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by Mary Jane Sterling
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Business Math For Dummies® Published by Wiley Publishing, Inc. 111 River St. Hoboken, NJ 070305774 www.wiley.com Copyright © 2008 by Wiley Publishing, Inc., Indianapolis, Indiana Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate percopy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, 9787508400, fax 9786468600. Requests to the Publisher for permission should be addressed to the Legal Department, Wiley Publishing, Inc., 10475 Crosspoint Blvd., Indianapolis, IN 46256, 3175723447, fax 3175724355, or online at http://www.wiley.com/go/permissions. Trademarks: Wiley, the Wiley Publishing logo, For Dummies, the Dummies Man logo, A Reference for the Rest of Us!, The Dummies Way, Dummies Daily, The Fun and Easy Way, Dummies.com and related trade dress are trademarks or registered trademarks of John Wiley & Sons, Inc. and/or its affiliates in the United States and other countries, and may not be used without written permission. All other trademarks are the property of their respective owners. Wiley Publishing, Inc., is not associated with any product or vendor mentioned in this book. LIMIT OF LIABILITY/DISCLAIMER OF WARRANTY: THE PUBLISHER AND THE AUTHOR MAKE NO REPRESENTATIONS OR WARRANTIES WITH RESPECT TO THE ACCURACY OR COMPLETENESS OF THE CONTENTS OF THIS WORK AND SPECIFICALLY DISCLAIM ALL WARRANTIES, INCLUDING WITHOUT LIMITATION WARRANTIES OF FITNESS FOR A PARTICULAR PURPOSE. NO WARRANTY MAY BE CREATED OR EXTENDED BY SALES OR PROMOTIONAL MATERIALS. THE ADVICE AND STRATEGIES CONTAINED HEREIN MAY NOT BE SUITABLE FOR EVERY SITUATION. THIS WORK IS SOLD WITH THE UNDERSTANDING THAT THE PUBLISHER IS NOT ENGAGED IN RENDERING LEGAL, ACCOUNTING, OR OTHER PROFESSIONAL SERVICES. IF PROFESSIONAL ASSISTANCE IS REQUIRED, THE SERVICES OF A COMPETENT PROFESSIONAL PERSON SHOULD BE SOUGHT. NEITHER THE PUBLISHER NOR THE AUTHOR SHALL BE LIABLE FOR DAMAGES ARISING HEREFROM. THE FACT THAT AN ORGANIZATION OR WEBSITE IS REFERRED TO IN THIS WORK AS A CITATION AND/OR A POTENTIAL SOURCE OF FURTHER INFORMATION DOES NOT MEAN THAT THE AUTHOR OR THE PUBLISHER ENDORSES THE INFORMATION THE ORGANIZATION OR WEBSITE MAY PROVIDE OR RECOMMENDATIONS IT MAY MAKE. FURTHER, READERS SHOULD BE AWARE THAT INTERNET WEBSITES LISTED IN THIS WORK MAY HAVE CHANGED OR DISAPPEARED BETWEEN WHEN THIS WORK WAS WRITTEN AND WHEN IT IS READ. For general information on our other products and services, please contact our Customer Care Department within the U.S. at 8007622974, outside the U.S. at 3175723993, or fax 3175724002. For technical support, please visit www.wiley.com/techsupport. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Library of Congress Control Number: 2008927911 ISBN: 9780470233313 Manufactured in the United States of America 10 9 8 7 6 5 4 3 2 1
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About the Author Mary Jane Sterling is the author of four other For Dummies titles: Algebra For Dummies, Algebra II For Dummies, Trigonometry For Dummies, and Math Word Problems For Dummies. She has honed her mathexplaining skills during her years of teaching mathematics at all levels: junior high school, high school, and college. She has been teaching at Bradley University, in Peoria, Illinois, for almost 30 of those years. When not teaching or writing, Mary Jane keeps busy by working with her Kiwanis Club, advising Bradley University’s Circle K Club, and working with members of the Heart of Illinois Aktion Club (for adults with disabilities). All the volunteer projects taken on for these clubs help keep her busy and involved in the community.
Dedication I dedicate this book to my two business math inspirations. First, to my son, Jon, who came up with the idea of writing a book for business professionals who needed a refresher — specifically for his real estate workforce. And second, to my husband, Ted, who is the financial guru of the family and has had years of experience in the business and financial arena.
Author’s Acknowledgments I give a big thank you to Stephen Clark, who took on this project and never ceased to be encouraging and upbeat. Also to Jessica Smith, a wonderful wordsmith and cheerful copy editor; her wonderful perspective and insights will pay off big time for the readers. Thank you to Technical Editor Benjamin Schultz who helped out so much by keeping the examples in this book realistic and the mathematics correct. Thank you to Lindsay Lefevere who took the initial suggestion and molded it into a workable project. And thank you to Composition Services, who took some pretty complicated equations and laid them out in the most readable forms.
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Publisher’s Acknowledgments We’re proud of this book; please send us your comments through our Dummies online registration form located at www.dummies.com/register/. Some of the people who helped bring this book to market include the following: Acquisitions, Editorial, and Media Development Project Editor: Stephen R. Clark Acquisitions Editor: Lindsay Sandman Lefevere Copy Editor: Jessica Smith Editorial Program Coordinator: Erin Calligan Mooney Technical Editor: Benjamin Schultz, MA, Lecturer, Department of Business Communication, Kelley School of Business
Composition Services Project Coordinator: Katie Key Layout and Graphics: Carrie A. Cesavice, Stephanie D. Jumper, Julia Trippetti Proofreaders: Melissa D. Buddendeck, Jessica Kramer Indexer: Christine Spina Karpeles Special Help David Nacin, PhD
Editorial Manager: Christine Meloy Beck Editorial Assistants: Joe Niesen, David Lutton Cartoons: Rich Tennant (www.the5thwave.com)
Publishing and Editorial for Consumer Dummies Diane Graves Steele, Vice President and Publisher, Consumer Dummies Joyce Pepple, Acquisitions Director, Consumer Dummies Kristin A. Cocks, Product Development Director, Consumer Dummies Michael Spring, Vice President and Publisher, Travel Kelly Regan, Editorial Director, Travel Publishing for Technology Dummies Andy Cummings, Vice President and Publisher, Dummies Technology/General User Composition Services Gerry Fahey, Vice President of Production Services Debbie Stailey, Director of Composition Services
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Contents at a Glance Introduction .................................................................1 Part I: Reviewing Basic Math for Business and Real Estate Transactions ........................................7 Chapter 1: Starting from the Beginning ..........................................................................9 Chapter 2: Fractions, Decimals, and Percents .............................................................15 Chapter 3: Determining Percent Increase and Decrease ............................................31 Chapter 4: Dealing with Proportions and Basic Algebra ............................................37
Part II: Taking Intriguing Math to Work ......................47 Chapter 5: Working with Formulas ................................................................................49 Chapter 6: Reading Graphs and Charts ........................................................................67 Chapter 7: Measuring the World around You ..............................................................79 Chapter 8: Analyzing Data and Statistics .....................................................................97
Part III: Discovering the Math of Finance and Investments ......................................................109 Chapter 9: Computing Simple and Compound Interest ............................................111 Chapter 10: Investing in the Future .............................................................................131 Chapter 11: Understanding and Managing Investments ..........................................149 Chapter 12: Using Loans and Credit to Make Purchases ..........................................165
Part IV: Putting Math to Use in Banking and Payroll .............................................................177 Chapter 13: Managing Simple Bank Accounts ...........................................................179 Chapter 14: Protecting Against Risk with Insurance .................................................193 Chapter 15: Planning for Success with Budgets ........................................................207 Chapter 16: Dealing with Payroll .................................................................................223
Part V: Successfully Handling the Math Used in the World of Goods and Services ...................235 Chapter 17: Pricing with Markups and Discounts .....................................................237 Chapter 18: Calculating Profit, Revenue, and Cost ...................................................251 Chapter 19: Accounting for Overhead and Depreciation .........................................273 Chapter 20: Keeping Track of Inventory ....................................................................291
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Part VI: Surviving the Math for Business Facilities and Operations ........................................................305 Chapter 21: Measuring Properties ..............................................................................307 Chapter 22: Taking Out Mortgages and PropertyRelated Loans ............................335
Part VII: The Part of Tens .........................................359 Chapter 23: Ten Tips for Leasing and Managing Rental Property ...........................361 Chapter 24: Ten Things to Watch Out for When Reading Financial Reports .........369
Index .......................................................................373
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Table of Contents Introduction..................................................................1 About This Book ..............................................................................................1 Conventions Used in This Book ....................................................................2 What You’re Not to Read ................................................................................2 Foolish Assumptions ......................................................................................2 How This Book Is Organized ..........................................................................3 Part I: Reviewing Basic Math for Business and Real Estate Transactions .......................................................................................3 Part II: Taking Intriguing Math to Work ...............................................4 Part III: Discovering the Math of Finance and Investments .............4 Part IV: Putting Math to Use in Banking and Payroll ........................4 Part V: Successfully Handling the Math Used in the World of Goods and Services ................................................4 Part VI: Surviving the Math for Business Facilities and Operations ..................................................................5 Part VII: The Part of Tens .....................................................................5 Icons Used in This Book .................................................................................5 Where to Go from Here ...................................................................................6
Part I: Reviewing Basic Math for Business and Real Estate Transactions ........................................7 Chapter 1: Starting from the Beginning . . . . . . . . . . . . . . . . . . . . . . . . . .9 Fracturing the Myths about Fractions, Decimals, and Percents .............10 Capitalizing on Patterns in Formulas ..........................................................11 Finding the Power in Exponents .................................................................12 Doing Some Serious Counting .....................................................................13 Painting a Pretty Picture ..............................................................................14
Chapter 2: Fractions, Decimals, and Percents . . . . . . . . . . . . . . . . . . .15 Changing from Fractions to Decimals ........................................................15 Considering the two types of decimals ............................................16 Rounding decimals up or down .........................................................17 Converting Decimals to Fractions ...............................................................20 Ending up with terminating decimals ...............................................20 Dealing with repeating decimals .......................................................22 Understanding the Relationship between Percents and Decimals .........24 Transforming from percents to decimals .........................................25 Moving from decimals to percents ....................................................25 Dealing with more than 100% ............................................................26
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Business Math For Dummies Coming to Grips with Fractions ..................................................................27 Adding and subtracting fractions ......................................................27 Multiplying and dividing fractions ....................................................29
Chapter 3: Determining Percent Increase and Decrease . . . . . . . . . .31 Working with Percent Increase ....................................................................31 Computing new totals with increases ...............................................32 Determining the percent increase .....................................................32 Solving for the original amount .........................................................33 Looking into Percent Decrease ....................................................................34 Finding new totals with decreases ....................................................35 Figuring out the percent decrease ....................................................35 Restoring the original price from a decreased price ......................36
Chapter 4: Dealing with Proportions and Basic Algebra . . . . . . . . . .37 Setting Up Proportions .................................................................................38 Solving Proportions for Missing Values .....................................................39 Setting up and solving ........................................................................40 Interpolating when necessary ...........................................................40 Handling Basic Linear Equations ................................................................42 Comparing Values with Variation ................................................................44 Getting right to it with direct variation ............................................44 Going the indirect route with indirect variation .............................45
Part II: Taking Intriguing Math to Work .......................47 Chapter 5: Working with Formulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . .49 Familiarizing Yourself with a Formula ........................................................50 Identifying variables and replacing them correctly ........................50 Adjusting for differing units ...............................................................51 Recognizing operations ......................................................................53 Simplifying and Solving a Formula ..............................................................54 Operating according to the order of operations .............................54 Making sure what you have makes sense ........................................57 Computing with Technology ........................................................................57 Calculators: Holding the answer in the palm of your hand ...........58 Repeating operations: Simplifying your work with a computer spreadsheet ........................................................62
Chapter 6: Reading Graphs and Charts . . . . . . . . . . . . . . . . . . . . . . . . . .67 Organizing Scattered Information with a Scatter Plot ..............................68 Lining Up Data with Line Graphs ................................................................70 Creating a line graph ...........................................................................70 Indicating gaps in graph values .........................................................71
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Table of Contents Measuring Frequency with Histograms ......................................................73 Taking a Piece of a Pie Chart .......................................................................76 Dividing the circle with degrees and percents ................................76
Chapter 7: Measuring the World around You . . . . . . . . . . . . . . . . . . . .79 Converting from Unit to Unit .......................................................................80 Using the conversion proportion ......................................................80 Lining up the linear measures ...........................................................81 Spreading out with measures of area ................................................82 Adding a third dimension: Volume ....................................................86 Making Sense of the Metric System ............................................................88 Moving from one metric unit to another ..........................................89 Converting from metric to English and vice versa ..........................91 Discovering How to Properly Measure Lumber ........................................92 Measuring Angles by Degrees ......................................................................94 Breaking down a degree .....................................................................94 Fitting angles into polygons ...............................................................95
Chapter 8: Analyzing Data and Statistics . . . . . . . . . . . . . . . . . . . . . . . .97 Organizing Raw Data .....................................................................................97 Creating a frequency distribution .....................................................98 Grouping values together in a frequency distribution ...................99 Finding the Average ....................................................................................102 Adding and dividing to find the mean ............................................103 Locating the middle with the median .............................................104 Understanding how frequency affects the mode ..........................105 Factoring in Standard Deviation ................................................................106 Computing the standard deviation .................................................106
Part III: Discovering the Math of Finance and Investments .......................................................109 Chapter 9: Computing Simple and Compound Interest . . . . . . . . . . .111 Understanding the Basics of Interest .......................................................112 Simply Delightful: Working with Simple Interest .....................................112 Computing simple interest amounts the basic way ......................113 Stepping it up a notch: Computing it all with one formula ..........115 Taking time into account with simple interest ..............................116 Surveying some special rules for simple interest .........................119 Looking into the future with present value ....................................120 Getting to Know Compound Interest ........................................................122 Figuring the amount of compound interest you’ve earned .........122 Noting the difference between effective and nominal rates ........124 Finding present value when interest is compounding ..................126
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Business Math For Dummies Determining How Variable Changes Affect Money Accumulation ........127 Comparing rate increases to increased compounding .................127 Comparing rate increases to increases in time .............................128
Chapter 10: Investing in the Future . . . . . . . . . . . . . . . . . . . . . . . . . . . .131 Calculating Investments Made with Lump Sums ....................................132 Reading interest earnings from a table ...........................................132 Doubling your money, doubling your fun ......................................136 Going the Annuity Route ............................................................................139 Preparing your financial future with a sinking fund .....................139 Determining the payment amount ..................................................141 Finding the present value of an annuity .........................................141 Computing the Payout from an Annuity ...................................................143 Receiving money from day one .......................................................144 Deferring the annuity payment ........................................................146
Chapter 11: Understanding and Managing Investments . . . . . . . . . .149 Interpreting the Daily Stock Market Quotations .....................................150 Getting to know the stock quotations ............................................150 Computing percent change ..............................................................153 Using the averages to compute prices ...........................................154 Wrangling with the Ratios ..........................................................................157 Examining the stock yield ratio .......................................................157 Earning respect for the PE ratio ......................................................158 Working with earnings per share ....................................................159 Calculating profit ratios ....................................................................159 Making Use of Your Broker ........................................................................161 Buying stocks on margin ..................................................................162 Paying a commission ........................................................................163 Investing in the public: Buying bonds ............................................164
Chapter 12: Using Loans and Credit to Make Purchases . . . . . . . . .165 Taking Note of Promissory and Discount Notes .....................................166 Facing up to notes that have full face value ..................................166 Discounting the value of a promissory note ..................................167 Borrowing with a Conventional Loan .......................................................168 Computing the amount of loan payments ......................................169 Considering time and rate ................................................................170 Determining the remaining balance ................................................171 Paying more than required each month .........................................172 Working with Installment Loans ................................................................174 Calculating the annual percentage rate ..........................................174 Making purchases using an installment plan .................................175
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Part IV: Putting Math to Use in Banking and Payroll ..............................................................177 Chapter 13: Managing Simple Bank Accounts . . . . . . . . . . . . . . . . . .179 Doing Business with Banks ........................................................................179 Exploring the types of business bank accounts available ...........180 Understanding the importance of account management ............181 Balancing Act: How You and the Bank Use Your Account Balance ......184 Computing your average daily balance ..........................................184 Determining interest using your daily balance .............................186 Reconciling Your Account ..........................................................................188 Making reconciliation simple ...........................................................189 Finding the errors ..............................................................................190
Chapter 14: Protecting Against Risk with Insurance . . . . . . . . . . . . .193 Surveying the Types of Insurance Available ............................................194 Living It Up with Life Insurance .................................................................194 Insuring with a group ........................................................................195 Protecting your business with endowment insurance .................198 Protecting Yourself from Loss by Insuring Your Property .....................200 Considering coinsurance ..................................................................200 Examining multiyear contracts ........................................................202 Taking advantage of multiple building insurance coverage ........203 Deferring premium payments ..........................................................206
Chapter 15: Planning for Success with Budgets . . . . . . . . . . . . . . . .207 Choosing the Right Type of Budget ..........................................................207 Cashing In on Cash Budgets ......................................................................208 Looking at an example cash budget ................................................209 Comparing budgeted and actual cash receipts .............................210 Varying with a Flexible Budget ..................................................................212 Budgeting Across the Months ...................................................................214 Using revenue budgets to deal with staggered income ................215 Budgeting for ample inventory ........................................................216 Measuring Differences with Variance Analysis ........................................218 Computing variance and percent variance ....................................218 Finding a range for variance ............................................................220
Chapter 16: Dealing with Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .223 Pay Up: Calculating Employee Earnings ...................................................224 Dividing to determine a timely paycheck .......................................224 Parttimers: Computing the salary of seasonal and temporary workers ................................................................226 Determining an hourly wage ............................................................226 Taking care of commission payments ............................................228
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Business Math For Dummies Subtracting Payroll Deductions ................................................................232 Computing federal income tax .........................................................232 Determining Social Security contributions ....................................234
Part V: Successfully Handling the Math Used in the World of Goods and Services ....................235 Chapter 17: Pricing with Markups and Discounts . . . . . . . . . . . . . . .237 Examining Markups and Retail Prices ......................................................237 Making sense of markups .................................................................238 Understanding how markups are a percentage of retail prices .....................................................................................238 Working with the retail price ...........................................................240 Exploring Discount Pricing ........................................................................242 Discounting once ...............................................................................243 Successive or multiple discounts ....................................................245 Going for a volume discount ............................................................247
Chapter 18: Calculating Profit, Revenue, and Cost . . . . . . . . . . . . . . .251 Figuring Profit from Revenue and Cost ....................................................252 Understanding how volume affects profit, revenue, and cost .....252 Seeing how price is sensitive to demand .......................................253 Sorting out variable and fixed costs ...............................................256 What’s It Gonna Be? Projecting Cost ........................................................260 Dividing up direct and indirect costs .............................................261 Weighing historical and differential cost ........................................263 Determining BreakEven Volume ...............................................................269 Solving for breakeven volume with a formula ..............................269 Working out breakeven volume from historical data ..................270
Chapter 19: Accounting for Overhead and Depreciation . . . . . . . . .273 Keeping an Eye on Overhead Costs ..........................................................274 Working with ordergetting costs ....................................................274 Deciding on allocation options ........................................................277 Getting the Lowdown on Depreciation .....................................................280 The straightline method ..................................................................281 The sumoftheyears’ digits method ..............................................283 The declining balance method ........................................................285
Chapter 20: Keeping Track of Inventory . . . . . . . . . . . . . . . . . . . . . . . .291 Controlling Inventory and Turnover ........................................................291 Comparing cost inventory and retail inventory ............................292 Estimating turnover with an inventory ratio .................................295 FIFO and LIFO: Giving Order to Inventory ...............................................299 Determining Economic Order Quantity ....................................................300
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Part VI: Surviving the Math for Business Facilities and Operations .........................................................305 Chapter 21: Measuring Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . .307 Exploring Area and Perimeter Formulas for Different Figures ..............308 Rectangles ..........................................................................................308 Squares ...............................................................................................309 Parallelograms ...................................................................................309 Triangles .............................................................................................310 Trapezoids ..........................................................................................311 Regular polygons ...............................................................................311 Circles .................................................................................................312 Ellipses ................................................................................................313 Squaring Off with Square Measurements .................................................314 Figuring total area in various measurements ................................315 Adjusting for increased area ............................................................317 Taking frontage into consideration .................................................320 Calculating acreage ...........................................................................320 Determining Cost per Foot .........................................................................321 Renting space .....................................................................................322 Estimating building costs .................................................................323 Measuring Irregular Spaces .......................................................................324 Breaking spaces into rectangles ......................................................324 Trying out triangles ...........................................................................326 Tracking trapezoids ..........................................................................328 Describing Property with Metes and Bounds ..........................................329 Surveyors’ directions ........................................................................329 Measuring a boundary ......................................................................330 Understanding the Rectangular Survey System ......................................331 Basing measures on meridians ........................................................332 Subdividing the 24mile square .......................................................332
Chapter 22: Taking Out Mortgages and PropertyRelated Loans . . .335 Closing In on Closing Costs ........................................................................336 Dealing with down payments ...........................................................337 Paying down using points ................................................................337 Considering appraisal fees ...............................................................338 Prorating property tax ......................................................................338 Amortizing Loans with Three Different Methods ....................................339 Taking advantage of online calculators ..........................................339 Consulting mortgage payment tables .............................................340 Working your brain with an oldfashioned formula ......................344 Going Off Schedule with Amortized Loans and Mortgages ...................345 Determining how much of your payment is interest ....................346 Altering the payments ......................................................................349
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Business Math For Dummies Talking about Borrowing Power ................................................................354 Investigating Alternative Loans .................................................................355 Taking out a contract for deed ........................................................355 Building a construction loan ............................................................357
Part VII: The Part of Tens ..........................................359 Chapter 23: Ten Tips for Leasing and Managing Rental Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .361 Getting the Full Treatment with a Gross Lease .......................................362 Using a Single Net Lease to Get Your Tenant to Share the Expenses ...363 Signing a Double or Triple Net Lease .......................................................363 Trying Out a Percentage Lease ..................................................................364 Stepping It Up with a Step Lease ...............................................................364 Inserting Expense Provisions into Your Lease ........................................365 Including an Allowance for Improvements in Your Lease ......................365 Protecting Your Lease with a Security Deposit .......................................366 Adding a Sublease Clause to Your Commercial Lease ............................366 Deciding Whether You Should Renew, Renegotiate, or Break a Lease ...........................................................................................367
Chapter 24: Ten Things to Watch Out for When Reading Financial Reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .369 Apologies for Shortfalls ..............................................................................369 Blurring in the Overall Picture ..................................................................370 WishyWashy Descriptions of Trends .......................................................370 An Overabundance of Footnotes ..............................................................370 Listings of the Directors .............................................................................370 Uncollected Revenues ................................................................................371 A High Working Capital ...............................................................................371 LongTerm Debt ...........................................................................................371 Low Profit Margins ......................................................................................372 Warning Words ............................................................................................372
Index........................................................................373
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Introduction
B
usiness and mathematics — they just seem to go together. Of course, I could make a case for any topic to successfully mesh with math. Then again, I’m a bit prejudiced. But you have to agree that you can’t do much in the home or in the business or real estate worlds without a good, solid mathematical background. I became interested in writing Business Math For Dummies because of Jon, one of my children. He works with real estate agents and managers, and over time he heard a recurring complaint: This or that agent hadn’t done math in a long time and couldn’t remember how to do the proper computations. Sure, computers and calculators do the actual arithmetic, but you have to know what to enter into the computer or calculator. Finding the area of a circular garden isn’t terribly difficult if you know how to use the formula for the area of a circle, but it can be tricky if you haven’t used that formula in a long time. For instance, you may not remember what pi is (and I don’t mean the apple or cherry variety). And who would have thought that you’d ever need to solve a proportion after you grew up and got a job? The math in the business world isn’t difficult, but it does take a refresher or a bit of relearning. And here you find it — all in one spot. In this book, you find tons of mathematical explanations coupled with some sample business or financial problems. I show you the steps used in the math and explain how the answers help you complete a transaction or continue on with a project.
About This Book In your business, you probably have all sorts of specialized procedures and formulas. And you’re probably pretty good at what’s particular to your situation. So what you find in this book is all the background info for more specialized material. I show you how to do financial computations that use simple formulas along with other moreinvolved formulas. You’ll find geometric structures and patterns and uses of fractions, decimals, and percents. Having said all that, I doubt you want to read this book from cover to cover. After all, no snooze alarm is loud enough to rouse you if you attempt a fronttoback read. But if you love math that much, please feel free to make this a pleasure read. However, most folks simply will go to those topics that interest or concern them.
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Business Math For Dummies This modularity is what’s so great about this book. You can jump backward or forward to your heart’s delight. In fact, I refer to earlier material in later chapters (if I think it would help explain the topic at hand), and I titillate you early on with promises of exciting applications further on as you read. In other words, you’ll find the organization to be such that you can quickly turn to the pages you need as you need them. Please use this book as a reference or a study guide. You don’t want to memorize the formulas and procedures shown here. If you did, your head would surely burst.
Conventions Used in This Book This book is designed to be user friendly. I’m guessing that you’re too busy to have to hunt up a dictionary if a word isn’t familiar or to poke around for a formula (and how to use it) if you need to determine an item’s markup or a loan’s payment amount. So as you read this book, you’ll see important terms highlighted with italics, and I always include a definition with these terms. Boldfaced text highlights keywords of bulleted lists and the actions you must take in numbered steps. Also, when a process requires a formula, I state the formula and identify all the letters and symbols.
What You’re Not to Read Occasionally in this book you’ll see some material accompanied by a Technical Stuff icon. And you’ll come across some sidebars, which are those grayshaded boxes with interesting but nonessential information. You’ll find these items when I just couldn’t help myself — I had to tell you about some mathematical property, geometric eccentricity, or financial feature because I found it to be so fascinating. Do you need the information in order to understand the process? No. Will it enlighten you and make your world a better place? Well, of course. You can take them or leave them; pass them by today and come back to them in the future — or not.
Foolish Assumptions I find that separating my foolish assumptions from my realistic assumptions is really difficult. After all, what you may consider to be foolish, I may consider to be realistic (and vice versa). But let me tell you what I think, and you can do the sorting.
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Introduction I’m assuming that you have access to at least a simple scientific calculator. You really can’t do some of the problems involving powers, radicals, and huge numbers without the help of a calculating device. So, you’re really handy with an abacus? All the more power to you — but I think you still want to invest in a calculator. Similarly, computers and spreadsheet software programs aren’t a necessity, but I assume that you can use a computer, even if you don’t have your own. After all, today’s financial world is handled pretty much using spreadsheets with formulas embedded into them. Most of the math in this book is arithmetic, but you also find some basic algebra. Here’s the deal: You don’t need to solve tricky quadratic equations or problems involving calculus, but I do assume that you understand how to solve an equation such as 1,000 = 3x – 8 (by finding the value of x). Don’t panic! I show you how to do these problems, but I assume that you’ve at least seen the algebraic process before and just need a reason to use it.
How This Book Is Organized Mathematics and business just seem to go together naturally, but I do try to organize the different topics and techniques in this book, and I give you some practical perspective of how they relate. Even when I start with the mathematics in the beginning, you see how those basic math operations and techniques relate to business topics; otherwise you wouldn’t be inspired to continue reading the material! In all the chapters, I reference other topics that are closely related to what you’re reading to save you time in your quest for the information you need.
Part I: Reviewing Basic Math for Business and Real Estate Transactions The basic math of business is really the basic math of life. So, the chapters in this part take you through the fundamentals of dealing with fractions, decimals, percents, and proportions. You see how the different forms that a percent can take are used to do computations necessary to be successful in business. A little algebra is even thrown in to make the topics interesting. Algebra is a rather cryptic language, but a simple translation is all you need to make your way.
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Business Math For Dummies
Part II: Taking Intriguing Math to Work Formulas make the world go ‘round — literally. But the formulas in this section mainly deal with money and financial situations, measurements, and statistics. In this part, you see how to use formulas in spreadsheets, and you find your way around statistical information.
Part III: Discovering the Math of Finance and Investments The chapters in this part are, well, interesting. In other words, simple interest and compound interest are used to a large extent in this part. You use formulas involving interest to determine how much an investment grows over time. And you use interest to determine the extra expense involved when borrowing money over different periods of time. Plus, no discussion of finance would be complete without talking about stocks and bonds. You find the ins and outs of their mathematics in this part. And, as promised, you find information on promissory notes as an option for borrowing.
Part IV: Putting Math to Use in Banking and Payroll Bank accounts are places to accumulate money and grow interest. You also use them to make payments to suppliers or employees. In the chapters in this part, you see variations on budgets and payroll management. Insurance and valuation of assets both play a big part in the overall financial picture of a business, which is why I include them in the general picture of managing the income and outgo involved in running a business successfully.
Part V: Successfully Handling the Math Used in the World of Goods and Services Whether you’re on the buying end or the selling end of a business, you need to understand that discounts, markups, overhead, and depreciation all play a part in your business’s profits, revenue, and costs. So in this part, I show you the mathematics involved and give you some examples. And because managing inventory is critical to the health of a company and its revenue figures, I explain methods for turnover and valuation.
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Introduction
Part VI: Surviving the Math for Business Facilities and Operations When purchasing property, you need accurate measurements, a fair assessment of the value, and a reasonable mortgage payment. Also, you need to secure a profitable rental amount if you’re leasing the property to others. You find the math necessary for all the aspects of measuring, borrowing money for, purchasing, and renting property in this part’s chapters.
Part VII: The Part of Tens A For Dummies book isn’t complete without the Part of Tens. In this part, I include two top ten lists that give you quick, fun, and relevant information. For instance, I provide ten tips for managing leases and rental property, as well as a list of the ten main things to look for when reading a financial form.
Icons Used in This Book In the margins of this book, you see little pictures, which are called icons. These icons highlight specific types of information. They aren’t meant to distract you. No, instead they’re meant to attract your attention to items that warrant notice. Here are the icons I include and what they mean: This icon calls your attention to situations and examples where the business math that’s discussed is used in a sample situation. This icon flags important information that you should keep in mind as you read or solve a problem. I often use this icon to highlight a rule or formula that you use in the current discussion. These rules or formulas are necessary for the mathematical computation and are applicable to other problems related to the topic. When you see this icon, you’ll know that you’re coming upon a helpful or timesaving tip.
You’ll find this icon attached to interesting but nonessential information. The information next to this icon is loosely related to the discussion at hand but isn’t necessary to your understanding of the topic.
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Business Math For Dummies This icon points out a particularly sticky problem or common misunderstanding. I use this icon sparingly so that, when you do see it, you know I’m serious about the information.
Where to Go from Here The range of topics in business mathematics (and therefore in this book) is pretty broad. However, because of the large scope of material shown here, you’ll be able to find what you need in one place or another. If you need some help with the basics, feel free to start with the first part. Then jump to the chapters that relate to your specific business situation. You just need to pick and choose what you need from the different parts of this book (and then use them or abuse them to your heart’s content). As you’re reading through the book, remember that if you come across a particular mathematical process that you can’t quite remember, you can be sure I refer you to the chapter that covers the process or something very much like it. You can then apply the concepts or processes to your particular situation. Feel free to use this book as a reference more than a guide. It’s here to clear up the puzzling points and get you set in the right direction.
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Part I
Reviewing Basic Math for Business and Real Estate Transactions
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In this part . . .
he mathematics of fractions, decimals, and percents is fully dissected and then put back together in these chapters. Why? Well, the world of business is tied to these topics. So, in this part, you investigate percent increases and percent decreases, and you see how the math goes right along with fractions and proportions. You also discover how to create new ways of using percents and proportions that you haven’t even considered.
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Chapter 1
Starting from the Beginning In This Chapter Aligning fractions, decimals, and percents to their place in business Understanding how formulas can help you solve business math problems Using exponents in everything financial Dealing with the math for inventory, overhead, and depreciation Picturing business scenarios using tables, charts, and graphs
B
usiness mathematics involves a lot of arithmetic, some algebra, a touch of geometry, and dibs and dabs of other mathematical topics. But the major portion of mathematics that’s found in business is arithmetic. Getting you off to a good start is the goal of this chapter. You may be looking for answers to some deep, dark mathematical secrets; this chapter helps you light the way toward realizing that the basic math involved in business was never meant to be kept a secret. You may not see the relevance in some mathematical processes. But this chapter makes the necessity for mathematics abundantly clear. On the other hand, you may have a firm grasp on the business math basics; you’re looking for more — for some explanations as to why, not just how. So, in this chapter, I show you many of these whys, and I direct you to even more complex mathematics when the occasion allows. Most of the math in business isn’t compartmentalized into one section or another. Fractions and decimals are found in all applications. Proportions and percents are rampant. And measurements are necessary for many different business processes. In other words, the math of business involves computations shared by all the different aspects. The main trick to doing the math is to know when to apply what. Use the material in this book to help yourself become comfortable with when to use what and how to use it successfully.
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Fracturing the Myths about Fractions, Decimals, and Percents It could be that adding fractions is something that you do every day; in that case, fractions are fresh in your mind, and you find them easy to deal with. On the other hand, you may not have found a common denominator in years (and hope never to have to again). You also may have made it a point not to deal with decimals. But fractions and decimals can’t be ignored; they need to be embraced — or, at least, tolerated. It’s an undeniable fact that fractions, decimals, and percents form the basis of much of the math in business. Before you run away, screaming and sobbing, let me tell you that in this book, I ease you into some of the less popular mathematical subjects when they arise. I show you the way to deal with the math in the most quick and efficient way possible. In Part II of this book, you find fractions cropping up in formulas and with various measurement situations. You probably never complained much when told that you had to take half of an amount to complete a computation. After all, a half is the simplest fraction. But, if you can manage one fraction, you can manage them all. In Chapter 2, I go over some of the operations needed with fractions, and I show you how to change them to percents and back again. Decimals are the middle ground between fractions and percents. You really can’t get around them — nor do you really want to avoid them. When figuring percent increases or decreases in Chapter 3, you see how the change from percents to decimals is necessary. Discounts and markups are often confusing to understand and compute, but Chapter 17 shows you how to handle the ups and downs correctly using our good friends, the percent and decimal. And how in the world can you deal with the interest earned on your account unless you haul out those delightful decimals? When you compute simple interest, you use the formula I = Prt. Nestled between the money amount (P stands for principal) and the number of years involved (t stands for time) is the rate of interest, r, which is given as a percent and changed to a decimal in order to do the computation. You find percents and decimals cropping up throughout this book. If you come across a conundrum (okay, even just a little challenge), you can always refer to the chapters in Part I, which deal with fractions, decimals, percents, and their basic applications and computations.
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Chapter 1: Starting from the Beginning
Capitalizing on Patterns in Formulas A formula is nothing more than a relationship between values that always works and is always true. Wouldn’t it be nice if formulas worked for people, too? But that’s the big difference between people and numbers. Numbers are known to behave much better and more predictably than people, which is why you can embrace formulas with such confidence. Formulas have been around since the beginning of recorded history, but in the Middle Ages, formulas weren’t in their current neatandcompact forms. It was only a couple hundred years ago that algebraic notation became popular and formulas such as P = 2(l + w) and a2 + b2 = c2 became a part of mathematical history. The trick to working with any formula is knowing what the different variables stand for and how to perform the mathematical operations involved. For example, you should know that A = 1⁄2 bh gives you the area of a triangle. You simply multiply one side of the triangle (the base, b) by the height of the triangle (h, which is measured from the base) and then find 1⁄2 of the product. (Check out Chapter 21 for more on the area formulas.) In Chapter 5, I go over the different rules for performing more than one operation in an expression. In all of Part II, you see how to use formulas in different settings. It’s a splendid situation when you can put a formula into a computer spreadsheet and let the technology do repeated computations for you. So in Chapter 5, I give you some spreadsheet guidance. Get ready, because you can find some pretty impressive formulas in Parts III and VI, where loans, mortgages, and other financial manipulations play a big part in the discussion. You don’t want to memorize the formulas for annuities and sinking funds, however. You just need to become comfortable using the formulas and have confidence in your answers. You can always flip to the actual formula when it comes time to use it. You probably remember how to do a mean average, but do you know whether the median or mode would be a better measure of the middle in your particular situation? Just use the formulas or rules in this book to find out. For instance, when you’re managing rental properties or another business, you need to do some comparisons from month to month and year to year. Your statistics skills, which you can gain in Chapter 8, will put you in good stead for the computations needed. You don’t find any heavyduty statistics or statistical formulas in this book. For further investigations, check out Statistics For Dummies (Wiley).
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Finding the Power in Exponents An exponent is a power. In other words, it’s shorthand algebra that tells you to multiply something by itself over and over again. Exponents are fundamental in compound interest formulas and amortized loan formulas. In fact, they’re great for everything financial. For example, do you want to know what an investment of $10,000 will be worth in 5 years? Part III presents lots of options for dealing with your money and for doing the computations necessary. Mortgage rates change constantly, and so you often need to make decisions on your mortgages and loans. Those decisions rely heavily on computations using exponents. You find the lowdown in Part III and, again, in Part VI. Are you a little shaky on the use of exponents? Check out Table 11, which gives you a quick reminder.
Table 11
The Rules for Operations Involving Exponents
Operation
How to Handle
Example
Multiplying the same bases
Add the exponents.
Dividing the same bases
Subtract the exponents.
ax · ay = ax + y a x = a x y ay
(ax)y = axy Handling negative exponents Move the power to the denominator a  x = 1x a (the bottom part of the fraction) and change the sign. Raising a power to a power
Multiply the exponents.
Dealing with roots
Roots change to fractional exponents.
x
a = a 1/x
Use the rules involving multiplication and roots to simplify 9 3/2 9 . First off, change the radical to a fractional exponent. Then multiply the two numbers together by adding the exponents like this: 93/2 · 91/2 = 93/2 +1/2 = 92 = 81 Okay, that was fun. But you may not be convinced that exponents are all that important. What if I asked you to do a quick comparison of how much more money you accumulate if you invest a certain lump sum for 10 years instead of just 5 years? I show you how the exponents work in the following example. (You can go to Chapter 9 to get more of the details.)
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Chapter 1: Starting from the Beginning Compare the amount of money accumulated if you deposit an insurance settlement for 10 years in an account earning 8% interest compounded quarterly versus just leaving that money in the account for 5 years (at the same interest rate). The formula for compound interest is: rm A = P c1 + n
nt
To do the comparison of how much money accumulates, write a fraction with the 10 years compounding in the numerator (the top part of the fraction) and the 5 years compounding in the denominator (the bottom). Here’s what your math should look like: 4 (10)
P c1 + 0.08 m Compounded10 years 4 = 4 (5) Compounded 5 years P c1 + 0.08 m 4 = =
P ^1.02h
40
P ^1.02h
20
P ^1.02h
40 20
P ^1.02h
= ^1.02h . 1.49 20
20
Performing some reducing of fractions and operations on exponents, you see that the amount of money accumulated is about 11⁄2 times as much as if it’s left for 10 years (rather than for 5). You can also use the formula to get the respective amounts of money for the two different investment times, but this equation shows you the power of a power for any amount of money invested at that rate and time.
Doing Some Serious Counting Keeping track of your inventory means more than taking a clipboard to the storeroom and counting the number of boxes that are there. Even a smaller business needs a systematic way of keeping track of how many items it has, how much the different items cost, and how quickly the items are used and need to be replaced. So, in Part V, you find information on inventory, overhead, and depreciation. The amount of inventory on hand affects the cost of insurance, and, in turn, the cost of insurance affects the overall profit. Profit is determined by finding
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Part I: Reviewing Basic Math for Business and Real Estate Transactions the difference between revenue and cost. And each part of the profit equation involves its own set of computations. One of the best ways of keeping track of inventory and the related costs and revenue is to use a computer spreadsheet. You get some formal explanations on spreadsheets in Chapter 5. I also tell you throughout the book when the use of spreadsheets is possible. Other types of counting or tallying come in the form of measurements — linear measurements, area, volume, and angles. You find uses for measuring lengths and widths and areas when you’re building something new or renovating something old. You need accurate area computations when you’re planning for the space needed for production or a particular volume. That way you can store what you’ve produced. In these cases and more, you need to be able to switch from one measurement unit to another — from feet to yards, for example — and apply the measures to the correct situations. In Chapter 7, you find the basics of measuring, and you apply these measures in the chapters dealing with insuring spaces, renting properties, figuring acreage, and computing depreciation, just to name a few.
Painting a Pretty Picture Many people are visual — they learn, understand, and remember better if they have a picture of the situation. I’m one of those people — and proud of it. Present a problem to me, and I’ll try to draw a picture of the situation, even if it means drawing stick figures of Ted, Fred, and Ned to do a comparison of their salaries. Pictures, charts, graphs, and tables are extremely helpful when trying to explain a situation, organize information, or make quick decisions. You find tables of values throughout this book. A table is a rectangular arrangement of information with columns of items sharing some quality and rows of items moving sequentially downward. Tables of information can be transformed into spreadsheets or matrices so you can do further computations. (Matrices aren’t covered in this book, but if you’d like, you can find information on them in Algebra II For Dummies, published by Wiley.) Charts and graphs are quick, pictorial representations of a bunch of numbers or other numerical information. You don’t get exact values from charts or graphs, but you get a quick, overall picture of what’s going on in the business. You can find pie charts and line graphs and more in Chapter 6.
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Chapter 2
Fractions, Decimals, and Percents In This Chapter Converting fractions to decimals and vice versa Relating percents to their decimal equivalents Performing basic operations on fractions
F
ractions, decimals, and percents are closely related to one another. Every fraction has a percent equivalent, but you have to go through decimals to get from fractions to percents or from percents to fractions. And, although percents may be the most easy to understand of the three different forms, you can’t really perform many operations involving percents without changing them to one of the other forms. You may want to just do away with all but one of these formats to avoid having to go through the hassle of doing all the conversions. However, you really wouldn’t want to do that because each format has a place in everyday life and business. In this chapter, I show you the ins and outs of changing from one form to another — fractions to decimals to percents, and back again. You’ll see why the different formats are necessary and useful (and not evil).
Changing from Fractions to Decimals Everyone loves fractions. In fact, you probably find it hard to believe that anyone would ever want fractions to change! Okay. I jest. The practical reason for changing from fractions to decimals is to aid in computations and get a sense of the value. It’s easy to trip up when entering a fraction into an arithmetic operation. But decimals work nicely in calculators. Also, the decimal equivalents of many fractions are easier to compare. For example, which is larger, 23⁄57 or 26⁄67? The decimal equivalent of 23⁄57 is about 0.404, and the equivalent of 26⁄67 is about 0.388. Much easier to compare now, aren’t they?
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Part I: Reviewing Basic Math for Business and Real Estate Transactions Changing a fraction to a decimal is pretty straightforward — you just divide until the division comes to a screeching halt or until you see a pattern repeating over and over. One or the other (ending or repeating) will always occur when you start with a fraction.
Considering the two types of decimals The two types of decimal numbers that arise from dividing a fraction’s numerator by its denominator are terminating and repeating decimals. A terminating decimal is just what it sounds like: it’s a decimal that comes to an end. You may need to do a bit of dividing to come to that end, but you will find the end. A repeating decimal is one that never ends. Instead, it repeats itself over and over in a distinctive pattern. The pattern may contain one digit, two digits, or a huge number of digits.
Terminating decimals Terminating decimals are created from fractions whose denominators have the following: Factors (divisors) of only 2 and 5 Powers of 2 and 5 Multiples of powers of 2 and 5 For example, the fraction 5⁄8 has a terminating decimal, because the number 8 is 23, a power of 2. And the fraction 137 has a terminating decimal, because 250 the number 250 is equal to 2 · 53, the product of 2 and a power of 5. In general, you divide as many times as 2 or 5 are factors of the denominator. For example, if the denominator is 16, which is the 4th power of 2, you divide 4 times. If the denominator is 3,125, the 5th power of 5, you divide 5 times. If the denominator contains both powers of 2 and powers of 5, then the number that has the higher power (the most factors) determines how many times you divide.
Repeating decimals When the denominator of a fraction has factors other than 2 or 5, the decimal equivalent of the fraction always repeats. Always. For example, the fraction 1⁄3 has a decimal equivalent of 0.3333 . . . . The 3s go on forever. You indicate a repeating decimal by showing enough of the numbers that it’s apparent what’s repeating and then writing an ellipsis ( . . . ). Or, if you prefer, you can draw a line across the top of the repeating digits.
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Chapter 2: Fractions, Decimals, and Percents Here’s what I mean: The fraction 2⁄7 has a repeating decimal, .285714. All six digits repeat; if you didn’t use the bar across the top, you’d write the decimal equivalent as 0.285714285714 . . . . Doing so shows that the six digits repeat over and over. Find the decimal equivalent of the fraction 7 . 375 Divide 7 by 375, and continue until you find the repeating pattern. How do I know it repeats? Because the denominator, 375, is divisible by 3 and 5 — the 3 factor causes the repeating part. When dividing the problem, your math will look like this: .01866 375 g 7.00000 375 3250 3000 2500 2250 2500 2250 250 You see that, after the first few divisions, the remainder 250 keeps appearing every time. The first three digits of the decimal don’t repeat, just the 6s. You’d continue to get only 6s, so the decimal equivalent is written 0.018666 . . . or 0.0186.
Rounding decimals up or down When you change the fraction 1⁄4 to its decimal equivalent, you end up with a nice, tame decimal of 0.25. But the fraction 1⁄6 has a repeating decimal equivalent that never ends — 0.1666 . . . . You can even have terminating decimals that get a little longwinded. For example, the fraction 79 has a decimal 3125 value of 0.02528, which isn’t all that long, but you may have more digits than you think is necessary for the situation at hand. Rounding off the extra decimal digits takes care of overly long numerical values. Of course, rounding a decimal changes the number slightly. You’re eliminating a more exact value when you drop pieces from the number. But rounding decimals under the right circumstances is expedient and useful.
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Part I: Reviewing Basic Math for Business and Real Estate Transactions Suppose, for example, that you’re planning to cut a piece of wood into four equal pieces. So you measure the wood, divide by four, and cut the pieces to size. Consider a piece of wood measuring 6 feet, 33⁄8 inches. Onefourth of the length of the board is 1 foot, 6.84375 inches. (Chapter 7 shows you how to deal with feet and inches, and later in this chapter I show how to divide fractions.) With that measurement in hand, you’re all set to create four pieces of wood that measure 1 foot, 6.84375 inches each, right? Of course not. You know that the sawdust accounts for at least the last three decimal digits of the number. So, to make things a bit easier, you round off the measure to about 1 foot, 6.8 inches, which is equal to about 1 foot, 67⁄8 inches. When rounding decimals, you decide how many decimal places you want in your number, and then you round to the nearer of that place and lop off the rest of the digits. You can also use the Rule of 5 when rounding. I explain the different ways to round in the following sections.
Rounding to the nearer digit The rule for rounding is that you choose how many decimal digits you want in your answer, and then you get rid of the excess digits after rounding up or down. Before discarding the excess digits, use the following steps: 1. Count the number of digits to be discarded, and think of the power of 10 that has as many zeros as digits to discard. 2. Use, as a comparison, half of that power of 10. For example, half of 10 is 5, half of 100 is 50, and so on. 3. Now consider the discarded digits. If the amount being discarded is smaller than 5, 50, or 500 (and so on), you just drop the extra digits. If the amount being discarded is larger than 5, 50, or 500 (and so on), you increase the last digit of the number you’re keeping by 1 and discard the rest. If you have exactly 5, 50, or 500 (and so on), you use a special rule, the Rule of 5, which I cover later in this chapter. In the following examples, I talk about rounding a number to the “nearer tenth” or “nearer hundredth.” This naming has to do with the number of placeholders present. To read more about this naming convention, check out the later section, “Ending up with terminating decimals.” Round the number 45.63125 to the nearer hundredth (leave two decimal places).
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Chapter 2: Fractions, Decimals, and Percents You want to keep the whole number, 45, and the first three digits to the right of the decimal point — the 6 and, possibly, the 3. The digits left over form the number 125. Because 125 is less than 500, just drop off those three digits. So your answer is that 45.63125 rounds to 45.63 when it’s rounded to the nearer hundredth. Round the number 645.645645 . . . to the nearer thousandth (leave three decimal places). You want to keep the whole number, 645, to the left of the decimal point and at least the first two digits to the right of the decimal point. You keep the 6 and 4 and make a decision about the 5. Because the numbers to be dropped off represent 645 (or 6,456, 64,564, and so on), you see that the numbers to be dropped off represent a number bigger than 500 (or 5,000, 50,000, and so on). So you add 1 to the 5, the last digit, forming the rounded number 645.646 to replace the repeating decimal part of the original number. Round the number 1.97342 to the nearer tenth (leave one decimal place). When you round, you’ll be dropping off the digits 7342, which represent a number bigger than 5,000. So you add 1 to the 9. But 1 + 9 = 10, so you have to carry the 1 from the 10 to the digit to the left of the decimal point. Your resulting number is 2.0 after dropping the four digits off. You leave the 0 after the decimal point to show that the number is correct (has been rounded) to the nearer tenth.
