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Decision Models and Optimization, Term 2, 2009-10 Homework 4

Important Note: Please follow the instructions below while submitting your homework.
1. Clearly indicate the steps in all your simulation models what random variables form the input and what are their distributions, what is the output that you are measuring. 2. In all your simulations, set the number of trials to 1000 and the seed as 1. Set the sampling type as Monte Carlo and the generator as Mersenne Twister. 3. Use confidence intervals to interpret your results. 4. Include a printout of the excel sheet that shows your simulation model along with your homework submission.

Question 1(B&F, Chapter 4, 4.1) According to Census data, household incomes in Boston have a mean of $37,907 and a standard deviation of $15,102. Suppose that a sample of household incomes of 100 Boston Households will be selected at random. Let X denote the sample mean of this proposed sample. (a) What is the distribution of X ? (b) What is the probability that X will exceed $35,000? Question 2 Suppose you are bidding for a contract to supply health care services to a medium sized company for next year. Two competing firms are also bidding for this contract. You do not know what they will bid, but you have an idea about their highest, lowest, and most likely bids as follows. Bid Estimates: Competitor A Competitor B Low Most Likely $100,000 $110,000 $105,000 $115,000 High $135,000 $140,000

The contract is awarded to the lowest bidder. So, if you bid too high, one of the competitors is likely to win the contract and you will get nothing. If, on the other hand, you bid too low, you will probably win the contract but your profit will also be low. Moreover, you are uncertain about the cost of fulfilling the contract. You believe that it is normally distributed with the mean of $100,000 and the standard deviation of $20,000.

Use simulation to determine how much you should bid in order to maximize your expected profit. Hint: Look up the triangular distribution in @Risk. Question 3 Catchem Corporation is considering development and introduction of a new mousetrap into the market and would like to assess the profitability of this project. There is a significant technological uncertainty about the cost of product development and production, as well as market uncertainty about products success and the competitors action. Specifically, the VP of R&D expects the product development cost to be $30,000, with standard deviation of $5000. The VP of production estimates that the production cost could be as low as $6 per unit, or as high as $9 per unit, but she believes that most probably it will be $8 per unit. Once produced, if the mousetrap does not become popular, the total sales can be expected to be 60,000 units at a price of $10 per unit. On the other hand, if the mousetrap does catch attention, the sales could be as high as 100,000 units. However, in that case, new competition can be expected to move in and drive the price down to $8 a unit. From the preliminary research, the marketing VP believes that there is a 60% chance that the mousetrap will be a hit. Use simulation to estimate the profitability of this project and assess the risk of the company losing money on this project. Question 4 After spending 10 years in academia, Laurie has decided to become her own boss. She has decided to buy a physical therapy practice for $550,000, paid in installments of $110,000 per year for 5 years. The current owners estimate that revenues will be about $800,000 per year, and that operating costs will be about 65% of sales. Thus, once the practice is paid for, Laurie would clear almost $300,000 per year, before taxes. Realizing that some uncertainty is involved in this decision, and believing that some of the current owner's estimates are exaggerated, Laurie decides to run a simulation of the next five years. In particular, she wants to see what could happen to the net present value if revenues vary uniformly between $600,000 and $850,000 per year, and if operating costs are allowed to vary between 60% and 85% of sales. She uses a triangular distribution for this percentage, with a minimum of 60%, a most likely value of 65%, and a maximum of 85%. Answer the following questions: i) What is the probability that the net present value will be between $350,000 and $575,000? Assume that the rate of interest is 5% per year. Hint: Look up the Excel function NPV().

ii) Construct a 95% confidence interval for the expected payoff .

Question 5 The GMAT score of students at a certain business school follows a normal distribution with a mean of 710 and a standard deviation of 30. Suppose that we pick three students at random. i. What is the probability that there are at least two students with a GMAT score exceeding 740? ii. What is the probability that the average GMAT score of the three students exceeds 740? iii. What is the probability that the maximum of the 3 GMAT scores exceeds 740? Clearly indicate your steps and reasoning.