - Sh 11 - is a constant.

Types of variables

Independent variable – this is a variable which determines the quantity or the value of some other
variable referred to as the dependent variable. In Illustration 1.1, Q is the independent variable
while S is the dependent variable.

An independent variable is also called a predictor variable while the dependent variable is
also known as the response variable i.e. Q predicts S and S responds to Q.

3. A function – This is a relationship in which values of a dependent variable are determined by

the values of one or more independent variables. In illustration 1.1 sales is a function of
quantity, written as S = f(Q)

Demand = f( price, prices of substitutes and complements, income

levels,….) Savings = f(investment, interest rates, income levels,….)

Note that the dependent variable is always one while the independent variable can be more
than one.

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Types of functions/equations

1) Linear equation

It takes the form y = a + bx

Where x and y are variables while a and b are constants.

e.g y = 20 + 2x

y = 5x

y = 15-0.3x

In graphical presentation of a linear equation, the constant ‗a‘ represents y-intercept and ‗b‘
Δ𝑦
represents the gradient of the slope. Δ𝑥

The linear equation can be presented either as 2 by 2 simultaneous equation. In general 2 by 2

equations are given as follows:

2x2

𝑎1 𝑥 + 𝑏1 𝑦 = 𝑐1

𝑎2 𝑥 + 𝑏2 𝑦 = 𝑐2

3x3 is given by as,

𝑎1 𝑥 + 𝑏1 𝑦 + 𝑐1 𝑧 = 𝑑1

𝑎2 𝑥 + 𝑏2 𝑦 + 𝑐2 𝑧 = 𝑑2

𝑎3 𝑥 + 𝑏3 𝑦 + 𝑐3 𝑧 = 𝑑3

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2) Quadratic equations

The general formula is 𝑎𝑥 2 + 𝑏𝑥 + 𝑐 = 0

When the equation is ploted, it yields either a valley or a mountain depending on constant a. if <
0 a mountain, if> 0 a valley.

In order to solve a linear equation, the equation is equated to zero.

Methods of solving simultaneous equations:

Substitution Method
Example:

𝑥 = 86000 + 0.01𝑦
𝑦 = 44000 + 0.02𝑥

Rewrite:

86000 + 0.01𝑦 − 𝑥
44000 + 0.02𝑥 − 𝑦

𝑌 = 44000 + 0.02(86000 + 0.01)

𝑌 = 44000 + 1720 + 0.0002𝑦

𝑦 − 0.0002𝑦 = 44000 + 1720

0.9998𝑦 = 45720

45720
𝑦=
0.998

= 45,729.15

𝑋 = 86000 + (0.01𝑥45.729)

= 86457.29

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 CHAPER THREE

TIME VALUE OF MONEY AND INTEREST RATE MATHEMATICS

Objectives
At the end of this chapter you should be able to:
1. Explain meaning of time value of money and its role in finance.
2. Explain the concept of future value and perform compounding calculations.
3. Explain the concept of present value and perform discounting calculations.
4. Apply the mathematics of finance to accumulate a future sum, preparing loan amortization
schedules, and determining interest or growth rates.

Introduction
A shilling today is worth more than a shilling tomorrow. An individual would thus prefer to
receive money now rather than that same amount later. A shilling in ones possession today is
more valuable than a shilling to be received in future because, first, the shilling in hand can be
put to immediate productive use, and, secondly, a shilling in hand is free from the uncertainties
of future expectations (It is a sure shilling).

Financial values and decisions can be assessed by using either future value (FV) or present value
(PV) techniques. These techniques result in the same decisions, but adopt different approaches
to the decision.

Future value techniques

Measure cash flow at the some future point in time – typically at the end of a projects life. The
Future Value (FV), or terminal value, is the value at some time in future of a present sum
ofmoney, or a series of payments or receipts. In other words the FV refers to the amount of
money an investment will grow to over some period of time at some given interest rate. FV
techniques use compounding to find the future value of each cash flow at the given future date
and the sums those values to find the value of cash flows.

Present value techniques

Measure each cash flows at the start of a projects life (time zero).The Present Value (PV) is the
current value of a future amount of money, or a series of future payments or receipts. Present
value is just like cash in hand today. PV techniques use discounting to find the PV of each cash
flow at time zero and then sum these values to find the total value of the cash flows.

Although FV and PV techniques result in the same decisions, since financial managers make
decisions in the present, they tend to rely primarily on PV techniques.