Rule of 5 When you’re rounding numbers and the amount to drop off is exactly 5, 50, or 500 (and so on), you round either up or down, depending on which choice creates an even number (a number ending in 0, 2, 4, 6, or 8). The reason for this rule is that half the time you round up and half the time you round down — making the adjustments due to rounding more fair and creating less of an error if you have to repeat the process many times. Round the number 655.555 to the nearer hundredth (leave two decimal places). Because there are only three digits, only the last digit needs to be dropped off. And because you have exactly 5, you round the hundredth place to a 6, giving you 655.56. Why? Rounding up gives you an ending digit that’s an even number.
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Part I: Reviewing Basic Math for Business and Real Estate Transactions
Converting Decimals to Fractions Decimals have a much better reputation than fractions. Why, for the life of me, I can’t understand. But many people do prefer the decimal point followed by a neat row of digits. For most applications, the decimal form of a number is just fine. For many precision computations, though, the exact form, a number’s fractional value, is necessary. Those working with tools know that fractions describe the different sizes (unless you’re working with the metric system). Changing a decimal into a fraction takes a decision on your part. First, you decide whether the decimal is terminating or repeating. Then, in the case of the repeating decimal, you decide whether all the digits repeat or just some of them do. What if the decimal doesn’t terminate or repeat and just goes on forever and ever? Then you’re done. Only decimals that terminate or repeat have fractional equivalents. The decimals that neither terminate nor repeat are called irrational (how appropriate). In the following sections, I explain how to change terminating and repeating decimals into fractions. (For more information on irrational numbers, check out the nearby sidebar “Discovering irrational numbers.”)
Ending up with terminating decimals Terminating decimals occur when a fraction has the following in its denominator: Only factors of 2 or 5 Powers of 2 or 5 Products of powers of 2 or 5 A terminating decimal has a countable number of decimal places, and the number formed has a name based on the number of decimal places being used. The names of the first eight decimal places with a 1 place holder are: 0.1
one tenth
0.01
one hundredth
0.001
one thousandth
0.0001
one tenthousandth
0.00001
one hundredthousandth
0.000001
one millionth
0.0000001
one tenmillionth
0.00000001
one hundredmillionth
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Chapter 2: Fractions, Decimals, and Percents
Discovering irrational numbers It is our famous friend, Pythagoras, who’s often given credit for discovering irrational numbers. Even though the ancient Babylonians have surviving documents that suggest that they were also onto the idea, it was the Pythagoreans who formalized the discovery with the irrationality of the square root of 2. The proof involves taking a square, drawing its diagonal, and setting up a proportion between the sides of the square and the diagonal. From the proportion, the Pythagoreans produced the equation 2a2 = b2 and were able to argue that the equation has no
solution if a and b are integers. (Integers, by the way, are positive and negative whole numbers and 0.) Other references to the irrational number proof show up in Aristotle’s works and Euclid’s Elements. The irrational square root of 2 has a decimal that neither terminates nor repeats; here are the first 60 or so decimal places of the square root of 2: 1.41421356237309504880168872420969807856967 187537694807317667973799 . . . . If you want more decimal places than appear here, go to www.rossi.com\sqr2.htm.
So, for example, you read the number 0.003456 as three thousand four hundred fiftysix millionths. The millionths comes from the position of the last digit in the number. And, as a bonus, the names of the decimal places actually tell you what to put in the denominator when you change a terminating decimal to a fraction. How? When changing a terminating decimal to its fractional equivalent, you place the decimal digits over a power of 10 that has the same number of 0s as the number of decimal digits. Then you reduce the fraction to lowest terms. Check out the following example to see what I mean. Rewrite the decimal 0.0875 as a fraction in its lowest terms. The number 0.0875 is eight hundred seventyfive tenthousandths. To rewrite this number as a fraction, you put the digits 875 (you don’t need the lead zero because 875 and 0875 are the same number) in the numerator of a fraction and 10,000 in the denominator (you use 10,000 because there are 4 digits to the right of the decimal point and 4 zeros in 10,000 ). Now reduce the fraction. To do so, first divide the numerator and denominator by 25, and then reduce the numerator and denominator by 5. The math should look like this: 35
7
35 875 = 875 = = 7 10, 000 10, 000 400 400 80 80 Yes, I know that I could have reduced the fraction in one step by dividing both the numerator and denominator by 125, but I don’t really know my multiples of 125 that well, so I chose to reduce the fractions in stages.
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Dealing with repeating decimals Repeating decimals come from fractions. But unlike terminating decimals, you can’t put the decimal part over a power of 10, because the decimal never ends. In other words, it doesn’t settle down to a particular power of 10, so you’d never stop putting zeros in the fraction. Repeating decimals separate into two different groups or types. The first type is the one in which all the digits repeat. You don’t have any startoff digits that don’t fit in the repeating pattern. The second type of repeating decimal consists of those that have one or more digits that appear just once and don’t fit into the repeating pattern. Each group has its own way of converting from decimals to fractions. I explain in the following sections.
Catching all the digits repeating A decimal number in which all the digits repeat looks something like these: 0.88 . . . 0.123123 . . . 0.14851485 . . . It doesn’t matter how many digits are in the repeating pattern. As long as all the digits are a part of the pattern, the number falls into this first group of repeating decimals. To find the fractional equivalent of a repeating decimal in which all the digits repeat, put the repeating digits into the numerator of a fraction, and put as many 9s as there are digits in the repeating pattern in the denominator of the fraction. Then reduce the fraction to lowest terms. Sounds pretty simple, doesn’t it? Try your hand at the following example. Find the fractional equivalents of 0.88 . . . and 0.123123 . . . For the decimal 0.88 . . ., put an 8 in the numerator and a 9 in the denominator. You get the fraction 8⁄9, which is already in reduced form. For the decimal 0.123123 . . ., put 123 in the numerator and 999 in the denominator. You reduce the fraction by dividing the numerator and denominator by 3. Here’s what your simplifying should look like: 41
123 = 123 = 41 999 999 333 333
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Chapter 2: Fractions, Decimals, and Percents Working with digits that don’t repeat in the pattern Repeating decimals with nonrepeating parts look like the following: 0.00345345 . . . 0.12699999 . . . 0.32517842842842 . . . The nonrepeating parts never show up again after the decimal starts repeating, but that part does affect how you determine the corresponding fraction. You can’t put the nonrepeating part over 9s and you can’t put it over 0s. The actual technique involves a bit of a compromise. To find the fractional equivalent of a repeating decimal with one or more nonrepeating digits, follow these steps: 1. Set the decimal equal to N. 2. Multiply both sides of the equation by the power of 10 that has as many zeros as there are nonrepeating digits. 3. Multiply both sides of the new equation by the power of 10 that has as many zeros as there are repeating digits. 4. Subtract the equation in Step 2 from the equation in Step 3, and solve for N. Put these steps to use with the following example problem. Find the fractional equivalent of the repeating decimal 0.123555555555 . . . . You can solve this problem using the steps as previously given: 1. Set the decimal equal to N to get N = 0.123555555555 . . . . 2. Multiply both sides by 1,000 (because the 123 doesn’t repeat), which gives you 1,000N = 123.555555555 . . . . 3. Multiply each side of the equation in Step 2 by 10 (because only one digit, the 5, keeps repeating), and you get 10,000N = 1235.555555555 . . . .
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Part I: Reviewing Basic Math for Business and Real Estate Transactions 4. Subtract the equation in Step 2 from the equation in Step 3, and then solve for N: 10, 000N = 1235.555555555...  1000N = 123.555555555... 9000N = 1112 N = 1112 9000 139 1112 139 = 1125 = 1125 9000 I divided the numerator and denominator by 8 to reduce the fraction to lowest terms.
Understanding the Relationship between Percents and Decimals Percents are found daily in newspaper ads, financial statements, medical reports, and so on. However, percentages aren’t really the same as the rest of our numbers. You need to change from a percent to a decimal before doing any computations involving percents of other quantities. A percent is a number that represents how many compared to 100. Percents are usually much quicker and easier to understand or know the worth of than their fractional counterparts. Sure, you have some easier equivalents, such as 1⁄2 and 50% or 3⁄4 and 75%. But a fraction’s worth may not jump out at you. For instance, you may not immediately realize that 7 is 35%. 20 In the earlier section, “Changing from Fractions to Decimals,” I show you how to get from a fraction to its decimal equivalent. In this section, you see how to change from decimals to percents and from percents to decimals. Percents are easy to understand, because you can quickly compare the percent amount to 100. If you’re told that 89% of the people have arrived at an event, you know that most of the people have come. After all, 89 out of 100 is a lot of those expected. Similarly, if you’re told that the chance of rain is 1%, you know that the chances are slimtonone that you’ll have precipitation, because 1 out of 100 isn’t a large amount. Decimals are fairly easy to deal with, but you may have more trouble wrapping your head around how much 0.125 of an estate is. Did you realize that 0.125 is the same as 12.5%? If so, you’re probably in the minority. But good for you for knowing!
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Chapter 2: Fractions, Decimals, and Percents
Transforming from percents to decimals A percentage is recognizable by the % symbol, or just by the word, percent. Percents are sort of pictures of amounts, and so they need to be changed to a decimal or fractional equivalent before combining them with other numbers. If I told you that 89% of the people had arrived at a meeting, and you’re expecting 500 people, you can’t just multiply 89 by 500 to get the number of people who have arrived. Why? Well, 89 × 500 = 44,500. So you can see that the answer doesn’t make any sense. Instead, you need to change percents to decimals before trying to do computations. To change a percent to its decimal equivalent, move the decimal point in the percent two places to the left. Moving the decimal point two places to the left gives you the same result as multiplying the percent amount by 0.01 (one hundredth). Why are you multiplying by 0.01? Because percents are comparisons to 100; you’re changing the percent to how many out of 100. The decimal equivalent of 12.5% is 0.125, and the decimal equivalent of 6% is 0.06. Notice that with 6%, I had to add a 0 in front of the 6 to be able to move the decimal point the two decimal places. You assume that there’s a decimal point to the right of the 6 in 6%. If you’re told that 89% of the people have arrived at the companywide meeting, and you’re expecting 500 people, how many people have arrived? To find out, simply change 89% to its decimal equivalent, 0.89. Then multiply 0.89 × 500 = 445 people. When checking on the latest shipment of eggs, your dairy manager tells you that 1⁄2 % of them are cracked. The shipment contained 3,000 dozen eggs. How many were cracked? First, change 3,000 dozen to an actual number of eggs by multiplying 3,000 × 12 = 36,000 eggs. Next, change 1⁄2 % to a decimal. The fraction 1⁄2 is 0.5 as a decimal, so 1⁄2 % is 0.5%. Now, to change 0.5% to a decimal, move the decimal point two places to the left to get 0.005. Multiply 36,000 by 0.005, and you discover that 180 eggs are cracked. That’s 15 dozen eggs in all.
Moving from decimals to percents When you change a number from a decimal to a percent, it’s probably because you have a task in mind. Most likely, you’ve started with a fraction and are using the decimal as the transition number — the number between fractions and percents. If the decimal terminates, you can just carry all the digits along in the percent, or you can round off to a predetermined number
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Part I: Reviewing Basic Math for Business and Real Estate Transactions of digits. If the decimal repeats, you want to decide how many decimal points you want in the percent value. To change a decimal to its percent equivalent, move the decimal point in the decimal two places to the right. If 13 out of 20 people received a flu shot, what percentage of people have received the shot? To find the percentage, first write 13 out of 20 as a fraction. Then you can divide 13 by 20 to get the decimal equivalent: 0.65. (You can see how to change fractions to decimals in the earlier section “Changing from Fractions to Decimals.”) Now change 0.65 to a percent by moving the decimal point two places to the right, which gives you 65%. (I don’t show the decimal point to the right of the 5 in 65%, because it’s understood to be there when it’s not otherwise shown.) The evening crew has completed 67 out of the 333 packets that need to be filled for the big order. What percentage of the packets has been completed? The decimal equivalent of the fraction 67 is 0.201201 . . . . As you can see, 333 this is a repeating decimal. Moving the decimal point two places to the right gives you 20.1201201 . . . . Now you need to decide how many decimal places to keep. Let’s say that you want just the nearer percent. In that case, you round off all the digits to the right of the decimal point. The number 1,201,201 is less than half of 5,000,000, so you can just drop all the digits to the right of the decimal point and call the percentage 20%. (See “Rounding decimals up or down,” earlier in this chapter, for more on how to round numbers and drop digits.)
Dealing with more than 100% Sometimes you may find it difficult to get your head around the report that there’s a 300% increase in the number of travelers in a company or that you’re getting a 104% increase in your salary. Just what do the percents really mean, and how do you work with them in computations? First, think about 100% of something. For instance, if you’re told that 100% of a job is complete, you know that the whole thing is wrapped up. But it doesn’t make sense that 200% of the job is complete — you can’t do more than all of the job. So, instead, think of 100% in terms of money. If I pay you 100% of what I owe you, say $800, I pay you all the money — $800. But if I pay you 200% of what I owe you, I pay you all of it twice — or $1,600. (Now, why would I do that? Because I really like you!)
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Chapter 2: Fractions, Decimals, and Percents For percents that exceed 100%, apply the same rule for changing percents to decimals. The equivalent of 200% is 2.00, and the equivalent of 104% is 1.04. Try this example to better understand how to work with percentages that are equal to more than 100. Suppose you’re promised a 104% increase in salary if you agree to stay in your position for another 5 years. If you’re currently earning $87,000, what will your salary be for the next 5 years? To start, multiply 1.04 by $87,000 to get $90,480. Now the question is: Does the $90,480 actually represent an increase — an amount to be added to your current salary? If so, you’ll be earning $87,000 + $90,480 = $177,480. Or did the person offering the increase actually mean to just increase your salary by 4%, in which case you’d be earning the $90,480? You need to be sure you understand the terms exactly. In Chapter 3, you can see how to be sure of your figures when talking about percentages and their ups and downs.
Coming to Grips with Fractions I’ll bet that fractions are your favorite things. Everyone I know just loves fractions. Oh, who am I kidding? I didn’t have you fooled for a minute. So fractions are way down on your list of things to talk about at a party, but they can’t be ignored. Fractions are a way of life. You cut a pie into eighths, sixths, or fourths (or, heaven forbid, sevenths). You whip out your 7⁄8inch wrench. You measure a board to be 5 feet and 9⁄16 inches long. See what happened when the United States decided not to go metric? We got stuck using all these fractions when computing. So, until that happy day when the country changes its mind regarding the metric system, you can deal with fractions and the operations that go with them. Fractions are still useful for describing amounts. They’re exact numbers, so a sale proclaiming 1⁄3 off the original price tells you to divide by 3 and take one of them away from the original price. Do you get the same thing changing the fraction to a decimal? No, not really. The decimal for 1⁄3 is 0.3333 . . ., which approximates 1⁄3 but isn’t exactly the same. You don’t really notice the difference unless you’re dealing with large amounts of money or assets.
Adding and subtracting fractions Fractions can be added and subtracted only if they have the same denominator. So before adding or subtracting them, you have to find equivalent values for the fractions involved so that they have the same denominator. One fraction is equivalent to another if the numerator and denominator of the one
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Part I: Reviewing Basic Math for Business and Real Estate Transactions fraction are the same multiple as the numerator and denominator of the other fraction. For example, the following three fractions are equivalent to the fraction 6 : 18 1 6 5 = 30 , 6 8 = 48 , 6 6 = 1 18 $ 5 90 18 $ 8 144 18 $ 1 3 6 You could find infinite numbers of fractions that are equivalent to the given fraction. The three I chose are found by multiplying the numerator and denominator by 5, 8, and 1⁄6. As I note earlier, you can only add or subtract fractions if they have the same denominator. So if two fractions that need to be added together don’t have the same denominator, you have to change the fractions until they do. You change either one or both of the fractions until they have the same (common) denominator. For example, if you want to add 3⁄5 and 7⁄10, you change the 3⁄5 to an equivalent fractions with 10 in the denominator. The fraction equivalent to 3 ⁄5 is 6⁄10, which has the same (common) denominator as the fraction 7⁄10. Find the sum of 3⁄4 and 3⁄8. Change 3⁄4 to a fraction with 8 in the denominator. Then add the two numerators together. Your math should look like this: 3 2=6 4$2 8 6+3=9 8 8 8 The sum of the two fractions, 9⁄8, is an improper fraction — it’s bigger than 1. So, you need to rewrite it as 11⁄8. To write an improper fraction as a mixed number, you divide the denominator into the numerator. The number of times that the denominator divides is the whole number, in front. The remainder goes in the numerator of the fraction that’s left. If you need to borrow from the whole number in order to subtract, you add the equivalent of 1 to the fraction. Find the difference between 91⁄3 and 47⁄8. The common denominator of the two fractions is 24. So write the two as equivalent fractions and then subtract. Here’s what the math looks like: 91 3 7 4 8
8 $ 88 = 9 24 21 $ 33 =  4 24
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Chapter 2: Fractions, Decimals, and Percents You borrow 1 from the 9, which you write as 24 before adding it to the top 24 fraction, like so: 9 8 + 24 = 8 32 24 24 24 21 21 4 =4 24 24 4 11 24 8
Whenever you have to borrow from a whole number in order to subtract fractions, you change the 1 that’s borrowed from the whole number to a fraction with the common denominator in both the top and bottom of the fraction that’s added.
Multiplying and dividing fractions Adding and subtracting fractions is generally more complicated than multiplying and dividing them. The nice thing about multiplication and division of fractions is that you don’t need a common denominator. And you can reduce the fractions before ever multiplying to make the numbers smaller and more manageable. The challenge, however, is that you have to change all mixed numbers to improper fractions and change whole numbers to fractions by putting them in the numerator with a 1 in the denominator. Multiply 51⁄3 by 41⁄5. To find the product of this problem, first change the mixed numbers to improper fractions. To do so, multiply the whole number by the denominator, add the numerator, and then write the sum over the denominator, like this: 5 1 = 5 $ 3 + 1 = 16 3 3 3 1 4 5 + 1 21 $ 4 = = 5 5 5 You’re almost ready to multiply the two improper fractions together. But first, remember that it helps to reduce the multiplication problem. Do so by dividing the 3 in the denominator of the first fraction and the 21 in the numerator of the second fraction by 3: 16 21 = 16 21 3 $ 5 13 $ 5
7
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Part I: Reviewing Basic Math for Business and Real Estate Transactions After you do that, you’re ready to multiply the two numerators and two denominators together. Your math will look like this: 16 7 = 112 = 22 2 1 $5 5 5 The final answer, 222⁄5, is obtained by dividing the numerator by the denominator and writing the quotient and remainder as a mixed fraction. To divide one fraction by another, you change the problem to multiplication by flipping the second fraction. In other words, division is actually multiplication by the reciprocal of a number. The reciprocal of 2, for example, is 1⁄2, and the reciprocal of 4⁄7 is 7⁄4. Divide 83⁄4 by 31⁄8. To begin, change the mixed numbers to improper fractions. Then change the division to multiplication by multiplying the first fraction by the reciprocal of the second fraction. Your math will look like this: 8 3 ' 3 1 = 35 ' 25 = 35 $ 8 4 8 4 8 4 25 Now reduce the multiplication problem by dividing by 5 in the upper left and lower right and dividing by 4 in the other two numbers. Then multiply across the top and bottom and write the final answer as a mixed number. Here’s what the math will look like: 7
35 8 = 35 4 $ 25 1 4
$
2
8 = 14 = 2 4 5 25 5 5
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Chapter 3
Determining Percent Increase and Decrease In This Chapter Applying percentages to increases and decreases Deciphering the percent change language Working backward from the percent changes to the original prices
I
nformation involving percentages is fairly easy to decipher. If you’re 45 percent finished with a project, for instance, you know that you’re almost half done. Percents are based on the idea how many out of 100, so the comparison of the percentage to the total amount is quick and universally understood. You’re probably confronted with percent increases and decreases on a daily basis. For example, you may deal with salary increases or decreases. Citing these changes as percentages is easier when it comes to comparing the changes. One person’s increase of $2,000 per year, for instance, is much different from another person’s increase of the same amount — especially when one person currently earns $10,000 and the other earns $100,000. In this chapter, you find methods for determining the percent increase or decrease so that you can do comparisons. You also find out how to work backward from an increased amount to see what the original figure was. If you’re a little shaky on percents and doing computations with them, flip to Chapter 2. There you can get reacquainted with the ins and outs of percentages.
Working with Percent Increase A percent increase isn’t just an increase in the original amount; it’s a comparison to the original amount. When you get a 5% increase in salary, you get what you originally earned plus an additional 5% of that original amount. If you’re told the dollar amount of your increase and want to determine what percent that increase is, you compare the amount of the increase by the original amount. The original amount, the new amount, the increase, and the
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Part I: Reviewing Basic Math for Business and Real Estate Transactions percent increase are all entwined with one another and allow you to solve for any one of the values when given the others. I explain how in the following sections.
Computing new totals with increases You can add or subtract percents to get their sums or differences; the answers in these cases are in percents. But when mixing percents with numerical amounts, such as money or time, you have to change the percent to a decimal before multiplying. (I discuss the percenttodecimal procedure in detail in Chapter 2.) When figuring the amount resulting from a particular percent increase, you change the percent to a decimal and then multiply by the original amount. After you have the amount of the increase, you add that amount to the original number to get the new total. Or, if you want onestop computing, you can add the percentage value of the increase to 100%. Then you change the total percentage to a decimal, multiply by the original amount, and have the new total amount as a final result. When you have amount A and want to determine a percent increase of p%, you find the Percent increase by multiplying A × 0.01p. New total by adding 100% + p% and then multiplying A × 0.01(100 + p). Tip: Multiplying the percent by 0.01 is the same as moving the decimal point two places to the left. Find the percent increase and new salary if your employer is going to give you a 5% increase on your current salary of $48,200. To find the percent increase, multiply 0.05 by $48,200 to get $2,410. The new salary is the sum of the increase and the original salary: $2,410 + $48,200 = $50,610. You also can get the new total by multiplying the original salary by 105% (add the 5% increase to 100%): $48,200 × 1.05 = $50,610.
Determining the percent increase When given the percentage that some number is to be increased, you change the percentage to a decimal and multiply by the original amount. So, for example, a 3% increase on 200 items is 0.03 × 200 = 6. As you can see, it takes multiplication to find the percent increase, so it takes division to find out the percent if you only know the increase.
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Chapter 3: Determining Percent Increase and Decrease To find the percentage amount that something has increased, you divide the amount of the increase by the original value. The formula you use looks like this: percent increase = amount of increase original amount increased amount  original amount = original amount Try out the following example to see how this formula works. Suppose that your best salesman sold 400 cars last year and 437 cars this year. What was the percent increase of his sales? To find the percent increase, first subtract 400 from 437 to get an increase of 37 cars this year. Now divide 37 by the original amount (last year’s number) to get the decimal value that you can then change to a percent. Here’s what the math looks like: percent increase = 437  400 = 37 = 0.0925 400 400 As you can see, the decimal answer is 0.0925, which is equal to 9.25%. (Refer to Chapter 2 if you need a reminder on how to change from a decimal to a percent.)
Solving for the original amount With the basic equation used to solve for the percent increase (refer to the previous section), you can solve for either the percent increase, the increased amount, or the original amount — as long as you’re given the other two values. I could give you three different formulas or equations, one to solve for each of the values, but it’s easier to just remember one formula and perform some simple algebra to solve for what’s missing. Imagine you’re told that all the prices in a store increased by 41⁄2% last year. You have a list of all the current prices and want to determine the original price of an item. To do so, you just have to use the formula for percent increase (provided in the previous section). You fill in the percentage and the new price, let the original price be represented by x, and then solve for x. Check out the following example for practice. Say that a hardware store is selling a power washer for $208.95. This current price is 41⁄2% higher than the price for the same power washer last year. What was the cost of the washer last year?
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Part I: Reviewing Basic Math for Business and Real Estate Transactions To find out, plug all the numbers into the equation for finding the percent increase: increased amount  original amount original amount x 4 1 % = 208.95 x 2 x 0.045 = 208.95 x
percent increase =
Now multiply each side of the equation by the denominator on the right, which is x. Then add x to each side and divide by the coefficient of x. Your math should look like this: x $ 0.045 = 208.95  x $ x x 0.045x = 208.95  x + 1x = +x 1.045x = 208.95 1.045x 208.95 = 1.045 1.045 x . 199.95 Last year’s price for the power washer was $199.95.
Looking into Percent Decrease Computing percent decrease has a lot of similarities to computing percent increase — you change percents to decimals, you multiply by the original amount, and then you refer to the original amount. However, sometimes the math is just a bit trickier, because you subtract rather than add (subtraction is a more difficult operation for most folks). And the amount of the decrease often gets obscured (you end up computing with a number that wasn’t in the original problem) when you find the reduced amount directly, without subtracting. I explain everything you need to know about computing percent decreases in the following sections. For many of you, the best method for determining whether you’ve made an error in computation is just common sense. You don’t have to be a mathematician to have a feel for the answer. If you’re figuring the percent increase in your salary and you get a 400% increase, you’ll probably realize that this isn’t realistic. (If it is realistic, then we need to talk.) Basically, you see if the answer resembles what you’ve expected; most of the errors come from using the wrong operation, not in the actual arithmetic (because most people use a calculator, anyway).
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Chapter 3: Determining Percent Increase and Decrease
Finding new totals with decreases Percent decreases play a huge role in the world of discount pricing. You see advertisements by merchants announcing that certain items, or even all items, are marked down by a particular percent of the original value of the item. The percent decrease is determined by multiplying the decimal equivalent of the percent decrease by the original amount. When you have amount A and want to determine a percent decrease of p%, you find the Percent decrease by multiplying A × 0.01p. New total by subtracting 100% – p% and multiplying A × 0.01(100 – p). Multiplying by 0.01 has the same effect as moving the decimal point two places to the left. (You can see more on changing percents to decimals in Chapter 2.) Tip: For the store that has to determine all the new prices of all the redtagged items, a nice spreadsheet does the job quickly and accurately. In Chapter 5, you see some suggestions for using a computer spreadsheet. This example should get you going in the right direction with percent decreases: Say that the aftertheholidays sale at a furniture store features 40% off all redtagged items. What’s the new price of a $3,515 sofa after the 40% decrease in price? The amount of the decrease is 40%, which is 0.40 as a decimal. First multiply the original amount by the percentage in decimal form: $3,515 × 0.40 = $1,406. Then subtract that product from the original amount to get the new price: $3,515 – $1,406 = $2,109.
Figuring out the percent decrease Say you purchase several thousand dollars’ worth of office supplies and are given a volume discount on the entire order. Your bill just shows the total before the discount and the net cost after the discount. You can determine the percentage of the discount by using the formula for percent decrease. To find the percent decrease, you divide the amount of the decrease by the original value. Here’s the formula: percent decrease = amount of decrease original amount original amount  reduced amount = original amount Using this formula, try out the following example problem.
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Part I: Reviewing Basic Math for Business and Real Estate Transactions What’s the percent discount if you paid $1,418.55 for an order whose original cost (before the discount) was $1,470? To solve, simply plug all the numbers into the formula for percent decrease, like so: percent decrease= 1470.00  1418.55 = 0.035 1470.00 The decimal 0.035 is equivalent to 3.5%.
Restoring the original price from a decreased price If you purchase a piece of machinery after getting the frequent customer discount of 10%, you may want to determine the original cost for insurance purposes. To find out that original cost, you use the formula for determining the percent decrease. You let the original amount be represented by x, and then you solve for x in the equation after replacing the other quantities with their respective values. For example, suppose you’re such a good customer at Tracy’s Tractors that you’re given a 10% discount on your purchase of a new tractor. You have to pay only $7,688.70. You need to insure the tractor at its replacement cost. What did the tractor cost before the discount? Using the percent discount formula, replace the percent with 10% and the discounted price with $7,688.70. Let the original price be represented by x and solve for x. Here’s what the new equation will look like: original amount  reduced amount original amount .70 10% = x  7688 x .70 0.10 = x  7688 x Now multiply each side of the equation by x. Then subtract x from each side and divide by the coefficient of x. Your math will look like this: percent decrease =
x $ 0.10 = x  7688.70 $ x x 0.10x = x  7688.70  1x =  x  0.90x =  7688.70  0.90x  7688.70 =  0.90  0.90 x = 8, 543 As you can see, the tractor originally cost $8,543.
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Chapter 4
Dealing with Proportions and Basic Algebra In This Chapter Working with proportions Writing and solving linear equations from algebra Considering direct and indirect variation
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ne of the most useful structures in mathematics is the proportion. You use it to parcel out amounts in fair and equal portions and to determine equivalent lengths, volumes, or amounts of money. A proportion is nothing more than two fractions set equal to one another, but it’s beautifully symmetric and functionally versatile. Working with proportions helps you solve simple algebraic equations. An algebraic equation has at least one unknown variable lurking in its depths. You’ve solved an algebraic equation when you figure out what a missing variable is worth. The rules for solving simple, linear algebraic equations make a lot of sense and are easy to remember. The key is to keep the equation balanced. I also cover direct and indirect variation in this chapter. Both of these are actually comparisons of things. Two items vary directly with one another if one of the items is tied to the other by some multiple. For example, if Henry always runs twice as fast as Henrietta, then when Henrietta runs at 3 meters per second, you know that Henry runs at 6 meters per second. Indirect variation takes a bit more explanation, but it’s basically an opposite type of relationship — as one thing gets bigger, the other gets smaller. You won’t get as much exposure to solving equations in this chapter as you would if you were reading Algebra For Dummies or Algebra II For Dummies (both from Wiley), but do know that I show you the basics and all you need to handle equations special to business math.
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Setting Up Proportions A proportion is an equation in which one fraction is set equal to another fraction. The following are examples of proportions: 3 = 25 6 50
Two fractions equaling 1⁄2
1 1 mile = 4 mile 5,280 feet 1,320 feet
Equating miles and feet
1 hour of work = $15.80 10 hours of work $158.00
Equating hourly rates with hours
When setting up a proportion, you keep the same units either across from one another or in the same fraction — above and below one another. Try your hand at proportions with the following example. Set up a proportion involving the fact that 1 pound equals 16 ounces and 80 ounces equals 5 pounds. To set up this proportion, you either have to write the pounds across from one another or above and below one another. Also, you have to keep the equivalences across from one another or above and below one another. The following are just four of the different ways that the proportion involving pounds and ounces can be written correctly: 1 pound 5 pounds = 16 ounces 80 ounces
1 pound 16 ounces = 5 pounds 80 ounces
80 ounces = 5 pounds 16 ounces 1 pound
5 pounds 80 ounces = 1 pound 16 ounces
A property common to all proportions is that the cross products (the diagonal products) are always equal. This commonality makes checking and solving proportions even easier. When you multiply the top left number by the bottom right number, you get the same result as multiplying the bottom left number by the top right number. For example, in the equation involving fractions equaling 1⁄2 (shown at the beginning of this section), you see that the cross products are both 150. The cross products in the proportion involving miles and feet have cross products of 1,320. You can check the other proportions so far and see that the cross products always come out the same. Proportions have several properties that make them easy to deal with and solve. Given the proportion a = c , the following are always true: b d
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Chapter 4: Dealing with Proportions and Basic Algebra The cross products are equal: ad = bc. The reciprocals (the upsidedown versions of fractions) also form a d proportion: b a = c. You can reduce either fraction vertically, dividing by a common factor: a = e$f , a = e$f , a = f . b e$g b e$g b g You can reduce horizontally, across the top or bottom, dividing by a common factor: a = e c$ g , a = c , a = cg . e$f e$f e$g f
Ready for some practice? Simplify the following proportion by reducing the 6 days 144 hours = fractions: 20 days 480 hours You have many choices for reducing the fractions. Take the most obvious first, and divide the two bottom numbers by 10. Then divide the numbers in the left fraction by 2. Here’s what your reductions should look like so far: 6 = 144 20 480 48 2 3
6 144 = 48 2 1 3 = 144 1 48 Next, divide the two top numbers by 3. Then divide the two numbers in the right fraction by 48: 1
3 144 = 1 48 1 1 = 48 1 48 1
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1=1 1 1 As you can see, you end up with 1 = 1. So what does that tell you? Nothing, really, except that proportions always act that way and give you a true statement. The real power and versatility of proportions come into play when you solve for some unknown value within the proportion.
Solving Proportions for Missing Values Proportions and their properties find their way into many financial and scientific applications. For instance, determining doses of medicine incorporates proportions involving a person’s weight. Vegetation and animal habitats are in a balance expressed with proportions as well. And figuring a seller’s share of the real estate taxes involves ratios and proportions.
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Setting up and solving The biggest challenge when solving a proportion for an unknown value is in setting the proportion up correctly. (I detail the correct way to set up a proportion in the earlier section, “Setting Up Proportions.”) When you have an unknown value, you let that value be represented by a variable, usually x, you crossmultiply, and then you solve the resulting equation for that variable. The following example gives you a chance to solve a proportion for a missing value. A distributor of garbage disposals has been getting complaints that pieces are missing from the boxes of new disposals. In the past month, the distributor has sold 143 disposals and has received 15 complaints. He has 200 more of the disposals in his warehouse. If the complaint pattern holds, how many of the remaining disposals can he expect to have missing parts? To find out, set up one fraction with the 143 disposals in the numerator (the top part of the fraction) and the 15 complaints in the denominator (the bottom part). The other fraction in the proportion needs to have the 200 disposals in the numerator — opposite the 143 disposals — and an x in the denominator, representing the unknown number of complaints. Here’s what the proportion looks like: 143 disposals 200 disposals = 15 complaints x complaints Solve for x by crossmultiplying and then dividing each side of the equation by the coefficient of x. Take a look at the math: 143 = 200 x 15 143x = 3, 000 143x 3, 000 = . 20.979 143 143 So, the distributor can expect to have about 21 more complaints — unless he decides to open the boxes beforehand to check whether the parts are all there.
Interpolating when necessary In Chapter 15, you find many charts and tables with rows and columns full of numbers. When reading tables and using the numbers in computations or reports, it’s sometimes necessary to read between the lines, or, mathematically speaking, to interpolate. Interpolation is basically inserting numbers between entries in a table. You assume that the change from one entry to another is pretty uniform and that you can find a number halfway between two numbers on the table by halving the difference. Proportions allow you to find numbers between the entries that are more or less than halfway between.
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Chapter 4: Dealing with Proportions and Basic Algebra Table 41 shows the cumulative sales of a realty company for the first few months of the year. (The word cumulative means that it’s the sum of everything up to that point.) On March 1, the total number of homes sold by the realty company was 50. On April 1, the total number of homes sold was 100. If you assume that the sales were relatively steady throughout the month of March, how many homes had been sold by March 20?
Table 41
Cumulative Number of Sales
Month
Number of Sales
January
10
February
20
March
50
April
100
May
180
To interpolate, set up a proportion in which one fraction has the number of days involved and the other fraction has the number of homes. Now you need to do the following three things to solve the entire problem: 1. Determine how many homes were sold from March 1 through April 1. 2. Solve for the number of homes sold by March 20. 3. Add the result from Step 2 to the 50 homes that were sold by March 1. First, 50 – 20 = 30 tells you that 30 homes were sold in March. Let the fraction involving the days have 20 in the numerator and 31 in the denominator. (“Thirty days hath September . . .”) Put the x opposite the 20 and the 30 opposite the 31. So your proportion looks like this: 20 days x homes = 31 days 30 homes Now crossmultiply and divide each side of the equation by the coefficient of x: 20 = x 31 30 600 = 31x 600 = 31x 31 31 x . 19.354 It looks like about 19 homes were sold between March 1 and March 20, so the yeartodate number on March 20 is 20 + 19 = 39 homes. Great work!
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Part I: Reviewing Basic Math for Business and Real Estate Transactions When using proportions to interpolate, be careful not to assume a relatively equal rate between the consecutive entries in the table. In the practice problem, if I would have tried to interpolate starting from the beginning of the year, I would have received a completely different (and incorrect) number. Only 20 homes were sold during the first two months and then 30 more during the third month. The average change is different for the different months.
Handling Basic Linear Equations When solving proportions for an unknown value, and when performing many mathematical computations involving measures, money, or time, you’ll likely find yourself working with an equation that has a variable in it. You solve for the value of the unknown by applying basic algebraic processes. These processes keep the integrity of the equation while they change its format so you can find the value of the unknown. When solving a basic linear equation of the form ax + b = c, where x is an unknown variable and a, b, and c are constants, you apply the following rules (not all will be used in every equation — you pick and choose per situation): Add the same number to each side of the equation. Subtract the same number from each side of the equation. Multiply both sides of the equation by the same number (but don’t multiply by 0). Divide each side of the equation by the same number (but don’t divide by 0). Distribute (multiply) each term in parentheses by the number outside the parentheses so that you can drop the parentheses. Check your answer in the original equation to be sure it makes sense. Here’s an example you can try: Solve this equation for the value of x: 3(2x – 7) = 4x – 13. First distribute the 3 over the terms in the parentheses by multiplying each term by 3. You get 6x – 21 = 4x – 13. Now subtract 4x from each side and add 21 to each side. Doing so allows you to get the x’s on one side of the equation and the numbers without x’s on the other side. Here’s how your math should look:
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Chapter 4: Dealing with Proportions and Basic Algebra 6x  21 = 4x  13  4x  4x 2x  21 = 13 + 21 + 21 2x = +8 Now divide each side of the equation by 2, and you get that x = 4. Always check your answer. If you replace the x with 4, you get 3(2×4 – 7) = 4×4 – 13. In the parentheses, you get 8 – 7 = 1. So the equation now reads 3(1) = 16 – 13, or 3 = 3. When you see a true statement — one in which a number equals itself — you know that you’ve done the process correctly. Just for kicks, try out another practice problem. Solve the following proportion for the value of x: 200 = 2x 400 x + 30 First reduce the fraction on the left by dividing both the numerator and denominator by 200. Then crossmultiply. Your math looks like this so far: 200
1
2x 2 = x + 30 400 1 = 2x 2 x + 30 1 ^ x + 30h = 2 ^ 2x h x + 30 = 4x Now solve the equation for the value of x. x + 30 = 4x x x 30 = 3x 30 = 3 x 3 3 10 = x Check to be sure that x does equal 10. By checking your answer to see if it makes sense, you’re more apt to catch silly mistakes. Go back to the original proportion and replace the x’s with 10s, like so: 200 = 2 ^10h 400 10 + 30 200 = 20 400 40
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Part I: Reviewing Basic Math for Business and Real Estate Transactions You can stop with the check at this stage, noting that both fractions are equal to 1⁄2. Or you can crossmultiply to get 8,000 on each side of the equation. You also can reduce both fractions to get the same numbers. In any case, you’ve shown that the 10 does represent the x in the proportion.
Comparing Values with Variation What is variation? It’s how one entity varies with relation to another. Variation comes in two varieties: direct and indirect. Consider the following statements: The pressure of a gas is indirectly proportional to its volume. The productivity of the team is indirectly proportional to the number of absences. The revenue earned is directly proportional to the hours worked. The speed of the truck is directly proportional to the acceleration. I explain the differences between the two types of variation in the following sections.
Getting right to it with direct variation When one quantity varies directly with another, one quantity is directly proportional to the other. An algebraic expression of how the two quantities a and b vary directly is: a = kb, where k is the constant of proportionality, which is the multiplier that connects the two quantities. If you divide each side of the equation by b, you get the following proportion: a=k b 1 And this shows you how the proportion and variation are tied together. When quantities vary directly, one quantity is a multiple of the other. If you know at least one of the quantities in the relationship, you can solve for the other (if it’s unknown). Check out the following example problem to see exactly what I mean. The revenue earned by the sales office varies directly with the number of hours spent out in the field. Last month, the sales team earned $450,000 and spent a total of 1,200 hours meeting with customers. How much will the team earn if it spends 2,000 hours out in the field?
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Chapter 4: Dealing with Proportions and Basic Algebra Using direct variation, you need to find the value of k, the constant of proportionality. Write the equation $450,000 = k × 1,200 for the relationship between the quantities. Divide each side of the equation by 1,200, and you get that k = 375. Now, to solve for the amount earned if the team is in the field for 2,000 hours, plug the numbers into the formula and solve: 375 × 2,000 = $750,000. What does the k, the constant of proportionality, really represent in this problem? You can interpret k to be the number of dollars earned per hour spent with a customer — a sort of average for the business.
Going the indirect route with indirect variation Two quantities vary inversely, or indirectly, if, as one quantity increases, the other decreases proportionately. Instead of a constant multiplier of k, like you find with direct variation, the equation tying the two quantities together is: a= k b Try your hand at the following indirect variation example. When a 2 x 4 pine board is suspended between two buildings (with just the ends of the board at the building edges), the maximum weight that the board can support varies indirectly with the distance between the buildings. If the distance between the buildings is 10 feet, the board can support 480 pounds. What’s the maximum amount of weight that such a board can support if the buildings are 20 feet apart? How about 30 feet apart? First write the relationship between the 10foot distance and the 480 pounds so you can solve for k by multiplying each side of the equation by 10: 480 = k 10 k = 4, 800 Next, solve for the amount of weight that can be supported, putting 4,800 for the value of k and the distance of 20 feet in the denominator: 4, 800 = 240 20 The board can support half as much at that distance — or 120 fewer pounds when the distance is increased by 10 feet.
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Part I: Reviewing Basic Math for Business and Real Estate Transactions Now, using the equation and replacing the denominator with 30, you get: 4, 800 = 160 30 Increase the distance by another 10 feet, and the amount of weight decreases by another 80 pounds.
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Part II
Taking Intriguing Math to Work
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In this part . . .
hether found in a graph, a table, or a computer spreadsheet, a formula is a powerful and dependable mathematical structure. You can find formulas for measurements of physical structures and formulas for determining averages and other statistical values. This part helps you master all of these intriguing mathematical formulas.
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Chapter 5
Working with Formulas In This Chapter Making sense of all the letters and symbols in a formula Solving formulas using the correct order of operations Using calculators and spreadsheets to simplify your math
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hether you want them to be or not, formulas are a part of your life. For instance, when you pay your income tax, the amount you owe is determined with a formula. Yes, I know that you may use a table of values, but where do you think those values came from? Why, a formula, of course! When the meteorologist on television talks about the heat index or wind chill factor, the numbers come from a formula. And when you order new carpeting for your office, you take measurements and determine the amount needed using a formula. You use lots and lots of formulas at work and at home. Like many folks, you may not have realized how much formulas are a part of your life. So, as you can see, formulas are our friends. They offer organization and structure in a chaotic world. A formula qualifies as such when it consistently gives you correct results and answers to questions. In this chapter, you see how to use formulas properly when you have more than one choice of operation involved. You also see how to simplify the complex parts of a formula. I even show you some of the ins and outs of using calculators to help you solve mathematical expressions. Finally, I show you the beauty of entering a formula into a computer spreadsheet, such as Microsoft Excel, and seeing hundreds of computations magically appear before your very eyes.
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Part II: Taking Intriguing Math to Work
Familiarizing Yourself with a Formula Formulas are usually longestablished relationships that you use in your calculator or computer spreadsheet (or, heaven forbid, with a pencil and some paper). You find formulas in textbooks, almanacs, mathematical tables, and, best of all, on the Internet. Having a formula such as I = Prt or S = 1⁄2 n (n + 1) is fine and dandy as long as you know what to do with it. Otherwise, it may as well be Greek. So the first course of action to use when confronted with a formula is to identify all the players. What do the I, P, r, t, S, and n stand for in the formulas? Lots of times the letters used in a formula have the same beginning letter as what the letters represent — but not always. After you’ve conquered the identification hurdle, you need to find numbers to replace the letters within the formula. Next, you check to see that the numbers you’re using are in the same units — you can’t mix feet and inches, pounds and tons, or apples and oranges. Finally, you get to the fun part: performing the mathematical operations. I explain each of these steps in the following sections.
Identifying variables and replacing them correctly A formula is essentially an equation in which some relationship between the values in the equation is always true. For example, the area of a rectangle is always equal to the product of the rectangle’s length multiplied by the rectangle’s width. So the formula for the area of a rectangle is written A = lw. (I introduce this formula in Chapter 21.) When using a formula, you first need to know what each letter represents, and then you need to replace the corresponding letters with the correct values from the problem. Consider, for example, the formula I = Prt. This is the simple interest formula. (You find more info on interest in Chapter 9.) The letter I represents the amount of interest earned when the principal, P, is deposited at the rate of interest, r, for a certain number of years, t. Here’s another way to view this formula: Interest = Principal × Rate × Time In the simple interest formula, you have three values being multiplied by one another on the right side of the equation. So if you’re told that $5,000 is invested for 6 years at 4% interest, you have to know that the $5,000 replaces the P; the decimal equivalent of 4%, 0.04, replaces the r; and 6 years replaces the t.
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Chapter 5: Working with Formulas After the letters are replaced by numbers, you have to resort to another notation to show the original multiplication. If you just fill in the numbers with no grouping symbols, you get I = 5,0000.046, which hardly makes sense. Instead, you use parentheses to separate the values: I = 5,000(0.04)(6). Now, as another example, consider the formula for computing compound interest: rm A = P c1 + n
nt
The letters in this formula are A for the total amount of money accumulated P for the principal or initial money deposited r for the interest rate as a decimal n for the number of times each year the interest is compounded t for the number of years involved Note that the letters in the formula pretty much represent the first letter of each word involved. It isn’t always possible to match each value with its corresponding letter, but, when possible, it’s most helpful to have the coordination. In the compound interest formula, if you’re told to find the interest rate that results in an accumulation of $150,000 when $100,000 is deposited for 5 years and the interest is compounded quarterly, you need to know how to replace the variables with the appropriate numbers. In this example, the $150,000 replaces the A, the $100,000 replaces the P, the letter n is replaced with a 4, and t is replaced with 5. When you replace the letters in the compound interest formula, you get the following equation: 150, 000 = 100, 000 c1 + r m 4
4 (5)
In reallife situations, the substitutions aren’t going to be given to you as A = 150,000, r = 4.5%, and so on. Instead, you have to read, interpret, substitute, simplify, and then solve.
Adjusting for differing units Formulas dealing with perimeter or area need input values in inches, feet, yards, or some other linear measure. Formulas dealing with interest need input values involving money, percentages, and time. But you can’t just enter
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Part II: Taking Intriguing Math to Work values willynilly without considering the units involved. Just because the t stands for time doesn’t mean that you get to put in days or months. You only get to replace with those units if the interest is coordinated with that time measure. The same goes for area and perimeter formulas. For example, say that you’re asked to find the area of a rectangle. If you’re given the length in feet and the width in inches, you need to change one or the other so that the measures use the same units. In general, to change units, you start with the known equivalence between two different units, and then perform multiplication or division to create the numbers that you need. The following examples provide you some practice with changing from one unit to another. Find the area of a factory floor space that’s 40 feet, 8 inches wide by 26 yards, 2 feet, and 9 inches long. The measurements given here are a conglomeration of units, so you need to change all of them to the same unit. However, if you change everything to inches, the numbers will get awfully big. Changing to yards, on the other hand, involves fractions of yards as well as fractions of feet (which I guarantee won’t be fun). So a good compromise is to change everything to feet before computing the area. Here are some tips to help with this problem: The area of a rectangle is found by multiplying its length by its width. (Refer to Chapter 21 for lots more information on area, perimeter, and measures.) Also, keep in mind these equivalents: 1 yard = 3 feet 1 foot = 12 inches So to change the width of 40 feet, 8 inches to a measure in feet only, you have to divide the 8 inches by 12. This calculation gives you 2⁄3 foot. So the width is 40 2⁄3 feet. To change 26 yards, 2 feet, 9 inches to feet, first multiply 26 × 3 = 78 feet. Then divide the 9 inches by 12 to get 3⁄4 foot. The length is 78 feet + 2 feet + 3⁄4 foot = 80 3⁄4 feet. Now, to find the area of this rectangle, you just have to multiply the length by the width, like this: 39, 406 80 3 # 40 2 = 323 # 122 = = 3, 283 10 = 3, 283 5 4 3 4 3 12 12 6
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Chapter 5: Working with Formulas So the area is 3,2835⁄6 feet, or 3,283 feet, 10 inches. You change the 5⁄6 feet to inches by multiplying 5⁄6 by 12. Here’s another example to help you practice unit conversion: What’s the interest on a loan of $21,000 at 9% annual interest if you’re borrowing it for 90 days? Interest is found with the formula I = Prt, where P is the principal or amount borrowed, r is the annual rate of interest (written as a decimal), and t is the number of years you’re borrowing the money. To use the interest formula, you need to change the 90 days into a part of a year. The simplest method is to use ordinary interest (where you use 360 for the number of days in a year) so that when you divide 90 by 360 you get 1 ⁄4 year. (In Chapter 9, you can find an explanation of the difference between ordinary and exact interest.) The annual rate of interest percentage, written as a decimal, is 0.09. And the fraction that will fill in for time, 1⁄4, is equal to 0.25 in decimal form. So, in this problem, I = $21,000(0.09)(0.25) = $472.50. You pay almost $500 for the privilege of borrowing the money for 90 days.
Recognizing operations A mathematical operation tells you to do something to a number or a set of numbers. The four basic operations are: +, –, ×, and ÷. These four basic operations are called binary operations, because they’re performed using two numbers. For example, you add 3 + 5. You can’t add 4 + . A second number is needed to complete the task. “Aren’t all operations binary?” you ask. No. And thank goodness they aren’t. Too many other tasks need to be performed — and many of them on one number at a time. Some of the nonbinary operations for finding a square root, ! for finding a factorial, and : 8 B D indicating to are round back to the greatest integer. While adding and subtracting are indicated only by the + and – signs, this isn’t the case for multiplying and dividing. You can denote multiplication and division several different ways. Read on for details.
Multiple ways of showing multiplication Formulas containing the multiplication operation seldom have the multiplication sign, ×, written in them. Because formulas have letters representing numerical values, a multiplication sign often gets confused with the letter x. The letter x is the most frequently used letter in algebra equations, too, so a multiplication sign isn’t used there, either. Instead of the traditional multiplication sign, multiplication in these cases is indicated with a dot, a grouping symbol, or with nothing at all.
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Part II: Taking Intriguing Math to Work For example, four ways of writing a times b are: ab, a·b, a(b), and a[b]. The simple interest formula I = Prt shows three values multiplied together on the right. And the formula for the sum of integers, S = 1⁄2 n (n + 1), has 1⁄2 multiplying n, which then multiplies the results inside the parentheses.
Dividing and conquering Division is another operation that’s seldom shown with its traditional division sign, ÷, in a formula. The two most commonly used methods of showing division in a formula are to use a slash (/) or to write the numbers involved in the division as a fraction. So 1⁄2 means to divide 1 by 2. And in the formula for n ^ n + 1h^ 2n + 1h , you divide the product finding the sum of squares, S = 6 (result of multiplying the numbers in the numerator) by 6.
Simplifying and Solving a Formula After you’ve determined which formula to use, what each letter in the formula represents, and where to substitute the various numbers (see the previous section for details), you get to simplify the formula and compute for the unknown value. In other words, you get to solve the problem. Most times, you’ll be solving for the lone letter on one side of the equation. But occasionally (when you’re so lucky!), you get to solve for a letter or quantity that’s embedded in the operations of the formula. Now you can’t just go in and start ripping a formula apart. The rules governing solving equations ensure that you get the intended answer. Everyone uses the same rules, so everyone gets the same answer (if, of course, they do their arithmetic correctly). I explain these rules in the following sections.
Operating according to the order of operations Centuries ago, before algebra was done symbolically with letters, exponents, and operations, the processes in math were written out in words and explanations. While this method of using words may have made the directions pretty clear, the method was long and cumbersome, and it wasted space. Along came the algebraic symbols, and the mathematics became neat, tidy, and concise. In addition to these shorthand symbols came some rules that were established so that everyone knew what the symbols meant. This way folks had a road map for following the processes indicated by the symbols.
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Chapter 5: Working with Formulas One important part of this list of rules is the order of operations. The order of operations kicks in when you have more than one operation to perform in an , and the expression. Just as the name implies, the operations of +, –, ×, ÷, exponents (powers) have to line up in order to be performed. When grouping symbols appear in an equation, perform the operations within the grouping symbols first. Grouping symbols include ( ), [ ], { },  , and fraction lines. The grouping symbols supersede any operations, because their contents need to be simplified and changed into a single value. After the groupings are dealt with, you proceed with the rest of the process. The order of operations dictates that, if no grouping symbols interfere, you perform operations in the following order, moving from left to right: 1. Take roots and raise to powers. 2. Multiply and divide. 3. Add and subtract. Try your hand at the order of operations with the example problems in the following sections.
Example 1 Simplify the following expression using the order of operations: 6 + 2 3  4 $ 3 + 18 121 2 Because the expression has no grouping symbols, you know that you first need to deal with the power and root. So raise 2 to the third power and find the square root of 121. Be sure to put a dot or parenthesis to indicate multiplication between the fraction and the answer to the root of 121. After the radical is dropped, you lose the grouping symbol that indicates multiplication. Here’s what your new expression looks like: 6 + 8  4 $ 3 + 18 $ 11 2 Now, moving left to right, multiply the 4 and 3, divide the 18 by 2, and then take the result of the division and multiply it by 11. After all these calculations, you get the following: 6 + 8  12 + 9 $ 11 = 6 + 8  12 + 99 Now, add the 6 and 8 to get 14. Subtract the 12 to get 2, and add the 2 to 99. The final answer is 101.
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Part II: Taking Intriguing Math to Work Example 2 Evaluate numbers in the following formula for compound interest (see Chapter 9): rm A = P c1 + n
nt
= 10, 000 c1 + 0.06 m 4
4 (25)
Note: In this version of the formula, the rate, r, is replaced with 6% (or 0.06), the n is replaced with 4 to represent quarterly compounding, and the t is replaced with 25 for that many years. Start by simplifying the fraction in the parentheses and adding it to 1. Then raise the result to the appropriate power and multiply the result by 10,000. Here’s what your math should look like: A = 10, 000 ^1 + 0.015h
4 (25)
= 10, 000 ^1.015h = 10, 000 ^ 4.43204565h = 44, 320.4565 . 44, 320.46 100
Example 3 Simplify the numbers in the following formula for the payment amount of an amortized loan (see Chapter 12 for more on amortized loans) where $120,000 is borrowed at 0.08 interest for 60 months: R=
120, 000 ^ 0.008h
1  ^1 + 0.008h
 60
You start by first working on the denominator. Add the numbers in the parentheses and then raise the result to the appropriate power. Subtract that result from 1. Multiply the two numbers in the numerator together, and then divide the sum by what’s in the denominator. Your math should look like this: R=
120, 000 ^ 0.008h 1  ^1.008h
 60
120, 000 ^ 0.008h 1  0.61996629 120, 000 ^ 0.008h = 0.38003371 960 . 2, 526.09 = 0.38003371 =
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Making sure what you have makes sense When simplifying expressions involving lots of numbers and operations, it’s easy to make a simple arithmetic error. You may have a mental meltdown, or you may enter the numbers into the calculator incorrectly. For these and several other reasons, it’s always a good idea to have an approximate answer in mind — or, at least, a general range of possible answers. For example, say you want to find the interest earned on a deposit of $10,000 for 10 years. If you come up with an answer of $100,000 in interest, hopefully you’ll realize that the answer isn’t reasonable. After all, that’s more interest than the initial deposit! Unheard of! (Or, if it’s correct, tell me what bank you’re using because I’m going to sign up!) Here’s another example: If you’re determining the monthly payments on a $4 million house and come up with $500 per month, you should be a bit suspicious of your answer (and ever hopeful). Why? Well, if you think about it, $500 per month is awfully low for such a large home — and it would take almost 700 years to pay back just the principal at this rate. True, you’ll come across some situations where you have no clue what the answer should be. I’m faced with them all the time. You just work as carefully as you can, and perhaps check with someone else, too. In the big picture of mathematics, though, using common sense goes a long way toward accuracy.
Computing with Technology Gone are the days of the abacus, the rolledup sleeves, the green visor, and the quill pen. Okay, I’ve really mixed up some computing centuries, but you probably get my point. Technology is here to stay. And that technology can make your life much easier. However, you also can get into trouble much more quickly when using technology; in a complex spreadsheet, a simple error in only one cell can create calculating havoc. In this section, I don’t try to sell you any particular brand of calculator or any particular spreadsheet product. I’m just going to whet your appetite — tease you with some neat features that technology brings to your business math table. The directions and suggestions are as general as possible. So it’s up to you to check out your own personal calculator or computer spreadsheet to find the specific directions and processes necessary.
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Calculators: Holding the answer in the palm of your hand No matter how much you love to crunch numbers in your head, you eventually come across calculations that are too big or too difficult. In that case, you look to a calculator for help. You can work most of these computations with a simple scientific calculator. A scientific calculator raises numbers to powers and finds roots and the values of logarithms. You can go fancyschmantzy and invest in a graphing calculator (or even in one that does calculus), but be aware that the more features you have in your calculator, the more opportunities you have of going astray. Besides, if you don’t need to do fancy calculations, why spend more money on a fancy calculator? The main challenge of using a calculator is to direct the calculator to do what you mean. The calculator computes with a certain set of rules — mostly based on the order of operations (see the earlier section, “Operating according to the order of operations,” for more). So you need to push the right button, use enough parentheses, and interpret the resulting answer. That way your calculator computes the right information and you answer your question correctly. The four basic operations each have their own button on a calculator. When you hit the + or  button, you see the + or – right on the screen. When you hit # , most calculators show the multiplication as an asterisk (*). The ' button usually conjures a slash (/).
