Solution Key

Average=22.2
Range 12-25
BOSTON COLLEGE
GRADUATE SCHOOL OF MANAGEMENT
Operations and Strategic Management Department
MD716 Modeling and Decision Analysis
Quiz 2

Spring 2001

Place-Plus, a real estate development firm, is considering several different development

projects. These include building and leasing an office park, purchasing a parcel of land
and building an office building to rent, buying and leasing a warehouse, building a strip
shopping center, and building and selling condominiums. The financial success of these
projects depends on interest rate movement in the next five years. The various
development projects and their five-year financial return ($ millions) given the interest
rates will decline, remain stable, or increase are shown in the following table.
Project
Office Park
Office Building
Warehouse
Shopping Center
Condominiums

Decline
0.5
1.5
1.7
0.7
3.2

Interest Rate
Stable
1.7
1.9
1.4
2.4
1.5

Increase
4.5
2.4
1.0
3.6
0.6

a. (3 points)
If the management of Place-Plus is pessimistic and unable to estimate any probabilities
for this analysis which alternative should they choose? Why?
A pessimistic manager would use the Maximin criterion
Office Park
Office Building
Warehouse
Shopping Center
Condominiums
Choose Office Building

Minimum Payoff
0.5
1.5
1.0
0.7
0.6

Maximum

b. (6 points)
Because of their lack of knowledge about interest rate movements the management of
Place-Plus has hired an economist to assign a probability to each direction interest rates
may take over the next five years. The economist has determined that there is a .50
probability that interest rates will decline, a .40 probability that rates will remain stable,
and a .10 probability that rates will increase.
If management is risk neutral, what decision should they make? Why?
P(Decline)=.5 P(Stable)=.4 P(Increase)=.1
ER(Office Park)=.5(.5)+.4(1.7)+.1(4.5)=1.38
ER(Office Building)=.5(1.5)+.4(1.8)+.1(2.4)=1.75
ER(Warehouse)=.5(1.7)+.4(1.4)+.1(1.0)=1.51
ER(Shopping Center)=.5(.7)+.4(2.4)+.1(3.6)=1.67
ER(Condominiums)=.5(3.2)+.4(1.5)+.1(.6)=2.26
Choose Condominiums since they have the largest expected return.

c. (6 points)
To continue the analysis the economist asks the management of Place-Plus to consider
two different hypothetical development projects. One project has a projected five year
return of $0. The second hypothetical project has a .50 probability of producing a $1.0
million five year return and a .50 probability of producing a -$0.5 million five year
return.
Assume that management indicates that they are indifferent about these two hypothetical
projects. Use this information and the payoff table and probabilities in parts a. and b. to
determine what decision Place-Plus should make about their real project alternatives.
U(x)=1-e-x where x is the payoff from the payoff table

Office Park
Office Building
Warehouse
Shopping
Center
Condominiums
Probabilities

Decline

Stable

Increase

.39
.78
.82
.50

.82
.85
.75
.91

.99
.91
.63
.97

.96
.5

.78
.4

.45
.1

Choose Condominiums since it has the highest expected utility.

Expected
Utility
.622
.821
.773
.711
.837

2. (10 points)
The manager of Computer World is attempting to determine how many laptop PCs the
store should order each week. A primary consideration in this decision is the average
weekly profit generated from the sale of laptop PCs. The sale of a laptop results in $4300
net profit (selling price - cost of a laptop to Computer World). The number of laptops
demanded each week is a random variable that ranges from 0 to 4. From past sales
records, the manager has determined the frequency of demand for laptop PCs for the past
100 weeks.
PCs Demanded per Week
0
1
2
3
4

Frequency of Demand
20
40
20
10
10
100

Computer World currently orders one laptop per week regardless of how many units they
have in inventory. They assess an inventory charge of $50 for each laptop in inventory at
the end of the week. Also, if there are too few laptops on hand to meet demand during
the week they assess a shortage cost of $500 per unit of shortage.
Use the table given below to simulate five weeks of this ordering policy.
PCs Demanded per Week
0
1
2
3
4
Shortage Cost $
Inventory Cost $

Week
1
2
3
4
5

Random Numbers
0.0-0.2
0.2-0.6
0.6-0.8
0.8-0.9
0.9-1.0

500.00 per unit

50.00 per unit

Random
Number
Inventory Demand Shortage Net Profit
0.9253822
1
4
3 $ 4,300.00
0.1994438
1
0
0 $
0.9487449
2
4
2 $ 8,600.00
0.8345382
1
3
2 $ 4,300.00
0.2106112
1
1
0 $ 4,300.00

Shortage
Cost
$ 1,500.00
$
$ 1,000.00
$ 1,000.00
$
-

Based on your simulation, what is the average weekly profit?

Average weekly profit = ($2,800-$50+$7,600+$3,300+$4,300)/5=$3,590

Inventory
Cost
$
$ 50.00
$
$
$
-

Total
Profit
$ 2,800.00
$ (50.00)
$ 7,600.00
$ 3,300.00
$ 4,300.00