Decision Models & Optimization

Term II, 2007

Sample Final Examination

Page 1 of 5

Indian School of Business

Hyderabad, India
Decision Models & Optimization
Term II, 2004
Professors Anjani Jain and Ziv Katalan
Department of Operations and Information Management
The Wharton School
University of Pennsylvania
Instructions
This examination is open book and open notes. Calculators are allowed, but
not laptop or handheld computers capable of running spreadsheets. The
examination will last exactly two hours; feel free to ask questions during the
examination if there is any confusion. Write all your answers in the space
provided within this exam booklet. Please show all work partial credit will
be given for all questions except the multiple-choice ones.

Final Examination
Good luck!
Last Name:

_____________________

First Name:

_____________________

Section:

_____________________

Question
.
3

Part

a
b
c
d
e
f
g
total

points

out of

6
6
4
6
6
6
6
40

Decision Models & Optimization

Term II, 2007

Sample Final Examination

Page 2 of 5

3 GlobTech Expansion Options (40 points)

Julie Dewent, the CFO of GlobTech, is considering building a new plant, which will start
generating revenues in one year.
The stream of revenues is uncertain, and GlobTech believes that the mean of its value one
year from now will be $108,329,000. At a discount rate of r = 8%, this is equivalent to
$100,000,000 = e-0.08 $108,329,000 today.
During the coming year, GlobTechs revenue expectations may change. More specifically,
GlobTech believes that one year from now, the expected value V (in $millions) of the
revenues is lognormally distributed with = 60% volatility,
V = 100 e(r ^2/2)+ *Z = 100 e(0.08 0.6^2/2)+0.6*Z
where Z is a standard normal random variable with mean value of 0 and standard deviation
of 1.
GlobTech is considering the following options:

Base Case Build the plant now

If the plant is built now, its cost will be a fixed $104 million. Because the expected present
value of the revenue today is only $100 million, simply building the plant now does not
appear to be worthwhile. That is,
Expected NPV(Build Now) = -104 + e-0.08 108.329 = -4.

Option 1: Postponement Option

GlobTech waits one year, at which time V is known, before making the decision of whether or
not to invest in this project. The delay will decrease the project revenues by 25% and
construction costs will grow at a rate of 8%. In this case,
NPV(Postponement Option) = e-0.08 MAX[0.75V e0.08(104), 0].

Option 2: Expansion Option

GlobTech invests $104 now and has the option to spend more in one year. By that time, the
company will know the value of V, and it can choose to spend $50 million at that time on a
plant expansion that will increase the project revenues by 50%. Alternatively, GlobTech can
just accept V. In this case,
NPV(Expansion Option) = e-0.08 MAX[(1.5V 50), V] 104.

Decision Models & Optimization

Term II, 2007

Sample Final Examination

Page 3 of 5

Note: For all of the questions that follow, simply check the correct answer. No partial credit
will be given.
GlobTech has simulated the performance of Options 1 and 2. The results of a 900 trial
Monte Carlo simulation are summarized in the tables below:
Statistics
Trials
Mean
Median
Mode
Standard Deviation
Variance
Skewness
Kurtosis
Coeff. of Variability
Range Minimum
Range Maximum
Range Width
Mean Std. Error
Percentiles
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%

NPV (Postponement)
900
9.71
0.00
0.00
33.11
1,096.00
5.85
48.61
3.41
0.00
413.44
413.44
1.10
NPV (Postponement)
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.98
26.27
413.44

NPV (Expansion)
900
11.07
-19.91
--95.64
9147.60
3.02
18.21
8.64
-91.69
884.72
976.41
3.19
NPV (Expansion)
-91.69
-64.25
-54.15
-42.87
-33.15
-19.91
1.44
28.07
59.80
110.38
884.72

a) (6 points) If the option to postpone the project by one year requires an additional payment
of $1 million now, what is the approximate probability that the NPV of the project will be
positive?
( ) 100%
( ) 80%
( ) 50%
( ) 20%
( )

0%

( ) It cannot be determined from the simulation

Decision Models & Optimization

Term II, 2007

Sample Final Examination

Page 4 of 5

b) (6 points) What would be the approximate width of the 95% confidence interval for the
true expected NPV of the postponement option if the sample size were 1800 instead of
900?
( ) $8.8 million
( ) $4.4 million
( ) $3.1 million
( ) $2.2 million
c) (4 points) Which of the following statements is true?
( ) The true expected NPV of the postponement option is higher than the true expected
NPV of the expansion option.
( ) The true expected NPV of the expansion option is higher than the true expected NPV
of the postponement option.
( ) It cannot be determined from the simulation results which of the true expected NPVs
is higher.
d) (6 points) Suppose the annual volatility of the project revenues increases to 80%.
Without running a simulation, which of the following statements would you expect to be
true?
( ) The expected NPV of the postponement option will be higher when the volatility
increases while the expected NPV of the expansion option will stay the same.
( ) The expected NPV of the postponement option will stay the same when the volatility
increases while the expected NPV of the expansion option will be higher.
( ) The expected NPV of both options will be lower when the volatility increases.
( ) The expected NPV of both options will stay the same when the volatility increases.
( ) The expected NPV of both options will be higher when the volatility increases.
e) (6 points) Looking at the distribution of percentiles, the observed chance that the NPV of
Expansion will be between -$54,150,000 and $59,800,000 is about 60%. Suppose the
number of trials were increased to 3600. What is the best estimate of the chance that the
NPV of Expansion will be between -$54,150,000 and $59,800,000 in these new results?
( ) about 90%
( ) about 80%
( ) about 60%
( ) about 30%
( ) about 15%

Decision Models & Optimization

Term II, 2007

Sample Final Examination

Page 5 of 5

Contraction Option
Instead of paying the entire $104 million plant cost now, GlobTech can pay ONLY $50 million
now. Then, one year from now, when V is known, the company can choose to pursue either
of two options.

Pay the remaining $54 million cost, plus interest, and obtain the full project value. Here,
total costs and revenues will be the same as they would have been in the base case.

Contract the scale of the project by paying only $25 million next year. Here, the present
value of the revenues will be worth only 50% of what they would have originally been
worth.

f)

(6 points) Which of the following expressions will evaluate correctly the NPV of the
contraction option?
( ) e-0.08 MAX[(V e0.08104), 0.5V - 25]
( ) e-0.08 MAX[(V e0.0854), 0.5V - 25] 50
( ) e-0.08 MAX[(0.5V 25), 0] - 50
( ) e-0.08 MAX[(0.5V 25), V] - 54

The results of a 100-trial Monte Carlo simulation of the contraction option are summarized in
the following table:
Statistics
Trials
Mean
Median
Mode
Standard Deviation
Variance
Range Minimum
Range Maximum
Range Width
Mean Std. Error

NPV (Contraction)
100
-6.86
-27.13
--63.89
4,081.62
-62.72
301.24
363.96
6.39

g) (6 points) How does the true expected NPV of the contraction option compare with that of
the base case, in which GlobTech simply invests $104 million today to build the plant?
( ) The true expected NPV of the contraction option is definitely no lower than that of the
base case.
( ) The true expected NPV of the contraction option is definitely no higher than that of
the base case.
( ) Given the simulation results, there is a significant probability that the true expected
NPV of the contraction option is either higher or lower than that of the base case. To
precisely determine which, one must run the simulation with a much larger number of
trials.
( ) It cannot be determined whether or not the true expected NPV of the contraction
option is higher or lower than that of the base case.