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MBA – II SEM
MB0032
Set – 1
1. Describe the broad classification of Operations Research
models in details. Name the different steps needed in OR
approach of problem solving?
Answer: A model is known as the representation of the reality. It is
known as an idealized representation or abstraction of a real life system.
The main objective of this model is to identify significant factors and their
interrelationship. A model is helpful is decision making as it provides a
simplified description of complexities and uncertainties of a problem in
logical structure.
The method of solving a LPP on the basis of the above analysis is known
as the graphical
method. The working rule for the method is as follows:
Working Rule:
Step I: Write down the equations by replacing the inequality symbols by
the equality symbol in the given constraints.
Step II: Plot the straight lines represented by the equations obtained in
step I.
Step III: Identify the convex polygon region relevant to the problem. We
must decide on which side of the line, the halfplane is located.
Step IV: Determine the vertices of the polygon and find the values of the
given objective
function Z at each of these vertices. Identify the greatest and least of
these values. These are respectively the maximum and minimum value of
Z.
Step V: Identify the values of (x1, x2) which correspond to the desired
extreme value of Z. This is an optimal solution of the problem.
Solution by Graphical Method
Let the horizontal axis represent x1and vertical axis represent x2. plot the
constraint lines,
feasibility region has been shown in fig.
Any point on the thick line or inside the shaded portion will satisfy all the restrictions of the
problem then ABCDE is the feasibility region carried out by the constraints operating on the
objective function. This depicts the limits within which the values of the decision variables
are permissible. The intersection points C and D can be solved by the linear equations 0.1x2
< 30, 0.1x1 + 1.5x2 = 600, and 0.2x1 + 0.2x2 < 100 i.e. C(150,300) and D(300,180).
From the above table we find that revenue is maximum at Rs.31500 when
150 unit of X1 and 300 units of X2 are produced.
Whenever artificial variables are part of the initial solution X0, the last row
of simplex table will contain the penalty cost M. The following
modifications are made in the simplex method to minimize the error of
incorporating the penalty cost in the objective function. This method is
called Big M method or Penalty cost method.
1) The last row of the simplex table is decomposed into two rows, the first
of which involves those terms not containing M, while the second involves
those containing M.
2) The Step 1 of the simplex method is applied to the last row created in
the above modification and followed by steps 2, 3 and 4 until this row
contains no negative elements. Then step 1 of simplex algorithm is
applied to those elements next to the last row that are positioned over
zero in the last row.
From the above resource allocation model, the primal problem has n
economic activities and m resources. The coefficient cj in the primal
represents the profit per unit of activity j. Resource i, whose maximum
availability is bi, is consumed at the rate aij units per unit of activity
j.Interpretation of Duel Variables –
For any pair of feasible primal and dual solutions,
(Objective value in the maximization problem) ≤ (Objective value in the
minimization problem) At the optimum, the relationship holds as a strict
equation. Note: Here the sense of optimization is very important. Hence
The strict equality, z = w, holds when both the primal and dual solutions
are optimal.
Consider the optimal condition z = w first given that the primal problem
represents a resource allocation model, we can think of z as representing
profit in Rupees. Because bi represents the number of units available of
resource i, the equation z = w can be expressed as profit (Rs) = Σ
(units of resource i) x (profit per unit of resource i) This means that the
dual variables yi,
represent the worth per unit of resource i [variables yi are also called as
dual prices, shadow prices and simplex multipliers]. With the same logic,
the inequality z < w associated with any two feasible primal and dual
solutions is interpreted as (profit) < (worth of resources) This relationship
implies that as long as the total return from all the activities is less than
the worth of the resources, the corresponding primal and dual solutions
are not optimal. Optimality is reached only when the resources have been
exploited completely, which can happen only when the input equals the
output (profit). Economically the system is said to remain unstable (non
optimal) when the input (worth of the resources) exceeds the output
(return). Stability occurs only when the two
quantities are equal.
Phase I is complete, since there are no negative elements in the last row.
The Optimal solution of the new objective is Z* = 0.
Phase II:
Consider the original objective function,
Maximize z = 3x1 – x2 + 0S1 + 0S2 + 0S3
Subject to
x2 + S3 = 4
x1, x2, S1, S2, S3 > 0
Since all elements of the last row are non negative, the current solution is
optimal.
The maximum value of the objective function
Z = 6 which is attained for x1 = 2, x2 = 0.
4. What do you understand by the transportation problem? What
is the basic assumption
behind the transportation problem? Describe the MODI method of
solving transportation
problem.
