EF5052 Investments Case 3: Arundel partners, The Sequel Project

EF5052 INVESTMENTS
CASE 3

Arundel Partners: The Sequel

Project

GROUP 8 :

Ngai Chiu Wing Edward / 51042814

Ng Cheuk Yiu Hugo / 50649257
Lau Chau Nan, Evelyn / 9700 4330
Kuo, Constantino / 5106 4265
Pang Hhong Yu, Francesca / 50191000
Ng Ka to, Irin / 9747 5858
Suen Hung Kit, Philip / 5114 4321
Kuok, Kenneth / 5101 2428

Page 1 of 7
 EF5052 Investments Case 3: Arundel partners, The Sequel Project

Why do the principals of Arundel Partners think they can make money buying
movie sequel rights? Why do they want to buy a portfolio of rights in advance
rather than negotiating film by film to buy the rights?

Making money in the movie industry is an unpredictable task. Weather a film

will be accepted by the general public depends on many factors which are difficult to
quantify. Is the story appealing? Will you find good actors in the casting? Will they
understand each other well with director? Will marketing catch the public’s attention?
These are just some of the questions which are uncertain up till advance stages of the
film production. So basically, the earnings of a studio or a company in the movie
industry will largely depend on its ability to choose good scripts and find the right
crew to harmonize the project. The returns in one year can vary widely from films
giving a 1224% profit to -91% losses.
Obviously, the movie business is a very unstable one and what the Arundel partners
were looking for was to stabilize or at least look for stable characteristics of this
industry, which could be measured with more accuracy, and use it to obtain some
profits. If they couldn’t have any hint of a film would be a hit or not, at least they
could find some predictions on how the sequels of movies would do. The fact that
almost all the sequels follow a successful film gave the Arundel partners a good point
to start with. They could use information from the first films to make results estimates
and calculate if the project was worthy or not. They proposed an innovative idea in
which they would buy the rights of making these sequels long time before and even
before the first films were started. They though this idea would be greatly accepted as
it would pour cash in the project when it was needed the most at early stages of the
movie. However, in order to eliminate the very subjective facts explained earlier, and
since the studios would eventually know more about the movie expectations than the
Partners, they had to negotiate the terms in a fair and neutral condition. That is why
they wanted to avoid negotiating a price per film; instead they would offer a single
price for the whole sequel rights of a studio during an established period of time. If
the first movie was a success they would exercise their right and make the sequel or
sell it to the highest bidder. Otherwise they would just write it off their investment
schedule. The chances of making a profitable business would largely depend on a
good estimate of the rights present value at the contract date. To less would not tempt
the studios (inquiries indicated not less than USD 2 million per movie) and too much
would not make the business profitable.

Page 2 of 7
 EF5052 Investments Case 3: Arundel partners, The Sequel Project

Estimate the per-film value of a portfolio of sequel rights such as Arundel

proposes to buy. You will try two different methods to solve this problem: some
appropriate DCF approach, and the Black-Scholes approach. You may find it
helpful to consult the Appendix, which explains how these figures were prepared.
(Suppose the appropriate discount rate for risky cash flows is 12%. Risk-free
rate, for discounting safer cash flows, is at 6%.)

The central stone of Arundel partners’ project is to establish a correct price for
the whole rights portfolio. To do this two methods are presented: a) calculating the
hypothetical sequel performances and obtaining a total value of investment using an
appropriate rate for discounting to present time b) using a simple Black-Scholes
options pricing model to calculate the price of the rights call.
The data which we will use to compute our calculations was provided by David Davis
and the Paul Kagan Associates which are presented in exhibits 6 to 9.

Calculating the NPV of all the profitable sequels of a studio.

The data used assumes that the sequel’s estimated negative cost and US theater rentals
are 120% and 70% respectively, of the corresponding items for the first film. On
exhibit 7 we find the present value at year 4 and the PV of the negative cost at year 3
from the hypothetical sequels. Since the right of a film give us the opportunity to
decide weather investing into the sequel is profitable, the decision is made on Year 3.
If at that time the first film had no big success, the sequel would be immediately
discarded, thus no investment would be made and the chances of loss would be null.
The following drawing presents the option on the sequel of a film:

Make the NPV>0

YES sequel
Movie a
Success ?
YES
NO Make the NPV<0
sequel
Buy right to
movie
sequel?

