Financial Applications

In finance, linear programming can be applied in problem situations involving capital budgeting, asset
allocation, portfolio selection, financial planning, and many others. In this

section, we describe a portfolio selection problem and a problem involving funding of an

early retirement program.

Portfolio Selection

Portfolio selection problems involve situations in which a financial manager must select

specific investments—for example, stocks and bonds—from a variety of investment

alternatives. Managers of mutual funds, credit unions, insurance companies, and banks

frequently encounter this type of problem. The objective function for portfolio selection problems
usually is maximization of expected return or minimization of risk. The

constraints usually take the form of restrictions on the type of permissible investments,

state laws, company policy, maximum permissible risk, and so on. Problems of this

type have been formulated and solved using a variety of mathematical programming

techniques. In this section we formulate and solve a portfolio selection problem as a

linear program.

Consider the case of Welte Mutual Funds, Inc., located in New York City. Welte just

obtained $100,000 by converting industrial bonds to cash and is now looking for other

investment opportunities for these funds. Based on Welte’s current investments, the firm’s

top financial analyst recommends that all new investments be made in the oil industry,

steel industry, or in government bonds. Specifically, the analyst identified five investment

opportunities and projected their annual rates of return. The investments and rates of return

are shown in Table 4.3.

Management of Welte imposed the following investment guidelines.

1. Neither industry (oil or steel) should receive more than $50,000.

2. Government bonds should be at least 25% of the steel industry investments.

3. The investment in Pacific Oil, the high-return but high-risk investment, cannot be

more than 60% of the total oil industry investment.

What portfolio recommendations—investments and amounts—should be made for the

available $100,000? Given the objective of maximizing projected return subject to the budgetary and
managerially imposed constraints, we can answer this question by formulating

and solving a linear programming model of the problem. The solution will provide investment
recommendations for the management of Welte Mutual Funds.

Projected Rate of Return

Investment (%)

Atlantic Oil 7.3

Pacific Oil 10.3

Midwest Steel 6.4

Huber Steel 7.5

Government bonds 4.5

TABLE 4.3 INVESTMENT OPPORTUNITIES FOR WELTE MUTUAL FUNDS

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in
whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook
and/or eChapter(s).

Editorial review has deemed that any suppressed content does not materially affect the overall learning
experience. Cengage Learning reserves the right to remove additional content at any time if subsequent
rights restrictions require it.

4.2 Financial Applications 163

Let

A5

P5

M5

H5

G5

dollars invested in Atlantic Oil

dollars invested in Pacific Oil

dollars invested in Midwest Steel

dollars invested in Huber Steel

dollars invested in government bonds

Using the projected rates of return shown in Table 4.3, we write the objective function for
maximizing the total return for the portfolio as

Max 0.073A 1 0.103P 1 0.064M 1 0.075H 1 0.045G

The constraint specifying investment of the available $100,000 is

A 1 P 1 M 1 H 1 G 5 100,000

The requirements that neither the oil nor the steel industry should receive more than

$50,000 are

A1

M1

P # 50,000

H # 50,000

The requirement that government bonds be at least 25% of the steel industry investment is

expressed as

G $ 0.25sM 1 Hd

Finally, the constraint that Pacific Oil cannot be more than 60% of the total oil industry

investment is

P # 0.60sA 1 Pd

By adding the nonnegativity restrictions, we obtain the complete linear programming

model for the Welte Mutual Funds investment problem:

Max 0.073A 1 0.103P 1 0.064M 1 0.075H 1 0.045G

s.t.

A 1 P 1 M 1 H 1 G 5 100,000 Available funds

A 1 P # 50,000 Oil industry

maximum

M 1 H # 50,000 Steel industry

maximum

G $ 0.25 sM 1 Hd Government

bonds minimum

P # 0.60 sA 1 Pd Pacific Oil

restriction A, P, M, H, G $ 0
The optimal solution to this linear program is shown in Figure 4.3. Table 4.4 shows

how the funds are divided among the securities. Note that the optimal solution indicates

that the portfolio should be diversified among all the investment opportunities except

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in
whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook
and/or eChapter(s).

Editorial review has deemed that any suppressed content does not materially affect the overall learning
experience. Cengage Learning reserves the right to remove additional content at any time if subsequent
rights restrictions require it.

164 Chapter 4 Linear Programming Applications in Marketing, Finance, and Operations Management

Midwest Steel. The projected annual return for this portfolio is $8000, which is an overall

return of 8%.

The optimal solution shows the dual value for constraint 3 is zero. The reason is that

the steel industry maximum isn’t a binding constraint; increases in the steel industry limit

of $50,000 will not improve the value of the optimal solution. Indeed, the slack variable

for this constraint shows that the current steel industry investment is $10,000 below its

limit of $50,000. The dual values for the other constraints are nonzero, indicating that these

constraints are binding.

The dual value of 0.069 for constraint 1 shows that the value of the optimal solution can

be increased by 0.069 if one more dollar can be made available for the portfolio investment.

If more funds can be obtained at a cost of less than 6.9%, management should consider

obtaining them. However, if a return in excess of 6.9% can be obtained by investing funds

elsewhere (other than in these five securities), management should question the wisdom of

investing the entire $100,000 in this portfolio.

Similar interpretations can be given to the other dual values. Note that the dual value

for constraint 4 is negative at –0.024. This result indicates that increasing the value on the