Wielding the power of exponents Many financial and geometrical formulas involve exponents (powers) of the values in the expression. Some examples of these types of formulas include the following: Area of a circle: A = πr2 rm Accumulated money from compound interest: A = P c1 + n Regular payment amount in a sinking fund: R =
nt
Ai n ^1 + i h  1
You access the power (exponent) button on a scientific calculator in one of several ways. If you want to square a value (raise it to the second power), you hit the button that looks like this: x2
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Taking advantage of handheld and online calculators Handheld calculators have been around since the 1960s. Some of the first calculators did little more than add, subtract, multiply, and divide. You had the choice between answers correct to two decimal places or the expanded five decimal places. Wow! We’ve come a long way, baby. Nowadays, you have more choices than you can ever fully investigate. For under $10, you can do exponential, logarithmic, and trigonometric computations to an impressive degree of accuracy. When deciding on a calculator, your main considerations are the following: What do you need the calculator for? What type of power source do you prefer (solar or battery, for example)? What type and how large a display do you want?
How big do you want the keys on the keypad (some of us have big fingers)? The big names in calculators are Texas Instruments, HewlettPackard, and Casio, but you’ll find more brands if you hunt around enough. The prices vary, and you can get spectacular deals on eBay. If you don’t want to invest in a handheld calculator, you can find many online calculators that are quite good. These online calculators are usually geared to a specific chore: computing a mortgage payment, figuring percentages, determining a rental amount, converting temperatures or times, computing areas, and so on. In some respects, online calculators make a lot of sense, because technology is changing so rapidly. After all, the calculator or computer you bought yesterday is already obsolete.
The square, or second power, is usually the only power to get its own button on a calculator. Too many other powers are used in computing, so the rest are taken care of with a general power button, which looks like one of the following: / , xy , yx The two buttons with x raised to the y or y raised to the x are sort of scripted. You have to enter the numbers exactly in the correct order for the calculator to compute what you mean. To use this button, you put in the x value first, you hit the button, and then finally you put in the y value. I’m sure you’re dying to try out these new tricks on your calculator. As practice, determine how to enter the following expressions in a calculator: 72 + 1 35 – 41/3 2(58 )
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Part II: Taking Intriguing Math to Work Here’s how you input each of the exponents into your calculator: 72 + 1 " 7 x 2 + 1 or 7 / 2 + 1 or 7 x y 2 + 1 3 5  4 1/3 " 3 / 5  4 / ( 1 ' 3 ) Notice here that the fractional exponent has to have parentheses around the numbers. Negative exponents also require parentheses around them. 2 _5 8i " 2 ( 5 / 8 ) or 2 # 5 / 8 The order of operations dictates that the 5 in this expression is raised to the power first, and then the multiplication takes place. You don’t need to input into your calculator the parentheses to be assured of having the operations done in the correct order. (But they don’t hurt either.)
Distinguishing between subtraction and negativity The subtraction symbol (–) is understood as being an operation. Subtraction is one of the four basic binary operations. And, in algebra, students are told that subtract, minus, negative, opposite, and less are all indicated with the same symbol: the subtraction sign. The algebra ruling works fine when dealing with algebraic expressions. But calculators are a bit fussy and make a distinction between the operation of subtraction (minus and less) and the condition of being negative (opposite). Most scientific calculators have a subtraction button. You also find a separate negative button, which is distinguished from the subtraction button by parentheses: (–). To get familiar with subtraction and negativity, determine how to enter the following expressions in a calculator: 16 –18 –16 – (–18) –34 Here’s how to enter the previous expressions in your calculator: 16  18 " 16  18  16  ^ 18h " ^  h 16  ^  h 18
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Chapter 5: Working with Formulas You can type in the parentheses, but they aren’t really necessary in this case. But when in doubt, always use the parentheses to avoid errors. Look at the difference between not using parentheses around a negative number being raised to a power and then using the parentheses. You get two different answers:  3 4 " ^ h 3 / 4 vs. ^  3h
4
"
( ^ h 3 ) / 4
The answer to this first expression is –81, because the calculator raises the 3 to the fourth power and then changes the number to the opposite. If you want the number –3 raised to the fourth power, you have to put parentheses around both the negative and the 3. Notice that the answer is positive. Why? Raising a negative number to the fourth power gives you a positive result. It’s all tied to the order of operations.
Grouping operations successfully Usually you won’t run into any difficulties if you use more parentheses than necessary. I’m usually pretty heavyhanded with parentheses in math and commas in writing (but my editor takes care of that). The parentheses help you say what you mean — mathematically. Parentheses are needed if you have more than one term in the denominator (or bottom) of a fraction or more than one term in a radical. They’re supposed to make your intent clearer. Using the grouping info I provide, determine how to enter the following expressions in a calculator: 28 and 18  2 2 32 + 5 You input the first expression like this: 28 32 + 5
"
28 ' ( 3 / 2 + 5 )
The parentheses ensure that the power and sum are performed in the denominator, and then the result divides the 28. And here’s how to enter the second expression: 18  2 2
"
( 18  2 / 2 )
You want the root of the result under the radical.
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Part II: Taking Intriguing Math to Work Going scientific with scientific notation Scientific notation is used to write very large or very small numbers in a useful, readable, compact form. A number written in scientific notation consists of [a number between 1 and 10] × [a power of 10] For example, the number 234,000,000,000,000,000,000,000,000 written in scientific notation looks like this: 2.34 × 1026 The power of 26 on the 10 tells you that the decimal point was moved 26 places, from the end of the last zero to directly behind the 2. The number 2.34 is between 1 and 10. Now here’s an example at the opposite end of the spectrum — it includes a number that’s quite small. Writing the number 0.000000000000000000000000000000000000234567 in scientific notation gives you: 2.34567 × 10–37. A negative power is used in this instance, because very small numbers require that the decimal point moves to the right to get the nonzero digit part (the first number) to form a number between 1 and 10. Calculators go into scientific notation mode when the result of a computation is too large for the screen or has more digits than the calculator can handle. Instead of displaying scientific notation like I do here, calculators show an E and then, usually, the exponent. So, if you multiply numbers together and get the result 4.3E16, the calculator is reporting that the answer is written in scientific notation and is 4.3 × 1016 = 43,000,000,000,000,000.
Repeating operations: Simplifying your work with a computer spreadsheet Computer spreadsheets are truly wonderful tools. You not only get orderly reports of numbers all typed out neatly and in regular rows and columns, but you also have computing capability that’s equal to a calculator’s capability. For instance, you can direct the computer spreadsheet to do all sorts of computations, such as adding all the numbers in a column and performing multiplications and additions on selected numbers. And here’s the best thing: You can then tell the spreadsheet to repeat these same operations over and over on lots and lots of numbers. Now you can spend all that extra time lying on a beach somewhere . . . .
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Chapter 5: Working with Formulas In this section, I don’t go into too much detail on how to enter formulas or values, because different computer packages have different rules. But after you see how tables of data are produced, hopefully you’ll be inspired to check into the particular spreadsheet program that you have and find the correct commands to type in. In the following sections, I show you two examples of spreadsheets that you can create. One shows you how to sum up the revenue from different sources, and another determines the payment of an amortized loan.
Summing across rows or down columns A useful type of table is one that shows the revenue from sales, where some of the money from the month’s sales come in that month, another percentage of those sales comes in the second month, and the rest (that actually does come in) is received in the third month. Every month, the total amount of revenue has to be tallied from the different sources — from previous months and from the current billing. Guess what? You can use a spreadsheet to determine the amounts of money coming in each month as a percentage of particular sales. You also can use the spreadsheet to find the sum of all the revenue sources for the month. Show the entries for the columns of a spreadsheet where you expect to collect 50% of the revenue from sales during the first month, 45% of the revenue during the second month, 4% during the third month, and write off the last 1% as a bad debt. Table 51 shows the setup. You copy the three percentage entries into the corresponding cells for each month. If you type in formulas and refer to sales amounts in the first column, the spreadsheet does the computations for you.
Table 51
Creating a Spreadsheet
Projected Sales
January
February
March
January: $400,000
0.5($400,000) = $200,000
0.45($400,000) = $180,000
0.04($400,000) = $16,000
= 0.5($500,000) = $250,000
= 0.45($500,000) = $225,000
= .04($500,000) = $20,000
= 0.5($700,000) = $350,000
= .45($700,000) = $315,000
February: $500,000 March: $700,000 April: $900,000
April
= 0.5($900,000) = $450,000
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Part II: Taking Intriguing Math to Work The table, which extends down for each month’s revenue, could be extended across for a full year or for several years. The spreadsheet does the computation for you, rounded to the number of decimal places you indicate in your setup. With one of the table commands available, you can find the sum of the numbers going across the rows of the table or those going down the columns. Just highlighting and dragging across the values you want usually does the trick. So the sum of the entries in the April column will come out to be 4% of February’s revenue, 45% of March’s revenue, and 50% of April’s revenue. If you change the sales amount (you find an extra $1,000 in April perhaps), the formula structure of the table will not only adjust the percentage amount across the row, but it also takes care of all the columns that are affected, too.
Creating an amortized loan schedule You can determine the monthly payment of a particular loan using one of the appropriate formulas (see Chapter 12 for more on loan formulas). But it gets a bit tedious if you want to find the monthly payments involved in more than one or two scenarios — where you change the interest rate a bit or the length of the loan a bit. You don’t want to have to type the numbers into the calculator over and over again. Thankfully, a computer spreadsheet makes a table of loan payments quickly and accurately. You do have to type in the equation and set up the input values, but after doing the preliminaries, you can immediately copy, drag, and observe all the possibilities. The following example will walk you through the process. Create a chart of the monthly loan payments on a $100,000 loan where you compare interest rates of 8%, 8.25%, 8.5% and 8.75%. Compare these rates at 15 years, 20 years, 25 years, and 30 years. You start with a spreadsheet that has the interest rates, as decimals, at the top of consecutive columns and the years at the beginning of rows. You can see what I mean in Figure 51.
A
Figure 51: Setting up a spreadsheet for loan payments.
1 2 3 4 5 6 7 8
B 0.08 15 20 25 30
C 0.0825
D 0.085
E 0.0875
F
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Chapter 5: Working with Formulas I typed in the interest rates and years, but you can have the computer spreadsheet fill in a bunch of consecutive amounts for you. By simply entering in a command to add a certain amount to each successive value, you save yourself a lot of typing. For instance, in Figure 51 you enter the 15 for 15 years. Then in the cell directly below that one, you enter a command such as “= A2+5.” The number 20 should appear in that cell. Now you can copy the command and drag down through as many cells as you want, and each will show a number that’s 5 more than the previous cell. The same thing works when moving across the interest rates. You can increase by 0.25%, as shown in the figure, or you can pick some other increment. Also, you can format the cells to produce just about any number of decimal points. For example, you can set the format to show you four decimal places; the numbers are then rounded to that many places. Now you’re ready for the fun part: entering the formula referencing the cell positions. The variables in your formula will be entries such as A2 or B3, telling the formula to look at that particular row and column. To begin, remember that the formula for the monthly payment amount of an amortized loan is Pc r m 12 R=  12t 1  c1 + r m 12 where R is the amount of the regular payment, P is the amount borrowed, r⁄12 is the interest rate each month, and t is the number of years. (You can find all the details on this formula in Chapter 12.) Now you type the formula into cell B2 of the table. The following is one possibility for the format of the formula (which is the one I use in my spreadsheet). However, you need to check the instructions and help menu with your particular computer spreadsheet. Here’s the formula I used: = a100,000* _ B1/12i k / a1  _1 + B1/12i / ^ 12*15 hk Yes, this all fits into the one tiny cell. Actually, what you’ll see is just the numerical answer in the cell. The formula should be available in the editing box. You can then copy that cell and hold and drag to the right until the whole row is highlighted. The spreadsheet picks up the interest values from the respective column heads. Figure 52 shows what your row in the spreadsheet should look like.
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Part II: Taking Intriguing Math to Work A
Figure 52: Part of the loan payment schedule.
1 2 3 4 5 6 7 8
B
15 20 25 30
C D E 0.08 0.0825 0.085 0.0875 955.6521 970.1404 984.7396 999.4487
F
When it comes to spreadsheets, you really need to just play around with them. Say to yourself, “I wonder if I can get the spreadsheet to . . .” And, amazingly, you usually can get the spreadsheet to do what you want. When in doubt, consult the program manual for help.
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Chapter 6
Reading Graphs and Charts In This Chapter Making sense of a scatter plot Discovering line graphs Reading and creating histograms Charting portions of a whole with a pie chart
S
ome people love numbers and find it easy to interpret pages full of them. But others are intimidated by them. How can numbers be presented so that they make sense to those who aren’t so great with numbers? Through visuals such as graphs and charts. Graphs and charts provide lots of information quickly. It’s true that a picture is worth a thousand words. After all, you can quickly grasp the financial situation of a business when you see a line on a graph that represents earnings sloping down. These visuals don’t give you detailed information, but they do set the scene as a whole. After you have the situation pictured in your mind, you can then decide how far you need to drill down into the material in order to make an informed decision.
The more common types of graphs are scatter plots, line graphs, and bar graphs (or histograms). Scatter plots are numbers represented by dots distributed about a rectangular area. A line graph connects points to one another. Trends and items that are connected — that affect one another — are best shown with line graphs. In the section on line graphs, you see how to get around the need for a uniform labeling. You also see how graphs can be abused. A bar graph is good for showing volumes or frequencies of items that may or may not have a connection to one another. Other graphs you may use include pie charts, where the differentsized pieces represent different portions of the whole scene, and pictorial graphs, which catch your eye and make a statement at the same time.
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Part II: Taking Intriguing Math to Work The purpose of graphs and charts is to show as much information as quickly, efficiently, and accurately as possible. The labels on the axes are an equal distance apart, and they have numbers that are the same distance apart. With the information in this chapter, you can become better at choosing the best type of graph or chart for your situation. This way you can easily get your information to those folks who need it.
Organizing Scattered Information with a Scatter Plot A scatter plot may look just like what its name implies: a bunch of dots scattered all over the place. A scatter plot is used to see whether the data that it represents has any visible trend or pattern. If the dots are scattered all over the chart with no rhyme or reason, you can safely conclude that there’s no correlation between the values that are being plotted. However, if you see the plotted dots lying more in a clump or in an upwardleaning gathering, you may determine that some connection or trend is taking place between the values. Scatter plots, line graphs, and histograms are drawn with respect to two axes. A horizontal axis and a vertical axis cross one another, and the intersection acts as a starting point for each set of information. For example, you may keep records of the days’ temperatures and make a chart of how many customers you have in your ice cream store on a day with that certain temperature. Or you may be keeping track of the number of hours a machine is run each day and how much it costs per hour to run the machine (averaging in all the labor, materials, utilities, and so on). In Figure 61, you see two scatter plots that are based on the previously mentioned examples. The scatter plot on the lefthand side represents customers and temperatures; on the righthand side, hours and average cost are plotted. Keep in mind that a scatter plot is designed to help you determine whether you see some cause and effect — some pattern or trend.
C o s t
C u s t o Figure 61: m Scatter e plots r s
p e r h o u r
showing trends.
Temperatures
Hours running time
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Chapter 6: Reading Graphs and Charts A scatter plot doesn’t tell you the exact mathematical relationship between two values, but it does show you whether such a relationship in fact exists. If you think that a connection between two different entities does exist, you can then try to write an equation or formula linking the values. (In Chapter 18, you see how the behaviors of costs are related with a mathematical statement.) To create a scatter plot, draw two intersecting perpendicular lines (called the axes) and assign units to the lines based on what’s represented by the numbers you’ll be plotting. You place a point or dot to represent each set of numbers by lining the points up with the units on the axes. Draw a scatter plot showing the data collected on the number of inches of rain during the summer and the yield per acre of a crop. Table 61 shows the data collected over an 8year period.
Table 61
Records of Rainfall and Crop Yield
Year
Inches of Rain
Yield per Acre
1
10
20
2
20
30
3
6
10
4
2
5
5
8
15
6
24
35
7
16
25
8
20
25
The scatter plot has the number of inches of rain along the xaxis (or bottom of the graph), and the yield per acre is shown along the yaxis (or side of the graph). If a relationship is present between the amount of rain and the yield, you should see a pattern emerging in the dots of the scatter plot. Just looking at the data tells you very little. The numbers are all over the place and difficult to decipher. Figure 62 shows you the scatter plot constructed from the data in Table 61. The upward movement of the yield numbers as the rainfall increases seems to suggest that there’s a relationship between the two values.
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40 35 30 Y i 25 e l 20 d 15 10 Figure 62: Comparing rainfall and crop yield.
5 2
4
6
8
10
12
14
16
18
20
22
24
Inches of rain
Lining Up Data with Line Graphs A line graph actually consists of a bunch of connected segments. A line graph connects data that occurs sequentially over a period of time. You use a line graph to show how values are connected when one point affects the next one. For example, a line graph often is used to show how temperatures change during a day, because the temperature one hour affects the temperature the next hour. Another use for a line graph is to show the depreciation of a piece of machinery or other property. The value of an item one year has a bearing on the item’s value the next year. The following sections explain everything you need to know about line graphs.
Creating a line graph The axes used when creating a line graph have numbers or values representing different aspects of the data. The two axes usually have different numbering systems, because the values being compared most likely don’t even have the same units. But the numbering on each axis should be uniform — spaced equally and numbered consecutively.
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Chapter 6: Reading Graphs and Charts When constructing a line graph, you start out somewhat like you do with a scatter plot: You draw your axes and then place points or dots to represent the numbers from your data. The difference is that you connect one dot to the next with a line segment. You do so in order to show that they’re connected and changing. Believe it or not, even a new Mercedes depreciates in value over the years. Table 62 shows the first few years of one car’s value. Draw a line graph to illustrate the value.
Table 62
Depreciation of a Mercedes
Year
Value
0
$56,000
1
$43,120
2
$36,650
3
$33,720
4
$31,360
5
$29,160
6
$27,120
7
$25,200
A line graph is used to display the information in Table 62, because one year’s value of the car is tied to the previous year’s value and the next year’s value. The line graph shown in Figure 63 shows the number of years since the car’s purchase along the horizontal (x) axis and the value of the car on the vertical (y) axis. The line graph helps you see how dramatically the value of the car drops at first and how the drops in the value taper off as the car gets older.
Indicating gaps in graph values You want your graphs and charts to do a lot of explaining without words. So you need to label the axes carefully, use a uniform scale on the axes, and plot the values carefully.
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$55,000 $50,000 $45,000 $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 Figure 63: The depreciation in value of a Mercedes.
$5,000 1
2
3
4
5
6
7
Years
Some data sets don’t cooperate very well when it comes to setting up axes that are constructed correctly and, at the same time, give good information. Sometimes, for instance, problems arise when you want the intersection of the axes to be 0 and the numbers to increase as you move to the right and upward. But you don’t want your graph to be, say, 6 inches across and 90 inches high just to accommodate the numbering protocol. Instead, in this case, you should indicate a gap in the numbering with a zigzag on the axis. For example, if you want to create a line graph of the total city budget from 1993 through 2000, you may have to enter numbers in the billions. Even if you knock off all the zeros and label your axis as being billions, the numbers go from $5,168 billion to $5,758 billion. So you wouldn’t get much detail in the graph from the numbers. On the lefthand side of Figure 64, you see a graph of the total budget for 8 years. The scale is kept uniform and the numbers on the axis go from $0 to $6,000 billion. You don’t see much detail or movement from year to year considering the breadth of the range. An alternative is to put in a break, which looks like a zigzag, to show that values are missing in the numbering system on the axis. By doing so, you’re still able to keep the remaining numbers uniformly distributed to give a better picture of what’s going on. In the righthand graph in Figure 64, you
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Chapter 6: Reading Graphs and Charts see how a break in the axis allows more information to be conveyed by spreading out the upper numbers for more detail. With this break, you see the detail on just how quickly the budget is changing during particular years.
Figure 64: Using a break in the vertical axis.
B i l l i o n s o f d o l l a r s
6,000
B i l l i o n s o f d o l l a r s
5,000 4,000 3,000 2,000 1,000 G 93
94
95
96 Year
97
98
99
6,000
5,000
G 93
94
95
96
97
98
99
Year
Measuring Frequency with Histograms A histogram isn’t some cold remedy (though, doesn’t it sure sound like it?). Histogram is another name for a bar graph. But, as you can probably tell, bar graph is a bit more descriptive; in fact, you probably already have a picture in your mind of what a bar graph is. However, because you’ll often hear these graphs called histograms, I’ll stick with that term throughout this section. Just know that you may see it referred to either way. A histogram is a graph of frequencies — it shows how many of each. With a bar’s height, a histogram shows the relative amount of each category. Unlike a line graph, a histogram doesn’t have to have sequential numbers or dates along the horizontal axis. Why? Because the value of one category doesn’t affect the next one. For instance, you can list the states along the bottom of a histogram to show the area or population of each state. Or you can show the production of some product. Another nice feature of a histogram is that you can compare two entries of each category — perhaps showing the difference between one year’s production and the next. However, the vertical axis has to be uniform in labeling so that the amounts or frequencies are represented fairly.
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Part II: Taking Intriguing Math to Work To create a histogram, you start out with intersecting horizontal and vertical axes. You list your categories to be graphed along the horizontal axis, and you label the units along the vertical axis. Draw a thick line or rectangle above each category to its corresponding height. The rectangles will be parallel to one another, but they’ll usually be different heights. Create a histogram showing the number of hurricanes that hit the United States in each decade of the 20th century. The numbers are as follows: 1901–1910, 18 1911–1920, 21 1921–1930, 13 1931–1940, 19 1941–1950, 24 1951–1960, 17 1961–1970, 14 1971–1980, 12 1981–1990, 15 1991–2000, 14 The histogram you create should have the decades listed along the horizontal axis and the numbers 0 through 24 or 25 on the vertical axis. The bar representing each frequency should be shaded in. The bars can be touching, but they don’t have to be. Figure 65 shows my version of the histogram. I chose not to have the bars touching, because only ten bars are needed. A histogram makes comparing the relative number of hurricanes over the 20th century quite easy. With this graph, you can easily pick out when there were twice as many hurricanes during one decade than there were in another. Try another example: Suppose a flag and decorating company sells five different types of products: flags, banners, table decorations, flag stands, and commemorative pins. The manager wants you to create a histogram showing the total sales of each category for two consecutive years. Table 63 shows the total sales for each category.
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Figure 65: A histogram showing the number of hurricanes that hit the U.S. each decade of the 20th century.
H 20 u r r 15 i c a n 10 e s 5
19011910
19111920
19211930
19311940
19411950
19511960
19611970
1971 19811980 1990
19912000
Decade
Table 63
Total Revenue for a Flag and Decorating Company
Category
Year 1
Year 2
Flags
$450,000
$540,000
Banners
$300,000
$330,000
Table decorations
$50,000
$90,000
Flag stands
$30,000
$40,000
Commemorative pins
$160,000
$290,000
You see that each category had an increase in sales. By creating a histogram with the two years’ sales side by side, you can see how the increases compare proportionately in each category. Also, the histogram allows you to better understand where the main emphasis is for the company — where most of the revenue comes from in the different sales. See Figure 66 to see a completed histogram for this scenario. A picture can’t tell you everything. You can see the relative changes and the comparable revenue amounts. But if you want to determine the actual percent changes and the proportionate amount that each product contributes to the total revenue, you have to figure the percentages. In Chapter 3, you find all the information you need on percent increases and decreases.
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Part II: Taking Intriguing Math to Work $600,000 S a l e s r e v e n u e
$500,000 $400,000 $300,000 $200,000 $100,000
Figure 66: A histogram showing two years’ sales.
Flags
Banners
Year 1
Table decorations
Flag stands
Commemorative pins
Year 2
Taking a Piece of a Pie Chart A pie chart is a circle divided into wedges where each wedge or piece of the pie is a proportionate amount of the total — based on the actual numerical figures. Pie charts are especially useful for showing budget items — where certain amounts of money are going. To create a pie chart, you divide the circle proportionately and draw in the radii (the edges of the pieces). The following sections explain pie charts in more detail.
Dividing the circle with degrees and percents Think of a circle as being divided into 360 separate little wedges. (A circle’s angles all add up to 360 degrees.) Just one of the 360 little wedges is difficult to see — you may not even notice a drawing of one degree in a picture. Table 64 shows you many of the more useful fractional divisions of a circle. (I talk more about degrees in Chapter 7, if you need more information.)
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Fractional Portions of a Circle
Number of Degrees
Fraction and Percent of a Circle 30 = 1 . 8.3% 360 12 45 = 1 = 12.5% 360 8 60 = 1 . 16.7% 360 6 90 = 1 = 25% 360 4 120 = 1 . 33.3% 360 3 135 = 3 = 37.5% 360 8 150 = 5 . 41.7% 360 12 180 = 1 = 50% 360 2
30 45 60 90 120 135 150 180
To give you an idea of how much of a circle some of the angles account for, Figure 67 shows you two circles and some wedges drawn in with their respective fractions. You’ll probably need fractions and degree measures other than those shown in the figure, but these circles show you some representative wedges that you can use to approximate other sizes.
1 = 60˚ 6
1 = 90˚ 4 1 = 45˚ 8 Figure 67: Wedges of a circle and their measurements.
1 = 180˚ 2
1 = 45˚ 8
1 = 120˚ 3
1 = 30˚ 12
5 = 150˚ 12
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Chapter 7
Measuring the World around You In This Chapter Moving between different measurement units Using the metric system Understanding the secret of properly measuring lumber Matching angles and degrees
W
henever you use a ruler, a yardstick, a tape measure, a scale, or a thermometer, you venture into the world of units of measurement. Measures are pretty much standardized throughout the different countries of the world. And gone are the days of using hands (although horses are still referred to as so many hands tall), joints of the thumb, and the distance from your nose to the tip of your outstretched arm. You can now depend on the simple plastic ruler to give you the same measures as the next person’s ruler. When using measurements, you pick the most convenient unit for the situation. For instance, you aren’t going to use inches when measuring the size of a parking lot, and you aren’t going to use tons when weighing boxes of nails. You go with what makes sense. But having said that, you still may have opportunities to mix and match measures, so in this chapter I show you a quick and easy setup that works for all your conversion problems. Also important in this chapter is my discussion on using the metric system. The world is roughly 96% metric and 4% English as far as measurement systems. The metric system seems to become popular periodically in the United States, but the interest comes and goes. In the mid1970s, there was a huge push to go metric. (I still have my “Go Metric” bumper sticker.) The switch to metric in the U.S. will probably never happen, but as long as Americans continue to do business with other countries, you’ll still occasionally (or often!) need to understand and work with metric measures. Finally, I round off this chapter with a section on using angles and degrees. I show you how to break degrees into smaller units, and I also explain how to subdivide angles.
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Converting from Unit to Unit You know that 12 inches equals a foot and that 4 cups are in a quart. But what about changing 16 yards to inches or 400 ounces to pounds? Are you still comfortable when faced with these measures? I hope so. But just in case you aren’t, I offer a basic conversion formula in this section that works for all unitswapping that you may have to do. You do need to start with the basic equivalents (such as 5,280 feet = 1 mile), but after those basics are established, the rest is straightforward and consistent.
Using the conversion proportion You can probably do the easier unit conversions in your head (such as 24 inches equals 2 feet), but sometimes you won’t be sure whether you have to multiply or divide to change from one unit to another. Don’t worry. In this case, you can fall back on a simple proportion. You put in the known value, create two fractions, crossmultiply, and pull out the needed values. In general, you always start out with an equation of a basic, known measurement formula (such as 1 bushel equals 1.24 cu. ft.). Then you put the two sides of the formula into the two numerators (tops) of two fractions. The value to be converted goes under one side of the fraction (the side with the matching unit). You place an x under the other side. Finally, you crossmultiply and solve for x. So in other words, the general setup for converting one unit of measure to another is Left side of known formula = Right side of known formula Same units as left side or x Same units as right side or x The proportion looks rather vague, so I offer several examples to help illustrate how to use the equation for conversions. (If you need help with proportions or basic algebraic equations, refer to those topics in Chapter 4.) If 1 U.S. dollar is equal to 0.65 euro, how many euros is 45 dollars? You may immediately say, “Piece of cake. I just multiply to find the euros.” And you’d be correct. But please bear with me and use the conversion proportion. Getting used to setting up the formulas and values in a simpler problem helps you out when the situation gets more complex. After plugging the numbers into the conversion proportion, you get this equation: 1 dollar = 0.65 euro x euros 45 dollars
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Chapter 7: Measuring the World around You Notice that you have dollars under dollars and euros under euros. Now crossmultiply to solve for x: 1 dollar = 0.65 euro x euros 45 dollars 1 $ x = 45 $ 0.65 x = 29.25 As you can see, 45 dollars equals 29.25 euros. Here’s another problem to practice: How many dollars is 39,600 euros? Do you multiply or divide to solve this problem? What do you divide by? Using the conversion proportion, you start with the basic formula (which you discovered in the previous example problem and can find daily on the Internet or at a bank) and put the 39,600 euros under the part of the formula with euros: 1 dollar = 0.65 euro x dollars 39,600 euros Now you crossmultiply. After doing so, you see that x has a multiplier. Divide each side of the equation by that multiplier. Here’s what your work should look like: 1 $ 39, 600 = x $ 0.65
39, 600 x $ 0.65 = 0.65 0.65 60, 923.07692 = x You find that it takes almost $61,000 to equal 39,600 euros.
Lining up the linear measures A linear measure has one dimension — how long it is. Think of measuring along a straight line. The standard linear measures are inches, feet, yards, rods, and miles. (Metric linear measures are found in the later section, “Making Sense of the Metric System.”) The following are some of the most commonly used linear measure equivalences: 1 yard = 3 feet = 36 inches 1 rod = 16.5 feet 1 mile = 5,280 feet 1 furlong = 660 feet = 220 yards
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Part II: Taking Intriguing Math to Work Try your hand at some linear conversions with the following example. Suppose you need to measure the length and width of a storage room but you forgot your tape measure. You have a pocket calendar that you know is 7 inches long, and you have your clipboard, which is 15 inches long. So you measure the length and width of the storage room with these items. You come up with a dimension of 18 clipboards and 12 pocket calendars long by 18 clipboards and 1 pocket calendar wide. What are the dimensions of the room in feet? First, change the clipboard and calendar measures to inches. The length is (18 × 15 inches) + (12 × 7 inches) = 270 + 84 = 354 inches. The width is (18 × 15 inches) + (1 × 7 inches) = 270 + 7 = 277 inches. Now change inches to feet using the conversion proportion. First, find the length: 1 foot = 12 inches x feet 354 inches 1 $ 354 = x $ 12 354 = x 12 x = 29.5 feet = 29 feet, 6 inches The width is 1 foot = 12 inches x feet 277 inches 1 $ 277 = x $ 12 277 = x 12 x . 23.083 feet = 23 feet, 1 inch So the garage is 29 feet 6 inches by 23 feet 1 inch.
Spreading out with measures of area An area measurement is really just the total number of a bunch of connected squares. When you say that you have a room that measures 36 square feet, you mean that 36 squares, each 1 foot by 1 foot, would fit in that room. Of course, most rooms aren’t exactly 6 feet x 6 feet, 9 feet x 4 feet, or some other combination of whole numbers. More often, a room will be 8 feet, 3 inches by 4 feet, 4.5 inches. If you’ve ever had to lay square tiles in a room, you know that even if the room was meant to be square it doesn’t always come out that way. Thank goodness for tile cutters.
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Area is used for orders of carpeting or tile; area is used to determine how much land you have to build on; area is important when you plan your factory or storage area. To find the area of a region, you use an appropriate area formula. To find the area of a rectangle, for example, you use a different formula than you would to find the area of a triangle. In Figure 71, I show you several types of regions and the formulas you use for finding the area.
Rectangle
w
c
a h
Triangle
l A = lw b A = 1 bh or A = s (s  a ) (s  b) (s  c ) 2 S = 1 (a + b + c) 2 r Figure 71: The areas of different regions.
Circle
A = π r2
You need to identify which type of region you have before you can apply the correct formula. If your region doesn’t match any of the types shown in Figure 71, you need to break the region into rectangles or triangles and find the area of each. You see examples of this method in Chapter 21. The following examples give you a chance to practice calculating some areas with the formulas given in Figure 71. Find the area of a rectangular room that measures 19 feet, 9 inches in length by 15 feet, 4 inches in width. As you can see in Figure 71, the area of a rectangle is length × width. For the computations, you need the measures to be in either inches or feet, and feet makes the most sense when measuring rooms. So first you need to change the feet and inches to just feet. The length is 19 feet, 9 inches, which is 193⁄4 feet. The width of 15 feet, 4 inches is 15 1⁄3 feet. Multiply the two measures, like so: 23
46 19 3 # 15 1 = 79 # 46 = 79 # = 1817 = 302 5 4 3 4 3 3 6 6 4 2
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Part II: Taking Intriguing Math to Work The area is 3025⁄6 sq. ft. (If you don’t remember how to deal with multiplying mixed numbers, head to Chapter 1 where I cover this math in detail.) A triangular lawn measures 300 yards on one side, 400 yards on the second side, and 500 yards on the third side. Find the area of the triangle. One method of finding the area of this triangle is to use this formula: A = 1 bh 2 In this case, you multiply one side of the triangle, b, by the height drawn perpendicular to that side up to the opposite corner, h. Then you take one half of the product. Quite often, though, you don’t have a way of measuring that perpendicular height. Your fallback in this situation is Heron’s formula. To find the area of a triangle whose sides measure a, b, and c in length, use Heron’s formula, which looks like this: A = s ^ s  a h^ s  b h^ s  c h where s is the semiperimeter (half the perimeter). In other words, s = 1⁄2 (a + b + c). For example, to find the area of the triangular lawn whose sides measure 300, 400, and 500 yards, use Heron’s formula. First, you have to find the semiperimeter, which is half of the sum of the sides. 300 + 400 + 500 = 1,200. So, the semiperimeter is found like this: 1⁄2 (1,200) = 600 yards. Now use Heron’s formula to get A = 600 ^ 600  300h^ 600  400h^ 600  500h = 600 ^ 300h^ 200h^100h = 3, 600, 000, 000 = 60, 000 So the lawn measures 60,000 sq. yd. in area. If you’re a fan of Pythagoras (the guy who discovered the relationship between the squares of the sides of any right triangle), you probably noticed that the sides of the previously mentioned triangle make a right triangle. With a right triangle, the two shorter sides are perpendicular to one another, and you can use the quicker formula (A = 1⁄2 bh) for the area of a triangle. But the sides of a right triangle also make for a nice result using Heron’s formula, and I preferred showing you a nice result. You may have looked at the area of 60,000 sq. yd. and said, “Wow. That’s a lot of yardage!” Or, maybe you’re having difficulty imagining 60,000 sq. yd. and need more of a hint of how big that is. If so, read on.
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Who was Heron of Alexandria? Heron of Alexandria, who lived around 67 A.D., discovered and wrote about many diverse mathematical topics. In fact, he’s credited with several formulas, and he commented on the work of other mathematicians, such as Archimedes. Heron is also credited with the following: Determining the formula for the volume of the frustum of a cone Discovering a creative technique used to solve a quadratic equation
Producing some good approximations of the square root of a number that isn’t a perfect square Much of Heron’s math is found in his work, Metrica, which was discovered in the late 1800s in a 12thcentury manuscript in Constantinople. Heron’s real claim to fame, however, is his formula for finding the area of a triangle using the lengths of the sides.
The following are the most commonly used area equivalences: 1 square foot = 144 square inches 1 square yard = 9 square feet = 1,296 square inches 1 square mile = 3,097,600 square yards = 27,878,400 square feet = 640 acres So 60,000 sq. yd. isn’t all that big compared to 1 sq. mi. How many acres are in 60,000 sq. yd.? From the previous list of area equivalences, you see that 3,097,600 sq. yd. is equal to 640 acres. Set up the conversion proportion with the equation involving square yards and acres in the numerators, and with 60,000 sq. yd. under the 3,097,600 square yards. Solve for the unknown number of acres. Your math should look like this: 3,097,600 square yards 640 acres = x acres 60,000 square yards 3, 097, 600x = 640 _ 60, 000i 3, 097, 600x = 38, 400, 000 38, 400, 000 x= 3, 097, 600 . 12.397 So 60,000 sq. yd. is a little over 121⁄3 acres.
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Adding a third dimension: Volume Volume is measured by how many cubes you can fit into a structure. (A cube is like a game die or a lump of sugar.) When you talk about the size of a factory or office building, you give measures in terms of square feet. But the building really has a third dimension: the height of each room. You don’t know, from the square footage of a building, whether the rooms have ceilings that are 7 feet, 12 feet, or more above the floor. The amount of volume in a building plays a huge role when trying to heat and aircondition the space. It also makes a difference when it comes to painting, wallpapering, and decorating.
Finding volume The volume of any right rectangular prism (better known as a box) is found by multiplying the length by the width by the height of the prism. The volume then comes out in terms of how many cubes can fit in the prism. Not all structures are made completely of right angles, so pieces and slices of cubes get involved. But the different formulas you can use make up for any adjustments from the standard cube. Here are the formulas for some of the more commonly used threedimensional structures: Right rectangular prism (box): V = lwh, where l, w, and h represent length, width, and height, respectively Prism: V = Bh, where B is the area of the base and h is the height Pyramid: V = 1 Bh , where B is the area of the base of the pyramid and h 3 is the height perpendicular from the base to the tip of the pyramid Cylinder: V = πr2h, where r is the radius and h is the height Sphere: V = 4 πr 3 , where r is the radius of the sphere 3 Suppose that a room is 20 feet by 35 feet and has a vaulted ceiling that starts slanting at the 7foot level and reaches a peak at 14 feet above the floor. The peak runs lengthwise down the room. What’s the total air volume of the room? Figure 72 shows a sketch of the room. The two ends of the vaulted ceiling form a triangle, so the area above the 7foot level of the walls is determined by finding the volume of a triangular prism. First, find the volume of the rectangular bottom part of the room with V = lwh: V = (35 feet)(20 feet)(7 feet) = 4,900 cu. ft.
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Figure 72: The measurements of a room with a vaulted 7 feet ceiling.
7 feet
35 feet 20 feet
Now find the area of the triangular upper part of the room (which has a triangular base). You can find the area like this: A = 1 bh = 1 ^ 20h^7 h = 70 2 2 The area of the triangle is 70 sq. ft. Multiply that area by the height of the triangular prism, 35 feet, and you get 70 × 35 = 2,450 cu. ft. Don’t confuse the base of the triangular prism that’s used to find the volume of the threedimensional figure with the base of the triangle that’s used to find the area of the end piece of the room. The Base of the triangle is an area measure and the base of the triangle is a linear measure. So the total air volume of the room is 4,900 + 2,450 = 7,350 cu. ft. A lot of warm air goes up into the peak of the ceiling — which is good in the summer but bad in the winter.
Heating and cooling the Great Pyramid When you begin to think that your energy bills are over the top, think about the challenges of climate control in huge structures such as amphitheaters, factories, or malls. And what about the Great Pyramid? It isn’t really hollow, but what if it were? Imagine the bill for airconditioning a structure of that size and dimension.
The Great Pyramid was originally about 481 feet tall, and its square base had sides measuring about 756 feet. The volume of the pyramid was V = 1 Bh = 1 ^ 756 $ 756h^ 481h = 91, 636, 272 3 3 Imagine trying to aircondition that volume in the middle of the Egyptian desert.
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Part II: Taking Intriguing Math to Work Understanding volume equivalences If I declare that the volume of the Great Pyramid is over 91 million cu. ft., you may not quite see the magnitude of the landmark. Even 1 million cu. ft. is difficult to comprehend. So here are some equivalences to help put the Great Pyramid (and other large stuff) in perspective: 1 cubic foot = 1,728 cubic inches 1 cubic yard = 27 cubic feet = 46,656 cubic inches 1 cord = 128 cubic feet 1 cubic mile = 147,197,952,000 cubic feet Some restaurants have woodburning fireplaces to add ambience to the dining experience. So they have to order and store firewood. How many cords of firewood can Gloria, manager of Gloria’s Fine Dining, fit into a storage shed that’s 12 feet long by 8 feet wide by 6 feet high? First find the volume in cubic feet by multiplying the length by the width by the height (V = lwh): V = (12 feet)(8 feet)(6 feet) = 576 cubic feet Now write a conversion proportion with the cord and cubic feet: 1 cord = 128 cubic feet x cords 576 cubic feet 1 $ 576 = x $ 128 576 = x 128 x = 4.5 cords Gloria can fit 4.5 cords of firewood in the shed.
Making Sense of the Metric System The metric system of measurement is used by 96% of the world’s population. The metric system is popular because of its simplicity. Each type of measure (length, volume, and mass) is based on a single unit and on powers of ten of that unit. For lengths or linear measures, the unit is the meter; for volume, it’s the liter; and for mass or weight, it’s the gram.
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Chapter 7: Measuring the World around You Another beauty of the system is the way the different types of measures interact with one another. The gram, for example, is equal to 1 cubic centimeter of water, which is equal to 1 milliliter. Add that to the fact that the metric units are interchangeable with one another and also that conversions use decimals rather than fractions, and the metric system seems to make the most sense for use universally. Even so, the United States is still holding out and chooses to stick to its traditional English system of measure. No matter what the United States does, you’re likely to run into metrics when you’re dealing with numbers from other countries. When that happens, just read through this section, which provides the basics.
Moving from one metric unit to another Converting from one unit to another in the metric system involves nothing more than sliding the decimal point to the right or left. Changing 4.5 decameters to centimeters, for example, means moving the decimal point three points to the right. So 4.5 decameters = 4,500 centimeters. If you know your prefixes, you’re in business to convert from one metric unit to another. The scale in Figure 73 shows the relative positions of the different prefixes used in the metric system.
Figure 73: A scale showing how Latin kilo – prefixes 1000 refer to numbers.
hecto – 100
deca – 10
Unit
deci – 1 10
centi – 1 100
milli – 1 1000
The prefixes tell you the size of a single metric measure. For example, a kilometer is 1,000 meters, and a milliliter is onethousandth of a liter. You use the same prefixes for each of the types of measures. So 1 kilogram equals 1,000 grams. As you can imagine, this uniformity keeps the conversions much simpler. Say that you buy 3.12 liters of olive oil and want to divide it into milliliter spoonfuls for your restaurant’s signature dish. How many milliliters are in 3.12 liters?
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Blame it on the French: Discovering where the metric system came from It was the French, in the late 1700s, who decided that enough was enough. The countries of the world used dozens of different measurement systems. The different standards of measurement caused a lot of confusion and difficulties, especially when the countries began trying to trade with one another. The French wanted to develop a system to be used throughout the world. They decided that a decimalbased system made the most sense; powers of ten allowed for simple conversions. Little by little, this same metric system has been adopted by countries around the world. As of 2007, only three countries in the world have chosen not to use the metric system: Liberia, Myanmar, and the United States. Even though the UK has officially adopted the metric system, it continues to use a mixture of metric and Imperial measures. The meter, the gram, and the liter are the three different types of measures making up the metric system. An attempt was made to connect the basic measures to naturally occurring structures or physical quantities. The meter was
originally defined as being one fortymillionth of the polar circumference of the world. And the kilogram was to be the mass of 1 liter (1 cubic decimeter) of water at 4 degrees Celsius. The meter was later defined as being the distance traveled by light in an absolute vacuum during about one three hundred millionth of a second. (Oh, yeah, I measure that every day.) The metric system also has measures of temperature. In the metric or Celsius system, water freezes at 0 degrees and boils at 100 degrees (rather than the Fahrenheit scale of 32 degrees to 212 degrees). The pros and cons abound regarding whether the United States should change or not change to the metric system. But I won’t bore you with the details here. Suffice it to say that if the U.S. did decide to change, why would we ever have to teach students how to add fractions? Imagine generations of children not having to find common denominators — so sad.
Look at the scale shown in Figure 73. To go from liters (the main unit on the scale) to milliliters, you have to move the decimal point three places to the right. So 3.12 liters is 3,120 milliliters. Not too difficult, is it? Now imagine that you measure along a stretch of road next to your bedandbreakfast with a centimeter ruler (don’t ask why you forgot your tape measure). You come up with 3,243 centimeters. When you order bedding plants to line that stretch of road from a European supplier, you have to use metrics. How many decameters is 3,243 centimeters? By looking at Figure 73, you can see that to go from centimeters to decameters, you have to move three decimal places to the left. The number 3,243 has its decimal point at the right end, so you get 3.243 decameters. Nice work!
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Converting from metric to English and vice versa One of the reasons that the metric system was developed was to eliminate the need for converting from one system to another. Two hundred years later, we’re still doing the measurement conversions. At least, we’re down to two basic systems and some pretty standard conversion values. However, in this section, you’ll see that the numbers aren’t exactly pretty. Converting from metric to English or English to metric isn’t an exact science — and I mean that literally. The measures are approximate — or as close as three decimal places can get you. Here are some of the more frequently used values when converting from metric to English or English to metric: 1 mile = 1.609 kilometers
1 kilometer = 0.621 mile
1 foot = 0.305 meters
1 meter = 1.094 yards
1 inch = 2.54 centimeters
1 centimeter = 0.394 inch
1 quart = 0.946 liter
1 liter = 1.057 quarts
1 gallon = 3.785 liters
1 liter = 0.264 gallon
1 pound = 453.592 grams
1 kilogram = 2.205 pounds
In practical, everyday computations, it’s more common to use 1.6 for the number of kilometers in a mile and 2.2 for the number of pounds in a kilogram. You have to decide, depending on the application, just how precise you need to be. While on a business trip in Europe, you read on a sign that it’s 400 km to Hamburg. How far is that in miles? You can use the following conversion proportion to determine the number of miles: 1 kilometer = 0.621 mile x miles 400 kilometers 1 $ x = 0.621^ 400h x = 248.4 You have about 250 miles to go. If you can drive at 50 miles per hour, that’s a 5hour drive. How many hours is that in Germany? (Just kidding — no conversion needed here. But do watch out for the 24hour clock!)
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Part II: Taking Intriguing Math to Work Suppose you’re told that you need to buy 23 gallons of paint so that your maintenance worker can finish a project in the apartment complex that you own and rent out. The paint you want only comes in liter cans. How many liter cans will it take to finish the project? Use the following conversion proportion involving gallons and liters to find out: 1 gallon = 3.785 liters x liters 23 gallons 1 $ x = 3.785 ^ 23h x = 87.055 So you can see that it will take a few more than 87 liter cans of paint. Now the difficult decision is whether to buy that 88th can. You have to decide whether the maintenance guy can squeeze an extra 0.055 liter of paint out of the last can.
Discovering How to Properly Measure Lumber Have you ever been to a lumber yard? No aroma quite matches that of stacks and stacks of wood — all types of trees and all ages of planks. I have a friend whose business is carving out and constructing cellos. He creates cellos from hunks (very nice hunks) of wood. He buys the wood and then lets it sit for about five years to age before working on it. Such patience. Your exposure to a lumber yard is probably more utilitarian: You need to do some repair to a rental property, you need more shelves in your shop, or you decide to subdivide the showroom portion of your business. In any case, you need to be aware of the pitfalls of measuring spaces and trying to get the lumber measurements to coincide. You’ve undoubtedly heard of pieces of wood referred to as 2 x 4s or 4 x 6s. But did you also know that these measures are lies? A 2 x 4 is really a 1.5 x 3.5. This discrepancy isn’t a conversion issue. It’s basically a shrinkage and finishing issue. Shocked? Yeah, I was too when I found out. But don’t worry. You just need to take into account the actual size of the lumber you’re buying if you need a particular thickness of a wall or deck area. If you don’t add on enough lumber, you’re apt to come up short! In Table 71, I give you some of the more common sizes of lumber pieces and their actual sizes.
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Chapter 7: Measuring the World around You Table 71
Lumber Dimensions
Stated Size of Lumber
Actual Size
1 inch x 2 inches
3
1 inch x 4 inches
3
1 inch x 6 inches
3
1 inch x 8 inches
3
2 inches x 4 inches
11⁄2 inches x 31⁄2 inches
2 inches x 6 inches
11⁄2 inches x 51⁄2 inches
4 inches x 4 inches
31⁄2 inches x 31⁄2 inches
4 inches x 6 inches
31⁄2 inches x 51⁄2 inches
⁄4 inch x 11⁄2 inches ⁄4 inch x 31⁄2 inches ⁄4 inch x 51⁄2 inches ⁄4 inch x 71⁄4 inches
Try your hand at this example: Suppose you’re building a loading dock on the back of a floral business that’s going to be 30 feet long and 12 feet wide. You plan to run the planks perpendicular to the building (and parallel to the 12foot side) and allow for drainage between the planks. If you allow a 1⁄8inch gap between each plank, how many rows of 1 x 6 planks do you need to build the deck? You need 30 feet of 1 x 6 planks laid side by side. As I mention in Table 71, the actual size of a 1 x 6 is 3⁄4 inch x 51⁄2 inches. Don’t worry about the thickness of 3 ⁄4 inch. Instead, simply add 1⁄8 inch (the gap) to each plank width of 51⁄2 inches to get 5 5⁄8 inch units (plank plus gap). Here’s the addition of the fractions: 51 + 1 =54 + 1 =55 2 8 8 8 8 Need some guidance on adding fractions? I show you how in Chapter 1. Now you need to change 30 feet to inches. Do so by multiplying 30 feet by 12 inches to get 360 inches. Now divide 360 by 55⁄8, like so: 360 ' 5 5 = 360 ' 45 8 8 8
360 = 360 # 8 = # 8 = 64 = 64 1 45 45 1 1 This math tells you that it will take 64 rows of 1 x 6 planks to build your loading dock.
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Part II: Taking Intriguing Math to Work
Measuring Angles by Degrees Angle measurements are important to carpenters, architects, pilots, and surveyors. The scientific measurement of angles is usually done in radians, because a radian is a more naturally occurring size (slightly more than 57 degrees). But most of us think of angles in terms of degrees. A degree is 1 of a circle — a very tiny wedge. Using the number 360 to 360 divide a circle into equal pieces was rather clever. After all, 360 has plenty of divisors. You can divide a circle into many, many equal pieces, because 360 divides evenly by 2, 3, 4, 5, 6, 8, 9, 10, 12, 15, 18, 20, 24, 30, 36, 40, 45, 60, 72, 90, 120, and 180. In this section, I show you the properties of angles in figures, and I explain how to subdivide an angle. In Chapter 6, I show you some sketches of the more commonly used angle measures. And in Chapter 21, you can find the different ways that angles are used in navigational and surveying directions.
Breaking down a degree Angle measurements are made with instruments specifically designed for the process. A protractor is one of these instruments. They’re usually in the shape of a half circle and allow you to measure angles of up to 180 degrees. The protractor has marks on it for all the degree measures from 0 to 180. It isn’t practical to try to divide a degree into units that are smaller than the ones on these handheld protractors. Most people wouldn’t be able to see the divisions, anyway. When navigating the skies or the seas, though, a fraction of a degree one way or the other can make a huge difference in whether you reach your destination. As I mention earlier, a degree is 1 of a circle. Each degree is itself subdivided 360 into 60 smaller units called minutes. Each minute is subdivided into 60 smaller units called seconds. So each degree — which is small to begin with — is divided into 60 × 60 = 3,600 smaller portions for increased accuracy. A single prime (') indicates minutes, and a double prime (") indicates seconds. So, the angle measure given as 55°45'15" is read as 55 degrees, 45 minutes, 15 seconds. The degreeminutesecond notation is just grand, but it isn’t very helpful when combining with other numbers in operations. For instance, if you want to multiply the angle measuring 55°45'15" by 6, you have to multiply each subdivision by 6, rewrite the minutes and seconds so that they don’t exceed 59 of each, and adjust the numbers accordingly. So usually you’ll find it much
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Chapter 7: Measuring the World around You easier to change the angle measure to a decimal before multiplying or otherwise combining. I show you how to do this in the following example. And, just in case you doubt my judgment on which method is easier, I include the math for both. Multiply 55°45'15" by 6. Method 1: Multiply each unit by 6 and adjust. 55° × 6 = 330°. 45' × 6 = 270'. To adjust, divide by 60. 270' ÷ 60 = 4 plus a remainder of 30. Because 60 minutes makes a degree, this result represents 4 degrees and 30 minutes. 15" × 6 = 90". Adjust by dividing 90 by 60. 90" ÷ 60 = 1 plus a remainder of 30. Sixty seconds makes a minute, so this result represents 1 minute and 30 seconds. Now combine all the degrees, minutes, and seconds from the multiplications and adjustments. Degrees: 330 + 4 = 334°. Minutes: 30 + 1 = 31'. So the final result is 334°31'30". Method 2: Change the measure to a decimal and multiply by 6. Divide the number of minutes by 60 and the number of seconds by 3,600 to get the decimal equivalent of each unit. Then add the decimals to the degree measure. 45' 60 = 0.75 and 15" ÷ 3,600 ≈ 0.0041667. If you add the decimals to the degree measure, you get 55 + 0.75 + 0.0041667 = 55.7541667. Multiplying the sum by 6 gives you: 55.7541667 × 6 = 334.5250002. Now to compare the answers from the two methods, change the 334°31'30" to a decimal by dividing the 31' by 60 and the 30" by 3,600. 31' ÷ 60 ≈ 0.5166667, and 30" ÷ 3,600 ≈ 0.0083333. So 334°31'30" = 334 + 0.5166667 + 0.0083333 = 334.5250000. With rounding, the two answers differ by 0.0000002. Not too bad.
Fitting angles into polygons A polygon is a dead parrot. Get it? Polly gone? Sorry. That’s lame math teacher humor. Okay, the real scoop is that a polygon is a manysided closed figure made up of segments. What I mean by closed is that each segment is connected by its endpoints to two other segments; in other words, you have an inside and an outside. You can determine the total number of degrees of the angles inside a polygon if you know how many sides there are.
95
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Part II: Taking Intriguing Math to Work A polygon with n sides has interior angles measuring a total of 180(n – 2) degrees. Here are some examples plugged into the formula: A triangle has three sides, so the total of all the degrees inside it is 180(3 – 2) = 180(1) = 180 degrees. A rectangle has four sides, so the total of all the degrees inside it is 180(4 – 2) = 180(2) = 360 degrees. A hexagon has six sides, so the total of all the degrees inside it is 180(6 – 2) = 180(4) = 720 degrees. You know that not all areas in a building follow the nice geometric shapes — you have nooks and crannies and other odd outcroppings. So does this rule for the total interior angles still work for odd shapes? You betcha! Check out the following example, which proves my point. Figure 74 shows a possible layout for a large work area. The angle measures are shown at each interior angle. What’s the total of the interior angle measures of the area shown in the figure? The area has eight sides. Using the formula, you get 180(8 – 2) = 180(6) = 1,080 degrees for a total of the inside angles. Does this match with the degrees shown in the sketch? Add up the angles to find out: 77 + 90 + 90 + 270 + 270 + 90 + 90 + 103 = 1,080 degrees. Yup! The formula works, even with oddshaped areas.
77˚
103˚
270˚
270˚
90˚ Figure 74: A room with many angles. 90˚
90˚
90˚
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Chapter 8
Analyzing Data and Statistics In This Chapter Taking your raw information and turning it into something useful Choosing which of the three average values you should use Including standard deviation in your analysis
D
id you know that an author has published a book entitled How to Lie with Statistics? Actually, you could change the word statistics to just about any mathematical term and easily come up with some examples of how to mislead readers. But statistics especially seem to lend themselves to misinterpretation and abuse. The world of statistics consists of figuring out how to collect data, organizing your data, and then drawing meaningful conclusions. The conclusions you draw will deal with the average (or middle value) and the spread around the average. You use computations with formulas or charts and graphs. In business, it’s important to present statistics as clearly and neutrally as possible. It’s always tempting to put a positive spin on data, but if the numbers are trending down, the leaders in the company need to know. And if you’re assessing the stats of another company, you need to understand how to determine whether the numbers have been slanted to present a pretty picture that doesn’t match reality. In this chapter, I don’t tell you how to ferret out all the spin, but I can make you more aware of the potential for misuse. If you’re a knowledgeable reader or consumer of statistics, you’ll have less of a chance of being duped. So I offer information on how data is organized and how computations are made.
Organizing Raw Data Data is information. Data is facts and figures. Data is something that’s known. One problem with raw numerical data is that it’s often presented or available in a format that gives little useful information regarding what it’s all about.
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Part II: Taking Intriguing Math to Work For instance, if you’re given a list of the number of cars sold each day of the year at a dealership and it goes something like 4, 7, 6, 5, 8, 7, 6, 5, 7, 5, 4, and so on, you’re likely to say, “Wait! This is meaningless!” And you’d be right. A list of numbers like this may tell you that no more than 8 cars were sold on any one day, but it doesn’t tell you such things as How many cars are sold on each day of the week? How much revenue is attached to the number of cars sold? What number of cars sold in a day happens more frequently? What days of the week yield the most car sales? What’s the average number of cars sold? Many other useful bits of information could add meaning to these numbers. The key to using data successfully is to have it organized. When the data is organized, you can draw conclusions, do computations, and make predictions. In the following sections, I provide a few options for organizing your data.
Creating a frequency distribution A frequency distribution is one structure or process for organizing data. It tells you how often a particular score or value occurs. For example, a frequency distribution is a good way to present the following information: The number of customers who come into your shop each day. The number of cell phones activated during each hour that your business is open. The number of stops made by the delivery person during each shift. With a frequency distribution, you gather all the scores or values that are the same and count how many of them you have. For example, say that you have a list of 75 numbers. Almost all the numbers repeat. Rather than add all 75 numbers one at a time, you can organize them in a frequency distribution. By doing so, you determine how many of each number there are (how many 5s, how many 7s, and so on), and then you use multiplication and addition to get the result. In other words, you multiply the number of times the number occurs by that number and add the products together. This method gives you an easier and more accurate result. After all, when a list of numbers is too long, you may tend to lose track of where you are in your addition and make errors. How many times have you had to start all over again when dealing with long lists of numbers?
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Chapter 8: Analyzing Data and Statistics A frequency distribution is usually presented as a table in which all the possible scores or numbers are listed in order (from lowest to highest or highest to lowest). A tally is made in another column. A tally consists of hash marks (  ) where you make a mark for each number and slice through four of the hash marks when you get to a group of five, like this:  . You probably used these tallies as a kid when you were in competition with your friends. Table 81 shows a frequency distribution of the following numbers: 4, 7, 6, 5, 8, 7, 6, 5, 7, 5, 4, 5, 6, 8, 8, 6, 4, 3, 5, 6, 7, 6, 5, 4, 3, 4, 5, 6, 7, 8, 8, 8, 6, 6, 3, 4, 3, 6, 4, 5, 6, 0, 6, 5, 3, 6, 3, 5, 6, 7, 7, 6, 5, 4, 3, 2, 2, 4, 5, 6, 7, 6, 7, 7, 8, 5, 6, 5, 4, 6, 6, 6, 4, 3, 3. The numbers in the table go from a low of 0 to a high of 8. The third column gives the frequency of each number, which is simply the result of the tallies in the second column. The total is obtained from adding the numbers in the frequency column.
Table 81
A Frequency Distribution of the 75 Numbers
Number
Tally
Frequency
0

