DMOP Homework

Milind Sohoni
Indian School of Business, Hyderabad, India 500032

1. LP and Production Planning

The management of One Mile Island Power Company (OMIPC) wants to make better short and
long run decisions regarding the operation of its Keyport electric generation plant. Managements
goal is to be able to run the plant to achieve maximum power generation during peak load hours.
Power output is limited both by engineering capacity of the equipment and by environmental
considerations. In particular, the plant must comply with the following emission standards:
1. Maximum SO2 emissions are 3,300 parts per million (PPM) in the stack gas at all times.
2. Maximum particulate emissions are 12 kg per hour.
Coal is brought to the Keyport plant by railroad and dumped into stockpiles in the coal yard.
From there it is carried by conveyor belt to a pulverizer and fed directly into the combustion
chamber at the desired rate. The heat produced by the combustion produces steam, which drives
the generation turbines. Two types of coal are used by the plant: hard coal which is expensive but
has low sulfur content and softer chunky coal which, while cheaper, is smoky and has higher sulfur
content. Technical specs on the coals are specified in Table 1.

SO2 gas output Particulate output Heat rating

Type (PPM) (kg/ton) (BTU/ton)
Hard coal 1800 0.65 24000
Soft coal 3800 1.05 20000
Table 1 Technical specifications

When mixing the hard and soft coals, the sulfur content in the output is a weighted average of
the two outputs. For example, a mixture consisting of equal parts of the coals would emit 2,800
PPM of sulfur gas. Similarly, a mixture consisting of three times as much hard coal as soft coal
would emit 2,300 PPM of SO2 . If the pulverizer were fed with hard coal only, it could handle 16
tons per hour. Similarly, if it were fed with soft coal only, it could handle 24 tons per hour. Thus,
an input of 8 tons/hour of hard coal would require 50% of the entire pulverizer capacity. An input
of 18 tons/hour of soft coal would require 75% of the entire pulverizer capacity. The pulverizer can
be fed with any combination of hard and soft coal that does not exceed its capacity.
The conveyor can handle up to 20 tons per hour of either coal. The conveyor can be fed with
any combination of hard and soft coal that does not exceed its capacity.

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1. The management of OMIPC wants to determine the mix of coals that will maximize the
amount of power (in BTU) produced per hour. This will be its summer-time peak hour operating
plan. Algebraically formulate an LP to find the optimal plan, but do not solve the LP. Define
the decision variables and their units of measurement and label each constraint in terms of the
requirements of the problem. (Hint: For the pulverizer capacity constraint, it may help first to
represent the constraint graphically, and then to deduce the algebraic version.)
2. OMIPC needs to produce 390,000 BTU per hour in off-peak conditions. If hard coal costs
15% more than soft coal, what will be the least cost way for OMIPC to meet this requirement?
Reformulate your LP model above to solve this problem? Report only the algebraic formulation of
the model.
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2. LP and Capital Asset Pricing

An investment company currently has $10 million to invest. Its goal is to maximize expected return
over the next year. The company uses the capital asset pricing model1 (CAPM) to determine each
investments expected return. The CAPM formula is

E(R) = Rf + (Rm Rf ),

where E(R) = Expected return (%), Rf = risk-free interest rate (%), = investment beta (market
risk), and Rm = market return (%). The market return and risk-free rates fluctuate, and the
company wants to be able to reevaluate its decisions on a weekly basis. Thus, it has automated this
investment decision by using a linear program. The companys only four investment possibilities
are summarized in Table 2. In addition, the company has specified that at least 30% of the funds
must be placed in some combination of treasury bonds and money markets, and no more than 40%
in common stock plus municipal bonds.

Maximum allowable
Investment investment ($ million)
Treasury bonds 0 $7
Common stock 1 $2
1
Money market 3
$5
1
Municipal bonds 2 $4
Table 2 Investment options.

Suppose T , C, M M , and M B represent the amounts ($millions) invested in Treasury Bonds,

Common Stocks, Money Market, and Municipal Bonds respectively.
Figure 1 shows the sensitivity report when the risk-free rate is 6% and a market return of 12%.
First, write down the corresponding LP problem. Then, answer the questions using only the output
given.
a) What is the expected rate of return from the optimal investment portfolio? What are the units
of the objective function value?
b) What is the optimal composition of the investment portfolio (i.e., how much should be invested
in each of the investment possibilities)?
c) Would the optimal investment portfolio change if the maximum amount of money to be invested
in municipal bonds is decreased to $2 million?
d) A bank offers varying interest rates on loans, depending on the total loan amount. In answering
the following questions, note that the only investment opportunities are in the four options listed
above. Note also that the three alternative loans are mutually exclusive.
i. Would you take out a loan in the amount of $3.5 million at a rate of 8%? Why or why not?
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MicrosoftExcel12.0SensitivityReport
Worksheet:[InvestmentOption.xlsm]Model
ReportCreated:6/21/20081:23:46PM

