PGPEX: Managerial Problem Solving

Monte Carlo Simulation

Prof. Preetam Basu (email: preetamb@iimcal.ac.in)
Problem 1: Shankar is a newsboy. One of the daily newspapers that Shankar sells
from his newsstand is the Financial Journal. A distributor brings the days copy of
the Financial Journal to the newsstand every morning. Any copies unsold at the end
of the day are returned to the distributor next morning. However, to encourage
ordering a large number of copies, the distributor does give a small refund for
unsold copies. Here are Shankars cost figures:
Shankar pays Rs. 1.50 per copy delivered
Shankar sells it at Rs. 2.50 per copy
Shankars refund is Rs. 0.50 per unsold copy.
Partially because of the refund, Shankar always has taken plentiful supply. However,
he has become concerned about paying so much for copies that then have to be
returned unsold, particularly since this has been occurring every day. He now thinks
he might be better off by ordering only a minimal number of copies and saving this
extra cost. To investigate this further, he has compiled the following record of his
daily sales. Shankar sells anywhere between 40 and 70 copies inclusively on any
given day. The frequency of numbers between 40 and 70 are roughly equal. The
decision that Shankar needs to make is the number of copies to order per day. His
objective is to maximize his average daily profit.
What happens to the optimal ordering decision if the demand follows a normal
distribution with mean 50 and standard deviation 15?
What happens to the optimal ordering decision if the demand follows the following
discrete distribution?
Demand
40
45
50
55
60

Probability
0.3
0.2
0.3
0.15
0.05

Problem 2: PortaCom manufactures printers. PortaComs product design group

developed a prototype for a new high-quality printer. Preliminary marketing and
financial analysis provided the following estimates:
Administrative costs=Rs.400000
Advertising cost=Rs.600000.
Calls
Probability
Labor cost=Rs.450/unit
80
0.10
Cost of parts=Rs.1000/unit
120
0.40
Demand is not known for certain and is considered
160
0.30
probabilistic inputs. Demand is forecasted to follow
200
0.15
300
0.05
normal probability distribution with mean 500 units
and standard deviation of 50 units.
Selling Price=Rs.3500/unit
PortaCom would like an analysis of the profit potential for the printer. Because of
tight cash flow situation management is particularly concerned about the potential
for a loss.

Problem 3: Brown Telecommunication Services needs to determine how many

telephone operators to employ. The management at Brown estimates that the
number of phone calls received each hour of a typical 8-hour shift can be described
by the following probability distribution:

Each operator can handle 15 calls per hour and costs the company $20 per hour.
Each phone call that is not handled is assumed to cost the company $6 in lost profit.
Use Simulation in Excel to determine the number of operators that minimizes the
expected hourly cost (labor plus lost profits). Run your simulation model for 1000
iterations and then make your decision.

Problem 4: You just bought an expensive car and now need to buy auto insurance.
You are considering two insurance policies, the first one has a deductible of
Rs.10000 and yearly premium of Rs.820 and the second one has a deductible of
Rs.5000 and a yearly premium of Rs.1500. Each year there is a probability of 0.3 of

having an accident. The damage amount if an accident occurs follows the discrete
probability distribution given below:

Damage
Probability
Amount (Rs.)
2000
0.3
4000
8000
12000
20000

0.2
0.1
0.2
0.2

Which insurance policy should you pick?

Problem 5: You are managing the warehouse of a major retailer. Everyday

truckloads of materials arrive at the warehouse. The number of trucks arriving and
the probability are given in Table 1. The daily unloading rate is also stochastic
based on the nature of the products being unloaded. The probability distribution of
the daily unloading rate is given in Table 2. Trucks are unloaded based on a first-in,
first-out basis. Any truck not unloaded the day of arrival must wait until the
following day. Run a 100-day simulation model to deduce: (i) the average number of
trucks delayed, (ii) the average number of trucks unloaded each day.
Table 1:

Daily
Probability
Unloading Rate
Number of Trucks Probability
1
0.05
Arriving
2
0.15
0
0.13
3
0.50
1
0.17
4
0.20
2
0.15
5
0.10
3
0.25
4
0.20
5
0.10

Table 2:

Problem 6: AOSN is an Internet Service Provider (ISP). AOSN is willing to give a

customer a free PC at a cost of $500 if the customer signs up for a guaranteed 3
years of service. During that time the cost of service to the customer is constant at
$263.40 annually. After 3 years we assume that the cost of service increases by 3%.
.