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1. COMPOUNDING
Two forms of treatment of interest are possible. In the case of Simple interest, interest is paid
(earned) only on the original amount (principal) borrowed. In the case of Compound interest,
interest is paid (earned) on any previous interest earned as well as on the principal borrowed (lent).
Compound interest is crucial to the understanding of the mathematics of finance. In most situations
involving the time value of money compounding of interest is assumed. The futurevalue of present
amount is found by applying compound interest over a specified period of time

The Equation for finding future values of a single amount is derived as follows:

Let

FVn= future value at the end of period n

PV (Po) =Initial principal, or present value
k= annual rate of interest

n = number of periods the money is left on deposit.

The future value (FV), or compound value, of a present amount, Po, is found as follows.
1
At end of Year 1, FV1 =Po (1+k) = Po (1+k)
2
At end of Year 2, FV2=FV1 (1+k) = Po(1+k) (1+k) = Po ( 1+k)
3
At end of Year 3, FV3 = FV2 (1+k) = Po ( 1+k) ( 1+k) (1+k) = Po (1+k)
A general equation for the future value at end of n periods can therefore be formulated as,

n
FVn = Po ( 1+k)

Example:
Assume that you have just invested Ksh100, 000. The investment is expected to earn interest at a
rate of 20% compounded annually. Determine the future value of the investment after 3 years.
Solution:
At end of Year 1, FV1 =100,000 (1+0.2) =120,000
At end of Year 2, FV2 =120,000 (1+0.2) OR { 100,000(1+0.2) (1+0.2)}=144,000

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At end of Year 3, FV3 = 144,000(1+0.2) =100,000 ( 1+0.2) ( 1+0.2) (1+0.2) = 172,800
Alternatively,

n
FVn = Po ( 1+k)

3
At the end of 3 years, FV3= 100,000 ( 1+0.2) = Sh.172,800
Using Tables to Find Future Values

Unless you have financial calculator at hand, solving for future values using the above
equation can be quite time consuming because you will have to raise (1+k) to the nth power.
n
Thus we introduce tables giving values of (1+k) for various values of k and n. Table A-3 at the
back of this book contains a set of these interest rate tables. Table A-3 Future Value of $1 at
theEnd of n Periods1 gives the future value interest factors. These factors are the
multipliersused to calculate at a specified interest rate the future values of a present amount as of
a given date. The future value interest factor for an initial investment of Sh.1 compounded at k
percent for n periods is referred to as FVIFk n.
n
Future value interest factors = FVIFk n. = (1+k) .
FVn = Po * FVIFk,n

A general equation for the future value at end of n periods using tables can therefore be
formulated as,

FVn = Po× FVIFk,n

The FVIF for an initial principal of Sh.1 compounded at k percent for n periods can be
found in Appendix Table A-3 by looking for the intersection of the nth row and the k %
column. A future value interest factor is the multiplier used to calculate at the specified
rate the future value of a present amount as of a given date.
From the example above, FV3 = 100,000 × FVIF20%,3 years

=100,000 × 1.7280
=sh.172, 800
Future value of an annuity
So far we have been looking at the future value of a simple, single amount which grows over a
given period at a given rate. We will now consider annuities.
An annuity is a series of payments or receipts of equal amounts (i.e. a pensioner receiving
Sh.100,000 per year for ten years after his retirement). The two basic types of annuities are the
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ordinary annuity and the annuity due. Anordinary annuityis an annuity where the cash
flowoccurs at the end of each period. In an annuity due the cash flows occur at the beginning of
each period. This means that cash flows are sooner received with an annuity due than for a
similar ordinary annuity. Consequently, the future value of an annuity due is higher than that of
an ordinary annuity because the annuity due‟s cash flows earn interest for one more year.

Example:
Determine the future value of a shs100, 000 investment made at the end of every year for 5
years assume the required rate of return is 12% compounded annually.

Solution.
The future value interest factor for an n-year, k%, ordinary annuity (FVIFA) can be found by
adding the sum of the first n-1 FVIFs to 1.000, as follows;

End of year Amount Number of years Future value interest Future value at
deposited companied factor (FVIF) from end of year
discount tables(12%)

1 100,000 4 1.5735 157350

2 100,000 3 1.4049 140490

3 100,000 2 1.2544 125440

4 100,000 1 1.12 112000
100,000 0 1 100000
FV after 5 635280
years.

