London Business School

Advanced Corporate Finance

Brandon Julio, Spring 2012
Students: Zeynep Saka | Trang Ho | Raj Sambasivan | Javier Echave | Kausik Ash
Arundel Partners: The Sequel Project
The maximum per-film price for the sequel rights that Arundel Partners should
pay is $5.12M.
If Arundel Partners were to use the traditional DCF methods to find the value of
the sequel rights, the NPV would be -$8.42M loss per-film (see Appendix 1).
Calculation Details
We assume that Arundel Partners will purchase a portfolio of films similar to one
used in the analysis. The average hypothetical net inflow of the sequel ($21.57M)
is used to figure out the value of the state variable for the real options model.
The state variable is the average hypothetical net inflow of the sequel,
discounted using a WACC of 12.36% back to 1989. Discounting back to 1989 is
important because this is the time of the first films release. Within several weeks
of release, the films success is known. This starting point value is $13.53M.
This state variable is unaffected by managerial actions and describes the main
source of risk that affects the sequel rights exercise option under consideration.
Parameters
Avg. Hypothetical Net Inflow of Sequel
Avg Hypothetical Negative Cost of Sequel
WACC (based on 6% semiannual discount rate)
Avg. Hypothetical Net Inflow of Sequel (discounted to
Year 0)
T

Values
$21.57
$22.67
12.36%
$13.53
0.083
121%
1.418
1.418
0.705
7.03%
1.006
0.422
$19.79

exp(T)
U (continuously compounded returns in up step in
binomial
tree)in binomial tree)
D (down step
risk-free rate (based on 10yr US Treasury rate in 1992)
exp(rT)
q (risk-neutral probability of up move, using Lognormal
model)
Avg Hypothetical Negative Cost of Sequel (discounted
to Year
Table
of2)
the parameters and values used to build the binomial trees and find the

option price.
Building the Binomial Tree for Asset Values
The binomial model is used to see how the state variable evolves over time,
specifically over a time period of 12 months (see Exhibit 1). The maturity or
expiration date of the sequel rights option is set for 12 months. Within the first
year, Arundel Partners will know whether it will want to exercise the sequel
rights. We build the binomial tree for the net inflow values using the CoxIngersoll-Ross model. This approach approximates a lognormal distribution for
the asset values (net inflow values). We assume that continuously compounded
returns on the asset are normally distributed and volatility remains constant. We
use the expiration date as one year from the purchase of the sequel rights and
the time interval of 1/12 (1 month). We use the standard deviation on the one
year return of the portfolio as an estimate for volatility (=121%).
Risk-Neutral Probabilities in the Lognormal Model

London Business School

Advanced Corporate Finance
Brandon Julio, Spring 2012
Students: Zeynep Saka | Trang Ho | Raj Sambasivan | Javier Echave | Kausik Ash
Once we have the binomial tree, we replace the asset values with the payoff in
each state, then value the option using backward induction or dynamic
programming. To do the evaluation, we calculate the risk-neutral probabilities.
These are weights on the cash flow that allow us to discount by continuously
compounded risk-free rate. We use the 10-year US Treasury bond rate in 1991 as
the risk-free rate. The 10-year time period is chosen because the ancillary inflows
from non-US markets and post-theatre rentals (pay TV, network TV, DVD, etc)
can be significant for 10 years. We use the lognormal model to arrive at the riskneutral probability of an up move of 0.422. The payoff takes is calculated by
discounting the average hypothetical negative costs of the sequel to 1992 (year
2) by the risk-free rate (7.03%). The discounted average hypothetical negative
costs is $19.79M. We assign the payoffs and work backwards to value the real
option using risk-neutral probabilities and discounting by the risk-free rate. We
arrive at an option price of $5.12M per film (see Exhibit 2).
Further considerations for Real Options Valuation approach
Real options valuations recognise that the partners at Arundel obtain valuable
information after the sequel rights have been purchased and the first films are
released in the theatres. This additional information allows the partners to make
informed actions in response, based on dynamic decision making. This approach
allows for valuing real assets with some degree of operating flexibility,
incorporating the value of the flexibility into the option price. It values the option
to exercise but not the obligation to make future investments. It is based on the
law of one price (the price of two portfolios with the same cash flows in every
state of the world must be the same). Option value increases with great
uncertainty (see Exhibit 3). The major uncertainties are Arundel Partners WACC
and volatility of return on assets. A sensitive analysis shows the degree of
changes with the changing uncertainties. The major disadvantage of this
approach is that it often requires changes in business process. In Arundel
Partners case, the terms and provisions in the contract will mitigate some of the
disadvantages.
Additional terms and provisions for the sequel rights portfolio
The terms and provisions for the sequel rights for one or more studios entire
production:
The maturity or expiration rate of exercising the sequel rights is 1 year.
This will allow Arundel enough time to make a decision about making a
sequel and enable it to more quickly write off its investment in rights it
chose not to exercise.
Arundel Partners can chose to produce the sequel or hire another firm to
do so.
Arundel Partners will grant right of first refusal to the studio on any rights
it planned to sell. If the studio is not interested, Arundel Partners can sell
the rights to the highest bidder.
Arundel Partners will disburse the payments for the sequel rights over 12
months in the first year of production. This gives the studio the cash flow
to produce the first film but mitigates Arundel Partners risk in case there
are issues with the production of the first film. Arundel Partners can
withhold the remaining payment if the studio abandons the production of
the first film.

