Investment Science

Chapter 5
Solutions to Suggested Problems
Dr. James A. Tzitzouris
<jimt2@ams.jhu.edu>

5.1

Project Benefit-Cost Ratio

1 2
2 5/3
3 3/2
4 4/3
5 5/3

So, the approximate method based on cost-benefit ratios implies projects 1, 2, and 5 would be
recommended. The optimal set of projects is the same. Note: projects 1,2, and 3 provide the same
total net present value and use the entire budget.

5.2

The zero-one problem is the same as in Example 5.2 with the one additional constraint. This
additional constraint can be expressed in several different ways. Here are two examples:

• (x2 + x4 )(1 − (x6 + x7 )) = 0

• x2 + x4 ≤ x6 + x7

The optimal solution funds projects 4, 6, and 10 for a total cost of $4, 700, 000 and a total benefit
of $7, 800, 000.

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5.3

The problem is to

maximize 150x1 + 200x2 + 100x3 + 100x4 + 120x5 + 150x6 + 240x7 ,

subject to 90x1 + 80x2 + 50x3 + 20x4 + 40x5 + 80x6 + 80x7 + y ≤ 250,
58x1 + 80x2 + 100x3 + 64x4 + 50x5 + 20x6 + 100x7 − 1.1y ≤ 250,
xi ∈ {0, 1}, ∀i,
y ≥ 0.

The maximal NPV is 610, acheived by funding projects 4, 5, 6, and 7, at a cost of 220 in the first
year and 234 in the second year. Another plan with NPV of 610 is to fund projects 1, 4, 5, and 7,
at a cost of 230 in the first year and 272 in the second year. Both plans are under the budget, but
the first costs less.

5.4

(a)
 
10 7 8 6 7 5 10 8 7 100

 10 7 8 6 7 5 10 8 107 0 

 10 7 8 6 7 5 110 108 0 0 
C= 

 10 7 8 6 7 105 0 0 0 0 

 10 7 8 106
107 0 0 0 0 0 
110 107 108 0 0 0 0 0 0 0
 
100
 200 
 
 800 
y=
 
 100 

 800 
1200
p and x are identified in Table 5.3

(b) We know the price of bond j is

n
X
pj = cij (1 + sn )i ,
i=1

2
so choosing
(1 + sn )1
 

 (1 + sn )2 

v=
 ... 

 (1 + sn )n−1 
(1 + sn )n
solves the equation C T v = p.

(c) To meet the obligation of period i exactly, we require

m
X
cij xj = bi , ∀i,
j=1

or in matrix form: Cx = b.

(d) The price of the portfolio is pT x = v T Cx = v T b. This shows that the present value of the
portfolio must equal the present value of the liabilities.

5.5

The trinomial lattice spanning three periods (with four time points) contains 42 = 16 nodes. In
general, a trinomial lattice with n time points contains n2 nodes. In a full trinomial tree spanning
the three periods there are 40 nodes. In general, a full trinomial tree with n time points contains
n−1
X 1
3i = (3n − 1)
2
i=0
nodes.

5.6

You are not responsible for this problem.

5.7

The decisions at times after the initial time do not depend on d. At time 1, the upper and lower
node values are
x2 = 14 + 14d,
x1 = 7 + 7d,

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respectively. The the initial value is

x0 = max [14d(1 + d), 7(1 + d + d2 )].

For d < d∗ we choose x2 . For r = 33%, we have d = 0.75 and for r = 25%, we have d = 0.8, so the
solution is the same for both.

5.8

(a) Since we mine forever, we have KK = KK+1 so that K is constant. So K = (g − dK)2 /100 + dK
implies K = 220 every period. Thus, the initial value of the mine, V0 = 220x0 = $11, 000, 000.

(b) The amount of gold remaining in the mine in period n (denoted by xn ) equals xn−1 − zn−1
where zn equals the amount mined in period n. Solving we find that x10 = 2393. Thus, by part
(a), the value of the mine in period 10 is found to be 220x10 = $526, 460 (at that time).

(c) The optimal extraction rate in each period is

g − dK
= 20%,
1000
so after 10 years, 5369 ounces of gold remains with a value of $1, 181, 116 (at that time).

5.9

(a) Set up a trinomial lattice with arcs:

• “up” means no pumping

• “middle” means normal pumping

• “down” means enhanced pumping

The reserve values can be entered on each node. (At the final time the maximum reserve is 100, 000
and the minimum is 26, 214 barrels.)

(b) Work backward to find P V = $366, 740. The optimal strategy is: enhanced pumping for the
first two years, followed by normal pumping in the last year.

5.10

4
You are not responsible for this problem.

5.11

Using the hint we have

1 S(1 + g)
S = + ,
1+r 1+r
implying that
 
1+g 1
S 1− = ,
1+r 1+r
or
1
S = .
r−g

5.12

(a) This part follows easily from (b).

(b) Let R = 1 + r. Then

" 0  1  k #   
G G G g k+1  g k+2
NPV = D1 + + ··· + + D1 + + ... ,
R R R R R
G k g
k+1
"
#
1− R R
= D1 + .
1 −G
R
1 − Rg