AdjustableCells
Final Reduced Objective Allowable Allowable
Cell Name Value Cost Coefficient Increase Decrease
$D$7 T 1.00 0.00 0.06 0.0198 1E+30
$E$7 C 2.00 0.00 0.12 1E+30 0.03
$F$7 MM 5.00 0.00 0.0798 1E+30 0.0198
$G$7 MB 2.00 0.00 0.09 0.03 0.03

Constraints
Final Shadow Constraint Allowable Allowable
Cell Name Value Price R.H.Side Increase Decrease
$H$9 MaxTBonds 1.00 0.00 7 1E+30 6
$H$10 MaxCommonStock 2.00 0.03 2 2 2
$H$11 MaxMoneyMarket 5.00 0.02 5 1 5
$H$12 MaxMunicipalBonds 2.00 0.00 4 1E+30 2
$H$13 Budget 10.00 0.07 10 5 1.666666667
$H$14 Atleast30%inT&MM 3.00 0.00 0 3 1E+30
$H$15 Atmost40%inS&MB 0.00 0.03 0 1 2

Figure 1 The Solver sensitivity report.

ii. Would you take out a loan in the amount of $4.5 million at a rate of 7%? Why or why not?
iii. Would you take out a loan in the amount of $5.5 million at a rate of 6%? Why or why not?
e) If the maximum allowable investment in common stock increased by $2 million, how much would
the expected return of the portfolio increase? Note that you still have only a total of $10 million
to invest.
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3. Modeling Business Logic

Model the following situations exactly using binary/integer variables and linear constraints:
1. A bookstore is trying to decide what books to sell. If it sells any large-sized books, it must
buy an oversized bookcase. It should not buy the bookcase if it is not going to sell any large-sized
books. At most, 100 oversized books will be sold.
2. A doctor is trying to make up his schedule for the next week. He needs to decide which days
to visit each patient. He has four patients, and he does not want to visit more than two in a given
day. However, he does not want to visit his patients on more than 3 days.
3. A group of friends are browsing through the local video store, trying to decide which movies to
rent. The friends, all ISB students, would like to plan their movie-watching schedule using integer
programming. Let Xi = 1 if movie i is rented, and 0 if not. Write exactly one constraint to say If
we rent both Taal (T) and Dhoom 2 (D), then we can only rent one of Krish (K), Omkara (O),
and Shootout at Lokhandwala (S).
4. Suppose a broker must choose to invest in four investments 1, 2, 3, and 4. Let X1 , X2 , X3 ,
and X4 denote the binary variables if he chooses the particular investment or not. Suppose he has
the following constraints: If he invests in 1 or 2 or both then he must invest in exactly one of 3 or
4. Otherwise, if he invests in neither (of 1 or 2) then there are no constraints on investing in 3 or
4.
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4. Combinatorial Betting and Prediction Markets

In a betting mechanism, people take bets on future events. Many such mechanisms (for example,
look at online prediction markets such as intrade.com) function by letting people buy or sell
securities in a particular event. For example, you may be able to buy a security that pays off 100 if
cricket team A defeats team B in their next game; let us suppose that this security can currently
be bought for 70. If you buy this security, then if A wins, you make a profit of 30, but if B wins,
you lose 70.
We will consider a setup in which bettors propose bets to a party that we will call the auctioneer.
A bet from a bettor might be If A wins you have to pay me 30, but if B wins I will pay you 70.
The auctioneer is only interested in accepting combinations of bets that result in a guaranteed
profit for her. Hence, the auctioneer will not accept the above bet by itself. However, suppose she
also has the following bet proposed to her: If A wins I will pay you 50, but if B wins you have to
pay me 60. Now, if the auctioneer accepts both of these bets, then no matter which of A and B
wins, the auctioneer will have a profit of at least 10 (the minimum profit value across all states
A wins or B wins), i.e., a guaranteed profit of 10. The auctioneers goal is to accept a subset of the
bets that maximizes her guaranteed profit.
For our problem, consider a betting market where we suppose that 3 states can materialize. For
example, consider the states as team A beats team B, team B beats team A, and the match
between teams A and B ends in a draw. A bet then consists of 3 numbers, negative or nonnegative,
that indicate how much the bettor will pay/receive in each state. For example, in this three-state
world, a bet (3, 3, -8) indicates that the bettor will pay 3, unless the third state materializes, in
which case he expects to be paid 8.
Suppose the auctioneer has received the following 4 bets for this three-state future event:
Bet 1: (a11 , a12 , a13 ),
Bet 2: (a21 , a22 , a23 ),
Bet 3: (a31 , a32 , a33 ),
Bet 4: (a41 , a42 , a43 ),
where aij (i = 1, . . . , 4 and j = 1, . . . , 3) can take any +ve, or -ve value. Write down model using
binary variables that maximizes the auctioneers guaranteed profit. Clearly state your decision
variables, objective function and constraints.
Now verify that your model provides the optimal solution to the following problem instance. If
you use Excel to solve this instance, please attach your model printout.
Bet 1: (2, 6, 3),
Bet 2: (5, 2, 8),
Bet 3: (9, 2, 2),
Bet 4: (3, 5, 2).