1
1
0
2

2
3
 
9
4
  
11
5
  
14
6
    
21
7
 
10
8
 
7
Total
75
Grouping values together in a frequency distribution Sometimes a tally involves many items with a wide range of values. For instance, you may have the length of time (in minutes) that customers walk through your company’s showroom. Listing all the possible values may take a page or two of paper — especially when the range is from 0 to 100 or from
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Part II: Taking Intriguing Math to Work 1,000 to 10,000 (that would be a long time to wander the showroom). One method that eliminates the need for so many numbers is to do groupings of values. For example, you can make groups that consist of all the numbers from 1 to 5, 6 to 10, 11 to 15, and so on. The only stipulation is that you keep the groupings equivalent in terms of size. A good rule of thumb is to plan on having about ten different groupings of numbers (give or take a few). Groupings are a good way to present information such as The salary amounts of your office’s employees. The number of light bulbs sold in your store on any given day. The number of plates of spaghetti sold in an evening at your restaurant. To determine how to divide a set of numbers into groups, look at the range of numbers or values that you have collected. What’s the range from the highest number to the lowest? If your listing of numbers goes from a low of 3 to a high of 97, your range is 95 numbers (97 – 3 + 1; you add the 1 so that both 3 and 97 are included in the count). After you find your range, divide that number by 10 (which, as I mention earlier, is a good number of groupings to have). If you divide 95 by 10, you get 9.5. In this case, the best arrangement probably would be to have ten groupings of ten numbers. So now you can let the first grouping be the numbers 1 through 10; the second grouping would go from 11 through 20. From there you can calculate the groupings all the way up to the last grouping going from 91 through 100. I know that the numbers you’ve collected don’t go down to 1 or up to 100, but this way the intervals are all the same size, and they cover all the numbers pretty symmetrically. Ready for some practice in setting up a frequency distribution with groupings? Great! Try this one out: Say that you’ve been keeping track of the number of miles driven each week by your sales associates. You want to organize them in a frequency distribution. What does your distribution table look like? To begin, take a look at Table 82, which shows the mileage records of your eight associates.
123 285 439 456 898 453 435
Week 1 Week 2 Week 3 Week 4 Week 5 Week 6 Week 7
Associate 1
868
228
456
599
842
483
444
Associate 2
456
866
522
444
576
533
574
Associate 3
456
856
464
113
488
563
893
Associate 4
235
266
533
634
574
234
938
Associate 5
956
234
222
331
267
442
722
Associate 6
762
155
453
165
55
433
422
Associate 7
544
442
886
986
466
532
349
Associate 8
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The Mileage Records of the Company’s Sales Associates
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Table 82
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Part II: Taking Intriguing Math to Work Looking through the list, you can see that the numbers range from a low of 55 miles to a high of 986 miles. The range is 932 miles (986 – 55 + 1), so your best bet is to have 10 groupings starting with 0 to 99 and going up to 900 to 999. Table 83 shows you the tally created and the frequency in each grouping.
Table 83
The Frequency Distribution of SalesAssociate Mileage
Range
Tally
0 – 99