Without the free PC offer service cost increases by 3% from year 1. After 3 years
AOSN assumes that the probability that the customer stays with AOSN is 0.5
(retention rate). Even for without the PC offer retention probability is 0.5. If the
customer switches to another ISP there is always probability of 0.1 that the
customer (without any free PC offer) willingly joins AOSN. Even customers with the
free PC can switch to other ISP and then switch back to AOSN. Here also the
switchback probability is 0.1.
AOSN wants to see whether in terms of NPV with a 10% discount rate and with an
investment window of 10 years this offer makes financial sense.
(For modeling simplicity, assume that quitting and switching takes place only at the
end of a year)

Problem 7: General Auto Corporation (GAC) is developing a new model of compact

car. The car is assumed to generate sales for the next 5 years. GAC has gathered
information about the following quantities through focus groups with marketing and
engineering departments:

The fixed cost of manufacturing the cars is $1.9 billion. The fixed cost is incurred
at the beginning of year 1, before any sales are recorded.
Margin per car: This is the unit selling price minus the variable cost of producing
a car. GAC assumes that in year 1 the margin will be $5000. Every other year the
margin will decrease by 4%.
The demand for the car is uncertain. GAC assumes that the demand for the cars
is triangularly distributed with parameters 100,000, 150,000 & 170,000. Every year
after that sales decreases by 5% of the sales made in the previous year.
The discount rate is 15%.
Using a simulation model help GAC evaluate the NPV of the cash flows for this new
car over the 5-year horizon.

Problem 8: Miller Construction Company must decide whether to make a bid on a

construction project. Miller assesses that the cost to complete the project has a
triangular distribution with minimum, most likely and maximum values $9000,
$10000 and $15000. The cost to prepare a bid has a triangular distribution with
parameters $300, $350 and $500. Four potential competitors are going to bid
against Miller. The lowest bid wins the contract and the winner is then given the
winning bid amount to complete the project. Based on past history, Miller believes
that each potential competitor will bid, independently of the others, with probability
0.5. Miller also believes that each competitors bid will be a multiple of Millers
.

most likely cost to complete the project, where this multiple has a triangular
distribution with minimum, most likely and maximum values 0.9, 1.3 and 1.8
respectively. If Miller decides to prepare a bid, its bid amount will be a multiple of
$500 in the range $10500 to $15000. The company wants to use simulation to
determine which strategy to use to maximize its expected profit.

Problem 9: Stock prices are estimated using Geometric Brownian Motion based on
the following equation:
ln(

St
2
) ( d d )t d N (0,1) t
St 1
2

You are deliberating to buy 1000 stocks of Indian Oil Corporation Ltd (IOCL). You
have collected IOCLs stock price for the last 252 trading days
(StockPriceData.xlsx). Use the historical stock prices and the above equation to
simulate stock prices of Indian Oil Corporation Ltd for the next 30 days and
calculate the average value of the investment and its standard deviation based on
the simulated stock prices on day 30.

Problem 10: Develop a simulation model for a 3-year financial analysis of total
profit based on the following data and information: Sales volume in the first year is
estimated to be 100,000 units and is projected to grow at a rate that is normally
distributed with a mean of 7% per year and a standard deviation of 4% per year.
The selling price is $10 in year one and the price increase is normally distributed
with a mean of $0.50 and standard deviation of $0.05 each year. Per unit variable
costs are $3 in year one and is expected to increase by an amount normally
distributed with a mean of 5% per year and standard deviation of 2% per year.
Fixed costs of $200,000 are incurred annually (for the three years). Based on 1000
simulations, find the average and the standard deviation of the 3-year cumulative
profit. What is the VaR at 90% confidence level for the 3-year cumulative profit?