Answer: This model studies the minimization of the cost of transporting a
commodity from a
number of sources to several destinations. The supply at each source and
the demand at each
destination are known. The transportation problem involves m sources,
each of which has
available ai (i = 1, 2, …..,m) units of homogeneous product and n
destinations, each of which
requires bj (j = 1, 2…., n) units of products. Here ai and bj are positive
integers. The cost cij of
transporting one unit of the product from the i th source to the j th
destination is given for each i
Set – 2
ANS 1.
The present value of cash outflows = initial cost of investment and the comment
of project at various points of time ^
Merits
1. The most significant advantage is that it explicitly recognizes the time value of
money, e.g., total cash flows pertaining to two machines are equal but the net
present value are different because of differences of pattern of cash streams.
The need for recognizing the total value of money is thus satisfied.
Demerits
2. The second and more serious problem associated with present value method
is that it involves calculations of the required rate of return to discount the cash
flows. The discount rate is the most important element used in the calculation of
the present value because different discount rates will give different present
values. The relative desirability of a proposal will change with the change of
discount rate. The importance of the discount rate is thus obvious. But the
calculation of required rate of return pursuits serious problem. The cost of capital
is generally the basis of the firm's discount rate. The calculation of cost of capital
is very complicated. In fact there is a difference of opinion even regarding the
exact method of calculating it.
4. The present value method may also give satisfactory results in case of two
projects having different effective lives. The project with a shorter economic life
Evaluation of IRR
2. It produces multiple rates which can be confusing. This situation arises in the
case of non-conventional projects.
3. In evaluating mutually exclusive proposals, the project with highest IRR would
be picked up in exclusion of all others. However in practice it may not turn out to
be the most profitable and consistent with the objective of the firm i.e.,
maximization of shareholders wealth.
4. Under IRR, it is assumed that all intermediate cash flows are reinvested at the
IRR. It is rather ridiculous to think that the same firm has the ability to reinvest
the cash flows at different rates. The reinvestment rate assumption under the
IRR is therefore very unrealistic. Moreover it is not safe to assume always that
intermediate cash flows from the project may be reinvested at all. A portion of
cash inflows may be paid out as dividends, a portion may be tied up with current
assets such as stock, cash, etc. Clearly, the firm will get a wrong picture of the
project if it assumes that it invests the entire intermediate cash proceeds.
Further it is not safe to assume that they will be reinvested at the same rate of
return as the company is currently earning on its capital (IRR) or at the current
cost of capital (k).
NPV versus IRR NPV indicates the excess of the total present value of future
returns over the present value of investments. IRR (or DFC rate) indicates on the
other hand the rate at which the cash flows (at present values) are generated in
the business by a particular project.
Both NPV and IRR iron out the difference due to interest factor or say higher
returns in earlier years and higher returns in later years (though the total returns
in absolute terms may be around the same for several projects).
Between the two, IRR or DFC rate is the more sophisticated method ¬a popular
as well, since:
DFC rate Vs Discount rate of return (on normal operations) ^ DFC rate Vs Cut
off rate of the company DFC rate Vs Borrowing rate (on cost of capital) DFC
rates between different projects
(c) The results under DFC rate approach are simpler for the management to
understand and appreciate. We should however be very careful in applying the
decision rules properly when NPV and IRR calculation shows divergent results.
The rules are ¬
(i) the projects be the basis of decision when mutually exclusive in character;
(d) IRR should be a better guide when there are plenty of project situations (as it
is there in a long enterprise) and no major constraints (for example, in respect of
macro projects).
Machines B C
A
Estimated life 3 Years 3 Years 3years
Cash inflows(in lakhs)
1 Year 27 06 12
2 Year 18 21 80
3 Year 55 33 30
Ans 2
A) Payback period
Machine A. Rs.27 lakhs will be recovered in 1st year & the balance 13 lakhs (40 –
27) will be recovered in 2nd year of 18 lakhs
machine B. Rs.06 lakhs will be recovered in 1st year & the balance 34 lakhs
(40 – 6) will be recovered in 2nd year of 21 lakhs
payback period = 1year +(35/21*12month) or =1year + 35/21
= 1year 20 month = 1year +1.66
2.66year
machine c. Rs.12 lakhs will be recovered in 1st year & the balance 28 lakhs
(40 – 12) will be recovered in 2nd year of 80 lakhs
payback period = 1year + (28/80*12month) or =1year + 28/80
= 1year + 4.2 month = 1year + 0.35
= 1.35year
machine A. Rs. 35.4546 will be recovered in 2nd year & balance 4.5454(40-
35.4546) will be recovered in 3rd year out of 39.149
=2year + (4.5454/39.149)
=2year + 0.1161
=2.11year
machine A. Rs. 22.0968 will be recovered in 2nd year & balance 17.9032(40-
22.0968) will be recovered in 3rd year out of 23.489
=2year + (17.9032/23.489)
=2year +0.7621
=2.76year
machine A. Rs. 74.4936 will be recovered in 2nd year & balance -34.4936
(40- 74.4936) will be recovered in 3rd year out of 95.8436
=2year + (-34.4936/95.8436)
=2year + -0.3598
= 1.64year
years 0 1 2 3 4 5 6
Cash flows -120 -100 40 60 80 100 130
(in millions)
The cost of capital is 13% find MIRR.