1
100 – 199

4
200 – 299
 
8
300 – 399

2
400 – 499
   
18
500 – 599
 
10
600 – 699

1
700 – 799

2
800 – 899
 
7
900 – 999

3
Total
Frequency
56
This frequency table is much more informative than the original listing of numbers in Table 82. In fact, this table is probably even more informative (and easier to set up) than listing all the numbers in order from smallest to largest or vice versa. Why? Well, for starters, the manager gets a feel for the expected or more frequent mileage numbers. Also, the highest and lowest numbers stand out more and may trigger some inquiries. Finally, the mileage information helps in planning the salesperson’s time and reimbursement projections.
Finding the Average When you read about the average income across the country, you probably think in terms of a number that falls in the middle of the entire spectrum of incomes. In general, that’s a correct thought — the average usually is the middle or most used value. But, in fact, the average value can be determined one of three ways. In other words, the “middle” average is just one way. The average can be the mean, the median, or the mode.
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Chapter 8: Analyzing Data and Statistics The purpose of having three different ways of measuring the average is to give the best and most descriptive number for the average of a particular collection of numbers. Unfortunately, having the three choices can lead to some abuse of numbers and some misrepresentation of what’s in the collection. So, in the following sections, I show you all three methods of finding the average, and I let you decide what works best for describing the average value in your situation.
Adding and dividing to find the mean The mean average is the number determined by adding all the numbers in a collection and dividing by the number of numbers that you’ve added together. Want to see the actual formula? The mean average of the numbers a1, a2, a3, . . . an is equal to the sum of the n numbers divided by n: a1 + a 2 + a 3 + g + a n n Find the mean average of these numbers: 8, 6, 4, 9, 2, 2, 5, 4, 7, 3, 9, 6. To find the mean, add the numbers and divide by 12. You divide by 12 because you have 12 numbers in the list. Here’s what the math looks like: 8+6+4+9+2+2+5+4+7+3+9+6 12 65 5 = =5 . 5.417 12 12 The mean average, 5.417, isn’t on the list of numbers, but it somewhat describes the middle of the collection. Suppose a notsoethical factory owner objects to the bad press that he has been receiving from his employees, who are complaining that his pay scale is much too low. When interviewed, he expresses incredulity that his employees would complain. After all, the average salary for everyone at the factory is $53,500. The nine employees who are complaining claim that they’re making only $15,000. How can this be? If the nine employees are each making $15,000, and if the average salary of the nine employees and the owner is $53,500, you can easily find the owner’s salary by solving for x, like this: 9 _15, 000i + x = 53, 500 10 135, 000 + x = 53, 500 10 135, 000 + x = 535, 000 x = 535, 000  135, 000 = 400, 000
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Part II: Taking Intriguing Math to Work If the owner is taking home $400,000, the mean average salary of the ten people is, in fact, $53,500. So the owner isn’t exactly lying, but he’s definitely using a method that doesn’t paint a true picture. This is a case of the mean average not really representing the true average or middle value. A better measure of the average salary in this case is the median or the mode, which I explain later in this chapter.
Locating the middle with the median The median is the middle of a specifically ordered list of numbers (to remember this one, just think about a median that runs down the middle of the highway). The median as an average or middle of a set of numbers is a great representation of the average when you have one or more outliers. An outlier is a number that’s much smaller or much larger than all the other values. For instance, you may remember in school when that one classmate always scored 100 or 99 even when the rest of you struggled for a 70. Those curvebreakers were so annoying. A curvebreaker is sort of like an outlier. The higherthanusual score hiked up the average for everyone. The median average is designed to lessen the effect of that unusual score. The median is the middle number in an ordered (highest to lowest or lowest to highest) list of numbers. If the list has an even number of entries (meaning there is no middle term), the median is the mean average of the middle two numbers. (Refer to the previous section if you need guidance on finding the mean average.) Find the median of the following numbers: 8, 6, 4, 9, 2, 2, 5, 4, 7, 3, 9, 6. First put the numbers in order from least to greatest: 2, 2, 3, 4, 4, 5, 6, 6, 7, 8, 9, 9. Because the list has 12 numbers, the 6th and 7th numbers in the list are in the middle. The two middle numbers are 5 and 6. So to find the median, you have to find the mean average of 5 and 6. You do so by adding the numbers together and dividing by 2. You get 5.5 as the mean. As it turns out, the mean average of the entire list is 5.417 (see the example in the previous section), so the mean and median are pretty close in value in this situation. Having two averages of the same list that are close together in value gives you more assurance that you have a decent measure of the middle. The ages of the 15 employees at Methuselah Manufacturing are 18, 25, 37, 28, 23, 29, 31, 87, 20, 24, 30, 21, 22, 93, 19. Find both the mean and median ages and determine which is a better representation of the average age.
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Chapter 8: Analyzing Data and Statistics The mean average is the sum of the ages divided by 15: 18 + 25 + 37 + g + 19 = 507 = 33.8 15 15 As you can see, the mean average age is 33.8, which is a higher number than all but three of the actual ages. Now find the median by putting the ages in order from lowest to highest: 18, 19, 20, 21, 22, 23, 24, 25, 28, 29, 30, 31, 37, 87, 93 You have an odd number of values, so your middle age is the eighth number in the list: 25. An average age of 25 (rather than 33.8 with the mean average) better represents most of the actual ages. The two oldest employees are so much older than the others that their ages skew the middle or average age.
Understanding how frequency affects the mode The mode of a set of numbers is the mostfrequently occurring number — it’s the one that’s listed most often. The mode is a good average value when the number occurs overwhelmingly frequently in the list. The following three sets of numbers all have a mode of 5: A) 1, 1, 2, 2, 2, 3, 3, 4, 4, 5, 5, 5, 5, 5, 5, 6, 6, 6, 7, 7, 8, 10 B) 1, 2, 3, 4, 5, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18 C) 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 999, 999 The mode of 5 in the first and third lists seems to make the most sense as representing the average of the list. In the middle list, however, even though 5 is technically the mode, it doesn’t seem to represent what the list of numbers is. In this case, you might want to find the average another way. Suppose you want to show that your nonprofit foundation is kidfriendly, but you don’t want to reveal how many children are in specific families. Determine which average is the best representation of the number of children of the 43 families served by your foundation: 0, 5, 6, 0, 3, 4, 0, 4, 10, 14, 7, 0, 6, 2, 3, 0, 4, 5, 4, 8, 7, 3, 5, 3, 2, 6, 3, 3, 0, 2, 2, 6, 1, 2, 3, 2, 2, 4, 4, 4, 6, 1, 2. First put the numbers in order. You must do this when finding the median, but it’s also helpful to have an ordered list when figuring the mean and mode. In order, the numbers are 0, 0, 0, 0, 0, 0, 1, 1, 2, 2, 2, 2, 2, 2, 2, 2, 3, 3, 3, 3, 3, 3, 3, 4, 4, 4, 4, 4, 4, 4, 5, 5, 5, 6, 6, 6, 6, 6, 7, 7, 8, 10, 14.
105
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Part II: Taking Intriguing Math to Work The mean is the sum of the numbers divided by 43. The sum is 158, and 158 ÷ 43 ≈ 3.674. The median is the middle number, which in this case is the 22nd number. So, the median is 3. The mode is the most frequent number, which after counting is 2 (there are eight 2s). So, which outcome —3.674, 3, or 2 — do you think is the best representation of the list? The two outliers (10 and 14) pull the average up a bit. I’d probably go with the middle (median) of the averages — but it’s really your call on this. You can correctly say that any of the values is the average.
Factoring in Standard Deviation The average of a listing of numbers tells you something about the numbers, but another important bit of information is the variance or standard deviation — how much the numbers in the listing deviate from the mean average (see the earlier section, “Adding and dividing to find the mean,” for more on mean averages). The standard deviation is a measure of variation and can be a decent comparison between two sets of numbers — as long as the numbers have some relation to one another. After all, as with other facets of statistics, you have to be careful not to misrepresent what’s going on just because you can.
Computing the standard deviation Standard deviation is a measure of spread. This spread has to do with how far most of the numbers are from the average. For example, you may be interested not only in the average number of sales of your staff members, but also whether the sales cluster closely around that average or are much higher and much lower than the average. Is your staff pretty predictable and steady, or are they all over the place with their sales endeavors? Standard deviation is a number representing the deviation from the mean. So the greater the standard deviation, the more numbers you’ll find that are farther from the mean average. To find the standard deviation of a list of numbers, use the following formula: s=
!x
 n^xh n1 2
2
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Chapter 8: Analyzing Data and Statistics where Σx2 represents the sum of all the squares of the numbers in the list, n is the number of numbers, and x represents the mean average of the numbers (which is squared in the formula before multiplying it by n). Each of the following three lists of numbers has a mean average of 5: A) 1, 2, 3, 4, 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 5, 6, 7, 8, 9 B) 1, 2, 2, 3, 3, 3, 4, 4, 4, 4, 5, 5, 5, 6, 6, 6, 6, 7, 7, 7, 8, 8, 9 C) 1, 1, 1, 1, 1, 1, 1, 1, 1, 1, 1, 5, 9, 9, 9, 9, 9, 9, 9, 9, 9, 9, 9 To find the standard deviation of list A, you square each number and then add up all the squares. Because the number 5 repeats 15 times, I show that as a multiple of 12: 12 + 22 + 32 + 42 + 15(52) + 62 + 72 + 82 + 92 = 635 You know that the mean average of the list is 5, and you know that there are 23 numbers in the list. Now all you have to do is substitute the numbers into the formula: s=
!x
 n^xh n1 2
2
635  23 ^ 5 h = 23  1 60 . 1.65 22 2
= =
635  575 22
Using the same process on lists B and C, you get standard deviations of about 2.132 for list B and exactly 4 for list C. So the first list of numbers has the smallest deviation, and the last list of numbers has the greatest deviation. At a local ice cream factory, the hourly wages of the employees are as follows: 4 employees earn $8.00 per hour 7 employees earn $8.50 per hour 20 employees earn $9.25 per hour 25 employees earn $10.00 per hour 4 employees earn $12.00 per hour What’s the (mean) average wage of the employees, and what’s the standard deviation?
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Part II: Taking Intriguing Math to Work This type of problem is solved more easily with a chart or table. So take a look at Table 84, which I created for this scenario.
Table 84
Hourly Wages of Employees
Hourly Rate
# Employees
Rate × # of Employees
Square of Rate
Square × # of Employees
8.00
4
32
64
256
8.50
7
59.50
72.25
505.75
9.25
20
185
85.5625
1,711.25
10.00
25
250
100
2,500
12.00
4
48
144
576
Totals
60
574.5
5,549
First, to compute the mean, you need to find the sum of the hourly rate of all 60 employees. Look at the sum of the third column, 574.5, where each rate has been multiplied by the number of employees earning that rate. Divide 574.5 by 60 (the number of employees) and you get 9.575. The (mean) average hourly rate is about $9.58. To compute the standard deviation, you need the sum of the squares of all 60 wage rates. The last column has the square of each rate multiplied by the number of employees involved. The sum of the squares is 5,549. You have to multiply the number of employees, 60, by the square of the mean. 9.5752 = 91.680625. Now you’re all set to put the numbers into the formula for the standard deviation: s= =
!x
 n^xh = n1 2
2
5549  60 ^ 91.680625h 60  1
5549  5500.8375 = 59
48.1625 . 0.816314 . 0.904 59
The standard deviation is about $0.90, or 90 cents.
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Part III
Discovering the Math of Finance and Investments
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In this part . . .
othing is more common to different peoples’ interest than the mathematics of finance. Whether you’re earning interest compounded quarterly or paying off an amortized loan, you’re involved with the intricacies of interest, principals, and percentage rates. With the chapters in this part, you can become better prepared to compare the many different financial products out there. By the end of this, you’ll be ready to stand as your own financial advocate. But it never hurts to get some professional advice either.
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Chapter 9
Computing Simple and Compound Interest In This Chapter Getting the skinny on interest Exploring simple interest computations Finding out the formulas for compounding interest Using interest to your best interest
I
nterest is basically a percentage of some amount of money. It’s either the amount of money that you pay someone for the use of their money (such as for a loan or credit card) or the amount that you’re paid for the use of your money (such as with a savings account at a bank). The concept and practice of determining interest has been around since ancient Babylonian mathematicians created tables of numbers to determine how long it takes to double one’s money at a particular interest rate. Interest can be simple — as is the case with simple interest — but it can also be complex — as with compound interest. (I explain each of these in this chapter.) Extensive tables that provide numbers that you can use in calculations of interest are available, but the computations are so easily achieved with a standard scientific calculator that you don’t need to tote tomes of numbers around with you. In this chapter, you discover the hows and whys of computing interest. You also see the effect of time and rate. It’s best if you have a calculator at hand to confirm or deny the computations of the example problems. However, even though the calculations aren’t difficult, you need to be careful when entering the entries into your calculator. Why? What you type in may not be what you mean. For example, if you want to raise a number to a fractional power, you need to put the fraction in parentheses. Typing 8^2/3 tells your calculator to raise 8 to the second power and
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Part III: Discovering the Math of Finance and Investments then divide by 3. If you really meant that you want to raise 8 to the 2⁄3 power, you have to put the 2⁄3 in parentheses. Calculators use the order of operations and perform powers before multiplication or subtraction (see Chapter 5 for more on the order of operations).
Understanding the Basics of Interest Interest is money. And if you’re the borrower, you pay for the privilege of using the money. If you’re the lender, you’re paid the interest for your service of providing the money. The amount of money being borrowed or loaned is the principal, or the initial amount. The rate of interest is the percentage of the principal that it costs to borrow the money (or that you’re paid for using the money). And the time is the period — in years, months, or days — that the transaction is taking place. Yes, I know, that’s a lot of terms to keep straight, but they’re all important when it comes to understanding how to compute interest. Here are the two basic types of interest that you’re likely to come across: Simple interest: This type of interest is computed on the principal — the amount borrowed — for the entire length of time of the transaction. Compound interest: This interest builds on itself. Money earned in interest for part of the time period is reinvested and used in the computation of interest for the rest of the time period. I explain both of these types of interest later in the chapter.
Simply Delightful: Working with Simple Interest Interest on money is the cost of buying things on credit. The fee you pay for the privilege of using someone else’s money is the interest, and the amount you get for lending someone money is also interest. The simplest computation of interest is simple interest (now, isn’t that handy). In this section, you see how simple interest works and how the different components, such as principal, rate, and time, interact with one another. Note: Many of the properties of simple interest are closely related to those of compound interest, so you see properties that are introduced here repeated — with an interesting twist — in the sections on compound interest.
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Chapter 9: Computing Simple and Compound Interest
Computing simple interest amounts the basic way The formula for computing the amount of simple interest earned on a particular amount of money is I = Prt where P is the principal (the amount of money involved in the transaction), r is the rate of interest (written as a decimal number), and t is the amount of time (usually in years, if r is the yearly rate). To compute, you simply fill in the numbers you have and solve for the missing ones. It can’t get much easier than that! (If you need guidance on decimal equivalents, check out Chapter 2.) Check out this example for practice: Suppose Jake borrows $4,000 for a new piece of equipment. He borrows the money for 2 years at 11.5% interest. How much does he pay in interest, and what’s the total amount he has to repay? To solve this problem, simply plug your numbers into the formula (I = Prt), like this: $4,000(11.5%)(2 years) = $4,000(0.115)(2) = $920. So Jake owes $920 in interest plus what he borrowed, which is $920 + $4,000 = $4,920.
Seeing how small businesses use simple interest Simple interest is frequently used when small businesses act as lenders in order to sell products. For instance, a local hardware store may sell you a mechanized posthole digger and arrange for payments over the next two years. In this situation, an interest rate is set and a time period is agreed on. The amount loaned (plus the interest) is repaid periodically rather than at the end of the time period. Here’s an example that shows what I mean: Say that Delores purchases a new bedroom set from a local furniture store. She makes arrangements with the store to pay for the $3,995 bedroom set over the next 4 years at 12% interest (simple interest). If she is to make equal monthly payments, how much are those payments? First determine the amount of interest that she’s paying by using I = Prt: $3,995(0.12)(4) = $1,917.60. Add the interest to the cost of the bedroom set to get the total amount: $3,995 + $1,917.60 = $5,912.60. Now divide the total amount by 48 (4 years × 12 months per year) to get $5,912.60 ÷ 48 = $123.17916.
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Part III: Discovering the Math of Finance and Investments The division doesn’t come out evenly, so Delores will pay $123.18 each month for the first 47 months, and then she’ll pay $123.14 for her last payment. How did I figure the last payment? Well, if you multiply $123.18 by 47, you get $5,789.46 in payments. That leaves $5,912.60 – $5,789.46 = $123.14 for the 48th payment. Sure, it’s only 4 cents, but Delores is a stickler for detail.
Solving for different values using the simple interest formula The simple interest formula allows you to solve for more than just the amount of interest accumulated. You also can use the formula to find the value of any of the variables — if you have the other three. For instance, you can determine the interest rate from the amount of interest paid. See how in the following example. Freddy agreed to make quarterly payments of $781.25 for 4 years on a loan of $10,000. What simple interest rate is he paying? You first need to determine the total amount of money being repaid. If Freddy is making 4 payments a year for 4 years, you know that he’s making 16 payments of $781.25. So his total repayment is 16 × $781.25 = $12,500. You also know that he borrowed $10,000, so the interest he’s paying is: $12,500 – $10,000 = $2,500. The interest amount, $2,500, is the answer to the interest formula, I = Prt. So replace the I with $2,500, replace P with $10,000, replace t with 4, and then solve for r. Your math should look like this: 2, 500 = 10, 000 ^ r h^ 4 h 2, 500 = 40, 000r 40, 000r 2, 500 = 40, 000 40, 000 0.0625 = r So, as you can see, Freddy is paying 6.25% interest on his loan. Now try out this example, which asks you to use I = Prt to solve for the principal amount. Say Hank was helping out his aunt with her finances. Auntie Em took out a loan for a new television set 2 years ago and agreed to pay $121.88 each month for 5 years at 121⁄2% interest. How much did the TV cost (before interest is added in)? The repayment amount is the principal (cost of the TV) plus the interest on the loan. If she’s paying $121.88 per month, that’s 60 payments (5 years × 12 months). So the total she’ll pay back over the 5year period is $121.88 × 60 = $7,312.80. The total, $7,312.80, represents the principal plus the interest (P + I = $7,312.80). You replace the I in this equation with Prt (so you can solve for the cost of the
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Chapter 9: Computing Simple and Compound Interest TV), which gives you P + Prt = $7,312.80. Now factor out the P, fill in the interest rate and time, and then solve for P, like so: P + Prt = $7, 312.80 P ^1 + rt h = $7, 312.80 $7, 312.80 P= 1 + rt $7, 312.80 = 1 + 0.125 ^ 5 h $7, 312.80 = 1.625 = $4, 500.18 The principal comes out to be $4,500.18. That’s some jazzy TV set that Auntie Em bought.
Stepping it up a notch: Computing it all with one formula The formula for simple interest, I = Prt, gives you the amount of interest earned (or to be paid) given an amount of money, an interest rate, and a period of time. You want the amount of interest as a separate number when you’re figuring your expenses or taxes as a part of doing business. But, as I show in the previous section, you frequently want the total amount of money available (or to be repaid) at the end of the time period. You add the principal to the interest to get the total. But guess what? There’s a better way! Here’s a formula that allows you to find the total amount all in one computation: A = P(1 + rt) where A is the total amount obtained from adding the principal to the interest, P is the principal, r is the annual rate written as a decimal, and t is the amount of time in years. Try your hand at using this formula: Imagine that Casey loaned her business partner $20,000 at 7% simple interest for 3 years. How much will Casey be repaid by the end of the time period? Using A = P(1 + rt), Casey gets A = $20,000(1 + 0.07 × 3) = $20,000(1.21) = $24,200. From this total, you can determine the interest paid by subtracting the principal amount from the total: $24,200 – $20,000 = $4,200.
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Taking time into account with simple interest Loans don’t have to be for whole years. You can borrow money for part of a year or for multiple years plus a fraction of a year. If the time period is half of a year or a quarter of a year or a certain number of months, the computation is pretty clear. You make a fraction of the time and use it in place of the t in I = Prt. When you get into a number of days, however, the math can get pretty interesting. For instance, when dealing with a number of days, the discussion then involves ordinary or exact simple interest. I explain each of the scenarios in the following sections.
Calculating simple interest for parts of years The simple interest formula (which I explain earlier in the chapter) uses the annual interest rate and t as the number of years. When you use a fraction of a year, you essentially reduce the interest rate. For example, to compute the interest on $1 for 1 year at 4% interest, your math looks like this: I = Prt = $1(0.04)(1) = 0.04. Now, if you take that same $1 at 4% for half a year, you get I = Prt = $1(0.04)(0.5) = 0.02. It doesn’t matter whether you take half the interest rate or use half a year; either way you get the same number. You just choose the one that makes the computation easier. Say Abigail is borrowing $6,000 for 3 months at 8% simple interest. How much does she repay at the end of 3 months? Using I = Prt, you let the time be 1⁄4 of a year (3 months ÷ 12 months = 1⁄4 ). So you get I = $6,000(0.08)(0.25) = $120. In this case, I replaced the 1⁄4 with 0.25 to enter the numbers in the calculator. I also could have taken advantage of the fact that 8% divides evenly by 4 and written I = $6,000(0.02) = $120. In any case, Abigail owes $6,000 + $120 = $6,120 at the end of the 3month loan period. Try out another example that stirs things up a bit: Say that Gustav repaid a loan in 30 months by making bimonthly payments of $880. How much did Gustav borrow, if the simple interest rate was 4%? Bimonthly means every other month, so a 30month loan period has 15 payments. So you multiply the payment amount by the number of payments to get the total payment amount: $880 × 15 = $13,200. The total of all the payments includes both interest and principal, so use this formula to solve for the principal amount: P(1 + rt) = total repaid
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Chapter 9: Computing Simple and Compound Interest I show you how to use this formula in the earlier section, “Computing simple interest amounts the basic way.” There I also show you how the formula is derived. Solving for the principal, you let 30 months be 21⁄2 years, and then you plug in all the numbers. Your math should look like this: P ^1 + rt h = $13, 200 $13, 200 P= 1 + rt $13, 200 = 1 + 0.04 ^ 2.5 h $13, 200 = 1.1 = $12, 000 So you can see that Gustav borrowed $12,000 21⁄2 years ago.
Distinguishing between ordinary and exact simple interest To liven things up a bit, here in this section I introduce two ways of looking at computing interest: using ordinary simple interest and using exact simple interest. You don’t need to be concerned about distinguishing between ordinary and exact interest unless you’re dealing with small periods of time — usually a number of days instead of a number of years. When computing simple interest in terms of a number of years or parts of years (half a year or a quarter of a year), you use whole numbers or fractions in your calculations. Shortterm transactions, on the other hand, may be measured in days. In that case, you have to decide whether to use ordinary or exact interest. The difference between these two is that ordinary interest is calculated based on a 360day year, and exact interest uses exactly the number of days in the year — either 365 or 366, depending on whether it’s a leap year. (See the nearby sidebar, “Don’t forget about the leap years!” for more information.) The following examples will help you understand how to use both ordinary and exact interest. What’s the difference between the ordinary interest and the exact interest on a loan of $5,000 at 6% interest for 100 days if the year is 2008? First, to compute ordinary interest, you divide the number of days by 360 (the number of days in an “ordinary” year), which gives you the fraction you use for the amount of time in the formula. In this case, you divide100 by 360. Now you plug all your numbers into I = Prt, like this, to get your answer: I = $5, 000 ^ 0.06hc 100 m = $300 c 5 m . $83.33 360 18
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Don’t forget about the leap years! Leap year days were added to the calendar in the 1700s when Pope Gregory determined that our seasons weren’t jibing with the actual weather. Our calendar had become out of sync with the sun. As it turns out, the lack of coordination of the calendar with the seasons came about because the Earth’s years are actually 3651⁄4 days long. The Pope’s new Gregorian calendar added leap year days to fix this problem. Here’s how to tell whether a year is a leap year: If a year is evenly divisible by 4, the year is a leap year and has 366 days instead of 365 (for
example, 2008 and 2012 are leap years, while 2009, 2010, and 2011 are not). The added day is February 29. But because this addition causes a bit of an error (the year isn’t quite 3651⁄4 days long), another correction in the calendar is applied to century years, such as 1700, 1800, 1900, 2000, 2100, and so on. A century year is a leap year only if it’s divisible by 400. So the year 2000 was a leap year, but the year 2100 will not be. (Hope you’re planning on sticking around to remind the calendar makers of all this!)
Next, you compute the exact interest. To do so, you divide 100 by 366 (because 2008 is a leap year), and then you use that fraction for the amount of time. Now fill in your formula: I = $5, 000 ^ 0.06hc 100 m = $300 c 50 m . $81.97 366 183 The difference between the two interest methods is just over $1. The ordinary interest number is more convenient, but the number 360 in the denominator of the fraction does make the fraction value larger than with a denominator of 365 or 366. And the difference will become more significant as the amount borrowed increases. Exact interest also is used when the starting and ending dates of a loan are given and you have to figure out the number of days involved. Most desk calendars include numbers on each date indicating which day of the year it is. For example, in the year 2007, November 4 was the 308th day of the year. I include the year because in 2008, November 4 is the 309th day of the year due to adding the leap year day. Say, for example, that Timothy borrowed $10,000 on April 17 and paid it back, with exact simple interest of 51⁄4%, on November 22 in the year 2007. What interest was charged on the $10,000 loan? First refer to a calendar and verify that April 17 was the 107th day in 2007 and November 22 was the 326th day. Find out the total number of days of the loan
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Chapter 9: Computing Simple and Compound Interest by subtracting: 326 – 107 = 219 days. Now, using the simple interest formula and 365 days, plug in your numbers: I = $10, 000 ^ 0.0525hc 219 m = $525 c 219 m = $315.00 365 365 Timothy will repay a total of $10,315 (which I found by adding $10,000 + $315) after 219 days.
Surveying some special rules for simple interest Simple interest is relatively easy to compute, but leave it to some folks to come up with shortcuts or rules to make the computation — or estimations of the computation — even easier. The rules I’m referring to are the Banker’s Rule, the 60day 6% method, and the 90day 4% method. I explain each in the following sections.
The Banker’s Rule The Banker’s Rule is a common method of computing interest that combines ordinary interest and exact time. This definition seems a bit of a contradiction, but here’s how it works: The ordinary interest rule of using 360 days is applied, and the exact number of days is used. So instead of computing interest on three months and calling it 1⁄4 of a year, you determine exactly how many days are in those three months and divide by 360. You may wonder just how different the figures might be when using the exact days in three months versus 1⁄4 of a year. Consider some of the months in the year 2007 in groups of three: January through March: 31 + 28 + 31 = 90 days February through April: 28 + 31 + 30 = 89 days March through May: 31 + 30 + 31 = 92 days The fractions formed by dividing the number of days by 360 are: 90 = 1 = 0.25, 89 . 0.247222..., 92 . 0.25555 ... 360 4 360 360 The decimal equivalents don’t seem to be too different, but when you multiply these decimals by big numbers, the slight variations make a significant difference!
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Part III: Discovering the Math of Finance and Investments How about an example? Using the Banker’s Rule, what’s the interest on a loan of $10,000 at 7% from April 1 to October 1? Determine the number of days involved. You can use a calendar or table that provides the number of each day and get 274 – 91 = 183 days. Or you can add up the days in each month: 30 + 31 + 30 + 31 + 31 + 30 = 183. (Note: You don’t count October 1st). Now, using the simple interest formula, calculate the interest: I = $10, 000 ^ 0.07hc 183 m = $700 c 183 m . $355.83 360 360
The 60day 6% or 90day 4% rules The 60day 6% and 90day 4% rules are two shortcut estimations of interest. These rules are great because both 60 and 90 divide 360 evenly and form nice fractions when you divide them by 360. For instance, take a look: 60 = 1 and 90 = 1 360 6 360 4 When you couple the fractions formed by dividing 60 or 90 by 360 with interest rates of 6% or 4% or 12%, you can do quick calculations of the interest (as long as the combination of the fraction and the percentage comes out to be a nice number). For example, if you have a 60day loan at 6%, you can multiply 1⁄6 × 6% = 1%. A 90day loan at 8% gives you 1⁄4 × 8% = 2%. The rest of the computations involving multiplying fractions and interest rates work the same, and, hopefully, you can do them in your head. As an example, use the 90day 4% method to estimate the interest on a loan of $25,000. This one is so easy. First, multiplying 4% by 1⁄4 gives you 1%. Then multiplying $25,000 by 0.01 gives you $250. Not too bad.
Looking into the future with present value When you’re talking money, the expression present value describes itself fairly well, but it’s also a bit confusing. Just remember this: What you’re really looking forward to is having a certain amount of money in the future when you talk about present value. In other words, if you have some goal for a particular amount of money in the future, you want to know how much money to deposit now (in the present) so that the addition of simple interest will create the sum of money that you need.
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Chapter 9: Computing Simple and Compound Interest For example, if you want $10,000 to buy a new piece of machinery 3 years from now, do you invest $8,000, $9,000, or $9,500 today? When these amounts of money earn interest, will the added interest bring you up to $10,000? Well, you can’t really answer this question yet, because I haven’t given you any interest rate. So this type of question will be a twopronged one. One plan of attack will be to determine how much money to deposit if you know the interest rate, and the other approach will be to find an interest rate if you know the amount of money available for deposit. In general, you can solve for the principal needed or the rate needed (or even the amount of time needed) after you know what your money goal is. The formulas used in the computations are all derived from the basic A = P(1 + rt) formula for the total amount of money resulting from simple interest. (You can find more on this basic formula in the earlier section, “Stepping it up a notch: Computing it all with one formula.”) Here are all the formulas that you’ll use when dealing with present value: A = P ^1 + rt h
P=
r= AP Pt
t= AP Pr
A 1 + rt
where A is the total amount after adding simple interest, P is the principal, r is the interest rate as a decimal, and t is the amount of time in years. Now it’s time to try your hand at these formulas with a few examples. Say that 3 years from now, you want to buy a new storage shed — and you need to have $27,000 set aside at that time. You intend to deposit as much money as is necessary right now so that when it earns simple interest at 53⁄4% it will be worth $27,000 in 3 years. How much do you have to deposit? You know the total amount needed, A, the interest rate, r, and the amount of time, t. So, use the formula to solve for the principal needed: P=
$27, 000 $27, 000 A = = . $23, 028 1 + rt 1 + 0.0575 ^ 3 h 1.1725
As you can see, you need to set aside about $23,000 right now. Here’s the same problem with a twist: Three years from now, you want to buy a new storage shed — and you need to have $27,000 set aside by that time. You have $20,000 at hand, which means that you need to find someone who will give you a high enough simple interest rate so that the $20,000 will grow to $27,000 (by adding the interest) in 3 years’ time. What interest rate do you need?
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Part III: Discovering the Math of Finance and Investments This time you know the total amount, A, the principal, P, and the time, t. Use the formula to solve for the rate needed, like this: $27, 000  $20, 000 $7, 000 r= AP = = . 0.1167 Pt $20, 000 ^ 3 h $60, 000 You need an 11.67% interest rate. Lots of luck finding that rate.
Getting to Know Compound Interest The biggest difference between simple interest and compound interest is that simple interest is computed on the original principal only (see the earlier section, “Simply Delightful: Working with Simple Interest,” for details). In other words, no matter how long the transaction lasts, the interest rate multiplies only the initial principal amount. Compound interest, on the other hand, multiplies the interest rate by the original principal plus any interest that’s accumulated during the time period of the transaction. As you can imagine, compound interest is pretty powerful. After all, the principal keeps growing, making the interest amount increase as time passes. The bigger interest amount is added to the principal to make the interest amount even bigger. Compound interest is the type of interest that financial institutions use. In this case, your money grows exponentially, so exponents (those cute little superscripted powers) are a part of the formula for determining how much money you have as a result of compound interest. Of course, for compound interest to have its full effect, you can’t remove the interest earned; compound interest is based on the premise that you leave the money alone and let it grow.
Figuring the amount of compound interest you’ve earned Computing the total amount of money that results from applying compound interest takes a jazzy formula. Besides involving multiplication, addition, and division, this formula also requires you to work with exponents (and who but mathematicians like to do that?). The hardest parts of working with the formula are entering the values correctly into the formula and performing the operations in the right order.
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Chapter 9: Computing Simple and Compound Interest The formula for computing compound interest is rm A = P c1 + n
nt
where A is the total amount of money accumulated (principal plus interest), P is the principal (the amount invested), r is the rate of interest (written in decimal form), n is the number of times each year that the compounding occurs, and t is the number of years. Some scientific and graphing calculators allow you to type the numbers into the formula pretty much the same way you see them. But if you don’t have a calculator with all the bells and whistles, you still can do this problem correctly — as long as you perform the steps of the equation in the correct order. You need to apply the order of operations. (If you don’t know how the order of operations works, refer to Chapter 5, where I discuss it in detail.) For the compound interest formula, you need to perform the operations in the following order: 1. Determine the value of the exponent by multiplying n × t (the number of times compounded each year times the number of years). 2. Inside the parentheses, divide the interest rate, r, by the number of compoundings each year, n. 3. Add 1 to the answer in Step 2. 4. Raise the result from Step 3 to the power that you got in Step 1. 5. Multiply your answer from Step 4 by the principal, P. Put these steps to use in the following examples. How much money has accumulated in an account that’s earning interest at the rate of 4% compounded monthly if $10,000 was deposited 7 years ago? Fill in the formula letting P = $10,000, r = 0.04, n = 12, and t = 7: A = $10, 000 c1 + 0.04 m 12
12 (7)
Now go through these steps (the order of operations) to find your answer: 1. Multiply 12 × 7 = 84. This is the value of the exponent. 2. Divide 0.04 ÷ 12 = 0.0033333. . . . Round this answer to five decimal places to get 0.00333.
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The power of compound interest What if a member of Christopher Columbus’ crew went into the Bank of the West Indies in 1492 and deposited $1 with the agreement that it would earn 3% interest compounded annually? And what if that crew member never returned (maybe he was on the ship that sank)? Now come back to the year 2007, and say that you were contacted by the Bank of the West Indies as the only living heir of this sailor. The bank now wants to close out this “nuisance account.” What if it was willing to give you the money accumulated in this account for over 500 years — as long as you pay a $50 per year maintenance fee retroactively? Does this sound like one of those spam emails that you’ve been
getting recently? Well, before hitting the delete button, take a gander at what the numbers say. A deposit of $1 earning interest at 3% compounded annually for 515 years (computing this to 2007) amounts to $4,084,799.30. Even if you have to pay 515 years of maintenance fees at $50 per year, that’s only $25,750 out of your $4 million. Of course, you’ll ask the bank to deduct the maintenance fee and send you the difference. If they insist on having the maintenance fee up front, it’s time to delete the message. This situation just goes to show you the power of compounding — how just one dollar can grow to millions of dollars — in a mere 500 years.
3. Add 1 to the answer in Step 2. After adding, you get 1.00333. 4. Raise 1.00333 to the 84th power. So 1.0033384 ≈ 1.32214. 5. Multiply 1.32214 × $10,000 = $13,221.40. Now you have the total amount accumulated in 10 years. Curious to know how this compares to investing the same amount of money for the same amount of time at the same rate using simple interest? Well, use the formula for the total amount, A = P(1 + rt), to find out. $10,000(1 + 0.04 × 7) = $12,800. By using compound interest, you earn about $400 more than you would have with simple interest.
Noting the difference between effective and nominal rates When you walk into a bank, you’re faced with an easel or other display that’s covered with decimal numbers. You see the latest on rates for car loans and home equity loans and the update on the effective interest rates for various
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Chapter 9: Computing Simple and Compound Interest products. So what’s this effective interest rate business? The effective interest rate is what you actually get as a result of compounding. The nominal rate is the named rate, or what you’d get without compounding. For instance, you may read that the nominal rate is 4.5% applied to certain deposits for 6 months. The effective interest rate is what you get as a result of compounding that nominal rate. To determine the effective rate of interest, use this formula: n
r c1 + n m  1 where r is the nominal interest rate (expressed as a decimal) and n is the number of compounding periods in a year. When doing the computation for the effective interest rate, be sure to use the order of operations correctly. Otherwise your calculations will be off. Here are the steps you need to follow: 1. Simplify the fraction inside the parentheses. 2. Add 1 to the result of Step 1. 3. Raise the sum from Step 2 to the power outside the parentheses. 4. Subtract 1 from the number you get in Step 3. What’s the effective rate of 4.5% compounded quarterly? Using the formula, the effective rate is computed like this: 4
0.045 m  1 = ^1.01125h 4  1 . 1.045765086  1 = 0.045765086 c1 + 4 So, while the nominal rate is 4.5%, the effective rate is about 4.5765%. Just how much difference does using the effective interest rate (versus the nominal rate) make? In other words, why is 4.5765% so much better than 4.5%? It’s all in the degree of involvement — or, to be blunt, in how much money you have. If you deposit $1,000 and use 4.5% interest, you’ll earn $1,000 × 0.045 = $45 in a year. The same $1,000 at 4.5765% earns about $45.76; you get a whole 76 cents more in a year. But if you have $10 million to invest, the difference between what’s earned at 4.5% and 4.5765% is $7,650 ($457,650 – $450,000 = $7,650). Guess the saying “Money begets money” is true after all.
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Part III: Discovering the Math of Finance and Investments
Finding present value when interest is compounding The present value of your money is what you deposit in your account today in order to have a certain target amount in your account in the future. Present value using simple interest is covered in the earlier section, “Looking into the future with present value.” In this section, however, you get to use the power of compounding to make the present value smaller — meaning that you don’t have to commit as much money right now in order to get your target amount later. To find the present value, P, of an amount of money, A, in t years when the money grows at r interest (expressed as a decimal) compounded n times each year, use the following formula: P=
A nt r c1 + n m
To use this formula, use this order of operations: 1. Find the value of the exponent nt by multiplying the number of times you compound by the number of years. 2. Divide the rate, r, by n and add the result to 1. 3. Raise the sum (after adding the 1) to the nt power to get the value in the denominator of the fraction. 4. Divide the amount of money, A, by the denominator. Say, for example, that you want to have $400,000 in 5 years to purchase a new piece of equipment. How much do you need to deposit today at 63⁄4% interest, compounded monthly, so there’s $400,000 in your account when you need it? To solve, you just need to plug your numbers into the formula for present value, like so: P=
400, 000 400, 000 60 = $285, 690.83 12 (5) = 0.0675 m ^1.005625h c1 + 12
After doing the math, you can see that you need to deposit about $286,000 right now. But look how much it grows in just 5 years!
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Chapter 9: Computing Simple and Compound Interest
Determining How Variable Changes Affect Money Accumulation Many different banks are available these days, and there are just as many options, offers, and arrangements that can be made with your money at the different institutions. For instance, do you choose the free checking or the unlimited account transfers? Decisions, decisions. I can’t help you in choosing one bank over another, but I can show you just how much the interest rate, the number of compoundings, or the time invested actually affect the end result. The rest is for you to sort through and decide. As you may know from reading this chapter, the compound interest formula has four different variables, or things that can change. The variables are P, the principal or amount of money invested r, the interest rate, entered as a decimal n, the number of times each year that the interest is compounded t, the time in number of years If you adjust any of the four variables, you change the output or end result. In general, increasing any of the variable numbers increases the output. But how much is the increase, and which variable has the greatest impact on an increase? I show you in the following sections.
Comparing rate increases to increased compounding Say that you have $10,000 and need to determine where to invest that money to earn the greatest amount of interest. If you invest your money at 4% interest, compounded annually, you’d have $10,000(1 + 0.04) = $10,400 at the end of one year. (Refer to the earlier section, “Getting to Know Compound Interest,” for the details on how to do this computation.) Knowing that, your next question is this: Will you do better to invest your $10,000 with an institution that increases the interest rate by onequarter of a percent, or should you stick with the same interest rate and go someplace that compounds interest quarterly? To answer this question, you need to determine the total amount of money in an account if $10,000 is deposited for 1 year at 41⁄4 % compounded annually. Then you simply compare that total amount with the result of $10,000 being
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Part III: Discovering the Math of Finance and Investments deposited in an account that earns interest at 4% compounded quarterly. Here’s what the computations look like: One year at 41⁄4%, compounded annually: A = $10, 000 c1 + 0.0425 m 1 One year at 4%, compounded quarterly: A = $10, 000 c1 + 0.04 m 4
1 (1)
= $10, 425
4 (1)
= $10, 406.04
Clearly, the increase in the interest rate has the greater impact on the total amount after a year. A 1⁄4% increase may not be realistic, however. In banking circles, a quarter of a percent is big money. Imagine that the total amount in an account where a deposit of $10,000 is earning 4% interest compounded quarterly is $10,406.04 at the end of 1 year. What are the effects of increasing the interest rate by onehundredth of a percent at a time and applying annual compounding? The following list shows the end results of interest rates of 4.01%, 4.02%, and so on, with annual compounding: A = $10,000(1 + 0.0401)1(1) = $10,401 A = $10,000(1 + 0.0402)1(1) = $10,402 A = $10,000(1 + 0.0403)1(1) = $10,403 A = $10,000(1 + 0.0404)1(1) = $10,404 A = $10,000(1 + 0.0405)1(1) = $10,405 A = $10,000(1 + 0.0406)1(1) = $10,406 It only takes a sixhundredths of a percent increase in the interest rate for the end result to equal the effect of compounding quarterly instead of annually.
Comparing rate increases to increases in time Maybe you’re stuck with one type of interest compounding. For instance, maybe you only deal with institutions that compound quarterly. Now you want to compare the effect of increasing the interest rate with the effect of increasing the amount of time you leave the money in the account. If you have your money invested at 4% compounded quarterly, would you be better off increasing the rate of interest to 41⁄4% or leaving it in the original account for an extra quarter of a year?
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Chapter 9: Computing Simple and Compound Interest Your math for solving this problem looks like this: One year at 41⁄4% compounded quarterly: 4 (1) A = $10, 000 c1 + 0.0425 m = $10, 431.82 4 One and a quarter years at 4% compounded quarterly: 4 (1.25) A = $10, 000 c1 + 0.04 m = $10, 510.10 4 As you can see, the increase in interest rate resulted in a smaller total than the increase in time. Using the information from the previous example, determine what rate of interest, compounded quarterly, earns the same amount of interest on $10,000 invested for one and a quarter years. Here’s how to get started: 4%, comp. quarterly,1 1 year = x%, comp. quarterly,1 year 4 4 (1.25) 4 (1) 0 . 04 = $10, 000 c1 + x m $10, 000 c1 + m 4 4 Next, divide each side by $10,000, and then simplify the exponents and the terms that are inside the parentheses, like so: 5 x ^1.01h = c1 + m 4
4
Now finish by computing the power on the left, taking the fourth root of each side, and then solving for the value of x: 1.05101005 = c1 + x m 4
4
1.05101005 = 4 c1 + x m 4 1.012515586 = 1 + x 4 x 0.012515586 = 4 0.050062344 = x
4
4
So, as you can see, you need an interest rate of about 5% to equal the effect of leaving the money in for 3 extra months.
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Part III: Discovering the Math of Finance and Investments The problems involving comparing interest rates and compounding and time show you that many variations are available when investing your money or borrowing money. Find some interest charts and look to see how much your money earns at each rate and amount of time. Sometimes, though, it’s more a matter of convenience and service (rather than a few extra dollars here and there) that draws you to a particular institution — and that’s okay.
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Chapter 10
Investing in the Future In This Chapter Investing with a lump sum Dealing with annuity calculations Understanding annuity payouts
Y
ou earn money in many ways. First and foremost, you work hard at your job. And maybe you also buy and manage apartment buildings, buy stocks or bonds, or invest your money with some financial institution where you have the understanding that the institution will put your money to work to earn interest or dividends. This chapter deals with the different opportunities available for investing your money. For instance, you can deposit a lump sum and let it grow by compounding. Or you can deposit that same lump sum and withdraw regular amounts until it’s all gone. You may even opt to make regular deposits of money and allow them to grow over the years. The choices (and variations on the choices) are many. When investing money, many folks use annuities. And sinking funds are often a form of annuity. The present value and future value of annuities translate into the various uses for annuities. In this chapter, by covering some examples, emphasizing the financialspeak vocabulary, and showing you the stepbystep process of the mathematics of investing, I show you how to take more control of your financial plans.
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Part III: Discovering the Math of Finance and Investments
Calculating Investments Made with Lump Sums Businesses are created with the ultimate goal of making a profit. And profit occurs when the revenue is greater than the cost. When a business produces items to sell, revenue is generated by that sale. But businesses have other options for creating revenue, in the form of investments of capital. When situations arise and a business can take advantage of the opportunity to make a greater profit through an investment, a firm understanding of the math involved is a must. Your investment opportunities are abundant, so care must be taken to ensure a safe investment as well as the best return possible. To determine the return or interest on deposited money, you can use either of the following methods: A formula and a calculator: This method has the advantage of compactness and flexibility. A table (and, frequently, a calculator): A table of values has the advantage of quick review of the results of different rates. Using a formula and calculator is okay, but for the purposes of this chapter, I show you how to calculate investment info for a lump sum using the tables — mostly because I’ve found them to be the quickest and easiest route.
Reading interest earnings from a table Investments earn interest based on four elements: The total amount of money invested The rate of interest The number of times the interest is compounded per year The number of years the money is invested The interest rate and number of times an amount is compounded are closely related. How so? Well, you divide the annual interest rate by the number of times it’s compounded each year. (Refer to Chapter 9 and the later sections in this chapter for more on how interest is computed.)
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Chapter 10: Investing in the Future One way to simplify all the possible variations of interest rates and the number of times the interest is compounded each year is to use a periodic interest rate in your computations. A periodic interest rate is what the percentage is for that short period of time; you divide the yearly rate by the part of the year being considered. For example, if the yearly interest rate is 8%, and the interest is compounded quarterly, you want the rate for onefourth of a year; use this calculation each period: 8% ÷ 4 = 2% per time period. You can obtain a particular periodic interest rate in several different ways — dividing a yearly rate by a carefully selected number. For instance, to have a periodic interest rate of 1% per period 1% per month comes from a 12% annual rate. 1% per quarter comes from a 4% annual rate. 1% per halfyear (semiannual) comes from a 2% annual rate. To have a periodic interest rate of 1.5% per period 1.5% per month comes from an 18% annual rate. 1.5% per quarter comes from a 6% annual rate. 1.5% per halfyear (semiannual) comes from a 3% annual rate.
Using a table to determine the future value of an investment Table 101 is a table that you can use to quickly determine the future value of your investment. The table is relatively limited, however. You need a complete book of compound interest tables if you intend to compute values of your investments using tables. In the meantime, follow my instructions and give the table a try; you may find that you like using interest tables. To determine the future value of an investment from a table, multiply the amount of your investment by the entry corresponding to the number of periods at which the investment has been compounded at the particular interest rate per period. Table 101 lists several interest rates and the number of periods that $1 is subject to compounding. You intend to invest more than $1? I hope so! Just multiply your investment amount by the corresponding value from the table.
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Part III: Discovering the Math of Finance and Investments Table 101
Future Value of $1 at Given Interest Rates
Periods
1%
1.5%
2%
2.5%
4
1.040604
1.061364
1.082432
1.103813
8
1.082857
1.126493
1.171659
1.218403
12
1.126825
1.195618
1.268242
1.344889
16
1.172579
1.268986
1.372789
1.484506
20
1.220190
1.346855
1.485947
1.638616
24
1.269735
1.429503
1.608437
1.808726
28
1.321291
1.517222
1.741024
1.996495
32
1.374941
1.610324
1.884541
2.203757
36
1.430769
1.709140
2.039887
2.432535
40
1.488864
1.814018
2.208040
2.685064
Here’s an example to help you understand how to determine the future value of an investment using Table 101: Say that you invest $40,000 for 10 years at 6% annual interest compounded quarterly. How much is your money worth at the end of the 10 years? After only a first glance, you may be wondering how you can use Table 101 to determine the amount of your investment. After all, 10 doesn’t appear as a period number, and 6% doesn’t appear as an interest rate. But that was just your first glance. Take another look and note that you can count how many times interest is compounded in 10 years if it’s compounded quarterly. You simply multiply 10 years × 4 quarters = 40 compounding periods. The rate of 6% annually becomes 6% ÷ 4 = 1.5% each quarter. So, in Table 101, reading across the row for 40 periods and down the 1.5% column, you find the number 1.814018. Now multiply your money like this: $40,000 × 1.814018 = $72,560.72. Your investment hasn’t quite doubled in that 10 years. That wasn’t so difficult, was it?
Interpolating for investment value Most compound interest tables are more complete than the example table that you find in Table 101. This sample is just a small excerpt of what usually are pages and pages of entries. Nonetheless, Table 101 still shows you how to use one of these tables. And now, with the same table, I want to show you how to find values that lie in between two rows or two columns (by the way, this type of estimation involving averaging is called interpolation).
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Chapter 10: Investing in the Future For instance, you may want to use the table to find the value of an investment at the end of, say, 30 periods. To do so, you need to use the entries for 28 periods and 32 periods and find the halfway point. To find the halfway point, just average the two values (add them together and divide by 2). What’s the value of an investment of $100,000 after 2.5 years if it’s earning 12% annual interest compounded monthly? First you have to determine how many periods 2.5 years of monthly compounding means. Here’s what your equation would look like: 2.5 × 12 = 30 periods. An annual interest rate of 12% divided by 12 is 1% per period. So, in Table 101, look down the first column to the entries for 28 periods and 32 periods. Now you have to average these entries. To do so, first add the entries together. 1.321291 + 1.374941 = 2.696232. Divide that sum by 2, and the average of the two numbers is 1.348116. Now all you have to do is multiply the amount of your investment by the average you just figured to get the value of your investment after 21⁄2 years: $100,000 × 1.348116 = $134,811.60.
Taking advantage of tables to determine growth time Tables of interest rates for compound interest are most useful for determining future values of an investment. But you also can use these tables to determine how long it would take a lump sum investment to grow to a particular level. Take another look at Table 101, and you see that the numbers in the rows and columns are all bigger than 1. The entry 1.429503 represents a resulting amount of money that’s about 1.4 times as much as what you started with. So, if you invested $100, you have $100 × 1.4, or about $140. Now you’re probably looking at the numbers starting with 2. That’s where I look, too; after all, doubling my money sounds rather attractive. The key to using a table to determine the amount of time needed to create a particular amount of money is to pick the multiplier that represents how much money you want. Then you work backward to determine interest rates. Say you have $1,000,000 and decide to invest it until it earns $500,000 in interest. You’re in a hurry, so you find an investment opportunity that promises an annual return of 18% compounded monthly. How long will you have to leave your money invested at this high (and scary) rate in order for it to earn what you need?