The Time line and Table below shows the future value of a Sh.100,000 5-year annuity
(ordinary annuity) compounded at 12%.

Timeline

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 CHAPTER FOUR

FINANCIAL FORECASTING

Introduction

Planning is a continuous process; every day business owners create and adjust short- and long-
term plans. Short-term plans are tactical in nature and are designed to adapt to normal
operational challenges and opportunities. Longer-term plans, because they are more strategic in
nature − including issues like whether to expand operations, purchase new equipment, or hire
more personnel − require decisions that could have major financial implications for the company.
Financial forecasting is often the key to making smart business decisions.

At the simplest level, financial forecasting is based on assumptions and estimates. Sales
forecasts, production forecasts, and cash forecasts are some of the most commonly-used financial
planning tools. The goal is simple: by analyzing historical data (if available) and market
research, and making a few key assumptions, financial forecasting is used to create plans for the
future of the business.

The Importance of Assumptions

While data is important − typically "the more data the better" applies to financial forecasting −
making some assumptions is required. Since no one can predict the future, the models created
rely on assumptions about what may happen: whether sales will increase or decrease and by what
percentage; whether labor, materials, costs, etc., will increase or decrease and by what
percentage; whether interest rates and the availability of capital will fluctuate, etc.

Assumptions are in effect educated, informed, and hopefully directionally-accurate

"guesstimates". Many companies build financial forecasts using a variety of assumptions, taking
into account different levels of projected results. For example, a sales forecast could be built
showing a growth in sales of 5%, 10%, 20%, or even reduced sales of -5% or -10%. The key is to
model different scenarios and gauge the potential impact on operations and on financial
performance − assumptions are a necessary part of building those models.

While existing businesses can rely on historical data that can, in part, indicate future results, new
or start-up companies are forced to make a number of assumptions. That's why a comprehensive
business plan based on a broad range of financial models is so critical.

The most basic assumption is usually future sales.

Sales Forecast

Sales drive a business − without sales, there is no business. The sales forecast attempts to predict
sales so that other operational requirements, like production forecasts, can be determined. In
order to estimate sales, most companies look at sales histories and other known factors that can
influence future sales. For example, market research could show that several competitors have

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dropped out of the marketplace, making increased sales possible. On the other hand, the
company may have decided to drop an under-performing product line, ensuring that sales will
dip, at least in the short-term.

After data is collected and analyzed, sales volume is predicted. Often companies also include
projected price levels in the sales forecast, since price has a dramatic effect on profitability. Most
companies develop several sales forecasts based on incremental changes in anticipated sales; a
"target" sales figure is used to drive most other models, but plus/minus sales figures can also be
used to model the effect on operations. For example, a projected 10% growth in sales could be
accommodated by current production capacity; if sales grow by 20%, more capacity will be
required, allowing the company to create proactive contingency plans in case sales exceed the
forecast.

Again, accurately predicting the future is impossible; the sales forecast is simply the company's
best estimate of future activity − and in most cases also serves as a goal for the company. Even
though the sales forecast does require at least some amount of guesswork, without a sales
forecast there is no real way to create estimates for other operational needs − like production.

Production Forecast

The production forecast is based primarily on assumptions made in the sales forecast. The first
step is to build a production plan based on anticipated sales; doing so is relatively simple, since a
good sales forecast predicts sales volume by month or even week. Using sales volume as an
assumption, a production forecast is built to meet demand. If capacity is flat but sales volume
includes spikes, a production plan could be developed that creates excess inventory to meet
seasonal swings in volume, or the company could plan to use overtime or to outsource certain
services to meet demand.

Once the production forecast is developed, other operational plans can follow: whether new
equipment is needed, if/when new employees are required, the timing of materials and supplies
purchases, etc. Costs can then be determined and profitability can be evaluated − again, all based
on a few key assumptions.

In effect the sales forecast and the production forecast create the foundation of a budget. Think
of it this way: if you know sales volume and prices, and you know the costs of producing,
marketing, and distributing what you sell, then you have created a blueprint for operations and
financial performance (assuming all the assumptions you made are correct).

