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Rudimentary Quantitative Analytics in Building A Financial Decision Support System

This document describes a simulation model to analyze the long-term value of customers for a credit card company. The simulation calculates the net present value (NPV) of profits from a customer over many years by modeling the customer's retention rate and annual profits as random variables. The results show that higher retention rates lead to significantly higher average NPVs per customer and longer average customer lifetimes. Offering incentives to customers to stay for a minimum of 3 years, such as a $50 gift certificate, increases the average NPV further and guarantees the customer stays for at least 3 years.

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College08
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27 views

Rudimentary Quantitative Analytics in Building A Financial Decision Support System

This document describes a simulation model to analyze the long-term value of customers for a credit card company. The simulation calculates the net present value (NPV) of profits from a customer over many years by modeling the customer's retention rate and annual profits as random variables. The results show that higher retention rates lead to significantly higher average NPVs per customer and longer average customer lifetimes. Offering incentives to customers to stay for a minimum of 3 years, such as a $50 gift certificate, increases the average NPV further and guarantees the customer stays for at least 3 years.

Uploaded by

College08
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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MGT 356 Simulation

Example 11.11 Long-term Value of a Customer


(CustomerLoyalty)

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Example 11.11
The Long-Term Value of a Customer

 Objective: To use simulation to find the NPV of a customer


and to see how this varies with the retention rate.
 CCAmerica is a credit card company that does its best to
gain customers and keep their business in a highly
competitive industry.
 After the first year, the profit from a customer is typically
positive and continues to increase.
 For nth year a customer is with the company, the profit
from that customer is normally distributed with:
mean = shown in the Excel file, Customer Loyalty.xlsx
standard deviation = 10% of the |mean|

2
Example 11.11 Background (cont)
 At the end of the year,
Prob(customer leaves the company) = 0.25 (= churn rate)
Prob(customer stays) = 0.75 (= retention rate)
 Goal: Estimate NPV of the net profit from a customer who
just signed up.
 Assumption:
 Discount rate = 15%
 Cash flow occurs in the middle of the year.
 Also, sensitivity analysis of NPV with varying retention rate.
 Solution: Keep simulating profits for the customer until the
customer churns. We simulate 30 years worth of potential
profits.
CustomerLoyalty
 Inputs:
 Parameters – retention rate (varied), discount rate, mean profit each
year, standard deviation each year
 Random variable
 Customer life time (# of years customer stays)
For each year, P(customer stays) = retention rate
 Profit each year
 Assumed to have a normal distribution with mean = given in the table,
standard deviation = 10% abs(mean)
 @RISK formula: =RiskNormal(mean,stdev)
 Excel formula: =NORM.INV(rand(),mean,stdev)

 Output:
 NPV (Net Present Value) of a customer
 Length of customer lifetime
4
Timing of Churn

 Stay at end of year?


 Yes if stay
 No if quit
 First Year
If RN < 0.75, then customer stays
=IF(RAND()< 0.75, “Yes”, “No”)
 Subsequent Years
If customer quit before this year, enter “No”

 Else, if RN < 0.75, then customer stays this year

=IF(Stay?(t-1)=“No”, “No”, IF(RAND()<0.75, ”Yes”, “No”))

5
Actual and Discounted Profits

 Actual Profit
 If customer is around, generate profit from a normal distribution
=IF(Stay?(t-1) = “No”, 0, RISKNORMAL(Mean, StDev))
 Discounted Profit
 Actual profit / (1+discount rate)^(year-0.5)
(Cash flow occurring middle of year – more realistic than end of
year)
 Try varying the retention rate:
Use =RiskSimTable with values: 0.75, 0.80, …, 0.95

6
NPV Calculation
 Since the cash flows occur in the future, we need to discount
them (compute their present values).
 Recall
CFt
Present Value of a Cash Flow =
(1  r )t
where
CFt  cash flow t years from now
r  discount rate

7
NPV Calculation: Example
 Suppose cash flows are:
-40 at end of year 1 40 66 72
NPV   
66 at end of year 2
1 2
(1.15) (1.15) (1.15)3
72 at end of year 3.  34.78  49.91  47.34
 62.46
 If they occur in the
middle of the resp years:
40 66 72
NPV  0.5
 1.5

(1.15) (1.15) (1.15) 2.5
 37.30  53.52  50.77
 66.99
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Outputs & Simulation

 NPV
Sum the discounted values (E11:E40)
 Lifetime Length (Years loyal)
=1 + number of years customer stays at end of year
= 1 + COUNTIF(E11:E40,”Yes”)
 Designate both of the above as @RISK output cells.
 Set the number of iterations to 1000 and the number of
simulations to 5 and run @RISK.
 Because Excel’s RAND() function used, the results will vary.

9
Histogram of NPV with 85% Retention Rate

10
Summary of Output

Name Sim# Min Mean Max % Increase


NPV 1 ($46.26) $102.66 $559.65
NPV 2 ($46.73) $131.23 $553.81 28%
NPV 3 ($45.53) $182.56 $579.32 39%
NPV 4 ($52.40) $259.09 $589.79 42%
NPV 5 ($46.73) $366.69 $598.49 42%
Years loyal 1 1 4 25
Years loyal 2 1 5 31 20%
Years loyal 3 1 7 31 36%
Years loyal 4 1 10 31 49%
Years loyal 5 1 16 31 62%
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Value of Customer vs Retention Rate

12
Incentive to Stay

 How about offering an incentive for the customer to stay?


 Suppose CCAmerica is considering offering a $50 gift
certificate for a customer willing to sign a 3-year contract,
i.e., the customer will stay with the company for at least 3
years. Is this a good idea?
 Do not allow customer to switch at the end of 1st year and
2nd year. Run simulation.

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Summary of Output with 3-year Contract
Name Sim# Min Mean Max
NPV 1 $43.91 $180.89 $551.64
NPV 2 $47.98 $212.01 $586.23
NPV 3 $43.91 $251.80 $565.87
NPV 4 $47.98 $312.09 $589.88
NPV 5 $47.98 $404.99 $597.09
Years loyal 1 3 6 31
Years loyal 2 3 7 31
Years loyal 3 3 8 31
Years loyal 4 3 12 31
Years loyal 5 3 17 31
14

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