London Business School

Advanced Corporate Finance
Brandon Julio, Spring 2012
Students: Zeynep Saka | Trang Ho | Raj Sambasivan | Javier Echave | Kausik Ash

London Business School

Advanced Corporate Finance
Brandon Julio, Spring 2012
Students: Zeynep Saka | Trang Ho | Raj Sambasivan | Javier Echave | Kausik Ash
APPENDIX 1
Calculations using traditional DCF and static NPV
Traditional DCF Method (average hypothetical sequel revenues and costs)
198
199
9
0
1991
1992
1993
1994
Revenues
US Theatre
$ 10.4
Other
$
37.9
Costs
Dist Fees
$ (12.9)
Dist Exp
$ (14.5)
Negative Costs
$ (21.2)
Totals
$ (21.2)
$ (27.4)
$ 10.4
$
37.9
$
(8.42)

DCF

$ (16.8)

$ (19.3)

6.5

21.2

Binomial Tree for Net Inflow of Sequel (using lognormal distribution)

0
$
13.53

$
19.19
$
9.54

2
$
27.21
$
13.53
$
6.73

3
$
38.59
$
19.19
$
9.54
$
4.75

4
$
54.73
$
27.21
$
13.53
$
6.73
$
3.35

$
77.61
$
38.59
$
19.19
$
9.54
$
4.75
$
2.36

6
$
110.05
$
54.73
$
27.21
$
13.53
$
6.73
$
3.35
$

7
$
156.06
$
77.61
$
38.59
$
19.19
$
9.54
$
4.75
$

8
$
221.30
$
110.05
$
54.73
$
27.21
$
13.53
$
6.73
$

9
$
313.82
$
156.06
$
77.61
$
38.59
$
19.19
$
9.54
$

10
$
445.02
$
221.30
$
110.05
$
54.73
$
27.21
$
13.53
$

$
631.07
$
313.82
$
156.06
$
77.61
$
38.59
$
19.19
$

11

12
$
894.90
$
445.02
$
221.30
$
110.05
$
54.73
$
27.21
$

London Business School

Advanced Corporate Finance
Brandon Julio, Spring 2012
Students: Zeynep Saka | Trang Ho | Raj Sambasivan | Javier Echave | Kausik Ash
1.66

2.36
$
1.17

3.35
$
1.66
$
0.83

4.75
$
2.36
$
1.17
$
0.58

6.73
$
3.35
$
1.66
$
0.83
$
0.41

9.54
$
4.75
$
2.36
$
1.17
$
0.58
$
0.29

13.53
$
6.73
$
3.35
$
1.66
$
0.83
$
0.41
$
0.20

Exhibit 1. Binomial tree based on average hypothetical net inflows of sequel

Binomial Tree for Per-Film Option Price (using Risk-Neutral Probabilities)

0
$
5.12

1
$
8.73
$
2.54

2
$
14.56
$
4.56
$
1.09

3
$
23.79
$
7.97
$
2.12
$
0.35

4
$
38.06
$
13.63
$
3.92
$
0.83

5
$
59.54
$
22.77
$
7.10
$
1.64
$
0.24

6
$
91.17
$
37.08
$
12.57
$
3.19
$
0.52
$
0.04

7
$
136.84
$
58.78
$
21.63
$
6.08
$
1.11
$
0.10

8
$
201.97
$
90.72
$
36.08
$
11.30
$
2.34
$
0.23

9
$
294.38
$
136.61
$
58.16
$
20.34
$
4.83
$
0.55

10
$
425.46
$
201.74
$
90.49
$
35.17
$
9.72
$
1.31

11
$
611.40
$
294.15
$
136.38
$
57.93
$
18.92
$
3.11

12
$
875.11
$
425.23
$
201.51
$
90.26
$
34.94
$
7.42

London Business School

Advanced Corporate Finance
Brandon Julio, Spring 2012
Students: Zeynep Saka | Trang Ho | Raj Sambasivan | Javier Echave | Kausik Ash
$
-

Exhibit 2. Binomial tree for per-film option price using risk-neutral probabilities

Sensitivity
81
%
0.8
6.36%
6
1.0
7.36%
0
1.1
8.36%
3
1.2
9.36%
7
1.4
10.36%
0
1.5
11.36%
4
1.6
12.36%
7
1.8
13.36%
1
1.9
14.36%
4
2.0
15.36%
8
2.2
16.36%
1
2.3
17.36%
5
2.4
18.36%
8

Analysis on uncertainties of WACC and (volatility)

91
101
111
121
%
%
%
% 131% 141% 151%
161%
0.8
6
0.86
0.86
0.86
0.86
0.86
0.86
0.86
1.0
0
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.1
3
1.13
1.13
1.13
1.13
1.13
1.13
1.13
1.2
7
1.27
1.27
1.27
1.27
1.27
1.27
1.27
1.4
0
1.40
1.40
1.40
1.40
1.40
1.40
1.40
1.5
4
1.54
1.54
1.54
1.54
1.54
1.54
1.54
1.6
7
1.67
1.67
1.67
1.67
1.67
1.67
1.67
1.8
1
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.9
4
1.94
1.94
1.94
1.94
1.94
1.94
1.94
2.0
8
2.08
2.08
2.08
2.08
2.08
2.08
2.08
2.2
1
2.21
2.21
2.21
2.21
2.21
2.21
2.21
2.3
5
2.35
2.35
2.35
2.35
2.35
2.35
2.35
2.4
8
2.48
2.48
2.48
2.48
2.48
2.48
2.48

Exhibit 3. Sensitivity analysis on uncertainty factors: WACC and (volatility)