Cash Forecast

The cash forecast is an estimate of future cash inflows (revenue) and outflows (expenses). Once
sales forecasts and production forecasts are complete, the timing of many expenses is known:
Wages, supply costs, utility costs, etc. The sales forecast should also provide a prediction of sales
and therefore revenue. The cash forecast creates a breakdown of revenue and expenses by time
period to show whether the company will have sufficient funds on hand at any given time to
meet operational needs. For example, due to anticipated volume swings the company may need

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to ramp up production in August, purchasing greater than normal levels of materials and supplies
and working heavy overtime. Sales of the items produced will not occur until October, and
payment for those items will not be received until November. As a result, cash flow could be a
major problem, requiring the company to borrow money to cover operating costs or to draw
funds from cash on hand.

Without a sales forecast, production forecast, and cash forecast, that type of financial and
operational planning would be impossible and the company may not have sufficient funds to
meet sales demands.

A few things to keep in mind about financial forecasting:

 Forecasting is based on historical data and educated guesses. If the market changes
significantly, historical data and "accumulated wisdom" will be of little use in predicting
future events.
 Forecasting is based on assumptions; always develop a variety of forecasts based on
different assumption scenarios, and create contingency plans for each scenario.
 The longer-term the forecast the more inaccurate it will usually be. Nothing is certain but
change − especially over the long term.

It involves determining the future financial requirements of the firm. This requires financial
planning using budgets.

Importance of financial forecasting

 Facilitates financial planning i.e. determination of cash surplus or deficit that are
 likely to occur in future.
 Facilitates control of expenditure so as to minimize wastage of financial resources.

 Forecasting using targets and budgets acts as a motivation to employees who aim at
achieving targets set

Strategic plan:
It‘s a blue print road map that indicates what the firm intends to do and how to do it. It
consists of:
- The mission/purpose of existence
- Scope: these are the lines of business
- Objectives: specific goals in quantitative forms.
- Strategies: instruments to be used in achieving firms objectives.

Role of financial manager in strategic planning

1. Educate strategic planning team on financial implication on various options
2. Ensure strategic plan is viable financially
3. Translate strategic plan into long range financial plans

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 CHAPTER FIVE

FINANCIAL CALCULUS
It explains how the value of the variable varies as the other variable changes.

Calculus is concerned with the mathematical analysis of change or movement. There are two
basic operations in calculus:

i) Differentiation
ii) Integration

These two basic operations are reverse of one another in the same way as addition and
subtraction or multiplication and division

Differentiation

It is concerned with rates of change e.g. profit with respect to output

i) Revenue with respect to output
ii) Change of sales with respect to level of advertisement
Savings with respect to income, interest rates
Rates of changes and slope (gradients)

Δ𝑦
-It estimates a slope (gradient of graph) of a particular point. The derivative of a function Δ𝑥
Gives the exact change of a point. It‘s the process of finding the derivative o f a function.

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Business purpose for calculus
For business purposes, it’s used in the profit functions, cost functions and revenue functions . it
will help the management in determining the levels of activities that will maximize profits or
minimize cost for max/min points in a function,

Δ𝑦
=0
Δ𝑥

Example 1
A firm has analyzed the operating conditions, prices and cost and they have developed the
following functions. Where Q is the no. of units sold.

𝑇𝑅 = 400𝑄 + 4𝑄 2

𝑇𝐶 = 𝑄 2 + 10𝑄 + 3𝑄

The firm wishes to maximize revenue/profit and wishes to know

i. The quantity to be sold.
ii. Price

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 CHAPTER SIX

DESCRIPTIVE STATISTICS

Introduction
Statistics is the art and science of getting information from data or numbers to help in decision
making.
As a science, statistics follows a systematic procedure to reach objective decisions or solutions
to problems.
As an art statistics utilizes personal judgment and intuition to reach a solution. It depends on
experience of the individual involved. It is more subjective.
Statistics provides us with tools that aid decision making. For example, using statistics we can
estimate that expected returns and associated risks of a given investment opportunity.
Statistics involves collection of data, analysis, presentation and interpretation of data.
There are various types of summary measures including averages and measures of dispersion.
An average is a figure which represents the whole data. It removes all unnecessary details and
gives a clear picture of the data under investigation.

