A Five-Step Algorithm for Solving Word Problems
A systematic approach to analyzing word problems offers a way to organize both your thoughts and your data. The
algorithm offered in this section is designed to help you systematically break a word problem down into its essential
elements, and then reconstruct those elements in the form of an equation or a financial model. By answering the
following questions, you can isolate the relevant data from the problem and determine the way to solve the problem.
1. What specific value are you required to solve for? Often contained in the last sentence of the problem, the
required answer should be stated either directly or indirectly. Your first task is to state concisely the exact
variable you are to determine the value of in your calculations. This first step is the most important, as it has a
bearing on every step that comes after it.
2. What data are you given? Numbers must be extracted from the text and labeled (identified as variables). All
numbers must be labeled, and the labels should bear some relationship to each other (i.e., the labels should fit
some formula common to financial theory). This is why it helps to have a good grasp of the underlying theory;
with an understanding of the theoretical models used in finance, you will quickly be able to spot clues within
the text of the word problem that indicate which model is best suited to determine the solution.
3. What formula is most appropriate for determining the solution? Clues to this lie in both the value you are
solving for (which is found in step one) and the data you are given (which are found in step two). These clues
together will usually offer sufficient evidence to indicate the proper formula for the problem. However, you
need to be certain that you have enough of the variables for the model you believe is best suited to solve the
problem. To solve a formula containing n variables, you must have the values of at least n-1 of the variables in
the formula (e.g., to solve the Security Market Line formula, ki = kRF + bi[kM – kRF], you must be given the
values of 3 of the 4 variables [ki, kRF, bi, and kM] in the equation). Therefore the first two steps must give you
either n-1 of the variables directly, or give you enough material from which you can derive n-1 of the variables.
4. Are you given everything you need for the chosen formula, or are you required to derive a term from
another one you’ve been given? If you are given everything you need, this is the point at which to solve the
problem. Sometimes, rather than being given all the values for the formula directly, you are given data from
which the values can be derived. Check what you have used of the data given, and then analyze what is left
unused to determine how it can help you get what you need to solve the equation. Often deriving these values
requires the use of algebra, so we will also spend some time going through algebraic manipulations. To aid in
the understanding of the algebraic manipulations, remember the key phrase introduced earlier in the text:
simplify, then solve.
5. After a solution has been determined, have you used all of the data given? Generally speaking, most word
problems (unless they are designed to test your understanding of some specific theory) give you just enough
information to solve the problem and not more. If you have solved the problem without using some of the given
data, you should have specific reasons for each item not used. If you do not have a good reason for leaving
some data out of the solution, chances are you have made a mistake. We will look at problems that give you just
enough data as well as those that require you to choose which data is relevant.
Each step in this algorithm has a distinct and important purpose, and omitting any of the steps decreases your
chances of success.
• Step one determines what you are aiming for, and thus establishes the focus of your efforts. Without this step
you will drift.
• Step two is an inventory of what tools you have to do the job. This step not only defines what data you have,
but, when combined with step one, offers clues to aid in the resolution of step three.
• Step three incorporates financial theory to pinpoint the area of finance the problem comes from. Knowing what
area of theory the problem comes from will help you choose the proper method (model) for solving it.
• Step four asks you to match your data to your model and see if everything falls into place, or if you need further
tools to finish the job. Sometimes you are given just what you need, other times you are given more than what
you need, and still other times you are given a tool that needs to be turned into another tool in order to complete
the job.
• Step five helps you make certain that you use all the proper tools and have a good reason for leaving any out of
the solution. Such end-of-job checks are very useful in helping you avoid mistakes.
Working through this technique at first will be time-consuming, because it is unfamiliar. If you continue to use the
method for numerous problems, the steps will come more readily to mind, and you will become more efficient at
using it. Like anything else, you just have to do it lots of times to get better at it. Eventually the steps will become
second nature, and they will blend together during the solving of the problem in a way that makes it seem like one
long step rather than five short ones.
The examples used in the future chapters will be solved using this technique. For now we will give one simple
example to show how the algorithm works in practice.
A Simple Example
Anthony is an analyst for a credit card company, who spends his days building mathematical models that explain the
relationship between customers’ weekly salary and their expected credit purchases. For a small suburb of Chicago,
Anthony has determined that a linear model with a slope of 2.5 and an intercept of –400 can best explain the
expected credit card purchases for the average customer in a given month. For a customer that earns $350 per week,
how much are they expected to charge to their credit card during the month?
Here we review the list of questions:
1. What specific item are you required to solve for? We are being asked to solve for the expected credit card
purchase amount for a customer from an unknown Chicago suburb.
2. What data are you given? We are given the terms for a linear model that explains the relationship between the
weekly salary and expected purchases for the area (slope of 2.5 and intercept of -400), and the weekly salary for
the customer in question ($350).
3. What formula is most appropriate for determining the solution? We are given three of the four variables
used in the Point-Slope formula, y = mx + b, where y is the expected (or predicted) value, m is the slope of the
line, x is the input variable, and b is the intercept. Therefore the Point-Slope formula is the best model to use.
4. Are you given everything you need for the chosen formula, or are you required to derive a term from
another one you’ve been given? Since we are given three (n-1) of the four (n) variables in the formula, we are
able to solve for the fourth.
• Plug the values into the formula: y = 2.5(350) - 400
• Simplify the expression including parentheses: y = 875 - 400
• Solve for y by simplifying the terms on the right side of the equation: y = 475
Thus the average customer that earns $350 per week is expected to purchase $475 worth of goods and services
during the month.
5. After a solution has been determined, have you used all of the data given? Yes, each data item given was
used.
This problem did not require any algebra, but many of those you see in later chapters (and in your finance textbook)
will. Let’s review the steps used in simplifying and solving equations:
• Plug the known values into the variables of the formula;
• Simplify the expression by removing any fractions and/or simplifying any terms in parentheses;
• Isolate the term containing the variable in question by removing any constants; and
• Isolate the variable by removing any coefficient (divide both sides by the coefficient).