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Part III: Discovering the Math of Finance and Investments You can solve this problem using Table 101. Well, you can get a pretty good estimate anyway. First, add the principal to the interest to get a total amount in the account: $1,000,000 + $500,000 = $1,500,000. Then divide that total by the initial amount: $1,500,000 ÷ $1,000,000 = 1.5. So this means that you want every $1 invested to grow to $1.50. To determine which column in Table 101 contains the 1.5 that you want, you need the interest rate. A rate of 18% annually when divided by 12 for the monthly compounding gives you 18% ÷ 12 = 1.5%. Use the 1.5% column and read down until you find the number closest to 1.5. The row for 28 periods has the number 1.517222. That’s pretty close to 1.5. So you’d have to have your money invested for about 28 periods. If each period is one month, you can figure out the amount of time that is by dividing the number of periods by 12, which would give you about 2 years and 4 months. You can get a more exact answer by either interpolating (which I discuss in the previous section) or using the formula for compound interest. In the upcoming section, “Doubling your money, doubling your fun,” I show you how to use the formula to solve for a time period.
Doubling your money, doubling your fun How long does it take to double your money? Well, that depends. If you have your money invested in an institution that pays 100% interest, compounded annually, your money doubles in one year. Okay, 100% interest that’s compounded annually isn’t reasonable — unless you have some interesting connections. Instead, how about 10% compounded quarterly? Look at Table 101. Under the 2.5% interest rate column (10% compounded quarterly is 10% ÷ 4 = 2.5% each period) you find the entry 1.996495 opposite 28 periods. The number 1.996495 is pretty close to 2, so a good estimate of the amount of time needed is 7 years (because 28 periods ÷ 4 = 7). You may have noticed that I carefully chose my examples for doubling using the table. One other entry is pretty close to 2. For instance, 2% interest with 36 periods also gives you twice your investment. But 2% interest might be 8% compounded quarterly or 12% compounded bimonthly or 24% compounded monthly. In other words, you can find many scenarios that accomplish the doubling. Likewise, with 2.5% and 28 periods, you could be considering 5% compounded biannually or 15% compounded every other month. Table 102 shows you how many years it takes to double your money, using the convenient 2% and 2.5% interest rates.
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Chapter 10: Investing in the Future Of course, the higher the interest rate, the less time it takes for the investment to double. But another consideration in the computation is the number of times each year that the interest is compounded. The first four lines of Table 102 show you situations where it takes a total of 36 periods to double the money. The last four lines of the table show you how it can take only 28 periods.
Table 102
Years It Takes to Double Your Money
Annual Interest Rate
Times Compounded Each Year
Percent
Years to Double
4%
2 (biannually)
2%
18
8%
4 (quarterly)
2%
9
12%
6 (every other month)
2%
6
24%
12 (monthly)
2%
3
5%
2 (biannually)
2.5%
14
10%
4 (quarterly)
2.5%
7
15%
6 (every other month)
2.5%
42⁄3
30%
12 (monthly)
2.5%
21⁄3
Using a table is a fine way to determine how long it takes for your money to double, but there are other ways that are also fabulous. The following sections explain these methods.
Taking the easy way out with a doubling formula You can use the following formula for finding the time it takes to double your investment: n=
ln 2 ln ^1 + i h
where n is the number of periods needed and i is the interest rate per period. This formula for doubling your investment is used for doubling and doubling alone. Just be careful when using the quick, slick formula that you’ve entered the correct value for i.
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Part III: Discovering the Math of Finance and Investments Using the slick formula that I just introduced, figure the following example: How long does it take to double your money if you can invest at 4.5% compounded monthly? To begin, obtain the interest rate per period by dividing the interest rate by 12. 4.5% ÷ 12 = 0.375% = 0.00375. After that, plug 0.00375 into the formula, which gives you: n=
ln 2 ln 2 = . 185.1856 ln ^1 + 0.00375h ln 1.00375
Because n is the number of periods, you divide the interest rate per period by 12 to get 185.1856 ÷ 12 ≈ 15.4321. So, as you can see, it will take almost 151⁄2 years to double the value at this interest rate.
Working with the Rule of 72 The Rule of 72 is a quick and fairly accurate method of determining how long it takes to double your money at a particular interest rate. You don’t get exact answers, but that’s okay because once you’re armed with an approximation, you can then decide if you want to pursue the issue further by hauling out your tables or calculator. Here’s how the Rule of 72 works: If you simply divide 72 by the annual interest rate, you’ll get an estimate on how long it will take to double your money. Check out these examples: 72 ÷ 7.2% ≈ 10 years to double your money 72 ÷ 10% ≈ 7.2 years to double your money 72 ÷ 6% ≈ 12 years to double your money 72 ÷ 9% ≈ 8 years to double your money One reason that this method is so popular is that it allows you to do quick calculations in your head. The number 72 is evenly divisible by so many numbers that you can either use exactly the interest rate you have in mind or you can do an estimate of an estimate by averaging for rates in between. For instance, the Rule of 72 says that it takes 12 years to double your money at 6% interest and 9 years to double your money at 8% interest, so you can guess that it will take between 9 and 12 years to double your money at 7% interest. You can also use the Rule of 72 to determine your rate of return when your money doubles. If you invested $4,000 8 years ago and now have $8,000, simply divide 72 by 8 and you see that the rate of return was 9%.
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Chapter 10: Investing in the Future
Going the Annuity Route Sometimes you don’t want to invest a lump sum all at once (see the earlier section, “Calculating Investments Made with Lump Sums,” if you do). In that case, you might choose to invest with an annuity. An annuity is a series of equal payments made at equal periods of time. You may, for example, sign up to contribute to an annuity in which you deposit $400 each month for the next 10 years. With annuities, your deposits or contributions earn interest, with the first payment or deposit earning interest the longest. And each payment’s interest earns interest — it’s a compounding of a piece at a time. For example, if you deposit your $400 each month in an account earning 6% interest compounded monthly, each month the interest is 6% ÷ 12 = 0.5%, which is 0.005 in decimal form. The following shows the first few payments and how each payment grows due to compound interest: Month 1: $400 Month 2: $400 + $400(1 + 0.005) Month 3: $400 + $400(1 + 0.005) + $400(1 + 0.005)2 Month 4: $400 + $400(1 + 0.005) + $400(1 + 0.005)2 +$400(1 + 0.005)3 Each month has a new deposit of $400 that hasn’t started to earn interest yet. The $400 that was deposited the month before is worth 1.005 times as much as it was when deposited. After two months, a deposit of $400 is worth (1.005)2, or 1.010025, times it was when deposited (and so on through the years). As you might imagine, the longer a deposit earns interest, the more it’s worth. I explain everything you need to know about annuities in the following sections. Some annuities are ordinary annuities and others are referred to as annuities due. The main difference between the two types is when the payment is made. In the case of an ordinary annuity, the payments are made at the end of each period. With an annuity due, the payment is made at the beginning of each period.
Preparing your financial future with a sinking fund A sinking fund is a fund that’s set up to receive periodic payments with a particular goal in mind. For instance, you may set up a sinking fund to pay off a note, or even better, to finance the purchase of some large piece of equipment 10 years from now. Why 10 years from now? Well, you know that the current
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Part III: Discovering the Math of Finance and Investments equipment will need to be replaced, so you figure out how much you’ll have to spend to replace it, and then you start saving toward that purchase. With a sinking fund, you’re making regular payments, and the payments you’re making are earning interest; so in reality you’re setting up an annuity. Remember that you have an ordinary annuity if you’re making payments at the end of each payment period and an annuity due if you’re making payments at the beginning. Sinking funds were used in 14thcentury Italy and in 18thcentury Great Britain in order to reduce the national debt. Perhaps the sinking expression came in because the countries decided to retire the debt or go under? Here’s an example you can work that deals with setting up a sinking fund: Imagine that you have a piece of equipment that’s expected to last for another 5 years. You set up a sinking fund in anticipation of having to purchase a new piece of equipment to replace the current one that will be outdated. At the end of each of the next 5 years, you deposit $20,000 in the sinking fund that earns 4.5% compounded quarterly. After those 5 years, how much will you have in that fund to help you purchase the replacement equipment? What’s described here is an ordinary annuity in which the payments and the compounding don’t coincide. So now you know you have to set up a sinking fund and use the following formula to determine the future value: ^1 + i h  1 nt
A=R
^1 + i h  1 n/p
All you have to do is plug the numbers you know into the equation. The regular deposits, R, are $20,000. The interest rate per compounding period is 4.5% divided by 4, which is 1.125%, or 0.01125. The number of times the interest is compounded each year is n = 4, and that compounding goes on for t = 5 years. The number of payments per year is p = 1. So with everything plugged in, the future value is A = 20, 000
^1 + 0.01125h
4 (5)
1
^1 + 0.01125h  1 4/1
^1.01125h  1 20
= 20, 000
^1.01125h  1 0 = 20, 000 .250751 0.045765 = 20, 000 ^ 5.479100h = 109, 582 4
In 5 years, you accumulate about $109,600, which includes about $9,600 in interest.
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Determining the payment amount With a sinking fund (which is described in the previous section), you contribute a regular amount of money each time period and accumulate a sum to be used some time in the future. But what if you need a particular amount of money? What if you have a specific goal in mind for a particular project? In that situation, you want to determine how much has to be contributed now, in regular payments, in order to have a specific amount of money accumulated then. The amount of the regular payment needed to accumulate A dollars in an ordinary annuity is found with this equation: R=
Ai n ^1 + i h  1
where R is the payment amount, i is the interest per pay period, and n is the number of periods over which the amount will accumulate. Wrap your brain around this equation by trying out this example: Suppose you want to accumulate $450,000 over the next 6 years in order to buy a new building for your business. You plan to make monthly payments into an ordinary annuity that earns 4.5% compounded monthly. What do your payments need to be? The interest per pay period is the annual rate of 4.5% divided by 12, which gives you 0.375%, or 0.00375, per period. Monthly payments for 6 years add up to 72 payments (12 × 6 = 72). By substituting these numbers into the formula, you get this math: R=
450, 000 ^ 0.00375h
^1 + 0.00375h  1 72
=
1, 687.5 . 5, 455.81 0.309303
So this means that you need to make monthly payments of about $5,456. Multiplying the payment amount by the 72 months, you get a total contribution of about $392,832. Add to this the almost $60,000 in interest, and you have what you need for the new building.
Finding the present value of an annuity The present value of an annuity is the amount of money that you would have to deposit today (in one lumpsum payment) in order to accumulate the same amount of money produced by contributing regularly to the annuity over some particular period of time. These types of annuities are referred to as
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Part III: Discovering the Math of Finance and Investments singlepayment annuities. In practice, some people prefer them. After all, if you could make one big payment today, you’d be all done with the payments. But coming up with a huge lump sum of money isn’t always possible. In this section, I compare two different ways of accumulating a particular amount of money: one way is with a lump sum payment (that you have to determine), and the other is with regular payments made to an annuity. You get to decide whether to make the lump sum payment today and let it earn interest over a certain number of years or to make regular payments into an annuity for that same number of years. The present value of an ordinary annuity is found with this equation: R n V S 1  ^1 + i h W P=RS WW i S T X where P is the principal (lump sum) or present value needed to be invested at this time, R is the amount that would have to be contributed regularly with the annuity, i is the periodic interest amount, and n is the number of periods for which regular payments will be made. Go over this example for some practice: What’s the present value of an ordinary annuity earning 4% compounded quarterly if payments of $500 are made every 3 months (quarterly) for 10 years? First you have to find out how many payments you’ll pay in 10 years. To do so, multiply the number of years by the number of payments per year: 10 × 4 = 40 payments. If you divide the interest rate by 4, the rate per quarter is 1%. Using the formula, you get R  40 V S 1  ^1 + 0.01h W 0.328347 P = 500 S WW = 500 ; 0.01 E 0.01 S T X = 500 6
[email protected] = 16, 417.35 If you deposited a lump sum of $16,417.34 in an account that grows at 4% compounded quarterly, you’d have the same total amount of money in 10 years that you would have if you decided to pay $500 every three months into the account. The following two formulas show you the figures. Compound interest: nt
r = 16, 417.35 1 + 0.04 A = P ;1 + n E ; E 4 = 16, 417.35
[email protected] = 24, 443.18 40
4 (10)
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The easy way to sum up a series Formulas used to find the total amount in an account after a number of years are based on the sum of a series of numbers. A series in mathematics is the sum of a list of numbers that are different from one another by some constant number or by some ratio. For instance, the sequence of numbers: 1, 4, 7, 10, 13, 16 . . . is an arithmetic sequence with the subsequent numbers found by adding 3 to the previous one. The sequence of numbers: 1, 3, 9, 27, 81, 243 . . . is a geometric sequence in which you multiply by 3 to get the next number in the sequence. Both types of sequences have formulas that give you the sum of the numbers you want to add. These formulas are handy because who wants to have to compute 1 + 4 + 7 + 10 + . . . + 3001 by hand (or even with a calculator!)? To find the sum of the first n terms of an arithmetic sequence, use this equation: S n = n 7a 1 + a n A 2
where a 1 represents the first term in the sequence, and a n is the nth term. You can find the sum of the first n terms of a geometric sequence with this equation: S n = a 1< 1  r F 1r n
where r is the ratio or multiplier getting you from one term to the next. So if you want to add up the first 20 terms in the sequence 1, 4, 7, 10, 13 . . . 58, you use the formula: S n = 20 61 + 58 @ = 10 6 59 @ = 590 2 To add up the first 10 terms in the sequence 1, 3, 9, 27 . . . 19,683, you use: S n = 1 < 1  3 F = 1 ;  59048 E = 29, 524 2 13 10
Future value of an ordinary annuity: R V 40 S ^1 + 0.01h  1 W 0.488864 A = 500 S WW = 500 ; 0.01 E 0.01 S T X = 500 6
[email protected] = 24, 443.19 The amounts are off by a few cents, which is due to rounding, of course. (If you need a refresher on computing compound interest, refer to Chapter 9.)
Computing the Payout from an Annuity As I mention earlier in this chapter, an annuity is set up to collect money and allow that money to earn interest over some period of time. Annuities allow people to make donations to organizations; regular payouts are made as donations over many years — or forever. Scholarships and businessstarting grants are often funded with annuities.
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Part III: Discovering the Math of Finance and Investments When you have an annuity, you can start the payout program as soon as the money is deposited, or you can defer the payments for a number of years, allowing the initial deposit to grow even more and the account to increase in size. You can even set up an annuity with payments in perpetuity, meaning that they pay out forever; as long as only the interest is paid out, the annuity can keep providing money. The payouts of an annuity are just the reversal of the payment into an annuity. In the earlier section, “Finding the present value of an annuity,” you see how a lump sum can be equal to making regular payments. In fact, depositing a certain amount of money can accumulate as much in an account as paying in over a number of years. The payout of an annuity is like taking that lump sum and parceling it out in regular, periodic payments, until it’s gone. The diminishing amount in the account still earns interest, but the amount of growth of the account gets smaller and smaller over time.
Receiving money from day one If you make a lump sum contribution into an annuity, and if you want to withdraw regular amounts of money from the annuity, how much can you take out, and how long will the money last? Both of these questions are dependent on each other, and both are dependent on how much money is in the account. But one thing is obvious: The less you take out each time, the longer the money will last. Be frugal, my friend!
Figuring out the amount of upfront money that’s needed When an endowment (a type of annuity) is made, the benefactor often has a goal in mind — an amount of money that he or she would like to see given each year for a certain number of years. With that goal in mind, the benefactor then determines how much to invest or deposit so that the desired allocations can be made. Consider this example: Imagine that an entrepreneur wants to give an endowment to a small business catalyst to help local fledgling businesses get a good start. The arrangement says that the entrepreneur will give $5,000 quarterly to young businesses over the next 5 years. The endowment is invested in an account earning 5% compounded quarterly. Upfront, how much did the entrepreneur have to put into the account? The present value of 20 payments of $5,000 earning interest at 1.25% per quarter (5% ÷ 4 = 1.25%) is found with the formula for the present value of an ordinary annuity (see the earlier section, “Finding the present value of an annuity,” for more on this formula):
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Chapter 10: Investing in the Future R R n V  20 V S 1  ^1 + i h W S 1  ^1 + 0.0125h W P=RS WW = 5, 000 SS WW i 0.0125 S T X T X = 5, 000
[email protected] = $87, 996.58 It looks like the benefactor gave approximately $88,000 to help the new businesses.
Discovering how much time the annuity will last If you deposit a lump sum into an annuity, regular amounts can be withdrawn from the account over a period of time until the money is gone. So you’ll likely want to figure out how long that annuity will last based on your withdrawals. Say, for example, that Hank gets a large insurance settlement and deposits it in an account earning 6% compounded monthly. He arranges for monthly payments of $5,000 to be made from that annuity to help offset his business expenses. If the insurance settlement was for $400,000, how long will he be able to get the monthly payments? Using the formula for the present value of an ordinary annuity, you can solve for the number of payments, n. The interest rate per month is 6% ÷ 12 = 0.5%, which is 0.005. The regular payments, R, are the amounts being paid to Hank each month. Here’s what your equation should look like: R n V S 1  ^1 + 0.005h W 400, 000 = 5, 000 S WW 0.005 S T X Simplify the equation by dividing each side by 5,000 and then by multiplying each side by 0.005, like so: R n V S 1  ^1 + 0.005h W 5, 000 S WW 0.005 S 400, 000 = T X 5, 000 5, 000 R n V S 1  ^1 + 0.005h W 0.005 # 80 = S WW # 0.005 0.005 S T X n 0.4 = 1  ^1 + 0.005h ^1 + 0.005h = 0.6 n
Now take the natural log of each side of the equation, which allows you to bring the exponent, –n, down as a multiplier. Divide each side by ln(1.005), and use a scientific calculator to do the computation:
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Are some of these steps a bit unfamiliar to you? If it has been a while since you’ve seen an algebraic solution like this, refer to “Doubling your money, doubling your fun,” earlier in this chapter, where you can see a similar process used to solve an equation. The value of n, the number of monthly payments, is about 102.42. Divide that amount by 12 months, and you see that Hank will receive about 8.5 years of monthly payments of $5,000 from his insurance settlement. $5,000 × 102.42 = $512,100, which is the total amount of money that Hank will receive during those 8.5 years. The settlement was for $400,000; the difference between $512,100 and $400,000 is $112,100. So about $112,100 of that total is interest.
Deferring the annuity payment You can deposit an amount of money into an account with the understanding that regular payments will be made, but only after several years. You may have deposited the money in the account all at once, or you may have accumulated it over a period of years as an annuity. In any case, the amount in the account grows with compound interest before being disbursed. To figure the present value of a deferred annuity, you need to determine the number of payment periods in the payout and the number of payment periods the payout will be deferred before starting the disbursement. The present value of a deferred annuity is found with this equation: R n V S 1  ^1 + i h W P=RS n S i ^1 + i h WW T X where R is the regular payout amount, i is the interest per period, n1 is the number of periods the annuity is deferred, and n2 is the number of periods that payments are to be made from the annuity. 2
1
The formula for deferred payments combines two other formulas: the present value of an ordinary annuity (to determine the amount of money needed at the beginning of the disbursement period) and the present value of that present value (to determine how much you need to deposit right now to have the required amount some time in the future).
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Chapter 10: Investing in the Future Check out this example: A trust fund is set up to pay for the college education of a 2yearold boy. With the arrangement, $60,000 will be paid to the student per year for 5 years, starting when he’s 18 years old. The fund earns 5.5% compounded quarterly. The payout will also be quarterly. What’s the present value of this fund? The quarterly payout amounts are $60,000 ÷ 4 = $15,000. The interest rate per quarter is 5.5% ÷ 4 = 1.375%, which is 0.01375 in decimal form. The number of periods that the annuity is deferred is 16 × 4 = 64, and the number of periods over which the payment will be made is 5 × 4 = 20. Putting all the numbers in their proper places, you get this equation: R V  20 S 1  ^1 + 0.01375h W P = 15, 000 S 64 W S 0.01375 ^1 + 0.01375h W T X = 15, 000 ; 0.2390035 E 0.0329517 = 15, 000 6
[email protected] = 108,797.19 So the present value is $108,797.
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Chapter 11
Understanding and Managing Investments In This Chapter Making sense of stock quotes in the newspaper Dealing with stock report ratios Contacting a stockbroker Lending money to a company by buying bonds
O
ne of the first things you hear on the evening news is how the stock market has behaved (or misbehaved) during the day. The ups and downs of the market seem to act as a barometer of how the country and the world are doing — on all fronts. And it doesn’t seem to take much to instigate a change in the market. When change happens, people become either sellers or bargainseekers. You may need to understand the basics of investing so you can answer questions from investors, help employees sort through investment choices, know how the competition is doing, and manage your own stocks. You want to understand the basic premises of stocks and bonds and be able to make the computations necessary to further your understanding. The daily price quotations in the newspaper and scrolling across your television screen are interesting — but only with the right perspective. And the stock averages at day’s end serve to summarize the day’s trading — but even those numbers need a little explanation. So, in this chapter, I show you how to compute and understand some earnings ratios and daily quotes and determine the percent change from the day’s activities. Bonds are a way of investing in a company, too, so I take a brief look at the earnings involved with this investment tool.
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Interpreting the Daily Stock Market Quotations Current technology allows for instantaneous information on all sorts of investment topics: the price of various stocks, the number of shares that have traded, and the performance of the different stock indexes. These indexes include the Dow Jones Industrials, NYSE Composite, NASDAQ, S&P 500, and others. Choose the average that makes you happiest — at that particular point in time. Blink and it’s changed, anyway.
Getting to know the stock quotations The daily price quotations for stocks appearing in the newspapers and on television are much easier to decipher than they used to be. Until the Common Cents Stock Pricing Act was passed in 1997, the prices used to be in dollars and fractions, with halves, quarters, eighths, and sometimes even sixteenths and thirtyseconds. Beginning in August 2000, the stock market began changing the prices to decimals until all of the stocks and markets were converted. Converting these fractions to pennies when the decimal value of the fraction had more than two places was especially difficult. For example, the fraction 1 ⁄8 is equal to 0.125, which is 121⁄2 cents. I don’t know about you, but I can’t recall seeing many halfpenny coins around in my time. Luckily, the new, enlightened quotation method uses pennies instead of fractions of dollars. Table 111 is set up something like the daily stock quotations that you see in the newspaper.
Table 111
Example Stock Market Report on Selected Stocks
Name
Ex
Div
Yld
PE
Last
Chg
YTD % Chg
Allstate
NY
1.52
3.0
6
50.84
–.36
–21.9
Archer Daniels
NY
0.46
1.3
11
36.41
+.14
+13.9
Boeing
NY
1.40
1.6
17
87.86
–.41
–1.1
Caterpillar
NY
1.44
2.1
13
68.28
+.08
+11.3
Daimler
NY
2.00
2.0
...
98.04
+4.09
+59.6
Google
NASD
...
...
51
648.54
+22.69 +40.8
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Name
Ex
Div
Yld
PE
Last
Chg
YTD % Chg
HarleyDavidson
NY
1.20
2.7
12
45.09
–2.02
–36.0
McDonald’s
NY
1.50
2.6
31
58.48
–.12
+31.9
WalMart
NY
0.88
1.9
15
45.50
+.03
–1.5
Wiley
NY
0.44
1.1
20
39.76
–0.15
–0.1
Table 111 shows a sampling of ten companies, most listed on the New York Stock Exchange (NYSE) and one on NASDAQ. Here’s what each of the columns refers to: Ex indicates the exchange Div tells you the current annual dividend per stock Yld is the stock yield ratio PE is the price earnings ratio Last is the column that has the price of the stock at the end of trading on that day Chg tells you how much the price of the stock changed during the day’s trading YTD % Chg gives you the percent change in the price of the stock since the beginning of the year
Counting on stocks with different indexes Even though the Dow Jones Industrial Average (DJIA) and Standard & Poor’s 500 are the most recognizable stock indexes, several other indexes are used, observed, and studied. The NASDAQ index, for example, includes many smaller companies. Russell 2000 and Wilshire 5000 include smaller companies as well. The 2000 and 5000 in the names tell you the number of companies included in the index. These big numbers are a far cry from the 30 companies measured by the DJIA. Some other indexes are the NYSE Composite, Amex Market Value, S&P MidCap, Dow Transportation, and the Dow Utility Index. Just as the last two names imply,
they include transportation companies and utility companies, respectively. Even though it isn’t as wellknown, the Transportation Index is looked at with great interest, because when it’s doing well, you know that goods are being transported. And that, of course, is great for the economy. Conversely, when the Transportation Index is doing poorly, goods likely aren’t being moved, which is bad for the economy. The different indexes measure different types and sizes of companies. And the companies included in any of these indexes are in flux — they can change over time.
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Part III: Discovering the Math of Finance and Investments In general, you compute the previous day’s value of a particular stock by either adding to or subtracting from the price of the stock at the end of the day’s trading (Last). If the change is negative, you add that much to the end value. If the change is positive, you subtract the change from the end value. I know that this seems backward, but that’s what you’re doing: going backward! To determine the value of the stock at the beginning of the year, divide the current value (Last) by (1 + YTD% Chg). Refer to Table 111 and determine the price of the HarleyDavidson stock at the beginning of the day’s trading. The price of the stock finished at $45.09, and the price went down $2.02 during the day of trading. To get the beginning price, simply add $45.09 + $2.02 = $47.11. The stock started at approximately $47. Refer to Table 111 and the information involving the Google stock. What was the price of the stock at the beginning of the year? The Google stock finished at $648.54, which reflects a 40.8% increase from the beginning of the year. To solve, let the price of the stock at the beginning of the year be represented by x. The increase in the price since the beginning of the year is figured with this equation: $648.54 – x. Set the fraction equal to 40.8%, which is 0.408 as a decimal. (Changing from percents to decimals is covered in Chapter 2.) To get the percent increase, you divide the difference by the starting price, x, like this: 648.54  x = 0.408 x Now solve for the beginning price by multiplying each side by x, adding x to each side, simplifying, and dividing. Your math should look like this: x $ 648.54  x = 0.408 $ x x 648.54  x = 0.408x 648.54 = x + 0.408x 648.54 = 1.408x 648.54 = 1.408x 1.408 1.408 460.61 . x And, essentially, you’ve divided the current value by (1 + the percent change). As you can see, the stock started out at a little more than $460 at the beginning of the year.
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Computing percent change As a part of the daily reports on the stock market, you’re told not only how much the stocks went up or down but also the percent change. Basically, percent change is the change (how much the price went up or down) divided by the starting amount. If the price of the stock goes up, the percent change is a positive number. If the price goes down, the result is negative. The percent change is different from stock to stock and from index to index, because each item has a different base amount. Dividing various changes by different base amounts gives different decimal values and percentages. Refer to Table 111 and compute the percent changes in the prices of the HarleyDavidson stock and the Caterpillar stock. To compute the percent change, you divide the change in the stock by the beginning value. The HarleyDavidson stock went down $2.02 during the day of trading, so it started at $45.09 + $2.02 = $47.11. The percent change is the change of –$2.02 divided by $47.11:  2.02 .  0.042878 47.11 The change in this case is negative because the stock went down that day. The Caterpillar stock went up 8 cents that day, so it started at $68.28 – $0.08 = $68.20. In this case, the percent change is the change of $0.08 divided by $68.20: 0.08 . 0.0011730 68.20 The HarleyDavidson stock went down by about 4.3% and the Caterpillar stock went up by about 0.1%. The less the stock costs, the more changes have the potential to affect the percent change. For instance, if the Caterpillar stock had cost $6.80 instead of $68, the percent change would have been closer to 1% than onetenth of a percent. Here’s another example: Say that you read in the newspaper that Wiley stock went up $12 on Monday, which is a 25% increase, and then it went down $12 on Tuesday, which is a 20% decrease. You get out your trusty pen and paper and start checking the computations (because they just simply can’t be correct). Here’s what you determined: The price of Wiley stock started at $48 at the beginning of trading on Monday morning. The price increased by $12, so the percent increase is: 12 = 0.25 = 25% 48
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Part III: Discovering the Math of Finance and Investments The price of the stock at the end of trading on Monday is $48 + $12 = $60. On Tuesday, the price of the stock falls by $12. So the percent decrease is: 12 =  0.20 =  20% 60 The stock is now back to $48, but the percent increase was based on $48 and the percent decrease on $60. The larger the denominator of the fraction, the smaller the percentage (when the numerators are the same).
Using the averages to compute prices The different stock market indexes (or averages) all give interpretations of the status of the price of stocks. For instance, the Dow Jones Industrial Average (DJIA) is based on the prices of 30 representative stocks — but not their exact stated prices, because a factor enters into the picture. The factor, or dividing number, is used on the actual prices to try to standardize the prices when stock splits are involved; you get a more accurate picture of the value of the stock when increasing the number of shares is taken into account. The S&P 500 is the Standard and Poor’s average of the 500 biggest companies in the world. These companies are weighted by their size. Other indexes include NASDAQ, Amex Market Value Russell 2000, and Wilshire 5000. Each has its own formulation for determining its value. And the companies used with any of the indexes today are probably not those used several years ago, because the companies often come in and go out of the various indexes. Then the situations of the stocks change, which in turn changes their impact on the average. In the following sections, I show you how to use the DJIA and the S&P 500 to compute stock prices. I include only these specific indexes because they’re the most recognizable, and the techniques used can be adapted to computations in other indexes.
Employing the Dow Jones Average The Dow Jones Industrial Average (DJIA) isn’t really an average of the values of the 30 selected stocks; it’s a sum of the worth of those stocks. And the DJIA doesn’t consist of just industrial stocks anymore. You have technology and energy stocks and a smattering of the different types of commonly held stocks, such as McDonald’s, CocaCola, Microsoft, Home Depot, and WalMart. Over time, stocks being used by the DJIA may split, making the price per share lower. In this case, a factor, or dividing number, is applied to the sum of the stock values to keep the comparison consistent and meaningful. The factor at any time divides the total cost of the 30 selected stocks. So, if the factor is greater than 1, the DJIA comes out to be lower than the actual total
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Chapter 11: Understanding and Managing Investments cost of the stocks. In late 2007, for example, the index was 0.13532775, which is between oneeighth and oneseventh. Dividing the total cost of the stocks by this rather small number makes the DJIA much larger than the actual cost of the stocks. A stock split is a way that a company makes more shares of its stock available to the trading public. For example, if you had 100 shares of Company Z worth $20 per share, after a split you’d have 200 shares of the Company worth $10 per share. You haven’t lost any money; you just have more shares that cost less. This process of splitting stocks was introduced to lower the cost of a share and make it more affordable for more people. If the DJIA is quoted as being 13,010.14 and the index is 0.13532775, what’s the actual total price of the 30 stocks being used in the index? Divide the actual total price of the stocks by 0.13532775 to get 13,010.14. Let x represent the total price of the 30 stocks. Then solve the equation for x by multiplying each side of the equation by the index value. Your math for this problem should look like this: x = 13, 010.14 0.13532775 x 0.13532775 $ = 13, 010.14 ^ 0.13532775h 0.13532775 x . 1,760.63 The total price of the 30 stocks is about $1,760.63. So the average price of the 30 stocks used is $1,760.63 ÷ 30 ≈ $58.67. On average, each stock is worth about $60. What’s the impact on the DJIA if the price of one stock goes up by $2.00? At first, you want to say that the DJIA increases by 2. But don’t forget the factor. You divide the $2.00 by the index, 0.13532775, and get roughly $14.78. So, when you read that the Dow Jones went up by $14.78 in one day, it could have been that one stock increased by just $2.00.
Weighting share values with the S&P 500 The Standard & Poor’s 500 Index (S&P 500) is one of the more widely watched indexes, and is probably the most popular after the Dow Jones Industrial Average. The 500 stocks that are represented in the S&P 500 are mostly those of American corporations. Another qualification of the index is that the S&P 500 uses only shares in a company that are available for public trading. The numerical value of the index is computed by weighting the share values (giving more weight or importance to the companies whose stock is worth more). The weighting is based on the corporation’s total market valuation — and is extrapolated (using what it was worth some time ago) back in time — to when the first S&P Index was introduced in the 1920s. The market
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Part III: Discovering the Math of Finance and Investments valuation of a company is its share price multiplied by the number of outstanding shares. The reason that a corporation’s shares are weighted is because price movements of companies that have a larger market valuation have more of an influence on the index than price changes in smaller companies. The following example shows you how a weighted average works. If Company A has 2,000,000 shares selling at $45.90 each, Company B has 1,000,000 shares selling at $60.80 each, and Company C has 500,000 shares selling at $120.40 each, what’s the weighted average of one share of each stock? If you want to average just the prices of the stocks, you add the three prices together and divide by 3. For example, you first add: $45.90 + $60.80 + $120.40 = $227.10. Now divide that sum by 3, like so: $227.10 ÷ 3 = $75.70. Unfortunately, this average isn’t a good representation, because too much emphasis is given to the price of the stock of Company C, which has onefourth the number of shares that Company A has. Instead, you have to find the weighted average. One way to find the weighted average is to multiply each number of shares by its price and divide by the total number of shares. Another method is to find the percent shares that each company has, multiply the percentage by the share price, and add the products together. I show you both ways in the following sections for contrast and clarification. The first method, multiplying the number of shares by the prices, introduces large numbers that can become difficult to manage. The second method of using the percentages involves dreaded decimals, but it also gives you a better perspective on the actual weighting and relative size of the company’s stock offering.
Method 1: Multiplying the number of shares by price To find the weighted average of the stock prices with this method, multiply each number of shares by the price of the stock: Company A: 2,000,000 × $45.90 = $91,800,000 Company B: 1,000,000 × $60.80 = $60,800,000 Company C: 500,000 × $120.40 = $60,200,000 Now add the products together and divide by the total number of stocks. First off, find the sum: $91,800,000 + $60,800,000 + $60,200,000 = $212,800,000. Then find the total number of stocks: 2,000,000 + 1,000,000 + 500,000 = 3,500,000. Now divide the two: $212,800,000 ÷ 3,500,000 = $60.80. The weighted average is quite a bit lower than the $75.70 obtained by just averaging the three prices.
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Chapter 11: Understanding and Managing Investments Method 2: Finding the percentage of the stocks As you discover in the previous section, the three companies offer a total of 3,500,000 stocks. The percentage held by each of the individual companies is found by dividing the number of stocks a company has by the total number of all three: Company A: 2,000,000 ÷ 3,500,000 ≈ 0.571 Company B: 1,000,000 ÷ 3,500,000 ≈ 0.286 Company C: 500,000 ÷ 3,500,000 ≈ 0.143 So Company A has about 57%, Company B has about 29%, and Company C has about 14%. Multiply each percentage (its decimal equivalent) by the price of the respective stock and add the results together, like this: (0.571 × $45.90) + (0.286 × $60.80) + (0.143 × $120.40) = $26.2089 + $17.3888 + $17.2172 = $60.8149, or about $60.81. The average with this method is about one cent different from the previous method because of the rounding that’s done with the fractions.
Wrangling with the Ratios The different stock averages or indexes offer a measure of the activity and worth of stocks as a whole. Ratios, such as earnings per share, price earnings, yield, return on investment, return on assets, and profit ratio, offer information on the individual stocks. The numbers associated with each ratio allow you to compare the stocks to one another on another front. In this section, I show you the various computations necessary for the ratios. A ratio is a fraction in which one quantity divides another. The ratio is represented by the fraction, such as 7⁄8, or by a corresponding decimal, in this case 0.875. When the fraction’s numerator (the top number) is larger than the denominator (the bottom number), the ratio has a value greater than 1. For instance, the ratio 9⁄4 = 2.25.
Examining the stock yield ratio The stock yield ratio, abbreviated Yld on a stock report, is the ratio of the annual dividend per share and the current value per share of the stock. The stock yield ratio changes when either the dividends change or when the price of the stock changes. By referring to Table 111, you can see columns for the dividend (Div), the yield (Yld), and the current price of the stock (Last). If you divide the dividend by the stock price, you get a percentage — which is how the value is reported under the yield.
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Part III: Discovering the Math of Finance and Investments For instance, from Table 111, Allstate stock has a dividend of $1.52 per share and is currently trading at $50.84. To get the stock yield ratio for this stock, divide $1.52 by $50.84: 1.52 . 0.0298977 50.84 The ratio rounds to about 0.03, or 3 percent. Using the information in Table 111, determine how much the stock yield ratio changed for Daimler during the day’s trading. According to the table, the Daimler stock has a dividend of $2 and, currently, a stock yield ratio of 2%. The stock yield ratio is determined by dividing the dividend, $2, by the price of the stock, $98.04. During trading that day, the stock went up by $4.09, so you know that the previous price of the stock was $98.04 – $4.09 = $93.95. You can now compute the previous stock yield ratio by dividing the dividend by $93.95: 2.00 . 0.021288 93.95 The ratio rounds to 2%. So it appears that the increase in price didn’t change the ratio. The apparent lack of change has to do with the rounding. Dividing $2 by $98.04 gives you a decimal value of about 0.0203998; dividing $2 by $93.95 gives you the decimal value of about 0.0212879. The decimals are different by about one thousandth (or one tenth of one percent). The daily fluctuations in a stock’s price usually have little or no impact on the yield ratio. Over the long run, however, the change is more significant and apparent. If your stock value goes up and the dividends stay about the same, the ratio will decrease. You have to decide what you want from your stock: growth or income.
Earning respect for the PE ratio The price earnings ratio, or PE ratio, is determined by dividing the price per share by the earnings per share. The earnings in this case aren’t the dividends paid to the stockholder. The earnings used in the PE ratio are the profits of the particular company. So the PE ratio is determined by dividing the number of shares the company is offering by the profit associated with those shares. Try out the following example to better understand what I mean. One problem with the PE ratio is that the earnings figures may not be absolutely uptodate. Even with computerized reporting and instantaneous figuring, the numbers may not truly reflect the exact value if the information input is several days old and the price of the stock is that day’s price.
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Chapter 11: Understanding and Managing Investments Refer to the Table 111 entries for WalMart. The PE ratio is given as 15, and the price per share is $45.50. What are the earnings per share, based on this information? You can find the PE ratio by dividing the price per share by the earnings. Let x represent the earnings in the equation, and then multiply each side by x and divide by the ratio. Here’s what your math should look like: PE Ratio =
Price per share Earnings per share
15 = 45x.50 15x = 45.50 x = 45.50 . 3.0333 15 So you can see that the earnings are slightly over $3 per share. If you know the total number of shares involved, you can multiply the $3 by the number of shares to get the total earnings of the company.
Working with earnings per share You can determine the earnings per share of stock if you have the price of the stock and the PE ratio. (Refer to the previous section, “Earning respect for the PE ratio,” for details on how to compute the PE ratio.) You may be wondering whether you can determine the earnings per share if you don’t have the PE ratio available. The answer is yes! Why? Well, by definition, the ratio is obtained by dividing the earnings (after taxes) by the number of available shares. So, if a company’s earnings (after taxes) come to $6,000,000 and 300,000 shares are available, the earnings per share ratio is: 6, 000, 000 = 20 300, 000 So the earnings per share is $20 per share.
Calculating profit ratios When investing in a business or corporation, the investor is usually interested in the prospect of profits. The revenue, cost, and profit values themselves don’t always give you the information that you’re seeking when deciding on an investment. But with standard profit ratios, you can compare one company’s ratio with another. Or you can just keep track of how the ratio is changing within one company.
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Part III: Discovering the Math of Finance and Investments The return on investment ratio (ROI), the return on assets ratio (ROA), and the profit ratio provide three different — but somewhat connected — bits of information about a company. I explain each of them in the following sections.
The return on investment ratio A company’s ROI ratio, which measures its ability to create profits for its owners or stockholders, is computed by dividing the net income of the company by the equity in the company. The ratio as a percentage represents the dollars in net income earned per dollar of invested capital. For some types of businesses, an ROI of 15% is satisfactory. After a particular target ROI is established, a business can adjust its prices and operations to best meet that mark. A company has equity of $1,000,000 and a net income of $40,000. What’s its ROI? To find out, all you have to do is divide the net income by the equity: ROI = net income equity ROI =
40,000 = 0.04 = 4% 1,000,000
The ROI, as you can see, is 4%. Depending on the business, this percentage is either satisfactory or unsatisfactory.
The return on assets ratio The ROA ratio is quite similar to the ROI (from the previous section), but there are a few differences, which can be better explained by an accountant. The ROA is computed by dividing the earnings (before interest and taxes) by the net operating assets. In general, both ratios are reported as percentages, and, unless unhealthily so, the higher the ratio the better. A company’s ROA is 8%, and its earnings (before interest and taxes) are $45,000,000. What are the company’s net operating assets? Because the ROA is computed by dividing the earnings by the assets, you find the assets by dividing the earnings by the ROA percentage. Dividing $45,000,000 by 0.08 you get $562,500,000. Again, you determine, depending on the business, as to whether this ROA is acceptable for your company or not.
The profit ratio The profit ratio is a percentage indicating the profit that’s generated for each dollar of revenue (after all normal costs are deducted). You can determine the profit ratio by dividing net income by net sales. The net income in this
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Chapter 11: Understanding and Managing Investments case is the income after all expenses; the net sales represents the total revenue less any returns. Some companies, such as appliance or software companies, expect a profit ratio of 30% to 40%. A grocery store, however, expects a profit ratio of 2% to 3%. Why does a grocery store expect less? Well, because it handles a lot of different merchandise that a lot of people need. Plus, the food found in grocery stores has already had additions to the cost of the raw product because of processing, transporting, storing, and stocking on the shelves. What’s the profit ratio of a company whose gross revenue is $50,000,000 with 5% returns expected? The net income, in this case, is 30% of the gross revenue. First determine the net revenue by reducing the gross amount by the returns. If 5% is returned, then 95% of the gross revenue constitutes the net revenue. So, to reduce the gross amount by the returns, you multiply the gross revenue by the net revenue: $50,000,000 × 0.95 = $47,500,000. Now find 30% of the gross income by multiplying the gross revenue by the decimal form of 30%: $50,000,000 × 0.30 = $15,000,000. Now you’re all set to find the profit ratio: net income Profit ratio = net revenue 15,000,000 = . 0.3157898 47,500,000 The profit ratio is about 31.6%.
Making Use of Your Broker A stockbroker or financial consultant is someone you can turn to if you need financial or investment advice. The brokers and brokerage houses have access to all sorts of information and resources to help you with your investing activity. The Internet offers lots of opportunities for individuals to do their own investing, but that means they have to do all the research and dirty work (which can be difficult). Those who prefer to go with a professional for advice and resources can take advantage of such options as buying stocks on margin and using puts, calls, straddles, and spreads. When you contract with a broker for a put or call, you pay a commission, because a deal has been brokered — someone had to put the two parties together to make the transaction work. Because brokers charge for their expertise, you also need to be familiar with the commission schedule and what this means to your bottom line. I explain many of the basics you need to know about investing in the brokerage world in the following sections.
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Puts, calls, straddles, and spreads I’ll bet you’re thinking that I’ve switched from math to a football game. No such luck. However, the calls made in investing are like the plans made by the quarterback. But football games can’t wait for days or weeks to see the results of the call. And, similarly, a spread in bond prices may act like a point spread prediction of a sportscaster; the investor is more leery when the spread is too great. Okay, enough of the analogies. A put is a contract that allows the owner of a particular stock to sell that stock if it reaches a particular price in a designated amount of time. A call is a contract that gives someone the right to purchase a given stock at a particular
price — if it reaches that price in a designated amount of time. An investor uses a straddle if he contracts for an equal number of puts and calls with the same price and the same expiration date (playing it both ways). And a spread is the difference between the amount in the contract and the current asking price. Puts are used by investors who are looking for a profit from a rise in the stock prices, and calls are used by investors who expect a profit from a fall in the stock prices. Confusing? Well, just remember that it’s more confusing than the rules for football, but less confusing than the rules for soccer.
Buying stocks on margin The usual procedure for buying some commodity is to make an offer, strike a deal, pay for the item, and then take it home. In the case of stock purchases, you make an offer — usually what the market price is at the time — pay for the item or items, and then receive a certificate showing your ownership of the stock. There are some variations on making the offer that your stockbroker can tell you about: calls, puts, and straddles are a few of these variations. Your broker can also explain the process of buying stock on margin. The margin purchasing option is sort of a cross between buying and borrowing — at the same time. Essentially, when you purchase stocks on margin, you arrange to buy a certain number of shares of stock, but you don’t pay the full price for the stock. Instead, you pay a percentage of the price. The percentage you pay is usually 50%, but it can fluctuate between 50% and 100%, depending on the circumstances. So, if you only pay 50% of the price of the stock, who pays for the rest? The brokerage house that you happen to be dealing with. It loans you the money for the rest of the purchase, and it charges interest, of course. The math involved in margin accounts can be a bit tricky, but that’s why I provide you with the upcoming example. The only downside to buying on margin is if the stock goes down instead of up. In that case, you’ll be asked by the brokerage firm to settle and pay off the loan or to add additional cash to the account to bring your investment up to the desired percentage.
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Chapter 11: Understanding and Managing Investments Suppose you establish a margin account with your broker. You arrange to purchase 100 shares of your favorite stock, which is now selling for $70 per share. The brokerage house sends you a bill for 50% of the cost of the stock, which you pay. You agree to pay 7% interest on the difference until the stock goes up 10% in value (which ends up taking four months). As soon as the stock increases in value by 10%, you sell the stock and pay back the broker. How much money do you make on this transaction? First of all, you determine how much money is being borrowed at 7%. One hundred shares of stock at $70 per share is 100 × $70 = $7,000. Because you paid 50% of this bill and borrowed the rest, you paid $3,500 and borrowed the other $3,500. The interest on $3,500 at 7% is about $20.42. (Computing interest on loans is covered in detail in Chapter 12.) You pay this amount of interest monthly for the four months until the stock goes up to the level you want. If the stock’s value increases by 10%, it’s then worth the original amount multiplied by the original 100% plus the increase of 10%: $7,000 × 110% = $7,000 × 1.10 = $7,700. (You can find out more about percent increases in Chapter 3.) You pay your broker $3,500, the amount borrowed. So your net profit is the $7,700 selling price of the stock minus the cost of the stock minus the interest payments. In other words, your net is: $7,700 – $7,000 – 4($20.42) = $700 – $81.68 = $618.32. You usually also have to pay broker fees, but you still end up with a nice profit.
Paying a commission You pay bankers, mechanics, and accountants for their expertise. Likewise, you can expect to pay a stockbroker for advice, guidance, and other services provided by the brokerage firm. Until a few years ago, stock was bought in lots of 100 (multiples of 100); those that weren’t purchased in lots of 100 were deemed odd lots. In this case, a price differential was then applied to the odd lots to make up for the inconvenience of not dealing with nice, round numbers. In other words, the broker received the usual commission, based on the purchase price, and an extra charge was added on for the strange number of stocks purchased. Nowadays, any number of stocks can be purchased, and the commission is a percentage of the purchase price. Different brokerages have different commission scales, but most charge somewhere between 1% and 3% of the purchase price. The more stock you purchase and the greater the price you pay, the smaller the percentage you’re charged. Table 112 is a possible commission schedule. The number of stocks being purchased is multiplied by the cost per share to determine the purchase price. The maximum commission is $500 and is paid for any transaction whose price is $50,000 or more.
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Part III: Discovering the Math of Finance and Investments Table 112 Purchase $ % Commission
Percent Commission Based on Purchase Price 0–1,000
1,001–5,000
3%
2.5%
5,001–20,000 20,001–50,000 +50,001 2%
1.5%
($500 max.)
What’s the commission paid on the purchase of 250 shares of stock that cost $47.90 per share? The purchase price is 250 × $47.90 = $11,975. An $11,000 purchase puts you in the 2% category. So the commission is $11,975 × 2% = $11,975 × 0.02 = $239.50.
Investing in the public: Buying bonds A bond is a way of investing in a corporation, university, or some other public project. Essentially, you’re lending money to the institution with the expectation of getting back your principal plus some interest. In most cases, the bond and interest are all paid back at the end of the agreedupon time period. In some cases, however, the bond is discounted — the interest is deducted from the amount loaned and is paid to the bondholder up front. Most bonds are arranged for with your stockbroker. You can purchase treasury bonds or savings bonds at a bank, but the others are negotiated through a brokerage firm. Bonds are different from stocks, because a stockholder is actually a partowner of the enterprise when they hold the stock certificates. A bondholder is just a lender. Many issues of bonds are available on the principal exchanges, which means that the stockbroker is aware of and can make recommendations as to their availability and advisability. Bonds come in all shapes and sizes and arrangements of payments. You have taxfree bonds, zero coupon bonds, premium bonds, and discount bonds. You decide with your broker how you want to arrange your profit — equally over the term of the bond, more upfront, or more toward the end. The variations are many. Check out this example to see how to calculate bond interest: Suppose you invest $10,000 in bonds at a 5% annual rate of interest. The agreement stipulates that the company make semiannual interest payments until the bond is repaid. How much interest is paid each year? The annual interest of 5% on $10,000 earns 0.05 × $10,000 = $500 each year; half is paid each six months. Not too bad!
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Chapter 12
Using Loans and Credit to Make Purchases In This Chapter Surveying promissory and discount notes Discovering how to work with conventional loans Purchasing products or services with installment loans Managing credit and debit cards
L
oans are a necessary part of life. They allow consumers to buy houses, cars, and furniture, and they help to pay for college. Loans allow business owners to expand their facilities, improve their inventories, and even weather tough times. The specifics of the loan depend on many things. Some of the questions you have to ask yourself are: Is the loan secured? (Do I have some asset that the lender will get if I don’t pay the money back?) How long will I be borrowing the money? Will I pay the money back all at once, or will I pay it back in installments?
Loans come in one of several forms. For instance, they can be in the form of a promissory note or a discount note. Discount notes are called such because the interest amount is deducted from the amount that’s borrowed. A credit card balance is also a form of loan. This type of loan doesn’t have a set end to it — you pay back the balance, but not necessarily for any fixed amount of time. Installment buying is another form of loan. And, finally, there are personal property or business loans. You need to arrange for the type of loan that best fits your needs. And you better know the ins and outs of the numbers involved. After all, you don’t want to get involved in a loan that costs more than it should or that puts you into a position that you don’t want to be in. This chapter helps with all this and more.
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Taking Note of Promissory and Discount Notes A promissory note is a legal document that requires the borrower to pay back the amount he or she owes at specific time intervals and at a specific fixed rate of interest. With this type of note, you determine the amount of interest based on the face value — the amount borrowed — and you determine how all the money will be paid back over time. The terms of the note may include the deduction of interest from the amount borrowed — in which case the note is called a discount note. Promissory notes may be used when a business borrows from other individuals and groups rather than banks or other institutions. The note is the legal, official statement of the terms. The terms of the note may be better than what you can get at the bank — if you’re dealing with good friends or relatives — or not necessarily all that good. But you may have no other option. The following sections describe both full face value notes and discount notes.