Definitions of key terms

Statistical inference is deduction about a population based on information obtained from a
sample drawn from it. It includes:
 point estimation
 interval estimation
 hypothesis testing (or statistical significance testing)
 prediction

Measures of central tendency are single numbers that are used to summarise a larger set of
data in a distribution of scores. The three measures of central tendency are mean, median, and
mode.
Measures of dispersion – These are important for describing the spread of the data, or its
variation around a central value. Such measures of dispersion include: standard deviation,
interquartile range, range, mean difference, median absolute deviation, avarage absolute
deviation (or simply average deviation)
Variance is the sum of squared deviations divided by the number of observations. It is the
average of the squares of the deviation of the individual values from their means.
Skewness describes the degree of symmetry in a distribution. When data are uni-modal and
symmetrical, the mean, mode and median will be almost the same value.
Kurtosis describes the degree of peakedness or steepness in a distribution.
Statistics has two broad meanings
1. Statistics refers to the mass of components or measures such as the mean, mode,

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 standard deviation etc. that help in describing the characteristics of a given set of
data or distribution. In this respect, statistics is simply, numerical facts about a given
situation.
This is the original meaning of statistics. Governments were the first organisations to
collect vital statistics such as death rates, birth rates, economic growth etc.
2. Statistics refers to a method of study. This is commonly known as the scientific
method.
Statistics is the process that gives thorough systematic steps to aid problem solving
or decision making.

The steps are:

a) Problem identification and definition
Once the problem is identified, it should be formulated as clearly and as unambiguously as
possible. The questions to be answered will clearly be defined at this point. This is necessary
because it enables us to make appropriate conclusion from the study.
b) Research methodology design
After formulating the problem, we need to come up with a defined plan on how the study will
be conducted to solve the problem.
Research design entails the following:
i. Determine the population of study. Population of study refers to the entire
collection of objects or subjects for which we want to make a decision e.g. the
number of customers of a supermarket; the number of students in public universities,
the number of matatus in Nairobi, the number of employees in campus, the number
of hospitals in Nyeri.
ii. Decide whether to use a census or a sample study. A census entails studying each
and every element in a population. A sample study entails studying a portion of the
population
iii. Decide the data collection techniques to use e.g. observation, questionnaires,
interviews, Internet pop-ups etc.
iv. Identify the data analysis technique to be used.
• Actual data collection/fieldwork
• Data analysis
After data is collected, it is analysed so as to enable us make decisions. Data analysis involves
the following:
• Organisation of data- This enables us to check for completeness, accuracy and reference.
Organising data can also involve coding the data for ease of analysis.
Data presentation – Diagrams, graphs, tables etc. are used to present data so asto highlight the
visual impression of the data. The kinds of graphs and charts used will depend on the audience.
Type of graphs and charts may also be determined by type of information being presented

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Statistical inference

The four steps above are referred to as descriptive statistics. Descriptive statistics helps us to
organise, summarise and present data in a convenient and informative way.
Inferential statistics, on the other hand, enables us to draw conclusions about the characteristics
of a population. Because most studies depend on samples, we use the sample results to draw
conclusions about the population from which the sample was drawn. The process of making
conclusions about the population based on sample statistics is known as sample inference.
Use sample statistics conclude on population parameters
Based on the statistical inference, then we answer the question or make the decision or solve the
problem that we set out to do.

Case Study
Statistics is applied in various fields. In the pension industry, actuarial methods are used to
measure the costs of alternative strategies with regard to the design, maintenance or redesign of
pension plans.
The strategies are greatly influenced by collective bargaining; the employer's old, new and
foreign competitors; the changing demographics of the workforce; changes in the internal
revenue code; changes in the attitude of the internal revenue service regarding the calculation of
surpluses; and equally importantly, both the short and long term financial and economic trends.
It is common with mergers and acquisitions that several pension plans have to be combined or at
least administered on an equitable basis. When benefit changes occur, old and new benefit plans
have to be blended, satisfying new social demands and various government discrimination test
calculations, and providing employees and retirees with understandable choices and transition
paths. Benefit plans liabilities have to be properly valued, reflecting both earned benefits for past
service, and the benefits for future service. Finally, funding schemes have to be developed that
are manageable and satisfy the Financial Accounting Standards Board (FABS)

Qualities of a good average

1. It should be clearly defined

2. Should be based on all values or observation
3. Should be easily understood and calculated
4. Should be capable of further statistical investigation/treatment
5. Should be least affected by fluctuations of sampling

Definitions of key terms

Measures of central tendency are single numbers that are used to summarize a larger set of data
in a distribution of scores. The three measures of central tendency are mean, median, and mode.