NO

YEAR 0 YEAR 3 YEAR 4

Since the positive branch of the tree would be the only path really followed, we will
only take into account those films which have a positive NPV. From the hypothetical
sequel data we discount the net inflows at year 4 and negative costs at year 3 to the

Page 3 of 7
 EF5052 Investments Case 3: Arundel partners, The Sequel Project

present time at year 0. The table below shows the 26 sequel films that have a positive
NPV.
The total sum of the 26 sequels account for 490.1 M$ which divided by all the 99
portfolio sequels gives us a price of 4.95M$ per film.
Arunde l Partne rs
Exhibit 7 (a mounts in millions of nomina l dolla rs )

As s umptio ns
S e mia nnua l infla tion ra te 1.50%
S e mia nnua l dis count ra te 6%

Hypothe tica l Se que l at 12% dis rate

Ne t Inflows Ne ga tive Cos t One -ye a r NP V NP V
Film S tudio P V Yr 4 P V Yr 3 Re turn Yr 3 Yr 0
1 P a re nthood MCA Unive rs a l $ 76.80 $ 28.25 1.72 $ 40.10 28.6970345
2 Born on the Fourth of J ulyMCA Unive rs a l $ 56.80 $ 25.43 1.23 $ 25.12 17.9977483
3 Fie ld of Dre a ms MCA Unive rs a l $ 47.30 $ 22.60 1.09 $ 19.49 13.971402
4 Uncle Buck MCA Unive rs a l $ 47.00 $ 21.19 1.22 $ 20.64 14.7862842
5 S e a of Love MCA Unive rs a l $ 44.40 $ 35.32 0.26 $ 4.20 3.07856025
7 K-9 MCA Unive rs a l $ 29.30 $ 16.95 0.73 $ 9.12 6.55422733
8 The Burbs MCA Unive rs a l $ 27.30 $ 24.02 0.14 $ 0.28 0.25550269
10 Do the Right Thing MCA Unive rs a l $ 21.20 $ 9.89 1.14 $ 8.98 6.43421938
12 S hocke r MCA Unive rs a l $ 12.40 $ 8.48 0.46 $ 2.56 1.84719799
15 Ha rle m Nights P a ra mount $ 51.10 $ 42.38 0.21 $ 3.10 2.30884289
16 P e t S e ma ta ry P a ra mount $ 41.10 $ 15.54 1.64 $ 21.04 15.0588784
18 Ma jor Le a gue P a ra mount $ 33.70 $ 16.95 0.99 $ 13.04 9.35050687
25 Look Who's Ta lking S ony $ 105.50 $ 14.13 6.47 $ 79.77 56.9917803
26 Whe n Ha rry Me t S a lly S ony $ 64.40 $ 26.84 1.40 $ 30.47 21.822148
27 S te e l Ma gnolia s S ony $ 61.70 $ 31.08 0.99 $ 23.83 17.0896361
28 S e e No Evil; He a r No Evil S ony $ 32.00 $ 25.43 0.26 $ 3.05 2.23689996
59 The Wa r of the Ros e s 20th Ce ntury Fox $ 63.80 $ 35.32 0.81 $ 21.46 15.407611
61 We e ke nd a t Be rnie 's 22nd Ce ntury Fox $ 22.30 $ 14.13 0.58 $ 5.72 4.11667618
70 Ba tma n Wa rne r Bros $ 229.10 $ 70.51 2.25 $ 133.39 95.4117194
71 Driving Mis s Da is y Wa rne r Bros $ 77.60 $ 11.30 5.87 $ 57.76 41.2719013
77 Young Eins te in Wa rne r Bros $ 10.20 $ 5.65 0.81 $ 3.43 2.46013361
89 Hone y, I S hrunk the Kids Wa lt Dis ne y $ 111.20 $ 31.08 2.58 $ 67.89 48.547781
90 De a d P oe ts S ocie ty Wa lt Dis ne y $ 74.40 $ 28.25 1.63 $ 37.96 27.1717911
91 The Little Me rma id Wa lt Dis ne y $ 62.00 $ 28.25 1.19 $ 26.93 19.2913669
92 Turne r & Hooch Wa lt Dis ne y $ 54.60 $ 25.43 1.15 $ 23.17 16.5996085
93 Thre e Fugitive s Wa lt Dis ne y $ 29.10 $ 24.02 0.21 $ 1.88 1.39943523

Ave ra ge $ 57.17 $ 24.55 1.42 $ 26.32

Firs t Qua rtile $ 29.98 $ 15.89 0.62 $ 4.58
Me dia n $ 49.20 $ 24.72 1.12 $ 20.84
Third Qua rtile $ 64.25 $ 28.25 1.57 $ 29.59
S ta nda rd De via tion $ 43.40 $ 13.01 1.53 $ 30.11
Inte rqua rtile ra nge $ 34.28 $ 12.36 0.96 $ 25.01

only profitable firm s are counte d. If the firs t film is not a s ucce s the proje ct will be abandone d NPV (26 pro fitable ) 490.158893
S ince the re is no inve s tme nt, the n no los s is m ade NPV (73 no n pro fitable ) 0
TOTAL NPV 490.158893
TOTAL # films 99
Value pe r film 4.95109993

Page 4 of 7
 EF5052 Investments Case 3: Arundel partners, The Sequel Project

Calculating the value of a right with the B-S-M model.

