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10 Advanced Finance Applications Review Questions

Lesson Topics
Portfolio Selection Problems with Asset
Classification help financial managers restrict the
maximum investment in any single class (equities,
debt, real estate, …) to ensure diversification.
Portfolio Selection Problems with Planning
Scenarios help financial managers predict returns
based on past performance. Hence, managers can
compute minimum returns and expected returns.
Portfolio Selection Problems with a
Maximin (2) (Maximize a Minimum) Objective help
compute minimum returns for risk-averse (pessimistic)
investors concerned with the worst-case scenario.
Production Scheduling Problems with
Adjustment Costs (1) help find an efficient low-
cost production schedule when there are costs of
increasing or decreasing production or storage.

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A.10 Advanced Finance Applications Review Questions

Portfolio Selection Problems with a

Maximin
Question. Portfolio manager Max Gaines needs to
develop an investment portfolio for his conservative
(pessimistic, risk-averse) clients. His task is to
determine the proportion of the portfolio to invest in each of the three
mutual funds listed below so that the portfolio provides the best return
possible with a minimum risk.

Annual Returns (Planning Scenarios)

Mutual Fund Year 1 Year 2 Year 3 Year 4
Large-Cap Blend 14.00 18.00 10.00 5.00

Mid-Cap Blend 19.00 18.00 5.00 -1.00

Small-Cap Blend 13.00 11.00 -2.00 6.00

Formulate the linear program that allows the portfolio manager to provide
the best return possible with minimum risk.

Tip: Your written answer should define the decision variables, and
formulate the objective and constraints.

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Answer to Question:

Max M

s.t.

- M + 14 LC + 19 MC + 13 SC > 0 (Scenario 1)

- M + 18 LC + 18 MC + 11 SC > 0 (Scenario 2)

- M + 10 LC + 5 MC - 2 SC > 0 (Scenario 3)

- M + 5 LC – 1 MC + 6 SC > 0 (Scenario 4)

LC + MC + SC = 1 (Total proportion must equal 1)

M, IS, LC, MC, SC, IB > 0 (Non-negativity)

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A.10 Advanced Finance Applications Review Questions

Portfolio Selection Problems with a

Maximin
Question. Portfolio manager Max Gaines needs to
develop an investment portfolio for his conservative
(pessimistic, risk-averse) clients. His task is to
determine the proportion of the portfolio to invest in each of the three
mutual funds listed below so that the portfolio provides the best return
possible with a minimum risk.

Annual Returns (Planning Scenarios)

Mutual Fund Year 1 Year 2
Large-Cap Blend 14.00 18.00

Mid-Cap Blend 19.00 18.00

Small-Cap Blend 13.00 11.00

Formulate the linear program that allows the portfolio manager to provide
the best return possible with minimum risk. Solve with the Management
Scientist.

Tip: Your written answer should define the decision variables, and
formulate the objective and constraints. And your written answer should
specify the proportion of the portfolio to invest in each of the three mutual
funds.

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A.10 Advanced Finance Applications Review Questions

Answer to Question:

Max M

s.t.

- M + 14 LC + 19 MC + 13 SC > 0 (Scenario 1)

- M + 18 LC + 18 MC + 11 SC > 0 (Scenario 2)

LC + MC + SC = 1 (Total proportion must equal 1)

M, LC, MC, SC > 0 (Non-negativity)

So, invest 20% in the Large Cap, 80% in the Mid Cap, and 0% in the Small
Cap.

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A.10 Advanced Finance Applications Review Questions

Production Scheduling with Adjustment

Costs
Question. EZ- Windows, Inc., manufactures
replacement windows for the home remodeling
business. In January, the company produced
15,000 windows and ended the month with 9000 windows in inventory. EZ-
Windows’ management team would like to develop a production schedule
for the next three months. A smooth production schedule is obviously
desirable because it maintains the current workforce and provides a similar
month-to-month operation. However, given the sales forecasts, the
production capacities, and the storage capabilities as shown, the
management team does not think a smooth production schedule with the
same production quantity each month possible.

February March April

Sales forecast 15,000 16,500 20,000
Production 14,000 14,000 18,000
capacity
Storage capacity 6,000 6,000 6,000

The company’s cost accounting department estimates that increasing

production by one window from one month to the next will increase total
costs by $1.00 for each unit increase in the production level. In addition,
decreasing production by one unit from one month to the next will increase
total costs by $0.65 for each unit decrease in the production level. Ignoring
production and inventory carrying costs formulate and solve (using the
computer) a linear programming model that will minimize the cost of
changing production levels while still satisfying the monthly sales forecasts.

Hint: This question uses some of the modeling developed in class, but it
also require some original thinking. The key to solving each problem is
defining the decision variables. Some of the decision variables that could
help solve this question are:

F = number of windows manufactured in February

IF = increase in production level necessary during February
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DF = decrease in production level necessary during February

SF = ending inventory in February

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Answer to Question:
Let F = number of windows manufactured in February
M = number of windows manufactured in March
A = number of windows manufactured in April
Im = increase in production level necessary during month m
Dm = decrease in production level necessary during month m
sm = ending inventory in month m

Min 1I1 + 1I2 + 1I3 + 0.65D1 + 0.65D2 + 0.65D3

s.t.
9000 + F - s1 = 15,000February Demand
or
(1) F1 - s1 = 6000

(2) s1 + M - s2 = 16,500 March Demand

(3) s2 + A - s3 = 20,000 April Demand

F - 15,000 = I1 - D1 Change in February Production

or
(4) F - I1 + D1 = 15,000

M - F = I2 - D2 Change in March Production

or
(5) M - F - I2 + D2 = 0

A - M = I3 - D3 Change in April Production

or
(6) A - M - I3 + D3 = 0

(7) F ≤ 14,000 February Production Capacity

(8) M ≤ 14,000 March Production Capacity

(9) A ≤ 18,000 April Production Capacity

(10) s1 ≤ 6,000 February Storage Capacity

(11) s2 ≤ 6,000 March Storage Capacity

(12) s3 ≤ 6,000 April Storage Capacity

Optimal Solution: Cost = $6,450

February March April

Production Level 12,000 14,000 16,500
Increase in Production 0 2,000 2,500
Decrease in Production 3,000 0 0

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Ending Inventory 6,000 3,500 0