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They are also called types of averages

Measures of dispersion – These are important for describing the spread of the data, or its
variation around a central value. Such measures of dispersion include: standard deviation, inter-
quartile range, range, mean difference, median absolute deviation, average absolute deviation (or
simply average deviation)

Variance is the sum of squared deviations divided by the number of observations. It is the
average of the squares of the deviation of the individual values from their means
Measures of central tendency

A) MEAN
It is the most popular measure of central tendency. It is the sum of all the values divided by the
number of values.
When the mean is computed from a sample, it is represented by the symbol (𝒙) pronounced x-
bar. When computed from a population it is represented by the symbol μ (mu) Types of means
are:

a) arithmetic mean/sampling average

b) Weighted mean
c) Geometric mean
d) Harmonic mean

ARITHMETIC MEAN

Arithmetic mean represents the sum of all observations divided by the number of observations.
There are two ways of computation
i. direct method
ii. Shortcut method

i. direct method

* Ungrouped/individual data

Add up all items in a series and divide the total by the number of items.

𝑥1 + 𝑥2 + 𝑥3 … … 𝑥𝑛 𝑥
𝒙= =
𝑛 𝑛

Where
𝒙: arithmetic mean
: ∶ summation
𝑋: items
𝑁: no of items

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 CHAPTER SEVEN

PROBABILITY THEORY

Introduction
Probability is a measure of likelihood, the possibility or chance that an event will happen in
future.
It can be considered as a quantification of uncertainty.
Uncertainty may also be expressed as likelihood, chance or risk theory. It is a branch of
mathematics concerned with the concept and measurement of uncertainty.
Much in life is characterized by uncertainty in actual decision making.
Probability can only assume a value between 0 and 1 inclusive. The closer a probability is to zero
the more improbable that something will happen. The closer the probability is to one the more
likely it will happen.

Definitions of key terms

Random experiment results in one of a number of possible outcomes e.g. tossing a coin

Outcome is the result of an experiment e.g. head up, gain, loss, etc. Specific outcomes are
known as events.

Trial- Each repetition of an experiment can be thought of as a trial which has an observable
outcome e.g. in tossing a coin, a single toss is a trial which has an outcome as either head or tail

Sample space is the set of all possible outcomes in an experiment e.g. a single toss of a coin,
S=(H,T). The sample space can be finite or infinite. A finite sample space has a finite number of
possible outcomes e.g. in tossing a coin only 2 outcomes are possible.
An infinite sample space has an infinite number of possible outcomes e.g. time between arrival
of telephone calls and telephone exchange.

An Event of an experiment is a subset of a sample space e.g. in tossing a coin twice S=

(HH,HT,
TH, TT) HH is a subset of a sample space.

Mutually exclusive event - A set of events is said to be mutually exclusive if the occurrence of
any one of the events precludes the occurrence of other events i.e. the occurrence of any one
event means none of the others can occur at the same time e.g. the events head and tail are
mutually exclusive

Collectively exclusive event - A set of events is said to be collectively exclusive if their union
accounts for all possible outcomes i.e. one of their events must occur when an experiment is
conducted.
Favourable events refer to the number of possible occurrences of a given event in an
experiment e.g. if we pick a card from a deck of 52 cards the number favorable to a red card is

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26, in tossing coin the number favourable to a head is one.

Independent events –Events are independent if the happening or non-happening of one has no
effect on the future happening of another event. E.g. in tossing two times of a coin, the outcome
of 1st toss does not affect 2nd toss.

Equally likely events –Events are equally likely if the happening of one is not favored over the
happening of others. In tossing a coin the tail and head are equally likely.

OTHER CONCEPTS
Unconditional and conditional probabilities –with unconditional probability we express
probability of an event as a ratio of favourable outcomes to the number of all possible outcomes.
A conditional probability is the probability that a second event occurs if the first event has
already occurred.

Joint probability –joint probability gives the probability of the joint or simultaneous
occurrence of two or more characteristics.

Marginal probability –is the sum of two or more joint probabilities taken over all values of one
or more variables. It is the probability that the results when we ignore one or more criteria of
classification when computing probability.
Probability is used throughout business to evaluate financial risks and decision-making.
Every decision made by management carries some chance for failure, so probability analysis is
conducted formally.
In many natural processes, random variation conforms to a particular probability distribution
known as the normal distribution, which is the most commonly observed probability
distribution.