Facing up to notes that have full face value A promissory note in which the interest isn’t deducted has full face value. In other words, you get the full amount of money, and nothing is deducted from what you’re given. When you pay back what you owe, you add the face value (the amount of money borrowed) and the interest and then make arrangements for payment of that sum. The upcoming example shows you the best way to calculate payment amounts when it comes to full facevalue loans. Here’s a clue that will help you with the example problem: Simple interest is determined with I = Prt, where I is the amount of interest, P is the principal or amount borrowed, r is the rate of interest, and t is the time in years. (You find lots of information on simple and compound interest in Chapter 9.) Say, for example, you borrow $20,000 for 3 months in order to pay for some holiday inventory. You agree to make 3 monthly payments and pay 9% interest compounded quarterly. How much is each of your payments? First you have to compute the interest using the simple interest formula that I mention earlier in this section. To do so, you simply have to plug the numbers you know into the formula. For instance, you replace the interest rate, 9%, with its decimal equivalent, 0.09. You also replace the amount of time with 0.25, which is onefourth of a year (3 months). And, of course, you know the loan amount, $20,000, which is put in place of the principal.
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Chapter 12: Using Loans and Credit to Make Purchases So, here’s what your math looks like: I = $20,000 × 0.09 × 0.25 = $450. Add the interest to the principal, and you owe a total of $20,450. When you divide the total by 3 (to get the amounts of the payments), the answer doesn’t come out evenly. So, instead, you can make two payments of $6,816.67 and one payment of $6,816.66.
Discounting the value of a promissory note Suppose you want to borrow $10,000. You arrange for the transaction and sign a promissory note. The note is then discounted — the amount of the interest is deducted from what you’re given. In other words, you don’t have the full $10,000 to work with, but you have to pay the face value, $10,000, back to the lender. Discounting a note isn’t an unusual practice, so make sure you know what you’re getting into. The payments for a discount note are fairly straightforward to determine. You may want to rethink the transaction, though, and increase the amount of the note so that you have more money to work with. One of the more wellknown types of discount notes is the U.S. Treasury bill, in which you’re the one loaning money to the U.S. Government for a period of time.
Working with a discounted note Say that you’re borrowing money for a short period of time and agree to the terms of a discount note. Now you need to determine what the payback looks like. To do so, you have to subtract the interest owed from the amount borrowed. Here’s an example to get you started. A discount note is arranged so that $10,000 is borrowed for 6 months at 12% compounded monthly. The interest is deducted from the amount of the note, and you agree to pay the money back in two installments — one at the end of 3 months, and the other at the end of the 6 months. How much money do you actually get to work with, and how much do you pay back? First determine the amount of interest using the interest formula, I = Prt. The interest rate of 12% is written 0.12 as a decimal; the 6month period is half a year, or 0.5. So the interest on the note is figured like this: I = $10,000 × 0.12 × 0.5 = $600. With this loan, you’re actually given $10,000 – $600 = $9,400. You pay back the full $10,000, so your two payments are each $5,000.
Increasing the amount of the discount note to cover expenses If you’re borrowing money using a discount promissory note, you may have a target amount in mind. To ensure that you get the amount you need after the discounting, you may have to increase the face value of the note.
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Part III: Discovering the Math of Finance and Investments For instance, if you need $50,000 to cover expenses for 3 months, and you arrange for a discount note charging 10% interest, you don’t get the full $50,000 to work with. Instead, you get $50,000 minus the interest charge. So, instead of borrowing $50,000, you need to increase the amount of the note to an amount that allows you to end up with $50,000 after the interest is subtracted. To find out how much you need to increase the note by, consider the following: The $50,000 you want is the difference between the face value of the note and the interest paid. Let f represent the face value and I the amount of interest. Three months is onequarter of a year, or 0.25. So here’s what the equation would look like: $50,000 = f – I = f – (f × 0.10 × 0.25) You replace the amount of interest, I, with the face value times the interest rate of 10% times the quarter year. Now you’re ready to solve for the value of f: 50, 000 = f  ^ f # 0.10 # 0.25h 50, 000 = f  0.025f 50, 000 = 0.975f 50, 000 0.975f = 0.975 0.975 51, 282.05 . f As you can see, if you arrange to borrow about $51,282, you’ll have your $50,000 to work with during those 3 months.
Borrowing with a Conventional Loan A conventional loan may come in the form of a mortgage on a building, a car or truck loan, a building equity loan, or a personal loan. Loans are available through banks, credit unions, employers, and many other institutions. Your task is to find the best possible arrangement to fit your needs. If you’re comfortable doing the legwork and computations yourself, get out paper, pencil, and a calculator and start searching the newspaper and Internet. If you don’t trust yourself quite yet, find an accountant or financial consultant whom you trust and feel comfortable talking to.
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Chapter 12: Using Loans and Credit to Make Purchases You can compute the interest and payments of a loan by using a book of tables and your handy, dandy calculator, or you can even find a loan calculator on the Internet. The variables involved in the computation of loan payments are Amount of money borrowed Interest rate Amount of time needed to pay back the loan Each of these variables (values that change the result) affects the result differently — some more dramatically than others. Dealing with a bank or financial institution may seem more impersonal than dealing with an acquaintance or small lender, but the tradeoff is more flexibility in payment schedules, availability of more money, and, usually, better rates and terms of the loan.
Computing the amount of loan payments You can determine the amount of your loan payments using tables of values or a loan calculator. If you’re more of a control person (like me), you probably want to do the computations yourself — just to be sure that the figures are accurate. The periodic payment of an amortized loan is determined with this formula: R=
Pi n 1  ^1 + i h
where R is the regular payment you’ll be making, P is the principal or amount borrowed, i is the periodic interest rate (the annual rate divided by the number of times each year you’re making payments), and n is the number of periods or payments. Try your hand at determining a payment with this example: What’s the monthly payment on a loan of $160,000 for 10 years if the interest rate is 9.75% compounded monthly? The interest rate per month is 9.75% ÷ 12 = 0.8125%, or 0.008125 per interest period. The number of payments, n, is 10 years × 12 = 120. Using all the values in the formula, you get: R=
160, 000 ^ 0.008125h
1  ^1 + 0.008125h
 120
=
1, 300 = 2, 092.32 0.621319
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Part III: Discovering the Math of Finance and Investments So the monthly payments are about $2,100. To find the total payback, simply multiply the monthly payment by the number of payments: $2,092.32 × 120 = $251,078.40. So more than $91,000 is paid in interest. (The interest is the total payback minus the amount borrowed: $251,078.40 – $160,000 = $91,078.40.)
Considering time and rate There’s no question that the amount of money borrowed affects the conditions of a payback. After all, the more you borrow, the more you’re going to owe. But the rate of interest and amount of time needed to repay the money act a bit differently in the overall payback. I explain both of these in the following sections.
Taking your time to repay a loan Spreading your loan over a longer period of time makes your regular payments smaller. But what does spreading out those payments do to the total amount of the payback? And how does spreading out the payments affect the total amount of interest? Well, it only makes sense that the longer you take to repay a loan, the more you’re going to pay for the privilege of doing so. Table 121 gives you an example of how time affects payback — both in the monthly payments and the total amount repaid. The figures in Table 121 are all based on a loan of $40,000 at 9% interest compounded monthly.
Table 121
Stats on a Loan for $40,000 at 9% Interest in Monthly Payments
Number of Years
Monthly Payments
Total Payback
Total Interest
10
$506.70
$60,804.37
$20,804.37
15
$405.71
$73,027.19
$33,027.19
20
$359.89
$86,373.69
$46,373.69
25
$335.68
$100,703.60
$60,703.60
30
$321.85
$115,865.70
$75,865.70
35
$313.60
$131,710.82
$91,710.82
40
$308.54
$148,101.40
$108,101.40
As you can see from Table 121, the payments are much smaller if you pay back in 40 years rather than in 10 years. But the amount of interest paid is enormously greater when spread over the longer period of time.
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Chapter 12: Using Loans and Credit to Make Purchases Showing an interest in the interest rate As astounding as increasing the amount of time to repay a loan can be in terms of interest paid, an increase in the interest rate tends to be just as astonishing. For instance, increasing the rate by only 1% makes a significant difference when you’re paying over a multiyear period. Table 122 shows you what happens to a $40,000 loan as the interest rate increases. In the table, you see the total payback and interest paid if the loan is for 10 years and if the loan is for 30 years.
Table 122
Stats on a Loan for $40,000 for 10 Years and 30 Years
Interest Rate
Total at 10 Years (Interest)
Total at 30 Years (Interest)
6%
$53,289.84 ($13,289.84)
$86,335.28 ($46,335.28)
7%
$55,732.07 ($15,732.07)
$95,803.56 ($55,803.56)
8%
$58,237.25 ($18,237.25)
$105,662.10 ($65,662.10)
9%
$60,804.37 ($20,804.37)
$115,865.70 ($75,865.70)
10%
$63,432.35 ($23,432.35)
$126,370.30 ($86,370.30)
11%
$66,120.01 ($26,120.01)
$137,134.60 ($97,134.60)
12%
$68,866.06 ($28,866.06)
$148,120.20 ($108,120.20)
Table 122 confirms it: The higher the interest rate, the more you pay in interest. At 6% and 30 years, you pay a little more than twice what you borrowed after adding interest. At 12% and 30 years, you pay over $100,000 more than you borrowed just in interest.
Determining the remaining balance If you borrow money using a 20 or 30year loan and then, all of a sudden, you have a windfall and want to clear all your debts, you need to know what’s left to pay on your loan. You may not expect to win the lottery, inherit a fortune, or receive some other type of windfall when you take out a loan, but you really should avoid any contracts that penalize you for making an early payment. Get rid of that type of clause, if you can. It won’t hurt anything if you do get that windfall, and you’ll save money if you’re able to settle up before the end of the loan term. By paying early, you avoid paying some of the interest. However, most amortized loans build in high interest payments at the beginning of the payback. So you want to get that windfall early in the game.
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Part III: Discovering the Math of Finance and Investments You can find the approximate balance remaining on a loan by using this formula: R  (n  x) V S 1  ^1 + i h W B=RS WW i S T X where B is the remaining balance on the loan, R is the regular payment amount, i is the periodic interest rate, n is the number of payments, and x is the number of payments that have already been made. Say that you’ve been paying off a 20year loan and are 10 years into the payments. You think you have close to half the loan paid, right? Wrong! Check out the following example to see why you aren’t so close to having your loan paid off. Ten years ago, you took out a 20year loan for $60,000 at 7.25%. You make monthly payments of $475. But now you’ve inherited some money and want to pay off the balance of the loan. How close is the balance to being halfway paid off? To find out, you use the formula to estimate the remaining balance. First figure out the values of all the known variables. The value of i is 7.25% ÷ 12 ≈ 0.604167%, or 0.00604167; n = 20 × 12 = 240; and x = 10 × 12 = 120. Now you’re ready to plug all these numbers into the formula and solve. Your math should look like this: R  (240  120) V S 1  ^1 + 0.00604167h W B = 475 S WW 0.00604167 S TR X  120 V S 1  ^1.00604167h W = 475 S WW 0.00604167 S T X = 475 ; 0.514618 E = 475 6
[email protected] 0.00604167 . 40, 459.60 Halfway through the loan period of 20 years, only onethird of this loan has been paid off. Yikes!
Paying more than required each month Say that you’ve taken out a loan and arranged for monthly payments over a 20year period. Then you realize that you’re able to pay a little more than the monthly payment. Is it a good idea to do so? Absolutely! Making payments larger than necessary is a splendid idea. You’ll finish paying off the loan much sooner, and you’ll save lots of money in interest.
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Chapter 12: Using Loans and Credit to Make Purchases Making largerthannecessary payments reduces the amount of the principal still owed, which in turn reduces the interest that needs to be paid. Why? Because the monthly interest is figured based on the current principal, and the interest is paid first. Anything left goes toward reducing the principal. At the beginning of an amortized loan schedule, most of the payment goes toward interest. Table 123 shows you how much of a payment on a 20year, $100,000 loan at 6% goes toward interest and how much goes toward the principal. The monthly payments are about $716.44.
Table 123
Principal and Interest on a $100,000 Loan
Principal
Interest That Month
Payment – Interest = Applied to Principal
$100,000
$500
$716.44 – 500 = $216.44
$99,783.56
$498.92
$716.44 – 498.92 = $217.52
$99,566.04
$497.83
$716.44 – 497.83 = $218.61
↓
↓
↓
$2,128
$10.64
$716.44 – 10.64 = $705.80
$1,422.20
$7.11
$716.44 – 7.11 = $709.33
$712.87
$3.56
0
You see that most of the payment goes toward interest at the beginning of the 20 years. Toward the end, most of the payment goes toward the principal. The last payment is only $712.87. By increasing the payment to $800 each month, the additional $83.56 goes toward reducing the principal. This way, the loan is paid off in about 16.5 years instead of 20. And the total amount of interest paid is reduced. To figure out how much interest is saved, multiply the payment amount by the total number of payments you’ll make in 20 years (20 × 12 = 240 payments): $716.44 × 240 = $171,945.60. The loan is for $100,000, so $71,945.60 is paid in interest. The number of payments in 16.5 years is 16.5 × 12 = 198. By increasing the payments to $800, you end up paying $800 × 198 payments = $158,400. The interest paid this time is $58,400. The savings is over $13,500. How did I get the number of payments needed at $800? The easiest way to figure this out is with a spreadsheet and formulas that you type in for the interest and payments. I explain how to set up spreadsheets in Chapter 5.
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Part III: Discovering the Math of Finance and Investments
Working with Installment Loans An installment loan is a loan in which the principal and interest are paid back in installments. What makes the installment loan different from a conventional loan or promissory note is that the amount paid in each installment and the number of installments are what drive the interest rate. The interest may or may not be clearly indicated. The annual percentage rate, or APR, is the actual rate of interest charged for the privilege of having the loan. The stated rate and the actual rate are usually completely different things. For example, the stated rate may be 4%, but if you take into account the effect of monthly compounding, that rate is really 4.07415%. The difference may not seem like much, but it adds up when you’re dealing with lots of money. A formula allows you to determine the annual percentage rate. I introduce this formula in the following section. Installment loans are commonly used when making purchases from retailers who are anxious to move their merchandise and earn a profit not only from the markup but also from the interest on the loan. You may be willing to purchase an item using an installment loan if your only option is to let that merchant be your banker. If you aren’t in the position to pay cash or borrow more money from a bank, the installment plan allows you the use of the merchandise immediately.
Calculating the annual percentage rate The APR isn’t something that’s widely broadcast on many installment loan contracts; you’ll see the stated interest amount, but the APR takes a little more figuring. It takes into account the effects of compounding and any fees and extra charges. If you’ve ever tried to find a formula for determining APR, you’ve probably discovered that it’s difficult to find one. Most Web sites just want to do the calculations for you. It must be assumed that you really don’t want to tackle a formula or that it’s beyond your capabilities. Well, I know better than that! Of course you want to do the math! The best formula I’ve found is a variation on Steve Slavin’s formula in Business Math (Wiley). Here it is: APR =
2m _ finance chargei 2m ^ Prt h 2mrt = = P ^ n + 1h P ^ n + 1h n + 1
where m is the number of payments made each year, P is the principal or amount borrowed, r is the interest rate, t is the number of years involved, and n is the total number of payments to be made. After you determine your variables, you’re all set to plug in and solve. Try out an example.
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Chapter 12: Using Loans and Credit to Make Purchases What’s the APR of a loan for $6,000 for 2 years at 10.125% interest with monthly payments? The number of payments per year, m, is 12; the interest rate, r, is 10.125, or 0.10125; the amount of time, t, is 2; and the number of payments, n, is 2 × 12 = 24. Plugging these numbers into the formula for APR and solving gives you an answer: APR = 2mrt n+1 2 ^12h^ 0.10125h^ 2h = 24 + 1 . 4 86 = = 0.1944 25 The APR of 19.44% is much higher than the stated interest rate of 10.125%. You don’t have any choice on the rate — the APR is what’s used in the computations. You just need to know what you’re getting into when you agree to a particular stated rate.
Making purchases using an installment plan Making purchases with an installment plan allows you to make use of the item or items you’re purchasing while you’re paying for them. Making installment purchases is often a necessary part of doing business. For instance, you may need machinery or supplies to provide services or produce products. The profit from those services or products allows you to make the installment payments. The trick is to be sure that you aren’t paying more than you intended for the machinery or supplies. The stated costs or payments may be deceptive. You may think that you’re getting a good deal — until you do the math and determine that the total payback far exceeds the value of the item. For example, an advertisement claiming that you can purchase a riding tractor for just $2,500 down and $200 each month for the next 5 years may seem like a great deal. But how good a deal is it? Read through the following example to find out. So, say that you’re deciding whether to purchase a $10,000 riding tractor using an installment payment plan in which you put down $2,500 and pay $200 each month for the next 5 years. What’s the APR on this plan?
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Part III: Discovering the Math of Finance and Investments You first need to determine the finance charge, because no interest rate is given. The total cost to you is the down payment of $2,500 plus 5 years of monthly payments of $200. So your cost is $2,500 + 5 × 12 × $200 = $2,500 + $12,000 = $14,500. You’ll end up paying $14,500 for a riding tractor that costs $10,000 in cash. So the extra charge is $14,500 – $10,000 = $4,500. Using the formula for APR, the number of payments per year, m, is 12. The principal, P, is $12,000 (the 5 years of payments), and the total number of payments, n, is 60. By plugging these numbers into the formula, you get APR =
2m _ finance chargei P ^ n + 1h
2 ^12h_ 4, 500i 12, 000 ^ 60 + 1h 108, 000 = . 0.147541 732, 000 =
The interest rate comes out to be more than 14.75%.
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Part IV
Putting Math to Use in Banking and Payroll
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In this part . . .
hen employees count on their employer to not only pay their salary, but also to help cover their insurance, taxes, social security, and so on, the importance of performing accurate and fair computations becomes abundantly clear. Similarly, a sound budget and reasonable account process make for a successful business venture and satisfied employees. This part shows you how to do all of this and more.
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Chapter 13
Managing Simple Bank Accounts In This Chapter Understanding banking basics Making daily computations of balance and interest Performing reconciliation on your bank accounts
Y
ou can find as many types of bank accounts as you do banks. And keeping the names of the types of accounts straight is as much of a challenge as keeping up with the current name of your bank (you’d think they were required to change every week!). What is consistent in banking, though, is the basic mathematics involved when doing the computations. No matter what type of account you have, the math for average balance, daily interest, and additional fees is always the same. The average balance versus daily balance affects the amount of money earned in interest over a period of time. Your bank’s computers do the computations swiftly and automatically. Luckily, though, you can reproduce them with a simple calculator — although maybe not quite as quickly. Reconciling your checkbook or savings account register is a necessary task. The reconciliation can go smoothly, if you keep good, accurate records. On the other hand, if you throw in a simple reversal of numbers or forget to enter a transaction, you’ll be faced with the challenge of making right a wrong. In this chapter, I help you gather the skills and arithmetic techniques needed to keep your banking house in order.
Doing Business with Banks Whether you like it or not, banks and other financial institutions are in business to make money. So you end up paying for their services in one way or another — even with free accounts. For instance, you may pay fees for the following reasons: Excessive check writing Falling below a predetermined balance
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Part IV: Putting Math to Use in Banking and Payroll Having insufficient funds Making telephone transfers Obtaining account printouts Replacing ATM cards Stopping payment on a check Transferring funds Withdrawing money from an ATM that isn’t on your system As you can imagine, it just makes sense to be familiar with all of your bank’s different services — and their corresponding fees. That way you can determine which account best accommodates your needs. The following sections give you some basic (but important) info on bank accounts, including the types available and how to maintain them.
Exploring the types of business bank accounts available Most banks offer many different options for large and small businesses. It’s up to the individual business to decide which type of account or accounts to use based on the type of balance the business can maintain and the types of services it uses most frequently. A good business manager will choose wisely when it comes to the types of accounts, and he or she will see that all the minimums and other requirements are met. The following sections show examples of the many accounts that are available and the services and benefits associated with the accounts. Every bank will have its own set of accounts, and the wise business manager will weigh all the benefits against the possible costs.
The small business checking account When a business is relatively small or just starting up, the small business checking account makes sense, because it requires a minimum daily balance of only $50 or $100. The small business checking account is usually noninterest bearing, and you assume that you’ll make few actual transactions. The bank may set a limit of 100 or 200 transactions, which are free of charge, and then it will charge for any transactions in excess of the limit.
The basic business checking account A business that’s well established or involved in a moderate level of activity will use a checking account that has a higher minimum balance accompanied by corresponding increased services. These basic business checking accounts may have an established monthly maintenance fee that’s waived if the
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Chapter 13: Managing Simple Bank Accounts minimum balance of $500 or $1,000 is kept in the account. The number of free transactions allowed with such an account may be as many as 400 or 500. After exceeding that number, a fee is charged. Other services that are often provided with such an account include night deposit service, coin processing, and free online bill payments or tax payments.
The commercial checking account Accounts for businesses that have large volumes of deposit and check writing activity fall into a commercial category of checking accounts. The minimum daily balance may be as low as $100, but the potential for earning interest on the funds in the account occurs if the daily balance stays above some higher amount, such as $1,500 or $2,000. Commercial accounts usually offer unlimited credit and debit activity.
The business interest checking account Businesses that can depend on having large daily balances — and that need to keep funds fluid — can arrange for a business interest checking account. With this type of account, businesses can get increasing interest rates depending on the amount of money kept in the account. For example, a rate of 0.37% may be paid if the balance is less than $25,000, and the increments may increase to 0.55% if the balance exceeds $250,000. Fees may or may not be charged on these accounts.
The community checking account Most banks offer special accounts, called community checking accounts, for nonprofit, religious, and other community organizations that have a moderate level of deposit and checkwriting activity. Such accounts usually waive any fees as long as the business keeps a minimum balance of $50 or $100 in the account. However, businesses often have the potential for earning interest if the amount in the account exceeds a predetermined amount such as $1,500 or $2,000.
The business savings account When a business wants to earn decent interest on deposited money but still wants to keep it relatively fluid (not invested in a bond or CD), the business savings account is the way to go. The rate of interest depends on the amount in the account, and the business can avoid service charges if a minimum balance is maintained.
Understanding the importance of account management Managing your bank account is important for a couple of reasons: It enables you to avoid unnecessary fees, and more important, it allows you to make
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Part IV: Putting Math to Use in Banking and Payroll smart decisions about your money. You choose the type of bank account that works best for the type of business that you have. You need to consider how many deposit and payment transactions you expect to make each month. And you need to determine how much money you can afford to have out of your reach. In other words, you need to know how much money you can have invested and earning interest or maintaining a minimum balance. After all, you want your money to be working for you, not against you. The saying that money begets money is true in the world of banking — as long as you know how to invest it properly. Depending on the type of account in which you have your money, you may be subject to some fees for the privilege of doing business with the financial institution. Some banks provide accounts that waive a monthly fee if you keep a certain minimum daily balance in the account. However, if you go below that minimum, even for a day, you end up paying the fee that month. Another charge that you may incur is a percheck fee after you’ve written a certain number of checks for the month. Keeping your money in an interestbearing account can help offset some of the fees, but you need to determine whether having the minimum amount of money in the account is worth it. You may be earning interest in that interestbearing account, but the rate of interest may be too small to consider having a large amount of money in that account. In other words, you may be better off investing the minimum elsewhere and simply paying the fees. When managing your accounts, it’s important to keep an eye on all the factors involved, and not just on your deposits and withdrawals. For instance, to manage your account successfully, you need to Know your bank’s fee policies. Determine which services are free and which have a charge (and under what conditions the charge is applicable). Consider the different types of accounts and the fees associated with each type. Determine which options are less costly. Compare the cost of fees for services with the loss of interest income from having substantial cash in a noninterestbearing account. Consider the cost of convenience in terms of travel and business. Keep track of your account balances. Arrange for a daily review using Internet access. Chart normal balances during different times of the month. Suppose you have a checking account in which you only pay the $7.50 monthly fee if your daily balance falls below $500 during any day of the month. Is this a good deal? Or are you better off paying the $7.50 monthly fee and keeping the $500 in a savings account that pays 1% interest? You’re probably better off keeping the $500 in the checking account. Why? Well, first of all, the total amount of interest earned on $500 at 1% interest,
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Chapter 13: Managing Simple Bank Accounts compounded quarterly, is slightly more than $5. And that’s for the whole year. Even if you tried to keep most of your money in a savings account and periodically transferred some of it over to the checking account as needed, you’d be hit by other fees for doing all the transferring. Just plan well, and don’t let the account balance fall below the $500 amount. Here’s an example to consider: Imagine that you have a checking account exactly like the one shown in Table 131. For this account, you pay a fee of $9 per month if the balance falls below $1,000 during any day of the month. You also pay a percheck fee of $0.25 per check for each check in excess of 35 for the month. Your account is interestbearing, paying 1.51%, which is credited to your account monthly. Suppose you wrote 40 checks (which all cleared) during April. What’s your balance on May 1, after all these transactions?
Table 131
Account Activity in April
Date
Transaction
Balance
April 1
No transaction
$4,321
April 2
Deposited $345
$4,666
April 5
Withdrew $2,456
$2,210
April 10
Deposited $1,234
$3,444
April 17
Withdrew $3,000
$444
April 20
Deposited $2,345
$2,789
April 22
Withdrew $1,000
$1,789
April 24
Deposited $4,567
$6,356
April 29
Deposited $1,234
$7,590
April 30
Withdrew $2,000
$5,590
To figure out the balance, here are the things you need to take into consideration: From Table 131, you see that the balance was below $1,000 for three days, so the monthly $9 fee will be applied. In Table 132 (which you can find later in this chapter), you can see the interest earned at 1.51% is computed and comes out to be $4.51 for the month of April. Because you wrote 40 checks, you have to pay $0.25 for each of the last 5 checks, which totals $1.25.
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Part IV: Putting Math to Use in Banking and Payroll To find the net result, you first have to add all the fees and interest, like this: –$9.00 + $4.51 – $1.25 = –$5.74 Now subtract that total from the balance of $5,590 on April 30, which gives you $5,584.26 at the start of May.
Balancing Act: How You and the Bank Use Your Account Balance Your bank or financial institution keeps track of the balance in your accounts on a daily basis. In fact, with today’s availability of online banking, the bank computers can tell you minute by minute what your account balance is. They do this in response to additions and subtractions to your account. The balance in your account is an important number to both you and the bank. Here’s why: The bank needs to know your balance in order to know how much interest to assign your account (if it’s interestbearing). It also needs the balance to determine whether you need to be charged for letting your balance fall beneath a predetermined level. You need to know your balance in order to decide whether you have enough money to pay those pesky bills. Plus, you want to know whether you’re earning the maximum amount of available interest. You and the bank also both need your balance to compute the average daily balance, which is used in determining whether any fees need to be charged for services rendered. And once your average daily balance is computed, you can use it to figure out the interest you’re earning on your account. Read on for details.
Computing your average daily balance An average daily balance is used by banks and credit card companies because the amount of money in an account (or the amount of money charged on a credit card) can fluctuate greatly from day to day or week to week. The bank would prefer that you have approximately the same amount of money in your account throughout the month so that it can accommodate business transactions and lending more easily. But the reality is that businesses need cash to pay bills and employees at certain times of the month; so those payment times may not coincide with the revenue deposits.
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Chapter 13: Managing Simple Bank Accounts When your bank uses an average daily balance for any of its reports or computations dealing with your account, it simply finds the balance in the account for each day and then averages them. In other words, the daily amounts are added up, and the sum is then divided by the number of days. The bank does this because it’s the fairest and best way of determining interest and fees. Instead of using the largest or smallest amount or the most frequent amount, the average amount is the figure used in the computations. You can figure the average daily balance one of two ways: You can do a simple average by adding all the daily balances together for a given month and then dividing by the number of days. You can use the method that employs a weighted average. A weighted average is useful because, with many accounts, the balance remains unchanged for several days in a row — or even for a week or so. Plus you have fewer numbers to deal with if you do a weighted average. Instead of having about 30 different numbers in the computation (depending on the number of days in the month), you have only as many numbers as there are different amounts in the account. Because of these advantages, I focus on the weighted average for purposes of this chapter. To find the weighted average, multiply each different balance by the number of days the account was at that amount, and then divide by the number of days. To practice with an example, check out Table 131 (you can find it earlier in the chapter), which shows an account and the activity in that account during the month of April. Using the info in that table, find the weighted average. Note: Because the numbers are all in whole dollars, they really aren’t all that realistic. But illustrating the average balance doesn’t require nitpicking with pennies, so I made the computations easier. April, as you know, has 30 days. To find the weighted average you have to account for the balance on each of the 30 days, add up the numbers, and then divide by 30. To determine the number of days at each value or balance, you subtract the date numbers. For example, the balance was $444 for three days (April 20 – April 17 = 3 days). The weighting part of the weighted average comes from multiplying each balance by the number of days that the account had that balance. For example, here’s what the math for the example should look like: $4,321× 1 + $4,666× 3 + $2,210× 5 + $3,444× 7 + $444× 3 + $2,789× 2 + $1,789× 2 + $6,356× 5 + $7,590× 1 + $5,590× 1 = $108,925. Now divide this weighted total by 30 to get the average daily balance: $108,925 ÷ 30 ≈ $3,630.83.
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Go Phish? Ebanking has increased in popularity over the past ten or so years because of certain services that ebanks provide. Consider these popular services: Online bank statements and daily transactions Instantaneous transfers from account to account Online bill payment, which helps you avoid checks, envelopes, or stamps Online deposits Accompanying the ease and convenience of ebanking are the opportunities for attacks by the unscrupulous. Phishing is done when scam artists send emails that are created to look like they’re from your financial institution. You’re told that you need to verify personal information to protect your account. However, the very email
is the attack upon you and your finances. Even clicking on the link could subject you to spyware, keylogging software, or Trojans being installed on your computer. You pay dearly for your curiosity. In your ebanking research, you may have come across the terms float or floating. What does floating have to do with online banking (besides adding to the rather tenuous theme)? Again, with the convenience of ebanking comes the blessing and curse of rapid banking processes. With instantaneous processing, you have less time to get money into a checking account (assuming it’s not already there). The key to using online banking effectively is to keep careful track of your account balances. Also safeguard your personal information at every turn, and don’t be tempted to answer unsolicited or unfamiliar emails.
If you look at Table 131 again, you’ll notice that for 11 days in April, the actual balance was higher than the average daily balance, and the other 19 days had an average daily balance that was lower than this average. Why is this important? Well, different accounts have different qualifications, and the average daily balance and exact daily balance each play a part in the fee figures. Because computerized computations are available, financial institutions can figure fees and interest on the balance daybyday rather than using the average. When you’re figuring your average daily balance for your own purposes, though, you don’t want to deal with that many numbers; the weighted averages are more efficient and quicker for you to compute.
Determining interest using your daily balance The interest earned on money in your account usually accrues for a certain amount of time — for a month or three months, for example — and then that interest is credited to your account as a deposit. To determine the amount of interest earned daily (or over several days, when your balance stays the same for a while), you have to divvy up the stated interest rate into a daily amount.
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Chapter 13: Managing Simple Bank Accounts The decimal values get pretty small when you divide them into daily amounts, so you have to carry some extra decimal places in your computation. And you have to be sure not to round off the numbers too soon. For example, when dividing 4.5% by 360 days, you get 0.045 ÷ 360 = 0.000125. If you rounded to the nearer tenthousandth, you’d have 0.0001, which would make the results too low when used in multiplications. To get some practice, use the numbers from Table 131 (shown earlier in the chapter) to find the interest earned by the money in the account for each balance shown. Assume that the bank in this case is paying 1.51% interest. The first step is to get a daily interest rate. To do so, divide the overall interest rate, in decimal form, by 365. (Refer to Chapter 2 if you need a reminder on how to change 1.51% to its decimal equivalent.) Here’s what your daily interest rate should be: 0.0151 . 0.00004136986301 365 The result of the division doesn’t come out evenly, which is why you see quite a few digits in the decimal answer. Keep all of the decimal places for now, and be sure to use them in your computations. Now, to compute the interest earned for each different balance, you multiply the amount of money by the number of days the account showed that balance by the interest rate per day. An electronic spreadsheet will make short work of the computations, even when using all those decimal digits. Refer to Chapter 5 for more on using spreadsheets for your calculations. Table 132 gives the account balances from Table 131, and it shows you the interest earned for each different balance and each different length of time. To save room in the table, I let I represent 0.00004136986301 in each case. The results are rounded to nine decimal places.
Table 132
Computing the Interest Earned in April
Date
Balance
Number of Days
Balance × Days × Interest Rate
April 1
$4,321
1
$4,321 × 1 × I = 0.178759178
April 2
$4,666
3
$4,666 × 3 × I = 0.579095342
April 5
$2,210
5
$2,210 × 5 × I = 0.457136986
April 10
$3,444
7
$3,444 × 7 × I = 0.997344657
April 17
$444
3
$444 × 3 × I = 0.055104658 (continued)
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Part IV: Putting Math to Use in Banking and Payroll Table 132 (continued) Date
Balance
Number of Days
Balance × Days × Interest Rate
April 20
$2,789
2
$2,789 × 2 × I = 0.230761096
April 22
$1,789
2
$1,789 × 2 × I = 0.14802137
April 24
$6,356
5
$6,356 × 5 × I = 1.314734246
April 29
$7,590
1
$7,590 × 1 × I = 0.31399726
April 30
$5,590
1
$5,590 × 1 × I = 0.231257534
Now, you just have to add up all the interest amounts for the month, which gives you $4.506212328. And that means the interest earned is about $4.51 for the month of April. Great work!
Reconciling Your Account All bank accounts that you put money into (deposits and interest, for example) and that you withdraw from, need to be reconciled. Reconciling your checking or savings account means that you’re performing an audit or check of the figures over a particular time period. The word reconcile literally means to bring into agreement or harmony — to make compatible or consistent. So, in other words, you want the money in the account to agree with what you think should be there. Reconciling isn’t a critical factor when it comes to stable accounts such as CDs, which are primarily accruing interest. However, checking accounts (and some savings accounts), which see a lot of regular action need to be reconciled on a daily or weekly basis. The following sections show you how to go about reconciling your account and correcting errors when you find them. Banks issue monthly reports to both aid your reconciliation process and to prompt you to do this periodic audit. However, the monthly printed reports that you receive in the mail are often out of date in terms of recent activity. These printed statements don’t reflect the past few days’ worth of deposits and withdrawals. Luckily, many banks provide online access in case you need records that reflect accountings to that day.
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Making reconciliation simple To reconcile your banking records, you need the statement from the bank and you need your own accounting records, such as a checkbook register or other bookkeeping device. It also helps to have a good head for numbers (or a calculator if you aren’t number savvy). Your bank statement will likely list your current balance, transactions during the previous time period (usually a month), and other tidbits of information, such as average balance, a numerical listing of cleared checks, and postings of fees and interest. Table 133 shows a shortened version of a checking account register. It has a column for checkmarks indicating that a transaction has shown up on the bank statement.
Table 133
A Portion of a Checking Account Register
Check Number
Date
Transaction
Debit
✓
1309
4/1
Allstate Insurance
$617.15
✓
1310
4/1
Bank of America
$411.11
✓
$1,823.45
4/3
Paycheck
✓
$3,245
4/5
Utility Company (trans)
4/7
Insurance settlement
4/10
EatALot Foods
4/10
Transfer to savings $4,000.00
4/15
US Treasury
$3,303.07
4/17
Checks
$22.20
1311
1312
Credit
$2,234.56
$313.07
$5,068.45 $4,755.38
$5,200 $245.16
Balance
$9,955.38
✓
$9,710.22
✓
$5,710.22 $2,407.15
✓
$2,384.95
Notice the checkmarks in the check register in Table 133. You insert these marks into your register to indicate the transactions that appear on the bank statement. For example, as shown in Table 133, at the time of the reconciliation, the automatic payment to the utility company and the check for taxes haven’t yet cleared the bank. The insurance settlement check isn’t showing on the statement yet, either.
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Part IV: Putting Math to Use in Banking and Payroll Most bank statements include forms on the back that you can use for your reconciliation computation. To actually compute the reconciliation, you need to add up all the outstanding checks or other debits (those that haven’t yet been cleared by the bank), and then you add up all deposits not shown on the statement. The general format of the reconciliation looks like this: + Bank balance shown on statement + Deposits not yet appearing on the statement – Checks and other debits outstanding = Balance showing in your register Try working a reconciliation as practice. Reconcile the account shown in Table 133, assuming that the bank balance on the statement is $801.09 (you don’t see the bank statement; just use this number for convenience). Here are the steps to follow: 1. Add up all the deposits in the register that aren’t shown on the bank statement. You see only one such entry, the insurance settlement of $5,200. 2. Add up the debits not appearing on the statement. The two such debits are: $313.07 + $3303.07 = $3,616.14. 3. Do the appropriate adding and subtracting. Your calculations should look like this: + Bank balance shown on statement + Deposits not yet appearing on the statement  Checks and other debits outstanding = Balance showing in your register
$ 801.09 + $5, 200.00 $6, 001.09  $3, 616.14 $2, 384.95
The numbers agree, so your accounting in the register appears to be correct. Good work!
Finding the errors Unless you’re a really perfect person, not all reconciliations of a checking or savings account come out correctly the first time, every time. In fact, even the most nimble of numbersmiths make occasional errors when adding or subtracting — especially when the person doing the computation is in a
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Chapter 13: Managing Simple Bank Accounts hurry or distracted by something. Or you may input one wrong digit in an amount, which subsequently throws you off. No matter what the problem is, if the amount that’s supposed to be in the account doesn’t coincide with the amount that you have in your register (or spreadsheet), you have to backtrack, do some checking, and find out where the error is. The following sections show you the different errors you might make and how to find them.
Adding incorrectly One of the first places I check when my numbers don’t jibe is the listing of outstanding checks and debits. Because I tend to add two consecutive checks in my head and write the total (supposedly to save time), errors can and do occur. If, after checking your addition, you get the same sum for the outstanding checks, go back and be sure that you didn’t miss one or write down a check that’s already cleared.
Reversing the digits Another common error in check registers involves reversing digits. Many people (including yours truly) have a tendency to reverse numbers when writing them down or entering them in a calculator or computer. I find that mumbling the numbers to myself helps keep them in the right order. (I do get funny looks at times, so it’s best to only mumble to yourself when you’re alone.) One indication that your error might be from reversing digits is when the sum of the digits from the number you’re supposed to have in your reconciliation computation and the sum of digits from the balance in your register are the same, even though the numbers are different. (Refer to the nearby sidebar, “Casting out nines,” for an explanation as to why this can be.) For example, if your check register shows a balance of $94.99 and the computations for the reconciliation come out to $95.08, you add up the digits in $94.99 to get 9 + 4 + 9 + 9 = 31. Then add up the digits in 31 to get 3 + 1 = 4. Now do the same thing with $95.08: 9 + 5 + 0 + 8 = 22, and 2 + 2 = 4. Having the same sumofdigits doesn’t for sure mean that you reversed digits, but it gives you a place to start when looking for the error.
Homing in on the difference Another way to find an error in your check register — if that’s where the discrepancy comes from — is to find the difference between the balance in your register and the balance that you think you’re supposed to have. For instance, if the difference between the two is $48, you can then look through your register and the bank statement for an item that’s $48 or for one that’s half that amount, $24. If you’ve missed checking the amount off or entered it in the wrong place, you’ll find your error more quickly if you know what number you want.
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Casting out nines A quick, neat trick for checking whether the addition in a long list of numbers is correct is called casting out nines. The procedure in casting out nines works like this: 1. Cross out all the 9’s and groups of digits that add up to 9 from the numbers being added. 2. Add up the digits that are left.
3419 6223 5401 + 8322 23365
3419 6223 5401 + 8322 23365
If the sum has more than one digit in it, add these digits together — and keep repeating until you have just one digit left. 3. Perform Step 2 for the sum. If the digit you got from the numbers being added and the digit in the sum aren’t the same, you know that the sum is incorrect. For example, look at the addition problem and the method of casting out nines side by side:
Cross out the 9. Cross out 6 and 3. Cross out 5 and 4. Cross out 8 here and the 1 above. Cross out 3 and 6.
The more obvious 9’s and the numbers adding up to 9 are crossed out on the right. (Other combinations and groupings can be crossed out, too, but enough digits have been eliminated to illustrate the method.) Look at the digits that haven’t been crossed out in the numbers being added. Their sum is: 3 + 4 + 1 + 2 + 2 + 0 + 3 + 2 + 2 = 19. Cross out the 9 in 19, and you’re left with 1. Or you can add 1 + 9 = 10 and then 1 + 0 = 1. You’ve been able to reduce all the digits above the addition line to a 1. Keep that number in mind; it’s your target or goal for the digits in the sum. Now look at the sum (the number below the addition line). Add up the digits in the sum that haven’t been crossed out: 2 + 3 + 5 = 10, and
1 + 0 = 1. The digits remaining above and below the addition line, after casting out nines, are the same. So you know that your addition is correct. Now, to be honest with you, the casting out nines method isn’t a foolproof one. If the two numbers that you’re comparing (the digits you got from the numbers and the digit you got from the sum) are different, you can be sure that your sum is wrong. However, if the two digits are the same, there’s still a slight chance that your sum is wrong. For instance, you’ll get a false positive if your incorrect answer is off by 9. However, this method is so quick and easy that it’s worth the slight chance of an error in your error.
And last, but not least (are you getting the impression that I have been there and done that with my check register?), when the numbers don’t agree, check to see if you’ve remembered to subtract automatic payments. It’s convenient to have bills taken out automatically, but you have to be careful that you subtract them from your register.
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Chapter 14
Protecting Against Risk with Insurance In This Chapter Looking at the different types of insurance Getting familiar with life insurance Understanding property insurance
I
nsurance is a risk pool. What’s that, you ask? It’s something that’s formed to reduce losses in the case of some huge, catastrophic occurrence. For example, insurance companies in Florida, where hurricanes are fairly common, may form a risk pool with Midwestern insurance companies, where you find seasonal tornadoes. The companies share the risk and the expense when claims are filed after a bad storm in one place or the other. Being a risk pool, an insurance company accepts risks. Accepting risks, however, isn’t the same as taking risks. The risks involved in the insurance business are closely tied to the chance that a loss will occur. The loss is based on a monetary amount for property, health, life, or some other entity that has value. And basic to this chance of loss is determining the probability that a loss will occur. When you start talking about probability of loss, that’s when actuaries come in. These folks are mathematicianaccountants who study conditions and histories to determine the probability (percentage chance) that a particular occurrence will transpire; this numerical probability helps determine the amount of the insurance premium and even whether the insurance company wants to do business with the client at all. Insurance policies are many, and they’re all varied. The pages of small print on most policies spell out all the details — what’s covered and what’s not. In this chapter, you see how to do some of the computations you need in order to be best served with insurance policies by the insurance companies. The math involved in this chapter is no more than percentages and ratios and some multiplication and division. However, it’s the application of those numbers and operations that sometimes gets a bit sticky. You won’t be on par with an actuary after reading this chapter, but you’ll definitely be able to keep up with the information from and structures of insurance coverage.
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Surveying the Types of Insurance Available In order to cover all of the important things in life, insurance comes in many different flavors. Here are the main types of insurance that you’ll run across in your quest for coverage: Liability insurance: Liability insurance covers claims made by others (not the insured) for losses caused by the insured. This type of insurance is probably most well known in terms of medical professionals. Health insurance: This insurance is used to make financial payments to hospitals, clinics, physicians, and other health professionals on behalf of the insured. Property insurance: This type of insurance involves buildings, various structures, contents of buildings, and vehicles. The risks included in property insurance are fire, storms, wind, earthquakes, water, and collision. Any or all of these risks may be covered by insurance — although sometimes with a high premium. I cover property insurance in more detail in the later section, “Protecting Yourself from Loss by Insuring Your Property.” Life insurance: Life insurance, which seems as if it’s misnamed, is payable at the death of an individual. Life insurance is designed to replace the loss of wages (due to an untimely death) of an incomeproducer. The funds or payout provided by a life insurance policy are intended to provide the income needed by the recipient or recipients of the policy until such funds are no longer needed. In order to establish how much life insurance needs to be purchased, you need to determine how much yearly income is needed and for how long. (See the upcoming section, “Living It Up with Life Insurance,” for further details.) Insurance comes in many different varieties, but the common theme of all of them is the quest to reduce loss if something catastrophic happens. You really hope that you’ll never need the insurance; but you have the insurance just in case you have to cover the expense of replacing what’s lost. Also common to the different types of insurance are the various computations necessary. Many of the mathematical procedures work much the same for the different types of insurance.
Living It Up with Life Insurance Many types of life insurance are available — and each type has its own contingencies and variations that are designed to fit the particular needs of an individual or a company. In this section, you find explanations of the types of life insurance that are designed to help individual employees. I also explain
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Chapter 14: Protecting Against Risk with Insurance the type that benefits the company. So, whether you’re deciding on a program for your employees or some protection for the company, here you find out how to deal with the options and mathematics of the decisions. Here are the types of insurance you’re likely to see: Ordinary life insurance is insurance that doesn’t expire before the death of the insured. This type has an initial premium that doesn’t increase, and it has a cash value. An advantage to this insurance is that you can budget a set amount for the insurance and not have to worry about the premium increasing as a person gets older. Participating whole life insurance provides premiums to the policyholder. If the insured expects to have income from the paid premiums, this insurance is an option. Endowment insurance has a term of a specific length (either in years or up until a certain age) and pays the premium if the person dies. This insurance also returns the premiums to the insured if they survive the term of the insurance. Each type of insurance has its pros and cons, can be purchased individually or with a group, and is suitable for different situations. One of the main considerations for any of these types of insurance is the cost. Ordinary life, for instance, may have cheaper premiums, but you don’t get the income. So you have to decide whether the income is worth the additional cost. You need to do the math and determine whether, in your specific situation, a type of insurance makes sense.
Insuring with a group Group insurance is arranged by a company or other organization (virtually any group of people) with the goal of decreasing the ratio of the overall risk — and consequently, the total amount of the premiums. Some companies offer more than one type of life insurance to their employees, but most find one type that fits their situation (and budget) the best. For example, a company can offer life insurance to its employees as a fringe benefit. The total amount of insurance provided to an individual is usually tied to earning level or longevity, and companies often offer options for employees to increase the amount of coverage if they want to. The insurance rate or cost is determined by the ages or conditions of the people being covered, and, because many people are involved, the risk is spread out (averaged) to make the cost less than if the policies were purchased individually. The policies may also have a provision that decreases the amount of life insurance to be paid out after an employee reaches the age of 65 or 70. When determining the cost of providing life insurance for employees, part of the computation involves the age of the individuals involved. You find the number of people in each age group and compute the cost at each level.
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Part IV: Putting Math to Use in Banking and Payroll Another factor to consider is the length of service of different employees. You can reward longserving staff by providing more coverage. Again, the computations involve how many are at each level and the projections of cost into the future. Start with a basic example. Say that Ajax Company offers life insurance for its employees as a fringe benefit. Each employee has $10,000 in life insurance for the first $25,000 in yearly earnings. The amount of insurance increases by $5,000 for each additional $10,000 earned by the employee. How much life insurance do employees Tom, Dick, and Mary get if their yearly earnings are as follows: Tom: $27,543 Dick: $47,343 Mary: $63,255 Tom only qualifies for a $10,000 life insurance policy. He needs to earn at least $35,000 to get an additional $5,000 added to the basic policy. Dick, on the other hand, qualifies for a $20,000 policy. He earns $47,343, which is $22,343 more than the $25,000 yearly earnings base. The difference of $22,343 is actually two $10,000 increments — each increases the policy by $5,000 for a total increase of $10,000. Mary qualifies for a life insurance policy of $25,000. If you subtract $63,255 – $25,000, you get $38,255. That’s three increments of $10,000 (plus the remainder), so she gets $15,000 added to the base policy of $10,000. If you have a large number of employees in your company, you’d be better off making a chart of the earnings ranges and insurance amounts. That way you don’t have to compute each person’s insurance coverage individually. Here’s an abbreviated example of what I mean: Earnings
Amount of life insurance
$25,000 through $34,999
$10,000 insurance
$35,000 through $44,999
$15,000 insurance
$45,000 through $54,999
$20,000 insurance
$55,000 through $64,999
$25,000 insurance