Ans 3:
1. project – specific risk: the source of this risk could be traced to something
quite specific to the project. Managerial deficiencies or error in estimation of
cash flow or discount rate may lead to a situation of actual cash flow relised
being less than that projected.
2. competitive risk or competition risk: unanticipated of a firm’s competitors will
materially affect the cash flows expected from a project. Because of this the
actual cash flow from a project will be less than that of the forecast.
3. industry- specific : industry – specific risks are those that affect all the firms in
the industry. It could be again grouped in to technological risk, commodity risk
and legal risk. All these risks will affect the earnings and cash flows of the
project. The changes in technology affect all the firms not capable of adapting
themselves to emerging new technology. The best example is the case of firm
manufacturing motors cycles with two stroke engines. When technological
innovation replaced the two stroke engines by the four stroke engines those
firms which could not adapt to new technology had to shut down their
operations. Commodity risk is the arising from the affect
of price – changes on goods produced and marketed. Legal risk arise from
changes in laws and regulations application to the industry to which the firm
belongs. The best example is the imposition of service tax on apartments by the
government of India when the total number
of apartments built by a firm engaged in that industry exceeds a prescribed limit.
Similarly changes in import – export policy of the government of India have led
to the closure of some firms or sickness of some firms.
4. international risk : these types of risk are faced by firms whose business
consists mainly of exports or those who procure their main raw material from
international markets. For example, rupee –dollar crisis affected the software and
BPOs because it drastically reduce their profitability. Another best example is
that of the textile units in Tirupur in Tamilnadu, exporting their major part of the
garments produces. Rupee gaining and dollar weakening reduced their
competitiveness in the global markets.
The certainty equivalent factor balance as per the following equation α t=1-05.05t. Calculate the
NPV of the project if the risk free rate of return is 9%.
Ans 4:
Ans 5:
For JAN:
Bank over Draft 21,000 for maintain minimum cash balance for
month of
February 21000+4000=25000.
For FEB:
No need to take bank over Draft because closing balance 25,000.
For MARCH:
Bank over Draft 10,000 for maintain minimum cash balance for
month of
April 15,000+10,000=25000.
ANS:-
Credit policy Variables
1. Credit standards.
2. Credit period.
3. Credit discount and
4. Collection programme.
1. Credit standards : The term credit standards refer to the criteria for
extending credit to customers. The bases for setting credit standards are.
a. Credit rating
b. References
c. Average payment period
d. Ratio analysis
There is always a benefit to the company with the extension of credit to its
customers but with the associated risks of delayed payment or non payment,
funds blocked in receivables etc. The firm may have light credit standards. It
may sell on cash basis and extend credit only to financially strong customers.
Such strict credit standards will bring down bad – debt losses and
reduce the cost of credit administration. But the firm may not be able to increase
its sales. The profit on lost sales may be more the costs saved by the firm. The
firm should evaluate the trade – off between cost and benefit ofany credit
standards.
2. Credit period: Credit period refer to the length of time allowed to its
customers by a firm to make payment for the purchase made by customers of
the firm. It is generally expressed in days like 15 days or 20 days. Generally,
firms give cash discount if payment are made within the specified period. If a
firm follows a credit period of ‘net 20’ it means that it allows to its
customers 20 days of credit with no inducement for early payments. Increasing
the credit period will bring in additional sales from existing customers and new
sales from new customers. Reducing the credit period will lower sales, decrease
investments in receivables and reduce the bad debt loss. Increasing the credit
period increases the incidence of bad debt loss. The effect of increasing the
credit period on profits of the firm are similar to that of relaxing the credit
standards.
3. Cash discount: Firms offer cash discount to induce their customer to make
prompt payments. Cash discount have implications on sales volume, average
collection period, investment in receivables, incidence of bad debt and profits. A
cash discount of 2/10 net 20 means that a cash discount of 2% is offered if the