Laws of Probability
1. Rules of Addition
a) Special rule of addition
If two events A and B are mutually exclusive the probability of one or other occurring is equal to
the sum of their probability

P (A or B) = P (A) + P (B)
P (A or B or C) = P (A) + P (B) + P(C)

Illustration
An automatic plastic bag - a mixture of beans, broccoli and other vegetables, most of the bags
contain the correct weight but because of slight variations in the size of beans and other
vegetables. A package may be slightly under or overweight. A check of 4,000 packages of past
reveals the following:

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 Weight Event No of packages
Underweight A 100
Satisfactory B 3600
Overweight C C 300

What is the probability that a particular package will be either underweight or overweight?
The two events are mutually exclusive
P (A or C) = P (A) + P (C)
P(A) =100/4000
P(C) =300/4000
P(A or C) =400/4000 = 1/10 =0.1

Note: The probability that a bag of mixed vegetable is selected underweight P(A) plus the
probability that it is not underweight P(NA) must logically be equal to one. This is referred to as
Complement rule.

b) General rule of Addition

The outcome of an experiment may not be mutually exclusive. This rule is used to
combine events that are not mutually exclusive.

P(A or B) = P(A) + P(B)- P(A and B)

Example
a) What is the probability that a card chosen at random from a pack of well shuffled deck will
either be a king or a heart?
P(king or heart) = P(king) + P(heart) - P(king and heart)

4 13 1 16
+ + =
52 52 52 52

b) R outline physical examination is conducted annually as part of the programme of a particular

organization. It was discovered that 8% needed correcting shoes, 15% needed major dented work
and 3% needed for both correcting shoes and major dental work.
What‘s the probability that an employee selected at random will either need correcting shoes or
major dental work?

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2. Rule of Multiplication

Special Rule of multiplication

For two events A and B the probability that A and B will both occur is found by multiplying the
probability

P(A and B)=P(A) × P(B)

P(A and B and C) = P(A) × P(B) × P(C)

This rule is applicable for independent events i.e. the occurrence of one does not depend on the
occurrence of the other.

Example
i) Two coins are tossed. What is the probability that both will land tails up
The two events are independent

P (T and T) = P (T) × P (T)

=1/2 × 1/2 = ¼ = 0.25

From long experience firestone tyres have a 0.8 probability that their xB.70 will last 40,000
miles before it becomes bald and adjustments made. If you purchase four xB.70
What‘s the probability that all tyres will last 40,000 miles?
What‘s the probability that at least two will last 40,000 miles?

Solution

P(L and L and L and L) =P(L) × P(L) × P(L) × P(L)

= 0.8 × 0.8 × 0.8 × 0.8
= 0.4096

Probability of lasting, P(L) = 0.8; Probability of not lasting, P(N)= 0.2

Probability of at least two tyres lasting 40,000 miles is given by the following combinations:

General rules of Multiplication

It states that of two events A and B the joint probability that both events will happen is found by
multiplying the probability that A will happen by the conditional probability of event B
happening

P(A and B) = P(A) × P(B| )

Where P(B/A) stand for probability that B will occur given that A has already occurred.

Example
1. Assume that there are 10 rolls of film in a box 3 of which are defective. Two rolls are to
be selected one after another. What‘s the probability of selecting a defective roll followed
by another defective roll?

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 P (D and D) = P (D) × P (D| D)
3/10 × 2/9 =6/90 =0.07

2. Three effective toothbrushes were accidentally shipped to a chemist by Clean Brand

Product along with 17 non-effective ones what‘s the probability that of the first 2
toothbrushes sold one will be effective and the other one will not.

Solution
P (One defective = P (D and N) or P (N and
D) = 2/20 x 17/19 + 17/20 x 3/19
Contingency Table
A two dimensional contingency table is formed by classifying two factors. One factor
determines the row categories and the other determines the column categories. Each element
in the table belongs to the two classifications known as a cell e.g. classifying subjects by
gender (M and F) and smoking status (Current/Former/Never). Such categories are said to be
mutually exclusive and collective. Exhaustive mutually exclusive means the categories
include all possibilities and so there is a category for everyone.

SMOKING STATUS
Current Former NEVER
GENDER Male a b c
Female d e f

The two factors here are smoking status and gender and the cells are a,b,c,d,e and f.

Example
A survey of executives dealt with their loyalty to the company. Out of the questions asked ―If
you were given an offer by another Company equal or slightly better than the present will you
remain in the Company or take another position. The responses were classified with their level
of service within the company.

Length of Service

Loyalty Less than 1 1-5 6-10 years More than 10 Total

year years years
Remain 10 30 5 75 120
Not 25 15 10 30 80
Remain
200

What‘s the probability of randomly selecting an executive who is loyal to the company (who will
remain) and who has been in the service in more than 10 years?