Try out this example, which has a bit of a twist: Beta Company offers its basic life insurance package to all employees and also offers supplemental coverage that’s paid by both the employee and the company. The cost of the supplemental coverage is based on the employee’s age. Say that there’s also a provision that the maximum amount of supplemental coverage may not exceed three times your salary. Having said all that, say that Moe, Larry, and Curly apply to increase the amount of their life insurance policies. Determine how much each pays for his supplemental coverage. Use Table 141 and the following information to determine your answer:
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Chapter 14: Protecting Against Risk with Insurance Moe, who’s 46 years old, earns $64,000 each year and requests $100,000 of additional life insurance. Larry, who’s 29 years old, earns $83,000 each year and wants $200,000 of additional insurance. Curly, who’s 60 years old, earns $57,000 and asks for $250,000 of additional insurance.
Table 141
Rates for Supplemental Life Insurance (Cost for Each $1,000)
Age
Company Contribution
Employee Contribution
Less than 25
0.002
0.068
25–33
0.002
0.078
34–42
0.003
0.097
43–51
0.005
0.175
52–60
0.012
0.468
61–69
0.073
0.687
The rates given are per thousand dollars, so you multiply each rate by the number of thousands in the supplementary policy. Here’s how the example would break down: Moe pays 0.175 per thousand dollars. Because he wants an additional $100,000, he pays 0.175 × 100 = $17.50 per month for the additional coverage. The company pays 0.005 × 100 = $0.50 per month for his supplementary insurance. Larry pays 0.078 × 200 = $15.60 per month for an additional $200,000 life insurance. The company pays 0.002 × 200 = $0.40. Curly is denied his request. Why? Well, according to the table, he earns $57,000. Because 3 × $57,000 = $171,000, the $250,000 life insurance exceeds his allowed amount (because he can’t have any amount over three times his salary). If he goes for the $171,000, he’ll pay 0.468 × 171 = $80.03 per month for the extra coverage. The company will pay 0.012 × 171 = 2.052, or $2.05 per month. Ready for a more advanced example? Consider this: Happa Kappa Company offers life insurance coverage for its employees to the tune of three times the salary of that employee for that year. However, the life insurance coverage starts to decrease, on a graduated scale, at age 65. Stella is 69 years old and earns $250,000 this year. If she gets a 61⁄4% raise next year, what will her death benefit be? Table 142 shows the payout schedule for Happa Kappa Company.
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Life Insurance Rates
Age
Death Benefit (Percentage of Three Times Annual Salary)
Less than 65
100%
65–69
80%
70–74
67%
75–79
45%
80 and older
30%
First determine Stella’s earnings for next year. A 61⁄4% raise means that she’ll earn $250,000 × 1.0625 = $265,625. Because she’ll be 70 next year, her death benefit would be 67% of three times that salary: $265,625 × 3 × 0.67 = $533,906.25. How does this payout compare to the benefit if she dies this year at her current salary, and the policy pays at 80%? To find out, simply multiply like so: $250,000 × 3 × 0.80 = $600,000. Tripling her raise doesn’t make up for the decrease in percentage. (If you need a refresher on percentages and percent increases, go to Chapters 2 and 3.)
Protecting your business with endowment insurance Life insurance is designed to replace the income or wages of a person who has dependents, partners, or a business. The insurance doesn’t replace the person and what he or she has to offer in physical production or guidance, but the monetary relief helps the family or business continue financially. Endowment insurance is a type of life insurance that can be used to protect a business partner in the event of the other’s death. With endowment insurance, you choose a particular term, such as 20, 25, 30, or more years. Or you pick a particular age of the person being insured to be the end date of the insurance, such as age 50 or 65. Then if the person dies, a set amount is paid to the partner. If the person survives the term or age, the premiums are repayable to the insured. When determining whether you want term insurance or endowment insurance, you consider several things: How much would it cost to replace the person and keep the business running as usual?
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Chapter 14: Protecting Against Risk with Insurance How much does each type of insurance cost, and can you afford either type? How likely is it that you’ll need the insurance? (Of course, you don’t know any more than the insurance companies actuarially, but you do have a better feel for the health and wellbeing of the people involved.) Try this example on for size: Stan and Ollie just opened a new pet shop and have invested most of their life savings in the endeavor. They have two other salespersons, but Stan and Ollie will only take a minimal salary until the business picks up. They decide to insure each other’s life for 10 years in order to cover the cost of hiring additional help should one of them die. Their choices are between term insurance and endowment insurance. At their age, term insurance costs $11.60 per thousand per year, and endowment insurance costs $44.60 per thousand per year. Which is the better choice? First, determine the cost of each over the 10year period. To do so, assume that the policy is for $200,000. The term insurance costs $11.60 × 200 × 10 = $23,200. The endowment insurance costs $44.60 × 200 × 10 = $89,200. If one of them dies and the other collects the $200,000, then it seems that the term insurance is the much better deal. After all, it’s more than $60,000 cheaper. But with the endowment insurance, the premiums are returned if they both survive. They’d each have $89,200 to spend at the end of 10 years. So, in this case, the endowment insurance is probably the way to go. As you can see, the difference in cost between term insurance and endowment insurance can be significant. So what if you decide to become your own “broker” and offset the endofterm settlement that’s available with endowment insurance by banking the difference in cost? Of course, you need to have enough discipline to keep your hands off the money you’re putting in an account. One way to help you with that selfdiscipline is to contract for an annuity — you’ll be more apt to make the regular payments with this type of account. In Chapter 10, I discuss all the details of annuities. For now, I just offer the basic equation: R V n S ^1 + i h  1 W A=RS WW i S T X where A is the total amount of money that’s accumulated, R is the regular periodic money payment, i is the interest rate for each payment period (written as a decimal), and n is the total number of payment periods. Using the scenario from the previous example, consider what would happen if Stan and Ollie put the difference between the two policies in an annuity during the 10year period (in other words, they pay for the term insurance and save the difference). How would the money in the annuity compare to the lump sum payment? The difference between the two policies is $33 per thousand dollars or $33 × 200 = $6,600 per year. If you put this in an annuity at 4% interest, the amount at the end of 10 years is
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Part IV: Putting Math to Use in Banking and Payroll R V 10 S ^1 + 0.04h  1 W Amount= $6, 600 S WW . $79, 240 0.04 S T X The $79,240 doesn’t quite match the repayment on the endowment policy, but if both partners survive for all or most of that 10 years and they bought the term insurance, they’d have the money in the annuity (they don’t get the refund if the insurance is paid out). It all depends on who you want to take the risk. In other words, are you willing to pay the higher amount to the insurance company and lose the chance of the lump sum if something happens to the insured? Or would you rather pay the insurance company a smaller amount and faithfully bank the difference so that you’re sure to have a lump sum at the end of the time period? That’s what insurance is all about: risk and chance and who takes the risk and chance.
Protecting Yourself from Loss by Insuring Your Property Owning property brings with it a lot of possibilities: pleasure, extra income, security, and, of course, risk. Many folks tend to focus on the risk because all pieces of property are at the mercy of the actions (or inactions) of nature and people. But luckily, insuring your property passes the risk of loss to another entity: the insurance companies. The insurance companies determine the risk of loss in your particular situation. Then they factor in the cost of operating expenses, add in some profit, and set an amount that you pay them for taking the risk. Different types of buildings have different rates of insurance. These rates are all based on what the buildings are constructed of, where they’re located, and what type of work takes place in them (storage or manufacturing, for example). Some buildings are constructed of brick and stone and others mainly of wood. Some are on the sea coast and others are in tornadoprone areas. Some buildings house families, others house retail enterprises, and yet others contain manufacturing activities. Actuaries, which I explain earlier in this chapter, weigh all of these factors and determine the risk for specific buildings. After the rates are set, you may consider coinsurance, multiyear contracts, multiple building insurance, and maybe some sort of deferred payment plan. I explain each of these in the following sections.
Considering coinsurance When you insure your property for just part of its value, you’re considered a coinsurer. You’re taking on part of the risk, and the insurance company is taking on the rest. A common coinsurance contract is the 80% coinsurance
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Chapter 14: Protecting Against Risk with Insurance clause. This clause stipulates that if the insurance covers at least 80% of the value of the property, the insurer will pay all of the losses up to the amount on the policy. An 80% coinsurance policy only applies if the property is insured for 80% of its value or less. If the property is insured for less than 80% of its value, the insurer will pay an amount that’s found with the following equation: Amount of insurance _ value of policyi Payment = # loss 80% of value of property The following two examples show you the difference between insuring your property for the full 80% of its value as opposed to insuring it for less than 80% of its value. You use the same equation for each, but you see that insuring for the full amount results in the first fraction just becoming the number 1. Here’s an example to try: Nancy has a summer home at Lake of the Ozarks worth $100,000, and she has it insured with an 80% coinsurance clause. Say a fire caused $40,000 in damage. How much can she expect in payment if she has insured the home at $80,000? After plugging the numbers into the formula, you get the following: Payment =
$80, 000 # $40, 000 = $40, 000 $80, 000
You can see that Nancy will collect the full $40,000, because she gets full coverage as long as the loss is less than the $80,000 face value of the policy. Now consider this example: Say that Chuck’s neighbor decides to economize and reduce the cost of insurance on his summer home. His 80% coinsurance clause has his $100,000 summer home insured at $50,000. If a tornado does $60,000 in damage, what will the insurance payment be? If you plug the appropriate numbers into the formula, your math looks like this: Payment =
$50, 000 # $60, 000 = $37, 500 $80, 000
As you can see, Chuck’s neighbor probably regrets being so frugal. Coinsurance is also used when you insure a property for less than it’s worth. You use coinsurance when a property appraises for less than what was paid for it. In general, coinsurance is used to save on the cost of the insurance policy. However, the insured is taking on some of the risk and responsibility for a portion of the loss if it occurs. A person who wants to insure property for the full value pays a higher rate; this higher rate is called the flat rate. Say, for example, that Helen bought a building for her quilting business and it cost her $100,000. The building was then appraised at $72,000, so she insured it for $72,000 (the full value of the building). One month after moving in, a fire caused $50,000 damage to the building. What did she collect under 80% coinsurance?
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The effects of the Great Chicago Fire The city of Chicago, Illinois, was growing rapidly in the mid1800s. In fact, the building industry was struggling to keep up with expansion. Much of the city at that time was constructed of wood. The buildings weren’t the only parts made of wood, either; most of the paved streets and sidewalks consisted of pine or cedar planks as well. On October 8, 1871, in the middle of a particularly dry Indian summer, the wind was blowing strongly from the southwest. A fire started in the O’Leary barn (because of a wellplaced cow hoof, as legend has it) and rapidly spread to the northeast, leaping across the Chicago River and
burning for more than a day. By the time the fire died out (it started to rain on Tuesday), it had burned a swath four miles long and threequarters of a mile wide. Almost 20,000 buildings were destroyed, and 100,000 people were left homeless. Nearly 300 people died; it was a miracle that the number wasn’t greater. Only about half the properties that were burned were insured. And only about half of those insured buildings were ever paid for. The insurance companies were not only overwhelmed with claims, but many were also burned down themselves. The fire destroyed roughly onethird of Chicago’s property value.
Using the formula, you would work the problem like this: Payment =
$50,000 # $50,000 = $45,000 $80,000
$45,000 is ninetenths of her loss.
Examining multiyear contracts Multiyear contracts are contracts for more than one year. Multiyear contracts are for two, three, or more years in which the rates are a specified amount. Either the same rate is charged each year, or a graduated rate is agreed on in the contract. Buildings and their contents are usually eligible for these types of contracts at reduced rates. Why? Well, insurance companies want to increase the number of years a contract is binding because it provides stability for their business. Businesses like multiyear contracts because they help them with their financial planning, and because the reduced rates save them money. Consider the following multiyear rates for premiums of a particular insurance coverage (you can assume that the premiums are paid at the start of the insurance term):
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Chapter 14: Protecting Against Risk with Insurance Length of coverage
Rate
1 year
1.00
2 years
1.85
3 years
2.70
4 years
3.55
5 years
4.40
Using these rates, compute the following: If the cost for 1 year’s insurance is $2,000, what’s the cost for 3 years of insurance? How much is saved? To find your answer, multiply the 1year cost by the 3year rate: $2,000 × 2.70 = $5,400. So, if 3yearlong policies were purchased, the cost would be: $2,000 × 3 = $6,000. As you can see, the savings is $600 because $6,000 – $5,400 = $600. Of course, that’s assuming the insurance can be purchased for the same amount 3 years in a row. It’s definitely nice to lock in the cost!
Taking advantage of multiple building insurance coverage When a person or company owns several buildings, it’s usually advantageous to insure all the buildings and the contents of the buildings under a single contract. This way, you spread the risk over all the different properties. Formulas for determining the overall cost of such a contract incorporate these items: Multiple building volume credit Multiple building dispersal of risk Loss ratio The credits and ratios are just small parts of the total calculation needed to determine the premiums. Computers are fed all the vital information and claim history, and the amount of the premium is spit out. But for you, knowing the parts that some of the listed items play in the overall picture helps you determine which factor is having the greatest impact on the cost of insurance. Knowing the impact helps with future plans and economizing efforts. I explain each of the parts in the following sections.
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Part IV: Putting Math to Use in Banking and Payroll Determining the multiple building volume credit A multiple building volume credit is an amount of money credited against the total premium. (Remind you of income tax credits?) In other words, if the annual premium exceeds a certain amount, the percentage of the premium in excess of the maximum figure is deducted. Consider this example: Suppose that the amount of a multiple building premium subject to the volume credit is the amount of the premium exceeding $3,000. The credit is 5% of the premium excess. If the annual premium is $14,000, what’s the credit? First find the amount of the excess by subtracting $3,000 from the premium amount: $14,000 – $3,000 = $11,000. Multiply the excess by 5% to get the volume credit: $11,000 × 0.05 = $550. So the premium of $14,000 is reduced by $550 due to the multiple building volume credit.
Exploring the multiple building dispersal risk The point of taking advantage of a multiple building rate is that the risk is spread over several properties. But if one property is worth considerably more than the others, the risk is centered too much in one place. For example, if you have ten properties worth $10,000 each and one property worth $1,000,000, most of the worth is found in just one of the properties. The risk (value) isn’t spread out very evenly. This is an extreme example, but I think it proves my point. Tables that are used to determine how much of a credit is given for multiple buildings incorporate the number of buildings involved and the maximum percentage value that any one building has. It’s best if no one building represents more than 20% of the total value of all the buildings. Consider again the extreme example of owning ten properties worth $10,000 each and one property worth $1,000,000. Of course, the value of the milliondollar property has the greatest percentage of the worth. But what exactly is that percentage? To find the percentage value of the milliondollar building, first find the sum of all the values of all the properties: 10 × $10,000 + $1,000,000 = $1,100,000. Now divide $1,000,000 by that sum in order to get 0.909, or 90.9%. The milliondollar building is worth too much — it’s almost 91% of the value of all the properties added together. You won’t get any percentage credit for that package, because the one building is worth so much more than all the others together. Now consider a more reasonable grouping of properties. Figure the percentage of the property worth the most. The eight buildings involved are worth the following amounts:
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Chapter 14: Protecting Against Risk with Insurance A: $500,000 B: $600,000 C: $700,000 D: $800,000 E: $1,200,000 F: $2,300,000 G: $2,400,000 H: $6,000,000 The total value of all eight buildings is $14,500,000. Property H has the greatest value, so divide its worth, $6,000,000, by the total value: $6,000,000 ÷ $14,500,000 ≈ 0.414, or 41.4% You may qualify for a small discount. However, that building is still worth much more than the others.
Computing the loss ratio The loss ratio is a percentage determined by dividing the total losses by the total premiums during a particular time period. Here’s the formula: Loss Ratio =
Total Losses During the Time Period Premium Amount# Number of Years
The loss ratio is used when determining the loss modification factor, which is an adjustment to the premium amount based on the loss history from the past few years. The idea is for the loss modification factor to result in a reduction in the premium. Check out this basic example: Say that a company is renegotiating its multiple building insurance contract. The agent needs the loss ratio as part of the loss ratio modification factor. In the past 5 years, the company has had $60,000 in losses and has paid premiums of $20,000 per year. Using these figures, determine the loss ratio. To compute the loss ratio, you divide the losses by the total premiums for the 5 years like this: Loss Ratio =
$60, 000 $60, 000 = = 6 = 0.60 = 60% $20, 000 # 5 $100, 000 10
So, as you can see, the loss ratio is 60%. Depending on what the projected or expected losses were — and how much of a variance from those losses is considered above or below normal — an adjustment may be considered.
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Deferring premium payments As you probably know, insurance is usually paid in advance. You pay for one year of coverage at the beginning of that year (or three years of coverage at the beginning of the three years). But, even though you sign up for insurance for three years, you may be able to defer payments for the second two years until the beginning of each of those years. Of course, the insurance company prefers that you pay for all three years at the beginning, so the company makes it more attractive for you to pay upfront with one payment. However, rest assured that if you aren’t in the position to pay the total amount all at once, you can opt for three installments instead. Before committing to one payment plan or another, you want to determine how much more it will cost you to pay in several installments than to pay all at once, at the beginning. The following example shows you what I mean. Suppose that a threeyear contract for property insurance has a total premium of $20,000. Two different deferred payment plans are possible: one for three payments and the other for six payments. The threepayment plan calls for 35% of the premium at the beginning of each of the three years. And the sixpayment plan has you paying 20% of the premium biannually at the beginning of each sixmonth period. How much more do you pay for the insurance if you opt for one of the deferred payment plans (as opposed to paying it all upfront)? If you pay three times, you pay 35% of $20,000 three times. You can find the amount of each payment by multiplying like this: $20,000 × 0.35 = $7,000. Three payments of $7,000 comes to a total of $21,000. You pay $1,000 more for the convenience. If you pay six times, you pay 20% of $20,000 six times. Multiply to find the amount of each payment: $20,000 × 0.20 = $4,000. Six payments of $4,000 is $24,000. That’s $4,000 more than you’d pay if you made one payment at the beginning of the three years.
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Chapter 15
Planning for Success with Budgets In This Chapter Introducing the different types of budgets Examining cash budgets Keeping track of changes in inventory and budget ramifications Completing a variable analysis
A
budget is really just a plan. It incorporates what’s anticipated in terms of revenues and expenses and provides a basis for comparison to what actually transpires. The figures in a budget are based on history and reasonable projections into the future. A budget helps a company make plans and motivate its employees, and it serves as a standard to measure performance. Budgets usually are created for an entire year, but some companies prepare new budgets more frequently in order to make necessary revisions. A variance analysis (which I discuss later in this chapter) is used to measure just how different the budgeted items are from the actual. With the figures, the variance analysis also helps determine future actions. In this chapter, you see different types of budgets at work, and I help you decide how to best use the one or ones that are right for you and your business. You also see different ways to compute, massage, manipulate, and analyze budgets and budget items.
Choosing the Right Type of Budget A budget can take on many different forms, so you have to pick the one or ones that work best for you. You can choose from several different types of budgets, including operating budgets, sales budgets, production budgets, cash budgets, and capital expenditure budgets. A budget can be as simple or complex as necessary to keep track of your company’s financials and to provide the needed information in a timely fashion.
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Part IV: Putting Math to Use in Banking and Payroll The following are some types of budgets that you may find used by companies or organizations. The different budgets can then be controlled by a master budget. The processes and mathematics found in each type of budget are similar, so you find examples from any that can be applied to the others. Here are some of the common types of budgets: Operating budget: An operating budget contains information on the resources that are needed to perform the operations and to provide reimbursement for services provided. A school system uses an operating budget to outline the salaries paid, cost of transportation and utilities, and so on. Sales budget: A sales budget outlines the projected sales levels and the amount of revenue expected to be collected. The sales budget helps production divisions determine how much product to provide. Production budget: A production budget includes beginning inventory from an earlier production period and projects the amount of production necessary to meet the new needs. The production budget is closely tied to the sales budget. Cash budget: A cash budget is responsive to the rest of the budgets in a company, because it’s used to estimate the cash flow needs of the different divisions of the company. Capital expenditure budget: A capital expenditure budget contains not only amounts of money to be used for purchases during the current time period, but it also outlines the accrual of money for purchases in the future. Master budget: A master budget can be used to keep track of the different divisions of a company through their individual budgets. It can be used to do periodic measurements of how the different departments are doing with respect to their projections.
Cashing In on Cash Budgets A cash budget is used to plan for the anticipated sources of cash and the consequent uses of it. In other words, this type of budget consists of numbers reflecting the cash that comes in and the cash that goes out. A cash budget, which is used to ensure that enough cash is on hand, shows the following items: Entries of cash on hand Expenditures Receipts of cash
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Chapter 15: Planning for Success with Budgets A cash budget allows a financial manager to determine whether a loan is necessary to meet the payment needs of the company — to compensate employees and cover bills, for example.
Looking at an example cash budget Table 151 shows an example cash budget for the first three months of the year.
Table 151
Cash Budget for LMNOP, Inc.
Item
January
February
March
Beginning cash balance
$50,000
$120,000
$240,000
Budgeted cash receipts
$350,000
$400,000
$350,000
Total cash available
$400,000
$520,000
$590,000
Disbursements – operations
$280,000
$280,000
$285,000
Disbursements – capital expenditures
0
0
$400,000
Total cash disbursements
$280,000
$280,000
$685,000
Minimum cash balance desired $50,000
$50,000
$50,000
Total cash needed
$330,000
$330,000
$735,000
Excess or deficiency
A: _____
B: _____
C: _____
Financing – bank loan
0
0
D: _____
Ending Cash Balance
$120,000
$240,000
$50,000
The first three lines of the cash budget in Table 151 show the cash balance (at the beginning of the month), the anticipated receipts, and the sum of the beginning balance and receipts. The next three lines show disbursements, or expenditures. The operational disbursements are roughly the same throughout the three months — at about $280,000. A big capital expenditure (new equipment) accounts for the much larger total disbursement in March. The total cash needed is the sum of the disbursements plus the desired minimum cash desired. The excess or deficiency entries are missing from the table on purpose. The following example shows you how to determine these figures when you have the rest of the budget worked out. Refer to Table 151 and determine the excess or deficiency for each month. Then determine the amount of money that needs to be borrowed in March to keep the cash balance at the desired level.
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Part IV: Putting Math to Use in Banking and Payroll The amount that belongs on line A is the difference between the total cash available in January and the total cash needed in January. So subtract it out like this: $400,000 – $330,000 = $70,000. Similarly, the amount that belongs on line B is the difference between the total cash available in February and the total cash needed. Subtract the figures: $520,000 – $330,000 = $190,000. The ending balance for both January and February is the sum of the excess or deficiency and the desired $50,000 cash balance. Notice that the ending balance for each month is carried up to the beginning cash balance of the next month. The amount on line C is a negative number, or deficiency. When you subtract the total cash needed from the total cash available, you get: $590,000 – $735,000 = – $145,000. Negative numbers are written in parentheses in a balance sheet, so you write “($145,000)” on line C. By borrowing $145,000 and entering that number on line D, the deficit is taken care of, and the ending balance is exactly what you want it to be: 0 + $50,000 = $50,000. Now you can carry the $50,000 to the top entry for April.
Comparing budgeted and actual cash receipts Preparing a budget is one thing, but if you never look at it to see how the actual business is behaving compared to the projections, you won’t end up making the necessary adjustments or corrections for the next year or business period. You want to know why the actual amounts don’t match those that were budgeted. Is the difference minor or significant? Is someone not doing his or her job? Comparing the budgeted amounts to the actual amounts can help you gain a better idea of what’s going on with the company or organization. The quickest way to compare budgeted items with the actual amounts is to prepare your budget with adjoining columns that show each entry. You can also make separate columns for each month in a year’s budget, with the yeartodate amount (the accumulated amount) in its own column. Table 152 shows an example expense budget with the first three months’ actual numbers and the accumulated total for each item.
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Chapter 15: Planning for Success with Budgets Table 152
Selling Expense Budget
Account
Budgeted for the Year
January
February
March
YeartoDate
Salaries
$39,600
3,300
3,300
3,300
$9,900
Commissions
$124,000
10,000
10,200
10,800
$31,000
Employee Benefits
$16,000
1,350
1,375
1,375
$4,100
Telephone
$5,000
400
500
550
$1,450
Travel
$80,000
6,000
6,000
6,000
$18,000
Supplies
$20,000
1,500
1,600
1,500
$4,600
Total
$284,600
$69,050
As careful as you may try to be, errors can occur in budget entries and totals. (You are human after all!) Amounts can (and should) be checked for accuracy. In Table 152, for instance, you can check that the yeartodate total is correct by first adding up the columns for January, February, and March and then by finding the sum of those three sums. You also can do a reality check to see if the expenses are on track with what has been budgeted. Compare the first quarter actual expenses with onequarter of the budgeted amount for the full year. However, remember that this type of comparison only works when expense items stay roughly the same each month. I further explain how to keep an eye on the accuracy of your budget in the following sections.
Checking the addition A good method to use when checking the addition in several columns is to compare the horizontal sums with the vertical ones. In a yeartodate accounting, you already have the horizontal sums all listed in the rightmost column. After that, all you have to do is add the numbers in each vertical column, find the sum of all those results, and then compare the sum of all the vertical sums with the total from the rightmost horizontal computation. Here’s an example to help you better understand what I mean: Check the yeartodate total in Table 152 by first adding up the expenses for the three months given, and then find the grand total so far. The expenses in January add up to $22,550. The totals for February and March are $22,975 and $23,525, respectively. The sum of the expenses for those three months is: $22,550 + $22,975 + $23,525 = $69,050. This jibes with the sum in the last column.
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Part IV: Putting Math to Use in Banking and Payroll Determining whether you’re on track for the year If expenses or income are fairly level throughout a particular time period, you can budget accordingly and do periodic checks to see whether you’re on track. You can check to see whether the percentage of the number of months that have passed corresponds to the same percentage of the budgeted amounts. (This system doesn’t work as well when amounts fluctuate significantly from month to month.) The following example will help you understand how to perform this reality check. Use Table 152 to determine how close the actual figures are to the budgeted figures for the year. The yeartodate totals in the righthand column are for the first three months (which is the first quarter of the year). Compare each total with onefourth of the entire budgeted amount for the year. All you have to do to perform this check is divide each budgeted item by 4: 39, 600 = 9, 900 4
124, 000 = 31, 000 4
16, 000 = 4, 000 4
5, 000 = 1, 250 4
80, 000 = 20, 000 4
20, 000 = 5, 000 4
The salaries and commissions are right on target — exactly what was budgeted. Employee benefits and telephone expenses are slightly under the budgeted amount. Travel and supplies are also under the budgeted amount. It’s always nice to have expenses be less than budgeted, but the manager may be asking why. Refer to the later section, “Measuring Differences with Variance Analysis,” to see just what the differences may mean. For those businesses that don’t have a relatively steady revenue or expense stream, this check involves the different budgeted figures and their individual percentages instead of what part of the year has passed.
Varying with a Flexible Budget The term flexible budget doesn’t exactly represent the type of budget that it really is. Budgets are pretty rigid. You have set numbers that are used for goalsetting, planning, and measuring performance. A flexible budget shows the expected behavior of costs at various levels of volume. A flexible budget allows you to put a then after each if. For instance, you say: “If the volume is 100,000, then the income is $4,000,000.” Or you might say: “If the volume is at 60%, then the expenses are $40,000.” A flexible budget allows you some flexibility in a rigid world. Table 153 shows an example of a flexible budget in which various levels of production are represented by percentages and overhead costs are represented in dollars.
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Chapter 15: Planning for Success with Budgets Table 153
March Overhead Budget
Expense
80%
90%
100%
110%
120%
130%
Office salaries
$2,500
$3,000
$3,000
$3,000
$3,500
$3,500
Office supplies
$1,400
$1,600
$1,800
$2,000
$2,200
$2,400
Utilities
$2,200
$2,300
$2,500
$2,800
$3,200
$3,700
Labor
$5,832
$6,480
$7,200
$7,920
$8,710
$9,585
Depreciation
$4,000
$4,000
$4,000
$4,000
$4,000
$4,000
The increases in each category aren’t linear. In other words, they don’t go up by an equal amount for each percentage increase. Instead, the numbers are usually determined by history and various formulas based on the volume. For percent volumes not shown on the table, you can interpolate or extrapolate to estimate the amount in the category. Interpolation and extrapolation are computations designed to determine a value between two given values or to project a value outside a list of given values — based on the given pattern. I explain each of these computations in the following sections.
Interpolating for an inbetween value As I mention earlier, Table 153 shows various expenses based on percentages of volume. The percentages increase by 10% as the columns move from left to right, so if you need to estimate an expense when the percentage isn’t a multiple of ten, you use interpolation. To understand how interpolation works, check out the following example. Use the information in Table 153 to estimate the cost of labor if the production volume is 115%. The production volume percentage, 115%, is halfway between 110% and 120%. So you need to find the expense amount that’s halfway between the respective amounts on the table. The labor expense at 110% is $7,920; the expense at 120% is $8,710. To find the halfway point, you simply average the two numbers. In other words, add the amounts together and then divide by 2. So, first you add the amounts: $7,920 + $8,710 = $16,630. Then you divide that sum by 2, which gives you $8,315. Now you have your labor expense at 115%. Great work! Not all production levels fall exactly halfway between two given values. You may want to determine an expense that’s onethird or onefourth of the way between two given values.
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Part IV: Putting Math to Use in Banking and Payroll Going off the chart with extrapolation Interpolation is usually a bit more reliable than extrapolation. Especially when you make an estimate of a value that’s significantly greater or smaller than any number you already have on a table, you run the chance of assuming something that just can’t hold. However, sometimes you absolutely have to find an estimate of some value outside the table. To do so, you simply set up a proportion comparing the differences of the entries. Check out the following example to see what I mean. Using Table 153, extrapolate the total overhead expenses if production is at 154%. Tip: The total of all expenses isn’t given in the table, but adding any column gives you the total for that percentage. To solve this problem, first find the total overhead expense at a production level of 130%. Then compare the difference in percentages between 130% and 154% with the differences between expenses at 130% and 154%. The difference between 154% and 130% is 24%. Let the unknown expense be represented by x. So the total overhead at 130% is: $3,500 + $2,400 + $3,700 + $9,585 + $4,000 = $23,185. The decimal equivalent for 130% is 1.30, and the decimal equivalent for 24% is 0.24. Now you’re ready for the proportion: 0.24 = x  23,185 1.30 23,185 0.24 _ 23,185i = 1.30 _ x  23,185i 5, 564.40 = 1.30x  30,140.50 35,704.9 = 1.30x x . 27, 465.31 Your estimate for the total overhead expense is $27,465.31.
Budgeting Across the Months It’s great when you can budget income or expenses week by week or month by month without having to worry about one number intruding on the next. But realistically, this ideal situation doesn’t necessarily happen in business. After all, the sales that you make during one month may not show revenue until the next month or even later. And the inventory that you amass during one time period may be predetermined by looking two or three months into the future — in other words, by looking to projected sales during that future time. Of course, you don’t create a budget using a crystal ball (but wouldn’t it be great if you could?). Instead, you simply have to make educated projections. And these projections are important because a good budget helps you have a
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Chapter 15: Planning for Success with Budgets successful business. And creating a budget that incorporates occurrences overlapping during the year is useful in the planning. The following sections explain.
Using revenue budgets to deal with staggered income A company may budget for a certain volume in terms of sales. In this case, the inventory needs to be available, and the product must be paid for. However, not all sales are paid for immediately. Some sales result in cash payments, but others are credit sales that come with the promise to pay within a particular time period. This is where revenue budgets come into play. A revenue budget indicates the revenue collected from sales over a period of time. It shows the total revenue for a particular month and the ways in which the revenue is expected to come in over time. Companies use these budgets to calculate the amount they need to assign as revenue from sales. I show you exactly what I mean in the following example. Suppose a company prepares a revenue for the first four months of the year. Historically, half of the customers pay cash (they pay upon delivery). Of the other half, 60 percent of the credit customers pay during the month in which they make their purchase. Thirtyeight percent of the credit customers pay the next month, and half of those who haven’t paid in that second month finally pay two months after the purchase. The remaining sales are considered bad debts and get written off. If the projected sales for January, February, March, and April are $88,000, $90,000, $96,000, and $104,000, respectively, what should the company budget as revenue from those sales during the first four months of the year? What amount should be written off as a bad debt? In other words, how much does the company expect to never be paid for? To determine the final figures, prepare a table that looks like Table 154, which shows the following items: The projected sales for each month The amount collected in that month (50% of the cash sales plus 60% of credit sales = 50% + 60%(50%) = 80%) The amount collected in the next month (38% of the credit sales from the previous month = 38%(50%) = 19%) The final amount collected two months later (1% of the credit sales = 1%(50%) = 0.5%) The amount written off — the bad debt (1% of the credit sales = 1%(50%) = 0.5%).
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Revenue Collected from Sales
Month
Total Sales Collected for Month in January
Collected in February
Collected in March
January
$88,000
$16,720
$440
$72,000
$17,100
$450
$76,800
$18,240
$70,400
February $90,000 March
$96,000
April
$104,000
Total
Collected Bad in April Debt $440 $450
$83,200 $70,400
$88,720
$94,340
$101,890
The amount collected in January represents 50% of the sales in cash and 60% of the credit sales. The total comes from this math: 50%($88,000) + (60% × 50%)($88,000) = 0.50($88,000) + (0.60 × 0.50)($88,000) = $44,000 + $26,400 = $70,400 The amount collected in February comes from three sources: 38% of the credit sales from the previous month, 50% of the cash sales from February, and 60% of the credit sales from February. So the total is determined like this: (38% × 50%)($88,000) + (50% × $90,000) + (60% × 50%)$90,000 = (0.38 × 0.50)($88,000) + (0.50 × $90,000) + (0.60 × 0.50)$90,000 = $16,720 + $45,000 + $27,000 = $88,720 A computer spreadsheet and formulas are invaluable when setting these budget amounts. (Refer to Chapter 5 for more on the use of computer spreadsheets.)
Budgeting for ample inventory When you set a sales budget, you have high hopes for your inventory. You probably imagine that it will fly off the shelves and result in great revenue and, consequently, wonderful profit. But to have this type of success, you have to have enough in stock to meet your customers’ needs. If you don’t have the item on hand, your customer will go elsewhere.
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Chapter 15: Planning for Success with Budgets It’s difficult to plan exactly what your inventory needs will be, but a good budget based on past sales and reasonable projections goes a long way toward keeping your inventory at its proper levels. To get some practice with this type of planning, take a look at the following example. Garry’s Gifts prefers to carry an ending inventory amounting to the expected sales of the next two months. Expected sales for April, May, June, July, August, and September are the following (respectively): $40,000, $44,000, $56,000, $60,000, $72,000, and $66,000. If the inventory at the end of March was $84,000, what purchases need to be made in April, May, June, and July? Start by preparing a table showing the sales and inventory needed (use the information given in the problem description to fill in the blanks). Table 155 shows you exactly what I mean. All the information given so far is included in this table. You enter the end needs by finding the sum of the projected sales for the next two months.
Table 155
Projected Sales and Needed Inventory
Item
April
May
June
July
August
September
Beginning inventory
$84,000
Sales
$40,000
$44,000
$56,000
$60,000
$72,000
$66,000
End needs
$100,000
$116,000 $132,000
$138,000
After you’ve created your initial table, find the purchases needed to make the beginning inventory equal to the budgeted sales for the next two months. Fill in the beginning inventory blanks by adding the sales for the two months after the blank (which is the same as the end needs amount from the previous month). For example, to find the beginning inventory for May, you add $44,000 to $56,000, which gives you $100,000. (Note: Because you don’t have the information for October, you won’t be able to find the beginning inventory for September.) Table 156 shows each of the beginning inventory amounts you should have come up with. Now add a row in the table to show the inventory at the end of the month. (You can label this row “Net.”) The net inventory is obtained by subtracting the sales from the beginning inventory. Then add another row for the purchases that are needed to produce the needed inventory at the beginning of the month. (Label this row “Purchases.”) Table 156 shows how your table should look with all this new information. Note that you can’t fill in the last entries for August and September without the sales information from the months that follow.
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Projected Sales and Needed Inventory
Item
April
May
June
Beginning Inventory
$84,000
$100,000 $116,000
$132,000 $138,000
Sales
$40,000
$44,000
$56,000
$60,000
$72,000
Net
$44,000
$56,000
$60,000
$72,000
$66,000
End Needs
$100,000
$116,000 $132,000
$138,000
Purchases
$56,000
$60,000
$66,000
$72,000
July
August
September
$66,000
Measuring Differences with Variance Analysis Computations are made to determine the difference between budgeted values and the actual values that occur. The results of the computations are in the actual numbers or percentages. The numbers tell you how much of a difference or variance there is. It’s up to you to determine the why or who (if a department head isn’t performing as he/she should) of the variance and just how significant the difference is in the big picture. You’ll come across all sorts of variances when creating budgets. Revenue variances are the differences between budgeted and actual revenues. Sales volume variance is the difference between the actual and budgeted sales volume. Cost variances measure differences in cost. In the following sections, I show you exactly how to compute variances and create a variance range that’s acceptable for your business.
Computing variance and percent variance The variance between the budgeted estimate and the actual value is the number or dollar amount difference between what was anticipated and what actually happened. Numerically, variances can be positive or negative, meaning that they can have either a positive or negative impact on your bottom line. For instance, a negative variance is a good thing if you’re talking about expenses (you spent less than expected), but a negative variance isn’t so good when you’re talking about income.
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Chapter 15: Planning for Success with Budgets A better way to measure variances than with actual numbers is by using percentages. Why? Well, consider this: A difference of $10,000 is huge if the budgeted amount is $20,000, but a $10,000 variance doesn’t have all that much impact if the budgeted amount is several million dollars. Whether you’re dealing with actual numbers or percentages, you always subtract the actual amount from the budgeted amount. You get a negative result if the actual number is larger than the budgeted number and a positive result if the actual number is smaller than the budgeted number. Here’s an example you can work for practice: Say that Suds and Stuff Enterprises budgeted $300,000 for production expenses, $200,000 for overhead, 150,000 units of production, and 450 visitors for April. The actual figures were $350,000 for production expenses, $250,000 for overhead, 200,000 units of production, and 200 visitors. What’s the variance and percent variance for each item? To work this problem, make a table showing the items (budgeted and actual), the variance, and the percent variance. To get the variance, you simply subtract the actual from the budgeted. To get the percent variance, divide the variance (which you got by subtracting) by the budgeted amount. (Percent differences — percent increases and decreases — are covered in Chapter 3 if you need a refresher course.) Table 157 shows you what your table should look like with all the information filled in.
Table 157
April Variances
Item
Budgeted Actual
Variance Percent Variance
Production Expenses
$300,000 $350,000 +$50,000
50, 000 = 1 . 0.167 = 16.7% 300, 000 6
Overhead
$200,000 $250,000 +$50,000
50, 000 = 1 = 0.25 = 25% 200, 000 4
Production Units
150,000
200,000
+50,000
50, 000 = 1 . 0.333 = 33.3% 150, 000 3
Visitors
450
200
–250
 250 =  5 . 0.556 = 55.6% 450 9
As you can see in Table 157, even though the variances for production expenses, overhead, and production units are the same number, the percentages are actually quite different.
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Finding a range for variance Making a budget is a matter of best guesses, good computations, and a bit of luck. Some differences are tolerable, but others may be too far off to be acceptable and run a good business. In order to monitor your variances without going nuts with anxiety, you can simply set a particular maximum difference or variance. That way you only have to be concerned when the difference is more than that maximum difference. A budget is just a plan, and you’re no crystal ballgazer, so you don’t really expect to be right on the penny with actual figures. You should expect to be a little above or below the budgeted amount when the final figures come in. How much of a difference is reasonable or acceptable? Businesses set a tolerance or range of values that they expect the actual values to fall into when the final numbers are tallied. For example, you may say that the revenues for April will be $40,000, plus or minus $2,000. So your range is from $38,000 to $42,000. As long as the actual numbers fall in that range, you don’t really need to take another look at the revenueproducing units in the business. Try out this example: Say that Best Builders has set a budget for the third quarter of the year and has determined that a 5% variance (up or down) on budgeted items is acceptable. Anything greater than 5% needs to be examined. The budgeted items for the third quarter are 1,000 units of raw material purchased 800 units of raw material put into process 500 hours of labor in production 400 hours of indirect labor $4,000 indirect costs $6.00 standard price of one unit of raw material Determine the acceptable amounts for each unit if 5% variance is acceptable. To accomplish this, find 5% of each item. Then subtract and add the 5% amount from the budgeted amount to determine the acceptable range. Table 158 shows the computations and results.
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Chapter 15: Planning for Success with Budgets Table 158
Range Allowable with 5% Variance
Item
Budgeted
5%
–5%
+5%
Raw materials
1,000 units
50
950
1050
Raw materials processed
800
40
760
840
Hours of labor
500
25
475
525
Hours of indirect labor
400
20
380
420
Indirect costs
$4,000
$200
$3,800
$4,200
Price of material per one unit
$6.00
$0.30
$5.70
$6.30
With the range of acceptable variances in place, you can quickly compare the actual values to see if they fall between the numbers desired.
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Chapter 16
Dealing with Payroll In This Chapter Figuring employee earnings Deducting taxes, insurance, and other withheld expenses
P
ayday can come monthly, bimonthly, weekly, or even daily, depending on your business’s chosen pay schedule. On the other hand, some royalty payments for books or movies come only twice a year. And with some contract jobs, an employee gets paid only after finishing an entire project. In any case, monetary payment involves more than just the gross pay amount that a job is worth. After subtracting taxes, Social Security contributions, insurance, and whatever else appears in the deductions list, the net pay usually doesn’t much resemble the lofty income figure. In this chapter, you find multiple ways of figuring earnings. The main payment types you have to choose from are salaries, hourly paychecks, and commissioned payments. Salaried employees usually get a set fraction of the total amount each pay period. Hourly workers are paid according to the time put in during that pay period. Commissioned employees, on the other hand, usually are all paid differently. The variations on commission payments are many, and some can be rather creative. Also important in this chapter are those pesky deductions. Figuring the amount to subtract from the base pay varies from deduction to deduction. Some deductions are percentages of the gross pay, and others are flat amounts. Some federally mandated deductions have caps or limits to the amount that can be deducted; others don’t. You see a lot of multiplying and subtracting (unfortunately, lots of subtracting) in this chapter on how to determine net or takehome pay.
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Pay Up: Calculating Employee Earnings Earnings from being gainfully employed are accumulated in many ways. Here’s a rundown of the types of employees and how they earn their pay: Salaried employees: These folks earn a set amount of money per year, and the amount is divided evenly between the number of pay periods. Salaried employees sometimes earn extra pay for extracurricular activities, or they may receive endofyear bonuses. Seasonal or partyear salaried employees: These employees may opt to take their salaries over the entire 12 months, or they may choose to be paid just during the 3 months or 9 months that they work. Hourly employees: The hourly worker is paid a set rate per hour, but there’s often the opportunity to work overtime at a higher rate. Commissioned employees: A commissioned employee is paid based on some performance. They aren’t paid according to the number of hours worked, however. Instead, they’re paid according to income activity or production. Salespersons are frequently paid on a commission basis; a base pay may be included and added to the commissions earned. One variation on a flat percentage rate of commission is having builtin increases for meeting certain levels of production. Determining the earnings for all these folks may sound daunting, but don’t worry. The following sections show you exactly what you need to know to calculate all four types of earnings.
Dividing to determine a timely paycheck To find out how much a person working for a set salary should earn each pay period, you simply have to use your division skills. You also have to determine how often you plan to pay your employees. Most employers pay monthly, bimonthly, or weekly. You can find pros and cons for each of these payment arrangements. Check out this list to get an idea of each arrangement: Monthly: Paying monthly means issuing paychecks 12 times each year. Most bills come monthly as well, so monthly payments make budgeting and keeping track of bills much easier. The downside to monthly payments is that the months don’t have the same number of days, so payday comes on different days of the week. Also, for some employees, a month between paychecks may seem like a really long time. Bimonthly: Bimonthly paychecks provide fresh cash to employees more frequently, but it also means more bookkeeping for the employer.
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Chapter 16: Dealing with Payroll Weekly: Paying weekly allows for more frequent paychecks on the same day of the week, which is good for the employee. But, like bimonthly checks, this arrangement can be a bookkeeping nightmare for the employer. A bonus for employees on this payment plan: Four months each year have five pay periods. Don’t forget that even though salaried employees receive a set amount each pay period, they also may be eligible for extra pay or bonuses that are added to just one or a few paychecks. Try your hand at calculating the amount of a monthly paycheck with this example: Sandy is a manager of SaveABunch, and she has been a wonderful employee for the store this year. Sandy filled in for a sick evening manager for six weeks (in addition to her regular job), and she was paid extra for the added responsibility. She’s also eligible for a bonus at the end of the year. Using the following information, determine the amount that Sandy is paid each month: Sandy’s yearly salary is $47,700, and her bonus, which she receives in December, is $6,000. She was paid $3,600 for taking on the extra work for six weeks. The extra work covered all of November and half of December. To determine Sandy’s monthly paycheck amount, first find her gross base pay by dividing $47,700 by 12, which gives you $3,975 per month. In November, Sandy gets extra earnings for the additional evening work. So divide the extra amount she was paid by the number of weeks she worked to get the amount per week: $3,600 ÷ 6 = $600. Now, multiply that $600 by 4 (the number of weeks in November) to determine her extra November payment: $600 × 4 = $2,400. To calculate her total November paycheck, simply add her gross base pay with the extra cash: $3,975 + $2,400 = $6,375. Don’t forget that in December Sandy gets two more $600 payments totaling $1,200 plus the bonus. So her December paycheck is $3,975 + $1,200 + $6,000 = $11,175. Merry Christmas, Sandy! Now try the following example, which has a bit of a twist on interim work. Mike is a professor at a local university. He has an opportunity to teach a summer interim course for extra pay. The arrangement with the university is that extra compensation is paid at the rate of 7% of a person’s base salary for each threecredit course. Mike currently makes $63,000 per year, and the course is a fourcredit course. How much will he be paid to teach during the interim?
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Part IV: Putting Math to Use in Banking and Payroll Sounds like a toughie doesn’t it? Don’t worry; it really isn’t that bad. First, determine the percentage rate for a fourcredit course. Use a proportion that has the number of credits in the lefthand fraction and the percentages in the righthand fraction. (Refer to Chapter 4 if you need a review of setting up proportions.) Let x represent the unknown percentage. Crossmultiply and solve for x. Here’s what your math should look like: 3 credits = 7% 4 credits x% 3 = 0.07 x 4 3x = 0.07 ^ 4 h x = 0.28 . 0.0933 = 9.33% 3 So Mike will be paid 9.33% of his salary. To figure out how much he’ll be paid to teach the interim course, simply multiply his current salary by the percentage (in decimal form), like this: $63,000 × 0.0933 ≈ $5,878.
Parttimers: Computing the salary of seasonal and temporary workers Seasonal or temporary workers may be employed for a few weeks, a few months, or a major portion of the year. And depending on what type of workers they are, they’re paid differently. Seasonal workers, for instance, are usually paid a salary during the months that they work. Others, such as temporary workers, who typically work for nine or ten months each year, may opt to be paid equal amounts each month, every month of the year. Suppose Clyde retired from a management position with a large heavyequipment manufacturing company. Now he does consulting with the company and works for eight months each year. He can choose to be paid monthly during those eight months, or he can even out his payment and be paid each of the 12 months for that 8 months’ work. Clyde is being paid $4,500 per month for his consulting. How much would he get per month if he chooses the 12month plan? First find the total amount Clyde receives for his work by multiplying the payment per month by the number of months he works: $4,500 × 8 = $36,000. Now, you just have to divide that total by 12 to find out how much he’ll be paid per month: $36,000 ÷ 12 = $3,000.
Determining an hourly wage Being paid an hourly rate means that for every hour that an employee works, she’s paid a set amount — and if she doesn’t work, she isn’t paid. Sounds pretty simple, but be careful; you can find contingencies and arrangements
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Chapter 16: Dealing with Payroll that make one hourly wage different from another. I explain some arrangements in the following sections.
Working with an adjustable hourly rate Businesses often choose an adjustable hourly rate for their employees. With this arrangement, the rates eventually change with the number of months or years of employment. In other words, employees are rewarded for their continued loyalty with wage increases. Hourly rates are adjusted according to some prescribed formula. The formula may add a set number of dollars after a particular amount of time, or the formula may incorporate a percentage increase. Say that Pete’s Produce has four hourly workers on staff; each of these employees works 35 hours per week. Pete’s pays an hourly rate of $8.00 for starting workers, and it increases the rate by $0.50 cents per hour after the worker has worked at the market for 6 months. Workers who have been with Pete’s for a year or more get an increase of $0.10 cents for every 6 months they have been employed after the first 6 months. How much do Amy and Ben each make at Pete’s if Amy has been employed for two years and Ben for six years? First, determine Amy’s hourly rate. At the end of her first year, she was earning: $8.50 + $0.10 = $8.60 per hour. Add two more increases, and Amy’s rate is $8.60 + $0.10 + $0.10 = $8.80 per hour. Ben has been employed at Pete’s for six years, so his rate is: $8.50 + $0.10 + $0.10 + $0.10 + $0.10 + $0.10 + $0.10 + $0.10 + $0.10 + $0.10 + $0.10 + $0.10 = $9.60 per hour. What if Ben had been there for 10 years or 15 years? Don’t you think there’s a better way to figure out his rate than adding up all those $0.10cent additions? Well, sure! You could use the following formula: Z ] ] $8.00 if: n