This approach consists of using the B-S option pricing formula to model the portfolio
right of the sequels. The variables of the BS model for a set of stochastic variables are
So, K, r, T, and sigma. And we apply it on the portfolio in the following way:

Var Description Value

So the PV of the portfolio value 13.71
K the average negative cost of the set of films 22.6
r the risk free rate at 6% 6%
T the time in which the decision of making the sequel is made (Y 3) 3
Sigma the standard deviation of the sequels return 1.21

Using the data on Exihibit 7, we can obtain the mean values of the Portfolio value at
Y4 which we will discount to Y0 using a rate of return of 12% for risky businesses.
The strike price K will be the mean value of the negative cost of films. The time T for
the maturity of the right will be set on Y3, time in which the production of the sequel
must be decided. Finally sigma, will be the standard deviation of the one-year returns
of all the films of the portfolio. The results are summarized in the above table.
If we were to use the Call option table the inputs for moneyness and Cumulative
volatility would be:
 Moneyness: 0.72483
 Cumulative Volatility: sigma*sqrt(T) = 1.21
The nearest value on the table would be 35.5% to equate C/S, but we will use a Call
option calculator to obtain the exact value.

The call price using the BS model calculator is 5.06M$ per film. This price is the fair
price considering the hypothetical revenues of the sequels. Purchasing any right at a
lower value would be profitable and vice versa.

Summary of both methods for the calculation of the rights price.

Method Price
NPV discounting 4.95 M$
BS Model 5.06 M$

As you can see on the table above, the estimated call price for the sequels’ rights is
quite similar. This confirms that the theory behind estimating options pricing is
correct, but weather it is truly reliable in the real case, will only depend on the
adequacy of the assumptions.

Page 5 of 7
 EF5052 Investments Case 3: Arundel partners, The Sequel Project

What are the primary advantages and disadvantages of the approach you took to
valuing the rights? What further assistance or data would you require to refine
your estimate of the sequel rights' value?

Our analysis of the proposal includes a net present value (NPV) calculation of
each movie production company. It is felt that waiting to purchase sequel rights until
after the movie goes into production will make it more difficult and costly to purchase
the rights. Below are advantages and disadvantages of the approach we took to
valuing the rights.

Advantages:

 Simplicity
 Because all available data was used, there is a greater sample in our analysis. We
assume that more data points will lead to a more accurate conclusion.
 We did not eliminate any outliers because we felt outliers are characteristic of the
industry.
 The analysis is based upon historical data rather than fabricated assumptions.
 We believe that breaking out the data by studio is an advantage because it
provides direction.

Disadvantages:

 It is assumed that historical performance is indicative of future performance in

the short term based on historical data. Our assumption is supported by Exhibit 1
which shows that all production companies tend to have similar performance
over time.
 Only 1 year of historical data is available
 We assume that production companies are willing to sell the sequel rights under
our terms.
 Probabilities of success have been calculated, but we have not been able to apply
them to the per film value. In short, it is necessary to be subjective about the risk
based on the probabilities of success.

Further Assistance or Data

 More historical data would be useful to support our assumptions

 More data on success probabilities may help to direct the course of action
 We would also like to have information about the willingness of production
companies to sell sequel rights at a pre-negotiated price

Page 6 of 7
 EF5052 Investments Case 3: Arundel partners, The Sequel Project

What problems or disagreements would you expect Arundel and a major studio
to encounter in the course of a relationship like that described in the case? What
contractual terms and provisions should Arundel insist on?

The studio’s future behavior can change because of the existence of the contract with
Arundel Partners (AP). It might make different movies. The studio wants to withhold
movies from AP if they know they will be big hits, it was virtually impossible to write
contracts with the studios that could avoid this opportunistic behavior.

Because of the conflicts of interest, AP probably needed some type of contractual

protection. There are many details of a potential contract between Arundel and studio
still needs to be worked out. First of all, a satisfactory method of the price of the
rights payment had to be agreed. One of possible ways should be Arundel to make
payments to an escrow account when a first film went into production.

Secondly, Certain films might have to be excluded from the arrangement if the studio
itself did not already own their sequel rights.

Thirdly, in order to keep the studio committed to the success of possible sequels, it
probably would be desirable to have studio retain an interest in the revenues or the net
profits of the sequels, or to have rights for subsequent sequel, i.e., third, fourth and to
her future films, revert to the studio.

Moreover, it is good for Arundel to fix an expiration date for the sequel rights,
perhaps three years from the first film’s release, by which time Arundel would have to
declare its intentions or forfeit the rights. This arrangement may help Arundel to have
enough time to decide whether they will make a sequel. And enable it to more quickly
write off its investment in rights it chose not to exercise.

Furthermore, Arundel could grand it a right of first refusal on any rights it planned to
sell.
At last, the contract could provide that Arundel would use the original studio for
distribution, assuming its distribution fees and expenses were competitive.

Page 7 of 7