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 CHAPTER EIGHT

INDEX NUMBERS

Introduction
An index is a numerical figure which measures relative change in variables between two periods.
The index numbers are important because they show that the value of money, securities,
commodities is fluctuating i.e. appreciating or depreciating accordingly as the index numbers of
prices are rising/falling. A rise in the index numbers of prices will signify deterioration in the
value of money and vice versa.

Index number classification will depend on variables they are intended to measure. An index is
used to measure changes, which have occurred. Share indexes are used to measure changes,
which have occurred for shares in specific stock exchange e.g. stock indices measures the
changes of price or value changes where the value changes are brought about by changes in the
capitalization of the share in the exchange. NSE index is based on share trading of 20 companies,
which are considered very active. The 20 companies‘ account nearly 30% of NSE capitalization.

- A fall in NSE share index represents a fall in market price per share. Arise in NSE index
represent arise in the market price per share.
- An index may act as an indicator of activities in NSE the higher the demand of the share, the
higher is it market price and as a result the higher will be index.

Uses of index numbers

1. Price index numbers are used to measure changes in a particular group of prices and help
us in comparing the movement in prices of one commodity with another. They are also
designed to measure changes in purchasing power of money
2. Index numbers of industrial production provide a measure of change in the level of
industrial production in a country.
3. Quantity index numbers show the rise/fall in the volume of production exports and
imports
4. Import and export prices indices are used to measure changes in terms of trade of a
country by the terms of trade is meant ratio of import to export prices.
5. Index numbers are also used to forecast business condition of a country and to discover
seasonal fluctuations and business cycle.
6. Consumer price indices indicate the movement in retail prices of consumption goods and
services.

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Computation of index numbers

Factors to consider when computing index numbers

1. Purpose of index numbers
When the purpose is known the true results can be obtained from the proper construction and
type of index numbers

2. Selection of commodities
It‘s easy when the purpose is known is accurate to reasonable extended. When selecting
commodities, a great care and skill should be used as the proper selection of the commodities is
the main thing in construction of index numbers.

3. Price quotation
It‘s impossible to collect the prices for selected commodities from all places in the country where
they are marketed. A sample of marked will therefore have to be selected randomly. The criteria
of selecting the sample will be those places where given commodities are marketed in a large
number. It‘s just possible that a sample may serve purpose for many commodities rather than one
commodity

4. Choice of the base period

It should be fairly normal year neither of very low prices nor of very high prices however it‘s
probable that no one year is sufficiently normal to be a good basis for comparison.

5. Choice of the average

Studying index numbers of a single commodity, average is not needed but in case of more than
one commodity, price relatives are computed and averaged

6. Choice of proper weights

Index numbers include many commodities which are not equally important therefore its
important to give weights according to importance of different commodities keeping in mind
purpose of index numbers

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TYPES OF INDEX NUMBERS

I. simple index numbers

Computation procedure

When construction of an index number involves a single commodity it is called simple index
numbers. There are two methods/procedures for construction of simple index numbers

a) Fixed base method

b) Chain base method

a) Fixed base method

In the fixed base method the base period is fixed and prices of subsequent years are expressed as
relatives of the prices of the base year.

Price relative is simply the price of an item in one year, relative to another year i.e.

𝒑𝟏
𝒑𝟎 × 𝟏𝟎𝟎

Where: p1 -is price of current year

P0 - is price of base year
For example: given the following information about a commodity Compute the price indices for
each year using fixed base method?

year price
1991 8
1992 10
1993 12.5
1994 18
1995 22
1996 25

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Solution:

P0 = 8

1991_______8 8 × 100 = 100%

1992________10 8 × 100 = 125%

1993________12.5 8 × 100 = 156.25%

1994_________18 8 × 100 = 225%

1995__________22 8 × 100 = 275%

1996__________25 8 × 100 = 312.5%

Price relative shows the percentage change of the price of a commodity in the current period as
compared to the base period. Price relative is also considered as the price index of a commodity.

b) Chain base method

Base is not fixed or it changes from year to year. Price of previous periods is taken as the base
period. This method shows whether rate of change is rising, falling or constant as well as the
extent of change from year to year

𝒑𝟏
𝒑𝟐 × 𝟏𝟎𝟎

Where p1 – price of the current year

P2 – price of the previous year

For example: given the following information about a commodity Compute the price indices for
each year using chain base method?

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