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Think you could still ace your way through Wharton? Well, here’s your chance to prove it.

In each issue of Wharton Magazine, we’ll test your knowledge with a question taken straight from an actual Wharton course exam. Submit the correct answer and you might just walk off with a great prize—not to mention the admiration of your fellow alumni.

Our first Final Exam challenge comes from Professor Jagmohan S. Raju, the Joseph J. Aresty Professor of Marketing and Chair of Wharton’s Marketing Department, who sent along this question from his Fall 2008 Marketing 621 final exam. Good luck!

The Basics

Multi-Lever, a leading transnational engaged in Leveraged Buyout activities, is considering diversifying by offering satellite TV service in Bricistan, an emerging market. The service is likely to be priced at $90/year per subscriber, and the variable cost of providing the service to a subscriber is $10/year. While other competitors typically rely on TV advertising to generate new users, Multi-Lever has been advised that offering a free one-year trial may be a more fruitful method for generating new subscribers. Therefore Multi-Lever plans to restrict its customer acquisition effort to offering free trials only.

Preliminary studies suggest that a typical paying customer has an 80 percent chance of renewing their service from one year to the next. However, emerging markets are quite unpredictable; once a customer is acquired, predicting their behavior beyond five years is very difficult.

Offering free service involves costs above and beyond the cost of providing the service. These include account setup, equipment and installation. These costs add up to $40 per user. The company is considering allocating a budget of $1 million for these activities.

The Question:

What fraction of consumers who are offered free service need to convert to regular users for this campaign to be successful?

Please explicitly state the assumptions used to arrive at your answer.

The Answer

Assumptions:

a. The five-year planning window includes the free year.

b. Discount rate = 0.

c. The customers acquired by the campaign are totally insensitive to advertising, so all acquisitions are 100% incremental.

d. The company will pull the free service offer as soon as its $1 million budget is depleted.

 

Analysis:

Cost of acquisition = Cost of Installation + Cost of service in 1^st year = $40 + $10 = $50.

Gross margin = $80/year.

Expected margins in subsequent 4 years = f $80 (1 + .8 + .64 + .512) = f $236

 

Conclusion: For the campaign to break even, the fraction of free triers that converts (f ) must be larger than $50/$236 = 21.2%.

Submit your response.

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