Optimization

Master of Science in Engineering Management

School of Science & Engineering
Merrimack College

Gabie Mack – worked with Fadel and George Antypas

Problem Set 4

Case: Prudent Provisions for Pensions

Among its many financial products, the Prudent Financial Services Corporation (normally
referred to as PFS) manages a well-regarded pension fund that is used by a number of companies
to provide pensions for their employees. PFS’s management takes pride in the rigorous
professional standards used in operating the fund. Since the near-collapse of the financial
markets during the protracted Great Recession that began in late 2007, PFS has redoubled its
efforts to provide prudent management of the fund.

It is now December 2017. The total pension payments that will need to be made by the fund over

m
the next 10 years are shown in the following table.

er as
co
eH w
Year Pension Payments ($ millions)

o.
2018 8
rs e
ou urc
2019 12
2020 13
o

2021 14
aC s
vi y re

2022 16
2023 17
2024 20
ed d
ar stu

2025 21
2026 22
is

2027 24
Th

By using interest as well, PFS currently has enough liquid assets to meet all these pension
payments. Therefore, to safeguard the pension fund, PFS would like to make a number of
investments whose payouts would match the pension payments over the next 10 years. The only
sh

investments that PFS trusts for the pension fund are a money market fund and bonds. The money
market fund pays an annual interest rate of 2 percent. The characteristics of each unit of the four
bonds under consideration are shown in the table below.

1
This study source was downloaded by 100000827213746 from CourseHero.com on 07-13-2021 20:46:24 GMT -05:00

https://www.coursehero.com/file/57866228/GEN-5810-Module-4-Problem-Set-4docx/
 Optimization
Master of Science in Engineering Management
School of Science & Engineering
Merrimack College

Current Price Coupon Rate Maturity Date Face Value

Bond 1 $ 980 4% Jan. 1, 2019 $ 1,000

Bond 2 920 2 Jan. 1, 2021 1,000
Bond 3 750 0 Jan. 1, 2023 1,000
Bond 4 800 3 Jan. 1, 2026 1,000

All of these bonds will be available for purchase on January 1, 2018, in as many units as desired.
The coupon rate is the percentage of the face value that will be paid in interest on January 1 of

m
er as
each year, starting one year after purchase and continuing until (and including) the maturity date.
Thus, these interest payments on January 1 of each year are in time to be used toward the

co
eH w
pension payments for that year. Any excess interest payments will be deposited into the money
market fund. To be conservative in its financial planning, PFS assumes that all the pension

o.
payments for the year occur at the beginning of the year immediately after these interest
rs e
payments (including a year’s interest from the money market fund) are received. The entire face
ou urc
value of a bond also will be received on its maturity date. Since the current price of each bond is
less than its face value, the actual yield of the bond exceeds its coupon rate. Bond 3 is a zero-
coupon bond, so it pays no interest but instead pays a face value on the maturity date that greatly
o

exceeds the purchase price.

aC s
vi y re

PFS would like to make the smallest possible investment (including any deposit into the money
market fund) on January 1, 2018, to cover all its required pension payments through 2027. Some
spreadsheet modeling needs to be done to see how to do this.
ed d

a. Visualize where you want to finish. What are the decisions that need to be made? What
ar stu

should the objective be? What numbers are needed by PFS management?

Purchase how many units of each of the four bonds?

is

Invest how much?

What is the ending balance for each year after all payments?
Th

Decisions:
How many units of each bond to purchase
The investment in the first year
sh

Objective:
Minimize the initial investment in order to make payments through 2027

b. Suppose that PFS were to invest $30 million in the money market fund and purchase
10,000 units each of bond 1 and bond 2 on January 1, 2018. Calculate by hand the
payments received from bonds 1 and 2 on January 1 of 2019 and 2020. Also calculate the

2
This study source was downloaded by 100000827213746 from CourseHero.com on 07-13-2021 20:46:24 GMT -05:00

https://www.coursehero.com/file/57866228/GEN-5810-Module-4-Problem-Set-4docx/
 Optimization
Master of Science in Engineering Management
School of Science & Engineering
Merrimack College

resulting balance in the money market fund on January 1 of 2018, 2019, and 2020 after
receiving these payments, making the pension payments for the year, and depositing any
excess into the money market fund.

Payment from bond 1 in 2019: (10,000 units)(1000face value) + (10,000 units)(1000face

value)(0.04 coupon rate) = $10.4 million
Payment from bond 1 in 2020: $0

Payment from bond 2 in 2019: (10,000 units)(1000 face value)(.02 coupon rate)
=$200,000
Payment from bond 2 in 2020: (10,000 units)(1000 face value)(.02 coupon rate)
=$200,000

m
Balance in money market fund 2018 = $30million - $8million = $22 million

er as
Balance in money market fund 2019 = $22million + $10.4million +$.2million –

co
$12million +$.44million =$21.04million

eH w
Balance in money market fund 2020 = $21.04million + $.2million - $13million
+$.4208million =$8.66million

o.
rs e
ou urc
c. Make a rough sketch of a spreadsheet model, with blocks laid out for the data cells,
changing cells, output cells, and objective cell.
o
aC s
vi y re
ed d
ar stu
is

d. Build a spreadsheet model for years 2018 through 2020, and then thoroughly test the
Th

model.
See excel file

e. Expand the model to consider all years through 2027, and then solve it.
sh

See excel file

3
This study source was downloaded by 100000827213746 from CourseHero.com on 07-13-2021 20:46:24 GMT -05:00

https://www.coursehero.com/file/57866228/GEN-5810-Module-4-Problem-Set-4docx/
Powered by TCPDF (www.tcpdf.org)